The reactionary myth that's letting finance managers ruin pharma companies

Pharma's finance managers have come in for some heavy hits in this space during the past two years.  They deserve every swat and then some.  CFOs and their henchmen have destroyed Big Pharmas foundation as research-driven, growth companies and have driven off some of its most experienced, capable people.  They manage operations strictly to create gains in short-term earnings while sacrificing their companies' prospects for long-term growth.  Finance people disparage biomedical research as well as marketing and sales, even as they prevent pharmas from entering new lines of business that can generate revenue and advance the larger goals of health care.

Finance managers have not been destroying this necessary industry because they are stupid, although their cleverness tends toward the idiot savant form that remains ignorant of the context around their formulas and ratios.  Neither are they entirely malevolent, although Professor Joel Bakan at the University of British Columbia contends their behavior resembles that of a psychopath (see here).  A more likely explanation comes from Lynn Stout, a professor of law at Cornell University.  Her book, "The Shareholder Value Myth," thoroughly exposes, ridicules and condemns this Right Wing ideology that has distorted pharma and much of corporate America during the past thirty years (see here).

The myth that legitimates the dysfunctional behavior of pharma's finance managers contends that corporations exist strictly to increase the wealth of their shareholders.  They serve that purpose by growing stock values and paying dividends.  Any other actions taken by corporate managers to distract from those measures can only benefit other parties such as employees, customers, suppliers, their communities and the society at large.  Proponents who see shareholder value as the corporation's exclusive goal contend that managements commit malfeasance if they undertake alternative efforts that benefit people other than shareholders.

The mythology behind this monomania of shareholder value is not some carryover from John Locke or Adam Smith.  Instead its major elements come from the writings of Milton Friedman and other reactionary economists at the University of Chicago who provided the intellectual fig leaf for Ronald Reagan, the Bushes, the Tea Party and the Koch brothers.  During the past thirty years, according to Stout, corporations that followed the Chicago School's admonitions to "unlock shareholder value" have sold key assets and fired loyal employees while ruthlessly squeezing the remaining workforce.  In pursuit of shareholder value, managements "cut back on product support and research and development," showered CEOs with "expensive pay packages to incentivize them, drain[ed] cash reserves to pay large dividends and repurchase company shares," and lobbied politicians to rig the laws in their favor. 

In 1993 Congress acted under the influence of the shareholder value myth by changing the federal tax code to favor tying executive compensation to stock performance.  As a result CEO pay in this country went from 140 times the average of their employees in 1990 to 500 times average employee pay in 2003.

Stout begins her exposure of the shareholder value myth by demolishing what its supporters cite as its justification in corporate law.  The legal fallacy behind the shareholder value myth is what its supporters term the "principal-agent model."  In this view a corporation's shareholders are its principals and the managements are their agents.  Following from this premise, managements at all times are required to act on behalf of "profit-maximizing" shareholders.  But Stout claims that corporate law provides no support for that view.

In the first place, shareholders do not own a corporation.  As established in legislation and case law, corporations are independent legal entities that own themselves.  Shareholders own shares of stock that give them limited rights.  The same relationship also applies to a corporation's creditors, bondholders and suppliers.  So for example, shareholders have no right to select the company's top managers.  They cannot require a company to pay dividends and cannot vote to sell assets or the company itself.  Nor can shareholders prevent directors from exercising discretion to spend corporate funds as they choose. 

Another legal fallacy behind the shareholder value myth is that shareholders are a corporation's "residual claimants," meaning they are entitled to all profits after a company pays its legal obligations.  Untrue, according to Stout.  Corporate law gives the board of directors wide discretion on how to spend discretionary assets.  Some times the corporation's durability as an ongoing entity may favor paying one set of stakeholders (employees or suppliers or the community), while at other times the corporation's well being favors another set.

Finally, the Right Wingers claim that managements are obliged to work strictly under the lash of enhancing shareholder value, lest the shareholders sue directors and managers for actions favoring other stakeholders.  As an expert in this area of the law, Stout concludes that shareholders "cannot successfully sue directors simply because those directors" prioritize the interests of other stakeholders.

But if legal justifications for managements to pursue shareholder value are illusory, then what do economic and investment analyses show about the results of this approach?  Stout finds the results are contradictory and inconclusive.  In large part such conflicting results emerged because economists studying the question focused on short-term results.  From a longer perspective, a shareholder value approach invariably harms a company's durability and competitiveness.  Yet despite that fact, Stout cites the results of a 2006 survey in which 80% of CFOs stated they would cut marketing and product development expenses to make quarterly earnings, knowing full well that it would hurt their companies' long-term performance. 

Managing for shareholder value diverts executives from managing real operations such as sales, growth, and developing new products.  Instead they concentrate on raising the share price.  Such single mindedness sets managers on the unachievable goal of constantly raising investor expectations.   The result seems to be a paradox.  Rather than focusing on admittedly difficult tasks such as developing better products and retaining innovative employees, managements would rather pursue the impossible goal of perpetually increasing their stock prices by firing people and slashing R&D expenditures to improve earnings.  When even those tactics appear insufficient, they resort to financial maneuvers such as asset sales and stock repurchases.

A classic example of that appeared a few weeks ago when Merck announced that its first-quarter sales fell below those of the same period a year ago.  How did the company's management deal with this downturn?  They promptly announced they were committing $15 billion to a stock buyback program and borrowing money through a bond offering to keep paying a ~6% dividend.

In her denunciation of the shareholder value myth, Stout offers a compelling hint that it may be a major reason why pharma has lost its moral compass.  She explains that managers' myopic effort to maximize shareholder wealth leads them to disregard the legitimacy of rules, other people and diverse interests.  Instead they cater to hedge funds and other short-term, psychopathic investors that aren't bothered by transgressions such as off-label marketing, bribing physicians, and burying the results of clinical trials.

Stout cites a few major instances where shareholder value thinking either destroyed or seriously damaged companies under its spell.  These include Enron, Worldcom and, most notably, BP.  In the last example managers tried to boost earnings and share price by skimping on safety procedures at the company's Macondo well as a means of saving $1 million a day.  This short-term cost saving caused their Deepwater Horizon drilling rig to explode in the Gulf of Mexico and create the biggest offshore oil spill in history.  The entire episode wound up costing BP's shareholders $100 billion in out-of-pocket expenses and reduced capitalization. 

So far pharma's devotion to the shareholder value myth has not caused such major economic reversals.  But their adherence to the myth is evident in nearly all ongoing operations.  None of these are more vital to pharma's long-term growth than clinical R&D, yet companies have genuflected to the myth by outsourcing control of this function to Contract Research Organizations (CROs).   The arrangement removes the fixed costs of employing clinical operations managers from pharma company books by assigning the responsibility for fielding studies to CROs that earn 30% of their revenues from gouging sponsors with change-order fees. 

The result is that pharmas pay more to conduct studies which take longer to complete.  Yet if any suppliers recommend new approaches to project directors, they receive reflexive responses such as, "We'll have to see what our strategic partner CRO says or bring in another one."  Like zombies staggering down the road, most project managers are only vaguely aware that their slavish loyalty to CROs as "strategic partners" places them at the mercy of agencies with a profit motive to screw up their programs.  Even fewer directors seem aware that their attitude has been induced by company CFOs pursuing a pernicious myth.

For their part the CFOs prefer the impossible over the difficult because in the long run, when the logic and the losses of the unattainable become apparent, they and their fellows in the C-suite will be long gone with their eight-figure hauls.

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