Innovative Enterprise Solves the Agency Problem

This chapter uses innovation theory to provide both a general theoretical critique and a selective empirical critique of the use of agency theory to rationalize the looting of the U.S. business corporation as enhancing economic efficiency. It focuses on three empirical works, Bebchuk and Fried, Pay Without Performance (2004); Bebchuk, Brav, and Jiang, “The Long-Term Effects of Hedge-Fund Activism” (2015); and Fried and Wang, “Short-Termism and Capital Flows” (2017). The chapter contends that MSV ideology as promulgated by agency theorists has contributed to inferior corporate and economic performance. It then argues that, for analyzing the operation and performance of the economy, innovation theory should replace agency theory.

The Value-Extracting Enablers

This chapter explains historical and systemic sources of institutional activism. Starting from re-examining underlying principles of New Deal financial regulations established in the 1930s that discouraged institutional activism, it argues that they were overturned in the 1980s and 1990s in the name of promoting “shareholder democracy.” It analyzes these misguided regulatory “reforms” including the introduction of compulsory voting by institutional investors, a proxy-voting rule change that greatly facilitated aggregation of proxy votes by predatory value extractors. The chapter argues that those reforms created a large vacuum in corporate voting because, contrary to the ideal of shareholder democracy and particularly with the increasing dominance of index funds, institutional investors had little ability and incentive to vote the shares in their portfolios. The main beneficiaries of these reforms have been the leading proxy advisory firms and a small group of hedge-fund activists intent on looting the business corporation.

The Value-Extracting Outsiders

This chapter exposes a particularly aggressive species of activist shareholder, hedge-fund activists, who are ready to take advantage of changes in proxy-voting and engagement rules to enhance their value-extracting power and to build private “war chests” that serve to enhance their value-extracting power even more. It examines the evolution and the current state of hedge-fund activism. After explaining this phenomenon’s origin and expansion, it investigates in particular Carl Icahn’s transition from the most representative corporate raider to one of the most “successful” hedge-fund activists in order to delineate vividly the characteristics and methods of the new value-extracting outsiders. It also examines how “co-investments” between hedge-fund activists and institutional investors are carried out.

The Business Enterprise as a Value-Creating Organization

This chapter presents a theoretical perspective—the Theory of Innovative Enterprise—that enables us to understand the evolving relation between value creation and value extraction. The Theory of Innovative Enterprise posits that business enterprises are central to the achievement of stable and equitable economic growth and offers an analytical framework for understanding the processes of value creation and value extraction as prime micro-level determinants of macroeconomic outcomes. Specifically, it analyzes the dynamic interaction of three social conditions of innovative enterprise—strategic control, organizational integration, and financial commitment—in determining both the value-creating capability of a business enterprise—its ability to generate higher-quality products at lower unit costs—and the distribution of value created by the enterprise among participants in the value-creation process. It provides a rigorous and relevant alternative to the prevailing market-based theories of the firm.

Reversing Predatory Value Extraction

This concluding chapter suggests the following changes in the United States’ corporate-governance regime that can get its economy back on the path to sustainable prosperity: (1) rescind SEC Rule 10b-18 and ban open-market stock repurchases; (2) redesign executive pay to incentivize and reward value creation, not value extraction; (3) reconstitute corporate boards of directors to include to include representatives of households as workers, as taxpayers, and as savers as well as households as founders—and exclude the predatory value extractors; (4) reform the corporate tax system so that it returns profits to taxpaying households and funds government spending on infrastructure and knowledge for the next generation of innovative products; (5) redeploy corporate profits and productive capabilities to support collective and cumulative careers, and thus enable widespread upward socioeconomic mobility.

The Value-Extracting Insiders

This chapter focuses on the general transformation of senior corporate executives in the United States from industrialist leaders dedicated to value creation into financial engineers intent on value extraction. It argues that, being incentivized by stock-based pay and legitimized by MSV ideology, senior executives of major American corporations began in the 1980s to turn their backs on long-standard practices of resource allocation: Ceasing to retain profits and reinvest them for the future, many executives placed the emphasis on cost-cutting and distributing profits to shareholders in the form of not only dividends but also stock buybacks Some companies’ distributions to shareholders have exceeded 100 percent of net income for years, even decades. This chapter emphasizes the dire consequence of executives turning from value creation to value extraction.

The Stock Market as a Value-Extracting Institution

This chapter debunks the conventional wisdom that the primary function of the stock market is to be a value-creating institution, raising cash for corporations by pointing to the fact that the separation of ownership and control in the past occurred because of a managerial constraint, not a capital constraint, as well as the fact that, throughout the twentieth century and continuing in the twenty-first century, the U.S. stock markets have been net extractors of money from the corporate sector. The chapter explains the five general functions of the stock market: Control; Cash; Creation; Combination; and Compensation. It then analyzes how a broad adoption of the MSV view changed the relative importance of those functions and eventually brought about the imbalance between value creation and value extraction.

The Growing Imbalance between Value Creation and Value Extraction

This introductory chapter explains how the US economy has transitioned from the “retain-and-invest” regime to the “downsize-and-distribute” regime, resulting in the growing imbalance between value creation and value extraction. It posits that this corporate-governance regime change was integral to the explosion of the incomes of the richest households and the erosion of middle-class employment opportunities through three major structural changes, “rationalization,” “marketization,” and “globalization.” It also highlights the academic roots of the regime change, that is, the nonsensical theory of the “unproductive firm” in neoclassical economics and the maximizing shareholder (MSV) view of the world that builds on it. The chapter then summarizes the contents of each chapter of the book.