Public Companies

Insofar as these posts have a consistent theme (a proposition sometimes questioned by friends), it is that people should almost always be expected to behave as they are incentivized to behave and equally expected to avoid taking actions that are penalized. So if on-the-books work, saving and other broadly responsible/self-reliant/socially contributory behaviors are seriously disadvantaged by our tax and entitlement systems, and they are, we should expect that those who are proportionally most affected by those systems, i.e., the poor, will behave in manners not pleasing to the bourgeois eye. To condemn those so situated for responding rationally to the incentives and disincentives we put before them is ridiculous.

What I have not yet touched upon that is equally true and based on the exact same principle is the way that business people also respond rationally to incentives that are sometimes just as ill-considered as the government programs that, for all their short-term benefits, misdirect the poor. People are people, rich or poor, and they do the best they can to take advantage of their opportunities as they see them.

Consider the incentives for employees of large, publicly-owned corporations.

Most companies are pyramids from an organizational perspective. The CEO is at the top, of course, and lots of people are at the bottom. In between are layers and layers of workers, almost every one of whom would like to be higher in the pyramid, as higher positions invariably entail better pay and perks and more power and prestige.

What it takes to rise in the pecking order is the approval of your boss – which may or may not have anything to do with meeting the needs of the broader organization, its owners or customers. Over the four decades in which I worked in all kinds of companies, public and private, I came to see that the bigger the company, the more the organizational behavior of its employees could be characterized as feudal – and nowhere is that comparison more apt than in big, public companies.

As a knight, your interest is in the success of your particular lord, not the Holy Roman Empire. If you help your lord, he helps you. Each lord, often in competition with others who may theoretically owe allegiance to the same emperor, depends on the absolute fealty of his knights. Show personal disloyalty to your lord, even if in the putative interest of the Empire, and you’re a dead man. So you follow him even into battles that make no sense at all.

Entirely apart from the positioning that it takes to get to the top of most large businesses, you might have observed that I wrote (as an “of course”, no less) that the CEO is at the top of the pyramid, the corporation’s emperor-equivalent, answering only to God. The government plays the role of the medieval popes, collecting taxes, setting the rules and sometimes selling indulgences.

In theory, that’s not right: the CEO is supposed to report to the board of directors, which represents the interests of the shareholders, so the board should be above the CEO, with the shareholders above it. In practice, good luck with that as far as most large public companies are concerned.

As evidence supporting my skepticism, consider the recent, long-running tenure of Jeff Immelt as CEO of GE. He ran the place for 17 years, during which time he earned aggregate compensation in the hundreds of millions. To be fair, in his last year of employment, in light of tough times at the company he took a pay cut to a mere $17m. We don’t have to worry about him starving, though, because his retirement benefits are reported to have added another $200m or so to his lifetime earnings. He’ll be ok.

During the time of his leadership, GE’s market capitalization declined from $400 billion to about $125 billion. Total returns to shareholders were approximately zero, raised to nominal breakeven from negative territory by dividends, so in a very real sense, it was a company in slow liquidation. In the same years, total returns from the S&P 500 were over 100%.

During this whole period, GE’s board, theoretically charged with protecting the shareholders’ interests, consisted of luminaries from across the land. In fact, since at the beginning of this period GE was the most valuable American company, it’s reasonable to assume that the company was able to attract literally whoever it wanted for its board.

No doubt those board members were (and are) exceptionally smart, accomplished people. And I’m sure they meant well.

Even so, what did they accomplish while on the GE board – a sinecure like few others? Nothing. They collected their board fees and got to hobnob with each other. Oh, yes, and they bought everything Jeff Immelt was selling, approving his pay packages year after year while the shareholders lost more and more relative value. No doubt they also got to do a lot of flying on one of the two jumbo-jets that Immelt used for every overseas trip.

Well, Immelt only flew on one plane at a time, naturally, but the other was always on similar flight patterns for use as a spare. Astonishingly, he now claims not to have known that his flights were being shadowed by another GE jet – so I guess he wasn’t ever exactly a detail-oriented, “the buck stops here” kind of guy. No doubt he had other strengths.

For a great, if horrifying, read, google “Immelt Success Theater”. You will come up with a terrific Wall Street Journal article that, for some reason, I can’t link to. Its point is broadly that Immelt bamboozled the board for seventeen years, forever promising, but never delivering, brighter tomorrows. The article is a searing indictment of Immelt, naturally enough, but also of GE’s board.

My point is a little different. The Immelt/GE fiasco is spectacular evidence that at large, public companies with widely held ownership, all too often, nobody really represents the owners. Does anybody think that Immelt would have held onto his position during all those years of lost value if GE had been owned and controlled by one person who was naturally incentivized to not allow the loss of hundreds of billions in his or her relative value? Impossible.

GE’s board members had really nice gigs. And who did they really think called the shots on their continued tenures? Jeff Immelt. Immelt had an absurdly good gig – whether or not the shareholders thrived – as long as the board let him run the show. The employees who worked under Immelt also had great gigs (the next level down executives earned annual pay of about $10m per annum, as long as they sang Immelt’s Success Theater tunes). Everybody was happy – except the folks who owned the company. They were the ones paying for the show, but presumably not enjoying it.

There’s no reason to believe that the managers at GE were or are any less bright than other businesspeople. On average they were probably more so – they have always recruited high achievers from fantastic schools and – clearly – they paid well. Nor is there any solid ground for assuming that they were more venal than most; to the contrary, I worked closely (as a corporate borrower) with a pretty senior person at GE Capital for more than a decade, and he is a thoroughly ethical guy.

I would even bet that if I knew Immelt I would be able to report that he’s a bright man who did his absolute best. He really thought that palling around with President Obama and dreaming big about “Ecomagination” would pay dividends for his shareholders. Bummer that it didn’t happen. Year-in, year-out, it didn’t happen.

Immelt, like everybody else, was most motivated to look after his own interests. And that’s what he did. Pretty much everybody did, except the shareholders, who trusted to a system that didn’t actually care much about their interests. Their bad.

I believe fervently in the merits of incorporation, which is a vital component of capitalism, the most innovative, wealth-generative, free and ultimately fair economic system ever devised. I also believe that the investing public, of which I am a member, is lucky to have opportunities to own shares in companies, small and large, that wish to raise capital.

But we investors have to be mindful that companies, like every other system involving human beings, will always be gamed by people seeking personal advantages. The inherent clashes of interests are often particularly unbalanced in large public companies, where the ultimate owners are out of sight and mind of the employees.

The mistake the shareholders of GE made was in not paying enough attention to making sure that management’s incentives – and the board’s – were well aligned with their interests. It’s an all-too-common mistake.

The bigger corporations are, and the more remote their owners are from exercising real oversight, the more the interests of the owners are likely to be lost in the sea of other employee motivations – which is why big public companies almost invariably lose their ways sooner or later.


M.H. Johnston

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