Friday, January 20, 2012

Richard Epstein: In Private Enterprise We Trust

The persistently fragile economic situation confronting the United States, Europe, and now perhaps Asia presents a grave challenge on how to best reverse the current trend of stagnation through the introduction of sound regulatory and business policies. In dealing with this issue, it is imperative to recognize that the proper response to short-term boom or bust cycles depends on developing those policies and practices that prove sustainable in the long run.

One notable attempt to chart the proper course was found in a recent op-ed in the Wall Street Journal by Al Gore and David Blood. It offered one prescription for how both the public and the private sector should work together to act on a “Manifesto for Sustainable Capitalism.” This energetic duo proposed a program calling on businesses to “embrace environmental, social and governance metrics” to turn their firms, and our nation, around. “That means abandoning short-term economic thinking for ‘sustainable capitalism,’” they wrote. The pair should be commended for their willingness to eschew stimulus programs, like the American Jobs Act, which many naïvely believe can revive our national fortunes.

Unfortunately, their general proposals set out the wrong balance etween government and private action, and run the danger of deepening the economic malaise that they hope to alleviate. The two great dangers that lurk in their framework point in opposite directions. The first risk is that any slavish attention to the “environmental, social and governance” metrics they propose imposes a procrustean bed on firms whose success may depend on their ability to adopt different business models tailored to their distinctive market niches. The second risk runs in the opposite direction. These guidelines will prove to be so bland that they will be useless for firms that have to make concrete decisions.

None of this fazes Gore and Blood. Their initial claim is that their version of sustainability should receive broad business support because it will allow firms to maximize profits over the long run. Indeed they point out how many successful modern corporations have followed their advice and, therefore, have not gone the way of BP and Lehman Brothers (which are poster children for how good firms go bad, they argue). But why propose a collectivist manifesto in the first place? The ordinary incentives that businesses have to make profits should direct them along the preferred path without any external exhortations from Gore and Blood, and without any direct regulation by government.

Indeed, it does. The basic logic of the corporate structure is that shares represent claims not only on the immediate revenues of the firm, but on all future revenues as well. One reason why the capital structure of most large corporations takes its current simple form is to encourage accurate assessments of long-term value. In direct contrast to small family-owned businesses, public corporations usually have simple capital structures: one class of common shares that is subordinated to particular debt issues, each for a discrete amount. That capital structure makes it easier for investors to determine the value of corporate shares because they do not have to wade through the difficult valuation issues posed by complex capital structures. Easier valuation of shares makes for thicker markets, which in turn leads to more accurate market valuations.

Pace Karl Marx, working out this program necessarily requires both buyers and sellers of shares to focus on the long-term value of the firm. Eating your seed corn works no better for corporations with complex assets than it does for farmers who know that if they ruin their soil today, there will be no bumper harvests in future years. All future revenues are caught by the current shareholders in the form of dividends and appreciation. All future liabilities are similarly impounded into share value, whether or not they have already been accrued on the corporate books. The ability of the current owners to sell their shares to outsiders allows them to cash out on the advantages of those future values, which their buyers then take in their place. That stock sale is not a simple wash. It creates gains by putting shares where they are valued most. In valuing firms, no responsible analyst of corporations looks exclusively at the short-term performance or quarterly reports. Current cash receipts and expenditures offer only a partial window into the welfare of the firm. But they are not the be-all and end-all of the entire analysis.

Unfortunately, Gore and Blood have picked a bizarre way to promote accurate assessments of long-term firm value. One of their odd recommendations calls on firms to “end the default practice of issuing quarterly earnings guidance” on the ground that these reports encourage a mentality that “overemphasizes” short-term profits at the expense of long-term wealth creation. But that criticism shows a profound misunderstanding of how valuation processes work. In general, the scarcity of information is one of the key stumbling blocks toward making an accurate assessment of the current value of the firm. Faced with this difficulty, too little information—not too much information—is the central problem. Wholly without regard to any requirements of the SEC, firms publish quarterly reports to supply some information to improve the estimates that shareholders and lenders make of the businesses. The want of this short-term information should have the predictable effect of reducing the value of assets. There is no way to evaluate the long-term prospects of a firm by ignoring all short-term data.

Nor does it help to say, baldly, that we need not worry about cutting out that information because the “standard” models of economics rely on, as Gore and Blood write, “the illusion of perfect information and the assumption that markets tend toward equilibrium.” Not so. The first part of this sentence has been uniformly rejected by economists and corporate experts of all stripes for well over 50 years. The only reason why valuation is so difficult is that the needed information is hard to obtain, verify, and interpret. No serious student in this area thinks that markets always tend toward some fixed equilibrium point. Rather, the view of efficient-market scholars is that, at the very least, markets will incorporate the best available public information on social and technological trends, which in turn helps prices to adjust quickly and accurately so as to minimize the deviation at any one time between market prices and underlying values.

Working in these complex environments also makes it difficult to figure out the proper compensation packages for key employees. Gore and Blood are surely right to note that it is risky to tie option values for certain corporate employees to short-term benchmarks, given the inevitable conflict of interest between the managers of the firms and the shareholders. But every other compensation plan also has its weaknesses too. A keen awareness of these pervasive conflicts of interest is not new information. Indeed, charting the best response to these conflicts has defined much executive compensation since the 1932 publication of The Modern Corporation and Private Property by Adolph Berle and Gardiner Means. The hard question is how best to tackle these difficult conflict issues. Alas, on this point Gore and Blood oversimplify a complex situation by insisting that financial compensation should be paid out over the long-term. Their approach would link compensation “to fundamental drivers of long-term value, employing rolling multiyear milestones for performance evaluation.”

Long-term targets are of course part of a comprehensive plan, but they are far from the whole story. Linking the performance of any individual manager to long-term conditions is not easy because the overall performance of a firm, or even a smaller unit within the firm, depends on the labor of many individuals, not just the particular employee. Holding off on compensation also makes it harder for individual workers to leave for other jobs, which in turn could easily make it more difficult to recruit prized employees in the first place.

In addition, it is important to let seasoned employees remove much of their capital from the firm in order to diversify their own portfolios. Doing this correctly usually requires committing employees to programs for orderly divestment, so as to avoid the risks of insider trading that could scare off outside investors who perceive that the deck is stacked against them. The ultimate solutions to these matters are at best provisional, but it is surely incorrect to think that tying key employees to long-term contracts is the only way to properly incentivize them. The supposed commitment to “sustainable capitalism” adds nothing to a proper understanding of the difficult issue of employee compensation. Anyone who says or hints that external government mandates might help on this issue is naïvely optimistic.

Any discussion of sustainable capitalism also has to pay attention to the roles of both bondholders and outsiders. The former is not addressed by Gore and Blood, but it is worth some attention. The key point here is that the officers and directors of a large corporation cannot be asked to shoulder fiduciary duties to two different classes of investors whose interests may diverge. The prime concern of bondholders is that firm asset values and cash flows never fall below the level needed to sustain interest and principal payments over the life of the loan. Accordingly, they gain little benefit from a large increase in firm value, all of which will be captured by the shareholders.

Shareholders are often more willing to roll the dice because they are cushioned from much risk, given that bondholders will bear a good deal of the loss if the business goes bankrupt. Yet those same shareholders are the only persons who win if the share value goes up. They therefore prefer riskier strategies. There is no one neat way to solve these conflicts. But it is clear that specific bond covenants, which indicate the targets that have to be met for the shareholders to stay out of default, offer the best general approach to this recurrent problem. These deals cannot be negotiated en masse, for each depends on concrete knowledge of firm and market conditions that no outside commentator or regulator could hope to understand. The entire process thus cries out not for manifestos, but for good judgment that has to be exercised on a case by case basis.

Controlling environmental externalities takes a somewhat different course. The great danger here is that pollution and other harms from business activities will produce negative externalities (soot, odors, and the like) which self-interested individuals and firms will not take into account, even if imbued with a sense of social responsibility. The situation can get more complicated with corporations, where limited liability can shield the personal assets of shareholders from answering for the firm’s derelictions. It is therefore incumbent to find some way to coerce corporations to take these obligations into account.

It is proper, as Gore and Blood suggest, to ask corporations (along with everyone else) to attribute “a reasonable price to carbon or water.” But the correct way to do this is not to jawbone companies about their social responsibility. It is to develop the best mixture of taxes, fines, and standards that will induce firms to minimize the risks in question. There are, of course, no markets for setting these prices. Government must take this job on directly or implicitly when it sets the appropriate level of taxes or defines some overall cap for particular pollutants. The Gore-Blood op-ed assumes that the great risk lies in setting these prices too low. In truth, setting the taxes too high or the quotas too tight is equally destructive if it results in the unnecessary curtailment of productive activities.

Setting the targets is a social function that should be based on the best scientific information available. Once that is done, the corporation is responsible for complying with the external demands. If the public signals are sound ones, the private responses should work relatively well without any grand manifestos. But if the social targets are set incorrectly, the efficient corporate response to those standards will have the unfortunate effect of spreading those government errors throughout the system. Just that happened when bad government signals, through mispriced loan guarantees, underestimated the default risk of subprime mortgages.

At the most general level, the Gore-Blood program contains a profound misdiagnosis of the sustainability problem. But the issue remains real. So the question arises, why all the current anxieties over the economic prospects of the nation? I address both of these issues in my essay Why Progressive Institutions are Unsustainable. The answer lies in the interaction of two key effects, neither of which they address. The first, on the fiscal and monetary side, arises from the unsustainable rise in transfer payments, which requires higher taxes to sustain. The second, on the regulatory side, comes when the government insinuates itself into the operation of private markets, most conspicuously with employment and real estate.

The growing edifice of transfer payments must now be supported by a smaller base of material assets. That one-two punch leads to chronic economic stagnation. Faced with these daunting constraints, it really does not matter whether firms buy into a model that features the high level of social responsibility that Gore and Blood preach. Virtuous firms can be strangled by excessive government regulation, even when propounded by the false friend of sustainable capitalism.

Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago.

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