FinanceProfessor.com

The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems

Michael C. Jensen

Journal of Finance July 1993

Note: this was the Presidential Address to the AFA in January 1993. It has been published in several Journals. I am using the Journal of Finance. The classic paper is one of my all time favorites and I urge all to read it.

Executive Summary:

Changes in many areas caused the Second Industrial Revolution which created excess capacity in many areas. For any number of reasons, internal controls failed to meet these changes. External forces (raiders and other capital market transactions) helped solve the excess capacity problems and helped reallocate resources back to their most highly valued use.

"Fundamental technological, political, regulatory, and economic forces are radically changing the worldwide competitive environment. We have not seen such a metamorphosis if the economic landscape since the Industrial revolution." As a result, business had to change the way they operate and the way they were organized.

Change is never popular, nor easy. Like in the Industrial Revolution, internal control systems did not keep pace and excess capacity developed. In each case (the Industrial revolution of the 1890s and the Modern Industrial Revolution in the 1980s-1990s), the capital markets came to the rescue.

Note that the merger wave of the 1890s is most known for horizontal mergers and the rise of the "Robber Barons" who consolidated many smaller firms. While the merger wave of the 1980s is often characterized as highly leveraged, hostile, and a core consolidation wave.  Note that each wave led to major changes in the legal environment.

In each of these merger waves, the leaders came under harsh criticism (here the author gives examples from the 1800s that show the similarities--example worries of two classes of people in the Populist Party's 1892 platform.)

Jensen goes into a fairly high level of detail showing that as the First Industrial revolution created excess capacity in certain sectors, so too did the Second Industrial Revolution. Specifically he shows that 1981 signaled major productivity improvements. These signaled the excess capacity that would be an impetus for the coming acquisitions. It is noted later in the paper that this excess capacity was the result of technological improvements that can be of two forms: capacity expanding or obsolescence-creating. The former is when we can produce more due to technological changes, the latter is when a new technology makes old technologies obsolete--here Jensen uses Wal-Mart as an example.

Jensen makes a point that the oil crises of the 1970s (1973-1979) may have been a motivating factor in forcing firms to become more efficient. This "original energy-motivated reexamination of corporate processes helped initiate a major reengineering of company practices and procedures that still continues to accelerate."

Macro Policies

Macro policies played a major role in creating the environment that allowed for these productivity gains. This topic can contain many topics but notably deregulation (banking, financial services, banking, airline, trucking, and telecommunications) and different tax codes. Jensen notes that decades of "managerial focus on growth…caused many firms…to overshoot their optimal capacity, setting the stage for cutbacks, especially in white-collar corporate bureaucracies. Specifically, in the decade from 1979 to 1989 the Fortune 100 firms lost 1.5 million employees, or 14% of their workforce."

Technology

Obviously "massive changes in technology" has played a major role in the development of excess capacity. Jensen gives many examples:

• Radial tires that last 3 to 5x's longer
• Personal Computers
• Aluminum and plastic advancements
• Fiber optics, satellites, cellular phones

Organizational Innovation

(Often tied to technology) Flatter hierarchies (as a result of easier communications), coupled with Japanese emphasis on JIT inventory systems, and flexible manufacturing have also caused excess capacity.

Other:

Globalization of trade and revolutions on Political Economy (and the end of the Cold War) also had major impacts.

Many firms found it difficult to exit their industry. "In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest." Why do firms not see the problem? They might, but might not have the proper incentives to do much about it. "For the managers who must implement these decisions, shutting plants or liquidating the firm, causes personal pain, creates uncertainty, and interrupts…careers. Rather than confronting this pain, managers generally resist such actions as long as they have the cash flow to subsidize the losing operations." (This in yet another example of the free cash flow problem Jensen 1986))

Contracting problems, both explicit and implicit, can cause many of these problems. These contracts can be between many different stakeholders. For example union contracts, CEO compensation, long-term supplier contracts.

"There are only four control forces operating on the corporation to resolve these" problems.

1. Capital markets
2. Legal/political/Regulatory system
3. Product and factor markets
4. Internal control systems

Due to the failure of the other forces, specifically the internal control systems, the capital markets played a major role in the resolution of the capacity problems.

Jensen then gives many measures that these market-driven changes were good for the economy.

Jensen also makes recommendations as to how to improve the Board as an effective monitor. Specifically he says the board Culture must be changed--no longer can the CEO and Board be as friendly, boards must have greater financial knowledge, boards should also be smaller, member liability issues must be addressed, and board and manager ownership should be increased.