David R. Henderson  

Sons of Wichita

Some thoughts on stock prices ... The Ethics of Charles Koch...

On my vacation, which is coming to an end, the first book I read was Daniel Schulman's Sons of Wichita. It's subtitled "How the Koch Brothers Became America's Most Powerful and Private Dynasty." Written by an editor of Mother Jones, Sons of Wichita is, in my semi-informed opinion, largely fair.

I found this passage interesting:

"Koch has a pattern of delaying needed repairs and maintenance, often neglecting them entirely," Linda Eads, the former Texas deputy attorney general, noted in a 2001 affidavit. "One reason for this failure to operate safe pipelines comes from Koch's so-called Market-Based Management approach. For example, under this management philosophy, each section of the Koch pipeline must show a profit, and this profit must increase every quarter. Environmental and safety compliance does not pay off quarter by fiscal quarter, and thus employees are not rewarded or encouraged to strive for safety or compliance. Indeed, safety improvements are regularly delayed or ignored even when recommended by employees. Employees at Koch are told that every decision has to be judged by its economic effect and how the decision will affect the company's profitability."

I have 4 comments.

1. Eads showed herself to be a strong, to put it mildly, critic of Koch Industries. So we can't assume that hers is an unbiased and accurate commentary on the issue of applying Market-Based Management.

2. I read Charles Koch's book on market-based management several years ago and I didn't bring it with me on my vacation. But my recall is that it was too loose a guide to making actual decisions. So I could imagine someone interpreting it her way and I could imagine someone interpreting it some other way.

3. I'm not saying I'm sure she's wrong but it's hard for me to believe that, as she says, "this profit must increase every quarter." If you're striving to maximize the value of a company, you will have quarters in which profit decreases. I agree with her that if you strive to increase profit quarter by quarter, you will make some very bad decisions. If drug companies did that, for example, they would, quarter by quarter, reduce research and development. But would Charles understand economics so badly that he would have, as a goal, profit increasing every quarter.

4. Notice the last sentence in the quoted passage. She seems to treat "its economic effect" as if an action has one effect. But, as noted in #3 above, an action can reduce quarterly profits but increase long-term profitability. Certainly, the Danielle Smalley case that Schulman discusses, in which a jury awarded $296 million in a wrongful death suit against Koch Industries, suggests that their failure to maintain a pipeline was not profit-maximizing. Of course, no one could have known up front that Koch Industries would face such a large award. Even the plaintiff had asked for "only" $100 million. But the point is that Koch's management would know that it would face some probability of a wrongful death suit with a big payoff.

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COMMENTS (8 to date)
Alan Goldhammer writes:

I'm no fan of the Koch's political views but they need to be given credit on occasion. When they bought Georgia Pacific there was great concern about what would happen with the paper manufacturer as it was an old line industry. They've focused a lot on reinvestment and trying to improve the productivity. There is a nice recent overview in the Chicago Tribune. Somewhat counter intuitive given my preconceptions.

Phil writes:

Why counterintuitive, Alan? Do you believe that people whose politics differ from yours are ipso facto bad at managing businesses?

Alan Goldhammer writes:

@Phil - it was because of the long history of violation of environmental regulations at other Koch Industry facilities and the fact that paper manufacturing is really an old line industry. I just found it a curious acquisition when it was made.

MikeP writes:

5. A deputy attorney general does not necessarily have the best understanding of economics or of management, and their musings on the same are not necessarily accurate or trustworthy.

Mike Hammock writes:

Regarding 2., that was exactly my reaction when I tried to read their management book years ago. It all sounds good, but actually implementing the ideas seemed like it would be difficult in practice. They were all based on standard economics ideas, but in a management context I couldn't imagine how some of the necessary data could be collected. Granted, it's been years since I tried to read it, but while I found it unobjectionable, I also wasn't much impressed.

I also read Charles Koch's market-based management book several years ago. What, I wondered, could be the advantage of the divisions which Koch describes (divisions within the corporation but managed as if independently owned) over truly independently-owned businsses?

Maybe I didn't understand it, but I came away with a theory that Charles Koch succeeds in his businesses for a reason (or reasons) which he himself does not perceive. Like J.D. Rockefeller he brings something to business which he can't pass on to others, try as he might.

Trevor H writes:

In a previous job one of the software products I was responsible for was for pipeline integrity management. Yes, every company maintains risk models that help them plan and prioritize maintenance spending.

The base case scenario always starts with legal compliance. I've never heard of otherwise and would be shocked to see that as policy of any kind of operator. Maybe I've been naive, I'd have to see the evidence here. The management decisions then are when and where to exceed legal minimums because the hazards and consequences to health, safety, and environment justify additional investment.

I'm always skeptical of this kind of 'management ignored our warnings' story simply because the risk can never be brought to zero no matter how large the investment. Heck, the inspection and maintenance activity itself carries risk of spill and injury. In other words, there are always opportunities for safety investment that are 'ignored' by every operator in every industry.

Actual failures are often attributable to bad/incorrect data on which decisions were based. Sometimes judgments about probability and severity of incidents are wrong. And if the probability of something isn't zero, eventually an accident is going to happen. Sizable judgments against operators are useful in helping them assess society's risk tolerance and to invest appropriately.

David R. Henderson writes:

@Trevor H,
Thank you for your thoughtful comments.

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