The Strategy of No Strategy: Shareholder Value

This is a continuation of my take on Karen Ho’s book, Liquidated- An Ethnography of Wall Street. I can’t do the book justice in a single blog post (it’s going to take at least four), I’m going to try to summarize some of what she is describing as the culture of Wall Street and how it is infiltrating our lives. I’m going to touch on four major themes in her book: “smartness”, “flexibility”, “shareholder value” and “the strategy of no strategy”.  Check here Part1 on Smartness and Part2 on Flexibility.  I am going to try to tie Karen’s analysis of the culture of Wall Street to the pharmaceutical industry because having had a first person perspective, it is my belief that Big Pharma has felt the worst effects of Wall Street on its core business- discovering drugs.

This post is about Shareholders vs Stakeholders.  In Wall Street culture, nothing is more important that enhancing “shareholder value”.  But why is it that shareholder value is more important than anything else, including the health of our modern economy and the companies that drive that economy?  Let’s talk about what it’s like to be a corporate stakeholder.

I used to work on a beautiful tree lined campus.  It looked like the science section of a university. Right about now, when it’s Take Your Children to Work month, the trees that were planted by the staff in honor of previous Earth Days would be in full bloom.  Pretty soon, the sidewalks would be edged in fragrant purple lavender.  I have pictures of myself and Brooke under a tree on a Take Your Children to Work Day, the tree abundant with clusters of white flowers and in the background, lots of kids working off energy with hula hoops and jump ropes before another tour of the labs after lunch.  My site also had a gym and after a hard session of spin or pilates in the evening, I would walk back to my office to finish a few things before heading home.  While I strolled back, I thought about how lucky I was to have the job I’d always wanted.  My life at work was like being a perpetual student, learning new things about biology and nature and never having to dress up.

As scientists, we make an unspoken deal with the corporation we work for: it provides the labs and resources we need to make discoveries and we sign those discoveries over to the company for a token amount.  They paid me well.  I have no complaints.  I would have never made the big bucks that I might have if I’d worked on Wall Street, but I was able to pay my bills, put some money aside for my retirement and college funds, and occasionally, I had money to splurge on a Royal Caribbean Cruise or to feed my gadget addiction.  Believe it or not, that was enough for me.  I was just delighted to be there.  No, seriously.

When I tell people that we sign our patents over to our companies for a buck, they can’t believe that we don’t feel cheated.  But you know, discovering drugs is an expensive proposition.  I could never do it by myself, and neither can most scientists, as we are finding out.  But it’s not the money that’s important.  For example, I used to work with the guy who invented Effexor, Morris Husbands.  His invention made the company, Wyeth, billions of dollars, though he never saw more than his own salary and a generous bonus/prize.  It was still a teeny fraction of the profits but that was Ok.  What Morris got that the rest of us envied was letters.  He got letters from patients who thanked him for helping them turn their lives around.  Yes, I know that Effexor isn’t the right drug for everyone but some people genuinely couldn’t pull out of depression without it.  And these patients were so relieved that they went out of their way to track down who this guy was and they wrote to him.  Morris was a lucky man but there’s a cautionary tale about the discovery of Effexor that I’ll get to at the end.

So, what does this have to do with shareholder value?  Bear with me on this because I only took two economics/business courses in college and my knowledge of this is a little rusty.  This was the most difficult part of the book for me to get through because it has to do with the history and philosophy of capitalism.

Here’s the part that I get: In modern capitalism, a corporation consists of many stakeholders.  Shareholders are stakeholders.  But so are managers, employees, vendors, government and the community, among others.  Stakeholders are dependent on the success of the corporation so it is in their interest that the corporation succeeds.  Ho describes a sort of golden age of the corporation post World War II where corporations took their responsibilities to the community and employees seriously.  Maybe it was just a temporal thing that had to do with the proximity to the Great Depression and all that that entailed to the society and economy at large.  This is not to say that corporations always had a rosy relationship with their employees.   But there was an understanding that managers and employees worked together in what was naturally an adversarial relationship to find solutions that would work for everyone.

Then, right around the early sixties, the shareholder contingent got the notion that they were being ripped off.  This was also a time of conglomeration, or what we called mergers and acquisitions before they got to be sexy.  In some cases, the conglomerate was created by the accretion of corporations that were not related to each other.  The conglomerate was sometimes big and unwieldy and not terribly profitable.  In other cases, CEOs were just not eeking out every dollar of profit from the corporation to the satisfaction of the shareholders.  Or they were sharing the profits with employees without a lot of shareholder input.  You know, pensions, health care, union contracts.  Shareholders began to feel like an aggrieved party.  They didn’t feel that lifting all boats on a rising tide was their responsibility.  They wanted a bigger share of the profits.  But how to do it without looking like greedy assholes and how would Wall Street arrange it so it would get a substantial cut?

Enter Adam Smith.  Here’s where Karen Ho describes the neoclassical capitalism as laid out by Smith and how it didn’t evolve to take the modern corporation into consideration and how shareholders took advantage of that lapse.  Ho writes:

The dominant theoretical perspective on the goals and values of corporations has arisen out of the discipline of economics, which in turn has been dominated by the neoclassical tradition (Schrader 1993).

To understand the history and persuasiveness of shareholder value, it is crucial to understand the ideological assumptions which render it natural and legitimate. The most obvious problem with neoclassical economic theory is simply that its core premises are significantly different from, and clash with, any understanding of the firm as a social organization. Neoclassical theories are derived from the “classical” worldviews of Adam Smith in the eighteenth century, built upon and reconfigured by the “neoclassicists” of the nineteenth and early twentieth centuries-all before the modern corporation was established as the major organizational form through which business in the United States is conducted. Even contemporary iterations of neoclassical theory bear the marks of their precorporate origins, having never attempted to take into account the corporation as a social institution and refusing to acknowledge how its multiplicity could change the very foundations of economic theory and business norms. David Schrader (1993, 2) has characterized neoclassical theory as “woefully inadequate to the task of providing a sound understanding of the managerial corporation.” Instead, corporations have been continually made to operate according to neoclassical values, however ill the fit.

At the center of Adam Smith’s The Wealth of Nations, the founding text of classical economics, is the notion that individual acts of economic self-interest combine, through the “invisible hand” of market forces, to further the best interests of society at large. Smith, like many classical economists who followed, centered his theories on the single individual, the notion of an entrepreneur who both owned a small, private enterprise and managed it. The dominant neoclassical assumptions in economics and mainstream business today are certainly grounded in these worldviews, though many pivotal additions and reworkings were necessary. Even after the modern corporation came to be the dominant form of economic organization in the early twentieth century and the “visible hands” of multiple constituents and managers became apparent, neoclassical theories maintained the centrality of the individual entrepreneur.

In fact, throughout the twentieth century, in the face of a completely new socioeconomic phenomenon, entire schools of economists, notably from the University of Chicago, “steadfastly maintained that all important work in economic theory could be carried on from the perspective of an individualistic analysis with an assumption of perfectly competitive markets” (Schrader 1993, 67). The resurgence of shareholder value in the 198os, then, can be read as part of a long line of neoclassically inspired worldviews attempting to collapse and treat the corporation as a single profit-maximizing individual in the market. Championed by Wall Street financial institutions and brought to prominence during the leveraged buyout movement, the shareholder value movement became, arguably, the culmination and most effective demonstration of neoclassical values in the history of American business. Specifically, neoclassical capitalist worldviews recognize the presence of two entities: the individual owner and private property, understood as an exclusive unit. The individual and his private property are the only two inputs into the equation;3 other actors or claimants cannot wedge themselves into this limited space.

Moreover, Adam Smith imagined that the individual owner-entrepreneur would necessarily manage his own enterprise, and as such, he would be solely entitled to all the fruits of his property, the profits. It is precisely because the owner controls the enterprise and gets to “own” the profit that he, driven by self-interest, is compelled to use his industrial property and labor “efficiently” and grow for the strict purpose of accumulating more profit. This pivotal sequence-ownership, control, full access to profits, efficiency-constitutes the neoclassical, logical order of the relationship between individuals and private property. The glue stringing this causal chain together is the concept of self-interest as motive and the invisible hand as automatic market mechanism. For the capitalist world to be aligned properly, capitalist owners must have full access to the profits through complete control over their private property (Berle and Means iggi).

So, shareholders consider themselves the primary owners and stakeholders of the corporation and all other stakeholders get relegated to interloper status.  Nevermind that modern corporations do not operate strictly by neoclassical principles.  The rights of ownership trump any other claims on profits.  And the shareholders found further justification for their views from Smith himself:

Adam Smith himself, who believed that the managerial corporation would inevitably fail because its very structure negated his assumptions about the interests and motivations of owners and managers:

“The directors of [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail … in the management of the affairs of such a company. It is upon this account that joint stock companies … have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege; and frequently have not succeeded with one. (A. Smith zooo, 800)”

To fit into this theoretical legacy, large, public companies had to be understood as if they were merely the creations and appendages of individual entrepreneurs.

(Karen Ho. Liquidated: An Ethnography of Wall Street Kindle Edition.)

I think we can see the problems with this view and the solutions that shareholders would impose.  For one thing, a corporation with many shareholders whose interest in a company can be reduced to trading those shares for greater value than they bought them is hardly the kind of owner that Adam Smith envisioned when he wrote the quote above.  Smith lived in a pre-industrial culture where owners were more closely associated with their businesses and where the rule of law was still in its infancy.  It made sense in the 18th century for an owner of a company to keep a close eye on his managers.  Those managers were his stewards but without a proprietary stake in the company itself, were not going to go bankrupt if the company failed.  In the 18th century, the owners bore the primary responsibility for the fate of the corporation so they were most likely to also profit by it.  Their hands were more in the pie so they were more justified in calling the shots and taking their share.  In the 20th century,  ownership is distributed among many thousands of individuals.  This should limit their ability to interfere with the way the corporation is run.  But if they feel they’re not getting their cut, they might start exercising control in different ways.

For example, if the manager CEO did not have the proper attitude of responsibility towards the owners and continued distributing the profits to stakeholders instead of shareholders, then the shareholders would instill that sense of obligation by making the CEO an owner.  Mid-century salaries for corporate managers were generous but modest by today’s standards.  Now, with much of the CEOs compensation in stock, the manager now sees the value of the stock as important to his own wealth so he’s motivated to maximize the value of the stock.  Note that I did not say he is motivated to maximize the value of the corporation.  With ownership as the incentive, money becomes the object.  Other shareholders, such as institutional investors, demand more of the profits as well and eventually, more of the corporations resources are used to pay the shareholders at the expense of the other stakeholders.

I don’t think any of this is new to anyone who has been paying attention in the past couple of decades.  But it’s interesting to know what shareholders have been using as a rationale for their rapacious behavior.  Owners are entitled to their private property.  As far as they’re concerned, everything that is produced by the corporation is theirs and does not need to be distributed to anyone else.  If you were employed by the corporation and stupid enough to buy into the idea that it owed you a pension after 30 years of service, that’s your problem.  The shareholders didn’t authorize that pension plan.  The corporate managers did, probably without consulting the shareholders as to whether they were in favor of such a long term commitment.  Not only that but since shareholders are changing all of the time, how is it possible to entail one’s private property to stakeholders who are not actually owners?  You can see how this logic as slowly infiltrated our culture and our politics.  Remember George W. Bush’s “Ownership Society”?  Not just a slogan, it was a philosophy that really didn’t include the vast majority of us.

In big pharma, we have seen an accelerating dismantling of the corporation and shedding of stakeholders.  It first started during the merger and acquisition frenzy of the late 80s and through the 90s.  With every merger and acquisition, the Wall Street firms that set up the deal would profit greatly, as would the CEOs with a lot of outstanding compensation in stock.  With those early mergers, it was the sales force and other executives that were laid off.  They generally didn’t have a problem landing jobs elsewhere.  There were also some therapeutic areas that were shuttered and the staff either reabsorbed elsewhere or laid off.  But since this was a relatively small number of scientists, it wasn’t alarming at first.  But then there were a couple of high profile deals in the 90s where a whole company’s research division was laid off.  A number of pharmaceutical companies  located in the midwest were shuttered after deals and some staff relocated to the east coast.  Sometimes, this was just the personal preference of the CEOs who didn’t want to live in the midwest.  Brand new labs were mothballed and families displaced.  But still, there was no panic.

It wasn’t until the last decade that the strategy of going “weightless” became clear.  Little by little, therapeutic areas were closed and certain scientific fields relocated to China and India.  Chemists, in particular, have been especially hard hit.  And since 2007, the bottom has completely fallen out of the research industry.  Research is very expensive so corporations aren’t doing it anymore.  They are contracting out everything, leaving former stakeholders on our own.  Without the support of the corporate lab, we can’t afford to do research.  Now, we are hobbling along, hoping we get far enough in a project to sell our patents to a corporation that is waiting, like vultures, for a small company to get out from under it’s R&D debts.  (Those of you who are concerned with the provisions of the JOBS bill that have to do with transparency with investors should take note.  I think there is an important connection here where Wall Street acts as a middle man.) Those companies will end up selling the patents for more than a buck but not anywhere near as much to keep their operations stable.  And in the meantime, the corporate owners, incentivized by ability to shed any obligations to share their wealth with stakeholders, continue to dismantle their infrastructure.  Before long, a corporation will consist of a pool of investors who own patents from which they will derive their wealth and have very light operational costs that are associated with the “smartest” scientists and engineers who will direct the outsourcing and CRO contracts.  R&D will become a commodity and the people who engage in it completely exposed to the free market.

There’s a big problem with this scenario.  Well, there are several, actually.  It turns out that the barrier to conducting research in this environment is too much for many scientists.  It’s not that they’re not business people.  There’s nothing we can’t learn if we put our minds to it.  It’s that startup costs are so astronomical and the amount of work to be done on a project indefinite and not easily quantified, that the probability of losing all your money greatly outweighs the likelihood of striking it rich.  So, scientists are getting out – of science.  In this environment, it’s strictly for the young and unencumbered.  Science will do better in Europe than here in America because European governments typically protect their scientific industries better and labor unions are stronger there.  The stakeholders are more thoroughly grounded.  And corporations will look to Asia for their non-proprietary science.  PhD chemists in China and India are cheap and plentiful.  They’ll do the knock offs and the synthetic work.

Effexor: The one that almost got away

But the other thing that is problematic with this scenario is that serendipity is much less likely to occur.  The corporation is only going to get exactly what it contracted for and nothing more.  Which brings me back to Morris and Effexor.  Morris was the junior PhD on the project and legend has it that the senior chemist called the shots.  Morris was synthesizing a bunch of compounds for testing and wanted to make one that the senior chemist discouraged him from making.  The senior chemist thought they had synthesized enough at that point.  But Morris had the lab and the resources and the time so he synthesized it anyway and that was the one that made Wyeth billions of dollars of shareholder value.

Under the new system, Morris would be working for a CRO and he wouldn’t be paid to make any extra compounds.  He wouldn’t be getting letters and people wouldn’t be getting better and no one would be getting rich.

Oh well.