26 June 2015

How to make capitalists think long-term

By

Sajid Javid, the UK government’s Business Secretary, recently said that the free market was the greatest force ever created for lifting people out of poverty. But, he continued, “we must not lose sight of the fact that it’s an artificial creation. It is not the natural order of things. We have to consciously choose to embrace it”. A free market is not “passed on but must be fought for, protected and defended”.

In his first speech as Business Secretary he had explained how his father and mother had run a clothing business in which he had worked from the age of ten. This experience gave him lasting respect for people who worked all hours and took personal responsibility for establishing and developing their business. It made him realise that it is not the government that creates jobs but the energy and ingenuity of entrepreneurs.

He went to explain how his Enterprise Bill will sweep away unnecessary obstacles to entrepreneurship. Moreover, the Bill will prevent big companies from imposing harsh or unfair terms on small and medium-sized enterprises by creating a new conciliation service to mediate between SMEs and big corporations. Wait a minute! We expect some sweeping away of burdensome regulations, but creating a new quango to protect small businesses from predatory big business. Isn’t this a bit Milibandish?

Not really. His remark that the free market is an achievement and not a state of nature reveals a pragmatist at work. As many free-market economists have noticed, throughout his voluminous masterpiece, The Wealth of Nations, Adam Smith barely has a good word for business and commerce. Famously he thought that, even when gathered together for social merriment, business leaders would seize every opportunity to put their customers at a disadvantage.

The atmosphere in which the Business Secretary learned to respect the hard graft of running a small family business is very different from the sentiments that pervade the modern boardroom. As Martin Wolf, chief economics commentator at the Financial Times, has argued, the “core institution of contemporary capitalism”, the limited liability shareholder corporation, has “inherent failings”, the most important of which is that companies are not effectively owned. As a result they are vulnerable to ‘looting’ by executives. Shareholder control, he said, was often an illusion and maximisation of shareholder value “a snare, or worse”.

There is no viable alternative to a market economy, but we need to confront the fact that some characteristics of today’s dominant institutions – above all the shareholder corporation and modern equity markets – are in urgent need of reform.

Consider our largest manufacturer, BAE Systems. In September 2011 it announced nearly 3,000 redundancies, mainly because of falling defence orders. A couple of months earlier, in July 2011, the company had announced a share buy-back of up to £500m. Investors welcomed the move, pushing the share price up over 5 per cent. BAE had cash of about £2.8bn on its balance sheet at the end of 2010 and during the year it had used £520m to buy back shares, bringing the total expenditure on buy-backs in 2010 and 2011 to £1.2 billion. Why did it not use its reserves to develop new products to take advantage of the proven capabilities of its highly-skilled workforce? Because buying back shares allows senior executives to increase their bonuses. Companies that buy back their own shares cancel them in order to increase earnings per share, without adding to real profitability. A Citigroup research note quoted in the Sunday Times said: “BAE management is, indirectly, incentivised to continue share buybacks … We would argue that buybacks are the easiest and least risky way to boost earnings per share.”

As a study by Simpson Associates has revealed, BAE also under-invests in research and development compared with the most successful companies, such as those entering the UK and German Manufacturing Excellence Awards. They spend about 6% of operating revenue on research and product innovation, whereas BAE spends about 3%, the general level in the UK. Outstanding German companies such as Bosch spend over 8%.

Do we need to encourage a new kind of private enterprise corporation committed to long-term prosperity? Based on developments already under way in America, reform could take three beneficial directions. First, corporate articles of association could be changed so that executives can lawfully take into account interests other than those of shareholders, including the interests of employees and the long-term interests of the company. The second possibility is to use corporation-tax rules to discourage arms-length shareholding and promote proprietorship. And third, dual share classes can be permitted.

Under the 2006 Companies Act the interests of shareholders are assumed to be dominant. To take one example, Sir Roger Carr, the chairman of Cadbury during the takeover by Kraft, told the Kay review of UK equity markets in 2012 that the board had believed it was under a legal obligation to accept the Kraft offer. Even if it had considered that an offer was not in the long-term interests of the company, the board believed it was bound to accept any bid that reflected the value of the business. In America, however, some states are now introducing a new type of corporation, the “benefit corporation” or B corporation.

This is how the legal obligations of directors are framed in some US states. They are permitted to take into account “the long-term prospects and interests of the Company and its shareholders, and the social, economic, legal, or other effects of any action on the current and retired employees, the suppliers and customers of the Company or its subsidiaries, and the communities and society in which the Company or its subsidiaries operate.” Specifically, when considering takeover offers, directors can accept the lower of two offers if they think it best serves the interests of all stakeholders.

The uncomfortable truth is that the vast majority of shareholders have no real commitment to the company whose shares they own. They value shares primarily because they can easily be turned into cash. According to the Bank of England’s Andrew Haldane, the average duration of equity holdings in the UK fell from about 5 years in the mid-1960s to two years in the 1980s. By 2000 it was slightly over 12 months and just before the crash in 2007, it was nearer 7 months.

A second remedy for irresponsible ownership has also been attempted in the USA. Since 1958 US companies have been able to register with the tax authorities as either a ‘C corporation’ or an ‘S corporation’. The chief difference is that a C corporation pays corporation tax, while an S corporation does not. In the latter case, all profits and losses “pass through” to the shareholders. Ordinary income tax is paid when individual owners take money out of the company, for example when dividends are received, but profits retained in the company are not taxed. To qualify, an S corporation must have no more than 100 shareholders. The small number of shareholders makes it more feasible for owners to know one another face to face. Shares cannot be sold in public markets but they can be sold privately. The proprietorship encouraged by American tax law is what gives its small-company sector its vibrancy.

Should we go a step further? It would be preferable to create companies whose objects obliged directors to serve the interests of the locality, the workforce and the nation, as well as those of shareholders. Let’s call such companies productive enterprise companies. In return for registering as a “productive enterprise company” and accepting the obligations to the workforce and the wider public, there would be no corporation tax and no capital allowances, so that investment was just another business expense. Any profits taken out of the company would be taxed as individual income at the highest marginal rate, while earnings retained for investment would be tax free.

Under such a regime decision making in a company like BAE would no longer be distorted by conflicts of interest, such as those between executives and shareholders, executives and employees, and large shareholders and small shareholders. Instead, directors could pursue the long-term interests of the company. Such companies would be more likely to see that their main business asset was the capabilities of the workforce. Faced with declining orders for one product, they would not judge some of their workforce to be “surplus to requirements”, but the solid foundation on which the business rests. Instead of sacking people, a productive enterprise company would find new products that could be made with the skills already in house. It’s what good companies already do, but not those driven by the frivolous buying and selling of modern stock markets.

Toyota has recently shown a third way of encouraging shareholder commitment. It is about to issue a new class of voting shares that must be held for five years. They will cost 20% more than ordinary shares and will receive guaranteed dividend payments rising from 0.5% in year 1 to 2.5% in year 2. At the end of the five years, they can be converted to ordinary stock or sold back to Toyota at the issue price. The five-year period was chosen because that is the timescale for the research projects that Toyota has in the pipeline. Different classes of voting shares are currently frowned on by the London Stock Exchange and the time has come to change the rules.

There is no alternative to a market economy. Few want a return to the collectivism of old, but the institutional shape of capitalism can take many forms. Above all, there is nothing inevitable about the limited-liability shareholder corporation in its current condition. As the great economist Hayek remarked, corporations are the result of “special conditions which the law has created and the law can change.”

 

David Green is Director of Civitas.