Maximizing Shareholder Value Is (Literally) Killing Us
We depend on the research and development efforts of pharmaceutical companies to develop treatments for the most dangerous diseases on the planet, but the largest of those companies appear more interested in financial engineering than creating lifesaving drugs.
As the death toll from the Ebola outbreak approaches 5,000, public attention has turned to the failure of the pharmaceutical industry to develop effective vaccines or treatments for the disease. World Health Organization director-general Margaret Chan lambasted the pharmaceutical industry, blaming the for-profit nature of the industry for its failure to invest in treatments for life-saving illnesses. “The R&D incentive is virtually nonexistent,” she said. “A profit-driven industry does not invest in products for markets that cannot pay.”
What does the pharmaceutical industry invest in? For one thing, it is more profitable to treat chronic conditions that afflict the wealthy, such as erectile disfunction, than to cure life-threatening diseases that only need curing once. But there is also a deeper problem: pharmaceuticals are slashing their budgets for developing new drugs in favor of ramping up spending on financial engineering.
In 2013, Pfizer, the world’s largest drug manufacturer by sales, cut its R&D budget by $800 million to $6.6 billion, which is $2.8 billion less than its R&D budget in 2010. The company expects to spend roughly the same amount in 2014. While it has been reducing the amount it spends on developing potentially lifesaving drugs, Pfizer has been disgorging enormous chunks of cash to its shareholders, buying back $39 billion of its own shares since 2013. By buying back shares from stockholders, corporations can inflate stock prices, hit earnings per share targets, and, not least, increase CEO pay: $12.94 million of Pfizer CEO Ian Read’s total 2013 compensation of $25.23 million came in the form of company stocks and stock options.
By cutting R&D expenditures and channeling cash to buybacks, Pfizer effectively redistributed funds from productive R&D investments to Wall Street (and its CEO’s pockets). As UMass-Lowell economist William Lazonick has documented, of the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012, those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock. Dividends absorbed an additional 37% of their earnings. As Lazonick points out, that left very little for investments in productive capabilities.
Beyond buybacks and dividends, mergers and acquisitions are also consuming company resources that could go to R&D. In May 2014, Pfizer made an unsolicited $100bn bid for the UK pharmaceutical manufacturer AstraZeneca. The stated motivation for the acquisition is that it would enable Pfizer to do a tax inversion, in which a US company acquires a foreign subsidiary and reincorporates in the foreign jurisdiction in order to avoid paying US taxes. Although rebuffed, Pfizer is preparing a second bid once the six-month cooling off period expires, with Ian Read continuing to publicly tout the benefits of tax inversion.
This is only the latest episode in a frenzied period of merger and acquisition activity in the industry. Rather than develop their own new drugs, pharmaceuticals corporations are buying each other for the patent rights to drugs that have already been developed. For example, in 2000 Pfizer acquired Warner-Lambert Parke-Davis. The driver of that $90 billion deal was control of Lipitor.
What makes the shameless pursuit of tax inversions so notable is that the pharmaceutical industry is a massive recipient of public subsidies, which go primarily to R&D in new drugs. Marcia Angell, former editor of the New England Journal of Medicine, has argued that public subsidies for drug research mean that “taxpayers pay twice, first for research and development, and then they pay high prices at drugstore.” According to a document obtained via a Freedom of Information Act request by the group Public Citizen, National Institute of Health funded scientists conducted 55% of the research projects that led to the discovery and development of the top five selling drugs in 1995.
Why do Pfizer and other drugmakers behave in this way? They say they are doing it to maximize shareholder value. The dominant theory of the firm in mainstream economics is that capitalist corporations best perform their social function of generating prosperity when the firm’s officers devote themselves single mindedly to the purpose of maximizing value for shareholders. According to so-called principal-agent theory, corporate managers will not act in this manner unless they are compelled to do so by empowered shareholders. The stockholders, in other words, are the principals, and the executives are their agents. Why, of all groups in the firm, are shareholders considered the principals? The argument is that is that while other constituencies within the firm—workers, bondholders, the government, and customers—are protected by contracts, shareholders are not and bear the residual risk. Thus, only by being accountable to shareholders will executives undertake risky but worthwhile investments.
But what we are seeing in the pharmaceutical industry is not entrepreneurial investment in lifesaving drugs, but “investments” in purely financial short-term pursuits like M&A, dividends, and share buybacks. Rather than a way for firms to raise money to finance productive investment, the stock market appears to be a way for shareholders and CEOs to shake cash loose from corporations that could have used the money to finance real investment.
The argument that maximizing shareholder value compels firms to undertake the most socially beneficial investments is fatally flawed. For one thing, the average holding period for a share is three months, hardly consistent with the notion of the shareholder as a committed steward of the firm’s assets. For another, shareholders have diversified portfolios and actually bear little risk if one of their investments goes sour. As Financial Times columnist Martin Wolf has pointed out, shareholders are not the only bearers of risk in the corporation, as many others are also exposed to risks against which they cannot be protected by contract: long-term workers; long-term suppliers; and, not least, the government jurisdictions in which companies operate. As Wolf argues, workers tend to stay with a firm longer than three months, and cannot easily diversify their employment. Perhaps workers should have more of a say in corporate decision making. And in the case of the pharmaceutical industry, the government stakeholder is one that has invested billions of public subsidies into these firms, and has an interest in seeing them both pay their fair share of taxes and develop new vaccines and cures.
If we want our pharmaceutical corporations to develop the lifesaving drugs that it is the function of that industry to create, we are going to have to do something about the dangerous ideology of shareholder value.