Adam Smith, the Father of Capitalism, did not like publicly traded companies. The problem, as Smith saw it, is that managers of public companies deal with other people's money instead of their own, which results in "[n]egligence and profusion ... in the management of the affairs of such a company."  Almost 250 years later, that proposition still holds some truth. But Eric Ries, a Silicon Valley entrepreneur and the author of The Lean Startup, has a remedy for  the "negligence and profusion": a new stock exchange, just approved by the SEC, called the Long-Term Stock Exchange, or LTSE.

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Ries, the creator of the LTSE, believes this new exchange (which will compete with the NYSE and NASDAQ) can fix myriad problems with the stock market by making investors and managers focus on companies' long-term interests. The LTSE, however, is more than just an exchange. Ries wants the LTSE to institute a corporate governance system for its listed companies that restructures the relationships among stakeholders. While laudable and intriguing, the LTSE also seems quixotic. Will revamping corporate governance really fix the problems in our capital markets? 

The tyranny of prioritizing share prices

Corporate governance refers to the rights among shareholders, managers, and directors to control a company. In the U.S., the prevailing governance theory holds that managers must maximize shareholder value -- i.e., they should primarily consider the interests of shareholders when making decisions. This theory has its origins in the 1970s when, after a conglomeration spree, many companies were comprised of multiple unrelated and unprofitable business divisions. People suspected that managers were not conglomerating to benefit the company, but rather to increase their compensation, which was based on the size of the company. Accordingly, in the late 1970s, companies made governance changes to make managers more accountable and focus them on shareholder interests. Executive compensation was tied to stock performance to align the interests of managers and investors. Hostile takeovers were cheered as a means to discipline managers. 

But this focus on share price has had unintended consequences. Once the goal became maximizing stock prices, managers became fixated on meeting the quarterly earnings estimates of analysts who influence stock prices. This focus on numbers came at the expense of long term goals, like research and development: cutting investment in R&D is a quick way to juice profits. What's more, this obsession with short-term numbers resulted in "earnings management" -- the manipulation of financial statements to paint an artificially positive portrait of the company. 

Maximizing share prices has also resulted in destructive executive compensation packages. As noted, shareholder value theory encourages companies to tie executive compensation to stock price. But companies have chosen to do this by giving managers stock options, which has ended up incentivizing ill-advised, consequence-free behavior. The never-ending quest to increase stock prices emboldens management to gamble with high-risk business decisions. If a risk pays off, managers can exercise their options and reap the rewards. If the risk fails, however, managers can decline the options and let shareholders eat the costs.

Additionally, prioritizing share price has had a deleterious effect on social welfare. When management is primarily concerned with interests of shareholders, they are less likely to worry about things like the environment and public health. Employee well-being will take a backseat, too. Indeed, downsizing is an easy way to boost quarterly profits. Moreover, the shareholder value paradigm has worsened the country's wealth gap. The wealthiest 10% of the population own 84% of stocks.  The preoccupation with shareholder value means that managers are working tirelessly to make the rich richer.

How the LTSE proposes to solve these problems

Ries believes the LTSE can solve these governance problems through its listing rules. While the exchange's specific rules have yet to be formulated -- they will be developed with the SEC in the coming months -- Ries has articulated some guidelines.

To list on the LTSE, companies will have to pledge to certain long-term commitments. These pledges will not be contractual but will instead be representations that could serve as the basis for securities fraud if broken. As an example, a company may pledge not to tie executive pay to near-term stock performance. This will discourage risky short-term decisions to boost profits -- like cutting R&D -- that threaten the long-term viability of the company.

The LTSE will also prod shareholders to commit to long-term investments. Short-term investing and short selling, where investors effectively gamble with stock, has made start-ups wary of going public. The recent IPOs for Lyft and Uber, for instance, were plagued by short sellers.  While the LTSE will not ban short selling, it will require investors to disclose whether they plan on bailing or sticking around. Investors that stay will be rewarded with greater voting power. Knowing that investors are in it for growth and not a quick buck will, in turn, encourage companies to go public while deterring management decisions made to satisfy the avaricious whims of speculators.

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Ries also believes that the LTSE's governance rules will foster positive societal changes. For instance, if short selling is constrained, and more start-ups are encouraged to go public, then the investing masses will be able to share in the growth of more companies. The LTSE's listing rules will also require boards to have committees concentrating on long-term, multi-stakeholder strategy. Each board member would be assigned to a class of stakeholders -- e.g., employees, consumers, investors, the local community -- for whom they will advocate. This will ensure that boards attend to social and sustainability issues and not just audit and compliance. 

Will the LTSE change anything?

The goal of the LTSE is undoubtedly admirable. But the concept also gives off a whiff of tech industry idealism, a Ted Talk come to life, another way for the very smart people in Silicon Valley to fix our problems. Can the LTSE change corporate behavior, or is it just bunch of venture capitalists talking to each other?

Corporate governance is a popular way to address economic and social problems because it is politically palatable. As Yale professor Mariana Pargendler notes, governance reform is progressive because it recognizes that market forces alone are inadequate.  But governance solutions also please conservatives because they are imposed by the corporation internally, not by the government. Moreover, corporate governance -- with its focus on shareholder democracy, independent boards, and checks and balances -- jibes with our political notions of how power is legitimized and exercised. Ries himself posits that corporate governance should resemble a constitutional republic. In other words, corporate governance reform goes down smooth. No one is going to have night terrors over a change in shareholder rights or board composition.

But maybe governance reforms do not provoke because they don't actually do much. For decades now, companies have tweaked their governance structures to add more independent directors, more shareholder democracy, and more social responsibility. Indeed, the Dow Jones Sustainability Index lists many companies that focus on long-term economic, social, and environmental sustainability. Yet the economy is bedeviled by short-termism, financial crises, environmental calamity, and wealth inequality. One could argue that the LTSE is choosing political expediency over effectiveness.

Still, although the LTSE may not be a sufficient remedy, it is unquestionably a necessary step to addressing systemic problems in the market. By codifying governance reforms in its listing rules, the LTSE is making an institutional attempt to formally impose these reforms on companies. Assuming companies choose to list on the exchange, it will be interesting to see whether the quasi-regulations of the LTSE's listing rules are enough to address the market failures that afflict the economy, or whether actual, government regulation is ultimately necessary.