What companies are good for

By Edward Hadas
May 2, 2012

The debate on executive pay is often just a shouting match, in part because there’s no agreement on what bosses are actually paid to do. The “shareholder value” approach provides a simple answer, but one that it is both practically and morally wrong. Aristotle had better ideas.

Citigroup’s shareholders recently voted against the pay package of Vikram Pandit, the bank’s chief executive. In Europe, the boards of Barclays, Credit Suisse, Aviva, Man Group and Xstrata are in similarly hot water. Many think the key is to link rewards to success. But what exactly does corporate success mean? What is Pandit being paid to do?

In the standard view of the modern company, Pandit ultimately serves only the shareholders who voted against his remuneration. Companies’ legal owners choose a board of directors to represent their interests. The board hires a chief executive to create “shareholder value” – that is, dividends and a higher share price. Shareholders have every right to be angry if managers serve themselves rather than their ultimate bosses.

The shareholder value perspective provides a simple way to think about corporations, but it’s neither true nor just. In practice, modern corporations aren’t run for the benefit of shareholders. Nor should they be.

Etymology provides a helpful hint. The term ‘corporation’ comes from ‘corpus’, the Latin for body. Shareholders are a vital organ necessary to sustain corporate life. But just as the physical body cannot survive without many healthy organs, corporations rely on many groups. Excessive attention to shareholders will lead to atrophy or disease in other corporate organs – employees, machinery, offices – and the inability to cope with the corporate environment – suppliers, customers, governments and the broader community.

In the case of Citi, the $181 billion of shareholders’ capital is indeed vital, but so is the other $1.8 trillion or so on the balance sheet. So are the 260,000 employees, the millions of customers, the legal systems in which the bank operates and – as the recent financial crisis made clear – politicians and regulators. And while corporations are often described in impersonal terms, but they are run by and for people. All of them deserve just treatment.

The promotion of justice, then, is an important part of Pandit’s job. But what is justice? For corporations, it is helpful to learn from Aristotelian approach. The Greek philosopher argued that an organisation is just when each involved person receives rewards that are in proportion to his or her merit. In corporations, shareholders have the merit of providing capital, chief executives give leadership expertise, employees’ merits are time and skills, and so forth.

Aristotelian corporate justice will always be fairly crude, because it is impossible to trace with complete accuracy the effects of particular contributions. Besides, today’s success can become tomorrow’s failure. In this fog of ignorance, it may be better to rely on another Aristotelian principle – moderation. It is unjust to give shareholders, bosses or any other group rewards which are either extremely high or extremely low.

Yet neither justice nor moderation feature in the standard view of corporations. Cheerleaders of shareholder value claim that in corporate life, only one thing matters: profits for equity investors from here to eternity. But that judgment relies on two assumptions that are obviously false. First, that the future can be anticipated accurately and, second, that shareholders will never sacrifice their long term good for the sake of short term gains.

Until about 1980, the shareholder value theory was pretty much ignored in practice. Managers mostly engaged in what is often called stakeholder capitalism. They balanced the needs, desires and capabilities of the various organs of the corporate body. They recognised that corporate success has many dimensions. Profit is on the list, along with improved products and services, environmental responsibility, service to the community and employees’ welfare.

In the last few decades, though, shareholders’ interests have become pre-eminent. The result is a morally impoverished view of corporate success. Shareholder value is invoked in debates over high executive pay and low worker pay. It is used to excuse reckless financial structures and to dodge criticism of deceptive advertising and harmful products.

Pandit, in common with most top executives, probably deserve less – no matter what the share price has done or what shareholders think.  Moreover, a wider and more ethical definition of corporate purpose is a prerequisite to better corporate governance. Stakeholder capitalism, now recognised in UK corporate law, should certainly replace shareholder value. But boards and bosses still need to think more about the complexities of keeping the corporate body in good health. Corporate justice is dynamic; different groups merit more or less at different times.

As for shareholders, their capital is vital and their profit is like the food that keeps the corporate organism alive. However, corporations should have other, higher goals than making shareholders fat. In the words of a recent document from the Catholic Pontifical Council for Justice and Peace, “An organism must eat, but that is not the overriding purpose of its existence. Profit is a good servant, but it makes a poor master.”

3 comments

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The problem really lies in how corporations are legally structured.

Take a partnership, for example. When a business operates as a partnership the owners share the profits according to the partnership agreement.

The downside of a partnership is that they also share the losses — including their personal property, should the business go bad.

The moment they elect to become a corporation, completely different laws apply.

Investors share in the profits, but not the losses.

Creditors cannot “pierce the corporate veil” to get at the personal assets of the true owners — the investors.

Instead, they must be satisfied with only what the corporation owns in its own name.

They cannot, as a general rule, even touch the personal assets of the professional managers running the corporation (i.e. the CEO, CFO, Board of Directors).

These professional managers are often paid mostly by performance bonuses, which creates incentives for them to run the corporation to maximize their own profit, which is not necessarily in the best interests of the investors or society at large.

The problem is easy to fix.

Simply remove the special status of corporations that make them immune to any control by anyone.

This means the investors would have direct control over the corporation and how it is managed by these professionals.

Why would they care?

Because presently only the profits flow to investors, but no losses.

Change the corporations laws to allow both profits and losses to flow to investors (in proportion to their percentage of ownership, just as profits are distributed now), thus creating a significant vested interest by stockholders to make sure the company is properly run.

Yes, it really is as simple at that!

Posted by PseudoTurtle | Report as abusive

At least part of the problem is that since the 80′s, the overall performance of the corporation has become divorced from the executive compensation packages. Regardless of how poorly some companies did, the CEO had a contract that endlessly increased his/her reward, in some cases to a ridiculous degree. Wall Street had a particular problem with this. Investment banks became gambling halls where traders used other people’s money in high stakes games. Corporate governance went out the window and profit became the only goal. Disaster predictably followed. Much of this has been justified throughout the corporate world on the basis that ‘we have to pay top dollar to get the best people’. It now appears that the ‘best’ were anything but. CEOs and senior managers should operate under the same rules as other employees. That means they have a job description which includes everything they should be responsible for, and the appropriate penalties should they fail to fulfill them. Conversely, no CEO should be responsible for the share price rise or fall. Historically, if you run a sound company, the share price will look after itself.

Posted by steve778936 | Report as abusive

Turtle, your post makes absolutely no sense. I don’t think you have a firm grasp on the subject matter to have an opinion on it.

Posted by Matt-Chicago | Report as abusive