Roger Martin, Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL. Harvard Business Review Press, May 2011.
Shareholder value theory has come under assault from several directions over the last few years. However, in Fixing the Game, Rotman School of Management dean Roger Martin offers one of the most articulate and hard-hitting critiques to date.
This is an important book that deserves to be widely read and discussed in academic, business and policy circles.
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In it, Mr. Martin takes on a number of big topics including the theory of the firm that underpins contemporary capitalism, executive compensation, board governance and hedge funds.
Over the last decade, financial markets have been badly shaken by the dot-com and subprime bubbles. Both crises resulted in a rush to legislate new regulations in the hope of preventing another. However, according to Mr. Martin, these attempts at regulation are based on a flawed understanding of the fundamental reasons behind the crashes, with the result that it is only a matter of time until the next one occurs.
As he sees it, the real problem that needs to be addressed is the shareholder value maximization mindset that informs contemporary American capitalism, and the model of executive compensation that flows from it.
The idea that a company’s principal aim should be to maximize profits for owners was first introduced in a 1976 article in the Journal of Financial Economics. The article also argued that stock-based compensation was the most effective way to align the interests of management with that of shareholders.
Today, stock option alignment is a fundamental principle of good governance. As a result, executive compensation is now heavily stock-based. Mr. Martin notes that in the early 1970s, less than one per cent of executive compensation involved this type of compensation. The current situation is radically different. For example, it is estimated that Oracle CEO Larry Ellison receives 97 per cent of his compensation from realized gains on options.
In Mr. Martin’s view, the fundamental problem with tying compensation to performance in the stock market – or the “expectations market,” as he calls it – as opposed to performance in the real market (i.e. selling products and services), is that it creates perverse incentives for management.
Among other things, he argues it has encouraged excessive risk-taking, a focus on short-term decision-making and accounting manipulation, all in an effort to manage earnings to meet market expectations, as opposed to creating real value.
This executive compensation model persists even though, as he notes, there is absolutely no empirical evidence to support that it actually benefits shareholders.
In line with the book’s subtitle, Mr. Martin suggests that the corporate world has much to learn from the NFL, which enforces a strict separation between the real market (the actual game) and the expectations market (betting on the outcome), recognizing that to allow players to bet on outcomes would destroy the integrity of the game. To extend the analogy, he posits that only in business is compensation built on performance against the point spread as opposed to actual performance.
Mr. Martin has a particular bone to pick with hedge funds, which he says are also driven by a compensation model that aligns interest only on the upside. As a result, he argues, they have encouraged rampant risk-taking and in many cases the actual promotion of market volatility from which they can benefit while creating no actual value for the real economy.
To address the problems he has raised, he offers a five-point plan. None of his proposed solutions are trivial and most of them will run headlong into some strong vested interests.
First, he suggests that companies need to refocus on performance in the real market and on their customers and away from shareholder value. Second, executive compensation should be based on meeting real goals and stock-based compensation should be eliminated. Third, the role of boards needs to be re-examined and, in particular, directors need to see their role as public service. Fourth, hedge funds and other players that focus solely on the expectations market should be heavily regulated to ensure that they are unable to damage financial markets. Finally, companies should take a broader view of their role in society with a focus on their responsibility to improve it by contributing to its “civil foundations.”
This is a highly readable and relevant contribution to the debate over the regulation of financial markets.
Micheal Kelly is a professor and former dean at the University of Ottawa’s Telfer School of Management.
