We are not experiencing one crisis caused by the Corona virus calamity, but four. The other three are hidden under it. They remain largely undetected in the mainstream media. They are about to surface for, as that intrepid investor Warren Buffet once quipped, “It’s only when the tide goes out that we see who has been swimming naked.” I’ll discuss the first in this post.
Not only are they going to cause an increase in the coming economic disaster, as they are main methods of siphoning up the wealth of a nation to the wealth class, their invisibility will be staunchly protected — and they will remain in full effect after the next recovery.
As historian Walter Scheidel wrote in his insightful book a couple of years ago, The Great Leveler, “It is not a crisis that increases or decreases economic inequality, it is the government’s response”. For a time, the government’s response to a crisis created economic equality, but then the ultra-high net worth group learned how to ensure that they profited from a crisis and not the salaried classes.
Recall that the reforms after the Great Depression created economic equality by giving the stimulus funds by mortgage relief to the homeowners (not the banks), social security and the Security and Exchange Commission. By 2008, the stimulus money benefited only the 10%; the income and wealth of the salaried classes stagnated. That was no accident. And we see that much of the 2020 Corona virus stimulus package is being grabbed by big businesses that can show bleak financial statements with absolutely no reserves for any downturn in the economy— a reserve fund they once kept. This failure to prepare was a conscious decision.
Not many voters understand that these businesses voluntarily put themselves in a position so, against all risk management principles, they would not have a penny put aside for a crisis. Thus, there was no public support for true reforms that could be demanded as part of the present handouts to corporations. True, the Democrats got some, but temporary, restrictions on a few of the mechanisms for the upward transfers of wealth to the super rich. But they entirely missed this one: shareholder value.
It’s too late to save our economy, but we might be able to prevent this from happening again for the sake of our grandchildren. It will take discipline to understand how it’s being done. As head of the Grantland L. Johnson Institute of Leadership Development, Lee Turner, wrote to me, the average reader lacks the ‘scaffolding’ to understand these issues. So, here’s an attempt to bridge that gap. It’s not an easy read because some of the concepts are unfamiliar.
Unnecessary Unmanageable Corporate Debt
A full two years before the new coronavirus challenge emerged, analysts warned that corporations were taking on so much debt that many would likely default on these debt payments on the next mild downturn in the economy. They had abandoned the practice of keeping a rainy-day fund for the bad times. Jeff Cox writing for CNBC in 2018 called the massive “corporate debt bomb was bubbling in the US economy”. With a certainty, the coronavirus has lit the fuse.
How come this mountainous corporate debt when the 2008 reforms returned corporations to prosperity? The fault lies with the neo liberal school of economics and especially with one of its most respected promoters, Nobel prize winner, Milton Friedman.
With the assistance of the authority of the New York Times, in 1970 (note this date as the beginning of the end of economic equality), Friedman promoted the theory of shareholder value.
The purpose of a corporation, he theorized from his armchair at the University of Chicago, is to maximize value for shareholders. It became known as the Friedman doctrine.
So, what happened? I can do no better than to repeat how, in 2012, Cornell Law Professor Lynn A. Stout captured the aftermath in her article in the Harvard Law Review: In the quest to
“unlock shareholder value” they [CEOs] sell key assets, fire loyal employees, and ruthlessly squeeze the workforce that remains; cut back on product support, customer assistance, and research and development; delay replacing outworn, outmoded, and unsafe equipment; shower CEOs with stock options and expensive pay packages to “incentivize” them; drain cash reserves to pay large dividends and repurchase company shares, leveraging firms until they teeter on the brink of insolvency;…”
Of course, her warning was ignored.
Every item she lists demands a full article, but this post will focus on ‘leveraging firms until they teeter on the brink of bankruptcy’. ‘Leveraging’ is a bit of jargon to hide that what the corporations are really doing is going into debt for business expanses so there is money to pay shareholder dividends.
Previously, sound corporate practice required saving 50% of profits for future needs, such as product development, expansion and the like, but also for risk management because of expected downturns in the business cycle with a special rainy day provision for the totally unexpected. Businesses knew to expect the unexpected and provide for it. All that prudence was abandoned after 1970 to strip every cent of profit by dividends to shareholders.
There is a false image in the public mind that all shareholders contribute cash to a corporation, but these shareholders only extract value from the corporation, giving it no benefit. These shareholders are not the investors who took high risk by funding the founders when they were working out of their garage. They are the money managers of hedge, equity and pension funds who search for well-established corporations with assets that they can wrest from the corporation. The money that they pay for the shares does not go to the corporate treasury, it goes to prior shareholders. That’s why the corporation gets no benefit.
Why the Shareholder Value Theory Is Nonsense
The purpose of a corporation is to protect the personal assets of businesspeople and investors so they can go into a high-risk ventures and lose only the money that they put into the corporation if it fails. Creditors cannot sue them personally.
Let’s go back about a hundred years to the early days when the idea of a corporation was being worked out. It involves the landmark decision in corporate law, which by the way is one of the very few decisions that has remained unaltered since its pronouncement: Salomon v A Salomon & Co Ltd  UKHL 1.
Joe Salomon operated a successful shoe factory as a sole proprietorship. He decided to incorporate. He sold his shoe factory to this new corporation Salomon Ltd. As the corporation had no money, it gave Joe a mortgage on all of its assets–the shoe factory.
Unfortunately, after a time, Salomon Ltd. failed. The factory was worth, let’s say, $1 million, and the corporation had creditors of that amount. The creditors got a judgment against the corporation and tried to seize the assets. Joe said, sorry blokes, my mortgage takes first. The creditors cried foul and sued in court. The court agreed with Joe. Although it is a legal fiction, the corporation is a separate entity in law, called a person, and the mortgage between it and Joe was valid.
The court commented that creditors had the opportunity to protect themselves. They should’ve checked that the assets were free and clear before selling to the corporation on credit. And so, if you’re a small businessperson, you will see that a bank will never give a loan to a small corporation without more; it always requires a personal guarantee from the controlling shareholder.
The purpose of a corporation is clear in an example like our Joe Solomon case. The creditors could never have sued Joe personally for the the goods sold to the corporation that it didn’t pay for. It also applies to public corporations. If you buy one share in a corporation and it tanks, the creditors cannot come after you. But this protection of your personal assets comes at a price; and that is the brilliance of the concept of the corporate form. Shareholders are not owners. And to the contrary (complete contrary I emphasize) to what Friedman alleged, they don’t have the slightest control over the CEO.
The concept of corporate ownership is divided. It’s probably safe to considerate the division as 99% in the Board of Directors and the CEO, leaving 1 % to the shareholders. Test this out. Buy some shares in Apple Computer, drive down to Cupertino, tell the receptionist that you are a shareholder, you want to see the new plans for the next product and see how impressed the security guards are with your claims to ownership as they escort you off the premises.
As a shareholder, you have very limited rights such as notice of the annual general meeting, to see the annual financial statements, attend the AGM and vote for directors who you probably have never heard of, but little else. And your vote is as effective as your vote in a government election. Try just to get something on the agenda of the AGM. You won’t even be able to do that. So, after your trip to Cupertino, you will complain to me that my estimate of 1 % ownership is probably an exaggeration.
When Can Inexperience Pass for Expertise - When You’re an Economist
As noted above, any risk management plan demands something be set aside for the unexpected. And while we average citizens may not have considered a return of the modern plague, some in the business community were discussing its realistic possibility. In 2017, Bill Gates said this at the Munich Security Conference:
“The next epidemic could originate on the computer screen of a terrorist intent on using genetic engineering to create a synthetic version of the smallpox virus … or a super contagious and deadly strain of the flu.”
Why should some abstract theory of some guy, like Freidman, who has never run a corporation, and has no background in corporate law, spread like a tsunami through the corporate world toppling all wise planning in it’s wake. And why would all corporate types ignore the warnings of one of the most successful and experienced business man of our era? Does greed make intelligent men stupid? Follow the money—who profits.
Executives love it because they have huge holdings of shares in their own corporations thanks to a bungled attempt by the Clinton administration in 1993 to put a cap on CEO pay.
More on how the Democrats helped The CEOs pay gap more than the Republicans here.
Banks, equity, hedge and pension fund money managers love it because they earn fabulous commissions on the now more lucrative and frequent dividends. Equity-hedge funds scour the nation to find vulnerable corporations that have cash or assets that can be converted to cash and then plundered through dividend extraction. Union pension fund money managers even invest in hedge funds that loot worker pensions. I explain the various techniques in the equity– hedge fund playbook and how they screw worker pensions in a series of posts beginning with this one using the recent Sears bankruptcy as an example.
Best of all, 80% of shareholders are in the 10%. So, it means more income inequality, which means more money in the pockets of the wealthy to buy politicians to preserve the upward transfer of wealth that has been going on since the 1970s.
So, no, greed does not make intelligent men stupid, it makes them sociopathic. They care only for the money mounting in their bank accounts, but not for the effect on others in their society. They are definitely not stupid for they have manipulated the situation so the taxpayers once again bear the burden of the crisis as the elite float above it.
The bottom line: just as in 2008, the super wealthy will cream off a substantial part of the stimulus money. In the method under discussion, the stimulus money will have to go first to pay outstanding interest installments, or the entire principal if it comes due. Another upward transfer of wealth from the taxpayers to the multimillionaires who holds these corporate bonds.
Those in control of a corporation are not going to give up the shareholder value policy that has made them so wealthy by articles like this that expose its fallacious assumption. Legislative change to the corporation acts specifying that the duty of the Board of Directors is to the corporation and not the shareholders would puncture the Friedman doctrine.
In 2019, the Trudeau government passed such an amendment to Canada’s business corporation act specifically overruling shareholder value by stating just that: the directors of the corporation had to act in the best interest of the corporation and not shareholders (s122). Albeit, that is only a small step, but in the right direction.
The corporate situation may appear very bad, but it gets worse. The two remaining camouflaged causes — coming soon.
Jan D. Weir is a lawyer who has advised international corporations, banks and accounting firms. He has taught business law at the University of Toronto, and is the co-author of The Critical Concepts of Canadian Business Law (6e) Pearson. Follow him for updates on laws that affect inequality @JanWeirLaw and Medium.com,
Acknowledgement: Title image courtesy of Blue Lagoon, Iceland, on Pexel.