Hello. Okay, folks. Before I start, I think we've solved the mystery of the sound that's coming in here. The school installed new receivers in the classrooms and they're picking up sound from other classrooms.
Don't even look at me. But they're going to resolve it. we should be okay.
We shouldn't be hearing other people's thoughts. So today I'm going to complete the last pieces of setting up the class. There are a few more loose ends, talk a little bit about the quizzes, the project, and then we're going to jump into talking about what the end game for business is.
What are we trying to do when we start a business? Now you might think the answer is obvious, but it's become incredibly muddled over the last 20 years as to what exactly. If you're the CEO of a publicly traded company, owner of a business, what are you trying to do with your business? So last session, we were talking about the first principles in corporate finance, and I said they were common sense, right?
So the investment principle, remind me again what the investment principle says. I'll help you along. So you need to take projects that...
earn a return that is greater than your minimum acceptable hurdle rate. The hurdle rate comes from the riskiness of the investment in the mix of debt and equity, and the return should be based on cash flows, not earnings. When you get the cash flows, have all side effects built into it. The financing principle says find a mix of debt and equity that's right for you.
Not right for everybody, but right for you. It minimizes your hurdle rate, maximizes your value, and the right kind of debt for your company is the debt that best matches your assets. And the dividend principle says if you cannot find investments that make your hurdle rate, give the cash back to the owners.
It's about as simple as you can think a set of principles can be, right? But here's the problem. There are people out there, many of them in cities like New York and London and Frankfurt, and I'll let you think about what they share in common, who think the rules don't apply to them. Why? Because they're special.
They went to Wharton or Harvard. They got an MBA. They work at Goldman Sachs or KKR.
They think they're special because they're too smart for the rules to apply to them. So every 10 or 15 years, there's a cycle you go through. They decide they're going to break the rules and it's going to be okay. So I'm going to take you back about 30 years and tell you a story about what happens when you break the rules. It's a company called SteadySafe.
I'm sure none of you have heard of this company. It used to be an Indonesian taxi cab company. Early 1990s, Indonesia is booming.
SteadySafe decides it wants to grow. What does that mean? Buy more taxi cabs, put them on the ground.
So you're going to be my investment banker. You know enough corporate finance already to help me on this one. I'm going to come to you asking for advice on what kind of debt I should take on to buy those taxi cabs.
So you're ready? How long, in terms of maturity, how long term should my debt be? You're allowed to ask me questions back.
So I'm a taxi cab owner. I want to borrow money to buy taxi cabs. How long term should the debt be?
What's the question you're going to ask me? Well, that's part of it. How long is the business going to be around?
But what am I buying with the debt? Taxi cabs. The question is, how long does a typical taxi cab last? Say it's 10 years. I run them into the ground.
It should be 10-year debt. In what currency, I want to say with you, in what currency should the debt be? What would we say about that? So if you're an Indonesian taxi cab company, when people get out of your taxi cab, what currency do they pay you in?
You say, what the heck is Indonesian currency? It's Indonesian rupiah, right? They pay in rupiah.
We've got it nailed. It should be 10-year rupiah debt, right? That was easy. So let's play back what actually happened. SteadySafe goes to Peregrine, not the same Peregrine you see now in Asia, but there used to be an investment bank in Asia called Peregrine.
You're saying why used to be? That's part of the story as well. They go to Peregrine Investment Bank, well regarded. They ask them exactly this question. And Peregrine tells them to borrow 10 years.
So they got that half, right? But in US dollars. Why would they do something stupid like that?
They gave a very compelling reason. And you can probably guess what that reason is. If you're from a market like India or Indonesia, this happens still all the time. Why do you think they told the company to borrow in rupee?
I'm saying dollars. It's cheaper, they said. Let me ask you a question.
Now, what part of the world are you from? Okay. Where in India? Okay.
If I asked you what the temperature in Chennai was today, give me a rough guess. That's good. You're already thinking in US terms.
But in Chennai, you'd have given me... No, the reason is when you are in Europe or much of the world, you think in Celsius. Today, I checked the temperature in Chennai. It's... hot again.
I mean, no surprise there. It's like 35 degrees. And the temperature, of course, in New York today is about 38 degrees.
You're saying Chennai is colder than that. You think that's absurd. One is in Celsius and one is...
We know we can't compare Fahrenheit to Celsius, but companies do this all the time, right? They compare interest rates in dollars to interest rates in rupee. And of course, the dollar rate is going to be lower. give SteadySafe credit, they asked Peregrine, should we be worried about the fact that we're borrowing in dollars to fund Rupiah assets?
And Peregrine said, don't worry about it. The Indonesian government has pegged the exchange rate. You know what that means? You know, basically the exchange rate is fixed and will not change and has promised us that nothing bad will happen. SteadySafe listens to Peregrine.
After all, you're the investment bank. You've got the expertise. They go out and borrow 10-year US dollar debt. And for a couple of years, things go swimmingly well. And then in 1996, Indonesia goes into a tailspin, a crisis.
And one day in 1996, the Indonesian government decides that it's going to revisit the peg. Never good news when you revisit the peg. And they devalue the rupiah by 70%. You ready?
Let's wake up to the morning after it's steady set. Your assets are all Rupiah assets, right? In dollar terms, what are they worth now? 30% of what they were yesterday. If your debt had also been Rupiah debt, it too would have been marked down 70%.
You wouldn't have been happy about what happened, but you're not in any trouble. But you see what happened to SteadySafe? Their assets get marked down by 70% because their assets are Rupiah assets.
Their debt stays what it was because it's dollar debt. Guess what happened to SteadySafe? They went bankrupt.
The good news is they took their investment banker down with them. If you ask me, it doesn't happen often enough, right? They're always there at the wedding.
They're never there at the divorce. Actually, they have divorce lawyers and wedding planners rolled into one outfit. So they get you in both places. But the truth is that this never made sense. But because you think you can override first principles, you go and override first principles, it blows up.
Take another example. Let's suppose I take 300 people who've had trouble making their debt payments in the past. Bad credit history. I put them in a room.
I run models that tell you that these people will never default again and said, lend to them as if they're default free. Do you think that even makes any sense? That's exactly what we did leading into 2008, right? We took people with bad credit histories. We told them and we created these mortgage-backed securities and we said, you know what, they've had bad credit histories, but we've run models that show they're like AAA rated based on our models.
Lend them money at AAA rates. And what do we have? We had the 2008 crisis.
If the definition of insanity is you keep doing the same thing over and over again, you can see that this process repeats itself. People think they can break first principles. It comes back. It comes back to bite you.
So one of the things I will come back to in this class is I will come back to reemphasize first principles. And if you see practices, maybe in the company you worked at or out there that are variants of first principles, let's talk about them. Is there an explanation? Are we setting ourselves up for another crisis somewhere along the road?
Because that's the way it always plays out. So those are the broad themes for the class. Let's get back to the specifics.
of what's involved in the class. So if you, rather than give you a traditional syllabus, I'm going to list out the sessions of the class in terms of the big picture. So we're going to spend the next three sessions talking about the end game.
During this period, I'm not going to talk about cost of capital, not a single number. And for some of you, this is going to be a relief because you don't like numbers. The first three sessions, it's going to feel like a strategy class, no numbers at all.
But I'll hold off because there will be numbers coming because I want to talk about what the end game is, because if you get the end game wrong, everything else is going to get blown up. Then in the next 10 sessions or so, we're going to talk about the investment principle. First, talking about risk and how it plays out hurdle rates and how to bring the mix in.
And then in terms of talking about returns, why cash flows as opposed to earnings, how do we bring the timing of the cash flows? And how do we build side effects? That's 15 sessions.
Session 16 through probably 19, we'll talk about the financing principle. First, by talking about the right mix of debt and equity for a company, and then talking about what the right kind of debt for your company is. And towards the end of the class, sessions 20, 21, 22, 23, we'll talk about, hey, how much cash can a company return?
And indirectly, we're also going to ask the question, how much of a cash balance is too much of a cash balance? It sounds like a stupid question, right? How much cash does Apple have right now on its balance sheet? Roughly $150 billion.
Is that too much cash? You say, of course, it's too much cash. It's not that simple. I'm going to argue that how much you will allow a company to accumulate as cash is directly a function of how much you...
trust that company with your cash. There are some companies who wouldn't trust with a dollar of your cash. There are other companies we let hold $100 billion, $120 billion. So we'll talk about what differentiates the two.
And then in the last session, last couple of sessions, we're going to circle back to the objective. Because in the objective, I said, the objective in all of this is to maximize the value of the business. You're saying, but what is value?
How do we estimate it? So the end of this class is going to be the icing on the cake of bringing all the corporate finance decisions you make back to what the value of a business is. So that's a plan.
And as I said, it's an applied corporate finance class. And here's what I mean by applied. Everything we do in this class, we're going to apply or I'm going to apply on real companies. And I'll give you the six companies that are going to be my lab experiments through the class.
These are not case studies. These are real companies. I'm going to run them through. I'm going to use 2013 as my point at which I'm running through them.
But I'll give you what the companies are still around. We're going to talk about what they look like in 2023 or 2024. The first company I'm going to use and perhaps the biggest lab experiment I'm going to run through is Disney. Why did I pick Disney? Because everybody... kind of knows what Disney does.
I mean, I could have picked Alcoa and we would have been wrestling for the next 15 weeks. And what exactly does Alcoa do? Disney, you've been in the theme park, you know about Mickey, you've seen the Avengers movies.
So large U.S. entertainment company. The second company I'm going to use. So everything we do in the class, I'm going to apply on Disney. I'm going to estimate Disney's hurdle rate, Disney's returns. And you can already see Disney 2013 looks very different from Disney 2024. So we're going to talk about what's changed over the last decade at Disney.
The second company I'm going to use is a company called Vale. Never heard of Vale. It's a Brazilian company, but it's really a global mining company. It's the largest iron ore mining company in the world that through the accident of history happens to be Brazil based.
Why did I pick Vale? To get as different from Disney as I can get, right? New economy, old economy. Service company, manufacture, mining company. Develop market, emerging market.
So I'm going to use Vale to talk about what's different when you have an emerging market company. You don't throw the principles out, but you got to adapt them. So that's going to be my second company. Third company I'm going to use is a company called Tata Motors.
It's part of a... one of India's largest and oldest family groups called the Tata Group. It's a mass market automobile company that's morphed into a global automobile company.
We'll talk about what allowed it to morph. But I want to talk about it as a family group company. You know that family group companies are more the rule than the exception in much of Asia, parts of Latin America. You're saying, so what if it's a family group company? I told you Tata Motors is part of the Tata group.
At one point in time, every Tata company shared the same headquarters building in Mumbai called Mumbai House. So two floors would be Tata Motors, Tata Steel. There are like 113 Tata companies in the group, and they all share that building. And on the very top floor sat Ratan Tata. the patriarch of the family.
He ran a company called Tata Sons, which was not publicly traded, but it's a holding company that controlled all of these companies. You see where this is going, right? We talked about companies making decisions.
We acted like companies are standalone, independent decision makers. Do you think there's a chance, any chance at all, that Tata Motors can make a big decision without it? the CFO or CEO of Tata Motors, taking the elevator up to the top floor and checking. With family group companies, often what's good for the group can come ahead of what's good for the company. And it's really unfair because you buy shares in Tata Motors, Tata Steel, TCS, and the family group can now make decisions that make you as a shareholder worse off because it makes the group better off.
It is reality. We have to face up to it. We'll see how it plays out in investing, financing and dividend decisions. So when I look at Tata Motors and how it picks debt, we have to bring in this player into the room of what does a family group think of your borrowing money? The fourth company I'm going to use is a company called Baidu.
What does Baidu do? Does anybody know? I'll make a confession.
I didn't even have any idea what Baidu was as a company. It's a long time ago. And I had to give a session in Shanghai.
The one and only time I've been there, I land and I had to look for something. Actually, the first thing that happens, I have a blog on Google. I'm very old fashioned. It's a Google blogger. I haven't done any of the up.
So I land and I was writing a blog post as I got on the plane. I land, I want to check and my blog has disappeared. Google has disappeared. I said, what the heck happened? While I was in the air, did a trillion dollar company just go into thin air?
The truth is, without having some kind of system, you can't really use Google as your search engine. Baidu is the Chinese search engine. It dominates the Chinese market.
I wanted to pick Baidu first because I wanted to pick a Chinese company in the mix. I wanted a Chinese tech company because I wanted a tech company in the mix. I got a twofer by this choice. So basically everything I do in this class, I want to apply on Baidu to see if things are different. for tech companies, for Chinese companies.
The fifth company I'm going to use as my lab experiment is Deutsche Bank. Why? Because I like horror stories.
Well, truth is, it's a bank. I wanted to bring a bank in because banks are regulated entities. You can't do whatever you want in terms of financing or dividends. I wanted... And as a bonus, of course, you've got a troubled bank.
And I'm using the word trouble loosely here. It's well beyond troubled. So I'm going to talk about how banks make investment financing and dividend decisions.
And I'm going to top it all off with a business called Bookscape. It's not a publicly traded company. It's a privately owned bookstore in New York City.
It's a small business. The owner is behind the counter. You say, why are you picking a private bookstore?
Because what did we say last session? Corporate finance principles matter to everybody. So I want to talk about how the owner of a small business uses corporate finance or should be using corporate finance to decide where to invest, how much to borrow, and how much cash he or she can take out of the business.
So as I do this, you're going to be tempted to sit back and watch me experiment, but I'm not going to let you. And this is where your project. comes in. Each of you, first, you're going to form a group. Every person in the group has to pick a company.
And the only thing I will require is there be some loose connection across the company. So your group might be travel. So give me some suggestions. What would go in your travel group as companies? You could do Expedia, you could do United, you could do Airbnb.
I mean, you can already see travel includes, you know. you know airlines it includes hotels it includes booking services so travel can include your group can be you know technology is too big so don't pick a group so it could be a portion could be software and you could have everything from microsoft to a small software company that provides entertainment software. I would encourage you to get diversity across the group.
Try to get a foreign company and try to get a small company and a big company. Why? Because what will make your project interesting are the differences across companies, which you can then use to say, hey, why does one company in my group never borrow money and another company borrows money?
So as I said, the project is in motion. Your job. is the first step is to find a group.
Don't pick a company before you find a group unless you have so much confidence in your persuasive powers that you can convince everybody else to pick the business. And then it's up to you to pick. You know, I am very loose in the grouping. I mean, I know there are groups in the past that have picked sin, like sin as opposed to good.
And the sin group, what do you pick? gambling tobacco think of yourself as the anti-esc group you're going to go out there and pick every company that is in a sense a bad company so i let you pick that and as you pick the companies i'm going to send you a master list i would like you to enter the name of the company you pick don't spend too much time going back and forth because if you pick a company and you want to change it that's perfectly okay i just want to know that you're starting on the process so I'll send that link to the master list and you can enter your, you know, whether you've found a group and picked a company. And as I said, by the end of the week, if you haven't found a group, I will try to put you on an orphan list, get adopted. You will have a group. So now one way or the other, I want that process out of the way.
So in terms of what the class will, in terms of the grading for the class, I'll give you a rough. breakdown of the grades. And this is determined by the finance group.
Other groups might have their own. So basically, there's an outline of what we can give. So I want to be completely transparent.
It's about 25% to 35% A's, about 50% to 55% B's. C's will be the bottom 10%, which means you can work really hard in this class and end up with a C. Life isn't fair. I wish I could guarantee you a B.
if you are here and you put in the work. But most of the time, if you're here and you put in the work, you are going to find your way to a B, B plus, A minus, A, wherever you want to go. But my job is to find a way to differentiate the A's, the B's, and the C's, and it's not based on what you've memorized or whether you know the equations. So if you look at the coursework for the class, the project that I talked about will be 40% of your grade.
There'll be one grade for the entire group. So no coming in and negotiating, saying I did the work in the group. Can you lower the grades for everybody else and raise mine?
No, I've had people actually with a straight face try to do that, don't even try. Which means part of your job in the group is to get people in the group to do what they need to do because the entire group rides on essentially everybody doing their share. There will be three quizzes for the class. First quiz is on March 4th.
The second quiz is on April 1st. The third quiz is on April 22nd. Each of the quizzes will be worth 10%.
They're open book, open notes. And every quiz or exam that I've ever given is online. So you will be able to see what these quizzes look like.
So you won't be able to walk in and say, I didn't know what the quiz would look like. You'll be intimately aware of what the quizzes will look like. The final exam right now is scheduled for May 13th from 11.15 to 1.15. I've already got...
a few emails from people saying I have to leave because remember that's towards the second week of the finals week. The finals week I think starts on a Wednesday. It's the following Monday. If you have to leave, I will give an early exam for those of you who have no choice.
My strong suggestion is you wait till Monday because you'll be turning in your project on May 6th, which is the last day of class. It'll give you a week to prepare for the final. But if you have to take the final before that weekend and you want to get out of here, just let me know.
And, you know, we'll figure out when that early exam will be. Now, I'm always explicit about things because that way we don't have any misunderstanding. I would like you to take all three quizzes.
But if you have to miss a quiz for whatever reason, you're sick, you're traveling, you have an interview, do it for a good reason. right and i've listed out you know some good reasons if you go to my website i've listed out good reasons for quizzes the truth is i'm not going to double check you i'm not going to ask for a doctor's note if you're sick so if you really want to lie and say i'm sick i can't take the quiz what am i going to do force you to show up But if you do miss the quiz, here's what's going to happen. The 10% on that quiz will be moved to the remaining quizzes and exams.
So let me be very clear. So let's say you take the first quiz and you miss the second quiz. I'll take the 10% of the second quiz, move it to the third quiz and the final exam. So the third quiz will now be worth 12.5%. Your final exam will be worth 37.5%.
If you miss the third quiz, it'll always be moved forward. to prevent what I call strategic quiz missing, which is if you do really well in the first two quizzes, otherwise you'll be tempted to miss the third quiz. So that's not, there is no benefit to missing a quiz, even if you're not quite ready, which is not a good reason for missing a quiz.
And you're tempted to make up an excuse to show up and take the quiz because the worst that can happen is you get a zero. But here's why that's going to be okay. If you take all three quizzes, your worst quiz I'll take the score of the worst quiz and replace it.
I won't throw it out, but I'll replace it with the average scores on the remaining exams. So you get a zero on the first quiz, tens on the next two quizzes and 30 on the final exam. In other words, you're perfect and everything, but you got a zero on one.
I'll take the zero and replace it with a ten. That's the most extreme scenario. But effectively, one of your quizzes is a freebie.
My advice is don't use it up on the first quiz if you can avoid it. It's nice to have a freebie holding out there. So, but, you know, recognize that that's, you know, that's, you know, one benefit to taking all three quizzes, but that'll apply only if you take all three quizzes. If you miss a quiz, that benefit is gone.
So any questions on the administrative stuff for the class? So in terms of group work, you know, pick your own groups and I will try to get you into group and the rest is pretty, pretty much. So let's talk about the end game for a business.
Now, why spend so much time in the end game? There's an old saying, if you don't know where you're going, it doesn't matter how you get there. So I want to talk about where we're going before we talk about what's the best way to get there.
So I'm going to start with a very basic description of why. we start businesses. Why does anybody start a business?
The pragmatic way to think about it is you start a business because you feel there's a need for whatever you're doing out there in the market, perceived or real. You think there's a need. You're going to produce a product or service to meet that need. And what do you hope to get in return? In addition to the gratitude of the people that get this product or service, you hope they will pay you.
I know it's incredibly mercenary, but you're starting a business, not a charity. And you hope that what they will pay you will cover the cost plus more. So that's the bottom line. You start a business.
But the pushback you get is that's so narrow minded. That's basically, if you think about the last 20 years, that's been the big pushback. This is far too narrow a vision of business. A business should not have an end game of making money.
It should have other end games. So that's kind of alluring, right? You're saying, I want to start a business.
I want to do good. I want to make the world a better place. It's human nature.
And if you think broadly about the three big pushbacks you see from people who look at the traditional objective. So think of this as the Milton Friedman description of business. One of Milton Friedman's most read articles was a New York Times article he wrote in the early 1970s, where he said the business of business is business. Basically, you're trying to. So his point was, hey, if you want to do all this side stuff, that's fine.
But that. the end game here is you got to make money. And the pushback has come from three different places, all of whom share a common theme.
And we'll talk about what the theme is. The first is relatively recent. The last 10 years, I'd never heard the word sustainability until about 10 years ago. Now I've got to put your plugs in and cover my eyes as I walk through this school. Because sustainability is all over the place.
You're probably taking three classes with the word sustainability in its name, right? So there is this push up. This is not about the end game should be to make your company sustainable. We'll kind of leave it hanging there because we've got to convert this to pragmatic decision rules. We'll come back and talk about how insane it is to talk about sustainability as your end game for a company.
You want to talk about the planet. That's a very different game, right? We all have to live on the planet. We want to talk about making the planet sustainable, making a company sustainable.
I'm a little hazy about what that means. And I'm going to come and push back. The second set, the second pushback we got was from people who said there are lots of stakeholders in a business.
Are there? Absolutely. There are stockholders, there are lenders, there are employees, there are customers, there's society. And the basis for this push is this is so unfair. Why are you just picking shareholders?
Why make this? This looks like favoritism, right? To pick one group and put them on top.
Why are you focusing on shareholders? We should be maximizing stakeholder wealth. Again, we'll take it on frontally because.
I'm sure there are classes you get about stakeholder wealth maximization. Let's play it out. And of course, in the last 15 years, you also have had this push on ESG as, hey, the end game for companies should be built around creating environmental, social, and governance objectives rather than maximizing.
So for the moment, those are the pushbacks. Clearly, the debate has been enjoyed, and I welcome it. because I think we need to get this cleared up. Otherwise, we're going to be completely confused for the rest of the journey. So let's start with the question of who the stakeholders in a business are.
So I've tried to list them out and maybe I've not a comprehensive list. Obviously, there are shareholders. What do shareholders do? They provide equity to a company to get it started. You have lenders.
They're stakeholders too, right? They lend money to a company. in return for interest and principal payments.
You have employees. A company without its employees is a shell. They're clearly big stakeholders. You have customers.
What's their stake? They buy your products and services. Does society have a stake?
Absolutely, because you create side costs and benefits to society. Even competition has a stake. They have a stake in making you fail, but they still have a stake. They're all stakeholders. And it seems...
strange again and i can see the basis of the stakeholder argument why when you have all these different stakeholders you put shareholders do you give shareholders privacy anybody want to give that a shot yes because shareholders provide the capital based on so do lenders right if that's your argument that lenders should be providing and employees are now they provide human capital so if you open that door you I could make the argument that all of those groups should be allowed to run it. Lenders lose the company, loses as well, right? Employees lose, you know, employees.
So in a sense, losing is an argument that any of these stakeholder groups are. Yes. Well, lenders can take a lot of risk if it's a low rated company with a lot of default risk.
Yeah. Not that's not the right word. But that's self-fulfilling. Right.
I made shareholders privacy. I made the Delaware courts enforce it. So that can't explain it. That's what happens when I put shareholders. But my question is why?
You're getting closer. Yeah. But that again is self-fulfilling.
I give them control because I gave them primacy. I could have given lenders control of the company. I could make employees run the company.
Yes. Okay, now we're getting closer. What kind of claim do lenders have?
No, no, but let's talk about lenders. What's a claim that lenders have? It's a contractual claim, right?
When you lend money to a firm, what do you do? You enter into a contract with a firm, and if you had a loan agreement, they put in covenants on what you can or cannot do. They set an interest rate and a principal payment. It's a contractual claim. When you go to work for a company, what do you sign on that first day before you start?
An employee agreement, right? It specifies both sides. Sometimes companies violate it, and you can sue them, but there's a contractual claim. Do customers have a contractual claim? When you buy a product or service, implicitly you have a contract, right?
So if I buy a product and it doesn't work, I can sue the company saying, I bought this product expecting this outcome, but it's not working. I can complain to the Better Business Bureau as a contractual claim. Does society have a contractual claim? You mentioned the word regulations and laws. Regulations are laws of societies.
contractual claim. And in addition, they have a financial contractual claim, which is called taxes, right? Every claim holder in here has a contractual claim, except for shareholders who get what?
Whatever's left over. Let me ask you a question. If you get only whatever's left over, and I don't let you control decision-making, how much do you think is going to be left over? Nothing. Why would I ever have a residual claim if you don't give me control of the decision making?
I still have to negotiate those contracts. This has nothing to do with putting people up. It's a fact that shareholders have a residual claim. And if you don't give them primacy, there will be no shareholders.
That might be a desired outcome, but that's a different fight you want to fight. We put shareholders at the top of this pyramid, not. because they're special, but because they have a residual claim. Now, we'll talk about whether this can create consequences you might not like, but that's the reason. So the next time somebody in some class says, why are you making shareholders special?
Be clear about what it is in this process that leads you to give shareholders privacy. So in theory. the objective of a business in corporate finance is to maximize the value of the entire business. But the value of the business comes from both debt and equity. So in practice, we start to narrow this objective.
Somebody mentioned that managers are accountable to shareholders. That's absolutely right. And if you're the manager in a company and you're accountable to shareholders, rather than maximizing the value of the business, you will maximize the value of equity, shareholder wealth.
Why? Because that's who you're answerable to. And if you're a publicly traded company, you might decide to narrow this even further. Because shareholder wealth is this kind of fuzzy concept, right?
Who's going to measure it? You can call it McKinsey. They make a subjective judgment.
There could be a bias. But if you're publicly traded, what can you observe that then becomes a stand-in for shareholder wealth? You can observe the stock price.
In practice, corporate finance, the objective, instead of maximizing fair value, becomes maximizing stock price. It is not the objective incorporation. It's a pragmatic choice we make. You can observe it. And that is where I'm going to start this discussion.
Because for a long time, that became the basis. You're a CEO or a company manager. Your job is to maximize stock price.
Can it potentially create prompts? Absolutely. We'll talk about the worst case scenarios and how it plays out. But I want to start about, you know, to talk first about why we need one objective.
Because some of you are saying, why do we need to pick one? Why can't we have five objectives or four objectives? If you've done operations research and I give you an optimization problem, every optimization problem has one objective and multiple constraints. Life is about picking objectives and constraints.
Because if you know. I'll give you the analogy. I know poor kids are all grown up now, but I remember we used to go on summer vacation, all six of us. If I said my objective this vacation is to keep everyone happy, you know what the outcome would have been? No one would have been happy.
So when we think about objectives, it's basically you've got to decide. You might have all these different things swimming in your mind. What is my primary objective?
To me, this is... The weakest link in many organizations, if you don't have a primary objective, things get really muddled. We'll talk about entities that have that. Nonprofits, classic example. I used to work with a homeless organization in New Jersey, and I think they made a mistake and put me on the board for a little while.
And I said, what's the mission here? They said it's to find housing for the homeless, to feed the homeless. work on legislation to make it easier for them to get ideas.
No, no, no. I said, which is the objective? And they said, why can't we use all of them?
I said, because you have scarce resources and you have to decide what your primary objective is to feed the homeless, where I will invest my resource will be very different than if the homeless. You have to decide what your objective is and what your constraints are. And that's basically a choice you have to make. So you can't cop out here and say, why can't I have five objectives? You have to decide what the objective is. objectivist.
You might disagree with my choice of objective, but then you've got to give me what your objective is. And if you think about why we pick stock prices as our optimizing tool, it's very simple. Stock prices are updated constantly. For instance, if you said, I want to maximize earnings, stock prices are too volatile.
You can maximize earnings, right? But then remember, earnings get measured once every three months, so you don't get that constant updating. The way this plays out in markets is Companies sometimes announce big news.
Yesterday, Elon had a bit of a setback in the Delaware courts. Do you know what happened? The Delaware courts basically went back and said the 2018 compensation agreement that the board signed off on with Elon, which was tens of millions of dollars, is illegal because the board was not independent.
We'll come back and talk about boards and how they made that assessment. Is that news? Yes.
Is it big news? And how will it move the value? We could go debate about this. But you know, the best measure of that was is this morning.
Tesla opened $2 lower. Is it news? Is it bad news? Yes, not hugely catastrophic news. They think there'll be.
But markets give you instant feedback on your decision making and never underestimate the advantage of having something that's instant feedback. And from an academic standpoint, from a theory standpoint, it's nice to have something you can observe because then you can check out right away when I make a decision, is it good or bad, looking at what the stock price reaction is. So we turned CEOs loose.
And for decades, we've done this thing, go out and maximize stock price. So I want to start with a nightmare scenario. What's the worst thing that can happen when you let a top manager be focused just on maximizing stock prices? I call this cutthroat corporatism, which is companies where basically it's not even managers, but insiders control the company.
And they're focused on maximizing stock prices. And all of the other stakeholders are so weak that the shareholders can, in the late 1800s, Andrew Carnegie, John D. Rockefeller built monopolies in the US. They used publicly traded companies as a facade, but it was really about advancing their interests. So what did they do? They basically...
got lenders to lend them money at below market rates because, you know, they were effectively controlling the financial markets as well as the companies. Their employees had no bargaining power, you know, so they made them work long hours with substandard wages. Their customers, they charged extraordinarily high prices because where can they go?
They're monopolies. They were doing maximizing stock prices, but because the other stakeholder groups were so weak. they were able to exploit those stakeholder groups, increase stock prices and make everybody else worse off, including society. So the oil wells in the late 1800s, you could create all the pollution you wanted. The government was either wasn't aware or couldn't do anything about it.
Think of this as the worst case scenario. So when people talk about maximizing stock prices are bad, if you're going to paint an, you want to create a straw man, this is what you want to create. Here's what your nightmare should be, a CEO for a company who's maximizing stock prices and absolutely no compunctions about taking everybody else to the cleaners. Have any of you heard of a guy called Al Dunlop? Al Dunlop was the CEO of Kimberly Clark, which is a paper company in the 1980s and early 90s.
And he got a reputation as... being a successful CEO. He was great at cutting costs.
He went in and Kimberly Clark, he cut costs, he cut employee benefits. He turned Kimberly Clark around and he acquired the reputation of being a turnaround CEO. In fact, he became CEO of Sunbeam, another company that was in trouble because in a company in trouble, what do you do?
You hire a CEO with the reputation of a turnaround CEO. And he came to Sunbeam and guess what he did? He cut costs.
He was one trick. point. There's no strategic bones in his body.
And Sunbeam's problems are not caused, he drove Sunbeam into the ground. And he also committed a lot of accounting fraud along the way. Because maximizing stock prices, that's your objective.
You can do it by doing shady things. He took it to an art form. In fact, in 1997, I think Fortune magazine or one of the business magazines, a fast company, I think wrote this, did this piece on, I is your CEO a psychopath? And Al Dundler passed every test.
And he was open about admitting to psychopathic tendencies. You put a psychopath on top of a company and the system is weak. I mean, you can maximize stock prices by doing horrifically bad things.
So if you ask me, can bad things happen when you ask companies to maximize? Of course they can. And I can give you anecdotal examples where that's happened, create case studies around it.
And use it as a warning for you don't want this to happen at your company. But let's make a more general statement. Is maximizing stock prices incompatible with your stakeholder groups doing well? Because the implied message when people say don't maximize stock prices is they seem to be saying if you maximize stock prices, you must be ripping off your employees. In fact, often the news stories that lead people to this conclusion is you'll see a news story that says such and such company laid off 2000 employees.
And you keep reading the story in the last paragraph. What does it say? It stopped. price jumped $3. And you're making the connection saying laying off employees leads to higher stock prices.
And with anecdotal evidence, again, I can back that up. But the question is, is this true in general? So here's what I did. I went into Glassdoor.
Glassdoor is this company where you can report to employees. I looked at the most, the companies where employees have the highest satisfaction and companies with the lowest satisfaction. Then I went into the...
into my stock price database and I looked at the companies that have done the best over the last 10 years and the companies that have done the worst. And you can try this out yourself. If you look at the top 10 companies, you see a lot of the FANGAM stocks.
People are happy. You look at the bottom 10, you see a lot of companies in trouble. And the reason is very simple.
To take care of your employees, you've got to be doing well. Remember, many employees get stock-based compensation. I mean, this morning I was reading about the company 23andMe.
Go to the company where you send in your DNA and they tell you where you were born. They probably make up crap, but they tell you what you want to know. You're half whatever, quarter this, quarter that. So that's a company that went public at a $6 billion market cap five years ago.
Today, the stock price is close to zero. I can almost guarantee you don't want to be working at 23andMe right now because your pay was primarily the form of stock. It's all gone to dirt and there's nothing you have to show for it. Most of them probably been laid off. For the most part, doing well as a company is what allows you to provide your employee benefits and add those extra things that make you happy at a company.
Again, there are exceptions. We can talk about the exceptions, but for the most part, doing well and taking care of your employees go together. And if you take care of your employees, sometimes for mercenary reasons, happy employees are more productive.
I mean, you go to Costco or a Trader Joe's. Trader Joe's, I think those people are on drugs. They're all happy all the time, right? I mean, you go to a cashier, you know, smile on his face, life is good.
No, but it does make you much better. feel much better about shopping there. So is there a payoff?
Absolutely. If there's a payoff from treating your employees better and it shows up as higher earnings and value, by all means, do it. But this is something, again, that we have to get out of the way that doing well as a company and taking care of your employees are somehow... I'd much rather work at Amazon than any brick and mortar retail. Would you want to work at Macy's?
The thought of doing it kind of makes me want to not... live, right? It's depressing, right? The company is on a pathway to nowhere.
And it's really got to do with the fact that the company is in bad financial health. They can't afford to give out benefits, add extra things. They're just barely making it. You're saying, what about stock prices and customs?
Again, you're given the choice. Do you want to maximize your stock price or do you want to- keep your customers happy. About 30 years ago, I was asked to give a talk to the Gap's top management.
This was in the Gap was actually a growing retail company, adding more stores. Those days are in the past. So I think they had it in Sundance. We've been in Sundance, extraordinarily expensive place, Robert Redford's Ranch, which tells you how well the Gap was doing. Usually you can tell how well a company is doing by where they have their get togethers.
If they have it in Oakland, you kind of hit rock bottom. If you have it in Sundance, you're doing really well, right? So, you know, it would show up. And I had the singular misfortune of following the marketing head honcho, the marketing guru. So it was somebody, I don't know which school he was teaching at.
And he got up and he said, the objective for the gap should be to maximize customer satisfaction. I got up and I said, that's the stupidest thing I've ever heard. Let's think about your experience at The Gap.
I don't know when the last time you visited. How many of you have been in a Gap store? Okay.
So think about your collective satisfaction from that experience. First, you walk into the store, it's well lit. You're pretty good, right?
You walk in, you find the khakis in your size and the shirts in your size. Even better, you put them in your shopping cart and you get ready to leave. And there's this small thing you have to do that crimps your satisfaction, right? What is that? You got to stop and pay.
I know this sounds absurd, but if I said the objective for the gap is to maximize customer satisfaction, what should they do? Remove the cash registers. They'd be bankrupt in two weeks, but they'll have really satisfied customers. You're saying that is absurd.
It is absurd, but that's what happens. We say, do I want satisfied customers? Absolutely. Why do I want satisfied customers?
Think in mercenary terms, because I want them to come back and buy more of my stuff. Again, if you take a look at the most successful companies and customer satisfaction, I can almost guarantee you that the two go together. I shop at Amazon because I get maximum satisfaction. I don't like something, I go drop it in a box.
Soon, I think they'll have the box right outside my house. You don't want to just drop it there, we'll pick it up. Again, let's not make this a choice.
Do you want to maximize stock? prices or do you want to increase customer satisfaction? The two usually go together.
And here comes the final critique of maximizing stock prices. If you maximize stock prices, you must be some kind of a social outlaw. You must not care about society. And this gets fed into, you watch enough Hollywood movies, it gets fed into in terms of the stereotypes.
You see, one of my favorite movies is a movie called Other People's Money. It's a 1980s movie. It's about a hostile acquisition of a telephone cable company.
You think that sounds incredibly boring. Trust me, it's a fun movie to watch. Because in this movie, there's a hostile acquirer. You know who plays the hostile acquirer?
A guy called Danny DeVito. So if you've seen Danny DeVito, you know exactly what comes to mind. And the phone company CEO is played by Gregory Peck.
Distinguished, noble. And here's how the story unfolds. Danny DeVito is planning to acquire this telephone cable company and shut it down and lay off the employees. So it's a movie, right? We've set up villain, hero, and Gregory Peck is going to stop it.
And this is what makes the movie at least a little bit fun. It doesn't have its natural arc of good guys win, the bad guys lose. The movie's climactic moment is at an annual meeting. I told you it sounds incredibly dry and boring, but trust me, this is a fun meeting to be at.
And Daniel Vito gets up and he tells the shareholders why he's shutting the cable. And he's saying, you guys are going to blame me. But the problem with your company is you're making cables and everybody's moved on to fiber optics. Nobody's buying your product.
But you can see the stereotyping. So if you think in terms of corporate finance, Gregory Peck is the anti-corporate finance, Danny DeVito is corporate finance, crude, money-oriented. And that's the message that you're often delivered is if you care about stock prices, you must not be taking care of society.
And this is at the heart of ESG and some of the other stuff, isn't it? But let's step back to do good for society. Let's say you feel that that is part of what you want to do.
to do good for society as a company. What is it you first have to do? You first have to be financially healthy and make money.
Do you think GM can afford to be good to society? I mean, the company is struggling to make it in a market where electric cars are eating up their market share. They can't afford to be good. I remember when Microsoft in 2018 gave away PCs to every library in the country.
That is so magnanimous. First, it probably wasn't that magnanimous. They wanted to get people hooked on this awful Windows operating system while they were young.
But the other is they were doing so well. What's computer and everything? When you think about doing well, you have to start with the question of, am I financially healthy enough to do well?
The companies that can do the most good are often the companies that are most profitable and valuable. It's a problem. with ESG scores is whether ESG scores are high because companies, I know ESG score people often talk about companies high ESG scores are doing financially they're doing well. And my question is, are the ESG scores leading to companies doing financially well or do financially, you know, companies that do financially well, better able to deliver the stuff that makes the ESG services give them a high score? For the most part, these are false choices.
And much as you might like to say, maximizing stock prices means you're breaking every other stakeholder's interest group. That's not the way. If you look at the broad cross-section.
It seems to work. So here's what I'm going to start with. I'm going to start to frame this debate by looking at four linkages that apply in every publicly traded company.
And I'm going to use those linkages to talk about the utopian world of corporate finance, which is where corporate finance was born, why it breaks, and how they play out in the linkages. Here's the first linkage. If you look at a publicly traded company, the decisions made at the company are made by managers. not the shareholders. Why there's a separation?
More so in some companies than others, because there are some companies where there's a lead shareholder, Facebook, Tesla, who's also the top manager, but in many companies, there's managers and shareholders. So first, we've got to talk about that linkage. Second, there's a linkage between the firm or managers representing the firm and lenders, because lenders lend money to the firm, they expect the firm to behave. We'll talk about that linkage.
Third, if it's a publicly traded company, there's a linkage between the firm and financial markets. It works two ways. The firm reveals information about itself to the market and the market assesses the price. And fourth, there is a linkage between firms and society. So I'm going to start with the utopian word from which corporate finance was born.
And what does the word utopian tell you about what I'm going to list on my assumptions? When did utopia exist? It didn't.
Now, it's the very fact I'm telling you up front is I'm going to give you assumptions that are patently unreal, and I'm admitting it up front, but that's where corporate finance was born. So here are the assumptions. First, we assume that stockholders have complete power over managers.
They can hire and fire managers, and the two mechanisms that they have are the annual meeting and the board of directors. Technically, I'm right. In practice, we can ask whether they actually have that power, but technically, it's the shareholders.
And because shareholders have so much power over managers, what do managers do? They do what's right for shareholders. They're just so terrified of what shareholders will do to them. They put shareholder interest first.
That's in the utopian world. In the utopian world, lenders lend money to the firm and they don't protect themselves. Why?
Because the firm has a good reputation. They like the... the managers of honest faces, whatever it is, they lend money, they don't protect themselves. And in this utopian world, these loan agreements might have loopholes the size of a Mack truck. Nobody takes advantage of those loopholes.
I told you, it's completely unrealistic. In this utopian world, firms reveal information about what's happening to them to financial markets honestly and on time. So something bad happens, you... You get out there and you reveal it to markets right away. And in return, markets are rational and cool about the way they react to this information.
You know what a trading room would look like in a utopian corporate finance world? It'd be full of intellectual people who think in long term. I don't know if you've ever been in a trading room, but intellectual is not the word that is not on the top 100 list of how you describe the people in the room. But in utopia, they think about information, they assess it on cash flows, they take a long-term view, and they adjust the price.
And this utopian world, we do what economists do with a problem they don't want to deal with. We just assume it away. There are no social costs. Everything can be traced.
Remember, the essence of a social cost, it's a cost you create that cannot be traced and charged to you. We assume there are no such costs, no such benefits. In the utopian corporate finance world, here's what we're doing.
We're essentially making the world safe for maximizing stock prices because there are no bad ways you can do it, right? You can't rip off your bond orders. You can't lie to markets. You can't create social costs.
I've taken all. What's the only way to increase stock prices in this world? You've got to go out and produce products and services customers want. You've got to produce it efficiently, sell it, make money the old-fashioned way.
And in this world, when you maximize stock prices, everybody will benefit from it because effectively you're not transferring wealth from other people to make your stock prices higher. So if you look at much of corporate finance theory and models, it's built on this premise that maximizing stock prices does not have the side costs of ripping off the other stakeholders. The unfortunate problem is that every one of those linkages I just described, the assumptions are made up patently unrealistic. So let's get to the real world and talk about what can go wrong, because the real question is what cannot go wrong, because everything that can go wrong will go wrong. Let's start with the linkage between stockholders and managers.
What did I say? Stockholders have complete power over managers. What are the mechanisms of annual meeting and board of directors? I'm going to argue that neither mechanism is that effective at keeping management line. We'll talk about why.
The annual meetings are very bad forums to get change in a company because of the way they're structured and who shows up. And the board of directors seems to be in many companies more interested in protecting protecting the management. The original objective of a board of directors was not to be a shield for management or a consulting group, but to protect the interests of shareholders.
In practice, that doesn't seem to be the case. So shareholders have little power or no power over managers, and managers therefore put their interests over shareholders. It's not because they're bad people.
It's human nature to put self-interest first. And if you made me unafraid of you as a group, And we'll talk about cases we have to pick. Is it good for me or is it good for the shareholders? Managers are going to put their interests over shareholder interests. If you lend money and you don't protect yourself, what's going to happen?
You are going to get ripped off. It's not a question of whether, it's a question of when. You're saying, doesn't it matter the reputation of the company? We'll talk about companies with reputations that were viewed as unassailable, that have borrowed money and taken advantage of lenders.
There are no exceptions. So in practice... You lend money, you don't protect yourself, you're going to get ripped off. In practice, do companies sometimes lie to markets? But more often, rather than lie, what they do is they try to manage the flow of information markets.
You know what I mean by that? They try to delay bad news till a good time comes around. We'll talk about what that good time might be.
They try to bundle it with good news. So they're not lying. It's not fraud, but...
they're trying to control the flow of information markets. And in return, are markets rational and cool? I mean, we're right in earnings season right now, right? I think yesterday, Microsoft announced, I mean, the big tech companies are going to announce in the next few days.
I want you to wait for the next big earnings announcement that's a big surprise, positive or negative, right? It'll usually come out after close of trading. on a day.
So it's Thursday or Tuesday, comes out after four o'clock, and it contains incredibly bad news on earnings. Wednesday morning, you know what the trading room for that company is going to look like? There's no intellectual assessment. People just panic.
They buy, they sell, they do something. Now, markets are not rational and cool. They often react.
They often react based on short-term assessments, and they sometimes screw up big time. And finally, in the real world, there are social costs and social benefits. And it's not just big companies.
I talked a little bit about that hot dog stand outside. That guy's cost me like 5,000 additional steps over my lifetime because he's right in the middle of the sidewalk. And I come down that sidewalk and every time I come up the hot dog stand, I've got to walk three steps to the left. I know it's petty. You know, it adds about 15 steps a day.
That's a social cost. I don't know how much my legs are wearing out because of the guy. Maybe it's good. I get good exercise.
Maybe there are social benefits as well. But every business creates social costs and social benefits. We have all those food vans on 4th Street, right?
Like four that I can count right now. That's good, right? We have more choices.
But it does make traffic on 4th Street a nightmare because it's become a one-lane street. So. again, every organization creates social costs and social benefits. Acting like they don't exist doesn't make them go away. This is the world that I live in.
And what I want to do is, what happens in this world when you ask companies to maximize stock prices? So let's start with the first of those linkages between stockholders and managers. What did I assume? That stockholders have complete power over managers.
through annual meetings and board of directors. And what I'd like to do is take each of those mechanisms and talk about why they've been so ineffective. Let's start with an annual meeting.
How many of you are shareholders in a publicly traded company, own stock in a publicly traded company? Okay, quite a few. The rest of you probably had to sell your shares to pay the tuition, which is what happens when you come back for an MBA.
How many of you have been to a company's annual meeting? Anybody? A couple of people.
I own shares in about 40 plus companies now. I have never in my lifetime been to an annual meeting. I'll give you an example.
I own shares in Coca-Cola. I've owned them for 20 years. I've never been to an annual meeting. You say, why not? First, to go to a Coca-Cola annual meeting, what do I have to do?
I have to fly to Atlanta. The airfare from New York to Atlanta, for some reason, I think is fixed. It's just way too high.
You call me $600 round trip. Once I get to Atlanta, what do I have to do? I have to stay in that beach, whatever section of Atlanta is, for about three nights, two nights. It'll cost me another...
400, $500. Altogether, this whole thing is going to cost me like $1,500. That's going to wipe out my profits on Coca-Cola this year if I did that.
It doesn't make economic sense for most of us, unless you happen to be in the city in which maybe living next door to the place where the annual meeting is going to do. I wouldn't even take the subway to an annual meeting. That's $5 off my returns.
I don't want to do that. So most people don't show up at annual meetings. That's absolutely a fact.
But at least in theory, even though I could not go to an annual meeting in person, they gave me a way to be at the annual meeting kind of indirectly, right? What do you get if you're a shareholder in a company and there's an annual meeting coming up? What is it that you have?
It used to be in the mail, but now it's online. What do you get? Proxy.
I still get proxies. You know what the first reaction I get that big fat proxy envelope is? If I'm feeling socially conscious, it's going in the recycling. If not, it's going in the trash. I'm not even opening up that envelope to see what's in it.
And I'm not alone. Most people who are shareholders who get these proxies do not return the proxies back to the company. So I have a question about it. Because if I have a thousand shares in Coca-Cola, that's a thousand votes.
I'm throwing it in the recycling or trash. What happens? happens to those votes at most publicly traded companies, those proxy votes that never get returned.
What do you think should happen? People don't vote. It's not a vote on either side, right?
But in almost every company, those proxy votes that don't get returned get counted as votes for incumbent management. And I'll give you the analogy. This is like having an election. where the incumbent gets the votes of everybody who doesn't show up to vote. No incumbent would ever lose an election, right?
It's a system designed to give incumbents more power. So if you look at annual meetings, most small stockholders don't go. The proxies don't get returned.
You say, but what about the big stockholders? Who are the biggest shareholders in almost every big publicly traded company in the U.S. now? BlackRock and...
and Vanguard. It's not just US. You look across the world.
BlackRock, Vanguard. Because what kind of... They're institutional investors, but BlackRock and Vanguard are very specific kinds of institutional investors.
What do they do? It's mutual funds, but they're actually index funds. What's an index fund? Vanguard's biggest fund is the Vanguard 500 Index Fund, which owns every single S&P 500. You're saying, so what? You own 500 companies.
companies, in this case, in the S&P 500, you can't stay and fight. So they might show up, but they basically are in there. They'll vote with incumbent management.
And if it's an active fund, they don't like the way you run, what are they going to do? Sell and move on. They won't put their feet.
You know what? Institutional investors vote with incumbent managers 90% to 95% of the time. So if you're saying those big investors are going to show up at meetings and act tough, questions, you're missing the point. No, actually check in on a meeting and you're going to see how few questions come from institutional investors.
So when you look at annual meetings, they're extraordinarily scripted. Now you can't go to an annual meeting and say, I have a proposal. It's not going to show up.
You've got to get that proposal through. It's got to be accepted before it even shows up for award. And you've got to jump through multiple hoops to get there.
That's why it's so difficult to get a no vote against incumbent managers in an annual meeting. I'll give you an example of how difficult it can be. About 10 years ago, Jamie Dimon, you know who Jamie Dimon is, right? CEO of JP Morgan, who sat on the board of directors, decides he's also going to, at that time, JP Morgan had done the right thing.
The CEO was not the chair of the board. But Jamie Dimon decides he's going to be chair of the board. And shareholders did not like it.
came up, they actually managed to get this vote at the annual meeting, resolved that Jamie Dimon should not be chair of the board. You'd think this vote would get a majority vote, right? But if you look at the actual vote numbers, 67% claimed to have voted for Jamie Dimon to be chair, and 33% voted no.
But it's a complete deception, because almost everybody who voted actually voted no. But because you had so many proxy votes and institutional investors voting automatically, You start with 67%. Anytime you see a no vote exceeding 20% of publicly traded company, there's something going on under the surface where people are unhappy. But it doesn't change because you still have this fixed system. You say, what about the board of directors?
What about them? First, take a look at, take any company, whether you're a shareholder, where you used to work. Pick up the annual report.
Look at who sits on the board, the names. And ask yourself a question. Who came up with these names?
In most companies, who comes up with the names of the people who sit on the board? It used to be the CEO. Now there are nominating committees which do it. But let's face it, that nominating committee is not putting a name on the list before checking with the CEO. So let's play a game.
You're the CEO of a company. You've got to put together a board of directors. And what's the job of the board? to keep an eye on you.
And you have two choices. One is you can pick the 10 or 12 most informed, intelligent, questioning people in the world. That's choice one.
The second is you can walk into your local country club, walk into the bar area, look for the 12 most sloshed people you can find and say, would you like to sit on my board? Ask yourself, which makes your life easier? Again, it's not bad or good people.
It's human nature. Companies, CEOs, when they pick directors, tend to pick directors. John Mack, when he became CEO of Morgan Stanley, the first three people he hired happened to be members of his country club.
I'd never chance to check their bar tabs. That's a little suspicious. How did the three best people to put on your board happen to be hanging out at your country club? For the most part, directors don't own shares. Or if they have shares, they're given the shares.
Big difference between buying shares in a company and being given the shares. They have tiny equity stakes. You're saying, so what? You're a director in a company. You get a pretty hefty compensation package, not just what you get paid.
Typical director in the US gets paid $200,000 to $250,000. In addition, you get pensions for life. Do you know that? Many companies, if you're a director, even for two or three years, you get a pension for the rest of your life.
You get paid as a director. And you own 100 shares in the company. Which one? is going to outweigh the other.
To me, a director is going to think in terms of, hey, I'm getting a pretty hefty package. I want to rock the boat. And I've never understood people who are directors in 11 companies.
How the heck do you have the time to actually do all of this stuff? Remember, Henry Kissinger was on the board of directors of 15 companies. What exactly is Henry doing on your board? He was on the Theranos board at the age of 92. What exactly? What did he come talk about the iron curtain?
It was a blood testing company. What's the iron curtain got to do with it? The reality is many directors don't have the time or the resources to do any kind of research to ask tough questions.
We've always known this as a corporate governance problem. And if you look at, now, what can you do about this? It turns out that the fixes you make don't quite do the job.
Because, again, director meetings are very heavily scripted. Robert's Rules of Order, you can't bring up stuff that's not supposed to be there. There's this big push.
It's human nature to be a team player, right? There are nine people on the board. You don't want to be this skunk at the party.
You don't want to be bringing up questions that make everybody uncomfortable. And here's the biggest, and this is a psychological issue. In psychology, there is a substantial amount of research.
what are called authority figures. That when somebody is anointed an authority figure, even when you disagree with that person, you tend to hold back because that person knows more than I do. When you're a board of directors for a publicly traded company, the CEO is on the board and the CEO says, trust me, this China project is going to make money.
Part of you doesn't trust the CEO, but that person knows more than I do. You know who's on Elon? You know, first, how many directors Tesla has? Five. Elon is on the board.
Anybody else want to guess? Kimball. his brother's on the board don't let me know he says it's an objective third-party director no i'll go along for the moment five people can you imagine being a director at tesla and elon comes in and says we're going to go full speed on automated driving an fsd would you i mean in the abstract so i'll question him would you really question elon musk on fsd because you don't have a background in electric cars this guy's built three companies he's got no smooth He's sending off satellites to outer space and used to be a food processing top manager.
So he said, OK, I think that all of them, I mean, we tried in the early part of the century to, you know, Sarbanes-Oxley. We tried to make boards more effective by making them more independent. That was a big push of Sarbanes-Oxley. And 20 years later, he's saying, why isn't it creating better corporate governance? And the answer is, we can make.
create a board which is independent and completely ineffective. You know, if you really want to pick boards of directors that are effective, I think we need to borrow from the Catholic Church. I'm not Catholic, but my wife is.
And for 30 plus years, every Sunday, I go to, I know, went to New York. I know I've got this whole thing nailed down. But the Catholic Church is a survivor, right?
2,000 years, it's managed to find a way to... keep itself central. So we should probably learn something from, you know, sustainable, right?
It's clearly made itself sustainable. So here's what the Catholic Church found was happening in the 14th century that they wanted to stop. They found that too many people were becoming saints.
You know how the process of sainthood works in the Catholic Church? You know, somebody from Spain will show up and say, so-and-so is a saint. And then they present examples of miracles that would that happen. And the 14th century, what was happening is people would show up from all over the world saying, here are the miracles. And nobody had the time or the resources to push back.
So basically, the people advocating for saints were getting this pathway to becoming a saint. There wasn't enough with, you know, anybody with enough incentive to spend the time and the resources to stop them. So you know what the Catholic Church created to slow the process down? The Devil's Advocate.
Amazing name. for them. What's the devil's advocate's job? Let's say you show up from Spain. You say, so-and-so is the saint.
These are the nine miracles. You know, my job is I'm given the resources. I go check each of your miracles up.
Not a miracle, not a miracle, not a miracle. So my job is I'm given the power and the resources to push back. How does this work in a board of directors?
Who's the authority figure? The CEO. He has or she has all the resources.
So. The CEO gets up and said, trust me, this is a good acquisition. They get Goldman Sachs, put the charts up, look at the synergy, look at this, look at that.
You know what you need in that room? A counter CEO, a devil's advocate with his own bank or her own bank is saying, hey, no synergy there. That growth rate looks a little shady to me. I know it sounds impractical, but we need almost a counter power in that room for this to actually work. So I'm going to leave you with Disney circa 1997. In my view, this is the worst board created at a large publicly traded company in history.
That's quite a contest to win. So I'm going to at least start to lay out the basis for why it's such a bad board. First, there are 17 people on the board. You think, so what?
I want you to try and experiment. It's almost lunchtime, right? I want you to get together as a group of 17. and decide where to go for lunch. I'll make a prediction.
You will not eat today. 17 people in a room. Nothing ever gets done.
Second, eight of those 17 members were insiders. They work for Disney. They used to work for Disney, which means you're overseeing yourself.
Strike two. Strike three, who's the chair of the board? A guy called Michael Eisner, who also happens to be the CEO.
Tell me how this works again. You chair the board that oversees what you do and you tell me whether you're doing a good job. I don't think that...
quite works. And I'll leave you with the final strike. Three strikes, you're out in baseball.
But in this case, I'm going to give them a fourth strike. You see, what about those outside directors? They must be bringing something to the table, right?
Let's take a couple. Rivera Bowers, head of an elementary school in Los Angeles. This is good.
Disney is a kid-oriented company. Get an elementary school principal. Coincidentally, she happened to be the principal of the elementary school that Michael Eisner's kids went through. Then there's Father Leo Donovan. Any Georgetown grads here?
So it's good to have some religious influence on this heathen board, right? But again, coincidentally, otherwise, Michael Eisen, his son, went to Georgetown. He sat on the board of Georgetown.
I'm not suggesting there's any quid quo pro, but it doesn't quite pass the smell test. And here's the topper on the cake on why this is a bad board. As you go down, there's this. Erwin E. Russell, attorney at law. You're saying, what do you have against lawyers?
An entire reams of stuff, but this is not the forum for it. But this guy was Michael Eisner's personal attorney. How do you pull this off? It's an objective. It's nice to have your lawyer in the room.
He's probably saying, Mike, don't answer that question. Take the fifth on that one, Mike. No, but don't tell me. And finally, Sidney Poitier, great actor, right?
In fact, he made the list of... top 10 directors in 97 of directors who missed the most meetings. So guess who's coming to dinner? Guess who's not coming to the meeting today? This is a rubber stamp board.
And we start next class. We're going to talk about what happens near a rubber stamp board and whether that's changed in the last 20 years.