September 15th, 2019


Dem Frontrunner's Surreptitious Socialism

Richard A. Epstein

By Richard A. Epstein

Published August 22,2018

 Dem Frontrunner's Surreptitious Socialism

Senator Elizabeth Warren has long been openly contemptuous of American business. She proved it yet again last week by publishing a dangerous and uninformed screed in the Wall Street Journal outlining a proposal that, if implemented, will shake markets to their roots. Like many proposals for radical reform, her Accountable Capitalism Act would destroy the institution she says she wants to save. The bill's central provision tells the whole story: all corporations whose annual revenues exceed $1 billion dollars would be required to receive a federal corporate charter to remain in business. Those charters will come with conditions attached, to force corporations to pay due attention not just to their shareholders, but to their employees, suppliers, and their local communities.

Warren believes the federal government can attach whatever conditions it wants to the charters it issues, and she further claims that it should act to reverse the purportedly dangerous trend of top corporate officials making cash distributions to their shareholders instead of plowing those proceeds back into their own businesses. Her intellectual nemesis, no surprise, is Milton Friedman, who in a seminal 1970 article argued that "the social responsibility of business is to increase its profits."

The most obvious problem with Warren's proposal is that it would likely lead to the largest flight of capital from the United States in history. Foreign investors will see little reason to put their wealth at the mercy of some crusading federal board that can override a company's board of directors. Current covered American corporations would have powerful incentives to dump assets or relocate overseas. Make no mistake about it, her proposal calls for the outright confiscation of wealth through the nationalization of corporate boards that would be forever beholden to political figures. Surreptitious socialism turns out to be her way of saving capitalism. And for the worst of all reasons.

Start with first her point. It is for good reason that corporate officers and directors of public companies owe fiduciary duties only to their shareholders. If someone extends similar duties simultaneously to employees, suppliers, customers, bondholders and community members, then directors and officers would be obligated to decide what to do when these interests clash. Bedlam would result. Family corporations often have complex capital structures because family members share ownership and job responsibilities overlap in complex ways.

Hence no one can sell shares to outsiders unless the business as a whole is sold. In contrast, large public corporations need very simple capital structures, in which each share of stock is fungible with any other now that management and ownership are largely separate. That simple structure puts all shareholders in the same boat, and thus reduces the risk that any general corporate transaction, at least in the absence of self-dealing, will favor one group of shareholders over another. Fungibility also creates an active market for the sale of shares so that shareholders who are uneasy about the direction of any given corporation can sell their shares, perhaps at a loss, to others who are more comfortable with the corporation's future.

This arrangement does not take into account the preferences and needs of so-called stakeholders who have not invested a dime in the business. Firms face competition in markets for capital, labor, products, and consumers. These groups will all deal with the firm on an arm's-length basis, often led by agents who owe them exclusive fiduciary duties. Competitive forces tend to produce win-win deals in all cases. Labor markets are a source of particular sensitivity and confusion. Warren laments that "average wages haven't budged over the past year," but there is good evidence today that wages are now outpacing inflation. Indeed, that understates the overall improvement, because unemployment rates among key groups—minority workers, ex-criminals and teenagers—are down to their lowest levels in over 50 years, another point she doesn't mention. These new workers will depress average wages because they usually command lower wages than their more established peers.

It is therefore even more impressive that overall wage levels are moving up when these new entrants drag down the pool statistics. In any event, why condemn the CEO who helps create new low wage jobs because he necessarily earns a larger multiple of his employees' average wages than before? Warren ignores the simple point that the boom in jobs and stock market prices works to everyone's advantage.

Nor does the traditional view of corporate responsibility ignore environmental and community risks. These are handled by imposing explicit public obligations to avoid pollution, fraud, and other misdeeds. Moreover, the ever-powerful threat of reputational loss quickly hits home whenever bad firm behavior comes to light. Friedman's view does not turn corporations into selfish actors, as Warren insinuates. Friedman's basic insistence that corporations prioritize their own business interests was meant to stop corporate insiders from using corporate funds to endow their own pet projects, for which they should use their own money.

But nothing in Friedman's position prevents large firms from engaging in charitable activities that engender good will towards the company which redounds to the benefit of all stakeholders. Corporate giving, like individual giving, is still on the rise.

Warren also misunderstands why it is a welcome development for corporations to increase their distributions to shareholders. These large distributions are not typically used for ostentatious consumption, but are reinvested in new businesses, often start-ups that carry both greater risks and greater returns. Successful firms create new opportunities for all of Warren's stakeholders. Indeed, we should look askance at firms that harbor capital for low-value uses in order to pad the position of its corporate leaders. Decentralized capital allocations by many independent actors may well outperform large firms in innovative activities. Adroit small firms are able to turn on a dime to seize new opportunities.

When the businesses grow larger, the original investors can sell their stock in an initial public offering, take their winnings, and start another high-risk venture. An increase in cash distribution is a good marker of increased competition. One telltale sign of this positive development is that the per-share value of corporations tends to increase with large distributions, so that everyone gains.

Warren is also wrong to criticize the trend of increasing the amount of compensation that corporate executives receive in the form of shares or options, the value of which depends upon the continued value of the corporation. Warren mistakenly insists that the shift in compensation packages operates as "a reward for producing short-term share-price increases."

But again she gets the economics exactly backwards. A CEO whose compensation is tied to the share value of the corporation knows full well that the stock market does not look just at quarterly earnings. Under standard financial theory, the value of a corporation's shares should equal the present value of all discounted future cash flows. In addition, vesting restrictions prevent managers from selling their stock before several years have passed. To give the CEO all-cash compensation makes him less sensitive to the long-term profitability of the business.

Accordingly, most compensation committees try to steer a middle path between excessive caution and excessive risk-taking by mixing cash, options, and stock to better align the CEO incentives with corporate welfare.

Finally, Warren wholly misunderstands the historical role and constitutional position of corporate charters. The last thing that any country needs for economic growth is a situation in which government officials decide which firms receive charters subject to what conditions. Does she really think that some public bureaucrat should have the power to refuse to issue Apple a corporate charter unless it puts community members or union members on its board, makes gifts to the Sierra Club, or adopts minimum minority hiring set-asides? And what should be done when thousands of firms balk at these conditions? Can they go to court, or does the federal board run the corporation directly?

Lest anyone forget, the great 19th-century corporate reform was the passage of general incorporation laws that allowed any group of individuals to form a corporation, with its attendant benefit of limited liability, so long as they met certain minimum conditions relating to their capital contributions, their ability to sue and be sued, and their board structures. The new legal regime ushered in sustained economic expansion by knocking out the political favoritism that had previously given some businesses corporate charters that gave them a huge edge over direct competitors denied similar authorization. It would be unsurpassed folly to re-open the doors to these abuses today.

Warren's proposal is unconstitutional to boot. The doctrine of unconstitutional conditions makes it clear that the government cannot attach whatever conditions it wants in the exercise of its monopoly power over corporate charters, any more than it can do so with licenses and permits. The state can tell drivers that they must take driving tests to use public highways, but it cannot insist that drivers surrender their rights to participate in political debate or against unreasonable searches and seizures to use public highways.

The regulation of corporations is similarly constrained, so that the conditions attached to corporate charters must be reasonably related to the safe and prudent operation of their corporate businesses—and not the stringent conditions that Warren champions under her progressive banner. Her egalitarian grandstanding gravely threatens the liberty and prosperity of our nation.

Richard A. Epstein is an American legal scholar best known for his writings and studies on classical liberalism, libertarianism, torts, contracts, and a wide variety of topics in law and economics. He is the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, the Laurence A. Tisch Professor of Law at New York University Law School, and a senior lecturer at the University of Chicago.

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