Why are you working harder for less? Scientific Management, management consulting, and leveraged buyouts – a century of being conned.

I described leveraged buyouts the other day — in connection with the demise of the maker of the Simmons Beauty Rest Mattress — as a symptom of why we don’t trust Wall Street. You might wonder why, if I’m right, we allow people again and again to “buy” companies by borrowing enormous sums of money — in essence, we allow the buyers to suck money out of successful companies for their own benefit in the same way we allowed home owners in a rising housing market to suck money out of their homes by means of home equity loans.

It’s perfectly clear why we allowed homeowners to do that — all involved figured the market would continue to rise at least until they could make their money and get out. But why do we let this keep happening on a much larger scale on Wall Street?

I hadn’t considered the question specifically at the moment I wrote that post about Simmons. It was enough for me that throughout the 25 years of my career both practicing (in connection with, among many things, leveraged buyouts) and teaching I’ve seen the phenomenon again and again. But this week I came across Jill Lepore‘s article “Not So Fast” in the New Yorker, an article which asks the question, “Scientific management started as a way to work. How did it become a way of life?” Lepore’s article is about the rise in the early 20th Century of “Scientific Management,” the foundation of modern “Management Consulting.” Scientific Management was created by Fredrick Winslow Taylor, who, as Lepore writes, sold himself as someone able to make businesses more efficient:

Speedy Taylor, as he was called, had invented a new way to make money. He would get himself hired by some business; spend a while watching people work, stopwatch and slide rule in hand; write a report telling them how to do their work faster; and then submit an astronomical bill for his services. He is the “Father of Scientific Management” (it says so on his tombstone), and, by any rational calculation, the grandfather of management consulting.

The problem, as Lepore notes, is that Taylor was a fraud, and Taylorism’s grandchild, management consulting, is as well.

What does all this have to do with leveraged buyouts? Plenty. The entire rationale of the leveraged buyout is that the buyers can take a company with a lot of unrealized value and realize it. How? By making the company more “efficient.” The debt taken on to buy the company (and to reward the “buyers” with profits along the way) will, the argument goes, easily be paid off given the as yet unrealized efficiencies. Thus, we’ve had decades of “downsizing” (massive layoffs), “consolidations” (elimination of competing businesses), and arguments that advances in productivity brought about by our new technologies would redound to the benefit of all (when the only benefit would redound to whoever could pull the money out quickest).

We’ve been had.

At least we have one consolation — none of us have been alone in being conned. The focus of Lepore’s work is Louis Brandeis, someone I’ve always thought was a very bright guy and who against all evidence remained convinced his entire life that Scientific Management would benefit the working person:

Neither unions nor businesses have lived up to Brandeis’s optimism. “If the fruits of Scientific Management are directed into the proper channels,” he wrote, “the workingman will get not only a fair share, but a very large share, of the industrial profits arising from improved industry.” Lately, that share has been going to shareholders and C.E.O.s. Home and work, separated since the first stirrings of the Industrial Revolution, have been growing back together again: BlackBerry on the nightstand, toaster in the photocopy room. Efficiency was meant to lead to a shorter workday, but, in the final two decades of the twentieth century, the average American added a hundred and sixty-four hours of work in the course of a year; that’s a whole extra month’s time, but not, typically, a month’s worth of either happiness minutes or civic participation. Eating dinner standing up while nursing a baby, making a phone call to the office, and supervising a third grader’s homework is not, I don’t think, the hope of democracy.

You’ll also find worthwhile on this topic the New York Times video series entitled “Flipped: How Private Equity Dealmakers Can Win While Their Companies Lose“

The Greening of Amsterdam

One of the joys of living in Amsterdam is the opportunity to bike everywhere and at any time. The city is built for and entirely operates around the predominance of bicycles as a means of transportation. It’s not U.S. bicycling, with expensive bikes and helmets. You ride one-speed junker bikes that no one wants to steal, but the city is small and flat, so you don’t care much.  But Amsterdam wants only to become greener and more energy efficient:

The City of Amsterdam has selected Accenture to help implement its ‘Amsterdam Smart City’ program and create the European Union’s first ‘intelligent city.’ The purpose of the Amsterdam Smart City program is to take a comprehensive and coordinated approach to developing and implementing sustainable and economically viable projects that help the city reduce its carbon footprint and meet the European Union’s 2020 emissions and energy reduction targets.

And Amsterdam, apparently, is on the cutting edge of energy efficiency in urban planning. According to Business Week, “unlike cities that could take decades to upgrade their infrastructure, Amsterdam aims to complete its first-round investments by 2012. That makes it one of the first and most ambitious adopters of the smart city concept, attracting attention from policymakers worldwide hoping to glean lessons from the green experiment.” Just last week, on Utrechtsraat, a major shopping avenue in the center of the Dutch capital not far from where I am living, electric trucks have begun to pick up the trash, and the electronic displays on the local bus and tram stops are powered by small solar panels. “Elsewhere, 500 households will pilot an energy-saving system from IBM and Cisco aimed at cutting electricity costs. An additional 728 homes will have access to financing from Dutch banks ING and to buy everything from energy-saving light bulbs to ultra-efficient roof insulation.”

Why do we enforce contract promises?

Over the course of my professional career, Law and Economics has grown from one school of thought among many to one so dominant that many of its postulates have virtually become unquestioned premises from which legal reasoning begins. The Law and Economics school of thought is wide-ranging, but might fairly be described the way Wikipedia puts it: Law and Economics is an “approach to legal theory that applies methods of economics to law. It includes the use of economic concepts to explain the effects of laws, to assess which legal rules are economically efficient, and to predict which legal rules will be promulgated.”

One of the most influential premises of Law and Economics is that contractual promises are enforced purely because of their capacity to maximize the society-wide allocation of resources. Thus, it is said that the contractual promise has no moral value over and above its economic value. This view both explains why typically someone suing for breach of contract can recover only the financial equivalent of the benefit they would have received had the contract been performed. There is no additional quantum of damages added to provide an incentive not to breach.

Thus, it is said, a contractual promise is in fact a promise either to fulfill the promise or to pay the damages that result from breach. This view, it is argued, has long been the view of the common law, as exemplified by Oliver Wendell Holmes’ late 19th Century statement that “the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it, and nothing else.” Thus, the thinking goes, if someone who has made a contractual promise can make out better by breaking the promise, paying damages for breach, and entering a different deal, that result is not merely tolerable — it is to be desired. Such a breach of promise is known as an “efficient breach” because it theoretically results in an increase in overall resources: the party injured by the breach is supposed to get everything he was supposed to get under the contract, the breaching party is getting something better, and the new party with whom the breaching party contracts is getting a deal he would not otherwise have gotten.

The Law and Economics view is by no means the only one current in the theorizing about the basis for enforcing contractual promises (and the interpretation Law and Economics devotees put on Holmes’ statement is disputed). As a contracts professor and litigator, though, my experience is that the idea that the contract promise has no moral value over and above its economic value is a very, very influential one.

It is a view, too, that is of a piece with the rise to virtual unquestioned dogma that unregulated free markets always result in the highest social good. One problem, though, is that unregulated free markets entrench the power of the wealthiest. So people bound by promises (the “promisor”) can force the person to whom they are bound (the “promisee”) to change the terms of the promises if the promisor has greater financial ability to force the promisee into a legal resolution that is unacceptable to the promisee.

The disparity in economic power the theory of efficient breach does not account for is on display in the power corporations hold to renegotiate employment contracts.  Since an employee can only recover for breach whatever damages are available to him through law, the threat of being limited to that remedy can be a powerful one. Thus, as the New York Times pointed out last week,

Contracts everywhere are under assault.

The depth of the recession and the use of taxpayer dollars to bail out companies have made it politically acceptable for overseers to tinker with employment agreements.

But, as David Skeel, a law professor from the University of Pennsylvania quoted in the article points out,

We run roughshod over some contracts and not over others. . . . Right now, employment contracts seem to be the type of contract that is viewed as eminently rewritable.

So we have Larry Summers, President Obama’s Chief Economic Adviser, arguing in connection with the bonuses paid to AIG employees that the contractual promises are too sacred under the law to undo: “”We are a country of law. . . There are contracts. The government cannot just abrogate contracts. Every legal step possible to limit those bonuses is being taken by Secretary Geithner and by the Federal Reserve system.” On the other hand, the UAW’s agreement to give up rights under its contract with the auto companies was required by the government as a condition of the federal monies the automakers received.

So, are contractual promises “sacred” in some way, or are they only worth whatever the parties to them can extract given their relative financial strength and political influence? I don’t think I know.