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Perhaps during the shutdown, when you’re watching more TV than you might like to admit, you’ve seen some new commercials a bit like this: a happy face-masked employee on the line or in a lab displaying all the sanitizing and other pandemic-related safety precautions that the company is taking to protect the employee’s work environment. Cut to the employee at home with giggling youngsters, illustrating the importance of safety measures at work to protect family at home.  Or a company emphasizing the value of its employees in keeping the country moving forward or its employees in lab coats that persevere to find a cure no matter what.   Or a shot of employees performing the essential service of implementing safety measures for customers.   What’s the point? To drive home that a company that recognizes the value of its employees and manifests such concern for their safety and welfare is a company worth buying from.   This new emphasis on employee welfare as a corporate selling point may have been sparked by COVID-19 but, at another level, it may well reflect broader concerns that have been marinating for a while—about the essential value of previously overlooked elements of the workforce, about physical risk allocation, about economic inequity and, to some extent, even about social justice.

How to address some of these concerns related to the workforce—particularly economic inequity—is the subject of a new paper co-authored by former Delaware Chief Justice Leo Strine, “Toward Fair Gainsharing and a Quality Workplace for Employees: How a Reconceived Compensation Committee Might Help Make Corporations More Responsible Employers and Restore Faith in American Capitalism.”  The goal is to reimagine the compensation committee so that it becomes the board committee  “most deeply engaged in all aspects of the company’s relationship with its workforce,” from retaining and motivating the workforce to achieve the company’s business objectives, to overseeing that the company fulfills its obligations as a responsible employer and, most of all, to positioning the company to “restore fair gainsharing.”

The authors open with a discussion of the growing recognition of prevailing economic inequity: “top executive pay and stockholder returns have soared as company profits have risen, but the pay for ordinary workers has stagnated,” a trend that has led to pressure on boards for change and corporate accountability. “A company, they write, “cannot be a good corporate citizen without being fair to the stakeholders most important to its success, its employees.”  They suggest that a “reconceived compensation committee” might be one way to help boards “sensibly address society’s demand” for fair pay and fair treatment for the workforce.

How did we get here?  The three decades after World War II witnessed a remarkable growth in middle class wealth, as economic gains of the expanding market economy  were widely shared.  During that period, workers were able to exert more power over companies, in part, the authors suggest, because investors, largely retail, tended to be more dispersed and more passive than today’s institutional holders.  During that period,  as worker productivity and corporate profits increased, companies shared the profits

“between their workers (in the form of pay raises and other forms of compensation, including retirement and health benefits) and stockholders (in the form of higher dividends and other forms of payouts)….From 1948 to 1979, worker productivity grew by 108.1% and wages grew in rough tandem by 93.2%.15 That is, as workers’ productivity enhanced the value of the corporate enterprise, they shared in the benefits of those productivity gains. Top executives were much better paid than the typical worker, but at a ratio that was merely substantial, not astronomical. For example, the CEO-to-worker pay ratio was 20-to-1 in 1965.”

In addition, the S&P 500 rose 554% from 1948 to 1979.

However, beginning in the 1980s, the authors assert, as “labor unions waned in influence, powerful institutional investors reaggregated equity capital and began to exert enormous pressure on public companies to be responsive to their desires for immediate returns.”  They used that power, according to the authors, to demand that executives “be paid in ways that encouraged them to be an instrument of the stock market, even if that hurt the company’s other constituencies, including workers.” Think, for example, stock options and performance metrics based on TSR. The authors observe that, from

“1979 to 2018, worker productivity rose by 69.6%, but the wealth created by these productivity gains went predominately to executives and stockholders, with worker pay rising by only 11.6% during this period, while CEO compensation grew by 940%. In terms of the split between the average worker and stockholders, the movement was even more profound: stockholders began taking a huge slice of the pie, with the S&P 500 gaining over 2,400% from 1979 to 2018.”

SideBar

Interestingly, while the authors indicate that the “causal story is complex,” they do not address as a causal factor for the change the rise of the “shareholder preeminence theory.” That theory,  widely attributed to the Chicago school of economists, began in the 1970s, with economist Milton Friedman famously arguing that the only “social responsibility of business is to increase its profits.”  Subsequently, two other economists published a paper characterizing shareholders as “‘principals’ who hired executives and board members as ‘agents.’ In other words, when you are an executive or corporate director, you work for the shareholders.” (See this PubCo post.) A number of academics and journalists point to the ascendency of that theory as a reason for the transformation.

The shift is illustrated in this 2013 article from Washington Post, “Maximizing shareholder value: The goal that changed corporate America.” The article begins by noting the depopulation of a small town in New York that once was home to 10,000 IBM employees and later was home to only 700. In contrast, investors in IBM shares received a 25-fold return over the same period. The decades after World War II saw a booming economy where “the interests of companies, shareholders, society and workers appeared to be in tune.” The author traces the rising disjunction between interests of the corporation and those of the community to “a deep-seated belief that took hold in corporate America a few decades ago and has come to define today’s economy—that a company’s primary purpose is to maximize shareholder value.”

The author points out that this change is reflected in statements from IBM’s leaders: when the son of IBM’s founder was CEO, he wrote “that balancing profits between the well-being of employees and the nation’s interest is a necessary duty for companies” and acknowledged the company’s “obligation as a business institution to help improve the quality of the society we are part of….” The first and most important component of the company’s philosophy at that time was respect for the individual employee, and the CEO was proud “that his father avoided layoffs, even through the Great Depression.” In the 1990s, though, the company’s competitive advantages were eroding. The CEO achieved a legendary turnaround, but part of the price, the author contends, was a 60,000-employee layoff and a shift in emphasis to earnings per share. Defenders argued “that the company has had to reinvent itself so many times to stay alive that the values of [the founder and his son] are no longer as easy to apply as they used to be.” The CEO “pledged to follow a plan called the ‘2015 Road Map’ in which the primary goal is to dramatically raise the company’s earnings-per-share figure, a metric favored by Wall Street.” In 1981, even the Business Roundtable recognized the responsibility of corporations to the society of which they are a part. By 1997, pronouncements from the Business Roundtable maintained “that the principal objective of a business enterprise ‘is to generate economic returns to its owners…’” (See my news brief of  8/30/13.)

The late Professor Lynn Stout also identified the same change and attributed the transformation to the rise of the Chicago school of economists. As discussed in The Washington Post, “Stout said…the idea that shareholders were king simplified the confusing debate over the purpose of a corporation. More powerfully, it helped spawn the rise of executive pay tied to share prices—and thus the huge rise in stock-option pay. As a result, average annual executive pay has quadrupled since the early 1970s.”   (See my news briefs of 7/2/12.)

Similarly, in “Profits without Prosperity,” published in the September 2014 Harvard Business Review, Professor William Lazonick describes the change this way:

“From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what [he calls] ‘sustainable prosperity.’ This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.” [emphasis added].

What led to this change? In Lazonick’s view, the surge in hostile takeovers in the 1980s proved to be a turning point.  These takeovers were justified by corporate raiders on the basis that “the complacent leaders of the targeted companies were failing to maximize returns to shareholders. That criticism prompted boards of directors to try to align the interests of management and shareholders by making stock-based pay a much bigger component of executive compensation. Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them ‘manage’ stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.” (See this PubCo post and my news briefs of 10/5/12 and 10/11/11.)

Although this theory was not statutory, a version was prevalent in the Delaware courts.  In a 2015 paper, The Dangers of Denial, former Chief Justice Leo Strine explained that corporate law is resolutely focused on stockholder welfare. “Within the limits of their discretion, directors must make stockholder welfare their sole end,” Strine wrote. “Other interests may be taken into consideration only as a means of promoting stockholder welfare.”

Strine said Delaware’s Supreme Court first established that principle in 1985 in Revlon v. MacAndrews, when it held that, in the context of a merger or acquisition, a board’s directors must act with the sole focus of maximizing the share price. According to Strine, subsequent Delaware rulings, such as then Chancellor William Chandler’s 2010 decision in eBay v. Newmark clarified that shareholder interests must come first even outside of M&A deals. “It is true that the business judgment rule provides directors with wide discretion, and that it enables directors to justify by reference to long run stockholder interests a number of decisions that may in fact be motivated more by a concern for a charity the CEO cares about, or the community in which the corporate headquarters is located, or once in a while, even the company’s ordinary workers, than long run stockholder wealth,” Strine wrote. “But that does not alter the reality of what the law is….If a fiduciary admits that he is treating an interest other than stockholder wealth as an end in itself, rather than an instrument to stockholder wealth, he is committing a breach of fiduciary duty.”

And in this essay, Strine expressed his perplexity with the naïveté manifested by commentators who are dismayed “when anyone starkly recognizes that as a matter of corporate law, the object of the corporation is to produce profits for the stockholders and that the social beliefs of the managers, no more than their own financial interests, cannot be their end in managing the corporation…. Despite attempts to muddy the doctrinal waters, a clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare.”

Instead, Strine has been an advocate of the Delaware benefit corporation as a more effective approach.  (See his paper, “Making It Easier for Directors to ‘Do the Right Thing’” and this PubCo post.)

In response to these striking disparities in pay and the impact they have had on our social fabric, the authors contend, “new strains of corporate governance reform emerged.” These strains are reflected in, for example, Elizabeth Warren’s Accountable Capitalism Act (see this PubCo post) and the recent adoption by the Business Roundtable of a new Statement on the Purpose of a Corporation, signed by 181 well-known, high-powered CEOs, which “moves away from shareholder primacy” as a guiding principle and outlines in its place a “modern standard for corporate responsibility” that makes a commitment to all stakeholders, including employees. (See this PubCo post.)

What’s more, the authors contend, after years of advocating pay for performance for executives, where performance is based on TSR or other stock-based metrics, even institutional investors are now advocating that companies recognize their obligation to benefit all stakeholders, including communities and employees.  This view is reflected in the new Business Roundtable statement of purpose (although, notably, the Council of Institutional Investors opposed the Statement, contending that it “gives CEOs cover to dodge shareholder oversight”). Similarly, Laurence Fink, the CEO of BlackRock, has made a number of statements advocating corporations’ broader social responsibilities.  (See this PubCo post.)

In addition, adverse publicity arising out of “high-profile situations”  has led to concerns about workplaces that tolerate, or even foster, sexual harassment or racial or sex discrimination.

The authors also point to a new “business reality”—the recognition of the value of human capital in a tech-driven economy. (Notably, the authors balk at the term “human capital,” viewing it as “reductive and demeaning.” Sign me up.)   This recognition has led executives to appreciate the benefit of a skilled and productive workforce that is capable of learning new skills.  They also observe that the emergency caused by “the COVID-19 pandemic is likely to make issues related to the fair treatment and economic security of American workers even more salient.”

SideBar

SEC Chair Jay Clayton has frequently commented on the change in views of human capital. Decades ago, companies’ most valuable assets were plant, property and equipment, and human capital was primarily a cost. But now, human capital and intellectual property often represent “an essential resource and driver of performance for many companies. This is a shift from human capital being viewed, at least from an income statement perspective, as a cost.” (See this PubCo post.) In addition, he has observed, increasingly, “human capital is the source of economic strength and, for some companies, “human capital is a mission-critical asset.”  (See this PubCo post.)

As a result of these trends, the authors expect that boards will be called on “to dedicate more time to considering how their companies treat their entire workforce, how inclusive their workforce is, the appropriate incentive systems that should exist not just for top management, but the whole employee complement, and the appropriate gainsharing that should exist among the company’s employees, stockholders, and top management.”

The authors contend that, to address these issues, “the most sensible answer is for the mandated board committee that is required to address the related area of top management compensation—the compensation committee—to expand its perspective and become a committee focused on the company’s workforce as a whole.” Reimagining the committee will require that the board gain some understanding of the historical context of “gainsharing” among executives, workers and shareholders over time. The committee will need to arrive at a fair balance that “will best align the interests of all stakeholders in sustainable wealth creation, and develop compensation plans for the board that implement that goal.”  The authors contend that understanding this broader context will help boards “constrain top management pay in sensible ways”:

“If, for example, the company’s workforce is getting no raise, does it really make sense to give top management an increase for “managing through tough times”? And if the company is doing well after a period of employee sacrifice, are their raises keeping up with gains for stockholders and the CEO? Does the company have a goal of paying its CEO and top management at or above the 75th percentile on the industry average? If so, does this goal extend to all company management? To all company employees? Or just to top management? If the latter, why? If the board has a better sense of how the entire workforce is compensated, and the importance of the workforce to the company’s plan for selling products and services, the board is also better positioned to understand what will have the most important effect on productivity. Is it increases to top executive compensation? Or increases that motivate a much greater number of company employees?… Perhaps it is just the magic four or five at the top who really have a bottom line impact, or perhaps, and much more likely, the overall workforce’s productivity is more vital to the company’s profitability, and that providing all the company’s workers with quality pay and the opportunity for continuous training, employment, and advancement makes good business sense.”

In addition, the variety of legal requirements, together with the growing sustainability focus on the workforce, make it logical to allocate these responsibilities to the comp committee.

The essay includes suggestions for specific data regarding worker and contractor pay information—along with key employee and contractor function, educational level and skill set—that should be provided to the committee to allow the committee to understand how the company deploys its workforce and how it relates to management’s business strategy.  The authors suggest that the committee consider questions such as the following:

  • What are the employee functions most critical to the company’s ongoing vitality?
  • And how is the company treating workers that are essential to its operations?
  • What are turnover rates?
  • What is the extent of retraining of existing workers to master new skills?
  • What is management’s process for setting employee compensation?
  • To what extent does the company bargain with workers or give them any leverage?
  • What is the company’s view regarding its employees’ right to form a union? If opposed, how does that harmonize with the company’s ESG commitments to workers and with its treatment of executives?
  • Does the company pay equally for equal work, regardless of gender, race or ethnicity? Does it promote equally? Is the workplace welcoming and inclusive?
  • Are employees treated with respect and dignity (perhaps by reference to surveys or other behavior monitors)?
  • Do the data provided by management reflect productivity and effectiveness of company practices?
  • Is the board using metrics and factors for determining executive comp (e.g., use of a 75th percentile goal) and not applying the same metrics to company employees?
  • Is executive comp “tilted toward the stock price and risk taking,” thus potentially undercutting the company’s commitment to sustainability? Is the salesforce incentivized to sell customers “things they do not need”?
  • Does the company’s compensation system appropriately recognize the importance of ethics and compliance executives or “hold them down in pay because they do not run ‘profit centers’”?

The role of the committee is this inquiry will help establish that the “tone at the top on fair treatment of employees, openness or hostility to unions, and the atmosphere in the workplace in terms of diversity and freedom from harassment emanates from a board-level decision, and that management must adhere to that decision in its treatment of employees at all levels of the organization.” In addition, the authors contend that these types of questions “will assure a top to bottom coherence and yield valuable insights into the company’s business strategy and its actual adherence to rhetoric about its regard for its workforce…. Of most salience to society, by means of this kind, the board will be better situated to analyze the basic question of gainsharing among employees, top management, and stockholders [the authors] view as fundamental and to make more enlightened decisions.”

Posted by Cydney Posner

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