Introduction I. Challenge #1: Shareholders, Sports Bettors, and the Dangers of the Expectations Market A. Appreciating that the Starting Point Matters B. Understanding the Relationship Between the Bettor and the Organization that Is the Subject of the Bet C. Calibrating the Concerns to the Context II. Challenge #2: Business Executives, NFL Players, and the Structure of Incentive Compensation A. Valuing Efficient Markets B. Designing Real-Market-Based Monetary Compensation C. Employing Non-Monetary Incentives III. Challenge #3: Business Customers, NFL Fans, and the Maximization of Customer Delight. Conclusion Introduction
The lovely double entendre in the title of Dean Roger L. Martin's book, Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL, (1) encapsulates Martin's argument that the American system of business and capitalism is rigged, but can still be repaired. (2) Drawing on an unlikely source--an analogy to the National Football League (NFL)--Martin argues that business should shift its focus away from the "expectations market" (i.e., in football, the betting world, and in business, the stock market, where stock prices reflect investor expectations of future performance) and back to the "real market" (i.e., in football, the game on the field, and in business, the creation of products and services). (3)
Martin contends that the business world's overemphasis on the expectations market leads to the sacrifice of long-term business growth in favor of higher short-term stock prices; (4) incentivizes inauthentic and amoral behavior by executives and other market players who withhold or manipulate information through earnings management, pumping of the stock price, and accounting fraud or otherwise; (5) entices market players to create economic volatility, which enables them to "tak[e] advantage of less-sophisticated investors while creating no net value for society;" (6) and creates a "downward spiral" in which market players try to increase their piece of a "finite pie" at the expense of other market players rather than trying to expand the size of the pie by creating societal goods. (7) That is, American capitalism's expectation-market orientation destroys shareholder value rather than increasing it. In contrast, Martin argues that reorienting business toward the real market could provide an "opportunity to build for the long run ... and produce sustainability"; restore authenticity in our executives; reduce volatility and the influence of parasitic market players; and create more value for customers and society, making everyone (including shareholders) better off. (8) To accomplish this reorientation, Martin makes several specific recommendations, (9) the unstated upshot of which is to recommend that businesses remain private to the extent at all possible.
Fixing the Game makes powerful and persuasive arguments. Martin's analogy between business and the NFL is quite useful, and not solely for the substantive lessons Martin distills. In addition, the analogy makes the debate about corporate governance accessible to a wider audience, (10) gives this audience a more familiar lens through which it can understand the sometimes arcane aspects of business law and practice, and enables each member of this audience to draw on her sense of good sportsmanship in order to develop her own intuitions about what constitutes fair business practices. Moreover, the analogy can help even sophisticated businesspeople better appreciate some of the flaws of the system in which they operate.
However, the analogy between business and the NFL is far from perfect. Martin clearly acknowledges this, (11) but a more thorough exploration of the flaws of the analogy will help to refine the analysis. Thus, this Article challenges three (12) aspects of the analogy and discusses how these challenges ought to alter Martin's recommendations. First, imperfection in the analogy between shareholders and sports bettors suggests a stronger condemnation of hedge funds and the derivatives market than of the traditional stock market. Second, the limitations of the analogy between business executives and NFL players weaken Martin's case against the use of stock compensation for executives. Third, the flaw in the analogy between business customers and NFL fans suggests that a reorientation of business toward the maximization of "customer delight" is unrealistic and perhaps unwise, particularly if the business needs capital. Ultimately, the intent of this Article is not to reject Martin's recommendations; rather, the goal of this Article is to help refine and further Martin's work as we face the daunting tasks of reforming corporate governance and growing the economy.
Challenge #1: Shareholders, Sports Bettors, and the Dangers of the
Martin analogizes shareholders to sports bettors and capital markets brokers to bookies, (13) and he uses this analogy to argue that, just as the NFL's business decisions are not driven primarily by the expectation (sports betting) market, American business should not be driven primarily by the expectation (stock) market. (14) Instead, he argues that, in both cases, the real market should be the focus. This is the main theme of the book, and this view motivates Martin's specific recommendations discussed in Part II and Part III.
However, this argument suffers from a flaw in the analogy. There is an important difference between shareholders and sports bettors. shareholders are owners of the underlying enterprise, while sports bettors are not. A sports bettor makes a naked wager, with no real stake in the enterprise, which makes a sports bettor more analogous to a trader in derivatives (15) than to someone who merely owns stock of a corporation. Thus, when Martin uses a sports betting analogy to argue that catering to the expectations market poses tremendous dangers, his argument resonates more strongly in the context of the derivatives market (particularly where the positions are used primarily for speculation rather than hedging) (16) than in the context of the traditional stock market.
Appreciating that the Starting Point Matters
While both a stock's price and a game's spread reflect projections about an outcome, the value of a stock is derived not only from the expectations of future earnings, but also from the value of the underlying assets. (17) That is, a sports bettor cares only about whether performance expectations are met (for example, did Team X beat the spread?), whereas a stockholder cares also about the starting point for setting those expectations (for example, is Team X a good team with a lot of wins or a bad team with no wins?). To illustrate, consider an example that Martin uses, comparing the 2007 New England Patriots and the 2007 Cleveland Browns. (18) The Patriots, who were unbeaten in the regular season, covered the spread on games only 10 out of 16 times, whereas the Browns, who had a 10-6 regular season record, covered the spread 12 times. (19) Martin argues that, if the expectations market mattered more than the real market, then the Browns would have been considered more successful and the Browns' quarterback would have out-earned the Patriots' record-setting quarterback. (20)
That discussion of performance relative to expectations disregards an important measure of each team's worth--its underlying value (that is, each team's starting point relative to which expectations are set). This can be illustrated by building on Martin's analogy: As of the start of the 2007 season, the Patriots averaged more than 11 wins per season since 2001, appearing in the playoffs five times and winning three Super Bowls. (21) In contrast, over the same time period, the Browns averaged fewer than six wins per season, and lost in their one and only playoff appearance. (22) Given these historical performances, the Patriots' pre-season odds for winning the year's Super Bowl (the futures odds) (23) were better than the Browns'. (24) Martin notes that the Browns performed better against the spread over the course of the season than the Patriots. As the Browns' over-performed (relative to expectations), the Browns' odds to win the Super Bowl improved. (25) Nevertheless, the futures odds for the Patriots to win the Super Bowl remained better than the Browns' futures odds even as the season progressed. (26)
That is, a very bad team that outperforms expectations is likely to have its long-term odds improve, while a very good team that underperforms may have its long-term odds worsen, (27) but the odds of the underperforming very good team should still be better than the odds of the over-performing but very bad team. Similarly, a company's stock price, like a team's long-term odds of winning the Super Bowl, reflects more than just under-and over-performance relative to expectations in any particular period.
Understanding the Relationship Between the Bettor and the Organization that Is the Subject of the Bet
A shareholder's ultimate economic claim (i.e., upon liquidation and winding up of the investment) is against the company, whereas a sports bettor's economic claim is against the bookie, not the team. Thus, a shareholder should always prefer the value of the company to increase because the terminal value of stock upon liquidation depends upon the company having value available to distribute. (28) In contrast, a bettor is not necessarily interested in increasingly good performance of the team that is the subject of his bet; if he bets against the team, he prefers bad performance by the team. To him, it is perfectly fine if the team loses all of its value (or games) because he does not depend on the team for his economic entitlement--he depends on the creditworthiness of the counterparty to the bet (i.e., the bookie). So too with derivatives, an investor in a derivative generally does not depend on the company from whose securities the derivative is derived...