The following guest post comes to us from Ilya Beylin of Seton Hall Law School.

It is assumed that stock prices of public companies should grow, and indeed, this has been the case consistently over the decades if something like the S&P500 index is considered in aggregate.  But stock price should only grow when firms become more profitable (or the discount rate decreases, which I am going to ignore).  Why should firms become more profitable?  A profitable firm is doing fine, and its stock represents an annuity.     

I raise these questions because of the operational predicates to profit growth.  Typically, growing profitability over the long term comes from either expansions of scale or scope.  I am ignoring cost cutting, which I believe tends to have more limited potential for sustained profitability growth.  But expansion (in scale or scope) within the hierarchical model of a firm results in an attenuation of internal monitoring.  Where expansion takes place, top management increasingly relies on middle management, dispersing information and control.  This then puts pressure on the systems through which information is aggregated and percolated to decision-makers.[1]  In the absence of an excellent team that somehow overcomes the challenges of managing a larger organization, the pressure to increase profits through growth undermines responsible leadership.[2]  

The attenuation through which firm leadership loses its grasp on firm operations explains a number of legal trends, such as:

• Challenges to prosecution under intent-based standards due to leadership rarely having concrete involvement in the day-to-day decisions resulting in traumatic business conduct;
• The growth of regulation requiring compliance functions.  Internal personnel devoted to compliance oversight provide for ex ante prevention and structural awareness of antisocial practices within organizations.
• Emphasis on Caremark oversight standards.
• Emphasis on controls in securities law.

These trends[3] illustrate the tradeoffs core to our economic system, which exposes public firms to market discipline aimed at growing share price.  It may be that the current system is the best available alternative, and comes with costs.  After all, public equity markets share economic growth with savers and enable retirement.  But there are two related sets of questions that give me pause. 

The first is a matter of being a responsible human.  Even if the status quo represents an optimal approach, awareness of its costs is an antidote to narcissism and ignorance particularly for its beneficiaries.[4]  So what are the costs of a system that predisposes firms to expansion and management to ignorance?  This question opens a subsidiary set of inquiries: Who suffers for the benefit of savers?  How much do they suffer?  How should the suffering be acknowledged (keeping in mind that most victims of the discussed attenuation have no legal recourse)?[5]    Is there good literature studying the social costs of expansion for firms?  I emphasize social costs rather than solely the financial risk because the weakening of internal monitoring may lead to a variety of shortcuts harmful to constituencies beyond investors.

There is a second, more ambitious set of questions that I offer halfheartedly:  Is the current level of market discipline[6] in managing the economy desirable or should improvement arrive less as reaction to investor demand and more through proactive firm innovation?  If we had an economic order less reliant on public equity markets and more reliant on debt financing (e.g., banks), would the social gains from more informed, responsible operations (partly) offset the loss to savers?[7]  Should our stock market be reconceptualized as an annuities market to relax the pressure to increase profitability?  Should investors be educated not to expect their shares will grow in value to change norms?[8]    

Another formulation of my questions may be what are the lessons from the Mittelstand? 

I know that folks say that those who do not expand lose market share, but I don’t see why that has to be the case — I can point to a number of longstanding, successful small businesses that keep with their core competencies.   Another reaction may be that advances have concentrated in industries (software, biosciences) where the intangible nature of the assets makes debt financing difficult.  It may be that available economic advances are uniquely suited to being financed through markets that exert unyielding expansive pressure.

If as you read you think of good studies addressing some of these questions, please feel free to e-mail me cites and I will add them as footnotes to later versions of this post (with the help of the fantastic blog team).  This admittedly very loose and rough set of musings is meant to raise questions, with full awareness that intelligent people have done work on them that I have not read or acknowledged.

[1] External monitoring may sometimes compensate for the loss of internal monitoring.  Where the expansion is successful, external monitoring may increase so long as disclosure practices are robust.  Large successful public firms such as Alphabet, Apple, etc, attract external feedback (although some of this feedback may be distracting or misleading).  However, prior to success (and often success does not come), the effort to expand reduces internal monitoring without external monitoring arising to help coordinate the organization.  Furthermore, investors and those producing information for investors may not care as much about the non-financial dimensions of firm operations as employees and executives do (or there may be other blind spots in external monitoring relative to internal monitoring).

[2] Due to (inter alia) overconfidence, firms may overestimate the competencies of their leadership teams.

[3] Growth also has implications for consolidation and antitrust.  Moreover, as industry leaders consolidate, it becomes harder to distinguish rule of law from political favoritism as regulation tends to target the few specific firms that lead the market.  This is visible in the financial industry, in tech, and potentially in others.

[4] Referencing the serenity prayer, my emphasis is more on understanding and acceptance than change.  Understanding and acceptance often require seeing harm in context as produced by a process that is overall good or at least necessary.  It is because comprehensive examination is a path to peace that I pose the understanding of harm as a responsibility.  As background, the serenity prayer with my modification is “God give me the serenity to accept what cannot [or should not] be changed, the courage to change what can [and should be] changed, and the wisdom to know the difference.”

[5] Do larger organizations’ pursuit of ESG measures represent a response to this problem? This may be the case if the measures are structured as budgets delegated from the top to the bottom that then enable bottom-up reaction to perceived shortcomings in firm operations.

[6] My own view tends to be that strong market discipline is desirable because in its absence, upper management tends to have too much power.  In other words, imperial CEOs are even worse than the distortions empowered shareholders introduce.

[7] The proposal is not to increase leverage and risk-taking through substituting external debt for external equity, but rather, over the lifetime of the business to maintain more of the equity in the hands of insiders who I am assuming are more risk averse because of their connection to the business in non-investor capacities.  Admittedly, this could lead to more income inequality as business productivity is not broadly shared with external shareholders.

[8] I am not questioning that shareholders will continue to elect directors and may do so on the basis of firms’ financial performance.