For anyone still struggling to get to grips with the issues surrounding corporate governance in the 1990s, the subheading of Margaret Blair’s new book – Rethinking Corporate Governance for the Twenty-First Century – may sound a little surprising and a little demanding. But the book’s main title, Ownership & Control, would have failed to give any real flavour of the forward-looking, even revolutionary, ideas that Blair offers.
In fact, as revolutionaries go, Blair herself is pretty unusual. She is not a mainstream political campaigner, nor a lobbyist acting on behalf of the kind of interest groups who usually line up on either side of the governance debate. Rather, she is an economist whose breadth of approach, and whose lack of any obvious personal axes to grind, make her ideas worthy of attention for anyone with more than a passing interest in the role of corporations in society.Economics is actually a second career for Blair. ‘My first degree was in journalism and after graduating I worked as a business reporter for a couple of newspapers and then, in the 1970s, for Business Week magazine.’ During that period she developed a strong interest in business and economics in general, but also particularly in the way corporations work – ‘both their internal workings and their wider social role.’
After five or six years at Business Week, Blair quit journalism to return to graduate school, where she acquired a PhD in economics. ‘My dissertation was on merger waves, trying to understand why M&A activity appeared to be highly episodic. The accepted view in the 1980s was that it was the result of bad management, but it never seemed plausible to me that bad management should come in waves,’ she says.
Instead, Blair got interested in the free cashflow theory. ‘If the hostile takeovers and leveraged buyouts of the 1980s were a response to some deficiency in management, you have to ask what created the conditions for so many firms to be in that position; and why the appropriate correction would be takeovers,’ she says. ‘Some argued that it was the financial innovations of the 1980s that had prompted the increase in merger activity, but financial innovation has always occurred, so that seemed an unlikely explanation. It might have made it possible, but it was unlikely to have been the cause.’
When she looked more deeply into the cashflow theory, Blair realised that there had been a significant deterioration in the quality of investment opportunities available to corporations relative to their cost of capital. ‘I put together data showing the dramatic decline in the returns on capital in the 1980s relative to the costs, and the implications this would have,’ she explains. Blair argued that in the mid-1980s the cost of capital was significantly higher than the historical returns on capital, which meant that the corporate sector was under tremendous pressure to disinvest. ‘The leveraged buyouts and takeovers were basically mechanisms to compel firms to disinvest,’ Blair maintains. ‘And this is borne out by the evidence that net investment – after depreciation – actually slowed down considerably during the 1980s.’
Refreshingly, Blair remains sceptical of any of the theories put forward to explain the peaks and troughs of M&A activity. ‘I still believe there are almost as many reasons for mergers as there are mergers,’ she says, suggesting that trying to treat them as a common phenomenon is probably fundamentally misguided. ‘And anyway, what was really unique about the 1980s was the degree of leverage – in takeovers, buyouts, recapitalisations and so on. Companies removed an enormous amount of equity from the securities markets during that decade, and replaced it with debt. This represented a totally unprecedented change in the way they were financing themselves and was far more unusual than the level of M&A activity itself.’
Blair followed up this work, by then from her current base, the Washington-based liberal think-tank, the Brookings Institution, with a project that continued her exploration of the corporate finance activity of the 1980s. This culminated in the publication of a book called The Deal Decade, which she edited and to which she contributed a number of the essays.
‘At that time, five or six years ago, organisational economics was not very well-defined and tended to be dominated by a handful of theorists doing mathematical modelling and looking at optimal compensation schemes and so on,’ she says. ‘The field has come together and coalesced into a more internally consistent discipline since then. There has been a growing interest among economists in understanding the institutional arrangements – taking into account the laws, the implicit and explicit contractual arrangements, as well as the background noise of how the securities markets work. People are now considering, for instance, what corporations are responsible for, and who they are responsible to.’
For Blair, the need to reverse this neglect was prompted in part by the break-up of the Soviet Union. ‘When all those countries in eastern Europe suddenly had to put institutions in place, starting from scratch, it became a matter of great urgency for us really to understand the nature of those institutions and what purposes they served,’ she explains. ‘The hundreds of economic models around were mostly based on assumptions that had gone pretty much unquestioned. But if we were going to start advising Lithuania or the Ukraine about how to replicate our system, it was important to ask whether our institutions were there for some compelling reason, or merely as a result of historical accident.’
Blair certainly has no fear of addressing such fundamental questions, and does so in Ownership & Control. As a result, the book serves two purposes, the first of which is to provide a thorough back-to-basics explanation of the core issues underlying corporate governance. In a chapter aptly entitled A Primer on Corporate Governance, she unpicks the woolly assumptions that underpin much of the prevailing consensus about the nature of corporations. She clearly and rigorously analyses issues like the rights of shareholders and the goals and responsibilities of corporate managements; the meaning of ownership and its separation from control; the respective roles of debt and equity; and the way corporate law works; and so on.
Having thus ensured that her readers are in a position to follow her critique of the present state of governance affairs, Blair then turns to her second purpose, at least in terms of the chronology of the book. In fact, of course, it is her main purpose, and that is to turn upside down most of the now standard views about the goals of companies and the best ways of achieving them; as well as to proffer some alternatives.
Blair queries most of the things shareholder rights campaigners have been saying over the last decade or so, most heretically – in the campaigners’ view – that the primary goal of management is to maximise shareholder value. She argues for the broadening of the standard governance model to take account of the input and the rights of other stakeholders in the corporate mix and to focus on maximising total – as opposed to just shareholder – wealth creation. But, because Blair is a hard-headed academic and economist, she is not arguing this cause on a soft basis but on that of a thoroughly reworked model, that relies on a reappraisal of the definitions of risk and capital, the nature of ownership, the ranking of shareholder rights above those of other participants, and much more besides.
The fundamental supposition that shareholders alone bear the residual risk of corporations so they should receive the residual return is also questioned by Blair. In a line of argument guaranteed to alienate vast swathes of equity investors and their spokespeople, she describes some of that residual risk as being borne by long-term employees, who have built up ‘firm-specific skills that are an important part of the firm’s valuable assets but which the employees cannot market elsewhere, precisely because they are specific to the firm.’
Blair describes such employees as having contributed human capital to the corporation and therefore themselves having some entitlement to a share in the residual return. But before the shareholder activists switch off altogether, they should at least follow Blair’s arguments through to their conclusion. There’s no room to do justice to them here, of course. But, in essence, her solution to this issue involves rewarding staff partly through wages or salaries as now, but also by making significant handovers of equity to them, in exchange for cuts in wages and other benefits. The equity used for this should be in restricted stock that cannot be sold immediately.
Blair’s recommendations for a new corporate model also require directors to represent all stakeholders, not just shareholders; and she calls for changes in accounting rules, to reflect returns on investments not just in capital equipment and other physical assets but also in staff skills. Importantly, she limits her definition of stakeholders in this context to people who contribute specialised resources to a corporation, and who therefore have assets at risk, excluding local communities and other groups often also described as stakeholders.
In short, Blair wants nothing less than a wholesale rethinking of the very nature of corporations and a replacement of the accepted notion that they are bundles of assets owned by shareholders. She believes the governance debate has become fixated on the relationship between management and shareholders. ‘This fixation is misplaced,’ she maintains, principally because running companies purely to enrich shareholders is not in the country’s long-term economic interests.
‘It is probably no longer reasonable to promise employees a lifetime of secure wages and benefits to encourage them to make investments in special skills or organisational capabilities,’ Blair concludes at the end of her book. ‘Yet, it seems likely that such investments will grow more, not less, important during the decades ahead. If so, the governance systems that do the best job of creating wealth will be those that provide the best alternative ways of encouraging and rewarding those investments.’
Ownership & Control by Margaret Blair. Published 1995 by The Brookings Institution, Washington, DC
