The Value-Extracting CEO: How Executive Stock …...The Value-Extracting CEO: How Executive...

The Value-Extracting CEO: How Executive Stock-Based Pay Undermines Investment in Productive Capabilities

William Lazonick∗

Working Paper No. 54

December 3, 2016

ABSTRACT

The business corporation is the central economic institution in a modern economy. A company’s senior executives, with the advice and support of the board of directors, are responsible for the allocation of corporate resources to investments in productive capabilities. Senior executives also advise the board on the extent to which, given the need to invest in productive capabilities, the company can afford to make cash distributions to shareholders. Motivating corporate resource-William Lazonick is Professor of Economics, University of Massachusetts Lowell; President, The Academic-Industry Research Network; Visiting Professor, University of Ljubljana; Distinguished Research Associate, Institut Mines-Télécom, Paris; Professorial Research Associate, SOAS University of London. (email: [email protected]).

This paper reflects research being carried out under grants from the Institute for New Economic Thinking (Collective and Cumulative Careers project through the Academic-Industry Research Network) and the European Commission (Innovation-Fuelled Sustainable and Inclusive Growth through the University of Ljubljana). It also builds on research done on previous grants from the Institute for New Economic Thinking and from the Ford Foundation (Financial Institutions for Innovation and Development through UMass Lowell). Some of the material in this paper draws on Matt Hopkins and William Lazonick, “The Mismeasure of Mammon,” Uses and Abuses of Executive Pay Data,” Institute for New Economic Thinking Working Paper No. 49, August 29, 2016, at https://www.ineteconomics.org/ideas-papers/research-papers/the-mismeasure-of-mammon-uses-and-abuses-of-executive-pay-data

Lazonick:TheValue-ExtractingCEO

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allocation decisions are the modes of remuneration that incentivize and reward the top executives of these companies. A sound analysis of the operation and performance of a modern economy requires an understanding of not only how much these executives are paid but also the ways in which the prevailing system of executive pay influences their decisions to allocate corporate resources. In the United States since the last half of the 1980s the overriding goal of U.S. corporations has been to “maximize shareholder value,” with corporate performance measured by a company’s “total shareholder return”: percentage stock-price appreciation plus dividend yield. Also since the 1980s, the most important components of the total compensation of senior executives have been modes of stock-based pay in the forms of stock options and stock awards. This stock-based pay is structured to incentivize executives to make corporate allocation decisions that will boost the stock prices of the companies that employ them and reward them for achieving that objective. There are three drivers of stock prices: innovation, speculation, and manipulation. The first critical question that this paper addresses is which of these drivers, individually or in combination, contribute to a company’s stock-price performance. Then we can ask the second critical question: Does executive compensation reflect the success of the company in value creation, or the power of senior executives to engage in value extraction? The “value-extracting CEO” hypothesis posits that, in the United States, a significant portion of senior executive compensation rewards them for making decisions that foment speculation and manipulate stock prices, and thereby extract value for their own personal gain. In section four of the paper, I invoke the theory of innovative enterprise to support this hypothesis and debunk the dominant ideology that companies should be run to “maximize shareholder value.” Finally, I elaborate the policy implications for controlling the power of the value-extracting CEO, including a) banning stock buybacks, b) requiring executive compensation that rewards innovation rather than speculation and manipulation, and c) placing stakeholders representing households as taxpayers, workers, and consumers on boards of directors of publicly listed companies, along with shareholders who represent households as savers. An intellectual precondition for these reforms is the rejection of the ideology that companies should be run to maximize shareholder value, which means replacing agency theory with innovation theory as a mode of analyzing how the operation of an economy, supported by the strategies and structures of the business enterprises within it, can attain the objectives of stable and equitable economic growth.

JEL Codes: D01, D21, D31, G35, J33

Keywords: Corporation, senior executive, stock-based compensation, stock prices, stock buybacks, innovation, speculation, manipulation, innovation theory, agency theory, shareholder-value ideology


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1. CorporateResourceAllocationandProductiveCapabilities

Thebusinesscorporationisthecentraleconomicinstitutioninamoderneconomy.IntheU.S.economy,asaprimeexample,employment,productivityandearningsdependheavilyonresource-allocationdecisionsmadebytheCEOsandtheirsenior-managementteamsata relatively small number of very large companies.1 In 2012, 1,909 companies that had5,000ormoreemployeesintheUnitedStates,withanaverageworkforceof20,366,wereonly 0.033 percent of all U.S. businesses. But, with the business sector representing 81percentofthetotalemployedcivilianlaborforce,these1,909companieshad11percentofall establishments, 34 percent of employees, 38 percent of payrolls, and 44 percent ofrevenues.2Inaddition,theprosperityofhundredsofthousandsofsmallerfirmsreliesonthegrowthoftheselargefirms.Acompany’sseniorexecutives,withtheadviceandsupportoftheboardofdirectors,areresponsible for the allocation of corporate resources to investments in productivecapabilities.Seniorexecutivesalsoadvisetheboardontheextenttowhich,giventheneedto invest inproductivecapabilities, thecompanycanaffordtomakecashdistributionstoshareholders. Motivating corporate resource-allocation decisions are the modes ofremunerationthatincentivizeandrewardthetopexecutivesofthesecompanies.CEOsmayalsobemotivatedbynon-pecuniaryobjectivesinmakingresource-allocationdecisions.Buta soundanalysisof theoperationandperformanceof theU.S. economy—oranymoderneconomy—requiresanunderstandingofnotonlyhowmuchtheseexecutivesarepaidbutalsothewaysinwhichtheprevailingsystemofexecutivepayinfluencestheirdecisionstoallocatecorporateresources.Modesofcompensation,characterizedbyanarrayofdifferentpaycomponents,ostensiblyincentivizeseniorexecutives tobehave inways that improvecorporateperformanceandreward them for achieving performance goals. But what is the measure of superiorcorporateperformancethatincentivizesandrewardsthem?IntheUnitedStatessincethelast half of the 1980s the overriding goal of U.S. corporations has been to “maximizeshareholder value” (MSV), with corporate performancemeasured by a company’s “totalshareholder return”: percentage stock-price appreciation plus dividend yield. Also sincethe1980s,themostimportantcomponentsofthetotalcompensationofseniorexecutiveshavebeenmodesofstock-basedpay intheformsofstockoptionsandstockawards.Thisstock-based pay is structured to incentivize executives to make corporate allocation

1WilliamLazonick,“LaborintheTwenty-FirstCentury:TheTop0.1%andtheDisappearingMiddleClass,”inChristianE.Weller,ed.,Inequality,Uncertainty,andOpportunity:TheVariedandGrowingRoleofFinanceinLaborRelations,CornellUniversityPress,2015:143-192.

2For964companieswith10,000ormoreemployeesin2012,theseshareswereninepercentofestablishments,28percentofemployees,31percentofpayrolls,and36percentofrevenues.UnitedStatesCensusBureau,“StatisticsofU.S.Businesses(SUSB),”Dataon“2012SUSBAnnualDataTablesbyEstablishmentIndustry”athttps://www.census.gov/data/tables/2012/econ/susb/2012-susb-annual.html.Themostrecentdatafor2014(whichdonotincluderevenues)showthat1,986firmswith5,000ormoreemployeesand994firmswith10,000ormoreemployeeshadslightlylargersharesofestablishments,employees,andpayrollsthanthelargestfirmsin2012:https://www.census.gov/data/tables/2014/econ/susb/2014-susb-annual.html


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decisionsthatwillboostthestockpricesof thecompaniesthatemploythemandrewardthemforachievingthisobjective.3Whether one admires or abhors the current system of executive compensation in theUnited States, there is a broad consensus that the achievement of a high and risingcompany stock price is the paramount corporate-performance objective.4 Does a risingstockpricereflectsuperiorcorporateperformance?Possibly,butbynomeansnecessarily.As I discuss in the next section of the paper, there are three drivers of stock prices:innovation, speculation, and manipulation. Only “innovation” reflects superior economicperformance, and the stock-market registers the impact of innovation only after it hasoccurred. The first critical question that this paper addresses iswhich of these drivers,individuallyorincombination,contributetoacompany’sstock-priceperformance.Then we can ask the second critical question: Does executive compensation reflect thesuccessofthecompanyinvaluecreation,orthepowerofseniorexecutivestoengageinvalueextraction?Based on intensive research into these questions for the U.S. case, my shortanswers are that a) the stock-price performance of major U.S. companies increasinglyreflects manipulation, and b) given the preponderance of stock-based pay in the totalcompensation of the senior executives of major U.S. business corporations, theirremunerationreflects theirpower toextractvalue far inexcessof thevalue theyhelp tocreateinthecompaniesthattheycontrol.Innovation is the process by which a company, embedded in a particular economic andpolitical context, generates a product that is higher quality and lower cost than thoseproducts previously available. When a company invests in productive capabilities, itcreatesthepossibility,althoughbynomeansthecertainty,thatthroughthedevelopmentand utilization of its productive capabilities, it will be able to generate an innovative(higher-quality,lower-cost)product.Astheinnovativeenterpriseexpandsitsextentofthemarket and becomesmore profitable, stock-market traderswill tend to bid up its stockpricetoreflectthegainsfrominnovationthatthecompanyhasalreadyachieved.At that point, stock-market speculation that future gains from innovation will occur candrive the company’s price still higher. Under certain conditions, this speculation maycontinueatarapidpaceforanextendedperiodoftime,withthestockpricepropelledtonewheightsbyspeculative traders’adherence to the “greater fool theory”: tradersbuyacompany’s shares at prices that they think are overvalued on the assumption that thereremain greater fools in themarketwhowill bewilling to buy the shares at even higherprices. At some point, however, as increasing numbers of traders lose their speculative

3SeeWilliamLazonick,“TakingStock:HowExecutivePayResultsinanInequitableandUnstableEconomy,”FranklinandEleanorRooseveltInstituteWhitePaper,June5,2014,athttp://www.theairnet.org/v3/backbone/uploads/2014/08/Lazonick_Executive_Pay_White_Paper_Roosevelt_Institute.pdf;MattHopkinsandWilliamLazonick,“TheMismeasureofMammon:TheUsesandAbusesofExecutivePayData,”InstituteforNewEconomicThinkingWorkingPaperNo.49,athttps://www.ineteconomics.org/research/research-papers/the-mismeasure-of-mammon-uses-and-abuses-of-executive-pay-data.

4Foracriticalrecognitionofthisconsensus(andtheneedtochangeit),seeJoeBiden,“Howshort-termismsapstheeconomy,”WallStreetJournal,September27,2016,athttp://www.wsj.com/articles/how-short-termism-saps-the-economy-1475018087


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optimism, the greatest fools are left holding the overvalued shares, and the stock pricedeclines,oftenprecipitously,astheyseektocuttheirlosses.Hence, asweobserve in practice, stockprices can go throughhighly volatile booms andbusts. Meanwhile, however, certain actors in the stock market may have the power tomanipulatestockprices,bothtofomentspeculationthatgeneratesfurtherpriceboostsontheupswingandto limitoroffsetthestock-pricedeclinesinthedownturn.Alternatively,short-sellers who have sufficient financial power to manipulate the market maydeliberately exacerbate stock-price declines. A major reason for the passage of the U.S.Securities Exchange Act of 1934, which established the Securities and ExchangeCommission(SEC)asthefederalgovernmentregulatorofthestockmarket,wastopreventmanipulationofstockprices.Seniorcorporateexecutivesareofteninapositiontoengageinstock-pricemanipulationbydisseminatingfalseormisleadingfinancialinformationandbyengaginginmonopolisticproduct-pricingbehavior.Sincetheearly1980s,however,themost ubiquitous, systemic, and direct way in which senior executives have been able,legally, tomanipulate their companies’ stockpriceshasbeen through stock repurchases,alsoknownasstockbuybacks.IntheU.S.corporateeconomyoverthedecade2006-2015,drivenbymassivestockbuybacks,netequityissueswereminus$4.1trillion.5Followingourdiscussionofthedriversofthestockmarket,wethenturntoananalysisofhow, through their stock-based pay, corporate executives may be incentivized to makecorporate resource-allocation decisions that can potentially result in product innovationbut that can also influence stock-price speculation and implement stock-pricemanipulation, both of which inflate their stock-based pay. The “value-extracting CEO”hypothesis posits that, in the United States, a significant portion of senior executivecompensation is rewarding them for making decisions that foment speculation andmanipulate stock prices, thereby enabling them to extract value for their own personalgain. In support of this hypothesis, I present data on the total compensation of the 500highest-paidcorporateexecutivesintheUnitedStatesfrom2006through2015thatshowthemagnitudeoftheirtotalpayandtheproportionsoftheiraverageannualpaythathavebeeninformsofrealizedgainsfromstockoptionsandstockawards.In2015,theaverageannualtotalcompensationofthe500highest-paidexecutivesaveraged$32.6million,with46percent fromrealizedgains fromtheexercisingof stockoptionsand36percent fromthevestingofstockawardsIn section four of the paper, I invoke the theory of innovative enterprise (and a body ofempirical research that underpins it) to support the hypothesis that the ways in whichsenior corporate executives are incentivized and rewarded undermines investment inproductivecapabilities.Todrivehomethisargument,Idebunkthedominantideologythatposits that, for the sake of superior economic performance, companies should be run to“maximize shareholder value” (MSV). My critique identifies two fundamental, buterroneous,assumptionsofMSVideology,asputforthbyagencytheory,6thatassertthata)

5BoardofGovernorsoftheFederalReserveSystem,FederalReserveStatisticalReleaseZ.1,“FinancialAccountsoftheUnitedStates:FlowofFunds,BalanceSheets,andIntegratedMacroeconomicAccounts,”TableF-223:CorporateEquities,September16,2016,athttps://www.federalreserve.gov/releases/z1/current/.

6Foraprominentstatement,seeSeeMichaelC.Jensen,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers,”AmericanEconomicReview,76,2,1986:323-329.


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ofallparticipantsinthecorporateenterprise,onlyshareholdersbearrisk,thusgivingthemsoleclaimoncorporateprofits,ifandwhen,theyappear,andb)throughthestockmarket,public shareholders are key parties who invest in the productive capabilities that theenterprisehasavailabletoit.In place of agency theory, which is a theory of value extraction, I basemy approach toanalyzing the operation and performance of companies, and the economy in whichcorporationsparticipate, oninnovationtheory,whichisatheoryofvaluecreation.7Fromtheperspectiveof“thetheoryofinnovativeenterprise,”wecanaddressthequestionabouthowstock-basedpayunderminesinvestmentinproductivecapabilitiesbyfocusingonitsimpactofthree“socialconditionsofinnovativeenterprise”thataretheessenceofthefirm-levelinnovativeprocess:• Strategic control: For innovation to occur in the face of technological, market, and

competitive uncertainties, executiveswho control corporate resource allocationmusthave the abilities and incentives to make strategic investments in innovation. Theirabilities dependon their knowledgeof how strategic investments in new capabilitiescanenhance theenterprise’sexistingproductivecapabilities.Their incentivesdependon alignment of their personal interests with the company’s purpose of generatinginnovative products. I argue that stock-based pay tends to undermine not only theincentives but also the abilities of those who exercise strategic control to allocatecorporateresourcestoinvestmentsinproductivecapabilities.

• Organizational integration: The implementation of an innovative strategy requirestheintegrationofpeopleworkinginacomplexdivisionoflaborintothecollectiveandcumulative learning processes that are the essence of innovation. Work satisfaction,promotion,remuneration,andbenefitsare important instruments inarewardsystemthat motivates and empowers employees to engage in collective learning over asustainedperiodoftime.Iarguethatstock-basedpayincentivizescorporateexecutivesto underinvest in collective and cumulative learning processes and to dissipate theinvestmentsthatthecompanyhasalreadymade.

• Financial commitment: For collective learning to cumulate over time, the sustained

commitment of “patient capital” must keep the learning organization intact. For astartup company, venture capital can provide financial commitment. For a goingconcern,retainedearnings(leveragedifneedbebydebtissues)arethefoundationoffinancial commitment. I argue that stock buybacks, incentivized by stock-based pay,deplete the corporation of internal financial resources that could otherwise form thefoundationoffinancialcommitment.

Finally, I elaborate the policy implications of the rise to economic power of the value-extractingCEO.These includea)banningstockbuybacks,which in theUnitedStateswill

7WilliamLazonick,“TheChandlerianCorporationandtheTheoryofInnovativeEnterprise,”IndustrialandCorporateChange,19,2,2010:317-349;WilliamLazonick,“InnovativeEnterpriseandShareholderValue,”LawandFinancialMarketsReview,8,1,2014:52-64;WilliamLazonick,“TheTheoryofInnovativeEnterprise:FoundationofEconomicAnalysis,”AIRWorkingPaper,August2015,atwww.theAIRnet.org;WilliamLazonick,“InnovativeEnterpriseorSweatshopEconomics?InSearchofFoundationsofEconomicAnalysis,”Challenge,59,2,2016:65-114.


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entailareversalofSECRule10b-18,adoptedinNovember1982,thatenablescompaniestodo massive stock buybacks for the purpose of manipulating stock prices; b) requiringexecutive compensation that rewards innovation rather than speculation andmanipulation, which as I explain in the concluding section, requires, as a start, atransformationof themeasurementofexecutivepay fromfictional “estimated fairvalue”numbers to factual “actual realized gains” numbers;8 and c) placing stakeholdersrepresentinghouseholdsas taxpayers,workers,andconsumersonboardsofdirectorsofpubliclylistedcompanies,alongwithshareholderswhorepresenthouseholdsassavers.Anintellectualpreconditionforthesereformsistherejectionoftheideologythatcompaniesshouldberuntomaximizeshareholdervalue,whichmeansreplacingagencytheorywithinnovationtheoryasamodeofanalyzinghowtheoperationofaneconomy,supportedbythestrategiesandstructuresofthebusinessenterpriseswithinit,canattaintheobjectivesofstableandequitableeconomicgrowth.2. DriversoftheStockMarketThere are three possible drivers of stock prices: innovation, speculation, andmanipulation.9TakethecaseofCiscoSystems,whichdid its initialpublicoffering(IPO)ontheNASDAQstockexchangeonFebruary16,1990.Ciscosharesthatcost$1,000attheIPOhadamarketvalue of $389,000 at the end of 2015.Meanwhile, however, as can be seen in Figure 1,duringthatquartercentury,Cisco’sstockpriceunderwentdramaticfluctuations,drivenindifferentperiodsprimarily(althoughobviouslynotwholly)byinnovation,speculation,ormanipulation.Onecanpositthatduringthefirstseventoeightyearsofitsexistenceasapubliccompany,innovationwas the primary driver of the increase in Cisco’s stock price as stock-markettradersobserved,after the fact, that thecompanywasgeneratinghigh levelsofprofitbybecomingthedominantcompetitorinthenewandboomingInternetequipmentmarket.InOctober1998,attheendofthisinnovationphase,CharlesO’Reilly,aprofessoratStanfordBusinessSchool,publishedacasethatbeganwiththestatement,“Ciscoisa$6billionhightechnology stealth company, largely unknown to the general public.”10 Yet at that pointCiscowasalreadythefastestgrowingcompanyinhistory,withsharesboughtfor$1,000atthecompany’sIPOworth$185,000atthebeginningofOctober1998.FromNovember1998toMarch2000,however,this“largelyunknown”companywasthefocusofintensestock-marketspeculation,withitsstockpricerisingbyalmostseventimes,givingCisco thehighestmarket capitalization in theworld inMarch2000.At its all-timestock-pricepeakonMarch21,2000,those$1,000insharesboughtattheIPOwereworthover$1million. InMay2000,ThomasDonlan,aBarron’seditor,calculatedthattojustify

8HopkinsandLazonick,“TheMismeasureofMammon”;MattHopkinsandWilliamLazonick,“Corporateexecutivesaremakingwaymoremoneythananyonereports,”TheAtlantic,September15,2016,athttp://www.theatlantic.com/business/archive/2016/09/executives-making-way-more-than-reported/499850/

9WilliamLazonick,“TheNewEconomyBusinessModelandtheCrisisofU.S.Capitalism,”CapitalismandSociety,4,2,2009:Article4.

10CharlesA.O’Reilly,“CiscoSystems:TheAcquisitionofTechnologyistheAcquisitionofPeople,”StanfordBusinessSchoolCaseHR10,GraduateSchoolofBusiness,StanfordUniversity,October1998.


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itsstockprice,whichstoodat190timesearnings,Ciscowouldhave to increase its1999profitsof$2.5billionto$2.5trillionby2010!11 This speculation had a profound impact on stock-based pay. Cisco CEO John Chambersreceived total compensation of $121.7million in 1999 and $156.3million in 2000,withover 99 percent in each year coming from realized gains from exercising stock options.Cisco’sotherfourhighest-paidexecutivesaveraged$25.9millionin1999(96percentfromoptions)and$38.0millionin2000(97percentfromoptions).Indeed,withitsbroad-basedstock-option plan, the average realized gains from exercising stock options at Ciscowas(not including the five highest-paid executives, whose incomes we know) an estimated$193,500acrossanaverageof18,000employeesin1999and$290,900acrossanaverageof27,500employeesin2000.12

Figure1.Stock-pricemovements,Intel(INTC),Microsoft(MSFT),andCisco(CSCO),andtheNASDAQCompositeIndex,andprimedriversofstockprices,March26,1990-June30,2016(March26,1990=100)

Source: Yahoo! Finance, daily data, adjusted close.

Then,withtheburstingoftheInternetbubble,betweenMarch2000andSeptember2001,Cisco’s stock price plunged by 85 percent, atwhich point the company entered into themanipulationphaseofitsstock-pricedeterminationasitbegandoingstockbuybacks.Ciscorepurchased $1.9 billion in fiscal 2002 (year ending July 27, 2002), $6.0 billion in 2003,$9.1billionin2004,and$10.2billionin2005.Sincethenthrough2016,Cisco’sbuybacksranged from a high of $10.4 billion in 2008 to a lowof $3.1 billion in 2013. From200211ThomasG.Donlan,“Cisco’sbids:Itsgrowthbyacquisitionwillcauseproblems.”Barron’s,May8.2000:31–34.12SeeWilliamLazonick,SustainableProsperityintheNewEconomy?BusinessOrganizationandHigh-TechEmploymentintheUnitedStates,W.E.UpjohnInstituteforEmploymentResearch,2009,pp.48-66.


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through2016,Ciscoexpended$97.5billiononrepurchases,equalto95percentofitsnetincome,while since2011 thecompanyalsopaid shareholders$18.1billion individends.Withneither innovationnor speculationdrivingCisco’s stockprice, thepurposeof thesemassivebuybackshasbeentomanipulateit.Thoseexecutiveswhohavebeenabletotakeadvantageofthepricebooststhroughthetimingoftheiroptionexercisesandstocksalesandbyhittingstock-relatedperformancetargetsthattriggervestingofstockawardshaveenhancedtheirrealizedgainsfromstockoptionsandstockawards. Thedramatic rise and fall ofCisco’s stockprice in the Internetboomandbustmake thestock-pricemovementsofIntel,Microsoft,andtheNASDAQCompositeIndex,asshowninFigure 1, appear as mere blips. Figure 2, with a more limited stock-price scale, showssimilar price movements for Intel, Microsoft, and the NASDAQ Index (in which Intel,Microsoft, and Cisco are included). I posit that over the past quarter century the stockpricesofIntelandMicrosoftfollowedasimilarsequencetoCisco’sinnovation,speculation,and manipulation phases. One difference is that, with speculation in its stock rampant,Ciscodidnobuybacks in1998-2000,whereas Inteldid$15.4billionandMicrosoft$10.3billionintheseyears,bothcompaniestryingtomaintainpacewithCisco’sexplodingstockpriceaswellasoffsetthedilutionofthecompanies’shareholdingsasemployeesexercisedtheir options. Like Cisco, both Intel and Microsoft have done massive buybacks tomanipulatetheirstockpricessincetheInternetboomturnedtobust:$85.7billionbyIntelfrom2001throughthethirdquarterof2016(endingOctober1,2016)and$163.0billionbyMicrosoftfrom2001throughthefirstquarterof2016(endingSeptember30,2016).

Figure2.Stock-pricemovements,Intel(INTC),Microsoft(MSFT)andtheNASDAQ Composite Index, and prime drivers of stock prices,March26,1990-June30,2016(March26,1990=100)

Source: Yahoo! Finance, daily data, adjusted close.


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More generally, the stockmarket rewards innovative enterprise after the fact, once theinnovationshavebeen successful. In the case of startups, venture capitalists canuse thestockmarkettodoanIPOandthereby,withthecompanylistedonthestockmarket,“exit”theirinvestmentsbysellingonthemarketpartoralloftheirshareholdings.Therapidityofthe time period from the founding of a company to an IPO is of prime importance toventure capitalists. Prior to the 1970s the dominant New York Stock Exchange hadstringentlistingrequirementsintermsofprofitabilityrecordandcapitalizationlevelthatgenerally precluded an IPO just a few years after the founding of a company. The 1971launchingofNASDAQ—theNationalAssociationofSecurityDealersAutomatedQuotationsystem—dramatically truncated the lag fromstartup to IPObydramatically lowering thelistingrequirements. Intel, founded in1968,wentpubliconNASDAQassoonas thenewelectronicexchangeopenedin1971.Asapioneeringapplicationofcomputernetworking,the emergence of NASDAQ as a highly liquid national stock exchange on which newventures coulddo IPOs justa fewyearsafter startupwascritical to theemergence from1972 of the organized venture-capital industry that has become integral to high-techindustryintheU.S.economy.13AsoccurredonNASDAQinthelasthalfofthe1990s—andaswehaveseenforthecasesofIntel,Microsoft,andCisco—stock-priceincreasesdrivenbyinnovationcantransformintobubbles driven by speculation. In such an environment, profitless and even productlesscompaniesmaybeabletousespeculationtoraisesubstantialamountsofcashonthestockmarket,makingtheirshareholderssuper-rich.Insomecases,suchasAmazonwithits1997IPO when it was unprofitable, successful companies may eventually emerge from thesespeculative IPOs. But given widespread, and in some cases spectacular, failures, thisspeculativefundingofyoungcompaniesthatalistingonNASDAQpermitsmayrepresentamajormisallocationofresources.14A case in point was Sycamore Networks, an optical networking company founded inFebruary1998andlocatedinBoston’sRoute128high-techdistrict.15Withonecustomer(whose executiveswere given Sycamore shares), previous year revenues of $11million,lossesof$19million,and155employees,SycamorediditsIPOinOctober1999,andwasabletotranslatethe“NewEconomy”hypeintoa$284-millioninfusionofcashforlessthan10percentofitsoutstandingshares.InDecember1999Sycamoreranked117thinmarketcapitalization in the United States, just behind Emerson Electric, a company founded in1890 that had revenues of $14.3 billion and 117,000 employees!16 Sycamore then did asecondary offering inMarch 2000, at the very apex of the boom,with its stock price at$150,andnettedanother$1.2billionforthecorporatetreasury.13Lazonick,SustainableProsperityintheNewEconomy?,ch.214JohnCassidy,Dot.Con:TheGreatestStoryEverSold,Harper,2002;MarkGimein,“Youbought.Theysold.”Fortune,September2,2002,athttp://www.markgimein.com/pages/greed.pdf.

15SeeWilliamLazonick,“TheUSStockMarketandtheGovernanceofInnovativeEnterprise,”IndustrialandCorporateChange,16,6,2007,pp1021-1022.

16In2015,with110,800employees,Emersonwasintheidentical118thplaceinmarketcapitalization,whileSycamorehasbeenliquidatedthreeyearsearlier.“EmersonElectricnow118thlargestcompany,surpassingReynoldsAmerican,”TheOnlineInvestor,April13,2015,athttps://www.theonlineinvestor.com/article/201504/emerson-electric-now-118-largest-company-surpassing-reynolds-american-EMR04132015mbumped.htm/.SeealsoEmersonontheFortune500list,publishedin2016,forrankingbyrevenuein2015,athttp://beta.fortune.com/fortune500/emerson-electric-128.


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At thesametime, topexecutivesandboardmembersofSycamoresoldaportionof theirownstockholdingsfor$726million.17BySeptember2001,itsstockpricehadplungedtoaslowas $3.80, and it never recovered to a significant extent. In2001Sycamorehadwhatturnedouttobepeaksof$375million inrevenuesand944employees,butthecompanyneverbecameprofitable.Afterdistributing$470millionindividendsin2010and2011—moneystillremainingastheresultofitssecondaryissueinMarch2000—Sycamorewentoutofbusinessin2012,havingrackeduplossesof$875millionoverits14-yearhistoryasa public company.18 Taken in by the hype of the Internet boom, the stock-marketspeculatorswhoendowedthecompanywith$1.5billionin1999and2000wereineffect“accidental”venturecapitalistswholosttheirmoneybettingonacompanythatproclaimeditsinnovativefuturebutnevergeneratedtheinnovativeproductstodeliveronit.Besidestheallocationof inordinateamountsofresourcestounproductiveNewEconomystartups,thespeculativeboomofthelate1990shelpedinflictevengreaterdamagetotheinnovativecapabilitiesofsomeestablishedOldEconomycompanieswhosetopexecutivesalso got caught up in theNewEconomyhype.19 In 2000 Lucent Technologies—formerlyWesternElectricandthenAT&TTechnologies,withahistorydatingbackto1869—wasthelargestcommunicationtechnologycompanyintheworld.Yetin1998through2000,itstopexecutivesmaderesource-allocationdecisionsthatcontributedtothedramaticpost-2000decline of the company. In particular, they lavished massive amounts of the company’sstockon“NewEconomy”acquisitionsthatitthenfailedtointegrateintotheorganization.ThemostexpensiveacquisitionsweredonetoconvincethestockmarketthatLucentwasan agile New Economy company. Yet, enriched by their equity stakes in the acquiredcompany, key personnel of the acquisitions exhibited their individual agility by leavingLucent to launch new companies, become angel investors, take jobs at other hypedstartups,orjustretire.IntheInternetcrashof2001-2002,tostaveoffbankruptcy,Lucenthad to sell stock at oneor twopercent of its price in theboom, andby2006, the vastlyweakenedcompanywastakenoverbyitsFrenchrivalAlcatel.20WhileanOldEconomycompanysuchasLucentwasdestroyingitselfbyusingitsstocktopay highly speculative prices to acquire New Economy startups that lacked provenproducts,otherOldEconomycompaniesweremakinga transition to the “NewEconomybusinessmodel”bydoing large-scalestockbuybackstogivemanipulativeboosts to theirstockprices. Intheinformation-technologyindustry,the leadingOldEconomycompanieswere International Business Machines (IBM) and Hewlett-Packard (HP). Inpharmaceuticals, the leading companies were Pfizer and Merck. Table 1 shows thedistributions to shareholders—dividends and buybacks—by these four companies by17Gimein,“Youbought.Theysold.”18StevenSyre,“Internet-eraboomicon’squietbust,”BostonGlobe,October26,2012,athttps://www.bostonglobe.com/business/2012/10/25/quiet-end-for-sycamore-networks-brief-star-internet-era/7GA6J0LQ1bz6NMrms4osoN/story.html

19MarieCarpenter,WilliamLazonick,andMaryO’Sullivan“TheStockMarketandInnovativeCapabilityintheNewEconomy:TheOpticalNetworkingIndustry,”IndustrialandCorporateChange,12,5,2003:963-1034;WilliamLazonickandEdwardMarch,“TheRiseandDemiseofLucentTechnologies,”JournalofStrategicManagementEducation,7,4,2011.ForthedistinctionbetweenOldEconomyandNewEconomycompanies,seeLazonick,SustainableProsperityintheNewEconomy?,chs.2and3.Thisbookfocusesontheinformation-and-communication-technologyindustries.Fortheproblemofproduct-lessIPOsinbiotechnology,seeWilliamLazonickandÖnerTulum,“USBiopharmaceuticalFinanceandtheSustainabilityoftheBiotechBusinessModel,”ResearchPolicy,40,9,2011:1170-1187

20LazonickandMarch,“TheRiseandDemiseofLucentTechnologies.”


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decadefrom1976-2015,inabsolutetermsandaspercentagesofnetincome.Buybacksareby nomeans new at these companies, but they have becomemassive over the decades,evenasdividendshaveincreased.Allfourofthesecompanieshavemadeatransitionfrominnovation to financialization—that is, from an orientation to value creation to anorientationtovalueextraction.21

Table1.Netincome(NI),cashdividends(DV),andstockbuybacks(BB)atHP,IBM,

Merck,andPfizer,1976-2015

NI,$m

DV,$m

BB,$m

DV/NI%

BB/NI%(DV+BB)/NI%

HP 1976-1985 3,118 281 382 9.0 12.3 21.31986-1995 10,057 1,541 4,150 15.3 41.3 56.61996-2005 23,777 7,192 21,935 30.2 92.3 122.52006-2015 47,316 9,471 63,347 20.0 133.9 153.9IBM 1976-1985 41,140 19,929 3,151 48.4 7.7 56.11986-1995 16,937 21,209 12,017 125.2 71.0 196.21996-2005 68,904 9,611 52,406 13.9 76.1 90.02006-2015 134,656 32,918 117,799 24.4 87.5 111.9Merck 1976-1985 3,948 1,760 595 44.6 15.1 59.71986-1995 18,670 8,624 6,146 46.2 32.9 79.11996-2005 58,163 27,657 25,825 47.6 44.4 92.02006-2015 51,147 43,929 29,667 85.9 58.0 143.9Pfizer 1976-1985 3,123 1,343 66 43.0 2.1 45.11986-1995 8,686 4,370 3,249 50.3 37.4 87.71996-2005 54,668 26,846 38,184 49.1 69.8 119.02006-2015 115,170 67,968 63,151 59.0 54.8 113.8Source:StandardandPoor’sCompustatdatabase

Large-scalebuybacksonapersistentbasisbeganinthemid-1980s,aftertheSECadoptedRule 10b-18 in November 1982.22 Rule 10b-18 gives a company a “safe harbor” againstmanipulation charges in doing open-market repurchases. The safe harbor states that acompanywillnotbechargedwithmanipulationif,amongotherthings,itsbuybacksonanysingledayarenomorethan25percentofthepreviousfourweeks’averagedailytradingvolume (ADTV).While remaining within the safe harbor, a large company can often dohundredsofmillionsofdollarsinbuybacksperday,and,ifitstopexecutivessochoose,itcandosorepeatedly,tradingdayaftertradingday.OnDecember2,2016,thesafe-harbordaily limitswere $142million for IBM, $54million for HP, $171million forMerck, and

21Lazonick,SustainableProsperityintheNewEconomy?,chs.2and3;WilliamLazonick,MattHopkins,KenJacobson,MustafaErdemSakinç,andÖnerTulum,“U.S.Pharma’sBusinessModel:WhyItIsBroken,andHowItCanBeFixed,”inDavidTyfield,RebeccaLave,SamuelRandalls,andCharlesThorpe,eds.,TheRoutledgeHandbookofthePoliticalEconomyofScience,Routledge,forthcoming.

22WilliamLazonick,“StockBuybacks:FromRetain-and-ReinvesttoDownsize-and-Distribute,”CenterforEffectivePublicManagement,BrookingsInstitution,April2015,pp.10-11,athttp://www.brookings.edu/research/papers/2015/04/17-stock-buybacks-lazonick;KenJacobsonandWilliamLazonick,“SECRule10b-18:ALicensetoLoot,”presentationtotheannualconferenceoftheSocietyfortheAdvancementofSocio-Economics,LondonSchoolofEconomics,July3,2015.


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$290million forPfizer. ForCisco, Intel, andMicrosoft, discussedpreviously, theseADTVnumberswere$200million,$167million,and$435million,respectively.UnderRule10b-18, moreover, there is no presumption of manipulation should the corporation’srepurchasesexceedthe25percentADTVlimit.Buybacks have come to define the “investment” strategies ofmany of America’s biggestbusinesses.Figure3showsnetequity issuesofU.S.corporations from1946to2015.Netequityissuesarenewcorporatestockissuesminusoutstandingstockretiredthroughstockrepurchases and M&A activity. Since the mid-1980s, in aggregate, corporations havefunded the stockmarket rather thanviceversa (as is conventionally assumed).Over thedecade 2006-2015 net equity issues of nonfinancial corporations averagedminus $416billionperyear.23For2016,atthetimeofwriting,netequityissuesareatanannualrateof-$540billion.Overthepastthreedecades,inaggregate,dividendshavetendedtoincreaseas a proportion of corporate profits. Yet in 1997, for the first time, buybacks surpasseddividends in the U.S. corporate economy and, even with dividends increasing, have farexceededtheminrecentstock-marketbooms.

Figure3:Netequityissues,U.S.nonfinancialandfinancialcompanies,1946-2015

Source:BoardofGovernorsoftheFederalReserveSystem,FederalReserveStatisticalReleaseZ.1,

“FinancialAccountsoftheUnitedStates:FlowofFunds,BalanceSheets,andIntegratedMacroeconomicAccounts,”TableF-223:CorporateEquities,September16,2016,athttps://www.federalreserve.gov/releases/z1/current/.

23Thespikeinequityissuesforfinancialcorporationsin2009occurredwhensomeofthelargestamongthemsoldstocktotheU.S.governmentinthefinancial-crisisbailout.Thebanksthatwerebailedouthadbeenmajorrepurchasersoftheirownstockintheyearsbeforethefinancialmeltdown.SeeWilliamLazonick,“Everyoneispayingthepriceforsharebuy-backs,”FinancialTimes,September26,3008,p.25;WilliamLazonick,“Thebuybackboondoggle,”BusinessWeek,August24&31,2009,p.96.


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Using the data in Figure 3, Table 2 shows the amounts of net equity issues, decade bydecade,from1946to2015,in2015dollars.ForthefirstthreedecadesafterWorldWarII,net equity issuesweremoderately positive in the corporate economy as awhole. In thefollowing decades, however, net equity issues became increasingly negative (even afteradjusting for inflation) and, as a gauge of their growing importance in the economy,representedarisingproportionofGDP.

Table2.NetequityissuesintheU.S.economy,bydecadein2015dollars,andasapercentofGDP

NETEQUITYISSUES,

2015$MILLIONS

NETEQUITYISSUESAS%OFGDP

1946-1955 143.2 0.561956-1965 110.9 0.301966-1975 316.0 0.581976-1985 -290.9 -0.401986-1995 -1,002.5 -1.001996-2005 -1,524.4 -1.092006-2015 -4,466.6 -2.65

Retained earnings have always been the financial foundation for business investment ininnovationandsustainedemployment.Theseretentionscanfundinvestmentinplantandequipment, researchanddevelopment, and,of critical importance, trainingand retainingemployees. If dividends alone are too high, investments in the company’s productivecapabilitieswillsuffer.Theadditionofbuybackstodividendsoverthepastthreedecadesreflects a failure of corporate executives to develop strategies for investing in theproductivecapabilitiesofthecompaniesoverwhichtheyexercisestrategiccontrol.Dividendsarethetraditionalandlegitimatewayforapubliclylistedcorporationtoprovideincometoshareholders.Dividendsprovideshareholderswithanincomefor(asthenamesays)holding shares.Moreover, if the firmretainsenoughof itsprofits to finance furtherinvestment in thecompany’sproductivecapabilities, there is thepossibility (althoughbynomeansthecertainty)thatitwillgeneratecompetitiveproductsthat,throughinnovation,will help lift its future stock price and the value of the shares held.When, forwhateverreason,shareholderswhohavebenefitedfromastreamofincomeontheirholdingsdecidetosellsomeoralloftheirshares,theystandtomakeacapitalgain.In contrast, by creating demand for the company’s stock that provides an immediatemanipulativeboost to its stockprice,buybacks reward thoseshareholderswho sell theirshares. The most prominent sharesellers are those stock-market traders, includingcorporateexecutives,investmentbankers,andhedge-fundmanagers,whoareabletotimetheirstocksalestotakeadvantageofbuybackactivitydoneasopen-marketrepurchases.Buybacksalsoautomaticallyincreaseearningspershare(EPS)bydecreasingthenumberof sharesoutstanding. SinceEPShasbecomeamajormetricbywhich financial interestsevaluate the performance of a company, buybacks tend to increase demand for a


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company’sstock,thuscreatingopportunitiesforstock-markettraderstoselltheirsharesatagainevenintheabsenceofincreasedcorporaterevenuesorprofits.As shown inFigure4, since theearly1980s,majorU.S.business corporationshavebeendoingstockbuybacksontopof(notinsteadof)makingdividendpaymentstoshareholders.Figure4showsdividendsandbuybacksfor236companiesthatwereintheS&P500IndexinJanuary2016thatwerepubliclylistedfrom1981through2015.Atthebeginningofthe1980s, buybacks were minimal, and from 1981 through 1983 buybacks for these 236companies absorbed only 4.3 percent of net income, with dividends representing 49.5percent.Thebuybackproportionofnetincomeincreasedto18.8percentin1984and30.8percent in 1985, while the dividend proportions were 42.5 percent and 52.4 percent.Thereafter, by ten-year periods, the buyback proportions of net income increased from25.8percent in1986-1995to42.9percent in1996-2005and49.5percent in2006-2015,while dividendpayouts over thesedecadal periodswere50.7percent, 39.0percent, and39.1percent, respectively.Even thoughdividendpayoutratioswere lower in1996-2005and 2006-2015 than in 1986-1995, total payout ratios to shareholders rose from 76.5percent to81.9percent to88.6percentover these threeperiods.Mostrecently, the totalpayout ratios for these 236 companieswere 97.0 percent in 2014 and 106.2 percent in2015.

Figure 4. Mean cash-dividend and stock-buyback distributions in 2015dollarsfor236companiesintheS&P500IndexinJanuary2016thatwerepubliclylistedfrom1981through2015

Source: Standard and Poor’s Compustat database; calculations by Mustafa Erdem Sakinç and Emre

GomeçoftheAcademic-IndustryResearchNetwork.Overtheyears2006-2015,the459companiesintheS&P500IndexinJanuary2016thatwere publicly listed over the ten-year period expended $3.9 trillion on stock buybacks,representing 53.6 percent of net income, plus another 36.7 percent of net income on


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dividends.Muchof the remaining9.7percentofprofitswasheldabroad, sheltered fromU.S.taxes.AsshowninFigure5,meanbuybacksforthese459companiesrangedfrom$291millionin2009,whenthestockmarketshadcollapsed,to$1,205millionin2007,whenthestock market peaked before the Great Financial Crisis. In 2015, with the stock marketbooming,meanbuybacksforthesecompanieswere$1,173million.Meanwhile,dividendsdeclinedmoderatelyin2009,butovertheperiod2006-2015theytrendedupinrealterms(the data in Figure 5 have not been adjusted for inflation). Many of America’s largestcorporations routinely distributemore than 100 percent of net income to shareholders,generating theextra cashby reducingcash reserves, sellingoff assets, takingondebt,orlayingoffemployees.24Figure 5. Mean stock buybacks (BB) and cash dividends (DV), and ratios to net

income (NI) for459companies in in the S&P500 Index in January2016 thatwerepubliclylistedfrom2006through2015

Source: Standard and Poor’s Compustat database; calculations by Mustafa Erdem Sakinç and Emre Gomeç of the

Academic-IndustryResearchNetwork.3. Stock-BasedCompensationIntheUnitedStates,acompany’sboardofdirectorscanauthorizeastockbuybackprogram24Lazonick,“LaborintheTwenty-FirstCentury”:WilliamLazonick,“HowStockBuybacksMakeAmericansVulnerabletoGlobalization,”PaperpresentedattheWorkshoponMega-Regionalism:NewChallengesforTradeandInnovation,East-WestCenter,UniversityofHawaii,Honolulu,January20-21,2016,athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2745387;


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ofacertainamount(say$10billion)overacertainperiodoftime(saythreeyears). It isthen at the discretion of the CEO, presumably in agreement with the company’s chieffinancialofficer(CFO),todoachosenamountofbuybacksasopen-marketrepurchasesonany given day.Within the scope of the buyback program and subject to the restrictionscontainedinRule10b-18,theCEOandCFOcanthenimplementbuybackssporadicallyorfor a series of days, as they see fit. Little is known about this decision-making process.Indeed,underRule10b-18,a companydoesnotneed todisclose,evenafter the fact, theparticularlydaysonwhichitdoesstockbuybacks.Since2004,theSEChasrequiredquarterlyreportsonbuybackactivityinacompany’s10-Q filing, with the monthly volume and value of buybacks and the weighted averagerepurchase price. But, even with SEC Rule 10b5-1,25 adopted in 2000 to increasedisclosureofmaterialinformationthatcouldbeusedforinsidertrading,thefailureoftheSEC to require reporting of the precise days on which buybacks are done createsopportunities for senior executives who are in the know to trade on this insiderinformation without being detected, except possibly by the SEC launching a specialinvestigation.26AndinthemorethanthreedecadesthatRule10b-18hasbeeninforce,theSEC has never investigated the use of insider information on the timing of open-marketrepurchasesforpersonalgain.27 Corporate executives, or the academics who provide apologetics for them, give threereasons fordoingbuybacks thatportray thismodeof resourceallocationasbeing in thebestinterestofthecompany.Allthesereasonsare,however,deeplyflawed:28• Executivesmay claim that buybacks are donewhen the company ismature andnew

investmentopportunitieshavevanished.ButanyCEOwhomakesthisargumentisnotdoinghisorherjobofdevisingastrategytoinvestinthecompany’sfuture.Infact,itisgenerallyfinancialeconomists,seekingtorationalizebuybacks,whomakethisclaim.29CEOs are generally smart enough to recognize how such a justification for buybackswouldcalltheirleadershipcapabilitiesintoquestion.

• Executivesoftenclaimthat,inrepurchasingstock,theyaremakinganinvestmentinthecompanybecausethemarketundervaluesitsshares.Buttheevidenceisoverwhelming

25SecuritiesandExchangeCommission,“FinalRule:SelectiveDisclosureandInsiderTrading,”August15,2000,athttps://www.sec.gov/rules/final/33-7881.htm

26See,forexample,JesseEisinger,“RepeatedgoodfortuneintimingofCEO’sstocksale,”NewYorkTimesDealbook,February19,2014,athttp://dealbook.nytimes.com/2014/02/19/repeated-good-fortune-in-timing-of-c-e-o-s-stock-sale/

27SeethelettersbyU.S.Sen.TammyBaldwintoSECChairMaryJoWhiteofApril23,2015,at(www.baldwin.senate.gov/imo/media/doc/Baldwin%20Letter%20to%20SEC%204%2023%2015.pdf)and

November16,2015(www.baldwin.senate.gov/imo/media/doc/111615%20Letter%20to%20SEC.pdf)andChairWhite’sresponsesofJuly13,2015(www.documentcloud.org/documents/2272283-sec-response-to-baldwin-07132015.html#document/p1)andJanuary29,2016(copyinthepossessionoftheauthors).SeealsoDavidDayen,“SECadmitsit’snotmonitoringstockbuybackstopreventmarketmanipulation,”TheIntercept,August12,2015,athttps://theintercept.com/2015/08/13/sec-admits-monitoring-stock-buybacks-prevent-market-manipulation/.

28WilliamLazonick,“ProfitsWithoutProsperity:StockBuybacksManipulatetheMarketandLeaveMostAmericansWorseOff,”HarvardBusinessReview,September2014,46-55

29See,forexample,TheodorosEvgeniouandTheoVermaelen,“IsHillaryClintonrightaboutsharebuybacks?”INSEADKnowledge,September23,2016,athttp://knowledge.insead.edu/economics-finance/is-hillary-clinton-right-about-share-buybacks-4941.


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thatmostbuybacksarecarriedoutwhenstockpricesarehigh,notwhentheyarelow.Moreover, by this explanation, wewould expect a company to bolster the corporatetreasurybyselling itssharesonthemarketwhentheyareovervaluedinaspeculativeboom—asindeedU.S.corporationsdidintheboomofthelate1920s.30Butintheeraof“maximizing shareholder value,” a stock issue in a boomwould send a signal to themarket thatwould depress the company’s stock price. It does sometimes happen, aswas the case with General Electric in 2008, that a company that has recently donebuybacks at a high price is then compelled to sell its stock at a low price when anunexpecteddownturnputsitinfinancialdifficulty.31

• ExecutivessometimesclaimthattheircompaniesdobuybackstooffsetdilutionofEPSthatresultswhenemployeesexercisestockoptionsthattheyhavereceivedaspartoftheir compensation.But if stock-basedpay is supposed to induce employees toworkharderandsmarter,thenthosewhoreceiveitshouldhavetowaituntiltheireffortspayoff in higher corporate earnings and stock prices rather than expecting to gain rightaway from buybacks that increase EPS by simply reducing the number of sharesoutstanding.Moreover,researchhasshownthatevenathigh-techcompaniesthathavebroad-based stock-based compensation programs, resulting in high levels of dilution,thevolumeofsharesrepurchasedtendstobeamultipleof thevolumeofshares thatemployeesreceivefromoptionsandawards.32

Theonly logicalexplanation for theprevalenceofbuybacks is thatstock-basedpaygivesexecutives ample incentives to do them.33 How ample those incentives are depends inlarge part on a process of CEO-pay determination that produces a “ratchet effect” that,acrossboomsandbustsinthestockmarket,inflatesthegenerallevelofCEOpayovertime.Hereisafive-stepguidetohowU.S.CEOsmanagetheirwaytohigherexecutivepay:1. The CEO appoints a compliant board of directors, with the most prominent and

influential members being other CEOs who all have an interest in increasing the“benchmark” levelof executive compensation. Ithas longbeenknown that,whateverthe formalitiesof theelectionof thedirectorsofaU.S. corporation, it is theCEOwhochoosesitsboardmembers.34ACEOdoesnotwanttobebeholdentodirectorswhofailto appreciate his or her talent to run the company. Occasionally, the disastrousperformanceof a companyora scandalmight result inapreviously compliantboardoustingaCEO.Hedge-fundactivists,eagerto lootanestablishedcompany,sometimes

30GeneSmileyandRichardH.Keehn,“MarginPurchases,Brokers’LoansandtheBullMarketoftheTwenties.”BusinessandEconomicHistory.2dseries.17,1988:129-142.

31Lazonick,“ProfitsWithoutProsperity,”p.51.32Lazonick,SustainableProsperityintheNewEconomy?,ch.233Lazonick,“TakingStock.”34 See JayW. Lorschwith ElizabethMacIver, Pawns or Potentates: The Reality of Corporate Boards, Harvard BusinessSchoolPress,1989.ForarecentdiscussionofCEOpowervis-à-vistheboard,anditsdeclineinthefaceofhedge-fundactivismandcertainregulatorychanges,seeMarcelKahanandEdwardRock,“EmbattledCEOs,”TexasLawReview,88,2010:87-1051.ThisallegeddeclineinCEOpowermanifestsitselfintopexecutivesbecomingevermorecommittedto“maximizingshareholdervalue,”whichinturngetstranslatedintoincreasesintheirstock-basedpay.Thereasonwhythe“hostile”takeoversthatmarkedthelate1980shavelargelydisappearedisbecausethereisnolongeranyhostilitybetweenwhatusedtobecalledcorporateraidersandtopcorporateexecutives.AsIdiscussbelow,bothpartiesstandready to disgorge cash to shareholders through stock buybacks and dividends. On the rise and dominance ofshareholder value ideology and its implications for corporate resource allocation and executive pay, see WilliamLazonick,“InnovativeEnterpriseandShareholderValue,”LawandFinancialMarketsReview,8,1,2014:52-64.


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seefit,andgarnertheproxyvotes,toousttheCEO.35Ingeneral,however,whenaboardkeeps a CEO and his or her top people in place, itmarks its stamp of approvalwithgenerouscompensationpackages.

2. The CEOhires compensation consultants who benchmark the pay of other CEOswhohirethesamegroupofconsultantstobenchmarkthepayofotherCEOs.ItistheroleofcompensationconsultantstojustifytheremunerationthattheboarddeemsCEOs(andtheirseniorexecutive team)deserve.Consultants,hiredby theCEOat theexpenseofthefirm,collectdataonthecompensationofotherCEOsofcomparablefirms.ThentheyrecommendpaypackagesfortheCEOforwhomtheyareworkingandthemembersofhisorherteamofseniorexecutives.Consultantswillalmostinvariablyrecommendthat“their”CEObepaidwellabovethemedian(the75thpercentileisacommonrating)oftheotherCEOs surveyed—a sign that theirparticular client is noordinary executive.Overtime,thisbenchmarkingexerciseinevitablyratchetsupthepayofallCEOs.GiventhatCEOs are keymembersof eachother’s boards, they rarely (andprobablynever)complainthatafellowCEOisbeingoverpaid.36

3. TheCEOandhisorherseniorexecutive teamgetpaid inacurrency—thecompany’s

shares—thattheboardcandoleoutabundantlyinstockoptionsandstockawards,withincreased numbers of shares included in newoptions and awardswhen stock pricesfall,andalsoinmanycasesforhittingfinancialtargetswhenexistingstockawardsvest,thus ratcheting up CEO paywhen stock prices rise. Executives and their boards canfurther influence the potential gains from stock options by securing more favorableexercisepricesby“repricing”or“backdating”optionsandby“spring-loading”(issuingoptionsaheadof“goodnews”)or“bullet-dodging”(issuingoptionsafter“badnews”).37Unlike stock options, which have no value if the market price of the stock remainsbelowtheoptionexerciseprice,stockawardsalwayshavesomevaluebecausetheyarebestowedontheexecutiveatnocost. It isoften thecase,however, thatstockawardsonlyvestifthecompany’sstockpriceorearningspersharereachesastipulatedlevel.Moregenerally,thehigherthepriceofacompany’sstock—evenif itturnsouttobeatemporary spike—themorebothoptionsandawards cancontribute to ratchetingupexecutivepay.

4. TheCEOandotherhigh-levelexecutivespotentiallybenefitfromSECRule10b-18that,

aswehave seen,permits a corporation togivemanipulativeboosts to its stockpricethroughlarge-scaleopen-marketstockrepurchases.Intheearly1980s,thecorporate-finance debate among academics, regulators, and executives was about how muchdividends a company could distribute to shareholders while retaining sufficient

35Forthecaseofhedge-fundactivistNelsonPeltz’stakeoverofDuPont,seeAlanaSemuels,“CanAmerica’scompaniessurviveAmerica’smostaggressiveinvestors?”TheAtlantic,November182016,athttp://www.theatlantic.com/business/archive/2016/11/activist-investors/506330/

36SeeGraefS.Crystal,InSearchofExcess:TheOvercompensationoftheAmericanExecutive,Norton,1991;LucianBebchukandJesseFried,PayWithoutPerformance:TheUnfulfilledPromiseofExecutiveCompensation,HarvardUniversityPress,2004;RogerL.Martin,FixingtheGame:Bubbles,Crashes,andWhatCapitalismCanLearnfromtheNFL,HarvardBusinessReviewPress,2011;MihirDesai,“TheIncentiveBubble,”HarvardBusinessReview,March2012:124-133;RanaForoohar,“WhyWarrenBuffettshouldvote‘no’onCoke,”Time,April24,2014;JoeNocera,“Buffettpuntsonpay,”TheNewYorkTimes,April25,2014.

37SeeHopkinsandLazonick,“TheMismeasureofMammon,”pp.16-17.


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earnings to invest in the company’s productive capabilities.38 Since then, however,encouragedbytheregulatoryauthority,buybackshavebecomenotonlyenormousbutalsopervasive.According to the consulting companyFactSet, from the secondhalf of2011throughthefirsthalfof2016,withthestockmarketbooming,between360and390 of the companies in the S&P 500 Index did stock buybacks in any particularquarter.39Companiesdeploybuybacksinacompetitiontoboosttheirstockprices,andthe winnings from the competition show up in the stock-based pay that corporateexecutivestakehome.

5. The CEO and his or her senior executive team potentially benefit from the SEC’s

reinterpretation in1991of Section16(b) of the SecuritiesExchangeAct that enablestopexecutivesasinsiderstoprofitfromtheimmediatesaleofstockacquiredthroughexercising stock options rather than having towait sixmonths as had been the casesince1934.Reflectingitspermissiveattitudetostockbuybacksfrom1982,throughthe1991reinterpretationtheSECmadeitmucheasierfortopexecutiveswhoareprivytothecompany’srepurchasingactivitytousethisinsiderinformationtotimetheiroptionexercises and stock sales to increase theirpay.Until1991, Section16(b)of the1934Securities Exchange Act prevented top executives from reaping short-swing profitswhentheyexercisedtheirstockoptions.UnderSection16(b),ifaninsidersoldsharesacquiredbyexercisingstockoptionswithinsixmonthsof theexercisedate, thegainshad to be forfeited to the corporation. In 1991, by arguing that a stock option is aderivative, the SEC determined that henceforth the six-month waiting period wouldbegin at the option’sgrant date, not the exercise date. Since the option grant date isalwaysatleastoneyearbeforetheoptionexercisedate,thisreinterpretationofSection16(b) meant that top executives, as company insiders, could now sell the sharesacquiredfromstockoptionsimmediatelyuponexercise.40

Theresulthasbeenanongoingexplosionofexecutivepaysincethe1980s,enablingseniorexecutivestobewellrepresentedamongthetopone-tenthofonepercentofhouseholdsintheU.S.incomedistribution.Figure6displaysdatafor1916to2011ontheincomesharesof the top 0.1% of U.S. households, collected from tax returns by Thomas Piketty,EmmanuelSaez,andtheircolleagues.41Ascanbeseen,thelargestcomponentofexecutivepayover thepastquarter centuryhasbeen “salaries,” supplementedby spikes in capitalgainsatthepeaksofthestock-marketboomsin2000and2007.The“salaries”data,whichalso display spikes in stock-market booms, include substantial stock-based pay taxed at

38See,forexample,thefinalspeechofHaroldWilliamsaschairmanoftheSECbeforeresigninghispositioninviewoftheelection of Ronald Reagan to the U.S. Presidency. Harold M. Williams, “The Corporation as Continuing Enterprise,”address delivered to the Securities Regulation Institute, San Diego, California, January 21, 1981, atwww.sec.gov/news/speech/1981/012281williams.pdf. Williams had previously been a corporate lawyer, businessexecutive,anddeanoftheUCLAbusinessschool.

39AndrewBirstingl,“FactSetBuybackQuarterly,”September20,2016,athttp://www.factset.com/websitefiles/PDFs/buyback/buyback_9.20.16

40CaroleGould,“Shakingupexecutivecompensation,”TheNewYorkTimes,April9,1989,p.F13;JanM.Rosen,“Newregulationsonstockoptions,”TheNewYorkTimes,April27,1991,p.38.

41“TheWorldWealthandIncomeDatabase:http://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,Top0.1%incomecomposition.


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ordinary rates, which is not distinguished as stock based in the data collected frompersonalincome-taxreturns.42

Federal taxreturns include informationona filer’soccupationand, throughanemployeridentification number (EIN) on FormW-2, the type of business sector that provides thetaxpayerwithhisorherprimaryemploymentincome.JonBakija,AdamColeandBradleyHeimaccessedfederaltaxreturndataforselectedyearsfrom1979to2005toanalyzetheoccupationsoffederaltaxpayersatthetopoftheU.S.incomedistribution.Theyfoundthat“executives, managers, supervisors, and financial professionals account for about 60percentofthetop0.1%ofincomeearnersinrecentyears,andcanaccountfor70percentof the increase in the share of national income going to the top 0.1% of the incomedistributionbetween1979and2005.”43

Figure6.ShareoftotalU.S.incomesofthetop0.1%ofhouseholdsintheU.S.incomedistributionanditscomponents,1916-2011

Source:http://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,Top0.1%incomecomposition.Note:Thecategory“salaries”includescompensationfromtherealizedgainsonexercisingstockoptionsandthe

vestingofstockawards.

42Almostallgainsfromexercisingemployeestockoptionsandthevestingofemployeestockawardsaretaxedattheordinaryincome-taxrate,notatthecapital-gainstaxrate,withtaxeswithheldbytheemployeratthetimethatoptionsareexercisedorawardsvest.Hencethesestock-basedgainsarereportedaspartof“wages,tips,othercompensation.”IRSForm1040forindividualincome-taxreturnshasthelineitem(no.7):“Wages,salaries,tips,etc.AttachForm(s)W-2,”inwhichrealizedgainsfromstock-basedpayareincludedbutnotshownseparatelyfromotherformsofcompensation.OnFormW-2,thecorrespondingitemis(no.1)“Wages,tips,othercompensation.”

43JonBakija,AdamCole,andBradleyT.Heim,“JobsandIncomeGrowthofTopEarnersandtheCausesofChangingIncomeInequality:EvidencefromU.S.TaxReturnData,”workingpaper,April,2012,athttps://web.williams.edu/Economics/wp/BakijaColeHeimJobsIncomeGrowthTopEarners.pdf.Thequoteisfromthepaper’sabstract.


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For 2005, they found that, of taxpayers whose incomes (including capital gains) placedthem in the top 0.1%, executives, managers, and supervisors in non-finance businessesmade up 41.3 percent of the total,while financial professionals (includingmanagement)were another 17.7 percent. Of the 41.3 percent who were non-finance executives,managers or supervisors, 19.8 percent were salaried and the rest were in closely heldbusinesses.44Besidesthe6.2percentofthetop0.1%whowere“notworkingordeceased,”the next largest occupational groupswere lawyerswith 5.8 percent, real estatewith 5.1percent,andmedicalwith4.1percent.WecanusetheStandard&Poor’sExecuCompdatabase,whichcompilesdataonexecutivepay that is in SECFormDEF14A—theproxy statement that a company filesprior to itsannualgeneralmeetingofshareholders—togetanideaoftherepresentationofhigh-paidcorporate executives among the top 0.1% of households in the income distribution. In2012, for example, the threshold income including capital gains for inclusion in the top0.1%of the incomedistributionwas$1,906,047.45FromtheExecuCompproxystatementdataon“named”topexecutives(theCEO,CFO,andthreeotherhighest-paidexecutives),in2012,4,339executives(41percentoftheexecutivesintheExecuCompdatabasethatyear)had total compensation greater than this threshold amount, with an average income of$7,524,168. Of that amount, 64 percent were realized gains from stock-basedcompensation,with32percentderivedfromtheexerciseofstockoptionsandtheother32percentfromthevestingofstockawards.Thenumberofcorporateexecutiveswho,in2012,weremembersofthetop0.1%clubwas,however,farhigherthan4,339fortworeasons.First,totalcorporatecompensationofthenamed executives does not include other non-compensation income (from securities,property,feesforsittingontheboardsofothercorporations,etc.)thatwouldbeincludedin their federal tax returns. If we assume that named executives whose corporatecompensationwasbelowthe$1.91millionthresholdwereabletoaugmentthatincomeby25 percent (to pick a plausible number) fromother sources, then the number of namedexecutivesinthetop0.1%in2012wouldhavebeen5,095.Second, included in the top0.1%of theU.S. incomedistributionwereapotentially large,butunknown,numberofU.S.corporateexecutiveswhosepaywasabovethe$1.91millionthreshold,butwhowerenotnamed inproxystatementsbecause theywerenot theCEO,CFO or one of the three other executives named by their particular companies in proxystatements. For example, of the highest paid IBM executives in 2012 named in thecompany’sproxystatement,thelowestpaidhadatotalcompensationof$9,177,663.TherewerepresumablymanyotherIBMexecutiveswhosetotalcompensationwasbetweenthisamount and the $1.91million threshold for inclusion in the top 0.1%. These “unnamed”executiveswouldhavebeenamongthetop0.1%intheincomedistribution.Therefore, top executives ofU.S. business corporations—industrial aswell as financial—areverywellrepresentedamongthetop0.1%oftheU.S.incomedistribution,withmuch,and often most, of their compensation income coming from the realized gains from44Ibid.,p.38.45TheWorldWealthandIncomeDatabase,athttp://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,P99.9incomethreshold.


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exercisingstockoptionsandthevestingofstockawards.WhenthismodeofcompensatingtopexecutivesiscombinedwiththefactthatWallStreethas,sincethe1980s, judgedtheperformanceofcorporationsbytheirquarterlystockprices,theimportanceofstock-basedpay in executive compensation is clear. Stock-based pay gives top executives powerfulpersonal incentives to boost, fromquarter to quarter, the stock prices of the companiesthat employ them. In stock buybacks, these executives have found a potent, and SEC-approved, instrument for stock-market manipulation from which they can personallybenefit,evenifthestock-priceboostsareonlytemporary.The ExecuCompdatabase provides the numbers needed to determine howmuchmoneythe highest-paid corporate executives in the United States take home in total and theproportionof their total compensationwhich is stockbased.Figure7shows theaveragetotalcompensationofthe500highest-paidexecutivesintheExecuCompdatabaseforeachyearfrom2006through2015.Itrangesfromalowof$15.9millionin2009,whenthestockmarkets had crashed,with stock-basedpay (realized gains from stockoptions and stockawards)makingup60percentofthetotal,toahighof$32.6millionin2015,withstock-basedgainsmakingup82percentofthetotal.U.S.corporateexecutivesareincentivizedtoboosttheircompanies’stockpricesandareamplyrewardedfordoingso.InSEC-approvedstock buybacks, they have at their disposal an instrument to enrich themselves. In theirmassive,widespread,andubiquitoususeofthisinstrument,theyhavebeenparticipatinginthelootingoftheU.S.businesscorporation.

Figure 7: Average total compensation and cumulative percentage shares of paycomponents,500highest-paidexecutivesineachyear,2006-2015

Source: Standard& Poor’s ExecuCompdatabase, retrievedOctober 11, 2016. Calculations byMattHopkins of the

Academic-IndustryResearchNetwork


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Note:The followingextraordinarilyhighlypaidoutliers,with$1billionormore in total compensation,havebeenremoved: 2012, Richard Kinder, Kinder Morgan, $1.1 billion, and Mark Zuckerberg, Facebook, $2.3 billion;2013,MarkZuckerberg,$3.3billion.

4. How,andWhy,theValue-ExtractingCEOUnderminesInnovativeEnterpriseDobuybacksaffectthecapabilityofthecompaniesthatdothemtoinnovateandcompete?Theanswer to thisquestion requiresdetailed research into companies and industries todiscern the impacts of a company’s financial behavior on the three social conditions ofinnovative enterprise—strategic control, organizational integration, and financialcommitment—and then relate these effects on innovative capabilities to competitiveoutcomes.Oneprobleminherentindoingthistypeofresearchisthat,liketheinnovationprocessitself,thedeleteriousimpactsofbuybacksonthatprocessonlyunfoldandbecomeapparentovertime.Ingeneratingcompetitiveproducts,thethreeconditionsofinnovativeenterprisearedynamicallyinterrelated,aprocessthatcanonlybeunderstoodthroughanin-depthlongitudinalcasestudyapproach.46 Throughthistypeofresearchintothesocialdynamics of innovative enterprise, we have gained a number of important insights thatenable us to pose hypotheses into how stock buybacks can undermine a company’sinnovativecapabilities.a) Strategiccontrol

Senior executives who are willing to waste hundreds of millions or billions of dollarsannuallyonbuybacksarelikelytolosethejudgmentalcapacitytocomprehendthetypesofinvestmentsinorganizationandtechnologythatarerequiredtoremaininnovativeintheirindustries. Executives’ use of financial tools to determine whether the “relevant cost ofcapital”(asJensenputitinanessayon“agencycosts”47)justifiesinvestmentininnovationreflects, inmy view, this loss of judgmental capacity.48 Instead, the current structure ofstock-based executive remuneration creates incentives for senior executives to allocateresources inways thatachieve “timely”boosts to stockprices thathelp to increase theirtake-homepay.49Thereareotherways inwhich,dependingonthe industry inwhichthecompany operates, an executive can generate manipulative increases in stock prices; aprominent example is price-gouging in the pharmaceutical industry.50 More generally,

46Forreferencestothebodyofempiricalresearchthathasbeencarriedoutfromthe“innovativeenterprise”perspective,seeLazonick,“LaborintheTwenty-FirstCentury”;MattHopkinsandWilliamLazonick,“WhoInvestsintheHigh-TechKnowledgeBase?”InstituteforNewEconomicThinkingWorkingGrouponthePoliticalEconomyofDistributionWorkingPaperNo.6,September2014(revisedDecember2014),athttps://ineteconomics.org/ideas-papers/research-papers/who-invests-in-the-high-tech-knowledge-base;WilliamLazonick,PhilipMoss,HalSalzman,andÖnerTulum“SkillDevelopmentandSustainableProsperity:CollectiveandCumulativeCareersversusSkill-BiasedTechnicalChange,”InstituteforNewEconomicThinkingWorkingGrouponthePoliticalEconomyofDistributionWorkingPaperNo.7,December2014,athttps://ineteconomics.org/ideas-papers/research-papers/skill-development-and-sustainable-prosperity-cumulative-and-collective-careers-versus-skill-biased-technical-change;HopkinsandLazonick,“TheMismeasureofMammon.”

47MichaelC.Jensen,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers,”AmericanEconomicReview,76,2,1986:323-329.

48SeeCarlissY.Baldwin,“HowCapitalBudgetingDetersInnovation–andWhatToDoAboutIt,”ResearchTechnologyManagement,34,6,1991:39-45;ClaytonChristensen,StephenP.Kaufman,WillyC.Shih,“InnovationKillers:HowFinancialToolsDestroyYourCapacitytoDoNewThings,”HarvardBusinessReview,January2008:98-105.

49Lazonick,“TakingStock.”50Lazonicketal.,“U.S.Pharma’sBusinessModel.”


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however, thestockbuyback isapowerful toolat thedisposalofcorporateexecutives formanipulatingthestockmarketfortheirpersonalgain.

b) Organizationalintegration

Collectiveandcumulative,ororganizational,learningaboutthetechnologies,markets,andcompetitors relevant to a particular industry is the foundation for generating the higherquality,lowercostgoodsandservicesthatresultinproductivitygrowth.51Productivityiscollective because one learns through the interaction with others in a hierarchical andfunctionaldivisionoflabor.Productivityiscumulativebecausewhatthecollectivitylearnstoday provides the foundation for what it is capable of learning tomorrow. What I call“collectiveandcumulativecareers”areessential fororganizational learning,especially inindustriesthataretechnologicallyandorganizationallycomplex.Itisonthebasisofhigherlevels of productivity generatedby organizational learning that business enterprises canpaytheirvaluedemployeeshigherwagesonasustainablebasis.Organizationallearninginturn depends on a “retain-and-reinvest” corporate resource-allocation regime in whichsenior executivesmake corporate resource-allocation decisions that, by retaining peopleand profits in the company, permit reinvestment in the productive capabilities that cangeneratecompetitive(high-quality,low-cost)products.52Ourresearchintothedynamicsofinnovative enterprise supports the hypothesis that, as part of a corporate resource-allocation regime that downsizes the U.S. labor force and distributes corporate cash toshareholders, stock buybacks are done at the expense of investments in collective andcumulative careers. The disappearance of this career employment in major businessenterprises is central to the erosion of the American “middle class” over the past threedecades.53c)FinancialcommitmentBuybacks represent a withdrawal of internally controlled finance that could be used tosupport investment in the company’s productive capabilities. For many of the largestrepurchasers, suchas the fourhigh-techcompanies included inTable1above,dominantproduct-marketpositionsbasedonpastinvestmentsininnovationgeneratethestreamofprofits that enable these companies to do billions of dollars in buybacks year after yearwithout running low on cash. The ability of some companies to use their cash reserves,oftenleveragedbyborrowedfunds,tomanipulatetheirstockpricesplacespressurestodolarge-scale buybacks on other companies whose “success” is measured by stock-priceperformance but whose cash flow is insufficient to support their buyback habits. Everyonceinawhile,asdocumentedinourresearch,acompanythathasdonemassivebuybacksover a period of years hits a financial wall, at which point the billions of dollars that it

51Lazonick,“TheTheoryofInnovativeEnterprise”;Lazonicketal.,“SkillDevelopmentandSustainableProsperity.”52WilliamLazonickandMaryO’Sullivan,“MaximizingShareholderValue:ANewIdeologyforCorporateGovernance,”EconomyandSociety,29,1,2000:13-35;Lazonick,“StockBuybacks.

53Lazonick,“LaborintheTwenty-FirstCentury”:WilliamLazonick,PhilipMoss,andJoshuaWeitz,“TheEqualEmploymentOpportunityOmission,”InstituteforNewEconomicThinkingWorkingPaperNo.53,December5,2016,athttps://www.ineteconomics.org/research/research-papers/the-equal-employment-opportunity-omission.


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wastedonbuybacksarenotavailabletosupportaprocesstorestructureitsaccumulatedcapabilitiestobecomeinnovativeonceagain.54Ifstockbuybacksundermineinnovativeenterprise,whydoestheU.S.governmentpermitthem? The answer is the dominance of a flawed economic theory that argues thatMSV,implemented in part through buybacks, leads to superior economic performance.Corporateexecutives,withtheirstock-basedincentives,haveembracedtheideologyoftheeconomic superiorityofMSV, justifying thismodeof “returning”value to shareholders—even though the executives should know that the vast majority of shareholders neveractuallyinvestedintheproductivecapabilitiesthatcreatevalue.Forover30years,underthe sway of MSV and with the acquiescence of senior corporate executives, the U.S.government agency that is supposed to regulate the stockmarkets “toprotect investors,maintain fair, orderly, and efficient markets, and facilitate capital formation,”55 has hadRule 10b-18 in effect that encourages companies to do open-market repurchases tomanipulatetheirstockprices.BuybacksbearaconsiderablepartoftheresponsibilityforadamagedU.S.economy.Thismode of resource allocation serves to concentrate income and wealth at the top of thedistribution and comes at the expense of investment in the types of stable andremunerativecareeremploymentopportunitiesthatcanyieldabroad-basedmiddleclass.Whenthemostprofitablecorporationsareinadownsize-and-distributemode,sustainableprosperity—stable and equitable economic growth— in the U.S. economy becomes animpossiblegoal.56Underpinning the legitimacy of the buyback corporation is the MSV ideology thatcompaniesshouldberun tomaximize thedistributionof income to thoseparticipants inthecorporateeconomywhomatterleasttoitsoperationandperformance.57MSVideologyis rooted in two misconceptions of the role of public shareholders in the U.S. businesscorporation.Themostfundamentalerroristheassumptionthatpublicshareholdersinvestin the productive assets of the corporation. That error is then compounded by theassumption that it is only public shareholders who make risky investments in thecorporation’sproductiveassets,andhencethatitisonlyshareholderswhohaveaclaimonthe corporation’s profits. Oncewe recognize the flaws in these assumptions, the factualfoundationforMSVideologyfallsapart.54Lazonick,“Everyoneispayingthepriceforsharebuy-backs”;Lazonick,“Thebuybackboondoggle”;WilliamLazonick,“TheFinancializationoftheUSCorporation:WhatHasBeenLost,andHowItCanBeRegained”SeattleUniversityLawReview36,2013:857-908;Lazonick,“LaborintheTwenty-FirstCentury.”

55U.S.SecuritiesandExchangeCommission,“TheInvestor'sAdvocate:HowtheSECProtectsInvestors,MaintainsMarketIntegrity,andFacilitatesCapitalFormation,”athttp://www.sec.gov/about/whatwedo.shtml#.VJN6FAlA.

56Lazonick,“LaborintheTwenty-FirstCentury.”57Valueextractionbythosewhohavemadenocontributionstotheprocessofvaluecreationismostobviousinthecaseofhedge-fundactivistswhopurchaseblocksofacompany’sstockonthemarket,andthenpressureexecutivesto“unlock”valueforshareholders.See,forexample,ouranalysisoftheroleofthestockmarketinthehistoryofAppleInc.andtherecentraidsonApple’scorporatetreasurybyhedgefundactivistsDavidEinhornandCarlIcahn.Lazonicketal,“Apple’sChangingBusinessModel”;WilliamLazonick,“NumbersshowAppleshareholdershavealreadygottenplenty,”HarvardBusinessReviewBlog,October16,2014,athbr.org/2014/10/numbers-show-apple-shareholders-have-already-gotten-plenty;WilliamLazonick,MattHopkins,andKenJacobson,“WhatwelearnaboutinequalityfromCarlIcahn’s$2billion‘nobrainer,’”InstituteforNewEconomicThinkingIdeas&Papers,June6,2016,athttps://ineteconomics.org/ideas-papers/blog/what-we-learn-about-inequality-from-carl-icahns-2-billion-apple-no-brainer


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The proponents of MSV argue that by making stock-based pay a major proportion ofexecutive compensation, the incentives of corporate managers in the allocation ofresourcescanbealignedwiththoseofpublicshareholders.58Onlyifthecorporation’s“freecash flow” is distributed (or as they put it, “disgorged”) to shareholders, the MSVproponentscontend,willtheeconomy’sresourcesbeallocatedtotheirmostefficientuses.Themoney fromthecorporatecofferscanbedistributed toshareholders in the formsofcashdividendsandstockrepurchases.59Central to the MSV argument is the assumption that, of all participants in the businesscorporation, shareholders are the only economic actors who make productivecontributions without a guaranteed return. All other participants such as creditors,workers, suppliers, and distributors allegedly receive amarket-determined price for thegoodsorservices that theyrender to thecorporation,andhence takenoriskofwhetherthecompanymakesor losesmoney.Onthisassumption, theverydefinitionof“freecashflow” includes corporate earnings that under a retain-and-reinvest resource-allocationregimethecorporationwouldhave invested in trainingandretainingemployees.Andonthisassumption,onlyshareholdershaveaneconomicallyjustifiableclaimtothe“residual”ofrevenuesovercostsafterthecompanyhaspaidallotherstakeholderstheirguaranteedcontractualclaimsfortheirproductivecontributionstothefirm.BytheMSVargument,shareholdersaretheonlystakeholderswhoneedtobeincentivizedtobeartheriskofinvestinginproductiveresourcesthatmayresultinsuperioreconomicperformance. As the only “residual claimants,” theMSV story goes, shareholders are theonly stakeholders who have an interest in monitoring managers to ensure that theyallocateresourcesefficiently.Furthermore,bybuyingandsellingcorporatesharesonthestockmarket, public shareholders, it is argued, can directly reallocate resources to usesthataremoreefficientthaninvestmentswithinthecorporation.Asalreadystated,therearetwofundamentalflawswiththisargument.60Thefirstflawisthecontention that,via thestockmarket,public shareholdersallocate resources tomoreefficient uses. As a general rule, they do not.Passive shareholdersmerely use the stockmarkettogeneratereturnsontheirhouseholdsavingstoaugmenttheirincomes,oftentofund their retirement. Most representative today of active shareholders are hedge-fundactivists,formerlyknownascorporateraidersandbetterdescribedascorporatepredators,who seek to extract value from companies by pressuring CEOs and their boards todownsizeanddistribute,andwherepossibleengageinpricegougingofbuyers,sothattheycanselltheirsharesathigherpricesandtherebybuildtheirhedge-fund“warchests,”thusincreasingtheir financialpowertoextractevenmorevalue fromcompaniesastimegoeson.61 MSV is the ideology, now widely accepted by conservative and liberal economistsalike,thatlegitimizesthislootingoftheindustrialcorporation.58SeeMichaelC.JensenandKevinJ.Murphy,“PerformancePayandTopManagementIncentives”JournalofPoliticalEconomy,98,2,1990:225-264.

59Jensen,“AgencyCostsofFreeCashFlow.”60SeeLazonickandO’Sullivan,“MaximizingShareholderValue”;WilliamLazonick,“InnovativeEnterpriseandShareholderValue,”LawandFinancialMarketsReview,8,1,2014:52-64;Lazonick,“StockBuybacks.”

61Asanexample,seeLazonick,etal.,“WhatwelearnaboutinequalityfromCarlIcahn’s$2billion‘nobrainer’.”SeealsoLazonick,etal.,“U.S.Pharma’sBusinessModel.”


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ThesecondflawwithMSVliesintheerroneousassumptionthatshareholdersaretheonlycorporate participants who bear risk. Taxpayers through government agencies andworkers through the firms that employ them make risky investments in productivecapabilitiesonaregularbasis.Fromthisperspective,householdsastaxpayersandworkersmay have “residual claimant” status: that is, an economic claim on the distribution ofprofits.Through government investments and subsidies, taxpayers regularly provide productiveresources to companieswithout a guaranteed return.Asan important example,butonlyoneofmany,the2016budgetoftheU.S.NationalInstitutesofHealth(NIH)is$32.3billion,with a total NIH investment in life-sciences research from 1938 through 2015 of $958billionin2015dollars.62Businessesthatmakeuseoflife-sciencesresearchbenefitfromthepublic knowledge that the NIH generates. As risk bearers, taxpayers who fund suchinvestmentsintheknowledgebase,orphysicalinfrastructuresuchasroads,haveaclaimoncorporateprofitsifandwhentheyaregenerated.Throughthetaxsystem,governments,representinghouseholds as taxpayers, seek to extract this return fromcorporations thatreaptherewardsofgovernmentspending.However,taxrevenuesontheprospectivegainsfrominnovationdependonthesuccessofinnovativeenterprisewhile,throughthepoliticalprocess, tax rates on those gains are subject to change. Hence, for both economic andpoliticalreasons,thereturnstotaxpayerswhosemoneyhasbeeninvestedforthebenefitofbusinessenterprisesarebynomeansguaranteed.Workers regularlymakeproductive contributions to the companies forwhich theyworkthrough theexerciseof skill andeffortbeyond those levels required to layclaim to theircurrentpay,butwithoutguaranteedreturns.63Anyemployerwhoisseekingtogenerateahigher-quality, lower-cost product knows the profound productivity difference betweenemployeeswhojustpunchtheclocktogettheirdailypayandthosewhoengageinlearningtomakeproductivecontributionsthroughwhichtheycanbuildtheircareersandtherebyreapfuturereturnsinworkandinretirement.Yetthesecareersandthereturnsthattheycan generate are not guaranteed, and under the downsize-and-distribute resource-allocationregimethatMSVideologyhashelpedputinplacethesereturnsandcareershavebeen,infact,undermined.As risk bearers, therefore, taxpayers whose money supports business enterprises andworkers whose efforts generate productivity improvements have claims on corporateprofitsifandwhentheyoccur.MSVignorestherisk-rewardrelationforthesetwotypesofeconomic actors in the operation and performance of business corporations. Instead iterroneouslyassumesthatshareholdersaretheonlyresidualclaimants.TheironyofMSVisthatthepublicshareholderswhomitholdsupastheonlyriskbearerstypicallyneverinvestinthevalue-creatingcapabilitiesofthecompanyatall.Rather,theypurchaseoutstandingcorporateequitieswiththeexpectationthatwhiletheyareholdingthesharesdividendincomewillbeforthcomingandwiththehopethatwhentheydecideto62NationalInstitutesofHealth,“Budget,”athttp://www.nih.gov/about-nih/what-we-do/budget.SeealsoLazonickandTulum,“USBiopharmaceuticalFinance.”

63Lazonick,CompetitiveAdvantageontheShopFloor;Lazonick,“TheTheoryofInnovativeEnterprise.”


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sellthesharesthestock-marketpricewillhaverisentoyieldacapitalgain.Followingthedirectives ofMSV, a primeway inwhich the executiveswho control corporate resourceallocationfuelthishopeisbyallocatingcorporatecashtostockbuybackstopumpuptheircompany’sstockprice.Yetitistheseniorexecutivesthemselveswhoarebestpositionedtogain fromthesemanipulativeprice increases.Seniorexecutives“disgorge”thiscashflow,notforthesakeofefficientresourceallocation,butratherforthesakeofincreasingtheirownstock-basedpay.645. ReinstallingtheValue-CreatingCEOMSVisnotsimplyabusinessideology.It isaproductofneoclassicaleconomicswhich, inboth its conservative and liberal versions, views the market as the mode of efficientresourceallocationandignoresthecentralroleofbusinesscorporationsinthesuccessorfailure of the economy to invest in productive employment opportunities.65 Inmy view,MSV is the most economically damaging ideology ever propounded by the economicsprofession. Any policy agenda that is concerned with employment opportunity mustengage in new economic thinking about the role of the corporation in the economy andtakestepstoputanendtotheeconomic—andonemightalsoaddthepolitical—disasterthatMSVhaswrought.Thedeeper intellectualproblem is that agency theory, like theneoclassical theoryof themarket economy from which it is derived, lacks a theory of innovative enterprise. Forneoclassical economics, strategic control is irrelevant because only the possession ofmoneymatters in the investmentprocess, as it flows fromoneprofitableopportunity toanother.Butliquidmoneyisacommoditythatplaysnoroleingeneratingthehigh-quality,low-costproductsonwhicheconomicgrowthdepends.Thegenerationof theseproductsdepends on a combination of strategic control that allocates resources in the face ofuncertainty,organizationalintegrationthattransformstechnologiesandaccessesmarkets,and financial commitment that sustains the innovation process until it can generatereturns. For agency theory, in sharp contrast, the innovative enterprise is a marketimperfection fromwhich, for the sake of superior economic performance, cashmust bedisgorged.There isnodoubt thatat certain timesand incertainplaces,with technologies,markets,and competitors undergoing change, a previously innovative enterprise can find itproblematictoremaincompetitive.ButMSVexploitsandexacerbatesthevulnerabilityofthe corporation that seeks to reallocate its resources to make this productivetransformation.Lackingatheoryofinnovativeenterprise,agencytheoristshavenowayofrecognizing, let alone analyzing, the sources of a malfunctioning corporation or thestrategic, organizational, and financial conditions needed to renovate it. Disgorging thecashflowtoshareholdersmayinfactcauseabusinessorganizationtofail,butevenwhenitcanbearguedthatmassivedistributionstoshareholdersisaresponsetocorporatefailure,

64HopkinsandLazonick,“TheMismeasureofMammon.”65WilliamLazonick,“TheTheoryoftheMarketEconomyandtheSocialFoundationsofInnovativeEnterprise,”Economic

andIndustrialDemocracy,24,1,2003:9-44;Lazonick,“InnovativeEnterpriseorSweatshopEconomics?”


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this flowof fundsdoesnot fix that failure.Rather itcontributestoan inequitable incomedistributionandanerodingmiddleclass.Fromtheperspectiveofinnovationtheory,theMSV-drivenpolicyprescriptionsofagencytheoryarepreciselytheeconomicinstitutionsthatmustbeundone.Forstarters,theSEC,astheregulatorofthestockmarket,shouldrecognizeitsmistakeintheadoptionofRule10b-18, andbanopen-market repurchases.Thenpolicy reformshouldbe focusedon thedisincentives to invest in innovation created by the current system of executive stock-basedpay,withanewsystemseekingtoensurethattheremunerationofseniorexecutivesdependsontheinnovativesuccessofthebusinessorganizationasawhole.Oncetheproblemsofstrategiccontrolhavebeenaddressed,theprocessoftakingbackthecorporation can turn to the critical role of organizational integration. Productivity in anadvancedeconomydependson theextent towhichmembersof the labor forcehave theopportunitytoengageincollectiveandcumulativelearningoverthecourseofcareersthatmayspan40yearsormore.UnderwhatIhavecalledthe”OldEconomybusinessmodel,”majorcorporationssupportedthissocialconditionthroughthenormofacareerwithonecompany, albeit almost exclusively for whitemales. It is unrealistic to assume that in aworldofopen-systems technologiesand intenseglobal competition thenormofa careerwithonecompanycould,orshould,berestored.That does not, however, lessen the need for collective and cumulative careers as theemploymentfoundationofahighlyproductiveeconomy.Itisreasonabletobelievethatintheprovisionoflifelonglearningthroughon-the-jobexperience,governmentagenciesandcivilsocietyorganizations, includinguniversities,willhavetocontinuetoplay important,and perhaps even growing, roles in enabling individuals to pursue collective andcumulative careers. The business corporation, however, will have to anchor a nationalsystem of career employment with a retain-and-reinvest resource-allocation regime.Jettison thedownsize-and-distribute ideologyofMSV,andU.S.businesscorporationscanfocusonbecominglearningorganizationsonceagain.If hundreds of billions of dollars annually stop flowing out of the nation’s majorcorporations to do buybacks, then vast amounts of resources will become available toprovidethefinancialcommitmentthatinnovationrequires.66Banbuybacksandcompanieswillbeabletousethesefundsnotonly,orevenprimarily,tofinancecapitalexpendituresbutmoreimportantlytoattract,train,retain,andmotivatetheircareeremployees.Inhigh-techcompaniesasignificantproportionoftheseemployeeswillbeengagedinR&D,buttheinnovative enterprise needs experienced and motivated employees in a range of otherfunctions as well. And some of fundsmade available by a buyback ban can flow to thegovernmentastaxrevenuestoenableittoinvestinthephysicalinfrastructureandhumanknowledgethatcanunderpinthenextgenerationofinnovation.The governance of innovative enterprise requires a dramatic change in the acceptedpurposeofthecorporationandthecompositionofcorporateboards.Fromtheperspective66See,forexample,WilliamLazonick,“WhatAppleshoulddowithitsmassivepilesofmoney,”HarvardBusinessReviewBlogNetwork,October20,2014,athttp://blogs.hbr.org/2014/10/what-apple-should-do-with-its-massive-piles-of-money/


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ofinnovativeenterprise,thepurposeofthebusinesscorporationistoproducehighquality,lowcost,i.e.,competitive,goodsandservices.Ifthebusinesscorporationcanperformthisrole, then profitswill follow. The board of directors should be composed of peoplewhohave insights into how a company can generate competitive products, includingrepresentativesofworkersandtaxpayerswhocollectivelyinvestintheinnovationprocess.These board members should be capable of exercising sound judgment of the types ofinvestment in productive capabilities that the company should make as well as thecompany’sresponsibilitiestothesocietyofwhichitisapart.Replacing agency theory with its focus on “downsize-and-distribute” with innovationtheory with its focus on “retain-and-reinvest” highlights, therefore, three institutionalchangesthatareessentialforreinstallingthevalue-creatingCEO:Banstockbuybacks:Householdsassaverswhoallocatesomeoftheirassetstocorporatestockscangetan income fromdividends ifandwhenaretain-and-reinvestcompanycanafford to pay them, and then, as a result of well-managed investments in productivecapabilities, expect to be able to sell shares at higher prices if and when they want toreadjust their financial portfolios. Stock buybacks that are permitted, and indeedencouraged,bytheSECunderRule10b-18aresimplyameansofmanipulatingstockpricesto reward those who are positioned to time their share selling, including the seniorcorporate executiveswhomake the buyback decisions, hedge-fundmanagerswho applypressure forbuybacks,and investmentbankerswhohelpengineer them.Stockbuybacksmakeamockeryof the SEC’s statedmission “toprotect investors;maintain fair, orderly,and efficient markets; and facilitate capital formation.”67 SEC Rule 10b-18 should berescinded,andstockbuybacksshouldbebanned.Restructure corporate executive incentives: The vast majority of the pay of seniorcorporate executives is stock based, rewarding them for selling corporate shares in thewakeofrapidstock-priceincreases,oftenassistedbybuybacksandotherformsofmarketmanipulation.Thestockpricesofpubliclylistedcompaniesaredrivenbyacombinationofinnovation, speculation, and manipulation, and increasingly executives have beenrewardedforvalue-extractingmanipulationratherthanvalue-creatinginnovation.Rewardsenior executives for generating high-quality products at low unit costs (the economicdefinition of innovation that results in competitive goods and services), and tie theirremuneration to the increasedemploymentstabilityandenhancedearningsof thebroadbaseofemployeeswhoseskillsandeffortshelptogeneratethoseproducts.Asafirststepin this process, the SEC needs to ensure that the public knows how much corporateexecutivesactuallygetpaid.AsMattHopkinsandIhaveshown,theSEChaspromulgatedwhat are called “estimated fair value” measures of stock-based executive pay thatsignificantly, and often dramatically, understate executives’ actual realized gains fromstock-basedpaybecausetheestimationformulae(Black-Scholes-Mertonpricingmodelsinthe case of stock options) fail to capture the roles of innovation, speculation, andmanipulationindrivingstockprices.6867U.S.SecuritiesandExchangeCommissionwebsite,athttps://www.sec.gov/about.shtml.68HopkinsandLazonick,“TheMismeasureofMammon”;HopkinsandLazonick,“Corporateexecutivesaremakingwaymoremoneythananyonereports.”Forexample,in2015forthe500highest-paidexecutives,totalcompensationincludingactualrealizedgainsfromstock-basedpayaveraged$32.6million,with82percentfromstock-basedpay,


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Transform corporate governance: Through government investment in physicalinfrastructureandthesociety’sknowledgebase,households-as-taxpayersrisktheirmoneyinhelpingtofundbusinessinvestmentinproductivecapabilities.Throughtheapplicationoftheirskillsandefforts,households-as-workersrisktheirtime,andhencelivelihoods,inhelping to generate competitive products that may result in future business profits. Onthese bases, households-as-taxpayers and households-as-workers should haverepresentation on the boards of directors of publicly listed companies. Households-as-shareholdersshouldalsohaveboardrepresentation,butitshouldbeassavers.Theydonotgenerally invest in the productive capabilities of the companieswhose shares they hold,and hence should not be called “investors,” as is typically the case. Parties who haveactuallyinvestedinacompany’sproductivecapabilitiesshouldhaveboardrepresentation.Butspeculatorsandmanipulatorswhomaketheirmoneybybuyingandsellingcorporateshares,andhencedonotmakeproductiveinvestmentsandwouldbeinpositionstoabuseinsider information, should not be permitted to be on corporate boards. And by thatcriterion, CEOs who sit on corporate boards and control corporate resource allocationshould be innovators who create value through a regime of retain-and-reinvest, notmanipulatorswhoextractvaluethrougharegimeofdownsize-and-distribute.

whereastheirtotalcompensationusingestimatedfairvaluemeasuresaveraged$17.1million,withthefair-valueestimatesmakingstock-basedpay62percentofthetotal.

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