Deplorables, lumpenproletariat and the one-person one-vote rule

Brexit and Trump brought back an old debate that marked the origins of democracy – should the right to vote be a universal right or be limited to some classes?

In the beginning the major concern centred on the possibility that the destitute would vote to expropriate the rich, and therefore the right to vote was restricted to those with property. This concern was progressively abandoned and, if anything, Trump’s victory promising huge tax cuts for the rich shows that the risk of voting to take from the poor to give to the rich also exists.

Another concern was in relation to socially marginalized persons.

In The Eighteenth Brumaire of Louis Napoleon (1852), Karl Marx named them as the lumpenproletariat, including: “Alongside decayed roués with dubious means of subsistence and of dubious origin, alongside ruined and adventurous offshoots of the bourgeoisie, were vagabonds, discharged soldiers, discharged jailbirds, escaped galley slaves, swindlers, mountebanks, lazzaroni, pickpockets, tricksters, gamblers, maquereaux [pimps], brothel keepers, porters, literati, organ grinders, ragpickers, knife grinders, tinkers, beggars—in short, the whole indefinite, disintegrated mass, thrown hither and thither, which the French call la bohème”.

This year, in a regretted declaration, Hilary Clinton coined her modern-day equivalent of “deplorables”, by saying: “to just be grossly generalistic, you could put half of Trump’s supporters into what I call the basket of deplorables. Right? The racist, sexist, homophobic, xenophobic, Islamaphobic — you name it. And unfortunately there are people like that”. Her definition enlarges the concept of marginal to those that do not share the values of western democracies.

A third category includes the so-called welfare bums, that is people without work living on benefits. This group has grown significantly in advanced economies and is likely increase further as the pace of robotics increases. Indeed, in the future they may become the majority.

The concern about giving such people the right to vote is that they may be easily manipulated to vote for unscrupulous populist leaders like Trump or Chavez.

This is certainly true, but it is no reason to abandon voting as a universal right.

It is the essence of democracy that, in any highly contested election, the winner may win the majority with the votes of a small group of voters, no matter how outrageous their views are.

Democracy does not guarantee that the electorate always selects the best candidates. What it needs to safeguard is that people remain free to vote out the leaders.

Here resides the safety and supremacy of democracy, and it must be secured in four main domains: a) some decisions, like constitutional amendments, must be approved by a qualified majority; b) direct democracy (referendum or plebiscites) must be limited to local or moral issues; c) those in government must not use the resources of the state to promote themselves or to harass their opponents; and d) last, but not least, the constitution must enshrine the principles of the division of powers and the rule of law.

At the present, the USA applies these principles. So, the election of Trump must be seen as the normal working of democracy. All that his opponents must do is fight any attempts to pervert the principles listed above and to show that his policies are wrong.

If they do it right, he will not be re-elected and the electorate will have learned a lesson. This has nothing to do with restricting the fundamental principle of democracy - “one-person, one-vote”.

Control theory and minority shareholders

Shareholder dispersion raises two related issues – the possible emergence of a control premium and how to protect minority shareholders from collusion between managers and controlling shareholders.

The growing size of firms requires an ever growing dispersion of shareholders and it becomes impossible or risky for a single investor to control 50% +1 of the votes. For instance, in 2015, the largest strategic shareholder (Mitchell’s Michael Kent) in the smallest cap constituent of the S&P 100 index - Devon Energy Corp – owned only 5.07% of the company, less than the 5.46% owned by The Vanguard Group which caters for retail investors. Moreover, the top 10 investors owned jointly less than 32%, while overseas investors from 30 different countries owned 28%.

So, since individual shareholders or groups of controlling shareholders often own less than 50% of the votes, it is normal that such control might be challenged by other investors, thus creating a market for company control. Of course, this requires the existence of an advantage in controlling a company sufficiently large to justify a so-called control premium.

Why should there be any advantage in being part of the control group if trading on insider information is forbidden and management has to treat all shareholders fairly? Finance literature usually explains such interest in terms of governance to discipline the incumbent management more efficiently than through internal control systems.

The assumption underlying such reasoning is that the influence it gives to controlling shareholders in terms of nominating and compensating managers following policies aligned to their interest is offset by a strong discipline preventing managers and controlling shareholders from engaging in tunneling and abuse of non-controlling shareholders.

Yet, even in large markets, like the USA where it is possible to have a lively takeover market, most of the takeover deals are driven by short term financial profits secured through buyout and arbitrage strategies, often at odds with the interest of long term investors. Moreover, even where the judiciary can be relied upon to prevent corporate raiders from expropriating the target’s resources there are still circumstances when some categories of investors can collude with management.

Elsewhere, Mendes (2011), I examined why trade investors may collude with managers to vote for star-like compensation, lowering the return to other investors which lack any self-interest market mechanism to prevent such predatory behavior. In the case of trade investors the materiality and scope for collusion depends on the possibilities to switch suppliers, their relative size and the greed of management. So, the question now is to discuss if it is possible to correct such inefficiency through regulation.

The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights or a combination of both. The first could be easily defined but it can be easily evaded. In particular, for suppliers of financial services, such limits could be easily circumvented by investing indirectly through investment funds managed by them.

Limiting the voting rights of trade investors who are major suppliers is probably a better solution. It does not disrupt arms-length trading relations and it is easily enforced. The only debatable issues would be about the classification of trade investor and the voting restrictions. Beyond the traditional restrictions on voting in related-party transactions, restrictions should cover voting for the election of management and their remuneration, but they could extend to voting in the governance and auditing committees.

Nevertheless, regulation always has its own costs, which cannot be disregarded lightly. In particular, discouraging trade investors may have its costs in terms of business intelligence and synergies.

Still, overall, I believe that easing takeover regulations and limiting the voting rights of trade investors are market perfecting policies, contributing to true market capitalism and the protection of minority shareholders.

Why trade investors collude with managers to vote for star-like compensation

The star-like compensation of CEOs and other senior managers is undermining the trust of people in the fairness of capitalism. The spiraling of shocking compensation packages continues because the market system does not have built-in self-interest incentives that prevent collusive behavior between trade investors and managers. The problem is more acute in listed companies with high levels of float and with significant shareholdings by trade investors that do not compete to supply or finance the company.

A simple numeric example is enough to illustrate the problem. Consider the case of an investor who is contemplating investing in two almost identical companies—Companies A and B—trading at the same multiple of earnings, with the same expected risk and a rate of return on equity of 20%. Company B is a potential major supplier or financier of A, but is not currently trading with Company A. Both companies have the same asset turnover and leverage. After paying the current market rate of 1% of profits as management compensation, they each generate a net profit of 10%.

Prudence dictates that the investor should diversify by investing in both companies. However, given that A and B have the same expected return and risk, regardless of how the investor chooses to split his investment (whether 50/50, 10/90, or any other way), his expected return will be always 20%.

Imagine now that the CEO of Company A only needs 10% to control the board of directors and approve a pay raise that triples his compensation to 3% of profits. Management approaches the trade investor and asks him to invest 10% in company A and vote for the proposed pay rise in exchange for A giving B 10% in new business, provided that B matches the price of the suppliers replaced.

As long as the investor is able to lead a majority of shareholders in Company B, they will keep the Company B managers’ pay at 1%, so that his total return from both companies will now increase by 8.81% to an average return of 21.76%. Since there is no new value creation, the gains obtained by management and the new insider investor are made partly at the expense of the remaining shareholders in Company A, but mostly at the expense of the replaced vendor. The reduction in return incurred by the shareholders in A would be just 0.39 percentage points (i.e. 1.94%). This small loss could be either concealed or compensated if the other 40% of insiders supporting management protest.

It remains to be shown if there are any self-interest market mechanisms to prevent this predatory behavior. There are three candidates to oppose the insider investor’s actions in the above example: the managers of company B, the suppliers displaced, and the other investors in Company A—but none will be able to prevent such behavior. Here’s why:

The managers of B could try to get a similar pay raise by threatening to leave and bid for the job of A’s managers. If they were to get a similar raise, this would offset a large share of the investor’s gain. However, as a controlling shareholder, the investor can easily collude with A’s managers and other insider shareholders to stop such a bid. Thus, the managers of Company B can only threaten to shirk on their increased workload and ask for a modest raise. For instance, if they manage to get a 20% raise, this would only reduce the trade investor’s return to 21.72%.

The suppliers replaced may or may not be among the current group of insider shareholders. In the first case, they would try to fight the managers, but unless they can attract other shareholders to their cause, the only way they can retaliate is to sell their position to hurt the stock price. However, this would mean the supplier’s adding a self-inflicted capital loss on top of his business loss as a supplier, while simultaneously lowering the entry price for the new rival investor.

Next, imagine that the non-insider investors of Company A wished to retaliate against the managers’ pay raise by selling their stock. This would result in a self-inflicted loss for the late sellers. This loss could only be prevented if the insiders stepped in to buy the shares, or if management acted to offset a possible decline in the stock’s price by promising to pay an increased dividend or by introducing a share buy-back program. Forced to choose between certain loss and a promise, they will be more inclined to bet on the manager’s ability to avoid a decline in the stock price.

Finally, if the replaced suppliers were not yet shareholders, they might try to keep the business by outbidding the investor and invest the same amount while supporting A’s management in a bid to get an even higher pay raise. However, they could not outbid the rival investor. The pay incentive would only work if they could compensate the other insider investors, and their investment in A would have a lower return than that of the new investor since they would not gain from increased sales to their business.

The numeric example given above can be replaced by a model to work out the optimal investment allocation between A and B, including the more common situation where Companies A and B are different, but it is easy to see that the optimal outcome will also depend on the possibilities to switch suppliers and the greed of Company A’s management. It is nevertheless unquestionable that there is a large incentive for collusion between management and trade investors against other investors in A and its current suppliers.

Are the costs of this market failure large enough to damage the working of market capitalism? If so, then the question now is to assess if it is possible to correct this inefficiency through regulation.

The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights, or a combination of both. The first could be easily defined, but it can be easily evaded. In particular, in the case of shareholdings by suppliers of financial services, such limits could be easily circumvented by investing through investment funds managed by those financial institutions.

Limiting the voting rights of trade investors who are major suppliers of Company A is probably the best solution. It does not disrupt arms’-length trading relations, and it is more easily enforced. The only debatable issues would be about the qualification of trade investors and the voting restrictions. These should cover voting for the election of management and their remuneration, but they could also extend to voting in the Governance and Auditing Committees.

Regulation always has its own costs, which should not be disregarded lightly in a full assessment of this proposition. In particular, the possibility of discouraging trade investing may have its costs in terms of business intelligence and synergies. However, overall, limiting the voting rights of trade investors would be a market-perfecting policy that would contribute to achieving the ideal of true market capitalism.