Politicians and journalists like to say that if you are being attacked from all sides you must be doing something right. However, some might counter that if you are being attacked from all sides it’s possible you are doing everything wrong. The latter is certainly not the case with Roger Martin, the highly accomplished Dean of Joseph L. Rotman School of Management at the University of Toronto.

Martin, along with other board members, has been attacked in the media of late by many Research in Motion investors and watchers for not doing enough to maintain product leadership for the ailing BlackBerry smartphone and to ensure timely, successful management transition. His defence, which in part might be loosely paraphrased as: “a clone of Steve Jobs was not available,” has done little to assuage the criticism, but the truth is that technology companies with a single dominant product have typically found it very difficult to keep their competitors permanently at bay by continuously being at the leading edge of innovation, a fact that every investor in high-technology stocks should know and should not find surprising.

He has also been attacked for his criticism of badly-structured, excessive executive compensation and its destructive effects on the very thing it is supposed to maximize—shareholder value. The chief business correspondent of a leading Canadian financial newspaper described this as “fairly worn ideas about how short-term executive compensation rewards greed not restraint. “However, Martin’s analysis goes far deeper than that, and it would be a great pity if his insights into the structural sources of instability and underperformance in our financial and economic systems were to go unheeded.

Martin’s latest book, Fixing the Game (Harvard Business Review Press, 2011), is described by Paul Volker, legendary former chairman of the U.S. Federal Reserve as “a gust of fresh air — blowing away some of the intellectual smoke supporting compensation and market practices that have come to place American-style capitalism at risk.” John Bogle, the founder of Vanguard Group and eminent pioneer of index funds for investors, described it as “original, insightful and inspirational.” Even more pithy words were used by Arianna Huffington, cofounder of the Huffington Post, who said, “we’ve gone from an economy based on making things to one based on making things up … Roger Martin offers a riveting account of how the expectations game is beginning to destroy the real game, threatening the future of American capitalism.”

Martin criticizes our slavish commitment to the theory that the purpose of a firm is solely to maximize shareholder value. He notes that this theory has led to huge growth in stock-based compensation for senior executives and, through this, to a simplistic, wrongheaded linking of the real market—the business of designing, making, and selling products and services—with the expectations market—the business of trading stocks, options, and complex derivatives. Martin outlines how this commitment has resulted in managements’ single-minded focus on the expectations market that continues to drive us from crisis to crisis and to detract their attention from building strong, thriving businesses over the long term. He traces the origins of this misguided theory to a 1976 paper written by Professor Michael Jensen and Dean William Meckling of Simon School of Business at the University of Rochester. Many people who were in the investment industry in the late 1970s and 1980s will remember the article well, as it subsequently became the single most cited article in business academia. The article first defined the principal-agent problem, whereby agents, namely management, have an inherent incentive to optimize activities and resources for themselves rather than for their principals, i.e., shareholders. The authors suggested that managements’ interests could be better aligned with shareholders interests by giving them large amounts of stock-based compensation. This writer can remember countless meetings between managements, institutional portfolio managers and analysts in the decades after the paper was published, during which managers were quizzed on their stock ownership and encouraged to seek more stock-based compensation from their boards and to cite the recommendations of the investment community when doing so.

“… we’ve gone from an economy based on making things to one based on making things up…”

Unfortunately, the proposed remedy was too simplistic. It had the major unintended consequence of causing managements to shift their attention from the real business world, which was difficult to control, to the stock market, i.e., the expectations market or the world of perceptions, which they found they could influence much more easily. Moreover, if they found they could not influence the expectations market, general fluctuations in stock market prices could still create large gains on their stock options without commensurate downside exposures. In 1970, in the U.S., stock-based compensation accounted for less than 1 percent of CEOs’ remuneration, which averaged US$850,000. By 2000, it accounted for 50 percent of CEOs’ remuneration, which averaged US$14 million.

Of course, improving business value by growing sales and earnings over the long term is one way to create wealth for both stock-owning managers and investors, but when the managers can do so more easily and quickly by managing expectations, the latter route proved all too tempting. The downside of this emphasis on the world of expectations has included companies’ efforts to manage their accounting earnings and to boost income in the short term, often at the cost of long-term benefits. The history of its adverse effects includes: the accounting scams of Enron, WorldCom, Global Crossing, and Tyco International; the ultimate expectations management feat of the technology and internet stock bubbles of the 1990s; the options back-dating scandal of the mid-2000s ; and the sub-prime mortgage-backed securities bubble, which triggered the global financial crisis of 2008–2009.

Martin points out that concentration on the expectations market has distracted management from its proper goal, which is the creation of long-term business value—the goal that best serves shareholders interests—and made managers’ roles inauthentic in the sense that they have come increasingly to present themselves as being able to keep expectations rising continuously to satisfy investors—something they cannot realistically be expected to do. It has also led to increased price volatility—something that has become a hallmark of modern capital markets—as variations from short-term expectations create fluctuations. These fluctuations have led to opportunities for new traders, notably hedge funds, who have exploited them and have flourished, creating value for themselves but no one else. Ironically, Martin notes, there is no conclusive evidence that the new era of focusing on shareholder value has enhanced returns to shareholders. The total return on the S&P 500 Index from the end of the Great Depression (1933) to the end of 1976, the beginning of the shareholder value era, averaged 7.5 percent per year, compounded, while from 1977 to the end of 2010 it has averaged 6.5 percent, compounded.

“… the composition of management’s remuneration should be shifted away from stock-based schemes and toward business goals – sales, customer satisfaction, sustainable profits…”

Martin recommends that managers should refocus on serving customers while earning a satisfactory return for shareholders. He notes that companies that focus on pleasing their customers, (e.g., Johnson & Johnson, Procter & Gamble, Apple) usually end up generating very good returns for their shareholders, while those that focus on pleasing their shareholders do not tend to do very much for their customers, and there is little evidence to suggest that their shareholders do any better either. He advocates restoring authenticity to managements’ lives, authenticity being defined as the degree to which one stays true to one’s own character and morals while dealing with external forces. Authenticity requires us to stay focused on real matters that we can influence and not pretend to be doing something in order to satisfy others. Martin recommends that the composition of remuneration be shifted away from stock-based schemes and toward business goals (sales, customer satisfaction, sustainable profits) and that board governance be transformed to make board members less motivated by prestige, compensation, social interaction, and personal growth and more by a sense of public service and a desire to engage in productive board–executive discussion and to provide wise counsel and judgement. He argues that expectations market players such as hedge funds should be managed more effectively to ensure their activities do not interfere with or damage the interests of long-term investors, notably the beneficiaries of pension funds. He adds that pension fund managers should be saved from themselves by curbing their ability to invest in hedge funds, venture capital, and leveraged buyout funds. He concludes that shareholder value maximization as a goal for businesses is too narrow and minimizes the contribution of business to society. As well as dedicating themselves to growing long-term business value, he states that companies should do something to improve society—to add to the “civil foundation”—by going beyond the laws and norms in place and contributing to making the world a better place.

That is Martin’s prescription for “fixing the game,” and it is hard to argue that it would lead to anything other than a much better world than the one we now face. While changing corporate cultures is an arduous task, removing the inappropriate link between management remuneration and stock prices and linking it to growth in business value would constitute a very powerful start. The opportunity exists for shareholders and the investment industry to press for such change and, in a manner reminiscent of Steven Spielberg’s popular 1985 movie, Back To the Future, to bring about a correction to the misguided restructuring of executive remuneration that began in the late 1970s, ensuring that the interests of managements and shareholders will be better aligned and on a much more productive course in the future.