Guard Dogs That Fail to Bark

Management and Shareholders
Listener 6 April, 2002.

Keywords: Business & Finance; Governance

In 1932 Adolph Berle and Gardiner Means showed that there was an increasing separation between the shareholders who legally own the corporations and the managers who control it. Their seminal insight suggests that managers may have sufficient independence to pursue their own objectives – higher pay, better conditions, prestige, technological excellence – at the expense of shareholders. (The New Industrial State by J.K. Galbraith is the best know book setting out the case.) Those committed to the pure market approach responded that the shareholder can sell the shares of under-performing companies to others whose managers would produce higher shareholder returns. They described the sharemarket as the ‘market for management’, where competition would result in higher returns to shareholders, as efficient managers took over inefficient businesses.

This ingenious argument suggests firms specialising in takeovers, such as Brierlys in the 1970s, serve a useful economic purpose. ‘Asset-stripping’ was shifting assets (and labour) into more productive uses and eliminating inefficient management. Meanwhile managers of other firms, fearful of takeovers, would raise their performance.

The purests went on to argue that privatised businesses were more efficient than nationalised ones, because their managements were under pressure from the threat of sharemarket takeovers, while publicly owned businesses were not. (Derek Frew cited a Journal of Economic Literature survey to dispute my assertion that privatised firms were not necessarily more efficient than nationalised ones. (‘Listener Letters’, December 15) But the article has many more cautions than he implied. Even had it not, he missed the point. Many nationalised firms become more ‘efficient’, in a particular meaning of the term, when privatised because their objectives are shifted from social purposes – say job creation – to shareholder value. The dispute is about the extent to which nationalised firms with the same efficiency objectives are less successful than privatised ones. The research suggest they need not be.)

Firms take the threat of takeovers seriously and have numerous strategies to repel them. Management grants itself ‘golden parachutes’ – generous redundancy payments following successful takeovers – form alliances with managers of friendly firms (‘white knights’) to protect one another, and create ‘poison pills’, ‘sandbags’, and other devices to protect them from takeovers. Sometimes the largest shareholder in the firm is its worker’s pension fund whose trustees are the management. None of these seem especially efficiency seeking, or in the shareholder interest.

Is the ‘market for management’ efficient? The research evidence shows that on many, but not all, occasions the effect of a takeover is to lower the unit shareholder value of the successful firm (although usually the shareholders of target firms do better). Apparently management typically overestimates its ability to improve the efficiency of the firm it is taking over.

More recently, another serious objection to the theory has appeared: how to measure the shareholder value. Measurement of a corporation’s profits and net worth is basically the management’s task and they have a strong incentive to bias the figures, which are an indicator of managerial competence. (Usually managers try to make them as large as possible, although when there is a loss that gets magnified too, unwinding past overstated profits.)

The accounts of a business involve numerous judgements over which honest accountants may differ. There are rules of ‘Generally Accepted Accounting Practices’ (GAAP), which limit the range of difference, but even then valuations still have a judgmental element. Moreover such rules cannot be comprehensive. (Some country’s are better than others. I am told that New Zealand’s would get a B measured against international best practice.) Meanwhile management uses the gaps and uncertainties to its advantage.

Auditors are meant to restrain management from fiddling the figures. Officially they are appointed by the shareholders and are meant to act on their behalf, but their appointment is normally the decision of the corporation’s board who are usually allies of management. Auditors’ practices are being increasingly questioned, especially following the demise of the American ‘energy-giant’ Enron. (The quotation marks are because the company’s collapse had little impact on energy markets. It was primarily a financial company posing as a major energy player.)

Enron’s auditors appeared to have been deceived by the Enron management. Some commentators have suggested that they may even have connived with them, a suspicion reinforced by the consultancy fees they received from Enron which exceeded their audit fees. Extraordinarily, despite the potential conflict of interest, there is no prohibition in America – or New Zealand, for that matter – on accountancy firms doing other work for the businesses they audit. Providing auditing and consultancy services to the same business is rife. Personal integrity may be insufficient to prevent impropriety. The auditing watchdog may be too busy chewing the (juicy) consulting bone.

The autopsies on Enron are incomplete, and the litigation and reflection will take years. In the interim shareholders would do well to ponder on the insights that develop from Berle and Means. This is not to say all corporate management is inefficient and corrupt, or even entirely self-serving. But again we see how an unregulated market does not fulfill the tasks the ideologists claim of it. At the very least there appears to be a need for major reforms in auditing and accounting practices.

Subjects Business economics