The Golden Passport

by Duff McDonald

  John McArthur, then dean of HBS, liked Jensen’s message and invited him to HBS as a visiting professor in 1984. In The Intellectual Venture Capitalist, HBS trots out a laughable rationale for hiring him: “Jensen had been interested in testing his unorthodox ideas against the experiences of practitioners and had agreed to come to HBS on a temporary basis to get increased access to high-level decision makers in business.”10 But that’s hogwash. “Theory of the Firm” was testable only in the sense that Keynesian economics is testable, or a theory of whether a hurricane might sweep beachfront houses out to sea—you can debate the issues until you’re blue in the face, but at some point, you’ve just got to wait and see what happens.

  Not to mention the fact that few “practitioners” worked in terms even slightly related to things like the paper’s calculation for a company’s founder’s wealth post-equity sale: W = So + aV' = (1-a)V' + aV' = V'. Not only that, there couldn’t be anything further from HBS’s always-flimsy claim to be on the front lines of business than Jensen’s ideologically based argument that managers aren’t to be trusted. They hired him because he was already famous. “That’s a recruiting strategy at Harvard, not just at HBS,” says David Sicilia. “If you get a job at Harvard as a history professor, for example, you’re either young and brilliant or you just won a Pulitzer Prize. Chandler was huge before he got to Harvard. They’re simply purchasing their intellectual success.”11 (At the same time, McArthur’s hiring of Jensen must have put the fear of God in HBS’s current finance faculty—they were out of the arc of modern finance theory.)

  They got what they paid for. Jensen provided intellectual underpinning for the leveraged buyout boom in two HBR articles during the 1980s, “Takeovers: Folklore and Science,” in November 1984, and “Eclipse of the Public Corporation,” in September–October 1989. He argued that the threat of being taken over—and fired—effectively created a market for corporate control, which helped executives stay focused. He also argued that the high indebtedness engendered by leveraged buyouts forced executives to be much more focused on their companies’ operations. And third, if and when executives did participate in the LBOs by amassing their own ownership stake, their incentives would then be directly linked to the company’s stock price. Following Jensen’s logic, takeovers and LBOs were just what the doctor ordered to cure the nation’s economic woes.12

  Twenty-two percent of the 150 largest public companies in the United States as of 1980 had merged or been acquired by 1988, with another 5 percent taken private.13 The highly public spectacle of the takeover of RJR Nabisco served as an object lesson for any and all CEOs who weren’t used to looking over their shoulders. Downsizing became the hymn song of the managerial church. Thanks in large part to Ronald Reagan’s tax cuts and deficit spending, the U.S. economy found its footing again after 1982, but, as Walter Kiechel points out, unlike in the 1950s, “[the] rising tide didn’t lift all boats. In the name of beating foreign competition, completing (or avoiding) takeovers, and serving the interests of shareholders, it became acceptable to sell off businesses that didn’t fit the new corporate strategy and to lay off battalions of workers.”

  Jensen was on a roll at that point, spewing out ridiculous blanket claims such as “corporate takeovers do not waste resources; they use assets productively,” and “shareholders gain when golden parachutes are adopted.” And it all came with the good seal of approval of the Harvard Business School. When Michael Eisner, CEO of Disney, paid Michael Ovitz stock options and cash worth more than $100 million when Ovitz was fired after just fourteen months as president, it was difficult to see how shareholders had gained.

  Jensen, who joined HBS full-time in 1989, expanded his remit with a 1990 HBR article, “CEO Incentives: It’s Not How Much You Pay, But How.” Along with coauthor Kevin Murphy, he opened the piece with one of the most absurd remarks in the history of executive compensation: “There are serious problems with CEO compensation, but ‘excessive’ pay is not the biggest issue,” they wrote. “The relentless focus on how much CEOs are paid diverts public attention from the real problem—how CEOs are paid.”14

  The solution, according to Jensen, was to pay them in stock and stock options, which would better align pay with “performance.” “Are we arguing that CEOs are underpaid?” the authors wrote. “If by this we mean ‘Would average levels of CEO pay be higher if the relation between pay and performance were stronger?’ the answer is yes. More aggressive pay-for-performance systems (and a higher probability of dismissal for poor performance) would produce sharply lower compensation for less talented managers. Over time, these managers would be replaced by more able and more highly motivated executives who would, on average, perform better and earn higher levels of pay. Existing managers would have greater incentives to find creative ways to enhance corporate performance, and their pay would rise as well.” Pay us more and everybody wins.

  Three years later, President Bill Clinton, who had campaigned on reining in executive compensation, eliminated the tax deductibility of any portion of executive compensation above $1 million unless the compensation was performance based. It doesn’t get much better in the annals of unintended consequences than this: Not only did the law actually increase many pay packages—salaries converged around the $1 million mark—but the shift away from salary and toward stock options resulted in the greatest explosion in executive compensation in history. In 1992, CEOs of Fortune 500 firms made an average of $2.7 million. By 2000: $14 million. Stock options as a percentage of compensation rose from 19 percent in the 1980s to nearly 50 percent in 2000.15 What also increased: short-termism and the tendency for executives to “manage” earnings, using aggressive accounting to give Wall Street analysts a “smooth” earnings trajectory on which to base their forecasts.

  Michael Jensen was right about the fact that CEO compensation would rise in the case of outperformance, but he was dead wrong about the fact that CEOs would suddenly be at risk of being fired for underperformance. The compensation of America’s corporate executives went through the roof in the 1990s, regardless of—and sometimes in spite of—their performance. In 2015, there remain serious problems in CEO compensation, and excessive pay is first and foremost among them.

  Jensen’s finance-based theory of the corporation has also lost significant credibility in the wake of the 2007–10 financial crisis. Specifically, observes the University of Michigan’s Jerry Davis, the ideas that financial markets are “informationally efficient” and that “it is appropriate for corporate governance mechanisms to guide corporations toward share price as their North Star” were revealed to be, well, misguided. “The merits of this view are debatable,” says Davis; “less so are the hazards to the economy when it is broadly accepted by executives, investors, and policymakers. Indeed, some would go so far as to argue that the financial view of the corporation helped create the crisis we are in now. There is no doubt that finance and financial markets are central to what public corporations do. What is less clear is that an ownership society is a workable model for prosperity and security.”16

  All the way back in 1951, the chairman of Standard Oil of New Jersey—the company founded by the ultimate robber baron himself, John D. Rockefeller—said the following: “The job of management is to maintain an equitable and working balance among the claims of the various directly affected interest groups . . . stockholder, employees, customers, and the public at large.”17 During the Michael Jensen era, everyone forgot about that. But then we sort of remembered it again. Even shareholder-friendly Jack Welch, the longtime CEO of General Electric, eventually came around. In March 2009, he told the Financial Times, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy . . . your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. . . . Short-term profits should be allied with an increase in the long-term value of a company.”18 Maybe, just maybe, we’re n
ot all whores.

  Here’s the problem with agency theory: By reducing everything to a single measure—the price of a stock—executive motivations become skewed, and long-term considerations were jettisoned for short-term boosts to the bottom line. But even when people started to get a little nervous about the distortions that shareholder capitalism had introduced into the American economy, Jensen wasn’t apologizing. Indeed, he went in the other direction, ripping into fellow members of the HBS faculty if they made the mistake of straying too far from orthodoxy. In his 2001 paper, “Value Maximization, Stakeholder Theory, and The Corporate Objective Function,” he attacked the work of colleague Robert S. Kaplan, whose Balanced Scorecard offered a way to think about executives’ jobs that didn’t boil down to stock price alone.

  First, he decided to attack the idea that executives have brains. “What is commonly known as stakeholder theory, while not totally without content, is fundamentally flawed because it violates the proposition that a single-valued objective is a prerequisite for purposeful or rational behavior by any organization. In particular a firm that adopts stakeholder theory will be handicapped in the competition for survival because, as a basis for action, stakeholder theory politicizes the corporation and leaves its managers empowered to exercise their own preferences in spending the firm’s resources.”19

  The man was parroting Milton Friedman, and committing the same crime. Stakeholder theory was flawed because it violated . . . his own point of view. According to Jensen, “It is logically impossible to maximize in more than one dimension, [so] purposeful behavior requires a single valued objective function.” That’s an economist speaking, someone who needs life to fit into a formula. For the rest of us, the idea of maximizing “in more than one dimension” is something we all try to do every single day of our lives. Just ask a parent who has more than one child.

  Because a Balanced Scorecard might have, for example, a few dozen measures, and provides no information on the trade-offs between them, argued Jensen, chaos would reign and no one would be able to decide anything. At least that’s what he seemed to say: “[Decision] makers cannot make rational choices without some overall single dimensional objective to be maximized,” he wrote. “Given a dozen or two dozen measures and no sense of the tradeoffs between them, the typical manager will be unable to behave purposefully, and the result will be confusion.”

  If it seems a little doctrinaire to suggest that people are unable to weigh competing interests against one another because it’s difficult to model that mental process, one need only remember that Jensen was an economist, not a manager. He had no clue what he was talking about, and was even starting to seem cartoonish, having flattened out man’s ability to balance competing objectives into his two-dimensional model of character. But to blame Jensen for the shareholder value revolution is to give him far more credit than he deserves. At most, Jensen served as nothing more than an instrument of intellectual violence. His dystopian view of managerial untrustworthiness was simply a lightning rod for a broader cultural ideological shift, useful only in buttressing the rhetorical frames that supported it.

  In 2004, along with coauthor Kevin Murphy, Jensen wrote another piece, “Remuneration: Where We’ve Been, How We Got to Here, What Are the Problems, and How to Fix Them.” It wasn’t that anybody was looking to Michael Jensen for solutions to the problems he’d played a part in creating, but consider his own psychological quandary: Just a decade before, he was the man with all the answers. By 2004, no one had any more questions for him. So he asked them of himself. The paper started with an endorsement of what Jensen called “enlightened value maximization/enlightened stakeholder theory,” but then once again dismissed the “balanced scorecard” of his HBS colleague Robert S. Kaplan. The man just couldn’t give an inch, even though at this point he was sounding cranky.

  “Two hundred years of work in economics and finance implies that in the absence of externalities and monopoly,” he thundered, “social welfare is maximized when each firm in an economy maximizes its total market value.” Setting aside the gaping holes in the remark—those “externalities” include, say, pollution that companies end up shirking responsibility for, or the crumbling of a community when a CEO closes a factory simply to juice share price—the “implied” increase in social welfare was just that, implied.

  Jensen’s thesis was given its final kick out the door when Sumantra Ghoshal laid out a comprehensive rejection of the arguments of agency theory. He began by dismantling Friedman’s—and by extension, Jensen’s—argument that shareholders are the “owners” of a company. They’re not, at least if by “own” one means owning something in the way that one can own a car, or an iPhone. They have zero ownership rights on the assets of the company. Those assets are owned by the company itself.

  “We . . . know that the value a company creates is produced through a combination of resources contributed by different constituencies,” Ghoshal wrote. “If the value creation is achieved by combining the resources of both employees and shareholders, why should the value distribution favor only the latter?”20 The answer: because it’s nice and neat. The principal-agent model wants us to believe that labor markets are perfectly efficient—that if an employee feels underappreciated, they can simply (painlessly and freely) move to another job. If you accept that premise, than the contribution of capital carries the greater risk to a company, because it is relatively immovable. But we all know that’s not true. Employee knowledge is truly valuable, and the risks employees take in committing to a job—and a company—are significant. Capital is simply a commodity, like oil, and in recent years it’s been in overly abundant supply.

  Why not adjust the model? Because it’s beyond the capability of economists to actually come up with the mathematics that describe how human organization, with all its complexities, really works. “Such a theory would not readily yield sharp, testable proposition, nor would it provide simple, reductionist prescriptions,” observed Ghoshal. “With such a premise, the pretense of knowledge could not be protected. Business could not be treated as a science, and we would have to fall back on the wisdom of common sense that combines information on ‘what is’ with the imagination of ‘what ought to be’ to develop both a practical understanding of and some pragmatic prescriptions for ‘phenomena of organized complexity’ that the issue of corporate governance represents.”21

  In 2002, when it was clear that the stock option bonanza had failed to do as Jensen had proposed, he claimed that it wasn’t the idea that was flawed, but a failure of implementation during a frothy market. Calling options “managerial heroin,” he told the Economist that what companies should have been using was a sort-of customized stock option that became possible only when the shares appreciated more than a firm’s cost of capital.22 The idea has merit, but it was also too little, and far too late. The damage was already done.

  It used to be that if you argued with Michael Jensen, you became persona non grata at HBS. Consider the case of William Lazonick. A longtime habitué of HBS, starting with a faculty post in 1984 at the invitation of Alfred Chandler, followed by a stint as president of the School’s Business History Conference, Lazonick made the mistake of daring to question the new king of finance on his home turf when in 1992 he presented his paper “Controlling the Market for Corporate Control: The Historical Significance of Managerial Capitalism” in a seminar centered on the work of Jensen.

  At that point, Lazonick was known to be a critic of Jensen’s ideas on shareholder value, but a critic in the academic sense—you sat across from each other on a podium during a seminar or you traded barbs in the gentlemanly forum of academic journals. Not this time. “Some sparks flew during the seminar,” he recalls. “Jensen was king of the hill, and he objected to me, an outsider—although not entirely—coming up there and daring to question him. He was livid that he had been set up in front of all his colleagues to be critiqued by an outsider. He told [HBS professor Thomas] McCraw not to invite me back, and I wasn’t invited
back to HBS for another seventeen years. And keep in mind that the year before that, I had been president of the Business History Conference. Have no doubt about it, the most powerful man at HBS in the early 1990s was Michael Jensen, not Michael Porter, no matter what you might hear. He was much more engaged with students, those students were all going to Wall Street, and Wall Street firms were all sending money back to HBS. The net effect of it all was that agency theory rendered business history irrelevant.”

  Lazonick doesn’t care so much about the personal insult from way back when—HBR awarded him best article of 2014 for his article “Profits Without Prosperity,” so it’s quite clear that the School has long since rediscovered the value in his work—but he does think that his own personal experience is indicative of an intellectual cowardice that came over HBS when it decided to hire Jensen and, even worse, when it allowed his influence to rise unchecked. In that, he blames not just the administration for hiring him, but the faculty for not standing up to that which they knew was wrong. “Almost immediately after they hired him, shareholder value ideology quickly took a dominant position at HBS,” he recalls, “even though, from their own experience, the vast majority of faculty members did not believe it. But there was absolutely zero critique. Even from those who should have known better, including Michael Porter and Kim Clark, there wasn’t a peep. It’s quite sad.

  “Both Derek Bok and John McArthur should have known better, but they went out of their way to recruit Jensen,” says Lazonick. “They even let him have a half-time appointment at Rochester, which was not done at the time, so they were even seen as making an exception for him. I asked a member of the faculty who is actually still there about it, and he said that McArthur thought that’s where the money was, and hiring Jensen would bring in donations from Wall Street.” As with many economists who don’t buy into Chicago School economics, Lazonick admits to a certain admiration for strength of their beliefs, and he saves his greater condemnation for those at HBS who should have stopped the rise of Jensen but instead chose to keep quiet. “They had a tradition at HBS which could have said that this isn’t the way business should be operating,” he says, “Instead, they just went with the flow. They kowtowed to Jensen.”