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1. The Functions of the Stock Market and the Fallacies of Shareholder Value

Author:
William Lazonick
Publication Date:
06-2017
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
Conventional wisdom has it that the primary function of the stock market is to raise cash for companies for the purpose of investing in productive capabilities. The conventional wisdom is wrong. Academic research on sources of corporate finance shows that, compared with other sources of funds, stock markets in advanced countries have been insignificant suppliers of capital for corporations. The purpose of this essay is to build a rigorous and relevant conception of the evolving role of the stock market in the U.S. corporate economy. In fact, the functions of the stock market go well beyond “cash” to include four other functions, which can be summarized as “control,” “creation,” “combination,” and “compensation.” In this paper, I argue, based on historical evidence, that in the growth of the U.S. economy the key function of the stock market was control. Specifically, the stock market enabled the separation of managerial control over the allocation of corporate resources from the ownership of the company’s shares. Yet, assuming that the key function of the stock market is cash, economists known as agency theorists see this separation of control from ownership as the “original sin” of American capitalism, and argue that the evils of managerial control can be overcome by compelling corporate managers as “agents” to maximize the value of corporate shareholders as “principals.” What is missing from the agency-theory argument is a theory of the value-creating firm, or what I call a “theory of innovative enterprise.” The value-creation process requires three social conditions of innovative enterprise: strategic control, organizational integration, and financial commitment. The functions of the stock market may support the types of strategic control, organizational integration, and financial commitment that can result in the generation of high-quality products at low unit costs—the economic definition of innovative enterprise. It is possible, however, that the functions of the stock market may undermine the types of strategic control, organizational integration, and financial commitment that the innovation process requires. In this paper, I provide a brief overview of the role of the control function of the stock market in supporting innovative enterprise in the historical rise to dominance of U.S. managerial capitalism from the early decades of the twentieth century. Then I elaborate the five functions of the stock market—control, cash, creation, combination, and compensation—in terms of the ways in which, from the perspective of the theory of innovative enterprise, each function can support value creation or, alternatively, empower value extraction. I then turn to a discussion of the evolving roles of the five functions of the stock market in major U.S. business corporations over the past century. The concluding section draws on the history of the actual functions of U.S. stock markets to critique the dominant ideology that, for the sake of superior economic performance, a company should be run to “maximize shareholder value” (MSV). I indicate how MSV undermines the social conditions of innovative enterprise: strategic control, organizational integration, and financial commitment.
Topic:
Economics, Economic Growth, Stock Markets, and Shareholder Democracy
Political Geography:
Global Focus

2. The Value-Extracting CEO: How Executive Stock-Based Pay Undermines Investment in Productive Capabilities

Author:
William Lazonick
Publication Date:
12-2016
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
The business corporation is the central economic institution in a modern economy. A company’s senior executives, with the advice and support of the board of directors, are responsible for the allocation of corporate resources to investments in productive capabilities. Senior executives also advise the board on the extent to which, given the need to invest in productive capabilities, the company can afford to make cash distributions to shareholders. Motivating corporate resource- allocation decisions are the modes of remuneration that incentivize and reward the top executives of these companies. A sound analysis of the operation and performance of a modern economy requires an understanding of not only how much these executives are paid but also the ways in which the prevailing system of executive pay influences their decisions to allocate corporate resources. In the United States since the last half of the 1980s the overriding goal of U.S. corporations has been to “maximize shareholder value,” with corporate performance measured by a company’s “total shareholder return”: percentage stock-price appreciation plus dividend yield. Also since the 1980s, the most important components of the total compensation of senior executives have been modes of stock-based pay in the forms of stock options and stock awards. This stock-based pay is structured to incentivize executives to make corporate allocation decisions that will boost the stock prices of the companies that employ them and reward them for achieving that objective. There are three drivers of stock prices: innovation, speculation, and manipulation. The first critical question that this paper addresses is which of these drivers, individually or in combination, contribute to a company’s stock-price performance. Then we can ask the second critical question: Does executive compensation reflect the success of the company in value creation, or the power of senior executives to engage in value extraction? The “value- extracting CEO” hypothesis posits that, in the United States, a significant portion of senior executive compensation rewards them for making decisions that foment speculation and manipulate stock prices, and thereby extract value for their own personal gain. In section four of the paper, I invoke the theory of innovative enterprise to support this hypothesis and debunk the dominant ideology that companies should be run to “maximize shareholder value.” Finally, I elaborate the policy implications for controlling the power of the value-extracting CEO, including a) banning stock buybacks, b) requiring executive compensation that rewards innovation rather than speculation and manipulation, and c) placing stakeholders representing households as taxpayers, workers, and consumers on boards of directors of publicly listed companies, along with shareholders who represent households as savers. An intellectual precondition for these reforms is the rejection of the ideology that companies should be run to maximize shareholder value, which means replacing agency theory with innovation theory as a mode of analyzing how the operation of an economy, supported by the strategies and structures of the business enterprises within it, can attain the objectives of stable and equitable economic growth.
Topic:
Leadership, Investment, Corporations, Redistribution, Stock Markets, and Wage Growth
Political Geography:
North America and United States of America

3. The Mismeasure of Mammon: Uses and Abuses of Executive Pay Data

Author:
Matt Hopkins and William Lazonick
Publication Date:
10-2016
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
On April 7, 2016, the Wall Street Journal ran an article headlined “CEO pay shrank most since financial crisis,” while on May 27, 2016, a similar New York Times story declared “Top CEO pay fell – yes, fell – in 2015.” Unfortunately, both the Journal and the Times mismeasured the actual take-home pay of each and every one of these CEOs in 2014 and 2015. The reason for this mismeasure is that both articles relied on “fair value” estimates of the stock-based pay of these CEOs as reported in the Summary Compensation Table of the definitive proxy statement (Form DEF 14A) that each publicly listed company files annually with the U.S. Securities and Exchange Commission (SEC). Yet the very same proxy statements also report the actual realized gains of these CEOs in the Option Exercises and Stock Vested Table. It is the realized gains on stock-based pay, not fair-value estimates, that enter into the total compensation that a CEO actually takes home and reports as income in his or her income-tax return. Moreover, including actual realized gains instead of estimated fair value of stock– based pay in the measure of total executive compensation can make a big difference. In 2014 average total compensation of the 500 highest-paid executives named on corporate proxy statements based on actual realized gains was $34.3 million, with 81 percent coming from stock-based pay. But average total compensation of the 500 highest paid based on estimated fair value was $19.3 million, with 62 percent attributable to stock- based pay. The excess of total actual realized-gains compensation over total estimated fair-value compensation was greatest in those years when the stock market was booming. Why would the Wall Street Journal and the New York Times report estimates of executive pay when they could be reporting the CEOs’ actual pay? In this paper, we answer this question by explaining the origins of the “fair value” estimates of stock-based pay and how the obsession with these estimates by the SEC, relying on the business-run Financial Accounting Standards Board (FASB), has relegated to statistical obscurity executives’ readily available, accurate, and actual realized gains from stock-based pay. We use Standard & Poor’s ExecuComp database to document that a) stock-based pay, in the forms of realized gains from stock options and stock awards, dominates both the size of and the changes over time in the total compensation of the highest-paid senior executives; and b) the fair-value estimates of stock-based pay tend to understate, often substantially, the realized gains from stock-based pay that these executives actually receive. An irony is that even critics of excessive executive pay, most notably the AFL-CIO on its Executive Paywatch website, use the fair-value estimates when the actual CEO compensation numbers would reveal a much larger ratio of CEO pay to the earnings of the average worker. Indeed, as we discuss in the conclusion to this paper, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, this mismeasure of executive pay has become institutionalized in U.S. government policy in the SEC’s Pay Ratio Disclosure Rule, which beginning in 2017 requires every company to publish the ratio of CEO to median-worker pay. Under this rule, the SEC requires companies to use the fair-value measure of CEO pay. The Pay Ratio Disclosure Rule is supposed to provide the public with a company-level indicator of income inequality. Instead it will tend to underestimate inequality, substituting fictitious estimates for actual known amounts of income that CEOs put into their bank accounts and declare in their income-tax returns.
Topic:
Financial Crisis, Inequality, Income Inequality, Stock Markets, and Wage Growth
Political Geography:
North America and United States of America