How All Profits are Dangerously Stripped Out of a Corporation
The Structure of The Corporation — In Practice Part II
In Part I, I explained the structure of the corporation in theory, but that’s not how it works in practice.
In practice, the corporation is more like a monarchy with the CEO at its head. This is due to the proxy. The proxy is a means by which shareholders can give their voting power to someone else.
Each spring when the corporation sends out its notice of the AGM, the package will contain a proxy circular asking the shareholders that if they cannot attend the AGM, to please sign and return the proxy form. That form names the person who will vote their shares. Often it is the CEO, but otherwise it is an employee that the CEO controls.
Investors want to help so they sign and send, giving the CEO substantial voting power to elect the Board of Directors the CEO wants.
And add this: that the CEO and senior executives take most of their pay in shares. They already have a substantial block under their control. Keep in mind that the CEO only needs a majority of the votes at the AGM at which few shareholders will attend.
This proxy solicitation is the key to understanding why the CEOs control the election of the Board of Directors, the very entity that sets their salary. And the CEOs will elect CEOs from other areas of industry who also have a vested interest in keeping up CEO pay.
Shareholder groups like the equity/hedge funds or pension funds are of no help to control outsized CEO pay. The money managers of those funds want as much return on investment as soon as possible for their commissions. So, they support any CEO who will strip the company using luxurious dividends and over-priced buybacks irrespective of their sky-high pay.
And once you understand how the CEO can control the vote at the AGM, you will see how naïve the reform was in the Dodd Frank legislation of 2010 that was aimed at putting some control on CEO pay. It requires the corporation to put the item of CEO pay on the agenda of the AGM as a voluntary vote. The CEOs had been able to defeat that minimal request from individual shareholders who had formed ‘say on pay’ groups since the 1980s. But it doesn’t matter, because the CEO and executives have so many votes under their control they are going to approve their own outrageous level pay packages — so they have. The media reports that the shareholders approve these sky-high pay packages as if the vote was independent.
The inability to stop rising CEO and executive pay despite reforms may be due to the fact that the educated voters, and perhaps the politicians themselves, don’t understand the corporate structure in practice to form effective policies to reform CEO pay.
Corporation’s Yearly Earnings
There was a time, prior to 1980, when about 50% of corporate profits were kept for corporate purposes including innovation, downturns in the business cycle, and shared with workers according to their increased productivity.
But that all changed beginning in the 1980s. So today we find many corporations paying out close to hundred percent of the year’s profits in dividends and buybacks and retain nothing for other corporate long-term needs; and even though worker productivity has increased that increase has not been shared with workers whose pay has stagnated.
According to a New York Times article in 2019, “Between 2008 and 2017, 466 of the S&P 500 companies spent around $4 trillion on stock buybacks, equal to 53 percent of profits. An additional 40 percent of corporate profits went to dividends.
American Compass is a think tank that describes itself as a conservative economic site. It published a study warning of the harmful effect of paying out too much yearly profit by dividends and buybacks on the future health of American corporations in strong language. It calls those corporations that pay out most profits, ‘Eroders’
“An Eroder is a strange type of firm that seems to harvest its own organs for its shareholders’ short-term benefit. While not all firms fit these categories, the vast majority do, accounting for 90% of market capitalization over the past half century.”
The support for stripping out all of the yearly profits came from a theory promoted by economist Milton Friedman and published in the New York Times in 1970 claiming that a corporation’s primary goal was to increase the wealth of shareholders.
Now it initially may seem a bit of a hair split, but the purpose of a corporation is determined by the legislation that permits incorporation and that purpose is to permit people to invest and not be liable for the corporation’s debts. This correct perspective leads to the fact that the government through legislation allows this special privilege. And it is the government that decides the purpose of a corporation, not a right-wing economist in his university office.
Some governments have exercised the right to counter Friedman’s shareholder value theory. For example, Canada added section (122 (1.1)) to its business corporations act permitting the directors to take into account more than the interest of the shareholders which includes employees, the long-term interest of the corporation and even the environment.
The Friedman theory is founded on a fallacy. The majority of shareholders today, especially equities/hedge funds, and other large investors, such as pension funds, did not assume the risk of the business nor contribute a penny to the corporation when they bought their shares.
They did not invest when the business was two guys working out of a basement. They waited until the business was highly profitable. And, these recent shareholders did not contribute one penny of capital to the corporation. They bought from other shareholders, whose shares might be traced to early buyers who did share some risk and contribute capital to the corporation. But the early buyers have been given their profit on the resale.
Corporate personhood has been incorrectly cited as a basis for unlimited corporate political donations to Super Pacs. I deal with that fallacy next.
