The Financialization of Corporate Governance

Members of the academic community, the business world, and law firms have long been debating shareholder primacy, stakeholder governance, and corporate purpose. In a forthcoming essay, I outline these arguments but suggest that reform of corporate governance should be focused on executive compensation and compelling fiduciaries subject to ERISA and other legal regimes to protect retirement savings. In my opinion, the financialization of corporate governance fomented by activist investors that led to compensating executives with equity is the primary cause of the dissatisfaction with corporate performance by non-shareholder constituencies.

My essay traces the development of the financialization of corporate governance to the takeover boom of the 1980s and the pressures activist investors put on corporate boards in that decade and the 1990s to think like stockholders. These pressures led to the elimination of cash compensation and the substitution of equity compensation for corporate managers and directors. Not surprisingly, such compensation led to a focus on stock market prices as the measure of corporate success, to the detriment of other important business goals. Research and development budgets shrank, quality production became less important, and labor was sidelined. Manufacturing was hollowed out and offshored; the financial services industry and its agents thrived.

One of the practices that aided the payment of equity compensation was stock buybacks. As executive compensation soared, so did stock buybacks. In 1980 the average S&P 500 CEO earned 42 times the average worker; in 2017 he earned 361 times the average worker. Over the past four decades, equity compensation pushed CEO pay obscenely high, rising more than 900 percent. Furthermore, this contributor to income inequality has been made possible by stock buybacks. Over the past decade, U.S. public companies have tripled the amount spent on buybacks to a record of $1 trillion in each of the past two years.

The use of equity compensation for executives and directors and stock buybacks are complementary. Equity compensation results in dilution of a corporation’s common stock and buy backs are the antidote to this hit to shareholders. Buy backs were justified as a way to return profits to shareholders, but in fact this was a smokescreen, although the differential between taxes on capital gains and ordinary income also encourage buy backs. Buy backs supported the financialization of executive compensation and increased share prices in the short-term.

The funds used for stock buybacks could not be utilized for other corporate purposes, including research and development and the development of quality new products. I believe this is at least a partial explanation for the proliferation of shoddy and dangerous products such as the Boeing 737 Max airplane. David Calhoun, Boeing’s current CEO, criticized his predecessor for turbocharging Boeing’s production rates before the supply chain was ready, a move that sent Boeing’s shares to an all-time high but compromised quality. Others have complained that stock buy backs diverted funds from fair payment to workers even as their productivity increased.

The Delaware judiciary and the Securities and Exchange Commission have not solved these problems and have generally kept hands off dealing with excessive executive compensation or stock buybacks. When Congress and the Securities and Exchange Commission woke up to the damage equity compensation was causing, they either made matters worse or mandated ineffectual remedies. The $1 million cap on straightforward executive compensation accelerated equity compensation schemes. Say-on-pay and comparisons between top executive compensation and lower paid employees accomplished nothing.

Much of the criticism of shareholder primacy and support for stakeholder governance has discussed long term versus short term horizons for managers and directors. Although this discussion is relevant, it is not sufficient. My essay concludes with a discussion of various remedies suggested for ameliorating the short term focus of corporations but suggests that, unless equity compensation of mangers and directors is addressed, most of these remedies would accomplish little. The conventional wisdom of the past 40 years has been that independent directors and investors should remedy corporate governance failures, but these groups have failed to do so because they have supported the financialization of corporate governance.

Although it is gratifying that the Business Roundtable has endorsed stakeholder interests, so far pious corporate statements regarding the interests of stakeholders and the public have not been matched by actions. Changes in law and regulation will probably be required to reset corporate governance norms. It has taken 40 years of a free-market ideology to place the governance of corporate America where it is today. So, it is likely that it will take cooperation from business interests, as well as a reorientation by the Delaware judiciary, the Securities and Exchange Commission, the Department of Labor, and Congress to put environmental, labor, and societal interests on a par with stock market interests.

This post comes to us from Roberta S. Karmel, Centennial Professor of Law at Brooklyn Law School. It is based on a chapter, “The Financialization of Corporate Governance,” to be published in the Cambridge Handbook on Investor Protection, 2020, and available here.