Disgorging the social settlement: What the Paradise Papers tell us about firms
The Paradise Papers reveal how debt and other financial mechanisms are used to move funds offshore and avoid tax. New constraints on firms and managers are needed
Adam Leaver, Professor in Accounting and Society and co-director of SPERI
Back in the 1980s, concern about lagging competitiveness in publicly listed firms led to the popularity of agency theory explanations for underperformance. Authors like Michael Jensen told a very simple, yet seductive story about the costs associated with the separation of ownership and control. For Jensen, successful, competitive firms must be able to generate a good return on a set of capital inputs, but the problem with PLCs was the propensity for managers to reinvest rather than disgorge the corporate ‘free cash flow’ (operating cashflow in excess of that required to finance positive return investments). Jensen argued that funds were diverted to finance unnecessary investment or unsuccessful acquisitions, when they could and should have been returned to shareholders. This reflected a tendency on the part of management to either satisfice and take the easy option or aggrandise by using someone else’s money to build larger, less efficient combines.
Jensen recognised that the key to boosting efficiency was to curtail the excesses of management by imposing constraints on their discretion. For Jensen, managerial performance could be improved by using the discipline of the capital market, specifically debt. Leveraged buyouts would apparently sharpen managerial wits because mandatory interest payments and an obligation to repay higher levels of debt pushed the firm that much closer to bankruptcy (and increased returns on equity). It would incentivise managers to divest underperforming assets and to select only those investment projects with some potential for high returns. Debt – it was said – made managers get up in the morning. This, combined with different governance and remuneration systems, would better align manager and owner interests and improve competitiveness.
It is easy to be cynical when returning to texts written close to 30 years ago. We should not disparage an author whose sharpness and clarity of thought are a hallmark of all of his writings. Jensen’s frame of reference was a unitary firm; he could not have foreseen the dramatic changes to the corporate form disclosed in the recent Paradise Papers – the uses of LLPs, the chains of holding companies and subsidiaries, the strategic importance of accounting and law expertise and the centrality of secrecy jurisdictions. In many of these cases debt is a central mechanism for diverting funds through inter-group networks to tax havens.
Far from imposing discipline on management, debt has opened up all kinds of opportunities for financial discretion and liberated managers (and manager-owners) from the sort of difficult operational decisions we would normally associate with their role and pay grade. What is the point, after all, in taking risks on future investments that might raise productivity and improve returns, if similar or greater returns can be made to owners by letting someone else rearrange the company’s tax affairs? A penny saved on tax now is in many ways better than a penny made on investment in the future. This is not even a particularly difficult enterprise. What the Paradise Papers show are common patterns of jurisdictional arbitrage and tax avoidance, suggesting this is now a mundane, routinized process – echoing recent international political economy work on the organization of wealth chains.
This ultimately is the problem with secrecy jurisdictions and the uses of debt and other financial methods of extraction – they sedate the creative impulses of socially useful entrepreneurialism. If money-making becomes too easy, capital will flow to those areas at the expense of others. It is now too easy for firms and individuals to strip cash out of bloated assets and shift the proceeds to tax havens and this now distorts the overall allocation of capital within the national economy. At a time when many are wondering why productivity has flat-lined and GDP growth is so low – it is not inconceivable that part of the story is that we’ve made it just too easy for capital to realise the kind of returns it will tolerate for minimal effort by improving the ease with which funds can be moved offshore.
Jensen was wrong about debt: it does not disgorge the free cash flow; it disgorges the domestic social settlement by evicting the claims of the state. But he was right about managers: they have too much discretion and it is now too easy to free ride on bought-in law and accounting advice, which keeps owners happy for minimal effort, but does little for anyone else.
If capital markets can’t impose the disciplinary constraint required to restore our economic fortunes, perhaps labour markets can? Higher wages would put a floor under competition and prevent management from using the other easy levers of casualisation and intensification to generate returns. More robust union rights could act as a bulwark against sleepy managers – to get them up in the morning; and increased workplace democracy, including a seat on the board, would add dissenting voices in the boardroom to aid the repatriation of capital from the offshore world, kicking in domestic positive externalities.Print page
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