Financialization of Corporations

Traditional corporate management practices prior to the 1980s focused on executing tasks to create value for customers, followed by developing and retaining employees and suppliers, and adopting long-term strategies. Developing new products and services was a core corporate activity, regarded as essential for successful management, which thrived by establishing conditions for employees to be effective, learn new skills, and grow in the workplace. The overarching belief was that sales and profits would follow if these tasks were done well.

Extraction of Money Becomes the Central Goal

Beginning in the early 1980s, a significant shift occurred in defining management success. Long-term profits, satisfied customers, innovations in products and services, and a stable workforce became obsolete. The sole purpose of a corporation became the maximization of profits returned to shareholders. Financial incentives, stock options, and performance bonuses were introduced to align top management with the goal of transforming corporations from focusing on producing goods and services to maximizing profits in the shortest time frame.

In a 1970 article in the New York Times, Milton Friedman stated, “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.  The phrase beginning with "so long as it stays within the rules" is, of course, to be greeted with an appropriate sense of irony. Who sets the "rules of the game"? The wealthy and corporations, of course. Do we observe any vast monopolistic corporations dominating most market segments demanding a return to competitive markets?

Shareholder value theory became the guiding principle for both real economy managers and those on Wall Street. More than just a principle, it evolved into a management operating doctrine that fundamentally changed how corporations function and significantly redefined their purposes. A corporation's purpose became inherently extractive. The primary objective shifted to maximizing financial returns in the shortest time possible, with all other management tasks being subordinated to achieving the highest profits for the next quarter.

Professor Bill Lazonick critiqued Shareholder Value Theory as follows:

“The truth is that a corporation’s profits are not the shareholders’ profits. They’re the people’s profits. The people who do the work, like the employees. The people who fund the infrastructure and the education of the employees, like us, the taxpayers. Shareholders don’t do any of those things. They don’t even really take on much risk; they can sell their shares in an instant. An employee takes on a lot of risk, investing time and know-how to help the company succeed.”

As demonstrated in the chart below, "investors" are not holding shares as investments, but rather as short-term speculation on market directions. When you consider that HFT (high frequency trading) now makes up approximately 50% of market volume, you can see that "investing" is no longer a useful concept in the large equity markets like the NY Stock Exchange.

So, how does financialization, energized by Shareholder Value Theory, actually work?

First, incentivize top management to, in fact, extract as much money as quickly as possible from the corporation. This is accomplished by structuring their compensation around performance bonuses and stock grants or options to buy. Typically, this means that roughly 75% of actual compensation is in the form of stock-related pay. The psychological framework here is obvious. You don't get paid for thinking and acting for the long term or for other objectives. It is only this quarter's and this year's profit results that matter.

Top management then takes the necessary actions to maximize their compensation. Keep wages and the number of employees down. Cut back on benefits. Drop traditional defined-benefit retirement plans in favor of 401K plans that cost the company a lot less or nothing at all. Reduce or eliminate health insurance. Use more part-time and/or temporary employees. Decrease investment in new products, services, plant, and equipment.

Money is returned to shareholders (including top management) chiefly through stock buybacks and dividends. Stock buybacks occur when a company uses its cash to buy its own shares on the market. This reduces the number of outstanding shares, thereby driving the share price up. Stock buybacks were illegal until 1982, when the Securities and Exchange Commission under President Reagan changed the rule. Earlier, the SEC considered this to be price manipulation, which it obviously is.

Dividends are a normal function for many companies. However, after the personal Federal tax rate on these earnings declined to 15% in 2003, they became a favorite way of distributing cash to shareholders. This is because previously, those who owned most stock were typically upper-income individuals paying the top personal tax rate of 50%.

As this chart demonstrates, shareholder payouts through buybacks and dividends have crowded out reinvestment.

Stock Buybacks are big bucks.

What changes in laws and regulations drove the financialization of corporations?

• The Securities and Exchange Commission (SEC) Rule 10b-18, established in 1982, legalized stock buybacks by corporations.
• Internal Revenue Code Section 162(m) – 1993 Clinton-Era Tax Reform What it did: Limited corporate tax deductions for executive pay over $1 million unless the excess was “performance-based” (e.g., stock options). This incentivized companies to pay executives with stock options and performance bonuses rather than cash salaries, thereby fueling the growth of equity-based compensation.
• The Jobs and Growth Tax Relief Reconciliation Act of 2003, under President Clinton, lowered the federal personal income tax rate on dividends for high-income individuals from 50% to 15%.