The US and UK pension funds control huge assets but the ownership rights of plan members are very unclear, enabling either corporate sponsors or fund management companies to wield – or abstain from wielding – the proxy power of the underlying owners. The pension fund can be thought of as a species of ‘grey capital’ because the property rights it embodies are a twilight zone or grey area. There are, in fact, multiple levels of ambiguity and uncertainty, depending on the type of pension fund, and it is these that I explore in this chapter. Some economic sociologists have taken to using the word ‘ambage’ to describe a world where the oscillations in meaning are embedded in the phenomena they are studying, not simply a trick of perception. More generally, the process whereby workers’ ‘deferred pay’ is siphoned off by pension contributions and handed to financial managers who funnel it to exotic new settings, far removed from workers’ own life world, is a new dimension to the alienation which Karl Marx thought defined capitalism. Some find that their savings are invested in shopping malls or shiny office blocks in distant lands, while their own community suffers neglect and decay. Others find that shares in their pension portfolio are being rented out to hedge funds that have targeted the companies in which they or their neighbours work.
While private sector DB pension funds in the United States are supposedly held for the benefit of plan members, they are controlled by trustees appointed by the corporate sponsors. Recent regulation in the UK has required a minimum number of the trustees in such schemes to be employees of the company, but there remains the problem that there are essentially two types of trustee, either well-informed and financially sophisticated personnel appointed by the Finance Director, or lay trustees who lack the expertise needed to chart a significantly different path. In the case of most DC funds, whether in the US or the UK, the plan members are equally removed from direct control of their savings, which are entrusted to a fund manager who undertakes and manages the direct investment process. In both types of plan the agents are formally required to give priority to the financial interests of the plan members, but the evidence assembled in the last chapter shows how empty this injunction can be. Nevertheless, prosecutions for breach of this ‘fiduciary duty’ are very rare (some exceptions will be considered below). In addition to private-sector DB plans, and the variety of DC plans, there are also public-sector DB plans which do give some representation to plan members through trade union representatives and local elected officials. There are also some US multi-employer funds where the trade unions play a coordinating role. Potentially the management of public-sector and multi-employer funds could be different from those of the private sector, but in practice the criteria by which they discharge their duties have been rather similar. While there are a number of quite well-run public-sector schemes which delivered good returns and have encouraged plan members to have some input, the record of the multi-employer schemes has been very mixed, with some cases of fraud.
A Double Accountability Deficit
When private sector DB schemes were established in the 1950s, the obligations were distant – they did not even appear in the company accounts – yet the advantages were immediate, encouraging employee retention and furnishing a new link to the world of finance. The last chapter stressed how burdensome DB schemes have become to many sponsors in recent years, but in their early years, and in buoyant conditions, they were widely embraced by management. The flow of contributions to the fund could be advantageously coordinated with the company’s overall financial planning. Seen from one standpoint the assets in the fund were simply there to ensure that the company could deliver on its promises, and to that extent belonged to the corporation. But when the law relating to DB funds was tightened up by the Employee Retirement Income Security Act (ERISA) of 1974, it was made clear that sponsors could not simply draw down the pension funds as if they were company reserves, and were instead obliged to maintain enough assets in the fund to cover the likely liabilities. British law was also tightened up in 1995 following the Maxwell scandal. (The British press magnate Robert Maxwell stole £400 million from pension funds sponsored by the companies he owned, using the cash to prop up the share value of his companies. He was probably breaking British law, but he committed suicide and the trustees who executed his instructions were never convicted. Goldman Sachs, his brokers, paid compensation to the pension funds.) Legislation reserving pension assets for use in paying employee pensions strengthened employees’ claims but did not make such assets their property or mandate any employee role in the management of funds. One legal interpretation has urged that pension assets in a DB scheme are ‘non-private property’ that are entitled to ‘protected storage’, as is the case with corpses, or body parts – though the wishes of the deceased are more likely to be consulted than are those of the member of a pension plan.1
The trustees of a DB scheme are bound by a rule which holds that the fund must be managed as a ‘prudent expert’ would manage it. According to a circular logic, the standards of the prudent expert are those observed by the financial services industry itself. The immense sums raised by pension funds of all types have hugely increased the importance of institutional investment. In the 1940s and early 1950s nearly all pension money was invested in government bonds, on the grounds that their future value was guaranteed and that this was therefore the safe and prudent thing to do. But before long pension fund trustees were invited to consider adding private securities to the portfolio. It was urged that corporate shares and bonds would earn a higher return over the long run; the sponsor could either economize on contributions, or use better benefits to attract key workers. The higher return to shares was, of course, a reward for risk but it was urged that a pension fund that had well-diversified shareholdings would, over the long-run, reduce that risk as the under-performance of some companies was compensated for by the out-performance of others. To this evolving debate over portfolio theory there was added the implications of a rising inflation rate. The government bonds in which pension fund managers had invested proved a poor hedge against inflation. Other things being equal, a fund with tangible assets, such as shares or property, would be able to keep abreast of rising prices. After about 1982, the cult of equity carried almost all before it and even quite cautious fund managers would happily contemplate corporate securities comprising 80 per cent of fund assets. Finally, in the dawning epoch of financialization, attention has focused not just on the right mix of assets but on financial products and treatments – swaptions and the like – which give one type of asset some of the characteristics of another. By the early twenty-first century the fund manager or board of trustees who are worried about inflation risk, or interest rate risk, can purchase a product that will hedge it. It would also be common for fund managers to earn a little more on their holdings by lending stock to hedge funds who would employ them in short-selling operations (i.e. selling the borrowed shares in the hope that this will drive down the share price, so that they can then repurchase the shares at a profit prior to returning them to the lender – on this more below). It will readily be grasped that such procedures have the effect of complicating and weakening ownership rights. There is also the problem that the trustees who permit or encourage the use of financialized techniques are more concerned with saving the sponsor money than they are with fortifying the pension promise.
Whatever the new sophistication of fund management, it remains the case that the nominal owners or beneficiaries of the assets in a pension fund have no say in how their savings are managed. The shareholding power of pension funds is used – or neutralized – in ways which sponsoring companies and fund managers find mutually convenient. In 2005, pension funds owned a big chunk of publicly quoted shares, amounting to a quarter of UK public securities and a fifth of US quoted securities. The holding of any one fund would not comprise more than a few per cent of the shares in any given company. Nevertheless the outlook and concerns of ‘institutional shareholders’, sometimes coordinated by bodies such as the Council of Institutional Investors (CII) in the US, or the National Association of Pension Funds (NAPF) in the UK, was something that managers were bound to take into account. Large companies have an executive whose job it is to keep in touch with the institutional investors and when major announcements are made the CEO will be available to answer the fund managers’ questions.
Nevertheless there is a double accountability deficit, with fund managers not answerable to plan beneficiaries and corporate management only sporadically answerable to shareholders. Indeed the now widely admitted crisis of corporate governance – several symptoms of which are to be considered below – has its roots in the failures of pension funds, and other institutional investors, properly to represent the interests and views of the ultimate owners, namely the plan participants. The evidence suggests that capitalism works better if its stewards are answerable to someone other than themselves.
The typical outlook of the corporate executive assigned to the job of looking after the pension fund has been evoked in a pioneering study by two US anthropologists, William O’Barr and John Conley. They report the following exchange with one corporate pensions executive: ‘ “Do you have any contact with the beneficiaries of the fund?” “None whatsoever.” “It never happened?” “None whatsoever.” “What kind of reporting is done to the beneficiaries every year?” “The legal requirement under ERISA.” “What does it look like on paper?” “I’m trying to remember.” ’2 In contrast to this distant relationship, the pensions executive will be in close and daily contact with the Chief Financial Officer (CFO) of the sponsoring company – indeed in some cases he will be the CFO.
In earlier decades sociologists used to debate what they called the managerial revolution.3 The atomization of share ownership, it was said, had permitted business leaders to establish undisputed sway over the corporations entrusted to them. In the 1960s and 1970s I was inclined to question this, since the exposure of management to the risk of takeover gave the owners real leverage, the power of ‘exit’ (selling their holdings) if not ‘voice’ (a say in company policy). The ambitions and share-stake of corporate managers also inclined them to share the concerns of large shareholders. And anyway the competitive context obliged them to follow a certain logic of accumulation whatever their private inclinations.
The rise of employer-sponsored pension funds created a new type of owner and potentially strengthened their hand, overcoming fragmentation and furnishing them with a knowledgeable agent. This was particularly the case with DC schemes but applied to DB schemes that are sponsored by an employer. And even pension products that are individually purchased and held, such as the contents of many IRAs (Individual Retirement Accounts) in the US or Stakeholder Accounts in the UK, are supposedly geared to the needs of the future retiree – this is how they are advertised and why they attract tax relief. The fund managers are offering those who participate in such schemes access to information, expertise and operational economies that are superior to those available to the individual small-scale investor. The price they charge for this may be exorbitant but they do offer market power.
In 1974, Peter Drucker, the doyen of management studies, published The Unseen Revolution: How Pension Fund Socialism Came to America. In it he argued that the American working class was becoming the real owner of US industry and would soon be able to ensure that management did its bidding. The events of the following decade showed this prophecy to be wide of the mark. Fund managers operated in two modes, neither of which was dictated by any concern for the workforce. The mass of pension-fund money was conservatively managed in ways that avoided challenging existing corporate leadership. The boards of the sponsoring companies chose the pension trustees, and through them, the pension fund manager. The relationship between fund managers and corporate officials could be cosy, or it could be distant, but in either case it was not antagonistic or even engaged, and in neither case was there any input from employees. If it was convenient for the corporation to skip a contribution, then the trustees would normally fall into line, with the consequences considered in the last chapter. Nevertheless, the managerial horizon was still the enterprise and its future, in a pattern that had been established during the postwar boom.
But there was a second mode in which the dynamics of corporate finance became detached from any given enterprise or workforce. Some sponsors, trustees and fund managers were anxious to boost returns, and realize ‘shareholder value’, even if it meant jeopardizing cosy relationships. If a more aggressive policy was pursued – for example lending support to takeover specialists – it would typically endanger the jobs of employees at target companies. If returns to a DB pension fund were consequently increased it might be thought that this would benefit those expecting to receive their pension from that fund. But, strictly speaking, this was not the case because the entitlement of each plan member would reflect their service in the company and their final salary, not returns to the pension fund. On the other hand good returns did help sponsors because it enabled them, to reduce, or skip, their own contribution to the fund.
There were thus occasional jousts, with fund managers backing attempts to reorganize corporate assets. In the 1980s pension funds and other institutional money was made available to corporate raiders like James Goldsmith and financial engineers like Michael Milken who successfully sought to boost the importance of share value in corporate affairs. As Michael Useem observed: ‘The challenge to the managerial revolution came with a novel twist. Ownership was resurgent, but not from the original founder entrepreneurs . . . The new ownership muscle came instead from major institutional investors, take over specialists and financial professionals.’4 The financial professionals and take over specialists organized a wave of mergers and acquisitions that boosted the share price of the target companies but often brought little lasting benefit to the shareholders in the predator company. Looked at from the employee’s standpoint, the pain was felt by those who lost their jobs in the post-merger reorganization. Teresa Ghilarducci charged that pension funds aided and abetted the downsizing of the late 1980s and early 1990s. She wrote: ‘the stewards of labor’s capital, used pension funds in speculative investment activity, which closed plants and strangled communities.’5 The supposed justification for this takeover activity was that it promoted the efficient reallocation of capital. But pension funds discovered that the majority of takeovers did not, in fact, benefit them overall. A study of 700 takeovers in 1996–8 by the accountants KPMG found that in 86 per cent of the cases studied the acquisition either added no value to the predator, or had lost it.6
Fund managers can gang up to remove CEOs who do not succeed in sustaining shareholder value. In the early 1990s CEOs at a string of underperforming giants were removed thanks, in part, to shareholder pressure – such exits were seen at, among many others, such important companies as GM, IBM, Westinghouse, American Express, Xerox and Coca-Cola.7 In other cases institutional shareholders pressed for corporate reorganizations that broke up historic companies like AT&T and ITT. Concern for shareholder value was the driving force in these dramatic developments.8
But so long as the share price was buoyant the fund managers would tolerate much by way of high-handed behaviour from CEOs, including actions that did nothing for the long-term interests of the companies’ stakeholders. Moreover the CEO can only be removed by the board of directors so that institutional investors only prevailed where they could find allies on the board, as well as a convincing alternative candidate for the top job. The wave of takeovers led CEOs and their boards to insulate themselves from shareholder pressure by such devices as staggered board elections (e.g. only a third of directors needed to be elected in any one year). By 1990 two-thirds of large companies were protected by ‘poison pills’ – in case of a takeover the pre-takeover shareholders would have the right to purchase additional stock at below-market prices, thus nullifying the predator’s gain. But if a company needs to raise new capital then it often finds that investors will require a dismantling of such defences. Management can also bolster its position by promoting employee stock ownership, since employees are known as loyal shareholders.9 (When the full scale of pension fund deficits became visible in the early years of the new millennium, it emerged that perhaps the best ‘poison pill’ of all was a generous, but underfunded, pension scheme).
Though some pension funds lent to the corporate raiders, the normal stance of privately run pension funds has been to support the existing leadership of a business. As Useem puts it: ‘private-fund managers know that their bosses look unkindly on overt challenges to other corporations’.10 The fund managers are naturally attentive to the interests and viewpoint of the sponsoring board, which has nominated the trustees who will renew or drop their mandate to manage the fund. The fund managers are often themselves divisions of large financial concerns like Barclays, State Street, Citigroup, Merrill Lynch and Morgan Stanley, which hope to make fat fees from supplying other services to the corporations – rights issues, initial public offerings (IPOs), mergers and acquisitions (M&A) and so forth. This gives them a further reason to ingratiate themselves to the sponsoring CEOs and boards of directors. When the money managers come to vote the shares they hold in trust at AGMs, they will defer to the board and often disregard poor governance. Sometimes the trustees themselves will mandate such a policy. Simple shareholder passivity is usually enough to allow the board a free hand. John Bogle, the veteran money manager, writes: ‘No mutual fund, pension manager, bank, or insurance company has ever sponsored a proxy resolution that was opposed by the board of directors or managers.’11 (The way this is phrased allows for a rare action of this sort taken by a public-sector pension fund.)
Managers of actively traded funds who are unhappy with the way a company is being run will sell its shares rather than openly challenge its managers at an AGM. But for reasons of diversification large funds have to own nearly all publicly quoted companies. Passively managed index funds, accounting for roughly half of all pension money, cannot respond to concern by selling shares. At the limit index-tracking funds may use abstention in board re-election votes at AGMs to express unhappiness, or may join informal representations to a failing corporate leadership warning of such action. In a takeover situation even index funds usually have some leeway for adjusting their portfolio.
Over the 1990s the investment banks, in their eagerness for extra business, became the handmaidens of executive aggrandizement. Business leaders, increasingly free from public regulation, found their most cherished schemes for expansion and enrichment cheered on by finance houses who made huge fees from mergers and acquisitions, IPOs and rights issues. This situation damaged the interests of policy-holders and bred many of the business scandals and disasters of the last few years. Shareholder ‘democracy’ has never been very robust but ‘classified boards’ (staggered elections), cumulative voting and poison pills have further weakened it at many companies. In good times CEOs urge that their sole duty is to deliver shareholder value; in bad times they urge patience. They doubt that shareholders, especially institutional shareholders, have the commitment and far-sightedness needed to pursue a long-term strategy.12
When fund managers feel unhappy with a corporation they simply sell its shares. Indeed shares are typically held for months not years – hence the common complaint of ‘short-termism’. Today the logic of financialization can add a further twist. The pact between boards and fund managers is eroded as the latter turn to hedge funds in a desperate attempt to boost returns. The hedge funds specialize in aggressive shorting operations, that is, they borrow shares in order to sell them, so an employee’s assets might well be used to drag down his employer. Even if the pension fund does not itself invest in the hedge fund, the latter still generally rely on institutional investors when borrowing shares to carry out the short selling operation.
The large companies are subject to regular audit, with the resulting audited accounts supposedly enabling shareholders to judge the effectiveness of managerial stewardship. But part of today’s crisis of governance has been the realization that corporations can capture the apparatus meant to invigilate their workings – examples will be given in the next chapter. Furthermore there are now only four accountants of truly global scale – Deloitte, Ernst and Young, Pricewaterhouse Coopers and KPMG – and this ‘big four’ operate a discreet cartel.
Among the signs of the indulgence extended to corporations by accountants and auditors are the fact that more than 700 large companies were forced to re-state their accounts between 1999 and 2003. Professional advisers allowed companies to issue so-called ‘pro-forma’ accounts which supposedly reported ‘underlying’ performance and earnings, while omitting ‘exceptional’ costs or write-offs. Corporations which were meeting very demanding quarterly earnings targets were nevertheless barely recording a profit when the tax-sensitive annual accounts were filed.13
Like the financial groups, the auditors wanted to curry favour with business leaders because these people could award them lucrative non-audit work. Auditors earned rich fees from the tax advice and consultancy they proffered to clients. And senior accountants have taken jobs with companies they had audited. Auditors are nominally appointed by the shareholders at AGMs, but in reality they are chosen and paid by the CEO and board, arrangements which by themselves compromise their independence. In 1999–2000 the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) sought to make auditors more independent of corporations, but they were defeated by tenacious lobbying from the accounting industry, with support from the Democrat Senator Joe Lieberman and the Republican Senator Phil Gramm.14
The allocation of pension fund mandates is arbitrated by a tightly knit structure similar to audit and insurance. Prior to renewing a pension fund mandate the trustees will engage one of the handful of consultants – Watson Wyatt, William Mercer and Hewitt being the largest – who, in their turn, have a network of relationships with the large financial houses. William Mercer also has its own fund management arm. The recommendations and endorsements of the pension fund consultants are deemed to satisfy the trustees’ fiduciary duty towards fund beneficiaries. While the structure is questionable, the pension fund consultants accumulate a formidable body of information on fund performance and can draw on the best actuarial, economic and accounting expertise.
A good summary of the implications of the existing ‘institutional investor’ model has been laid out by John Bogle, founder and former CEO of Vanguard: ‘The failure of investment America to exercise its ownership rights over corporate America has been the major factor in the pathological mutation that has re-shaped owners’ capitalism into managers’ capitalism. That mutation in turn has been importantly responsible for the gross excesses in executive compensation, as well as flaws in the investment system itself that emerged in the late twentieth century . . . Whatever the reasons for turning a blind eye, the record clearly shows that investment America largely ignored corporate governance issues. Using Pogo’s formulation, “We have met the enemy of corporate governance and he is us”.’15 It remains to explore the consequences.
Passive Investors and CEO Enrichment
The 1980s and 1990s witnessed the eclipse of corporate man and the rise of the superstar CEO, who trampled on employees, pensioners and, eventually, shareholders too. Leading financial economists such as Michael Jensen and Kevin Murphy argued that a device was needed to reinforce the priority of shareholder value and to align executive interests with those of the owners. They recommended that CEOs and directors should have a much larger equity stake in the companies they ran.16 While it would be good if directors could buy at least some of this stock with their own money this was not always practical and the stock option achieved nearly the same result. The public should not be squeamish about rewarding executives, they argued, so long as they had an equity stake: ‘By aiming their protests at compensation levels, uninvited but influential guests at the management bargaining table (the business press, labor unions, political figures) intimidate board members and constrain the types of contracts that are written between managers and shareholders.’17 The fear that boards would shrink from properly rewarding CEOs was to prove laughably misplaced, with Jensen’s own expert recommendations playing a modest role in loosening all restraint.
In a presidential address to the American Finance Association in 1993 Jensen argued that capitalism was undergoing a new revolution as far-reaching in its consequences as the industrial revolution of the nineteenth century. In his view, CEOs and boards of directors should no longer think it their task to come up with bold plans for investment or product improvement. They should be just as willing to consider downsizing, returning value to the shareholders by means of buy-backs, and preparing their company for ‘exit’. Jensen even had a kind word for those unfairly demonized figures, the corporate raiders, who were simply promoting a more rational allocation of capital.18 In fact Jensen was lending his own gloss to a financial revolution that was already well underway. Executives were already learning to love share options as a powerful supplement to salary, and began to see possibilities in combining them with share buy-backs and the pursuit of shareholder value.
Stock options gave an option to buy at the prices current when issued, giving senior executives an interest in ramping up share values. If their company’s shares rose they could make millions by exercising their options, and immediately selling the cheaply acquired shares. CEOs and CFOs boosted share price in a way that did nothing to serve the long-term interests of shareholders. Between 1994 and 1999 they borrowed $1.2 trillion from the banks, supposedly for the purpose of strengthening their investment programmes. But instead they used most of this money – 57 per cent – to buy back shares in the companies they ran.19 This naturally boosted shares prices. The CEOs and CFOs then sold their share options for a massive profit. Men like Jack Welch of GE, Charles Wang of Computer Associates and Ken Lay of Enron became multi-millionaires. Huge inequalities opened up. By 2001 the chief executive of one of the top US 500 companies earned 224 times the annual salary of the average employee. In most cases the cost to the company of employee options did not appear on the books even though it amounted to 19.5 per cent of profits in 2000. Some of this total related to options given to employees in new tech start-ups, but the lion’s share went to senior executives in large companies.
Nomi Prins writes: ‘According to a Fortune Magazine study one thousand corporate executives siphoned off $66 billion between 1998 and 2001, with $23 billion going to insiders at the top twenty five firms . . . Quest led the Top 25 club with $2.3 billion transferred from the pensions of its workers to the pockets of its leaders. How did this happen? Workers’ pensions were invested in their own company’s stock. When the senior circles cashed out at the peak just before the crash, they reduced the value of the shares and thus the value of the workers’ pensions.’20
The years following the collapse of the share bubble saw no abatement in the exorbitant payment of chief executives. Boards were even willing to re-price share options that were under water (i.e. below the strike price and hence not yet ‘in the money’). Research by the Corporate Library of Portland, Maine, found that overall executive compensation rose each year from 1999 to 2004 at 1,522 of the larger US companies, with the median payment (i.e. the payment at the mid-point of the distribution from largest to smallest) rising from $1 million to $2.5 million annually over this period.21
Chief executives of the top companies were likely to receive total compensation worth $25–35 million a year, as were CEOs of major finance houses. Indeed at the latter, in a good year, such largesse reaches quite far down the organization chart. In 2005 Goldman Sachs, with 22,425 employees in the US, paid average compensation of $521,000, with senior staff receiving between $1 million and $25 million.22
The enrichment of senior executives, whether corporate or financial, was so great that it can be seen in national income statistics. Over the last thirty years the income of the top 10 per cent of US tax-paying households has grown significantly at the expense of that of the remaining 90 per cent. But this statistic exaggerates the benefit to some of the top 10 per cent. In fact all the gains have accrued to the top 5 per cent, and 80 per cent of these gains have been reaped by the top 1 per cent of incomes. Furthermore, even this is misleading since within the top one per cent most of the gains went to the top 0.1 per cent.23 To qualify for the top 1 per cent in 2000 a household had to be receiving at least $313,500, but the real winners were the top 0.1 per cent of households who had to be gaining at least $1.6 million in that year. There were 129,000 households in that category and together they earned $505 billion – as much as the other nine tenths of households in the top 1 per cent.24
The foregoing figures may understate the recent growth in income inequality, because they are based on IRS returns and because they do not reflect wealthy tax-payers’ growing sophistication. Tax planning, as we will see, is central to the financialized world and leads to a multiplicity of devices for hiding income from the tax authorities, either by directing it to an off-shore tax haven or disguising it as something else. Partially offsetting this would be the lowering of top tax rates after about 1982, which somewhat reduced avoidance incentives – though the top rate after the Bush tax cuts was still 35 per cent in 2002, and many of the rich found this high enough to be worth avoiding. Whatever their imperfections, the IRS records do register the growing significance of ‘partnership’ income at the top end of the income scale. Gérard Duménil and Dominique Lévy have shown that those earning over $200,000 in 2001 received just over a half of this as wages, 29 per cent as capital income and capital gains and 14 per cent as partnership income. Tax-avoidance strategies are likely to be more effective at ‘disappearing’ capital income than at hiding salary or partnership income. Large investment banks or law firms earn revenue within the tax jurisdiction and need to pay it out as salary or partnership income if they are to avoid paying tax themselves. Duménil and Lévy report that partnership income relating to ‘core finance’ and the pay of CEOs were two key factors behind the galloping momentum of inequality. ‘Core finance represents 59.2 per cent of total partners’ capital accounts. This industry comprises 33.7 per cent of the total net income, and 57.8 per cent of the total net portfolio income distributed to partners.’25 They add: ‘The scale of this should be emphasized: the $2,216 billion of partners’ capital accounts amounts to 23 per cent of the total net worth of US non-farm, non-financial corporations, and just over the total net worth (104 per cent) of all financial corporations.’26 Whereas the US CEO with the tenth largest salary in 1970 earned 47 times the average salary of an employee, by 1999 the tenth best rewarded CEO earned 2,381 times the average salary, and the average of the top 100 CEOs was over 1000 times the average salary of an employee. Duménil and Lévy add: ‘By 1999, salaries represented only 9.7 per cent of the total pay of CEOs (although note that the salary of the tenth [highest paid] CEO was $10 million); stock options accounted for 58.5 per cent, and other shares 31.8 per cent of the total pay. This rise of top “remunerations” was so concentrated at the apex of the hierarchy, and so accentuated, that it can hardly be interpreted as a reward for improved managerial skills – or for rising “marginal productivity”, in the neoclassical jargon, measured by the hike in stock prices. Rather, what is at stake is a privileged device to channel surplus towards a fraction of the ruling elite.’27
It might be thought that during the share bubble the fund managers would have seen the warning signals and would have curbed executive aggrandizement or at least tried to dampen the speculative fever of the late 1990s. But they did not. They were playing with other people’s money and the incentives they were offered encouraged irresponsibility. Managers usually receive a bonus related to the performance of the funds they manage over the previous year. In a prescient 1992 article entitled ‘Churning Bubbles’, two financial economists, Franklin Allen and Gary Gorton, warned of the design flaw in fund manager incentive schemes, encouraging them to join a speculative bandwagon even if they knew that it would eventually run into a ditch. As they explained: ‘The call option form of portfolio managers’ compensation schemes [exposing them to upside gains but not downside losses] means they can be willing to purchase a stock if there is some prospect of a capital gain even though they know with certainty that its price will fall below its current level at some point in the future.’28 And beyond such calculations there was the fear of losing mandates, and even losing their jobs, if they carried out a rigorous assessment of company worth. In the late 1990s the analysts retained by the big banks joined the throng with 97 per cent ‘buy’ or ‘hold’ recommendations on the stocks they tracked.
Another trial lying in store was that of dubious business practices that might help a company over a bad patch but which could prove lethal if the bubble burst – as it inevitably would. J. K. Galbraith pointed out in The Great Crash – 1929 that there is always a bit of ‘bezzle’ around even when things are going well.29 When the bad times arrive the bezzle can no longer be hidden, and embezzlement leaps to view. We were told that Enron and kindred organizations were companies of the future, with their complex derivative products that could hedge everything from the price of oil to next year’s weather. Yet scrutiny of the malpractices at Enron and other collapsing giants reveals that most of them were ancient ruses dressed up in the language of up-to-the-minute financial engineering. The bankers and professional advisers should have been highly suspicious of revenue boosted by hollow swaps and sham transactions, of the booking of current costs as capital assets, or the hiding of liabilities in Special Purpose Entities (SPEs). When Citibank and Morgan Stanley helped the energy company to devise SPEs, they would have gained enough knowledge to smell a rat. Merrill Lynch, in a sham transaction designed to boost Enron’s profits, become the temporary owner of three energy barges off the coast of Nigeria. The bank had a commitment from Enron that it would buy back the barges as soon as the new reporting period had arrived. Citibank and Morgan Stanley lent large sums to Enron but they then constructed so-called ‘credit derivatives’ chopping up the loan into many pieces each carrying a different level of default risk. These were then sold, in a game of pass the parcel, to pension funds and other institutional investors. When Enron went bust many fund managers had to pick up the bill on behalf of their clients.
The banks subsequently agreed with the SEC and the attorney-general of New York that they would pay $1.4 billion in fines and compensation, though insisting that they do not admit that they were in any way at fault.30 In several cases the banks, so far from being duped by their corporate customers, had actually themselves devised and sold obfuscatory or fraudulent devices to the deliquents.31 Many fund managers fell over themselves to acquire what were touted as glamorous new financial products. Despite the ‘deal’ between regulators and banks, and the latter’s protestations of future good behaviour, the accountability and regulatory deficits which allowed the scams to happen have not been remedied.
The Sarbanes-Oxley Act (2002) – to be considered in the next chapter – focused on corporate governance, not the role of the banks. Leading executives at Worldcom, Enron and dozens of other failed corporations were prosecuted and sentenced to between eight and twenty years in jail. The banks’ role in helping to construct opaque – or even fraudulent – financial instruments was deemed less culpable. As already noted, the banks never admitted any guilt. However the fund managers, institutions and individuals who had lost tens of billions of dollars pursued, and sometimes won, private suits alleging malpractice, neglect and absence of due diligence on the part of their financial advisers and brokers. The banks’ 2003 settlement with the regulators involved a penalty totalling $1.4 billion, as we have seen. However they paid out much larger sums in settlement of private suits brought against them by investors – by the end of 2005 they had paid $6.9 billion to settle Enron-related suits and $6.0 billion to settle Worldcom-related suits. In each case the total losses stemming from the collapse were about ten times as great as the indemnity paid out. However inadequate, Wall Street seemed to accept that it owed some compensation. But their insurers discovered that even this expiation was not what it appeared. As a Wall Street Journal report explained: ‘The banks . . . are battling to recover a portion of the more than $13 billion they paid in fines for settlement and regulatory actions related to the frauds. They say insurance policies they bought during the 1990s should cover payments the banks made to settle class action suits over their roles in advising Enron and Worldcom. The Swiss Reinsurance Co. and some other large insurance companies are balking.’32 One of the banks concerned, Bank of America, had taken out insurance to provide coverage of up to $100 million for claims ‘arising out of any wrongful action committed by the insured’.33 Insurance of this sort exacerbates representational problems by insulating the agent from the most likely sanction for malpractice, a fine.
The business scandals were partly explained by pressure to produce results at a time of underlying deterioration in the profitability in the provision of non-financial goods and services in the major western economies.34 The wave of deregulation in the 1990s made its own contribution, with scandals proliferating in sectors where controls had been most thoroughly abandoned – finance, energy, communications. The Litigation Reform Act of 1995 shielded from legal challenge the claims and promises made by CEOs and company promoters.35 Repeal of the Glass-Steagall Act in 1999 meant that investment banks were no longer constrained from going into the brokerage or retail business, even though this would mean that their brokers would be trading, and their analysts assessing, stock their bank had itself underwritten. But the scope and nature of the scandals also pointed to underlying ‘agency problems’, namely the betrayal of policy-holders by their own representatives, the hallmark of what I have called ‘grey capitalism’. Financial concerns were helping CEOs out of a tight spot at the expense of millions of small savers. While the CEOs were anxious to conceal poor results, the banks were expecting and demanding double digit annual returns. The fund managers were flattered to have their business solicited by swanky ‘bulge bracket’ investment banks, even though they struggled to understand the nature of the credit derivatives and ‘collateralized debt obligations’ (CDOs) that they purchased. Much of the money lost in speculation was being handled by agents who were not responsible to plan members and pension policy holders.
In a study of the corporate-scandal wave Abraham Gitlow, a former Dean of the Stern School of Business at New York University who has served on the boards of several public companies, pinpoints the overweening power of the CEO as the single most disastrous factor, seeing this as a reflection of tame boards and marginalized and comatose shareholders: ‘The corporate accounting scandals . . . involved more than the separation of ownership and management control. They involved a massive concentration of power in the hands of the chief executive officer. Many CEOs achieved complete dominance over their boards thereby neutralizing their board’s power over them. Once that domination was achieved it was not difficult to find professional people retained by the corporation to do its audit and perform other services . . . And, in a feedback symbiosis, significant numbers of those professionals became, with time, active initiators of schemes that helped misbehaving executives.’36 Overcompensation as well as fraud was the consequence.
The ‘managerial revolution’ model is more useful that I used to suppose – it is a striking fact that it appeals to so many who have been close to the investment process like John Bogle, Allen Sykes and Robert Monks.37 But it has the weakness that by focusing on owners and managers so tightly it fails to grasp the way that corporations are shaped by the environment in which they compete. The legal charter of the corporation has given them and their owners extraordinary privileges. They have the rights of persons while being exempt from many of their responsibilities. The limited liability of the corporation encouraged shareholders to make their investment secure in the knowledge that their potential loss was limited to what they put in. However imperfect, the competitive environment encouraged corporations to seek the rewards of specialization and of scale. This could favour rationalization and rising productivity of labour, though particular enterprises would always seek to corner the market or establish a cartel. Even Karl Marx saw the joint stock corporation as the expression of an attempt to overcome the limitations of private property and to reach new levels of co-operation.38 Marx did not believe that after socializing the means of production working people would have to remake the world entirely anew, they would instead be able to salvage what was positive in the capitalist organization of productive processes. Today’s corporate critics sometimes narrow their concerns to particular corporate malpractices without tracing the ways in which these really spring from the wider context of capitalist accumulation. Of course campaigners against corporate abuse are up against formidable, and quite amoral, antagonists but they should be aware that there can be functions fulfilled by companies which its employees, customers and suppliers will value. Likewise they should be aware that even welcome changes in corporate practice may have little or no overall effect if the competitive environment is not changed, and that even the appointment of the most progressive chief executive could leave many problems still unresolved. The admirably hard-hitting documentary film The Corporation (2004) sometimes failed adequately to reflect the contradictory yet systematic character of today’s corporate capitalism, but the accompanying book by Joel Bakan, despite occasional psychologization of the corporate entity, nevertheless made a whole series of important and valid criticisms.39 Naomi Klein’s No Logo fully deserved its huge success and its stress on the coercive character of branding was accompanied by recognition that brands can increase corporate vulnerability.40 But important as the cultural promotion of corporate products may be, it should not be allowed to hide the ultimately financial imperatives of capitalist accumulation. It is not household names like Nike or Coca-Cola which are the capstones of contemporary capitalism but finance houses, hedge funds and private equity concerns, many of which are unknown to the general public. In the end even the largest and most famous of corporations have only a precarious and provisional autonomy within the new world of business – ultimately they are playthings of the capital markets. The pension fund is very much a (subordinate) part of this world which is why I am seeking to place it in this context. This fact has been underlined by the advance of financialization, a development dating from the last two decades of the twentieth century, which is profoundly reshaping the corporate world.
Financialization and the Disposable Corporation
The distribution of power within corporations and financial networks has been shifting and unpredictable because of the growing exposure of all institutions and arrangements to the opportunities of financialization, as well as to the more familiar pressures of globalization. The term financialization refers to the growing and systemic power of finance and financial engineering in all spheres of life. In 1948 the profits of financial concerns comprised 7 per cent of all US profits; by 2004 the proportion had grown to 34 per cent.41 These profits can arise from merging two or three corporations and then, a little later, breaking them up again. Money is made not only by those who garner the direct M&A fees but by others who practice risk arbitrage, buying and selling the newly merged or separated entities. Underwriters earn good fees from initial public share offerings (IPOs) and rights issues even though Google has shown, by successfully launching itself as a public company, that those fees are often excessive. Financial returns can also be earned by managing consumer debt, by commodifying the life course, or from the sale and use of financial products such as lease-backs, derivatives and hedging techniques. Financialization involves the eclipse of the realm of production by that of circulation, though with real effects on future production.
Financialization affects even the most powerful corporations because the banks and the ratings agencies determine their credit-worthiness and hence the cost of their capital. They may be able to finance all the investments they wish to undertake from their own resources, but this will not mean that they are free from the pressures of financialization. In drawing up their investment plans they will have to show that they will achieve the benchmark or ‘hurdle’ rates of return established by the financial sector.42 Even the largest corporations have to submit to the inspections and interrogations of the ratings agencies – Standard and Poor’s, Moody’s and Fitch Ratings – if they wish to reassure investors and ensure cheap access to capital. Making a good profit is no longer enough; a triple A rating is also needed.43
The competitive process, and the changeable state of the company’s outstanding obligations and assets, all exercise a constant pressure. From the standpoint of the pure investor, the corporation itself is an accidental bundle of liabilities and assets which is there to be rearranged to maximize shareholder value, which in turn reflects the fickle enthusiasms of other investors. The corporation and its workforce are, in principle, disposable. In the 1980s hundreds of thousands, if not millions, of employees discovered this, and in the ‘downsizing’ of the early 1990s swathes of middle and upper management discovered that they too were surplus to requirement. By the turn of the century Enron’s managers became famous for a managerial regime in which each employee knew that one tenth of the staff, those who failed to reach trading targets, would be sacked each year, no matter how good or bad the overall performance. Wal-Mart, with over a million employees, occupies a quite different niche but it too ensured the malleability of its workforce, by specifying physical norms to its recruiters, by instilling a corporate ethos of emulation and by rigorously monitoring performance. Paradoxically, the disposable workforce went hand-in-hand with a new corporate doctrine of ‘human relations’, which celebrates ‘flexibility’, innovation and learning. The worlds of rhetoric and reality neatly dovetailed when the HR department of PGE, an Enron subsidiary, offered grief counselling to employees who had lost both their jobs and their savings, the better to enable them to adjust to what was happening.
Financialization’s lack of commitment to employees or communities is supposedly dictated by the pursuit of the efficient allocation of capital. But because financialization is not embedded in a macro-policy or strategy it often plays a part in strangling growth. Booms lose their way if they are channelled into short-term speculation and arbitrage, rather than long-range investment. Sustained growth requires infrastructural and educational investments that may not pay off for decades. While arbitrage can help to spot and eliminate excess costs, if unregulated it will wipe out all long-range projects. While previous booms saw the construction of railroads or interstate highways the stock market thrills and spills of the 1980s and 1990s lacked the sort of commitment and foresight displayed by Henry Ford, and other founders of industrialism, or John Maynard Keynes, and other architects of the postwar boom. The managers of pension funds were part of the problem since they wanted investments that yielded immediate returns and which could easily be turned into cash. This was, in part, the result of accounting methods which required that assets be ‘marked to market’ every year.
In the mid-1990s Kevin Phillips and Giovanni Arrighi warned that the profits of financialization would have the further defect that, unlike advances in manufacturing, communications or trade, they tend to enrich only a small part of the population and do not create a broad basis of sustainable mass demand.44 For a while this can be concealed by a ‘wealth effect’ as millions of small investors see the nominal value of their assets – whether shares or the homes they live in – climb, but once the bubble bursts demand plummets. From 2000 to 2005 consumer confidence was shored up by a house-price boom, borrowing and tax cuts, but ballooning debt, rising interest rates, and a weak recovery, stored up problems for the future and created a difficult climate for manufacturers. In the speculative process large-scale finance has the edge over the small saver and the cash-strapped corporation. In the past the large banks were able to grow at the expense of the savings of the small man, because they had larger reserves and better information.45 Today the small savers’ holdings in pension, insurance and ‘mutual’ funds play this role. The mass of employees may own a significant slice of productive assets but they do so in ways that render them vulnerable to hedge funds and other finance houses, which are better informed and more nimble.
In the 1990s and after, the small investors with holdings in mutual funds, 401(k)s or unit trusts reacted to the exorbitant cost of ‘actively managed’ funds by steering their money towards passive ‘index tracking’ funds. The latter came to comprise half or more of funds held for retirement. While fees are certainly lower in such funds there are other problems with this investment approach. The funds which really do mimic the big liquid indices, like the S&P 500 or FTSE 100, find that they are buying dear and selling cheap – when companies enter the index they are already doing well, while by the time they exit problems will have long been apparent. The hedge funds charge heavy fees but are able to exploit the clumsy and predictable movements of a market heavily influenced by index funds. The trading desks of the investment banks service the hedge funds, and are well placed to seize arbitrage possibilities opened up by bids and counter-bids. On large transactions these concerns will be able to spread trading costs until they leave a handsome profit.
High Finance and Distressed Debt
In another dimension of financialization, companies that were having difficulty making a profit from selling goods found that it was sometimes easier if they offered finance too, from the humblest consumer credit network to complex deals where a company sold its product to a subsidiary which then leased it to the customer. Not infrequently the transaction passes through a tax haven. GE Capital has long helped the company’s customers acquire its aero-engines and other machinery using tax-efficient lease-back arrangements. GE Capital soon diversified into consumer credit because of the attractive return this generated. By 2003 42 per cent of the group’s profits were generated by GE Capital. In the same year GM and Ford registered nearly all their profit from consumer-leasing arrangements, with sales revenue barely breaking even. When these two auto giants encountered real difficulties in 2005 and after, they came under pressure to sell their profitable leasing divisions as a way of raising badly needed resources. In 2004 the General Motors Acceptance Corporation (GMAC) division earned $2.9 billion, contributing about 80 per cent of GM total income. GM hoped that GMAC would be valued at $11 billion or more and that it could retain a major holding even while selling a 51 per cent stake. The company’s creditors, including the PBGC, were said to be scrutinizing all such proposals, ready to make a claim on behalf of the company’s own employees and pensioners should they deem that necessary.46
In a kindred development it was striking to see the eagerness with which gigantic financial concerns like Citigroup and HSBC sought to acquire consumer finance operations and even ‘sub-prime’ lenders (‘loan sharks’) which they would have previously regarded with disdain. Citigroup acquired Associates First Capital, and HSBC bought Household Finance, blazing a trail others were to follow. Finance houses have teamed up with retailers to shower so-called gold and platinum cards on all and sundry with the hope of ratcheting up consumer debt – running at over 110 per cent of personal annual disposable incomes in the US in 2002, rising to 130 per cent by 2005 – and subsequently charging an annual 18 or 20 per cent on money for which the banks were paying three or four per cent. It was the hot rates of return which attracted the banks to seamy lending. They believed that they could repackage the debts in ways that allowed them to slough off the risk while retaining most of the high return that was supposedly the risk premium.
With direct access to sub-prime mortgages, the banks and hedge funds could then bundle together and divide up the debt into tranches, each of which represents a claim over the underlying loans or securities but with the lowest tranche representing the first 5 per cent to default, then the next 25 per cent to default, leaving 70 per cent in the supposedly safe ‘senior’ tranche. Borrowers who can only negotiate a sub-prime mortgage have either poor collateral or poor income prospects, or both, and so are required to pay over the odds. Of course the bottom tranche – designated the equity – has very weak prospects but can still be sold cheaply to someone as a bargain. The top tranches, and even many of the medium tranches, will be far more secure yet will pay a good return. The chief executive of a mortgage broker boasted: ‘Sub-prime mortgages are the ideal sector for the investment banks, as their wider margins provide a strong protected cash-flow and the risk history has been favourable. If the investment bank packages the securities bonds for sale, including the deeply subordinated risk tranches, it can, in effect, lock in a guaranteed return with little or no capital exposure . . . Generally investment banks do not like lending money but they are good at measuring risk, parcelling this up and optimising its value.’47 This statement captures the hubris of the fianancial sector at the time. The banks brought up mortgage portfolios and bundled, tranched and insured millions of subprime mortgates, turning them into Collateralized Debt Obligations (CDOs). Ratings agencies were paid a handsome fee to award them a tripe A grade, after which they were sold to other financial institutions or stored away in a Special Investment Vehicle (SIV). These were ‘over the counter’ transactions, using ‘model’, rather than market, prices. In the years 2001–6 sub-prime CDOs grew into the main asset base of a fabulous, off-balance-sheet – hence unregulated – ‘shadow banking system’.
The credit derivatives boom enabled the banks to achieve record profits in the years up to 2006. However, the increasingly indebted households turned out to be unrealiable debtors for those who now held their debt. For a while a continuing housing bubble kept alive the illusion of expanding wealth but by 2006 US consumers had to spend 18 per cent of their earnings simply to service their debts. As millions fell behind in their mortgage payments it became a source of systemic risk. Even banks which had sold on the CDOs before they soured could not escape exposure to the consequent disaster. (For the latter see the preface).
Perilous Ways of Hedging Risk
I have already drawn attention to hedge funds and their ability to outwit large institutional investors. The years 2000–6 have witnessed a mushrooming of thousands of hedge funds – by mid 2006 the total was thought to be around 8,000 controlling $1.5 trillion of assets (this compared with $7 trillion in US mutual funds of all types). The hedge funds started out as the preserve of the really wealthy investor, though eventually several pension funds gave them a small slither of their holdings. In the bear market of 2000–2 the hedge funds often made positive returns when most conventional funds, especially index funds, made heavy losses. Conventional funds, whether actively managed or index-linked, were ‘long only’, which is to say that they bought and sold stocks but did not short them. Hedge funds also offer and employ ‘derivatives’, investment products like options which allow the purchaser to place a bet on the movement of sections of the market. Spotting price discrepancies, hedge funds made money by arbitrage, rapid trading and the novel use of credit derivatives, which would repackage corporate debt. Investment banks and the treasury departments of large corporations also engage in large-scale hedging of currency and interest rates but hedge funds have the greatest latitude and are closest to the unbridled spirit of financialization.48
Banks and mutual funds are lightly regulated, but the hedge funds do not have to reveal their holdings at all, and effectively escape all regulation. They charge fees that are often 2 per cent of the money invested plus 20 per cent of the annual rise in capital value. Their charging structure usually allows them to make a lot of money when they do well, but not to forfeit these gains if the returns then collapse. The hedge funds do have higher costs than other fund managers because of heavy trading, but claim that this will enable them to outperform the market and to generate positive returns during a downturn. Many have performed very well for particular clients, encouraging pension-fund managers to take a lively interest in them, an interest generally encouraged by regulators and consultants on both sides of the Atlantic.
While hedge funds may deliver the consistent, double-digit returns which justify their fees for special clients, can they pull off the same trick for the entire class of pension funds, given that the latter constitute such a large component of the market? A shorting operation can deliver results to its practitioner but it does not directly benefit all investors, as does a rising market.49 And while a ‘long’ investment can rise and rise, the price of a share cannot drop below zero, limiting the profits of shorting. The pension funds which invest in hedge funds usually do so by purchasing a ‘fund of funds’ vehicle, yet in doing so lose the edge which the best hedge-fund managers will be able to offer. A diversified stake in the sector may offer a little more security but also lowers the return, since it will include poor performers and perhaps even those that go bust. Between 1998 and 2003, 1,800 hedge funds closed their doors, yet most statistics on the performance of the sector will display ‘survivor bias’ by failing to include their losses.50
Due to their modus operandi the hedge funds were to have a starring role in the mutual funds scandals. The large finance houses which sponsor mutual funds discovered that they could earn extra fees from hyperactive traders, on top of the good fees they were already earning from the mass of their investors. They granted hedge funds privileges not extended to other investors. They even gave the hedge funds credit to enable them to take advantage of their clients’ funds still valued at ‘stale prices’ (on which more in the next chapter). This way the finance house can charge interest as well as earn a transaction fee. Furthermore, trades do not have to be only in already-existing shares. If new issues are imminent then hedge funds and other punters can purchase sell and put options on the not-yet-existing shares on what is called, appropriately enough, the ‘grey market’. Shorting shares in the grey market can lead to extraordinary complications and the embarrassment of ‘naked shorts’, where the short-seller is discovered to have no stock, whether borrowed or not.51 Another problematic issue is where hedge funds use the voting power of borrowed stock to endorse takeover bids, especially where shareholders in the target stand to lose, but the hedge fund will gain because of other positions it has taken on the outcome of the bid.
The hedge-fund manager uses derivatives to unpack bundles of property rights or claims on flows of income, and to reassemble them in a supposedly more advantageous configuration. They may be guided by a hunch as to what is the next big thing but they don’t aim to take responsibility for running a business. On the face of it, ‘private equity’ concerns are quite different. They specialize in taking over under-capitalized and underperforming businesses, with the aim of reorganizing management and relaunching the business. This may take three or five years, during which money is borrowed, loss-makers are spun off and the core business overhauled. Investors – including pension funds – are invited to back these operations. Most pension funds will only be able to set aside a small slice of their funds for such ventures because they are usually required by consultants and fiduciary regulations to invest in ‘liquid’ assets, while a private-equity stake has to be held for a few years and is difficult to value. The private-equity fund is really a sort of collective entrepreneur, and may deliver a good return to the large-scale investor, but the relaunched business will have been loaded with debt. Like hedge funds their charges are higher than those of ordinary fund managers and normally comprise both a standard annual fee of 2 per cent together with a portion of the eventual pay-off, or ‘carried interest’, once the reorganization and refloat is complete.52 The investor thus contributes not to the private-equity organization as such but to a specific fund which it will launch. It will raise a given sum – from as little as £10 million to several billions of dollars or pounds – which will be used to make acquisitions in a given sector. When the Texas Pacific Group announced a $15 billion fund in April 2006 this was a record, but the scale of private equity had grown over the previous decade, albeit with a dip in 2001. The private-equity concern will have real costs, such as legal ‘due diligence’, insurance and staff, but as the size of funds grows the annual management fee will tend to become more interesting than the entrepreneurial profit, which itself will be spread over several years. Private equity ‘club deals’ enable different concerns to aim at larger targets, pool costs and increase their funds under management.
The combined effect of such trends is to bring private equity closer to a generalized fund-management logic where the real goal is to boost the size of the funds under management, because this in turn will boost the fees.53 The capital raised, and the loans issued, may exceed the good investment opportunities that are available. Those engaged in a range of takeover and buy-out possibilities will tend to have advance knowledge of market events, with those whose bid fails being most likely to talk or seek compensation by acting on the information in their possession – in February 2006 London’s Financial Services Authority pointed to evidence that suspicious trading activity preceded about one-third of all major deals.
Just to round out the picture of the triumph of financialization, mainstream fund managers, in a bid to retain mandates, are also now prepared to abandon their ‘long only’ approach and make some use of ‘shorting’ and derivatives.
Criticism of the new world of finance should avoid the mistake of treating finance itself as necessarily a domain of delusion and chicanery. The financial techniques employed by hedge funds or the finance departments of large corporations are not all designed for some dubious purpose. The use of derivatives to hedge currency or interest-rate swings can aim simply to reduce uncertainty. It may make sense to offset other, similar, risks to achieve a balanced portfolio. But hedge funds, finance houses and accountants invariably go far beyond such tame procedures. They don’t limit themselves to a plain ‘vanilla swap’ – say to replace fluctuating by fixed interest rates – but will sell clients a lease-back within a sale within a swap in order to thoroughly befuddle regulators, tax authorities and shareholders alike. Likewise they often use leverage (borrowed money or assets) to increase their profits on a transaction, but in so doing also increase the exposure of their clients. Those who buy an asset stand to lose what they have paid. Those who buy a derivative can be exposed to unlimited loss. The barely contained collapse of Long Term Capital Management in 1998 – patronized by central banks and staffed by brilliant minds – illustrated several of these dangers.54 More generally, as Edward LiPuma and Ben Lee urge, the use of derivatives in contemporary financialization aims at short-term gains that short-circuit flows of production and trade, garnering an immediate gain at the expense of what might have been a long-term social surplus. 55 Private equity aims to be different but operates in a financialized context which can subvert any longer-term, constructive purpose.
The techniques of the financial revolution – derivatives, hedging, SPEs, CDOs, etc. – can be used simply to insure a corporation against hazard. But several of these devices lend themselves to manipulating a firm’s basic numbers (a case in point, ‘finite insurance’, will be considered in the next chapter). The cult of shareholder value and financial engineering could seem to conjure immediate gain out of any merger or acquisition. Companies which perfected the art of growth by acquisition – GE, Vodafone, AOL, Worldcom and so forth – became the darlings of Wall Street. Sometimes this corresponded to real growth and a more logical business. But it could also betoken ‘aggressive accounting’ and herald future share-price tumbles. The willingness of the old-fashioned type of investor to accept the consequences of ownership vanishes in the hedge fund world. As a recent survey notes: ‘The hedge funds’ case has not been helped by behaviour such as that of Perry Capital which in 2004 bought shares in Mylan Laboratories only in order to vote in favour of its acquisition of King Pharmaceuticals in which Perry was a big shareholder. Perry hedged its exposure to movements in Mylan’s share price and was thus able to exercise its voting rights without having any apparent exposure to the consequences.’56
In the 1980s and 1990s GE took over scores of companies and reduced its US workforce by more than two-thirds. Earnings predictions were met with clockwork precision. By 2001, 43 per cent of its earnings came from financial activities, ranging from consumer credit to aircraft leasing operations which encouraged airlines to buy GE products. In 2001 the European competition commissioner ruled against a proposed merger with Honeywell because of the belief that it would create monopoly power in some markets. Faced by earnings decline, in 2003 GE acquired Amersham, a large medical company with products that complement GE’s: analysts wrote that ‘revenue synergies’ and ‘cross-selling’ opportunities should help share price, since GE sells imaging machines to hospitals while Amersham supplies the injection agents. A hospital procurement officer explained: ‘. . . most hospitals regarded large medical equipment like M.R.I. machines as a capital expense, which is not directly billable to patients, while the injectable agents are charged to patients or their insurers. The company could begin providing deep discounts on the equipment while increasing the price of the agents.’ An industry consultant commented: ‘Will everyone pay more? That would be their goal. They are not missionaries.’57 The report carried a denial from GE that it would behave like this. But the possibility conjured up shows the need for new types of regulation, backed up, if possible, by a new type of owner.
Fooling the Tax Man
The wish to outwit the tax system plays a large role in the spread of financial engineering. In 1965 corporate taxes accounted for 4 per cent of US GDP; by 2002 they comprised only 1.5 per cent of GDP. Already in 1985 the Wall Street Journal published an op-ed by two students at Harvard Business School. In it they explained: ‘[We] have discovered that a large portion of the school’s curriculum is devoted to preparing us to both understand and “beat” the U.S. tax system’.58 They added that, after a typical class, ‘We might have learned how to be more successful businessmen and wealthy individuals, but certainly not through any creation of wealth. We had merely spent another day learning how to beat Uncle Sam. As we looked at our real estate homework for the next day, with its tax shelters, sale-leasebacks, and depreciation rules, we realized that tomorrow would be more of the same.’
This article is cited by Myron Scholes and Mark Woolfson in an influential book which triumphantly codified the achievements of financialization, Taxes and Business Strategy: A Planning Approach, first published in 1991. According to Scholes and Wolfson, who quote the article, the two students had flunked the test. The purpose was not to beat the US tax system or to minimize taxes. The purpose was to arbitrage the tax systems of all countries and to maximize profits and shareholder value, which might require paying some taxes, since countries where profitable openings were to be found often had the capacity to tax. In their view businessmen should accept that the taxing authority was an ‘investment partner’ in their firm, who should be cut in where necessary but who couldn’t really know what you were up to. The ‘tax planning’ approach sought to ‘repackage ownership rights’, through the use of derivatives and swaps, with the aim of switching income or assets from high-tax to lower-tax periods, locations or monetary forms. As they explain: ‘With financial engineering, many different combinations of assets, securities and “synthetics” [a contract that duplicates the financial effect of an underlying asset] can lead to economically similar cash-flows. Yet taxing authorities often impose different tax treatment across the economically similar bundles.’ Thus a US tax-exempt entity might wish, for the sake of diversification, to invest in Europe while a European tax-exempt entity might want for the same reason to invest in the US. Both face the problem that their tax-exemption applies to home and not overseas markets. They therefore have an incentive to reach a swap agreement, such that each makes an investment in the home market and pledges all returns to their foreign partner. Prior to the 1980s such swaps were unknown, but since then they have been almost infinitely elaborated. Likewise if there is differential taxation of dividends and capital gains a financial device can turn the more highly taxed into the less taxed. Scholes and Woolfson explain: ‘The market typically does a better job than the taxing authority in sorting out the economic characteristics of securities. At first blush it might appear sensible to decompose a transaction into its component parts and tax each part accordingly . . . The decomposition approach, however, faces practical difficulties. It is not always obvious how to decompose a contract into its constituent parts. Assets can be decomposed into multiple ways that are equivalent except for taxes . . . Should the taxing authority adopt a more conceptual approach, wherein it attempts to determine whether a particular set of transactions is motivated solely by tax purposes and re-characterize such transactions to afford a less tax-advantageous outcome for the tax payer? Probably so, but as a practical matter, the taxing authority can only guess what is behind a complicated string of transactions. What is the authority to do? For the most part it has given up in the financial innovation market.’59
These authors do not argue that such considerations entirely nullify the powers of taxing authorities, since the latter can impose uncertainty. Finance houses which discover a new tax avoidance device are encouraged to register it with the authorities, thus earning brownie points. But as accountants found an ever-widening market for tax avoidance products the inducement to register was weakened. In the case of one such product marketed by KPMG an internal memo noted: ‘The rewards of a successful marketing of the OPIS product (and the competitive disadvantages that may result from registration) far exceed the financial exposure to penalties that may arise.’60 The tax-shelter business is huge. Deutsche Bank furnished $10 billion of credit over a three-year period to clients who purchased just one of KPMG’s tax shelter products. Testifying before a Senate committee, a former ‘structured finance executive’ at Deutsche Bank admitted that the loans involved no risk – they were backed by 100 per cent collateral – and that they were repaid within two months. He denied they were sham loans or simple tax shelters, preferring to describe them as investment deals with ‘significant tax benefits’. 61
Companies do not want to undergo the hassle of a special investigation, even if they know their tax-planning strategies to be impregnable. But the IRS is just one organization, with a limited staff; it can, for example, only check the returns of one partnership in 400, with ‘partner’ being the designation of choice for those on very high incomes. Companies also have to worry about shareholders, who are thought to favor proper tax planning. Thus in Fall 2003 Citigroup announced a record quarterly profit of $4.7 billion, but was concerned that it was paying tax at the rate of 31.3 per cent of its profits while GE was only paying at the rate of 23.5 per cent. At this point Citigroup already derived 40 per cent of its revenue from outside the US. Todd Thompson, chief financial officer, promised analysts and shareholders that the tax rate could be lowered: ‘There are possibilities to manage that number down through some of our international operations.’62 A study of 250 major US companies in 1996–8 found that they were paying an average of 20.1 per cent of their profits in tax, instead of the official rate of 35 per cent.63 A study of the 50 largest UK companies in the years 2000 to 2004 found that they paid corporation tax at an average rate that was 5.7 per cent less than their earnings seemed to warrant. It calculated that the likely ‘expectation gap’, or shortfall below official rates, amounted to £9.2 billion a year, or 28 per cent of corporation tax receipts in 2004–5.64 (When citing such statistics it is important to note both that tax avoidance is on a large scale and also that, if we assume that these companies would prefer to pay nothing, that large sums are nevertheless raised by corporation tax. The implication is that, notwithstanding globalization, companies can be made to pay taxes.)
The strategies adopted to fox the tax authority are also capable of confusing the shareholder. The taxing authority and the shareholder have different sources of information and leverage, but both can be bamboozled by a complex maze of financialized transactions. Fund trustees and managers have sought to tackle these problems by focusing relentlessly on shareholder value, but long-term prospects for the latter have frequently been eroded, by a combination of executive willfulness, inappropriate gambles and financial sleight of hand.
In most American states the electrical utilities are allowed to charge customers a tax that legislators intended should be handed on to the fiscal authorities. But many utilities are now part of business groups which can claim these taxes to offset losses in other operations so that the money meant for the state or municipality never reaches its destination: ‘many utilities have expanded into unregulated businesses such as energy trading or aircraft leasing, while others have been acquired by companies that own other businesses. When those other businesses lose money or create artificial losses through tax planning, those losses can be used to offset income earned by the utilities. As a result the parent company owes less in tax than their electric customers paid. Sometimes these companies owe nothing or receive large tax refunds. By not remitting taxes [paid by customers], the companies effectively save more money to invest in their operations or pay to shareholders in dividends. The ability to intercept tax payments is not limited to electric utilities. Natural gas, water and telephone utilities can use the same techniques.’65 This report quoted Mike Hatch, the Minnesota attorney general, as commenting: ‘Essentially the utilities customers pay the tax twice, once through the utility bill and again through the lost revenue to the government that means higher taxes for them or less government services.’66
The sums involved run into many billions. In ten Western states, Xcel Energy managed to hold on to $723 million which a utility stand-alone would have had to hand over to the government. Another utility owner, Pepco Holdings. held on to $546 million in 2002–4. Enron acquired Portland General Electric in order to absorb tax-enriched revenues of $900 million and offset them against losses in 881 companies registered in the Cayman Islands and Bermuda. To allow an enterprise to offset its own losses against profits in a later period is one thing, but to extend this concession to other unrelated entities has the economic effect of giving free insurance to the loss-makers involved, and of offering a windfall to those who tie up the deal. A spokesman for Pepco saw matters very differently: ‘Utility customers did not bear the risk of that business, and they should not benefit either’.67 But the owners of the other, loss-making, business should not be compensated at the expense of taxpayers for their own mistakes.
During the 1950s US corporations accounted for 28 per cent of federal revenues; by the first years of the twenty-first century this contribution had fallen to 11 per cent, and 61 per cent of all US companies paid no tax whatsoever. And many whose income was drawn from the United States had learned how to re-route it via Bermuda, with the Bermuda ‘head office’ receiving lavish and untaxed payment for management services, use of copyright, and interest on loans. While US banks and insurance houses would explain to customers how to exploit such schemes, their European counterparts were certainly no slouches and are believed to have devised off-shore funds for wealthy individuals holding about $2–3 trillion of assets, compared with perhaps $1.6 trillion held for wealthy Americans.68
But tax havens, with their often flimsy safeguards, are problematic places to stow assets. Many wealthy corporations and individuals simply send their profits on a round trip to be laundered in a haven but then return to some more secure locale. The wealthy require havens with some security and for this reason opt for territories that are dependencies of an EU state or the United States – Bermuda, Cayman Islands, Monaco, the Isle of Man and so forth. The US and European authorities are beginning to monitor these financial hidey holes more closely and could do a lot more. The desire for security without onerous regulation is also seen within the US, with companies flocking to Delaware because of its corporate-friendly regulatory regime.
The financialized world girdles the planet with transactions worth trillions of dollars, euros and pounds, yet there comes a time when the deal has to be registered, and perhaps enforced, or cash handed over, or trades settled. And many of these elaborate transactions still depend on trust, personal contact and a certain density of well-regulated and reasonably transparent financial institutions. It is striking that even the hedge funds tend to cluster their operational HQs not in some tropical tax haven but in locations not so far from the old financial districts – London’s Mayfair or Greenwich, Connecticut. Of course this is just the tip of the iceberg. The main offices of banks and funds are located in or near London, New York or Tokyo, but the financial device or analysts’ report will often be drawn up overnight in branch offices in India.
I am not arguing here that such financial institutions are today either transparent or well-regulated. The next chapter will show that this is still far from being the case, notwithstanding new legislation in both the US and Europe, and a new vigilance from international agencies. My point is rather that even in the supposedly borderless world of globalization some territories are very much more secure and advantageous for corporations and wealth-holders than others, and that this offers considerable scope to a determined regulatory authority.
Financialization is defined by the use of sophisticated mathematical techniques to distribute and hedge risk, so it might be thought that these instruments are themselves a major part of the problem of what I have called ‘grey capitalism’. But this would be an error. It is true that the collapse of Long Term Capital Management in 1998 was deemed to pose a systemic threat, leading to a bail-out coordinated by the Federal Reserve Bank of New York and the major Wall Street institutions. In today’s highly financialized world such a threat could easily reappear but this is more likely to be the result of poor institutional structures than of faulty calculations. The collapse of Enron and Worldcom was a disaster for the pension funds and employees who had invested in the shares and financial instruments offered by these concerns. But the tangled mass of derivative contracts unwound with much less pain. In the second half of 2005 Refco, the largest US futures trader, was forced to declare bankruptcy after revealing that an entity owned by one of its key executives had owed the company $300 million since 1998. The individual in question had, it is true, used a small hedge fund to help conceal this debt. But the financial manipulation he used was of breathtaking simplicity – the debt was simply rotated around three accounts with different reporting periods, one of the hoariest scams known to financial history. What permitted the fraud to succeed was the willingness of highly respected lawyers and accountants to prepare and endorse the rotating payments. The errant executive acquired his colleagues’ trust because of his access to funds held for an Austrian workers’ pension fund, which suffered a heavy loss. On the other hand the complex mass of the company’s derivative and futures contracts were settled by counterparties who had freely entered into them.
Soviet planners learnt long ago that managers who are told to maximize one number – say tonnage of output – will have an incentive to bend the whole enterprise to that end regardless, even if it means goods that are heavier than consumers want. Linking executive compensation to shareholder value will, over time, have similar distorting results. It will encourage the massaging of the numbers that influence share price and this over-riding concern with today’s quote may very well undermine longer-term reputation, and hence value. The critique of Soviet planning by Friedrich von Hayek stressed that owners spread throughout the economy could be aware of many local opportunities that were invisible at the centre. And they would therefore be willing to exploit them at their own cost. The regime of ‘grey capitalism’ fails to control the managers or to give the ultimate owners any responsibility. The Soviet Union produced vast quantities of steel, cement and electricity but failed to meet its people’s needs. The financial engineering regime produces vast quantities of financial products but leaves people more insecure, poorer and less in control.
Just as the Soviet system produced its nomenklatura so financialized and grey capitalism has thrown up an extraordinarily privileged social class of over-compensated CEOs and financial ‘partners’. When I wrote Banking on Death I compared this layer to the nobility of France’s Ancien Régime. I had in mind such echoes as that the estates of the pre-1789 French nobility had been formally exempt from taxation, that the Régime financed itself by bringing in private contractors to collect the tolls on the poor (the ‘tax farmers’) and its recourse to lotteries to plug holes in the royal revenue. The wealth of today’s financial aristocrats is held in the form of corporate securities. For most ordinary citizens the home they live in is their most valuable possession and they have to pay a tax on it. But those who own property in the form of shares and bonds pay no tax for so doing. They are only liable to capital gains tax when they realize the gain and, if they use a tax haven, not even then.
The financial aristocrats live lives as far as possible removed from those of the common herd. No facility is more prized than the private jet, usually paid for by the corporation. While all this is scarcely a secret it is nevertheless gratifying to find the picture – and the historical parallel – confirmed by the following e-mail to colleagues sent by Conrad Black (Lord Black) at a time when control of his media empire was slipping from his hands: ‘There has not been an occasion for many months when I got on our plane without wondering whether it was really affordable. But I’m not prepared to re-enact the French Revolutionary renunciation of the rights of nobility. We have to find a balance between an unfair taxation on the company and a reasonable treatment of the founder-builders-managers. We are proprietors after all, beleaguered as we may be. Care must be taken not to allow this to degenerate into decadence, as it did with the old Argus. But nor should we allow the agitations of shareholders, amplified by certain of our colleagues discountenanced by the performance of their stock options, to force us into a hair shirt, the corporate equivalent of sackcloth and ashes.’69
Black retained control of Hollinger, the company which owned the Chicago Sun Times, the UK Daily Telegraph and Sunday Telegraph and the Jerusalem Post by means of special voting rights that conferred over 73 per cent of the votes on a share stake that comprised only 30 per cent of the outstanding stock. Black used his position as CEO, and his leverage over the board, to extract from Hollinger some $300 million, which he then used both to fund an extraordinary extravagant lifestyle – his wife Barbara Amiel confessed that she was a hopeless shopaholic – and to fund a string of right-wing causes. Among the directors of the holding company that channeled many of these funds were Henry Kissinger and Richard Perle. Some of the long-suffering shareholders, led by the institutional investor Tweedy Browne, sued Black and his colleagues for violating their fiduciary duty. They succeeded first in removing Black from his post as chief executive, and then winning full control of the company in the Delaware courts in February 2004. The humbling of Black was a signal from the courts of Delaware – where so many US companies are registered – that there were limits to the extent to which imperial CEOs could trample on the interests of shareholders. Delaware is popular with the corporate community precisely because its regulations are not too onerous – Ireland and the Netherlands play this role in Europe. However the Chancery Court of Delaware evidently believed that Black had gone too far, that a proper respect for the duty of care owed by boards to shareholders had to be upheld and that underlying ownership counted for something after all. This conflict was part of a larger battle, to be considered in the next chapter, in which a small band of regulators sought to check abuse and in which the political authorities also sought to shore up the comprised structures of the business community and to curb some of the more outrageous privileges of the new financial aristocracy.
1 J. W. Harris, ‘What Is Non-Private Property?’, in J. W. Harris, ed., Property Problems from Genes to Pensions, London 1997, pp. 175–89, 185. I have further discussion of these issues in Banking on Death, pp. 125–8.
2 William O’Barr and John Conley, Fortune and Folly: the Wealth and Power of Institutional Investing, Homewood IL, 1992, p. 107.
3 The term derived from James Burnham, The Managerial Revolution, New York 1944, but the evidence for a fragmentation of ownership was laid out in Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property, New York 1932, and the argument was further developed by Ralph Dahrendorf in Class and Class Conflict in Industrial Society, London 1959, and by J. K. Galbraith, The New Industrial State, New York 1965. I presented a critique of the concept in ‘The New Capitalism’, in Robin Blackburn, ed., Ideology in Social Science, London 1972, pp. 164–86. The cult of shareholder value in the 1970s and after was to make it clear that owners still had great leverage and provoked some reassessment of the classic argument for the eclipse of ownership by control (see, Robert Hessen, ‘The Modern Corporation and Private Property’, Journal of Law and Economics, vol. xxvi, June 1983.) J. K. Galbraith urged that the managerial ‘technostructure’ had acquired a degree of immediate control, or relative autonomy, as a result of share dispersal in The New Industrial State in 1965 and in this he was right. But the strong professionalism he believed was restraining use of this leverage has been less and less evident in recent years amongst senior executives. Across the last decades of the twentieth century, and into the twenty-first, there is evidence of a tug of war between owners and managers, with the balance tipping first one way and then another, according to the sector and period. My concern here is the impact on this balance of networks of institutional ownership which were in their infancy when the managerial revolution thesis was first elaborated. For a cross-national study of such new networks see John Scott, Corporate Business and Capitalist Classes, Oxford 1997. And for a review of the ‘managerial revolution’ debate, see Mark Mizruchi and Linda Brewster-Stearns, ‘Money, Banking and Financial Market’ in Neil Smesler and Richard Swedberg, eds, The Handbook of Economic Sociology, Princeton NJ, 1994, pp. 313–41, and Thomas Clarke, ed., Corporate Governance Critical Perspectives, vol. 2, Anglo-American Corporate Governance, London and New York 2005.
4 Michael Useem, Executive Defense: Shareholder Power and Corporate Re-organisation, Cambridge MA, 1992, p. 243.
5 Teresa Ghilarducci, Labor’s Capital, Cambridge MA, 1992, p. 130.
6 KPMG, Unlocking Shareholder Value, the Key to Success, January 2001.
7 See Robert Reich, ‘Look Who Demands Profits Above All’, Los Angeles Times, 1 September 2000, and Robert Reich, Success, New York 2000.
8 Michael Useem, Investor Capitalism: How Money Managers Are Changing the Face of Corporate America, New York 1996, pp. 1–3, 108–9, 126–7. This outstanding study, drawing on interviews with senior officers at twenty large financial and non-financial corporations, is an essential reference point for understanding the impact of institutional investors. It brings out vividly the managerial ‘culture of resistance’ to shareholder pressure, but it does not yet fully register the cult of the superstar CEO which was to burgeon in the later 1990s, nor does it foreground the conflicts of interest that were to erupt spectacularly in 2001–3. For the latter see the remarkable insider’s account: John C. Bogle, The Battle for the Soul of Capitalism, New Haven 2005, pp. 3–46. John Bogle is the founder and former CEO of Vanguard, the third-largest money manager in the United States.
9 Useem, Investor Capitalism, pp. 28–9, 110.
10 Ibid., p. 57.
11 Bogle, The Battle for the Soul of Capitalism, p. 90.
12 Useem, Investor Capitalism, pp. 70–106.
13 Bogle, The Battle for the Soul of Capitalism, pp. 36–7.
14 Arthur Levitt, Take on the Street, What Wall Street and Corporate America Don’t Want You to Know, with Paula Dwyer, New York 2002, pp. 192–4, 241. Levitt was the chairman of the SEC at this time. See also Bogle, The Battle for the Soul of Capitalism, p. 39 and Abraham L. Gitlow, Corruption in Corporate America, Lanhan MD, 2005, pp. 51–68.
15 Bogle, The Battle for the Soul of Capitalism, pp. 92–3.
16 Michael Jensen and Kevin J. Murphy, ‘CEO Incentives: Its Not How Much You Pay, but How’, Harvard Business Review, May–June 1990, pp. 138–53. See also Kevin Murphy, ‘Top Executives Are Worth Every Nickel They Get’, Harvard Business Review, March–April 1986.
17 Jensen and Murphy, ‘CEO Incentives’, p. 139.
18 Michael Jensen, ‘The Modern Industrial Revolution, Exit and the Failure of Internal Control Systems’, Journal of Finance, 1993, pp. 18–36, p. 33.
19 Robert Brenner, ‘The Boom and the Bubble’, New Left Review, no. 6, November–December 2000, pp. 5–44, 24. See also Robert Brenner, The Boom and the Bubble, New York and London 2002, pp. 150–1. For an account of how these options operate, and how attempts to make them more visible were frustrated, see Joseph Stiglitz, The Roaring Nineties: a New History of the World’s Most Prosperous Decade, New York 2003, pp. 115–27. See also Andrew Glyn, Capitalism Unleashed: Finance, Globalization and Welfare, Oxford 2006, pp. 58–63.
20 Nomi Prins, Other People’s Money: The Corporate Mugging of America, New York 2004, p. 1. Prins is a former managing director at Goldman Sachs. The article from which her data were drawn was Mark Gimein, ‘You Bought, They Sold’, Fortune, 11 August 2002. Gimein’s totals are less than are implied by Brenner’s account quoted in the previous footnote. This is because they concern fewer people and a shorter period, ending with a downturn.
21 Joann S. Lublin, ‘Another Boost for the Boss’, Wall Street Journal, 12 December 2005.
22 Jenny Anderson, ‘Profit at Goldman Sachs Rose by 37% in Fourth Quarter’, New York Times, 16 December 2005.
23 The data here is drawn from Thomas Picketty and Emmanuel Saez, ‘Income Inequality in the United States, 1913–1998’, The Quarterly Journal of Economics, vol. cxviii, no. 1, 2003.
24 David Cay Johnston, ‘Top 1% in ’01 Lost Income, But Also Paid Lower Taxes’, New York Times, 27 September 2003.
25 Gérard Duménil and Dominique Lévy, ‘Class and Income in the US’, New Left Review, no. 30, November–December 2004, pp. 105–33, 112.
26 Ibid., p. 112.
27 Ibid., pp. 117–8.
28 Franklin Allen and Gary Gorton, ‘Churning Bubbles’, Review of Economic Studies, vol. 60, 1993, pp. 813–36, p. 832.
29 J. K. Galbraith, The Great Crash – 1929, Boston 1954, p. 138.
30 Kurt Eichenwald, ‘Merrill Reaches Deal with U.S. in Enron Affair’, New York Times, 18 September 2003.
31 This is the contention of a very slightly fictionalized ‘novel’ written by an English banker directly involved in these events. See Robert Kelsey, The Pursuit of Happiness, London 2000. Note that this book, describing how an English bank helped to devise fake revenue for a Texas energy trader called ‘Hardon’, was published a year before the collapse of Enron.
32 Charles Fleming and Carrick Mollenkamp, ‘Insurers Balk at Paying Wall Street’s Penalties’, Wall Street Journal, 23–26 December 2005.
33 Ibid.
34 Robert Brenner, ‘Afterword’, The Boom and the Bubble, paperback edition, New York and London 2003.
35 A point stressed by Nomi Prins, Other People’s Money: the Corporate Mugging of America, New York 2004.
36 Abraham L. Gitlow, Corruption in Corporate America, Lanham MD, 2005, p. 13.
37 See Allen Sykes, Capitalism for Tomorrow, Oxford 2000 (which I drew on in Banking on Death) and Robert A. G. Monks and Neil Minow, Corporate Governance, Cambridge 1995.
38 Karl Marx, Capital, vol. 3, London 1991, p. 567.
39 Joel Bakan, The Corporation: The Pathological Pursuit of Profit and Power, London 2004. While I would like to have seen more attention to systematic economic forces, the author’s concluding checklist of reforms remains very useful.
40 Naomi Klein, No Logo, London 2002.
41 For a wide-ranging account which focuses on the 1980s and early 1990s see Greta R. Kippner, The Fictitious Economy: Financialization, the State and Contemporary Capitalism, Ph.D. awarded at the Sociology Department of the University of Wisconsin-Madison, 2003. See also Andrew Glyn, Capitalism Unleashed, pp. 5–76.
42 John Grahl, ‘Globalized Finance’, New Left Review, no. 8, March–April 2001, pp. 23–48.
43 See Timothy J. Sinclair, The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness, Ithaca NY, 2005.
44 Kevin Phillips, Boiling Point: Republicans, Democrats and the Decline of Middle Class Prosperity, New York 1993, p. 197; Giovanni Arrighi, The Long Twentieth Century, London 1994, pp. 314–15.
45 The ways in which big capital bullies and battens on small capital has been a theme of socialist and progressive writing from Marx’s Capital to Rudolf Hilferding’s Finance Capital, and from Jack London’s Iron Heel to Naomi Klein’s No Logo.
46 Dennis K. Berman, Henry Sender and Ian McDonald, ‘GM Auction Won’t Be Simple’, Wall Street Journal, 9 December 2005.
47 Jane Croft, ‘Banks Pile into Sub-Prime Lending’, Financial Times, 21 December 2005.
48 Edward LiPuma and Ben Lee, Financial Derivatives and the Globalization of Risk, Durham NC, 2004, pp. 90–2.
49 Shorting is not all bad. It can boost liquidity, or help to uncover inflated assets (as did the Ursus Fund in the case of Enron) but better regulated and more modest hedge funds could do this. Or these functions could be better fulfilled by other institutions.
50 Bogle, The Battle for the Soul of Capitalism, pp. 120–1.
51 In the UK, short-selling of ‘grey market’ shares in Room Service in November 2003 led to a situation where there were more trades than shares to fulfil them. The short sellers were exposed as ‘naked’ because a promised rights issue stalled. When the authorities suspended trading, and cancelled some prior trades, this damaged many who had not knowingly been involved in the shorting operation. Elizabeth Rigby, ‘Room for Change on Short-Selling’, Financial Times, 29 November 2003.
52 Richard Freeman, ‘Venture Capitalism and Modern Capitalism’ in Victor Nee and Richard Swedberg, eds., The Economic Sociology of Capitalism, Princeton and Oxford 2005, pp. 144–67.
53 Notebook, ‘Why Take Risks When You Can Take Fees?’, Guardian, 4 April 2006. See also Matthew Bishop, ‘Capitalism’s New Kings’, The Economist, 25 November 2004.
54 Donald MacKenzie, ‘Long Term Capital Managemenbt and the Sociology of Arbitrage’, Economy and Society, vol. 32, no. 3, August 2003, pp. 349–80; and Brenner, The Boom and the Bubble, pp. 171–2. For informative material on the use and abuse of derivatives see Randall Dodd, Derivatives Study Center, at financialpolicy.org. See also Henwood, Wall Street, pp. 28–41.
55 LiPuma and Lee, Financial Derivatives and the Globalization of Risk, pp. 9–10, 125.
56 ‘Battling for Corporate America’, The Economist, 11 March 2006.
57 Melody Peterson, ‘G.E. to Buy British Medical Company’, New York Times, 11 October 2003. See also Lex, ‘General Eclectic’, Financial Times, 12 October 2003.
58 ‘What Do They Teach You at Harvard Biz?’, Wall Street Journal, 23 December 1985.
59 Myron S. Scholes and Mark A. Woolfson, Taxes and Business Strategy: a Planning Approach, Englewood Cliffs NJ, 1991, pp. 410–11. Scholes, who went on to win the Nobel prize for his work on pricing options, may have been unwise to speak so confidently of the incomprehension of the tax authorities. He became a partner in Long Term Capital Management – the hedge fund which collapsed in 1998 – where he devised tax-planning vehicles. For the past few years the IRS has been prosecuting LTCM in an attempt to prove that one of its devices – a swap involving sale-lease-backs and preferred stock – was illegal since it lacked ‘economic substance’ and existed only to allow tax to be evaded. Scholes was alleged to have helped devise similar products. See Kara Scannel, ‘Meriwether Provides Glimpse into LTCM at Tax-Shelter Trial’, Wall Street Journal, 3 July 2003.
60 Cassell Bryan-Lowe, ‘KPMG Didn’t Register Strategy’, Wall Street Journal, 17 November 2003.
61 Joshua Chaffin, ‘Deutsche Bank “Provided Tax Shelter Funds” ’, Financial Times, 21 November 2003.
62 Gary Silverman, ‘The “Healthy” Pursuit of Reduced Tax’, Financial Times, 1–2 November 2003.
63 Institute on Taxation and Economic Policy, Corporate Income Taxes in the 1990s, October 2000.
64 Tax Justice Network, Mind the Tax Gap, February 2006.
65 David Kay Johnston, ‘Many Utilities Collect for Taxes They Never Pay’, New York Times, 15 March 2006.
66 Ibid.
67 Ibid.
68 Lucy Komisar, ‘Profit Laundering and Tax Evasion’, Dissent, Spring 2005, pp. 48–54.
69 Quoted Sandor Joo, ‘Is Hollinger Deal a Sale?’, International Herald Tribune, 30 March 2003.