Improve Value | Reduce Compliance Risk
Image from “Moshidora” (2009), by Natsumi Iwasaki (English title “What if a high school baseball manager read Drucker’s Management”). Moshidora follows protagonist Minami Kawashima as she manages her school baseball team with inspirational lessons from Drucker’s “Management” (1973), which is always clutched to her chest. I’ve included this Drucker reference because, at over 2 million copies sold, it speaks to the breadth of his influence on Japanese business philosophy and manufacturing, particularly in the 1950s-1980s. It also says something about the ongoing relevance of Drucker’s ideas, which lose none of their rigor in this adorable presentation.
SHORT TERM-ISM ERODES SHAREHOLDER VALUE
In a post here last week I wrote about the harmful impact of the “Friedman doctrine” or “shareholder value” model on product safety and regulatory compliance. Boards that bought into the shareholder value model used stock options and bonuses tied to short-term earnings to incentivize CEOs to prioritize earnings and only earnings.
Management by numerical goal is an attempt to manage without knowledge of what to do, and in fact is usually management by fear.
– Deming, Edwards. The MIT Press. “Out of the Crisis. 1986 (at page 76)
Friedman’s big idea was that shareholders would benefit because higher earnings would increase share value or be paid out as dividends. As it turns out, that is not what happened.
The data clearly shows that the “shareholder value” model has disproportionately benefited shareholders in the C-Suite. See, Graham, John, Campbell Harvey, and Shiva Rajgopal. “The Economic Implications of Corporate Financial Reporting” Journal of Accounting and Economics 40.1-3 (2005): 3-73; Edmans, Alex. “Managerial Myopia: How CEOs Pump Up Earnings for Their Own Gain.” University of Pennsylvania, Wharton Business School, 7 Feb. 2014; Lazonick, William. “Profits Without Prosperity”, Harvard Business Review, September 2014.
Not surprisingly, when the CEO and Chairman roles are combined, it only gets worse for average shareholders. Over a five-year period, companies with a combined CEO and Chairman generated 28% lower returns than companies where the roles were divided. Hodgson, Paul. “The Costs of a Combined Chair/CEO”, The Harvard Law School Forum on Corporate Governance and Financial Regulation, 13 July 2012.
SHORT TERM-ISM INCREASES COMPLIANCE RISK
In addition to the corrosive effect it has on long-term share value, there is also a positive correlation between option based CEO compensation and product safety recalls. See, Mortenson, Gretchen. “Safety Suffers as Stock Options Propel Executive Pay Packages” New York Times, September 11, 2015., citing Wowak, Adam J. “Throwing caution to the wind: The effect of CEO stock option pay on the incidence of product safety problems.” Strategic Management Journal, July 2015.
Cascaded down through the enterprise, options, bonuses, and other KPI based compensation schemes focus rewards on “results-oriented” individuals. Successful employees learn to deny, deflect or delay anything that can interfere with short-term earnings, including potential product safety and regulatory compliance concerns.
Excessively frequent promotion or transfer of key decision makers can also exacerbate the accountability gap by insulating star employees from the long-term consequences of their actions.
Sure it’s problematic when “results oriented” managers drive short-term results by deflecting or delaying an investigation into compliance concerns. And yes, it’s troublesome when CEOs promote subordinates who obtain short-term results at the expense of long-term value.
But the real problem is neither the CEO nor the manager. They are simply symptomatic of a much more fundamental issue. The root cause is poor governance.
Adopting a value proposition that says earnings are the only thing that matters inexorably leads to incentives that conflict with compliance requirements.
HOW TO ELIMINATE SHORT TERM-ISM
Mihir Desai (Professor at both Harvard Law and Harvard Business School) offers a roadmap for boards to drive out short term-ism and better align executive compensation with long-term performance (and I would add product safety results).
First, boards must stop delegating CEO compensation to the financial markets. This means eliminating incentives for short-term earnings at the expense of long-term value. This will eliminate most buybacks and other manipulations that buoy short term price and option value at the expense of long-term shareholder value.
Second, boards need to think back to the good old days before short term-ism and recall that managers can and do a great job in the absence of option incentives.
Third, boards need to accept the fact that, buybacks and other manipulations aside, share performance is not about CEO skill as much as it is about luck and other factors outside CEO control.
Finally, to the extent that stock-based incentives still make sense after these changes, boards should work with restricted stock with vesting based on long-term metrics. See, Desai, Mehir. “The Incentive Bubble” Harvard Business Review, March 2012.
Thanks for reading!
Also published on LinkedIn.