More than most in the field of corporate governance, Margaret Blair is asking fundamental questions and is taking a broad look for answers. In The Deal Decade: Assessing the Causes and Effects of Corporate Restructuring in the 1980s, Blair hypothesized that a sustained rise in real interest rates reduced investment opportunities; “restructuring was largely fueled by the conflict among managers, financial institutions, and shareholders over whose interests should take precedence.”

Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century attempts resolution of this conflict by proposing “maximizing total wealth creation by the firm.” The key to wealth maximization is to be found in providing ownership-like incentives to “those who control critical, specialized inputs and to align the interests of these critical stakeholders with the interests of outside, passive shareholders.” Blair argues the importance of “human-capital,” and particularly firm specific human capital, is growing in importance in relation to financial capital.

In the fall of 1997 and the spring of 1998 I was in Washington, D.C. and got together with Margaret Blair at the Brookings Institute

McRitchie: How did you get interested in corporate governance?

Blair: Before I went to graduate school and studied economics, I was a journalist with Business Week in Houston Texas. I was immediately caught up in the interaction between the oil companies and the government and got interested in large corporations and their performance in the economy. My Ph.D. thesis focused on why mergers seem to happen in a sort of episodic way. Corporate governance was a natural follow-up.

The predominant theory, in the popular business press, was that takeovers were about correcting bad management. That always struck me as ludicrous because of their episodic nature. Why would bad management occur in episodes? It just didn’t seem plausible. Instead there were, what I argued, compelling macroeconomic factors at work during the 1980s that shifted the dynamics in place. Corporations were under enormous pressure from financial markets to disinvest to redeploy capital out of the corporate sector. The reason was that return on capital had fallen to historic postwar lows in the 1980s.

What happened was the return on capital began bottoming out around 1979 or 82, depending on how you measure it. Interest rates shot way up to get inflation under control but then continued at a high rate even after inflation fell. With real interest rates at an all time high, return on equity was really quite low. Financial markets put enormous pressure on corporations to disinvest low profit centers. But disinvestment ran counter to all the cultural training of corporate executives. It wasn’t so much bad management; everything they’d been taught to do and all the ways they defined themselves no longer applied. The economic signals were saying disinvest, reduce, shrink, cutback…all their training was grow, get bigger, get stronger, reinvest.

McRitchie: So the cost to capital wasn’t accounted for and the 1980s really drove that home. Maybe that’s about when Stern and Stewart began developing their EVA (economic value added) system which recognized the need to build in those costs?

Blair: Yes, in the 1960s and 70s the cost of capital was so low that it didn’t matter what you invested in. Almost anything would make more than you could get in the bond market. If you were growing and expanding, you were likely to be making money relative to the cost of capital. Not true in the 80s. A huge government budget deficit created increased demand for capital. Higher interest rates permanently changed the mentality of what constitutes a good investment strategy.

McRitchie: The deal decade brought efficiencies in the use of capital but the downside was an increase in short term thinking?

Blair: Yes. If the discount rate is 2%, you can invest in a lot of things that may not pay out for 20 or 30 years. If the discount rate is 10% you can’t afford to take those risks. Managers, trained in the importance of looking at the long run…building up good community relations, taking good care or employees, were forced to take companies that historically earned 3-4% and force them to earn 12%. They had to dump many of their long term projects.

What I keep thinking will happen is some sort of a return of the pendulum. Corporate profits have been quite high by historic standards for the past 4 or 5 years. A lot of people are saying that it’s because we’ve gotten productivity turned around. In some companies productivity has improved but in the aggregate it has not. So what does that mean?

McRitchie: Wealth is being redistributed.

Blair: You got it. I think there are political limits as to how far you can push that. I can’t believe corporate profits are going to continue to grow as fast as they have. Something has to give in terms of wages and benefits. People have been baring the brunt for 15 years. But many of the growth areas are in low wages sectors such as health care and personal services.

Going back to corporate governance; I viewed with enormous suspicion that takeovers were the result of a bad management story. Nonetheless, there were some powerful issues about the redistribution of rents. I always thought the real issue was, who gets the rents that are generated? In the 60s and 70s employees were getting a larger share of the rents…profits were not growing particularly fast but wages and benefits were growing. We’re now back to what it looked like in the 1950s.

McRitchie: If income is being redistributed to the wealthy, won’t that result in greater investment? The wealthy don’t spend as fast as the poor, so wouldn’t that drive up savings and productivity? (playing the devil’s advocate)

Blair: Yes, that’s the standard argument, but after 15 years of redistribution the predicted rise in productivity isn’t showing up in the aggregate data.

McRitchie: Ten or fifteen years ago I became keenly interested in employee ownership. In fact, I went out to Rath Meatpacking in Waterloo Iowa when it become the largest employee buyout. I thought if workers were also owners, they would be more productive. I was even more interested in the potential that a shift in accountability and control might occur with political, as well as economic, ramifications. Rath succeeded for several years but then stumbled. There were a lot of reasons for their demise. After working heavily with cooperatives for many years, including heading the state of California’s efforts to foster cooperative development, I concluded firms with a mixture of employee and publicly traded ownership may have the greatest potential for positively transforming society.

Blair: However, recently I finished reading Michael Useem’s new book where he talks about “shareholder mix campaigns.” Managers are apparently trying to get more employees as owners because, in proxy battles, employees tend to side with management, against other shareholders…especially against those interested in a takeover. Being more compliant isn’t exactly what I had in mind for employee owners. I’m more interested in dignity, empowerment, and the redistribution of rents.

McRitchie: Are you familiar with Henry Hansmann‘s work? He looks at cooperatives and employee ownership from the standpoint of contracting costs. In some situations the contracting costs are high and ownership costs low. In others it’s reversed. What tends to make employee ownership costly is a broad divergence of opinion about what the firm does. If one group is homogeneous then that group has a good chance of getting the decision rights and will contract with others for the remaining work. Employee ownership seems to works well for taxi cab drivers. Plywood co-ops hire managers. Attorney’s become partners but secretaries don’t. The more variance at work, the less likely a firm is to be employee owned. (see also, Contract Theory, Team Production, and Fiduciary Obligations of Corporate Directors, by Blair and Stout)

Blair: I’m coming around to believe that Hansmann is right in why employee ownership doesn’t work….it’s too hard to get agreement in a diverse workforce. UPS, for example, is employee owned, mostly by management. They let the rank and file in two or three years ago but they haven’t accumulated enough to represent a significant block. If shares had been more broadly distributed they might have avoided a strike but not dissension. Clearly there are diverging interests between management and rank-and-file. On the other hand, we are seeing a fairly sizable shift…and in ten years we’ll see this wasn’t just a fad…20 to 25% of the shares will probably be held by employees. Right now were only up to about 4-5%…I may be wrong, 20% may be too high but that’s the direction.

McRitchie: I think that would be a very positive development but there is a lot of discussion lately about options and dilution among institutional investors.

Blair: If the employees are bringing something to the table, then that should be fine. A higher proportion of earnings in options or stock and a lower proportion of cash will allow employers to keep on more workers in bad times.

McRitchie: That seemed to be where you were going with your book on ownership and control.

Blair: Yes, it was something of an intellectual trick…thinking of corporations and human capital in ways that are parallel to investments in physical capital. It drew attention to some of the issues I wanted to raise. But, of course, human capital is different than physical capital. You can’t measure it easily and you can’t assign ownership to a third party. I haven’t done the numbers on this but what is being thrown out is that something like 75% of the value of the corporate sector cannot be accounted for in plant and equipment…tangible assets on the books. We need to revise our compensation systems to reward people with cash for their generic services and with a stake in the enterprise for contributions which are firm specific.

McRitchie:  Yes, that sounds like a very practical ideal.

Blair: Its a way to think about the way the economy is moving.

McRitchie:  At Boston College, one of our big questions was the union role in living with or promoting employee ownership and the mind set that goes along with that role. For example, when Rath meatpacking was bought out by the employees the former union president became president of the company and the former vice president of the union became the president of the union. As I recall, the former VP drew an unrealistic line in the sand which contributed to Rath going bankrupt. They didn’t come up with a model that said, let’s pay our workers the same wages as IBP and then, based on profits, provide additional bonuses in wages, stocks and/or options. They didn’t reward people with cash for their generic services and with an increased stake in the enterprise for contributions which are firm specific.

Blair: I think that Hansmann is right but these are fundamentally hard things to do. The pool of rents don’t just belong to the shareholders by virtue of the fact that they exist. Rents are generated by all of the participants together. The question is how do we create rules of engagement that allow a reasonable, appropriate and equitable division of rents? I think we need acknowledgment that some component of their input, it may be large for some employees and small for others, represents an investment in the company…an investment that they will recover if they stay with the company for a long period of time. It’s inappropriate to think the shareholders own human capital. On the other hand, in most cases, the employees can’t walk out with it…it’s stuck in the enterprise.

I think the pendulum may have swung as far as it will go in one direction and we’ll see pressure to redistribute income more equitably. But maybe this is wishful thinking on my part.

McRitchie:  Yes, American labor is competing with people who are close to starving. So, why should American workers end up getting anymore than anyone else?

Blair: IBP brought in immigrants to undercut wages. Suddenly these were rents up for grabs. Who gets them? The airline industry was regulated based on cost and you could pay the union rates. The big hurdle was getting regulatory approval. Without artificial competition, rents get competed away. How do you share that loss? You can cut employee pay and give them some stock. That will give the firm more flexible because their base cost structure is much lower.

McRitchie:  It also gives the workers more incentive to find ways to increase productivity. Studies by Blasi and others have shown a combination of ownership and participation works.

Blair: But it doesn’t give the incentive not to bargain for higher wages. No, they will always want it in wages because you don’t want to share it with others. Regarding productivity, the studies show that once employee ownership and participation are implemented productivity goes up a step but there isn’t any continuing accelerated growth rate.

McRitchie: In Ownership and Control you mentioned the possibility of mutual funds based on employee ownership and innovations in the workplace. Do you know if any mutual funds have adopted such a strategy?

Blair: I understand Johnathan Low was looking into this. If you look at the history of socially responsible investing it takes a while to move into these new markets. You’d think people would be interested in enlightened workplace practices as an issue, safety at the workplace, good decent pensions and secure jobs, but by and large this has not been a major focus of SRI funds.

McRitchie: I read a paper this morning (see Del Guercio) that discussed the strategies of CalPERS compared to SWIB. SWIB takes larger positions, seeks changes, and then sells. CalPERS holds forever but works with others, taking an active role in threatening poor performers.

Blair: I’m skeptical as to whether the “CalPERS effect,” if there is one, represents a change brought about by the actions CalPERS takes or if they just happen to pick companies which are undervalued and which are due for a price correction anyway. Regression to the mean may bring about the same result.

McRitchie: What should CalPERS and other large pension funds be doing?

Blair: Pay for performance is one thing to look at. The way it’s being done for CEOs, there’s no downside. When you create high powered incentives in a narrow band you’ll get performance there but you could also have deterioration in every other measure. CalPERS needs to work to put some restrictions on stock and especially option bonuses which provide a longer timeframe….several years. (ed. see 3rd story in April on CII @ CGNews) CalPERS also needs to be concerned with wages and working conditions because its directors represent a broad constituency of employees and taxpayers. The other thing I would push for would be working more with researchers.

McRitchie: Unfortunately, the only time CalPERS uses much of the information they would get from corporate governance researchers is when creating and using the target list. If they really believe there is a CalPERS effect, why not invest more in these firms before they are announced and before they take action to improve performance? Why let Warren Buffet and Michael Price make all the profit?

Blair:  It’s probably worthwhile for them to do…especially if they could get others to do the same. It would also be much better for event studies, which are usually done by looking backward.

In the late spring of 1998 I stopped in on Margaret Blair again, largely to snap the photo included with this article. Margaret was preparing for a trip to China, having been invited by the Center for Enterprise Reform and Development to meet with scholars, policy makers, and business people to talk about enterprise reform and employee ownership. She will be giving seminars at the Center, at the Academy of Social Sciences, at Beijing University, and other various places. I’ll be eager to hear of her reception and her impressions of developments in China.