Milton Friedman and James Otis: Defenders of Liberty

I’m going to warn everyone upfront this entry may be considered controversial. Some of you won’t like it. I doubt I will get invited to sit on any boards after this (though I would suggest my arguments below are precisely why I should). It is going to border on political, even though I really want to keep politics off this blog. However, it is mostly about the future of the business environment in this country. For the record, I don’t like the direction it’s heading.

ESG has gone from an interesting development to a full-blown virus within corporate America. Companies trip over themselves to make the list of Most Sustainable Companies. Just within the last few weeks, both Travelers and AIG hired Chief Sustainability Officers. How that is an executive position at a corporation I don’t know, but I’m sure I’ll be hearing a lot more about it.

Recently, the Business Roundtable essentially set itself on fire, changing its objective from maximizing profits for shareholders to prioritizing “stakeholder” concerns. This is a tragic moment for America.

I have much to say below about why I think this is happening, what it means, and better alternatives. I will lead here with my conclusion which is I think the CEOs who signed this statement did so only secondarily because they care about stakeholders interests. Their primary motivation was their own self interest.

I will share upfront before diving into the details that very few people have shaped my professional worldview more than Milton Friedman. So, yes, I have a bias here. I doubt I am up to the task of defending him, but I will give it my best shot.

First, A History Lesson

Nearly 50 years ago, Milton Friedman wrote a famous editorial for the New York Times which was essentially a mission statement for corporations. I suggest you all click the link and read it.

One of the first things that will probably be impressed on you is that the “stakeholder” movement is nothing new. Friedman was fighting it 50 years ago (and won). The naive perception that “it was different back then” and we need something “new” for our more “complex” times is hogwash. We are literally repeating history.

The most powerful part of Friedman’s case is made on the second page.

What does it mean to say that the corporate executive has a “social responsibility” in his capacity as businessman? If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers. For example, that he is to refrain from increasing the price of the product in order to contribute to the social objective of preventing inflation, even though a price increase would be in the best interests of the corporation. Or that he is to make expenditures on reducing pollution beyond the amount that is in the best interests of the corporation or that is required by law in order to contribute to the social objective of improving the environment. Or that, at the expense of corporate profits, he is to hire “hardcore” unemployed instead of better qualified available workmen to contribute to the social objective of reducing poverty. In each of these cases, the corporate executive would be spending someone else’s money for a general social interest. Insofar as his actions in accord with his “social responsibility” reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers‘ money. Insofar as his actions lower the wages of some employees, he is spending their money. The stockholders or the customers or the employees could separately spend their own money on the particular action if they wished to do so.

Milton Friedman (any emphasis above is mine)

This point is so often lost on people. Their heart may be in the right place, but they don’t understand the consequences of what they are advocating. The “stakeholders” they are fighting for will get paid less at work and pay more for that which they consume. They will have a lower living standard. Is this what we want???

I will quote one more section at length because of the irony involved given today’s rapidly changing political climate.

The whole justification for permitting the corporate executive to be selected by the stockholders is that the executive is an agent serving the interests of his principal. This justification disappears when the corporate executive imposes taxes and spends the proceeds for “social” purposes. He becomes in effect a public employee, a civil servant, even though he remains in name an employee of a private enterprise… This is the basic reason why the doctrine of “social responsibility” involves the acceptance of the socialist view that political mechanisms, not market mechanisms, are the appropriate way to determine the allocation of scarce resources to alternative uses.

Milton Friedman (any emphasis above is mine)

Yes, concerns over the spread of socialist thought were just as present fifty years ago as today. The main difference today is we are (so far) lacking a Milton Friedman to step up and defend capitalism.

What Did the Roundtable Do Exactly That Was So Bad?

They abandoned shareholders to grant themselves more power. Think I exaggerate? Read their own words. Instead of re-affirming their commitment to corporations being run for the benefit of their owners (i.e. shareholders), they threw shareholders overboard to make room for the “stakeholders” (aka Friedman’s “social responsibilities”).

Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance that include language on the purpose of a corporation. Each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders. It has become clear that this language on corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable. (added emphasis is mine)

Before one suggests “maybe what they’re trying to say is there’s room for both”, you might want to read how they took the above principle and re-wrote the mission statement.

While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:
* Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
* Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
* Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
* Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
* Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders. (added emphasis is mine)

Notice what comes last in that list! Only after we serve all our other interests, will we worry about you, the shareholder, who hired us to manage your business!

Why Are CEOs Doing This?

Great question! Let’s revisit Friedman’s editorial again to remind ourselves what a CEO’s job is.

[I]n his capacity as a corporate executive, the manager is the agent of the individuals who own the corporation…and his primary responsibility is to them

Milton Friedman

This is often forgotten. A CEO’s job is to represent the owners of the company. In this sense, it is no different than a hotel owner who hires a manager to run the business or even a football team’s owner who hires a general manager to evaluate players.

Imagine if Brian Cashman went to the Steinbrenners and said gender diversity was very important to him so he was going to make the team half female and that, to save cows, he would make his fielders use gloves made from corn husks instead of leather. The Steinbrenners would fire him immediately. They are the only ones with the authority to make social statements with their team if they so choose.

The general manager’s job is to gather the best players, not to do social good. He is the owner’s agent, not the principal. He doesn’t have autonomy. In fact, I’d bet the New York based CEOs who signed the Roundtable document would be aghast if the Yankees did things that would hurt their ability to win games.

Most CEOs forget they are agents. They often treat shareholders as an inconvenience to be dealt with, rather than as their employer. This is the crux of the problem. CEOs want more power. They want to be the principal.

CEOs Are Emulating Politicians

Recall Friedman’s statement about how when CEOs act in their social interests, rather than for the shareholder, they have become “public employees”, i.e. politicians. Now we’ve gotten to motive! These CEOs want the power and job security of politicians! They don’t want someone else telling them what to do!

What is one of the secrets of successful politicians? They appeal to multiple interest groups, rather than be beholden to one. This allows them to do a little bit to keep each one sort of happy and none of them alone have the power to vote the bum out.

Notice what CEOs did with this statement: they created five “interests”. Now, if the stock is doing poorly, they can tell the board “you can’t fire me. I helped the community and raised wages”! They enhanced their own power.

Is this a cynical view? No, I don’t think so at all. It’s an accurate reading of human nature. Those in power seek to keep their power and/or gain more. Friedman understood this viscerally which is why he went to such lengths in describing the agency/principal conflict.

It’s probably worth a brief mention to debunk the “but CEOs still own lots of stock” theory. The Wall Street Journal espoused this view recently. The problem though is once again the agent vs. principal conflict. Yes, CEOs get compensated in stock and thus have an incentive for it to go higher.

However, CEO compensation schemes can be manipulated for personal gain. Some probably recall the backdating scandal, but there are subtler ways like lowering performance hurdles and hoping ISS doesn’t notice.

I’d also add that most CEOs didn’t ultimately suffer from the financial crisis. Yes, their stock went down temporarily, but as long as they held on, it rebounded and they got obscene amounts of new options at the lows (since they were $ target awards, they got way more shares). Most CEOs fared far better than their shareholders who weren’t given options at the bottom as a reward for continuing to support the company. Again, principal/agent conflict.

The ESG Hypocrisy

Honestly, this could be a whole separate post, but it is all tied together and, frankly, I blame the ESG crowd for the Roundtable behavior. These CEOs have been brainwashed by a vocal minority. Somehow, a small group of investors in their stocks have gotten outsized attention from corporations. As mentioned, companies are tripping over themselves to produce sustainability reports and hire new executives to oversee these efforts.

Yet, when an activist owns a similar amount of the stock, they are seen as the enemy. Why? In both cases, they are minority shareholders. The only difference is the latter is a threat to the shareholders’ agent, the CEO. (Personally, I think both groups have too much influence but more on that in a minute.)

Let me explain the ESG scam. ESG is not about saving the world. It is not about doing right. It is about making money…and I don’t mean through investment returns! No, ESG is about making $ for the managers of ESG assets. It is a marketing scam, nothing more.

Let’s start with the obvious. The active asset management industry is in really rough shape. All the flows are moving to index funds and ETFs. Then, along comes this cute new fad called ESG. The CIOs at the asset gatherers realizeif we launch an ESG fund, we may actually get some inflows. Let’s promote the hell out of these things!” If you think there is any other reason ESG became popular, you are hopelessly naive.

Actually, there is one other reason. ESG funds can charge high fees and nobody cares. Not only do I get inflows, I get margin! It’s like the 90s are back! From the customer’s view, who cares if I pay a little more? I’m sticking it to big oil! It’s the same reason people will pay up for electric cars even when the payback math is poor for most buyers. It’s not about the math. It’s about the “social responsibility”.

To be clear, I have no problem if investors want to pay up for ESG funds and accept lower returns. That is their right. I don’t blame the fund complexes for selling the product (other than misleading about the expected returns). They’re addressing a preference of certain customers.

It’s no different than people who will pay more for an Impossible Burger that doesn’t taste as good as the real thing. They are getting non-financial utility that they believe offsets the extra cost. It’s a free market!

My problem is when corporate CEOs can’t see past the marketing gimmick and instead fall for it themselves, hook, line, and sinker. The ESG promoters are playing you just as well as they’re playing the retail investor!

I expect you to be smart enough to recognize this! I further expect you not to express any personal preferences and remain my agent as Friedman says. If the majority of shareholders want you to focus on ESG, they will let you know that. But it is their choice, not yours.

What Can We Do Instead?

Man, I might already be at a record for longest post and we’re not even at the payoff. Let’s keep trucking…

As I hinted at earlier, letting minority shareholders have undue influence has risks. There is a time mismatch in decision making. I discussed this concept of temporal differences in the recent Argentina post and it applies again here.

Do CEOs have a beef that a short term 5% shareholder can change the direction of the company? Yes! Or that the fate of a merger is driven by the risk arb community who rents the stock rather than those who will own it afterwards? Absolutely!

What these situations point out is that there are multiple categories of shareholders and how is the humble CEO to decide whose agency he should be representing? This is a terrific question and is worthy of debate. Of all the issues facing Corporate America today, I think this is the most important!

Should all shareholders be treated the same or should some be different? In many tech companies, they already are treated differently. Founders get extra votes vs. the secondary shareholders. Could we do something similar more broadly?

Some Alternatives

1) Give more votes to those who have held the stock longest. This would establish the principle that, all else being equal, the CEO should advocate for the long term shareholder over the short term owner. Please note the “all else equal”. I am introducing a rule for breaking ties.

2) Have two classes of shares for most stocks: the single vote share class and the multi-vote share class. There are companies where this A & B structure exists and historically there has been very little premium placed on the A shares. However, that is because of the perception that the extra votes are often meaningless. We can change this though! If votes become more effective, investors will pay a premium for those A shares.

3) Bring more democracy to shareholders. There should be more things up for vote. Investment firms should have to make their own decisions on voting rather than outsource to ISS. There should also be more choices, rather than yes or no. We need alternatives.

For example, rather than voting yes or no on a board member election, there should be two candidates for the spot and we pick one or the other. These two should have different reasons for being on the board. Thus, investors can signal which views are more important to them in a way an up or down vote doesn’t allow.

I can’t blame CEOs for being confused about what investors want. Voter participation is low and there are not distinct choices. Participation may remain low among the short term crowd, but the long term holders who have that extra vote may pay begin to pay more attention.

I would even encourage collaboration among larger holders. If there is a block of ten long term shareholders who control 20% of the stock and say 40% of the votes, they will win most votes if they can successfully collaborate. It will then be clear to the CEO who he or she represents. If that block believes long term returns will benefit from doing more for stakeholders, they can clearly vote that way and give the CEO that mandate. The short term holders will respond by selling, but at least there is no agency conflict.

Final Thoughts

I’ll wrap by elucidating a few principles I didn’t explicitly state earlier. First, any company that believes “profit maximization” comes from screwing over your customers, suppliers, and employees is not likely to be a successful company. Yes, there are times it can work in the short run, but it’s not a sustainable (no pun intended) strategy. The debate is over what to optimize. If you put shareholders last, instead of first, there will be less growth and less innovation and thus there will be fewer jobs and worse off customers.

Second, there is a cynical view I’ve seen expressed that the Roundtable doesn’t really believe in these principles. Supposedly, they only did this for political reasons, a sort of defensive retreat to appease Bernie or Liz so they won’t ask for more. First, good luck with that approach. Second, that’s an incredibly dangerous game and shows these CEOs don’t understand the consequences of their actions.

Third, if a CEO has personal views that they think would be in the best interest of the shareholders, then ask for a vote and make the case rather than assume you are in the right. It is a democracy, not a dictatorship.

Fourth, the Business Roundtable’s mission should be to act as appropriate agents for the shareholders. That is what they were hired for. Frankly, the existence itself of the Roundtable is virtually proof that they view themselves as principals, not agents. The Roundtable should disband.

Fifth, the stakeholder movement establishes special interest groups. Special interest groups lead to crony capitalism. If you don’t know what that is, google “crony capitalism great recession.” It’s bad enough that the government interferes with markets to protect special interests. We don’t need corporations doing the same thing.

Sixth, markets have a funny way of finding solutions. I’d advise CEOs to be careful what they wish for. One natural consequence of the stakeholder movement is public companies will underperform private ones who can follow the “classic” model.

If more companies are owned by private equity and fewer by shareholders, the CEO works for one large owner and they are clearly then in the “general manager” role. There may be more job security in the stakeholder model than the shareholder model, but don’t forget there is also more in the many shareholder model than the one owner model.

Finally, I will point out that implicit in Friedman, if unsaid, is that corporations that advocate for the CEO’s personal interest rather than the shareholder are an attack on economic liberty. I will re-quote the end of one of the earlier Friedman passages while adding on what he wrote next.

The stockholders or the customers or the employees could separately spend their own money on the particular action if they wished to do so. The executive is exercising a distinct “social responsibility,” rather than serving as an agent of the stockholders or the customers or the employees, only if he spends the money in a different way than they would have spent it. But if he does this, he is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other.

Milton Friedman (added emphasis is mine)

And thus this post finally ends with the words of the great revolutionary James Otis, “taxation without representation is tyranny!”