A Very Constructive Inflection Point for Global Capitalism

Twenty five years ago, the leaders of the Caux Round Table for Moral Capitalism (CRT) from Japan, Europe and the U.S. published our Principles for Responsible Business to affirm that modern capitalism should seek the wellbeing of stakeholders. Yesterday, the Business Roundtable, composed of 200 CEOs, issued a statement affirming that core belief and recommendation of the CRT:

Statement on the Purpose of a Corporation

Americans deserve an economy that allows each person to succeed through hard work and creativity and to lead a life of meaning and dignity. We believe the free-market system is the best means of generating good jobs, a strong and sustainable economy, innovation, a healthy environment and economic opportunity for all.

Businesses play a vital role in the economy by creating jobs, fostering innovation and providing essential goods and services. Businesses make and sell consumer products; manufacture equipment and vehicles; support the national defense; grow and produce food; provide health care; generate and deliver energy; and offer financial, communications and other services that underpin economic growth.

While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:

Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.

Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.

Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.

Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.

Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.

On behalf of the CRT board of directors, I welcome this statement as an inflection point in the evolution of modern capitalism towards achieving the common good. This validation of CRT efforts over many years now is reassuring. It is also an opportunity to continue forward with determination, good sense and high purpose in line with our principles to make them useful to all companies, large and small.

Valuation of Intangibles Could be a Slippery Slope Down to Fraud

Last Wednesday, I spoke with our Chairman Emeritus, Lord Daniel Brennan. He brought me up to date on the current and heated public discussion in London over a report by Muddy Waters Research on Burford Capital Ltd. as it pertains to the importance of company valuations.

Burford has a market capitalization of 2.45 billion English pounds. Its business is to invest in litigations and share in any proceeds recovered from defendants. The assets of the firm are mostly contract claims for a share of future winnings. These are very intangible assets. The underlying factors which determine the probability of winning the selected lawsuits are human skills in judgment as to the merits of the plaintiff’s case, research, data analysis, legal argument and persuasion of judge and jury. Rather like betting on who will win a prize fight or a football or soccer game. The bet is only a contract claim to be paid a sum of money depending on an outcome. How, then, should the chances of winning be valued in either case?

The Muddy Waters Research report concluded:

We are short BUR. For years, it was the ultimate “trust me” stock. Thanks to a light disclosure regime, the esoteric nature of its business, and unethical behavior by its largest shareholder, Invesco, it turned Enron-esque mark-to-model accounting into the biggest stock promotion on the AIM. This has all recently changed though. Just this year, BUR began publishing more detailed investment data. This data proves that BUR has been egregiously misrepresenting its ROIC and IRRs, as well as the state of its overall business. We have identified seven methods by which BUR manipulates Concluded Investment ROIC and IRR.

BUR’s top management, through their shareholdings (and sales), is in effect primarily compensated for aggressively marking cases in order to generate non-cash fair value gains. Until now, BUR has gotten away with aggressive and unwarranted marks by touting ROIC and IRR metrics. We show that BUR heavily manipulates these metrics. BUR then actively misleads investors about how its accounting for realized gains works. As a result of this deception, we believe investors give credence to BUR’s fair value gains. In actuality, BUR’s net realized returns have relied on a very small number of cases. Just four cases have produced approximately two-thirds of BUR’s net realized gains since 2012. (One of the four outsized contributors was actually a loss at trial, and was bailed out by BUR’s largest shareholder, Invesco, at the direction of Neil Woodford protégé Mark Barnett. Absent the bailout, the case almost certainly would have been a total loss.)

BUR is a perfect storm for an accounting fiasco. BUR’s governance strictures are laughter-inducing. The CFO is the wife of the founder/CEO. Under the best of circumstances, this should alarm investors; however, with a company that consistently books non-cash accounting profits, it is unforgivable. BUR has cycled through four prior CFOs or senior finance managers (none of whom stayed for long). These facts beg the question “Is (current CFO) Elizabeth O’Connell the only CFO who can be relied upon to approve the accounts?” (see here)

The full Muddy Waters Research report can be found here.

The issues around Burford’s accounting and valuation estimates raise very difficult questions about the valuation of intangibles. One set is how to do this responsibly. Another set is how to prevent misrepresentation and fraud in the use of assumptions about the probability of future events. And a third set is what rules and standards should be adopted to constrain forecasts which will easily and quickly slip-slide away into fairytales and artfully constructed ratios and financial categories which will mislead even sensible investors.

Since it is more and more accepted that in today’s global economy, intangible assets are growing in importance as drivers of profits, getting them measured properly and their valuations disclosed properly is also more and more necessary.

Stock Buybacks: Short-term Gain Over Long-term Value?

I noticed recently what might be another big ethics issue with corporate use of profits in the U.S. – stock buybacks. According to Federal Reserve data compiled by Goldman Sachs, over the past nine years, American corporations have used profits to buy some $3.8 trillion of their shares from owners.

I noted that in the 2nd quarter, Apple spent $17 billion on stock buybacks.

This use of funds, rather than for dividend payments, gets a share of corporate profits back to investors at capital gain, not income tax rates. By reducing the shares outstanding, it raises the price of shares remaining in the public market, thus adding booster fuel to rising equity market prices and enticing the diversion of money to such markets from other alternatives, such as investment in startups.

But the practice is not evenhanded in its distribution of benefits. Money spent on share buy-backs is not there for wage increases, R&D or factory expansion.

Corporate executives have been found to have sold five times as much stock in the eight days after the announcement of a buyback as they did on an average day.

Of course, one reason for executive preference for stock buybacks is that much of their total compensation comes not from salary, but from grants of options to buy company stock. The net value of the option is directly related to a rising market price for the shares. If share prices go up and up, executives cash out very nicely.

The preference for using stock options for compensation responds to a populist law passed under President Clinton which limits the amount of salary a corporation can deduct as a business expense on its taxes. Options are not considered an expense of the company.

The law could be repealed and executives could be paid cash only, as is done with wage earners.

Many investors also like buybacks. They have no intention of being long-term owners of the company. Any market move which gives them a quick profit on their investment has its attractions – a bird in hand is worth two in the bush. The world of owners of public companies these days is one of short-term “hookups,” trading and speculation, not marriages ‘til death do us part.’

Debt – Good or Bad? It Depends…

A recent story in the Wall Street Journal brought to mind – once again – the two-edged sword which is debt: it can cut for you and it can cut against you. It all depends.

An inability to borrow to bring future income into the present and use it wisely is a curse of being poor. Lack of credit keeps people from accessing capital with which to take risks and create wealth.

Hernando de Soto wrote about the “mystery” of capital as a magical force which could propel the poor into prosperity – if only they had assets against which they could borrow. We have seen the growth in income made possible by microcredit loans.

At the same time, too much debt brings too much risk and often leads to financial failure. Poor people who borrow against paltry income just entrench themselves in poverty, losing their few assets to the money lenders and falling into wage slavery.

As has been said many times, asset bubbles get bigger and bigger through debt. Irrational exuberance is never so enticing as when you are speculating with other people’s money, borrowing and betting that market prices will just keep on rising.

Debt is necessary for wealth creation and growth, but excess of debt leads to loss of wealth and recession. Too much of a good thing turns good into bad. One drink of wine may be tasty and even healthy, but too many drinks make for an alcoholic.

As the Greeks and the Buddha advised, keep to the middle path of moderation.

The Wall Street Journal also reported that for the American middle class, the majority of American voters, incomes have largely been stagnant for two decades while cars, college education, houses and medical care have steadily become more costly. Debt has made up the difference between income and consumption expenditure.

U.S. consumer debt is now $4 trillion, the highest ever.

But thanks to low interest rates, courtesy of government provision of credit, households spend only 9.9% of income on debt service.

Profit Really is Material to Capitalism

Two recent news stories brought me back to basics:

In New York City, the renown men’s store Barneys is filing for bankruptcy. It’s not making enough money. Rent on its flagship store went up to $27.9 million. Buyers use the internet more and more. In short, the company is not meeting consumer demand in a way that produces a profit.

Secondly, America’s two largest chains of print newspapers are merging. Ad revenue is no longer enough to sustain them as separately profitable businesses. The rise of the internet with “free” news and entertainment articles for many customers has cut readership for newspapers. If the old print newspapers can’t make money, they too will go out of business, like Barneys.

More than 2,100 newspapers have closed since 2004 and now Google and Facebook are expected to take in 51% of all digital advertising revenue in the U.S.

So, no matter how much we should be concerned with ethics, responsible stakeholder relationships and the social and environmental footprints of companies, if they can’t make a profit, they have no claim on our charity for keeping them going with subsidies.

That is a hard but necessary reality of capitalism – every tub on its own bottom.

Monopoly Power and High Tech – Wither the Upper Hand?

Giant, high tech firms with vast earnings and even greater stock market valuations are the cutting edge of evolving capitalism. I have suggested in previous commentaries that market power can lead a company to be placed under obligations to seek the common good. In the U.S., long after anti-trust officials in the E.U. looked askance on the market power of Google and Facebook, the U.S. Department of Justice has opened a broad review of whether dominant technology firms are unlawfully stifling competition.

The review will examine on-line platforms as gateways to commerce in internet searches, social media and retail services.

One point of worry for me is the ability of internet firms to suck in advertising revenues and so drive older forms of media – print media – into economic failure and closure, directing our politics towards demagoguery, delusions and dumbing down our people.

I have noted before that the opinion of the U.S. Supreme Court in the 1876 case of Munn v. Illinois, a case of cartel monopoly power over grain storage elevators in Chicago, provides an ethically based reason for restraining companies which stand at the gateway of commerce and take a toll to permit passage of goods. The Court asserted that a willing assumption of monopoly power brought upon a company acquiescence to the right of society to assert a license over the company to take care that the good of the public was not harmed.

The Court held by imputation that if a company did not want to operate under such a restricting license from public authority, then it need only not seek monopoly power. Instead, the company was free to choose to do business facing the hazard of competition.

The policy of the Court was to ensure that lawful commercial arrangements would not be misused and lead to inequitable outcomes in practice; that financial and economic power would be diffused widely and decentralized. This policy was the natural corollary to the principle of constitutional democracy that government power must be disbursed across institutions where one would check another from aggrandizement and tyranny.

I am reminded of the admonition of James Madison in commenting on the provisions of our U.S. Constitution: “If men were angels, no government would be necessary.”

Where there are no ethics, law must safeguard our wellbeing. Or to put it slightly differently: where there is no virtue, power assumes control and must be disciplined by law – even in capitalism.

Landing on the Moon

Fifty years ago when the American Neil Armstrong first walked on the surface of the moon, I was in South Vietnam. I was actually in a car driving myself from the District of Tam Binh in the Mekong River delta Province of Vinh Long up to Saigon along National Route 1. I had been reassigned from serving as a civilian Deputy District Advisor to the position of Chief, Village Government Branch in the Saigon headquarters of our advisory effort to assist all South Vietnamese nationalists from hamlets and villages to urban centers in fighting back against unwanted conquest.

I had placed a transistor radio on top of the dashboard leaning against the front window of my International Scout to hear news of the moon landing in real time as I drove north. Just as Neil Armstrong spoke – “That’s one small step for a man, one giant leap for mankind.” – a U.S. Army truck passed me going south. One young GI sitting in the back of the truck threw his half-eaten ration can to the side of the road. Three young Vietnamese boys, about 10 years old each with delighted smiles on their faces, ran up from the shacks where they lived next to the highway and took the can, a trophy perhaps to them.

I still remember the stunning moral contrast that came to my mind between the two events – one so remarkable and the other so ordinary, even tawdry; one so magnificent as a marker of human achievement, the other so profane for its celebration of the timeless human condition – war and poverty.

As we reflect on humanity’s power over nature, the gaining on our own without help from God or the spirits the ability to reach the moon, what might we learn that would help elevate us away from more wars and move poverty?

I offer only one suggestion: human achievement depends on intangibles. We tend to pridefully rest our self-confidence on things – great buildings, pyramids and walls, cathedrals and bridges, money and machines, houses, cars, jewels and other owned possessions. But is it not our ideas, our ideals, our sense of purpose, our psyches, our cultures, our interpersonal relationships, our courage, our aspirations, our fears and our desirings which lie at the origin of all our achievements – good and bad?

I am reminded of Kipling’s warning to us all, a bit of wisdom from an imperialist who nevertheless worried that we humans too often lose a sense for the transcendental:

For heathen heart that puts her trust
In reeking tube and iron shard,
All valiant dust that builds on dust,
And guarding, calls not Thee to guard,
For frantic boast and foolish word—
Thy mercy on Thy People, Lord!

The then unsurpassed technical achievements which put Neil Armstrong on the moon – science, math, design brilliance, computers, manufacturing perfection and organizational harmony – all rested on social and human capital. The money, metallurgy, guidance mechanisms and flag planted by Armstrong were second order goods derived from human genius which can be neither touched nor boxed and shipped anywhere, much less to the moon.

As we seek to engineer a more optimal economic ecology for our global human family, let us have more respect for the moral factors in our civilizations.

What Happens When There is No Leadership?

A new colleague, Hans Reus of The Netherlands, just sent me an article he wrote titled “Call to Action: Accelerating Sustainable Business Leadership” on a vital topic: encouraging leadership.

As I ended my 2004 book Moral Capitalism, Hans agrees that leadership, not systems, is a key variable in human wellbeing, for better and for worse. Leaders make systems and sustain them. Systems sustain themselves by grooming leaders who align with status quo values and interests.

So if we want to make global capitalism more responsive to the demands of sustainability or fairness, we need to cultivate the right kind of leaders.

I put it: moral capitalism does not happen by itself; it must be made to happen.

The selection of leaders is paramount.

I believe his article is an excellent statement on how to improve corporate leadership.

Please read it and let me know your thoughts.

Who Benefits When Money is too Cheap?

It seems to me that there is a non-trivial dependency of increasing concentration of wealth in the top 10% and the expansion of tradable contract rights such as stocks, bonds, derivatives, ETFs, futures contracts, options. Parallel with the expansion of financial opportunity in the buying and selling of such contracts has been government generated expansion in money and credit. Central banks have become expert in using fiat currencies and the provision of credit to pump liquidity into national economies. Qualitative easing has kept the OECD economies growing; China has funded much of its remarkable growth with government provided loans. There is so much liquidity in the E.U. that some instruments have negative interest rates.

Thus, when I read last Friday that the Dow Jones Industrial Average hit a record by closing above 27,000 for the first time, I was not overjoyed.

That day, the S&P 500 index climbed above 3,000 for the first time.

And this happened when, as Corrie Driebusch reported for the Wall Street Journal that “Second-quarter earnings are shaping up to be a challenge, but the stock trajectories of some companies that have already reported show that investors are forgiving. A handful of companies that reported disappointing earnings in June are now in a surprising place—their shares are near or above their levels prior to reporting results.”

My first questions was: what is driving stock prices up? Low interest rates making money cheap for those who have it?

My second question was: cui bono? – “For whose benefit?”

This was Cicero’s insight into explaining human behavior: finding out who benefits from an action will lead us to understand the cause of what happened.

Then, on Saturday, the Wall Street Journal ran a story that “prospects of a Fed rate cut propel stocks, oil prices.” So those with the means to speculate are made more wealthy by government policy.

And with low interest rates, savings – most important to the middle classes and even the poor – are discouraged. Asset accumulation is titled towards the rich.

As has long been said of financial capital: “Those that have, get.”