Putting Shareholders First

Corporations, Securities & Antitrust Practice Group Newsletter - Volume 1, Issue 2, Spring 1997
By Al Dunlap
June 01, 1997

I would like to touch on four points that generate a great deal of controversy today in the area of corporate governance: the reasons for being in business, the problems with boards of directors, the shareholders versus stakeholders debate, and, finally, corporate restructuring and executive compensation.

First, why should someone be in business? To make money. If you are not in business to make money, then you are totally misplaced in your career. People in business have an obligation to deliver good products and services for which there is a need. People in business, of course, should obey all laws, respect their fiduciary duties, and conduct their affairs in a way that is consistent with good morals. But they should never forget that they are in business to deliver good products and make money.

Business is not a social experiment. If you want to conduct social experiments, join the Rotary Club or a church group. When in business, your obligation is to do the best possible job you can for the owners of the company. When people forget that they are in business to do the best job that they can by making good products and money, then they cease to be in business.

America has lost many of its basic industries. Our shoe business, our small appliance industry, and television manufacturing, to name just three. We were on the road to continue to lose more business. Why was this happening? People started thinking differently about how business should work.

When America was losing its global competitiveness, everybody chastised executives for doing a bad job, and, by the way, they were doing a bad job. Today there is a handful of executives who are doing a good job, and now they are being chastised for doing better, for creating a competitive American marketplace, and for putting our country in the forefront of the international free enterprise system. Criticism today focuses on corporate downsizing, executive compensation, the role of stakeholders in running corporate America. But the attacks on business these days are much more fundamental than these single issues. Critics are challenging the very essence and future of the free enterprise system, and I do not think I am being too dramatic.

If American businesses had listened to the critics and had not made the changes they did in order to become more competitive, job losses eventually would have been five or six times as large as they actually were. Why, then, hasn't there been fairer debate about what businesses are doing today? Well, you need only look at a recent story in Newsweek. The magazine asked 50 CEOs to comment on restructuring and what is happening in corporate America. I was the only CEO who commented. To be sure, when a CEO comments on such controversial issues, he will almost certainly be criticized. But I think these issues are so important that someone has to speak out, and I don resent that other chief executives don't defend what they're doing. If these CEO's are making decisions that they don't believe in, then why are they making them? And if they are making decisions that they do believe in it, they have an obligation to explain their actions and defend themselves.

The second issue I want to discuss involves boards of directors. God forgive them, for they know not what they do. Boards are the weak link in the chain of corporate governance. The boards are organized and managed in order to pander to various constituencies. For example, there are people who come to boards with great social causes. Affirmative action on boards -- and in whole companies, for that matter -- is quite popular. But as far as I'm concerned, diversity for the sake of diversity makes no sense. It's outrageous. Today's women and minorities are as good as anyone, and they certainly don't need to be anybody's token on a board. In any event, business is not the place for social engineering. Directors have a sacred responsibility to the employees and to the people who invest their capital. Directors are not on boards to further their own social agenda. To do so is irresponsible.

Boards also should not be the pension for failed CEOs. A CEO sinks a company and then is invited to serve on five boards. How can than be? I'm obviously missing something here.

This kind of nonsense should lead people to ask: what do boards of directors see as their role? You would not have the downsizing that is taking place today if CEOs had only done their job in the first place. Why don't CEOs do their job, and when they don't, why aren't they just fired by the boards? Because there is an all too cozy relationship between the directors and the CEOs who put them on the boards.

CEOs, though, are not a board's natural constituency. A board works for shareholders. Directors are there to protect the value of the shareholders' investment. Regrettably, boards have failed in this regard. They have a cozy relationship with management, and not surprisingly, chief executives who fail miserably each year are not fired. In fact, last year, 73 percent of the companies that lost money actually incentivized their chief executives. Now, I would think you could lose money without being incentivized. And what happens if boards incentivize their executives for losing money? Well, CEOs are pretty clever fellows: next year they lose more money, knowing full well that whatever they do a bigger incentive is on the way. The whole arrangement is obscene.

Cozy consulting arrangements are equally disturbing. Some people who serve on boards have large consulting contracts with their companies. Now, whose side are they on? You are all very clever -- I will leave that to your imagination.

Why do we see these problems with boards? Why don't directors care more about company performance? One root cause of the irresponsibility we see is the whole compensation system for directors. Everyone says that directors work so hard, but that's utter nonsense. In many cases, serving on a board is a free ride. Directors are grossly overpaid. I strongly believe that boards of directors should be paid 100 percent in stock and should be forced to own stock. That will provide the right incentives. I started a revolution doing just that at Scott Paper. Only two corporations in America instituted the practice last year, Scott and Travelers. Now such reform is the subject of proxies at most corporations.

Shareholders should be very concerned if the directors who serve on their company's board are not willing to be paid in stock but invest in other companies. If board members are paid 100 percent in stock and are required to own stock, they will be most responsive to the shareholders who actually own the company. Shareholder-oriented boards are those that actually own a piece of a company and take a risk on the company's future performance. On the other hand, it is a losing proposition to have directors who simply receive a pension an other perquisites, or a chairmanship, or compensation each time they pick up the phone or attend a meeting -- without respect to how well a company is doing. In short, if someone is not willing to put his faith in a company by being paid in stock, then I don't think he has any business serving on its board.

The third issue I want to talk about involves the controversy over the role of shareholders and stakeholders. This debate is quite unbelievable. Who owns the corporation and therefore has ultimate control over the business? Naturally, the shareholders. After all, they take all the risk. The idea that people other than shareholders have a stake in the company makes no sense -- unless, of course, you change the rules of the game by guaranteeing the shareholders that they will get their original investment back if management loses their money and share value drops 50 to 60 percent. In such a world, shareholders would have no gripe with stakeholders who lack any ownership interest in the company calling the shots. But I have yet to see a corporation make such a guarantee to its shareholders.

When a business serves the interests of the one and only legitimate constituency -- the shareholders -- it will have the best employees, the best products, and the best facilities. The company will be able to provide the most opportunity and hope to its employees and the communities in which they live. Do the best job you can for the shareholders and you will do the best job for everyone. The employees will get paid every day. You will have capital to create more jobs in the future. The towns will collect their taxes, the customers will receive their products, the suppliers will be paid. In contrast, when a company decides that everyone has an equal stake -- which is just not the case -- it ends up doing a tremendous disservice. Of course, list enough stakeholder constituencies, and a company is going to do something for somebody. Even a watch that is broken tells the right time twice a day. But how can a company be serving its employees when it's going down the tubes because of decisions that turn away the shareholders -- the very people who supply the capital that makes the business thrive?

If you want employees to have an ownership stake in the company, encourage them to invest and become shareholders. Our employee stockholders at Scott Paper realized a 235 percent increase in the value of their investment. These types of stock options are much more valuable than may of the benefits employees historically have sought from their employers.

Why is the whole debate about shareholders and stakeholders out of shape right now? We, of course, are in the silly season -- it's a presidential election year. You've got Pat Buchanan on the right, Robert Reich on the left, and everyone else is in between. You've got politicians of all stripes pandering to constituencies and creating fear in people. Who is an easy target for all the politicians across the ideological spectrum? The CEOs. Why? Because they never speak out. But if you could find 12 CEOs out there who actually would explain what is happening in the business world and thereby have a balanced debate, the emotional rhetoric regarding these corporate governance issues would come to pass.

The fourth and last topic I would like to talk about today is restructuring and executive compensation. Restructuring is viewed as the great sin of the day. But the fact is that corporate America has been restructured because it was crippled. If the restructuring hadn't taken place and major corporations hadn't been saved, you would have had five or six times the number of lost jobs. You would have had corporations going totally bankrupt. Instead, during the last three years, and thanks to the economic benefits of restructuring, more jobs have been created than lost, at equal or better pay.

I traveled around the globe more than three times last year. I can tell you that our free enterprise system is the envy of the world. And yet, with each passing year, we drift further into socialism. Europe has double-digit unemployment despite every conceivable social program. They are dying financially and they are ultimately going to have to correct the situation. In America, we have 5.6 percent unemployment, half of what they have in Europe. The European worker produces about 25 percent of what the American worker is producing, and, in the last 30 years, America has generated five times the number of jobs created in Europe. That's because we still have a free enterprise system of sorts. But God help the American worker if we enact further social welfare programs and more restrictions on business. Current job losses in this country would pale in comparison to future unemployment rates. It is a fool's game to sacrifice 100 percent of the people to save 35 percent of the people.

Of course, nobody wants to fire people. I come from a working class family. I was born in Hoboken before it was fashionable. My father was a passionate union member. And many times he was out of work, so I know the pain of a working class family. But I would be doing injustice to workers if I sacrificed corporations because I didn't have the ability, discipline, or fortitude to make the tough decisions. The downsizing of America -- which really should be called the right-sizing of America -- is making America more competitive globally.

What about executive compensation? Many executives don't deserve what they are getting. Others do. Executive compensation should be looked at in the light of who is doing what to whom. Take Scott Paper as an example. When I came on board, Scott had just lost $277 million, its market share was eroding, and it was on credit watch. The company was a basket case, with its total value at a mere $2.9 billion. In 18 months, the value of that company went to $9.5 billion. I created $6.5 billion in value, and , in return, I received less than 2 percent. By the way, keep in mind that I took risks with my own capital, going into the market and buying shares just like any ordinary shareholder.

Let me conclude by saying again that the free market works. When businesses seek to make money by supplying good products, and when they put the interests of their shareholders first, everyone wins in the long run. Ultimately we'll have a better economy with more wealth, jobs, and opportunity. But God help the American worker when companies pander to constituencies that want to abandon free market ideas and the shareholder-driven model of corporate governance. That brave new world will only lead to a governance structure that would kill any corporation, balance sheets that are appalling, and management that is woefully inadequate.

Mr. Dunlap, current President of Sunbean and former President and CEO of Scott Paper, delivered this speech at the Federalist Society's May 9 conference on corporate governance in held in New York City.