Recreating Shareholder Capitalism

Martin Hutchinson

Over the past 50 years, the United States and most other wealthy economies have moved to a system of managerial capitalism, in which resources are controlled, not by the owners of those resources but by a cadre of professional management that leeches more and more returns out of the system. No viable economic theory suggests that a system of capitalism in which capital's owners do not control its use is likely to prove effective in creating or allocating resources. We had thus better start thinking about ways in which this trend could be reversed, and the control of capital tied more securely to its ownership.

I have discussed in a previous column the reasons for the development of managerial capitalism, how shareholdings migrated over the quarter-century after 1950 from primarily individual, often related to the original corporate founders, to primarily institutional, in pension funds, endowments and insurance companies. I have also discussed how tax changes, in particular the huge increases in estate tax after 1932, over time abetted this process, and how their reversal might to some extent reverse it. In this column I would like to consider whether, rather than attempting to reverse engineer the social changes of the postwar period, we might through adept securities design achieve much of the same effect, even while shareholdings remained primarily institutional.

Currently, the great majority of companies' equity capital comes in the form of common stock, the holders of which collectively control the company. Fifty years ago, there was a significant volume of preferred stock issued, which generally had votes in certain circumstances, but common stockholders have more recently been in full control of the vast majority of non-bankrupt companies.

Since common stock is also the most widely traded security in most companies, its holders, if dissatisfied with management, have always had the option of selling their stock and investing elsewhere. With institutional shareholders predominating, this has led to a concentration of voting power in favor of company management, since it is cheaper and much less dangerous to a fund manager's career to sell the fund's shares than to start a shareholders' revolt. With the major institutional shareholders favoring management, the chances of a shareholder revolt are slim and management becomes correspondingly entrenched, using consultants to increase its annual take, gambling in the derivatives market, fiddling the accounts and empire-building at will.

If we were still in 1970, we would have little chance of solving this problem, but then in 1970, we didn't have the problem to anything near the same extent. Fortunately, Modern Finance has given us new techniques as well as new problems, in particular the ability to design securities for any bizarre cash flow pattern and governance outcome we want. This ability can be used for good as well as evil, to design a new type of security that removes the misaligned incentives of managerial capitalism.

The problem is the institutional investor's ability to sell the shares. If the institution was stuck with the investment, it would be forced to participate actively in corporate governance, ensuring that management stayed under control and didn't overpay itself. For most private investors and for some institutions such as banks and mutual funds, the ability to sell the shares is crucial, because those institutions need liquidity to meet redemptions of deposits or fund shares. However, for other institutions, in particular for the large college endowments, life insurance companies and pension funds, superior long-term investment performance is far more important than liquidity. That's why many college endowments now follow the "Yale Model" of investment, in which they buy timberland, private equity and hedge funds in order to diversify from the stock market and (they hope) achieve superior returns. The result of this diversification is mostly the payment of huge management fees to shysters, but the principle of sacrificing liquidity to long-term return is surely correct.

Any security that is designed to improve corporate governance must thus be non-transferable. In that way, the institution holding it will not have the possibility of selling the shares if it doesn't like management's policies, but will be forced to vote in a way that maximizes the return on its investment. I propose that companies wishing to improve their governance issue Founders' Shares, with the following characteristics:

• They are completely non-transferable (this must be locked up tight legally so some fast-buck takeover artist can't find a way to unlock it).
• They convert to common stock after 50 years.
• For the first 45 years of their life, they get an additional 1% per annum dividend above whatever is paid on the common, payable in common at the average price of the year/quarter.
• They have all other rights of the common, as to voting etc.

Founders' shares should probably be issued for around 20% to 40% of the company's capitalization, in order to give their holders a substantial and in most circumstances controlling influence on the company's direction, while preserving a sufficient volume of ordinary shares to maintain their liquidity and the company's ability to raise equity capital. Their buyers should primarily be pension funds and endowments, although in some circumstances they might be offered to individual buyers, with a strict provision as to transfer on death but not otherwise.

Holders of Founders' shares would receive an additional annual return, to compensate them for the lack of liquidity. For institutions with long enough time horizons, that compensation should be sufficient incentive to purchase them. Such holders would be motivated solely to maximize the long-term value of the company, and would oppose all strategies that increased the share price short-term while depressing the ultimate value. They would approve acquisitions only if they were clearly in the long-term strategic interest of the company, rejecting such deals as Prudential/AIA or Kraft/Cadbury that muddied the company's strategic focus, increased its risk and diluted shareholders. They would object to management's self-enrichment schemes and excessive stock option grants, and would be forced to oppose them through their votes, since they would not have the option of selling their shares. They would reject excessive leverage, since that would increase the chance of the company going bankrupt before their long-term value was unlocked.

In other words, Founders' shares holders would behave in the same way as an economically rational strategic shareholder in the company. By doing so, they would restore rationality to the company's operations, and reduce bloated costs in its management. That in turn would make the company more competitive against its domestic and international rivals. Research and development would be adequately funded, regardless of the short-term hit to earnings, because they would offer the best avenue to increase the company's long-term value. Thus you would once again see the equivalents of Bell Labs in the 1940s and Xerox PARC in the 1970s (although one hopes without the latter institution's total disregard of commercial realities). Acquisitions would only be undertaken if they offered long-term strategic benefits. Product quality would not be sacrificed, because its sacrifice would provide only short-term benefits at the expense of long-term value.

With institutional shareholders taking control of the companies in which they invest, and forcing them to act in those companies' long-term interests, the incentives in capitalism would be realigned along lines that actually made the system work to create wealth for all. Without such a realignment, large corporations will remain primarily wealth-destroying entities, providing rents for their top management but reducing the welfare of society as a whole, as they pursue short-term strategies that destroy long-term value.

The Kraft takeover of Cadbury has destroyed an iconic British company that had existed for over 200 years and was family-run until 2000. Tempting though it was to urge the British government to intervene and stop the takeover, that would not have been the appropriate response. Such an action would merely have handed control over to government, a proven destroyer of value. Instead, the takeover should have been stopped at the Kraft end, by shareholders' resolving to oust the Kraft management that was engaging in such value-destroying empire building (and if the corporate statutes allowed management to proceed without shareholder approval, then management should have been removed at the first opportunity and the statutes changed). Warren Buffett, holding 9% of Kraft shares, attempted to stop the Cadbury takeover; by issuing Founders' Shares we will lead their holders to vote like Buffett and put a stop to such transactions.

Other reforms will be needed to transform capitalism back into a system that creates value. In particular, 15 years of sloppily over-expansionary monetary policy need to be reversed, and the inevitable economic costs in terms of bankruptcies borne that will come with that reversal. However, only when Founders' shares or some equivalent instrument are introduced into the financiers' arsenal will incentives be properly realigned so that managers are forced to manage in the long-term interests of shareholders, thus ensuring that research is adequately funded, takeovers do not threaten the existence of value producing operations and product quality is not compromised.

The final question to be answered is whether existing market participants have enough incentive to organize Founders' shares issues. For existing shareholders, the dilution of value through Founders shares' additional dividends is significant, but should be more than counteracted over even the medium term by better and cheaper management. For management, the chance of huge wealth through empire building and stock options is lost, but so also, almost completely, is the chance of job loss through takeover (because Founders' shares holders will almost always vote against such a takeover), while the chance of corporate bankruptcy is greatly reduced. For employees, the quality of existence is enormously improved, as the company's activities are refocused on its core operations and innovation in its products is increased, while management's distractions are removed. Needless to say, each company that stops producing bonanzas for management and job losses or bankruptcy for everybody else will greatly improve the long-term wealth of the population as a whole.

The incentives thus exist. All that is needed is a pioneer of the new shareholding structure.

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com