October 11, 2015

The Challenges of Delivering “Shareholder Value”

In the Saturday, August 11, 2012, issue of The New York Times, op-ed columnist Joe Nocera wrote an insightful piece called “Down with Shareholder Value.” Nocera points out the obvious fact that the single-minded focus on shareholder value has had many negative consequences for publicly held companies in terms of meeting their obligations to other constituencies. He also makes the less obvious point that by concentrating on share price appreciation, executive management destroys shareholder value over the long run.

I agree with Nocera’s observations. I would also state that the analogy of shareholders to owners of the corporation is flawed, as is the notion of management alignment with owners in terms of pay packages. There are two flaws with the analogies of shareholders to “owners” and managers being “aligned” with “owners:”

  • Implicit in the concept of an “owner” of a business is the principle that the owner has a stake in the survival and long term success of the business. In the case of public company shareholders, the hyper-liquidity of stock and the availability of derivative securities both mean that the “owner” can hold on to a share of stock or an underlying derivative security, such as an option, put, or call for no more than a few seconds. Many shareholders are not “owners” as we understand the term; they are “traders.” The concept of a “trader” is meaningless in a private business because stock cannot be traded; it can only be sold at the time of a “liquidity event” that happens occasionally and after a long period of time, and under the control of the majority owners.
  • The management can exit the company at any time and cash in on the benefits of having increased the stock price. In many respects, executive managers are more aligned with the company’s stock “traders” than they are with its “owners.”

Every public company shareholder population has some combination of traders and owners, and the public company CEO is responsible for helping each constituency achieve its goals. Even owners have to sell portions of their shareholdings to realize profits, and companies accommodate them by repurchasing shares from them in a large block outside the public trading markets. The benefit of a private share repurchase is that it does not drive down the price of the stock as it is happening. Companies also declare dividends to give shareholders some economic value, and increase those dividends over time.

However, the mix of “owners” and “traders” has skewed far more in the direction of “traders” in the last two decades. The holding periods for all publicly held companies have shrunk, and the need for short-term profit taking has increased, especially as institutional investors like pension funds are under severe pressure to meet unrealistically high investment returns to prevent them from having their companies or governments make cash contributions to top up the pension.

There is another problem with the analogy of “alignment.” Many decisions that improve the stock price today and for the next 12-24 months hurt the company’s long term prospects. For example, as we discovered when we acquired companies at Pitney Bowes, many companies produced relatively high earnings in the years before we acquired them, only to find that they had many assets that required immediate replacement and upgrade after the acquisition. It’s like buying a house and finding out that the roof is rotting and that the basement has termites. The earnings are obvious; the risks to future earnings are not. It is too tempting for many executives to pump up short term earnings, increase the stock price, cash out their stock options, get the lucrative incentive pay, and leave the company long before the problems with their short term actions are obvious.

Although Pitney Bowes Financial Services executives did not do this intentionally in the 1986-1989 time frame, the company realized significant profits from doing a number of leases with domestic commercial airlines, such as US Airways, United Airlines, and Delta Airlines. They took advantage of lucrative tax benefits, but there were three problems that were hidden from shareholder view:

  • None of the leases had protection against a credit downgrade of any of the lessees;
  • The transactions were effectively 24 years in duration; and
  • All of the tax benefits would have to be returned to the IRS if the leases were ever sold to another party.

Not surprisingly, the problems with these leases hit with a vengeance in 2002, as a result of the combination of a short term recession and the devastating effects of 9/11 on the airline industry. US Airways and United Airlines both filed for Chapter 11 bankruptcies and the other airlines threatened to do so. As a result, the value of these leases dropped by almost 70% and the company had to take a one-time charge against earnings that was over $213 million. The senior management team in place in 2002 was completely different from those who benefited from the leases in 1986-1989.

In fact, when I became the CEO, I attempted to sell all these leases, and my board of directors and I made a decision not to do so because the tax liability would have been in excess of $500 million. We made a collective decision to take the risks associated with holding on to the portfolio through the end of its useful life and to a later time. We ended up selling the business in 2006. The combination of the charges against earnings, improving economic conditions, and increased values of other assets gave us the ability to sell the external financial services business at a breakeven point, and increase the share price as a result.

We were a case study of why focus on shareholder value in the 1980’s was a bad move. The leadership at the time was applauded by a generation of “traders” who saw significant share price increases in the 1980’s. The leadership was responding to the shareholder value demands of those who held the stock, but the negative consequences of their actions hit a later generation of leaders and shareholders.

I concluded that the safest course of action for me and my executive team was to focus on shareholder value, but to do so on behalf of those shareholders who wanted to hold the stock for the long term. We essentially concluded that not all shareholders should be treated alike.

If I could wave a magic wand on corporate governance, I would award more voting rights to shareholders the longer they hold stock. I do not believe that someone who holds 1,000 shares for one week should have the same rights as someone who has held 1,000 shares for 20 years. However companies do this, they should design their capital structure to reward those who are committed for the long haul, whether it is through a class of preferred shares or through warrants or options that attach the longer someone is a shareholder of record, or through periodic stock dividends that attach to long term shareholdings.

I believe we get what we design, and a system designed to reward longer term “owners” will produce behavior that not only aligns with shareholders, but with employees, customers, and the community. Today the corporate governance rules imposed by federal and state law are insufficiently targeted at the real “owners” of public companies.