Adam Jones Journal

While free-enterprise is one of the great inventions of the western world, a few changes in the "rules" have gradually changed it from a creator of freedom and liberty into a soul-destroying anti-human machine.

This is not saying that corporations suddenly decided to stop being nice guys. Many companies played by some ethical rules because they believed it was in their own interest. Unfortunately, some of our more predatory corporate leaders demonstrated that ethics is quaint and obsolete.

Free enterprise and corporations are not the same thing; but at the moment, the corporate form of business has more influence on our daily lives than any other type of organization.

A corporation is a legally created artificial person. It has been granted some human rights such as the ability to own property, engage in business, sign contracts and so on. It is a convenient way of doing business since a corporation cannot die and partial interests in the business can easily be transferred to new investors. And by legislative choice, a shareholders liability is limited to the amount of money invested.

In the early history of the United States, every state had rules that prevented one corporation from owning shares in another corporation. At first, this was evaded by use of a legal entity called a trust.

Anti-trust legislation was passed to control this concentration of economic power, but eventually the restriction on owning shares of another corporation was relaxed, first in Delaware, and later in all states. Anti-trust continued to be applied to corporations, but little by little the control of one corporation by another became a normal form of doing business.

While a corporation cannot be a citizen or vote in elections, modern corporations have claimed the right of free speech and the right to buy politicians.

There is one major difference between a corporation and a person -- a corporation does not have a conscience.

There are human beings who lack a conscience -- people who seem to be missing some basic emotional equipment that lets the rest of us of us know right from wrong.

We call these people sociopaths.

How we deal with them depends on what kind of damage they do and how clever they are about concealing their actions. If they injure or kill someone, they are subject to the same legal penalties as anyone else -- if you can catch them.

It usually requires some fairly extreme behavior before someone is tagged with a psychiatric diagnosis. Usually we just take note of them as people who don't give a damn and who cannot be trusted. If we have the choice, we stay out of their way. Its pretty much barnyard logic. When the big chicken is on a rampage, stay out of his way. Don't fight unless it is absolutely nessessary to fight for something.

There are sociopaths who do immense amounts of damage to others without ever breaking a law. Sociologists hypothesize that many high achievers exhibit antisocial personality disorder.

With individuals and smaller businesses, the marketplace and the legal system sometimes work. If a company gets a little too greedy or a little too predatory, people eventually notice. After a while, the company has a hard time keeping good employees and their customers go elsewhere. Lawsuits provide satisfaction for some victims.

Nevertheless, there are dishonest, predatory companies that continue in business, year after year, and the system doesn't actually stop them. But if you take the time and do your homework, you can avoid doing business with them.

The large public corporations are where the real problems occur.

In theory, the board of directors sets the ground rules for corporate management, and since shareholders elect the directors, there is supposed to be some human influence that provides for ethical behavior.

In practice, it no longer works that way. Every corporation operates in a complex financial system that includes both individual and intuitional investors. Most individual investors are too lazy to manage their own money, so most stock is controlled by institutions which make up the financial system.

The system defines the real rules which govern how a public corporation behaves.

So let's make a brief detour to examine how it does behave.

The following is not the whole story. It's not intended as proof of anything. It's a description of the obvious combined with some assertions that try to explain why today's free enterprise works against us when it should be working for us.

Stockholder control of corporations is only part of a much larger picture that includes business, finance, accounting, law, politics, unions and government regulation. Each of these groups have a set of written or unwritten rules that define "how it's supposed to be".

Prior to deregulation in the 1980's, investment banking was controlled by a relatively elite group of people. They were hardly nature's noblemen, but they did have a shared sense of how business should be conducted - a kind of collective conscience.

Investment bankers could afford a conscience because they operated in a protected enclave. Regulation prohibited large commercial banks, from competing with them.

Had they been running a gambling casino, they would have been disgusted at the thought of rigging the roulette wheel. They would have believed that it's unnecessary and they would have felt that there was something degrading about doing business in that way.

These attitudes affected both the conduct of their own business and the conduct of the companies that they helped finance. When they worked with a company, they were putting their own reputation on the line. There are some who might disagree with some of their ideas of right and wrong, but they did at least have some kind of collective conscience.

In today's financial marketplace, their attitudes would be considered quaint and naive.

Today, most public corporations are controlled by a collection of institutional investors. The corporate managers usually do not have a significant ownership interest in the company, and they serve at the pleasure of those same institutional shareholders. The Board of Directors is, of course, selected by the same peope.

The institutional investors have one goal -- increasing shareholder value.

Many of these institutional investors have declared that they want to make "increasing shareholder value" to be management's highest priority. They have stated quite clearly, in writing, that they believe that management compensation should be tightly tied to shareholder value.

They also have reams of studies by conservative "think tanks" to support the idea that this is "how it's supposed to be".

And they really believe that this is free-enterprise at its best.

One problem is that what they are increasing is perceived shareholder value, and this may or may not have anything to do with real value.

Those shareholders with the greatest influence operate according to their own set of rules and incentives. The analysts and portfolio managers in a mutual fund get paid for short term performance. The fund itself usually gets a flat fee based on the total amount of money it manages, plus a percentage of any profits made through that management.

Private investment firms may have a longer planning horizon - but usually no more than one or two years - and they still work for a piece of the action.

In most cases, the managers' bonus checks are based on quarterly results. And that's the way they like it.

The managers of institutional investment companies prefer bonuses to salary because bonuses are usually larger, and bonuses are more palatable to their own shareholders. Bonuses are supposed to be a reward for above average performance.

And it fits the mythology that management should be totally dedicated to shareholder value.

But you can't justify a quarterly bonus if performance is measured over several years. By the time you see the results of good decision-making, the person who made those decisions may have changed jobs several times. Or he or she may have been promoted to a position where previous good decisions have no effect on compensation.

The rule that governs many decisions had it's own acronym - IBGYBG - "I'll be gone, you'll be gone". That cliché may or may not still be in use, but the attitude is the same.

So naturally, the focus of most portfolio managers is on short-term gains.

Investment companies make a profit from an illusion of future profitability - an illusion which increases the value that others will pay for a stock.

Brokerage firms make a profit by peddling shares of stock. They provide financial "analysis" that supports this supposed corporate profitability. And every time a well-known company meets or fails to meet targeted earnings, the financial community treats this as earth-shaking information.

The purpose of this hype is to get the attention of investors and to get them thinking about selling one investment and purchasing another. In some cases, a consultant advises a pension fund, and part of his compensation is a well disguised kick-back from a broker. The hype gives him something to work with when he is trying to sell the managers on a change.

The analysts are, of course, competing against analysts from other companies, and there is a complex dance involving corporate management and friendly analysts.

The real-world consequence of this kind of "analysis" is that the price of a stock is affected by these short-term considerations. Many people in the investment community know very well that quarterly results have little meaning and lead to crappy corporate decisions.

They still have to pay attention to the numbers because they know that other investors will be influenced by this kind of bogus information.

There is always a story that goes with the numbers, but the credibility of the story is strongly influenced by the numbers. Numbers are printed on paper - in black and white.

And there are people with a limited understanding of accounting or business believe that they represent something real.

Some companies have to work very hard to get the numbers to show what they and the analysts want to see. A very few fortunate companies have many divisions and a variety of accounting adjustments that allow them to make the numbers sing and dance and show whatever they need to show.

All the analysts and other interested parties care about is whether the story is compelling enough to influence the stock price. The analyst wins when his story works and his believability is increased when the stock price follows the story.

Once the analyst has shown that his story affects share value, he is in a position to extract more information from corporate management. And the portfolio managers he is associated with become more able to dictate management decisions.

If all of this seems to be completely insane, you may be right. But these are the rules, such as they are.

No one is going to make an effort to change the rules. If the rules were changed, a lot of people would take a big cut in pay.

In pursuit of short-term gains, institutional shareholders can push corporate management into actions that weaken the company, but inflate the paper value of the stock.

With a little arm twisting, corporate management can be persuaded to "right-size" the company by getting rid of its best employees. Profits will increase drastically for a few quarters because it takes the customers that long to figure out that service and support have gone to hell.

After this was written, a few people called it an exageration and an out-of-date description of how it works. Then Circuit City dumped over 3000 employees because they were making as much as 18.00 per hour. These were their best and most experienced sales-people. They intended to replace them with new hires in the 9.00 range.

It's gratifying to note that quarterly results went through the floor after this action was taken. You can also expect that this will be covered up in some way in the near future, and future quarters will show better performance. Either that, or all of the accountants will have to be replaced.

When the price is right, the investors cash in and move on. If the price goes wrong, the investors bite the bullet and move on. You can't win them all.

The long term success or failure of a company does not matter. You can make a buck on failure as easily as you can on success -- as long as you see it coming before everyone else does -- but even institutional advisors are unwilling to advocate actions that would obviously depress the price of a stock. And mutual funds are prohibited by regulation from selling a stock short. So most of the pressure is for increased "shareholder value".

So there has to be a rationale that what they recommend will benefit the company they are manipulating. If their well meant advice doesn't work out, they can blame it on management, Investors other than mutual funds and pension funds can sell short, and make a killing by getting out at the right time.

If the stock price goes up, it's possible to cash in, and sometimes the whole mess gets transferred to a newer, dumber set of institutional investors. Or the existing gang, can cash their bonus checks and continue the pursuit of further short term gains.

There are any number of different actions that corporate management can take to continue the illusion of increased profitability. You can trash the product, screw the employees, steal the pension fund, screw the customers and juggle the accounting.  And when you have used up all of the other alternatives, you can simply lie about profits.

(Outright lying is usually the last resort of those who never quite understood what it was that they were actually doing.)

And at the end of the trail, what is left of the company can be prettied up and sold to another conglomerate. When this happens, corporate management also gets screwed; but in recent years, the key players have figured out the game -- they have already taken care of their own interests.

Since there is very little reality behind the stock value or the financial statements it becomes very difficult to determine exactly what happened. And in some cases, tax considerations make it possible to sell a gutted company for more than it is now worth. The purchaser can still make a net gain because the US taxpayer is last in line to be screwed.

And there are other investors who are smart enough to watch the entire process and sell short when they can see that a drastic decrease in "profitability" is on the way.

The interesting part of this whole process is that many of the players are shrewd enough to  work the rules for their own benefit, but many of them really do not know or care how the entire system actually works.

An intelligent set of managers might resist this process since they are smart enough to see what is going to happen. But resistance may not be a workable choice. If you don't have the power, you go along or you get out.

You could make a case that some CEO salaries are so very high because it takes a really big incentive to get a CEO to take actions that he knows will hurt his own company. And remember, the institutional shareholders changed the rules so that management compensation is tightly tied to producing that perceived increase in shareholder value.

Since the term of a CEO is usually only about five years, the lucky ones cash their checks and retire before the chickens come home to roost.

Currently there is a small scandal because some executives who are compensated with stock options have had the striking price of the options backdated. If they played the game and it didn't quite work out, they were still taken care of by the system.

Note that nowhere in this scenario does the idea of a conscience show up. The rules have been carefully constructed to leave out certain human values.

When the financial system says that it wants management to be focused entirely on increased profitability, the important issues are hidden in what they are saying in silence:

    * They are saying that profitability is more important than any obligation to the employees that made those profits possible. If you can break an agreement, you must break it.

    * They are saying that if you can steal the pension fund, you must do so. Money sitting around in a pension fund is not contributing to enhanced shareholder value. Accumulated pension obligations are going to reduce shareholder value if the corporation lives up to its word. You may need to declare Chapter 11 to dump these obligations, but the government will, in theory, pick up on the pension obligations. Except, of course, the government bail-out fund is under water and no one knows where the money is going to come from.

    * They are saying that if you can create a cheaper, crappier product you can make a temporary increase in "shareholder value" before the customers notice that this is not the same product that the company offered while they were building their reputation. They are saying that crappy is now required.

    * They are saying that if you provide no medical care for your employees, the state will pick up the difference. And the money that was not spent on medical care goes to increase shareholder value -- at the expense of everyone else.

If an individual behaved this way we might reasonably conclude that the person is a sociopath. And in our own interest, we refuse to do business with people like this.

When a corporation behaves this way, the financial community sings the praises of free enterprise in three part harmony.

When they tightly tied executive compensation to profitability they created a system where executive conscience and morality were deliberately excluded from the corporate decision making process.

And the pathetic part is that shareholder value is not really being served. The institutional investment managers are looking after their own interests and any real benefit to the shareholders is often by accident. The only shareholders who benefit are those who sell out right after the "value" has been inflated.

If we go back to the original theory that a sociopath is nothing more than a person without a conscience, then we have to conclude that a public corporation is simply a state-chartered sociopath.

There are still companies that behave as though they have a conscience.

Any business is supposed to show a profit; but there are businesses where the owners actually make ethical decisions. Sometimes those decisions mean the company will make a little less profit than possible if ethics and morality are ignored.

There are corporate managers who plan years ahead, and make decisions that limit short term profit in favor of the long term success of the company.

In a private company, the owners and management are often the same. They own it and they run it - and the company's goals and ethics are the owners goals and ethics.

There are still a few public corporations where a founding family owns enough stock to control the company. Very often, management is selected from members of that founding family and the family has a very proprietary interest in how the company operates. If the family is ethical, so is the company.

Little by little, this kind of company is going away.

Today, the institutional framework permeates the entire financial system. Angel investors are concerned that the corporation will be attractive as an IPO. They insist on control, and from day one, corporate decisions will be made according to the shared values of Corporate America.

Today, there are very few entrepreneurs who have the capital to begin building a major corporation without connecting to the financial system early in the game. And that means accepting the rules laid down by the system.  The new rules have been in place just long enough that few wanna-be corporate managers even question the rules of the game.

Any organization that plays by the current rules is going to wind up behaving like today's corporations.

If you don't like the way today's corporations operate, where do you start?

One place to start is by a look at the mythology of free-enterprise.

There's always been a sort of "anything goes", "rugged individualist" tradition in business. The seller is allowed to use whatever tricks he wants; and the buyer is supposed to take care his own interests. Free enterprise at its best. Caveat emptor.

There are some who have a simple Darwinian view of the world: Nature red in fang and claw. These are people who believe that the strong shall live, and that's how it's supposed to be. They take their personal ethics into business, and very often it is not a pretty sight.

Of course they never consider the fact that these same rules justify both the mugger and the mafia protection racket.

No one flat out proclaims that mugging and theft are justified under the creed of free-enterprise. But corporate culture does have a kind of group-think that justifies almost anything. (If you use a contract instead of a club, and if the victim can still walk out the door, it isn't really a mugging.)

Competition and the marketplace are supposed to eliminate the worst abuses of free enterprise. But competition doesn't work well when all of the competitors are other corporations that are controlled by the same rules and incentives.

And the marketplace doesn't work very well when the worst abuses are considered to be normal and acceptable ways of doing business.

While there were a few fools who actually admired Al Capone, we usually do not make hero's out of thieves and gangsters. Once in a while someone who steals from the greedy exploitive rich becomes a folk hero. We admire those who take what they want, as long as they are not directly taking it from us.

Despite this rugged individualist philosophy, we decided a long time ago that we do not want to live in a society where the strong can mug you for your paycheck and the weak get to starve to death. Despite any lingering belief in social Darwinism, we passed laws against theft and murder.

Part of this is just common sense -- we do not want to be victims. Part of it comes from empathy and a sense of kinship -- we do not want our neighbors and friends to be victims. Whether our compassion extends to anyone else depends on how we were raised and who we define as "our people".

In the days of the robber barons, there was still a degree of human control over the average corporation. Most of them were run by ordinary human beings who applied their personal morality to the conduct of their business. Some of those ordinary human beings were sociopaths and the corporation behaved as you might expect.

And the rules of the marketplace do have some effect. Anyone running a business has to be pretty hard-nosed just to survive. A successful sociopath teaches others that they have to toughen up to compete effectively.

Today, we have very few started-from-the-ground-up businesses. Most entrepreneurs plan to start a business, take it public and cash in at IPO time.

During the Dot Com boom I got to closely observe one company that had just been funded to the tune of $25 million. There were always people from the venture capital company hanging around. It was interesting listening to the mantra "increased shareholder value" repeated forty times per day by the newly enobled management.  This was to let the venture capital guys know that everyone understood the rules.

Everyone there worked their tails off to produce that increased shareholder value - in order to make sure that their options would be worth something.

(Six months later when the bloom was off the dot com rose, the venture capital people pulled their investment because it was obvious that an IPO would not be possible in the near future.)

Once a corporation is public, it's now hooked into the same control system that runs most other public corporations. The only goal is to increase shareholder value - which actually means to support the agendas of the institutional shareholders.

A corporate executive who tries to impose his own conscience and values on today's corporation will find out very quickly what it means to be replaceable.

So maybe it's not that complicated after all. Maybe we just need some kind of corporate mechanism that acts as a conscience.

Actually, that was one of the original jobs of the board of directors, but it's a job that can't be done when the board is selected by the same institutional investors that are responsible for the current problems.

The rules of corporate finance have nullified most of the mechanisms that were supposed to control corporate behavior. Law firms and accounting firms will bend the rules and break the rules in order to keep their corporate clients happy. Government regulatory agencies have been co-opted by the companies they are supposed to regulate.

And the individual sociopaths among our corporate leaders have influenced the beliefs and behaviors of many otherwise ethical individuals. They have demonstrated that ruthlessness pays and they have created a set of shared values for Corporate America.

Theoretically, every public corporation should have an independent ethics committee that insures that corporate directors and managers play by a set of rules that have been approved by the shareholders.

Unfortunately, the corporate shareholders like things the way they are.

The people who are the beneficiaries of the pension fund and the people who own the 401k are separated from the power of their own money by two or three layers of institutions.

The other thing that tells you that you are dealing with "the system" is that all of the rules interlock and you can't change any one thing without changing a lot of things.

Recent Changes

The information in this section is accurate up to a point. It describes how the rules work in many mutual funds. In the last few years, mutual funds have intensified their efforts go genarate above