Tuesday, January 29, 2013

Who Really Supports "Maximizing Shareholder Value"?

According to Roger Martin, Dean of the Rotman Business School and author of the book "Fixing the Game", among others, the theory of "maximizing shareholder value" was first promulgated in 1976. According to Raj Thamotheram of the Network for Sustainable Financial Markets, this theory was actually demanded by investors.

Despite widespread criticism of the theory and practice of maximizing shareholder value, the practice continues unabated.

According to Roger, this is because of the large and powerful infrastructure of commercial practice that has grown up around this theory.  But if the theory has been discredited, why can't commercial practice be changed?

This brings us to a question that needs to be given much more academic investigation and practical consideration.

Is it investors who support the theory of share price maximization, or is it Asset Managers?

The theory of share price maximization asserts that the purpose of corporate management is to "maximize shareholder value".  According to this theory, since the shareholders own the corporation, it is their values that should determine the values of the corporation, and what shareholders want is for the value of their shareholdings to always and only go up. So, the job of management is to always be driving the share price up.

Do you see the subtle existential transformations that are being introduced through this theory?

There are many of them. First, there is the transformation of shareholders into investors. This is not a matter of corporate law. It is a consequence of the practice of securitization.

Since a corporation is a fiction, real people have to be the real actors.  Under the law of corporations, there is actually a complex assemblage of people who are the real actors, each shielded in different ways from personal liability for the actions they take through the corporate fiction.  Shareholders are one group. The directors elected by the shareholders to direct the business and affairs of the corporation are another. Shareholders are not really "owners" of the business conducted through a corporation, even under the law.  What they own is a right to vote, and a right to receive their share of the capital and profits of the corporation, if, as and when the corporation, by vote of its Directors, or by legal override, decides to distribute all or any portion of its capital or profits. Directors don't own the business either, since they can act only as a Board, by majority or super-majority vote. Decisions of the Board are executed by the executive officers of the corporation, who are not owners, but employees, and who, under this legal construct, act as agents for the corporation, not as principals for their own account.

So, even under the law, nobody actually "owns" an incorporated business.  The rights and responsibilities of ownership are actually divided up and parceled out among many different roles.

In some cases, a few individuals may hold all these different roles, so that the parcels of ownership are effectively re-assembled in the hands of a few natural persons, but in large, securitized corporations, that is not usually the case.

So, the theory of share price valuation is based on this fundamental misinterpretation of the law of the corporation: the shareholders are not the owners of the business; they are only the owners of certain rights with respect to the activities of the corporation that owns the business.

But the theory of share price maximization goes further. It transforms shareholders into investors. It does this not through the operation of law, but through the process of securitization. Shares of ownership in the corporate fiction are registered for sale to the general public, and listed for trading over an Exchange. Shareholders are transformed into holders of a position in a trade to be made over the exchange. The whole complex of values that are part of any human activity, including the activity of commercial value creation, get reduced to a single point of value: the price at which the shares will trade over the Exchange.  This gives rise to what Roger Martin calls the expectations market, and the whole complex of problems with irrational exuberance that drives so many of the intentional choices that drive those markets in very problematic ways.

The theory of share price maximization talks about holders of positions in the expectations markets as shareholders, and shareholders as investors, but these word obfuscate and conceal the radical (in the Latin sense) truth that the process of securitization converts the indirect participation in business ownership that comes with incorporation into speculation on changing expectations for changes in the price of shares traded as commodities over an exchange.

There is more.

The theory of shareholder value was advanced only recently, in 1976. Corporate securitization has been a popular choice for financing large scale enterprise for over 150 years, since the 19th Century. Why did it take so long for this theory that is supposed to be so fundamental to be worked out?

The truth is that the theory of shareholder value is not a theory of corporate finance. It is a theory of institutional investment, and the practice of institutional investment through corporate share price speculation was illegal in the United States, until 1972.

That year saw the adoption of the Uniform Management of Institutional Funds Act, which revised the prudent man rule of fiduciary duty for endowments and foundations when investing funds entrusted to their custody and care under a charter of trust.  The Act was quickly followed by ERISA laws governing pensions. In the Act, the long-standing prohibition against speculation by fiduciaries investing other people's money was re-affirmed, but the interpretation of that rule was revised to allow a test for speculation to be made at the overall fund level, if that was considered prudent according to the accepted practice of reasonable people of business, when acting for their own account.

What was really going on here was legal sanctioning of Modern Portfolio Theory and the belief that through proper diversification, the negative impacts of speculation in trading shares of securitized corporations could be effectively neutralized at the portfolio level, making it proper for fiduciaries to participate in speculation through diversification.

This brings us to another important existential point underlying the widely recognized failure of modern institutional investment theory.  This is the difference between intentional action and inertial momentum. Modern Portfolio Theory, like all of modern financial economics, is built on the unvoiced assumption that price movements within the capital markets are inertial.  That is, they conform to the physical laws of inertia: a body at rest will stay at rest, and a body in motion will stay in motion, unless and until acted on by another force. What the law of inertia asserts is that the movements of physical objects through space and time are not irrational or intentional.  They are inertial.

People, however, are not inertial systems.  Neither are the constructs that people build, such as economies and markets, whether commercial or capital. These construct are, like the people who build them, use them and maintain them, willful, volitional and intentional. They are not inertial. So, the laws of inertial systems are not a proper paradigm for the laws of market behavior.

Market Portfolio Theory may work well enough when the people participating in the exchange trading activities at issue are largely individuals acting for their own account, but something happens when institutions replace individuals as holders of speculative positions in an expectations market.

Individuals are speculating their surplus wealth for the period of time, however long or short that may be, during which that wealth is surplus to their spending needs.  They sell when they need to spend.  Speculators provide a useful override to individual decisions to add to, or subtract from,  their speculative accounts.  They provide a constant level of trading volume -- liquidity -- that evens out what might otherwise be a lumpy -- and illiquid -- pattern of buying and selling driven by individuals adding to or subtracting from their investment accounts, episodically and idiosyncratically. They are the buyers and sellers of last resort, providing certainty of sale, although at an uncertain price.

Institutions are investing the principal amount of funds entrusted to their care in order to generate an income that will support the payment of the obligations imposed on them by their respective charters of trust.  They never need to sell.  They always need to earn.

What benefit does speculation provide here?

There is one other important change in the laws of fiduciary duty governing investment by institutions acting as stewards of a chartered trust that was made in 1972, and needs to be considered here.  The Act reaffirms the longstanding duty of responsibility that has always held that a trustee cannot abdicate responsibility for the actions taken with trust property by delegating discretionary authority to others, but goes on to recognize, although not is so many words, that building and maintaining a properly diversified portfolio of trading positions according to Modern Portfolio Theory is a specialized skill that not every otherwise perfectly competent and diligent trustee can be expected to personally possess.  So, the Act allows the delegation of trading authority to persons possessing the required skills, if the choice is prudent by ordinary standards.

Two things happen here.  First, investors are transformed into Asset Owners, who are passive and uninvolved, and trading discretion is vested in a new class of professional speculators with other people's money, who have come to style themselves as Asset Managers. Second, peer benchmarking takes over as the standard of care applied to fiduciaries when they delegate trading authority over entrusted funds to these Asset Managers. No matter how much the performance of the Asset Manager fails to serve the underlying purposes - financial or societal - of the governing charter of trust, as long as returns on trades are in line with the overall average performance of all Asset Managers within the industry, overall, the trustee is considered to be doing his or her job. It is a beautiful exercise in making sure that nobody is ever responsible for anything, as long as everybody is doing the same thing.

So, is it the investors who demand and support the theory and practice of "maximizing shareholder value", or is it the professional speculators who have appropriated to themselves discretionary trading authority over vast quantities of other people's money entrusted to stewardship institutions under a governing charter of trust?

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