[MUSIC] But what we're going to do today is review this concept of shareholder value. Put it through a kind of critical lens and see what conclusions we can draw. I'll remind you that one of the, sort of, recurring ideas behind our class is to examine common management practices. And to consider them in critical perspective. So, in the first in our first session, one of the things that we talked about was, is growth a reasonable or is, as growth as the only benchmark of success? Is that a reasonable a reasonable idea for a firm to pursue should we, constrain ourselves by using growth as the only metric that we know to define success. We also look for example, at the question of constraining agency cost. A question we're going to look at today and we said, you know, is monitoring the most effective way for constraining agency cost and operation. Or should we consider other forms of constraining agency cost like, and we focused particularly on reputation mechanisms. Do reputation mechanisms serve those outcomes better? We also looked at the question of innovation. We asked is innovation as a strategy really the best kind of idea for firms to use, as a sort of road map going forward? Are there other ways that firms should be able to assess their own performance operations, so on? What happens to a firm if it can only think in terms of innovation as a way to move forward? And then we also looked at this idea of narrative. We looked at the question of how we form the decisions that we take. What kinds of information we choose to select. We noted that there seems to be systemic confirmation bias that exists in our world. And that we often take very important strategic decisions based on essentially self-selected information, which often produces adverse results. Well, today we're going to come to, perhaps one of the most important elements of management theory. The question of shareholder value. It's an idea that I think is still very prevalent today in the public marketplace and ask some critical questions about it. And then, further on, we're going to look at and do an exercise. And we'll ask then. We'll take a real world example and see what are the consequences of the shareholder value paradigm of corporate governments? But to begin, I'd like to tell you a story, basically. And I'd like to being my story in 1957. With a quotation which will probably be familiar to many of you all be it bowdlerized or incorrect form. It's a quotation that comes from Charlie Wilson during his confirmation hearings as the Secretary of Defense under the Eisenhower administration. Before being named to the Secretary of Defense position, Charlie Wilson was the CEO of GM. And so when he came up before the senators, there was a reasonable suspicion that Charlie Wilson as Secretary of Defense might steer contracts GM's way. He might in fact, be acting in the interest more of General Motors than he was in the interests of the country. And so the normal comity of the senate was somewhat disrupted as a result of this suspicion. And he was subjected to unusually harsh questioning by the standards of the time. And in response to those questions, he said something which has subsequently become extremely famous although in a version different from a way that he stated it. You will know the quote as what is good for GM is good for America. That's the most famous thing that Charlie Wilson never said. What he actually said was I have always assumed what is good for the country is good for GM and vice versa. What is good for the country is good for GM. And visa versa. And I think we can take an abstraction from that idea and make it into a proposition that what is good for a country is good then for the firms that operate in those countries. I think that is a reasonable proposition for us to use as a starting out point. And we can then take that proposition and at the end come back to it and see if shareholder value and these other forms of corporate governance that have arisen over the last 40 years. Are consistent with that proposition articulated by Charlie Wilson back in 1957. What is good for the country is good for the firm, and vice versa. And in turn, that invites us to ask another important critical question that we don't, I think often, ask ourselves often enough. Which is: what kind of capitalism do we want? And I ask that question not only from the point of view of individuals. We as individuals sitting in this room, we as individuals participating in this discussion, what kind of capitalism do we want? But also what kind of capitalism do we want from the point of view of the firm? Is the kind of capitalism that we have developed over the last 40 years in the best interest of the firms that are operating under that system? We will also come back to that question at the end of our discussion. So in the context of shareholder value theory, I think the real question here, to ask here is, why? Why does shareholder value theory emerge when it does, with the force that it does, such that within several decades it becomes the dominant, overwhelming framework for driving corporate governance? Where does it come from? And I'm going to give you two theories, I'm going to give you an orthodox theory. And I'm going to give you a heterodox theory about why shareholder value theory emerges in the 1970s as a reigning principle driving the future of corporate governance. Let's start with the orthodox theory first because the heterodox theory is one of my own invention and so therefore I don't think quite as solid as the orthodox one. The orthodox theory in a nutshell, and you'll have to accept that I'm obviously simplifying for the purposes of time. We might start the orthodox theory with a famous article published by Milton Friedman in 1970, in the pages of the New York Times. In which he wrote in this op-ed, that management is an agent of the owner. That the job of management is to return money back to the owners of the firm. And therefore a manager should essentially seek to make as much profit as possible for the owners within ethical boundaries. That's sort of clarion call issued by Friedman in 1970 was followed up with an extremely important academic work in 1976, Jensen and Meckling's, article Theory of the Firm. In which they essentially review the firm from the lens of agency. We've already seen this question of agency in our earlier session. And Jensen and Meckling brought that question of agency into focus when it came to the firm. For this, to understand the Jensen and Meckling argument, we need to simply evaluate a little about what these firms were like that Jensen and Meckling were surveying in 1976. These were these large American conglomerated firms that had widely diversified operations, traded publicly. That was the sort typical operation that Jensen & Meckling were using with which to scrutinize then, firm operations. And their argument, and I'll have to simplify it a little bit, but their argument was fairly straightforward. Which was that in that kind of a firm context, with those kinds of firms, there were systemic agency cost at the level of senior management. Which is to say that the management of these large conglomerated firms were more interested in securing their own future than they were in optimizing firm results. And that led to systemic inefficiencies and adverse outcomes for the firms involved. We've seen this already about practices that we've set up today to monitor agency costs at lower levels. So we've seen at the kind of lower strata of employees, what kinds of strategies firms use in order to minimize agency costs. We evaluate, we, we looked at the so-called force rank distribution scheme. We see that the answer that most firms use today is monitoring. So in other words, if you can monitor your agents, you will be able to minimize agency costs. But once you get to the level of senior management, monitoring becomes rather more awkward. Who monitors the CEO, the CFO, the, the top, the top brass? We might remember that quote from Juvenal, right? Quis custodiet ipsos custodes? Who shall guard these same guardians. And that was the problem then that Jensen and Meckling identified in their famous 1976 article. Was that there were systemic agency problems at the level of senior management. In other words, senior management was engaged systematically in extractive practices, seeking to draw wealth out of the firm for their own gain, seeking to pursue strategies in their own interests, rather than in the interests of the firm itself. To put this into a sort of specific example, we might say when a firm, firm x, decides to buy an asset, why does it choose to buy that asset? Does it choose to buy that asset in order to improve its results, create more profitability, expand its operations? Or does it buy that asset in order to improve the career prospects of the person who's in charge of the decision? And one of the problems with the systemic agency cost is, that's not always so clear. So, Jensen and Meckling identified, as a failure, or as at least a weakness of the firm, the presence of these systemic agency costs within the firm and suggested that one of the ways you could control for those agency costs was to find a form of oversight that would serve as an effective counterweight to that kind of management behavior. Well, we might say it's the Board of Directors. But the problem with the Board of Directors is they also suffer from this kind of agency problem, a kind of a crony environment. How do you know that the Board of Directors are providing the kind of oversight that the firm needs in order to generate those best outcomes? Well, happily for the evolution of shareholder theory there was a developing economic idea starting in the late 1960's, the early 1970's, known as efficient market theory. EMT, or efficient capital market hypothesis. Some of you may have heard of this. And the argument behind that is that given information available, markets will always price assets in the most efficient way possible. This then gave the opportunity, or at least gave the potential for con, controlling solving for that, that agency cost problem. Who can provide the oversight? [FOREIGN] And the answer could be, perhaps, the markets themselves. If the market can become an oversight mechanism for these firms. If you use the markets by which to judge performance, then perhaps you can optimize performance and minimize agency costs at the level of senior management. What is the tool, what is the piece of information that the market has to provide a firm about it's performance? It is it's share price. It is the price of a share of a company. And if the share goes up, the market is signaling good things. And if the share price goes down, the market is signaling bad things. And if you put the focus then on that share price, what you're really doing is you're providing the kind of oversight that management, senior management needs in order to constrain its own systemic agency problems. And so from that sort of idea introduced by Jensen and Meckling in 1976 in the Theory of The Firm. In which the firm is read as embedding these inherent agency costs market oversight seems to become a É or does become a critical part of the equation in terms of resolving that dilemma. In other words, if firms start to focus on their share price, the outcome will be a minimization of the agency costs at the level of senior management. And the kinds of extractive strategies that senior management hitherto had used, had employed, in order to secure their own gain, their own benefit, would no longer be effective or efficient, because markets would effectively punish strategies like that. Such that by the 1980s, following the Jensen and Meckling hypothesis, and additional work on the efficient market, efficient capital market hypothesis, Shareholder value becomes an increasingly compelling idea for firms to drive their own enterprise value in the context of the public marketplace. That's the orthodox story. And it's a pretty good story. It sounds pretty good. [BLANK_AUDIO]
