I’ve had some time now to reflect on the Volkswagen scandal
having now discussed the topic on TVO
here in Canada. During my interview
on the program, I was asked whether I was surprised by their behaviour.
Although disappointed as a business professor, there have other egregious
examples of this sort of behaviour, equally distasteful in their demonstration
of disregard for moral principles and rule of law. Big bank deliberate manipulation of the Libor
interest rates in Europe that affected millions of people, HSBC’s money
laundering for drug cartels and here at home SNC Lavalin’s bribery charges come
to mind.
The host Steve Paikan asked me to comment on what goes on in
the minds of executives of these companies.
I spent some time discussing the shareholder primacy ideology that
pervades business decision-making and the business schools that groom these types
of decision-makers. There are several
articles that have come out supporting this view (see Fortune Magazine’s article for
example).
But one thing I didn’t
get a chance to elaborate on is that if the mandate is shareholder wealth creation
and nothing else, why would companies like Volkswagen break the law when getting
caught would result in substantial erosion of the very shareholder wealth they
were taught to protect?
The cost/benefit analysis I discuss in the interview (the
benefit to shareholders of not getting caught far outweighs what is only a
potential cost) only explains part of the reason.
There is a more complex and accurate explanation reason for
this paradox.
In a recent book entitled The Shareholder Myth, Lynn Stout
explains that there is no evidence that focusing on shareholder wealth
maximization actually increases wealth for investors. In fact, evidence suggests that during the
last few decades where the ideology of shareholder wealth maximization pervaded
board rooms and business school curricula, the aggregate financial performance
of business has actually eroded. Let me
say that again! During a time when shareholder
wealth maximization has been the so-called “religion” of business, profit
levels declined.
How could this be?
Let’s draw on a medical analogy. It is common knowledge that while medical
specialists are experts in highly specific parts of the body, they are limited
in their ability to see the patient as a whole. That is, they struggle to see the patient holistically
where the health and well-being is inextricably tied to the complex interactions
of hundreds of physical and mental parts that work in unison. Even general physicians have often been
criticized for not seeing how the patient’s physical welfare is highly connected
with its psychological, intellectual, and emotional welfare. The natural tendency for physicians to
prescribe drugs is meant to deal with the symptom, for instance, when the
patient might need emotional and psychological support.
You can therefore consider the treatment of patients to fall
into two categories. The first is seeing
the patient as the sum of individual and disconnected parts where one can isolate
and remedy parts of the patient in isolation.
The second is seeing the patient holistically where the whole is greater
than the sum of the parts. Here, the
treatment of a seemingly isolated part of the body has important and often
unpredictable implications for other parts of the body just like a person’s
emotional state affects and is affected by its physical state in very nonlinear
and unpredictable ways.
There are at least two potential consequences associated
with the first reductionist approach. The
first is that treating one part of the patient will likely cause negative
consequences for other parts. We see
this all the time when considering the physical and psychological effects of
prescription drugs. Specialists, who
work to keep, say the liver in good shape, may end up engaging in behaviour
that compromises other vital organs. In
his highly touted book Being Mortal, Atul Gawande explains how the ideology in
medicine to keep the patient alive at whatever cost completely ignores the
mental and emotional consequences of this ideology to the patient. Here, the patient may live a longer life but
their actual health has completely eroded because, by keeping them alive,
they’ve compromised their ability to do the things that kept them
fulfilled. We’re only now seeing a
growing awareness of mental health but it is far from being incorporated into a
more holistic approach to medicine.
The second is that treating the patient as a sum of individual
parts may produce effects that ultimately erode the very part that was being
treated. This is a very common
characteristic of complex systems because it means that the general physician
who continues to prescribe prescription drugs to treat a symptom of a more
underlying problem will find that the problem might actually grow in intensity
and may resort to prescribing a higher dose of drugs. More simply, while an
operation might temporarily remedy a physical ailment, the neglect of mental or
emotional health in this process, might strongly impact the ability of the
patient to fully recover, thereby making the physical ailment much worse. This happens often with specialists where the
treatment of a part of the body impacts others in ways that require subsequent
treatments and drugs.
The relationship between these two consequences is typically
chronological. That is, the doctor’s
decisions initially benefit the targeted body part, causing negative
consequences for other parts, making it seem like the treatment is
working. But then, over time, as
complexity theory would prescribe, the negative consequences to other parts
start to compromise the initial body part that received the attention as the
physical and mental state itself might start to shut down.
Now let’s take this analogy and apply it to management. At business schools, we do not train students
to be generalists. We train them to be
specialists. By that I mean we train
them on how to maximize wealth for one stakeholder – the investor. In the same way that specialists are trained
to know everything and anything that is related to the diagnosis and treatment
of one specific body part, students coming out of business school are trained
on how best to maximize shareholder wealth.
Yet just as the health of any human body is a function of understanding
its complexity across multiple body parts physically, emotionally and
physiologically, the success of any business is entirely a function of understanding
the complexity of the environment in which it operates; that is, the wide range
of diverse stakeholders that influence or are influenced by the business.
Let’s consider the first consequence of reductionist
thinking described above and apply it to business. Focusing on shareholder wealth in isolation
has dramatic consequences for other stakeholders like communities, the
environment, employees, consumers, and suppliers. You might say, “but Mike, wouldn’t the
manager see that eroding consumer satisfaction or treating your employees
negatively adversely affect shareholder wealth?” Not necessarily. First, you have to think of variations in the
time horizon. We tend to presume that
the time it takes to maximize shareholder wealth is equal to maximizing
employee and consumer wealth. This is
not the case. Shareholder wealth can
initially be maximized at the expense of employee and consumer wealth. I published a paper
in Sloan Management Review that looked at the relationship between shareholder
wealth maximization and external stakeholders and found that the more the board
of directors were compensated with stock (a proxy for shareholder wealth
maximization), the more value for consumers, the environment, employees, and
communities eroded.
Second, we need to think about resource allocation. To a specialist, every dollar allocated to
non-shareholders such as consumers and employees means a one dollar loss that
could have gone to shareholders. With
this way of thinking, a management specialist is going to search for ways to
maximize shareholder wealth in ways that don’t require attention to other stakeholders. Thinking back to the medical analogy, if the
goal is to prolong human life and to therefore trivialize or at least
de-prioritize mental and social well-being, physicians would try to convince patients
that the obvious choice is to find alternative ways to fulfill their life and
to be thankful that they’re still alive.
Investment banks leading up to 2008 found ways to maximize
shareholder wealth without having to meet their consumer needs. In fact, they found ways to maximize
shareholder wealth by undermining the returns of their consumers. This seems odd doesn’t it? Goldman Sachs was particularly egregious here
when they marketed poor financial securities to their consumers as premium and
then made huge bets that these very securities would fail. So not only do they earn the commission from
their duped consumers, they also earn massive payouts when the securities
fail. This creates way more shareholder
wealth than if they simply marketed healthy financial securities to their
consumers.
This is not that different from the food and beverage
industry, where taking advantage of the addictive qualities of fat, sugar and
salt to hook your consumer leads to consumer loyalty and shareholder wealth but
an increasingly unhealthy and obese consumer.
We can say the same thing for employees where the obvious question one
would have is, “don’t companies know that employees treated well are more
productive and loyal to the company”? But
studies show that despite solid science that prescribes specific strategies to
improve employee productivity through motivation, job satisfaction and a positive
work environment, only 18% of companies use these strategies. But
more importantly, we have to think about how the mindset of the specialist in
this case is going to find clever ways to avoid the costs that come with
positive employee treatment.
This then brings us to the second consequence where the
specialist ultimately hangs him/herself with their own noose because their
efforts to maximize shareholder wealth neglected parts of the environment upon
which shareholders were highly dependent.
Because shareholder wealth is highly dependent on understanding the
complex nature of multiple stakeholder interests, that wealth is eventually undermined. But maintaining a focus on shareholder wealth
exclusively tricks a manager into a reductionist frame of thinking that overlooks
that shareholder wealth is contingent on a manager’s ability to understand and
respond to the complexity of a wide range of stakeholders who interact with
shareholder wealth in ways that are very unpredictable. As a consequence, we hear about Lehman
Brothers, Volkswagen, and British Petroleum because they fail to understand
that shareholder wealth can’t be sustained using a reductionist approach.
Let me end with Volkswagen.
The reductionist approach of shareholder wealth maximization facilitates
decisions that undermine the interests of consumers, the environment, and
public health. Initially, shareholder
wealth is maximized as it was from 2005 to 2014. But eventually, like the physician who
continues to ignore the mental and psychological states of her patient for the
goal of physical well-being and sees her efforts undermined because of the
patient’s mental or emotional condition, executives at companies like Volkswagen
failed to see how shareholder wealth was inextricably tied to long-term
environmental welfare and public safety (in the form of regulation), consumer
trust, and employee loyalty.
In sum, business schools are still very far from teaching
its managers to think about business in a complex way. We remain committed to a very reductionist
approach where we argue that maximizing shareholder wealth will naturally
maximize the wealth of other stakeholders.
This is like the general practitioner saying that the well-being of the
patient will be maximized if we prolong their life or a skin specialist arguing
that if we simply keep your skin healthy, all other parts of your body,
including internal organs and mental and psychological health, will improve as
well. The notion that shareholder wealth
maximization will naturally improve the welfare of other actors is a façade
backed by no evidence.
It will take some time to convince business school deans
that the shareholder value maximization ideology needs to change. For the time being, these Volkswagen type
stories will continue to arise – one out-shocking the other – until we begin to
look in the mirror as business schools to consider revamping the ideology that
guides our courses, culture, and the mentality of the professors and graduates
entering the workplace.
