PDF Download (Paid Subscription Required): What is Permissible
Everything is permissible, but not everything is beneficial.The Bible, 1 Corinthians 10:23
It happens once every decade or so.
Around then – more often if they are accidentally paying attention – investors get a glimpse into the hellish roundelay that is the charade of corporate governance. This time around maybe it was Hertz or Toys ‘R Us being used as leveraged bets and piggy banks for the purposes of a small minority of short-term flip-oriented investors and captive management. Maybe it was Whiting Petroleum‘s board deciding to throw caution and even the most perfunctory hand-waving at fiduciary duties to the wind in order to defend management’s interests over those of owners and creditors alike. Or maybe it was the board of American Airlines wildly diluting shareholder value with equity and options grants to disproportionately benefit management under the absurd pretense of “shareholder alignment.”
Every decade or so the curtain gets pulled back on the ways that managerial class rent-seekers and intermediaries exploit capital, risk-taking entrepreneurs and labor alike.
Every decade or so, the investors peering behind it get the idea in their heads that it is time for an asset owners’ revolution.
Every decade or so, that revolution launches and fails.
It doesn’t have to be this way.
But it usually is. And often for the same reasons.
Most of history’s asset owner revolutions fail for the same reasons most revolutions fail: the narrative of the revolutionary is simply co-opted and absorbed into a retelling of the narrative of status quo powers. They take your story and makes it theirs. Even if that doesn’t make immediate sense, I feel certain you know exactly the kind of thing I’m talking about.
Here is one example of it in the wild.
Below is a simultaneous image from a Twitter user in Turkey of the various regional official social media accounts operated by Bethesda Softworks, publisher of the popular Elder Scrolls and Fallout video game franchises. Under pressure from customers and the public alike – maybe even some of its private shareholders – it has absorbed the human rights revolution into its corporate DNA. That is, so long as it doesn’t require them to make any kind of expression in regions where it would be at all risky.
I’m guessing this kind of thing isn’t new to you. And to be fair, I am not saying that a company like Bethesda should be in the business of marketing its wokeness through, say, clever modifications of a corporate logo at all. I don’t care if they do or don’t. Doubly so since their private ownership is concentrated in one family and one private equity portfolio. What I am saying is that it shows just how painfully easy it is for corporations to defuse revolutionary sentiment by reframing success and progress as the adoption of riskless outward expressions of change.
This is why companies love to participate in and sponsor ESG forums. It is why they are thrilled to become signatories to toothless multi-decade environmental impact action plans they have literally zero intention of adhering to. It is why their extravagantly indifferent boards happily subject themselves to best practices seminars (minuted and on the record, of course) on inclusiveness and belonging. It is why we have photo ops like the one that headlined this note, which would be even funnier to you if you knew what Mt. Kisco – the branch Dimon visited – was like. If you can recast a real-world change objective into one of “showing leadership” and “raising awareness” on a social or governance issue, you have taken control of the narrative.
If this sounds like virtue signaling, that is because it IS virtue signaling. That is also a big reason I think “ESG” as a thing (rather than its very real underlying nominal aims) is most often a pure expression of industry-driven marketing and narrative co-option. But it is not ONLY that. The most powerful force to blunt revolutionary sentiment about corporate governance isn’t vacuous moral expressions from moralless legal entities, but rather the “grudging” submission by corporate rent-seekers to explicit standards and watchdogs.
That is, the most effective tool corporations have to defuse a shareholder revolution over mismanagement and self-dealing is to abstract asset owners’ specific complaints into principles – and then willingly adopt them.
There are a lot of those sets of principles today. Even the most fundamental of them – the fiduciary standard – is subject to this problem. And it IS a fundamental idea, a fulcrum concept on which the diffuse public corporation as a workable transmission mechanism for capital and its rewards rests. The idea of a fiduciary boils down to a simple idea – that board members and executives have duties to shareholders. They have a duty of loyalty, a responsibility to act only in shareholders’ interests and to avoid conflicts and self-dealing. They have a duty of care, a responsibility to act diligently, to do the necessary work. These duties aren’t just right-sounding. These sound like right principles because they are right principles. But there’s a problem.
Fiduciary duties as fundamental ethical principles exist to protect owners.
Fiduciary duties as legal requirements exist to protect managers and directors.
The moral hazard of the institutionalization of an ethical standard is that it inevitably transforms the necessarily open-ended, wide-ranging process of ethical evaluation and judgment required of a steward into the cover-your-ass-minded thought process of a securities lawyer. This doesn’t have to be true, of course, but be serious. You and I and everyone else can instantly discern the difference between good faith deliberation and deliberation that is designed to optimize the appearance and public record of “good faith.” If you have sat in a board room of any organization in the world for any amount of time, you know exactly which one these bodies tend to deliver.
Instead of evaluating what is beneficial, they evaluate what is permissible.
Where exceptions exist, they are exceptions driven by remarkable individuals. Yet make no mistake: permissibility evaluation is the direction that the gravity of things like the fiduciary standard inexorably pull. When management proposes a compensation plan laden with, say, short-term equity issuance immunized by share buybacks, it will not be framed in terms of whether it will be beneficial to shareholders. It will be framed in terms of whether it can be prudently argued that it will be beneficial to shareholders. In other words, it is framed in terms of whether it is permissible. An evaluation of what is beneficial inherently frames topics in terms of owners. An evaluation of what is permissible frames topics in terms of management.
This is a minor linguistic distinction, but it makes all the difference in the world. In addition to the inherent framing bias, it is important to observe that the evaluation of what is permissible exists almost completely in the world of narrative. Over decades, corporate, media and business school missionaries have steadfastly promoted common knowledge about corporate practices, especially around executive and board compensation, that has coalesced into those narratives.
Everybody knows everybody knows, for example, that equity compensation creates alignment. Everybody knows everybody knows that it doesn’t matter how much you pay executives so long as they produce more shareholder value than you paid them (or more than you would have gotten from a management team you could have paid less). Everybody knows everybody knows that returning excess cash to shareholders is inherently shareholder-friendly.
Each of these narratives is rooted in some truth or another, maybe even tautologically so on some narrow basis. But in a decision-making process based on the evaluation of what is permissible instead of what is beneficial, boards and executives have very little incentive to evaluate the specific merits of a policy or decision. After all, a structured debate around the abstracted principle has the benefit of better satisfying the legal standard, optimizing the board’s own risk-reward profile, requiring the least effort and ensuring that the board members maintain a reputation for playing by the rules. That’s how decisions about the term and volume of equity-based compensation are effectively made less in terms of whether it will have any impact on specific executive retention or business results, and more in terms of the narrative that equity compensation is inherently aligning and de facto prudent.
If executives like being thrown into the briar patch of deliberative processes structured around fiduciary duties, however, then they positively beg to be thrown into the briar patch of third-party proxy voting. Another idea with its heart in the right place, the original theory behind proxy voting services was to make sure that institutions with broad holdings but limited resources could pool their influence to empower oversight over the board and management’s stewardship of the company. It is a further layer of institutionalization of the principles of corporate oversight, stewardship and fiduciary duties.
Yet in practice, a combination of commercial sensibilities, a client base with diverse interests and risk-aversion of their own has meant that the third party proxy recommendation and voting services are functionally passive participants in corporate oversight (please don’t argue). Management slates are widely approved, outside activists are frequently viewed with skepticism (change is disruption, and disruption is rarely ‘prudent’, you see) and the language of permissibility permeates nearly of the recommendations they provide.
The abstraction of specific deliberative items into narratives strengthens management’s ability to extract economic rents from their incumbency. The further abstraction of those principles into the protective judgment of a third party like a proxy voting service cements it. That is how narrative co-option reaches its zenith – with management itself weaponizing the language of the right-sounding standards in support of their proposals.
There are other stories of failure from the history of asset owner revolutions in which narrative co-option was not the culprit, of course. By that I mean cases in which the managerial class fought back and won against the interests and arguments of diffuse public capital. In most of these cases, we think the revolutions failed because asset owners sought to impose solutions on corporate governance from the top down, usually in the form of explicit rules to be adopted across the board.
And to be fair, there are some of these top-down proposals we favor and would support if they came up. Depending on the terms, we could probably get behind policies that dealt with the most common sources of self-dealing shenanigans: restrictions on executives as chairpersons, limitations on management participation in compensation committees and limitations on equity compensation of board members. We also think that change of this variety can happen, albeit very slowly, so there is value in promoting the ideas even when they have a low likelihood of success.
But here, too, the overwhelming power of existing narratives and their curious alignment with our bimodal political environment make it nearly impossible to force change from the top-down.
In America, everybody knows everybody knows that there’s nothing wrong with getting obscenely rich by being the best at what you do. Everybody knows everybody knows that the market for executives is a market like any other, with the prices set at the margin by companies and executives. Everybody knows everybody knows that interfering in those markets is a form of socialism that will be a tide that lowers all boats.
Each of these narratives, too, like most effective narratives, is built on a kernel of truth.
And like most effective narratives, they are modified for battle on adjacent-but-not-actually-overlapping topics. For example, if you argue that a professional managerial class has somehow managed to create a persistent, market-distorting you-scratch-my-back structure with the professional board member class that extracts excessive value from equity owners, your view WILL be framed in narrative world as anti-capitalistic and anti-market. If you attempt to express a view that the magnitude of short-term equity-based incentive compensation at many US public companies seems almost completely untethered from long-term value creation or any sense of what would be necessary to retain staff, that view will be autotuned to a narrative of “left-wing anti-rich rhetoric” even if its source is literally the opposite of that.
This is the weaponization of what we have written about as yay, capitalism! memes.
And yes, those memes are so divorced from reality that those who argue for the better treatment of asset owners – actual capital – will be asked “don’t you believe in capitalism?” when they propose practically any top-down solution to managerial self-enrichment. Even if they aren’t, if history has demonstrated anything in each of these revolutions, it is that the political risk appetites and differences in objectives among asset owners make it nearly impossible to summon sufficient support to make sweeping, top-down changes to the roles of boards and executives in stewarding the capital of America’s families, pension plans, endowments and foundations.
It is a metagame that is designed for corporate management to win consistently, to the detriment of all other stakeholders.
So what is the Answer?
I have no idea. But I think I know the process.
It is the same as what we have argued elsewhere, about politics, social markets and culture. Not “as above, so below.”
Historically, institutional asset owners who felt the revolutionary zeal to change the quality and nature of governance of American public companies have generally focused on either (1) changing the narratives of corporate responsibility or (2) imposing top-down solutions. There is a reason there are so many roundtables, position statements and publicized, press released-driven ESG programs. There’s a reason there are so many consultants, advisers jockeying for an opportunity to provide more CYA advice, op-eds, white papers, policy pieces, conferences, and joint working group best practices publications. It feels good. It feels like action. We feel heard. We feel connected, like others are there with us.
But it hasn’t worked. It isn’t working. It is simply too easy for managers and boards to absorb and co-opt these narratives, or else to fight them with the powerful “Yay, capitalism!” memes they have at their disposal, even in defense of capitalism’s most damaging perversions.
For most of those same asset owners, it has been a fifty year journey from broad, direct security ownership to external manager-focused mandates to today’s world of index-beta-sprinkled-with-tactical-and-opportunistic-investments. We can justify these as the right decisions from a portfolio management perspective until we’re blue in the face, and on that dimension we’d be right. Of course we’d be right. AND we must also recognize that this generational transition has given the managerial class an opening to pursue short-term incentives at the expense of long-term growth of capital.
We have written that we believe the birthrights of freedom in our political and social lives can only be claimed today from the bottom up.
We think the same is true for markets.
Do you fear what corporate mismanagement, self-dealing and revolving door corruption are doing to impair long-term returns? Do you fear what “prudent man” compensation structures designed to simultaneously maximize short-term compensation and the appearance of alignment are doing to impair the efficient allocation of capital?
If so, it is time to reestablish the right – the responsibility – for asset owners to exert direct, bottom-up influence over the oversight of public companies. It is time for each of our institutions to treat defending and exerting those rights as a core investment function, not an ancillary function to be farmed out to a third-party service or ignored entirely.
It is time to take back your ownership.
Well written and terrific article Rusty. Thanks.
Although I hope we can change from within, I suspect that only the “denouement” in markets will force attention and true structural change.
similar to the 1930’s.
IMO, Fair to say that the Federal Reserve Board has added one more carving in their “Wall of Shame” by actively supporting (with public dollars) any and all badly run, greedy management teams.
Well put, Rusty. I’m sure you’ve read Venkatesh Rao’s web series “The Gervais Principle”? I’m struck by your ability to clearly describe one of the key mechanisms of what he splits into “Powertalk” and “Babytalk”, the first being how the management classes communicate among themselves in CYA fashion, and the second being the ESG PR-type stuff.
I am a fan of his work but haven’t seen this series. It’s now on my weekend reading list - thank you!
I think that’s probably right - and part of why I think that seeking structural change is a fool’s errand, especially if we are right about the underlying causes and need to make markets into utilities. But there are not so many public companies that asset owners cannot make meaningful change on a company-by-company basis without spending effort on “structural change.”
Not very sanguine…Hard for a frog to adjust the temperature of the boiling water. Best to JUMP out…The only way for this to STOP is to LEAVE…
Rusty bringing fire today. Beautiful.
I had a pure ET moment today when I read this story: https://www.bloomberg.com/news/articles/2020-06-24/bank-dividends-in-peril-with-crisis-veterans-warning-of-trouble?sref=5dE0gZJ9
Why am I reading this now? Are the banks using their missionaries at Bloomberg to soften the ground for a sector-wide dividend cut? They’d be happy to do it. Companies want to keep the money rather than pay it to us as shareholders. But usually they get clobbered when they cut dividends. But what if you could engineer an environment where not returning money to shareholders was viewed as the prudent thing to do? How would you go about doing it? Would anyone stop them? Not their respective boards, certainly.
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