The Shareholder Value Myth
Page 2
Even former champions of shareholder primacy are beginning to rethink the wisdom of chasing shareholder value. Iconic CEO Jack Welch, who ran GE with an iron fist from 1981 until his retirement in 2001, was one of the earliest, most vocal, and most influential adopters of the shareholder value mantra. During his first five years at GE’s helm, “Neutron Jack” cut the number of GE employees by more than a third. He also eliminated most of GE’s basic research programs. But several years after retiring from GE with more than $700 million in estimated personal wealth, Welch observed in a Financial Times interview about the 2008 financial crisis that “strictly speaking, shareholder value is the dumbest idea in the world.”8
It’s time to reexamine the wisdom of shareholder value thinking. In particular, it’s time to consider how the endless quest to raise share price hurts not only non-shareholder stakeholders and society but also—and especially—shareholders themselves.
Revisiting the Idea of “Shareholder Value”
Although shareholder-primacy ideology still dominates business and academic circles today, for as long as there have been public corporations there have been those who argue they should serve the public interest, not shareholders’ alone. I am highly sympathetic to this view. I also believe, however, that one does not need to embrace either a stakeholder-oriented model of the firm, or a form of corporate social responsibility theory, to conclude that shareholder value thinking is destructive. The gap between shareholder-primacy ideology as it is practiced today, and stakeholders’ and the public interest, is not only vast but much wider than it either must or should be. If we stop to examine the reality of who “the shareholder” really is—not an abstract creature obsessed with the single goal of raising the share price of a single firm today, but real human beings with the capacity to think for the future and to make binding commitments, with a wide range of investments and interests beyond the shares they happen to hold in any single firm, and with consciences that make most of them concerned, at least a bit, about the fates of others, future generations, and the planet—it soon becomes apparent that conventional shareholder primacy harms not only stakeholders and the public, but most shareholders as well. If we really want corporations to serve the interests of the diverse human beings who ultimately own their shares either directly or through institutions like pension and mutual funds, we need to seriously reexamine our ideas about who shareholders are and what they truly value.
This book shows how the project of reexamining shareholder value thinking is already underway. While the notion that managers should seek to maximize share price remains conventional wisdom in many business circles and in the press, corporate theorists increasingly challenge conventional wisdom. New scholarly articles questioning the effects of shareholder-primacy thinking and the wisdom of chasing shareholder value seem to appear daily. Even more important, influential economic and legal experts are proposing alternative theories of the legal structure and economic purpose of public corporations that show how a relentless focus on raising the share price of individual firms may be not only misguided, but harmful to investors.
These new theories promise to advance our understanding of corporate purpose far beyond the old, stale “shareholders-versus-stakeholders” and “shareholders-versus-society” debates. By revealing how a singled-minded focus on share price endangers many shareholders themselves, they also demonstrate how the perceived gap between the interests of shareholders as a class and those of stakeholders and the broader society in fact may be far narrower than commonly understood. In the process, they also offer better, more sophisticated, and more useful understandings of the role of public corporations and of good corporate governance that can help business leaders, lawmakers, and investors alike ensure that public corporations reach their full economic potential.
The Structure of This Book
This book offers a guide to the new thinking on shareholder value and corporate purpose. Part I, Debunking the Shareholder Value Myth, discusses the intellectual origins of conventional shareholder-primacy thinking. It shows how the ideology of shareholder value maximization lacks solid grounding in corporate law, corporate economics, or the empirical evidence. Contrary to what many believe, U.S. corporate law does not impose any enforceable legal duty on corporate directors or executives to maximize profits or share price. The philosophical case for shareholder value maximization similarly rests on incorrect factual claims about the economic structure of corporations, including the mistaken claims that shareholders “own” corporations, that they have the only residual claim on the firm’s profits, and that they are “principals” who hire and control directors to act as their “agents.” Finally, although researchers have searched diligently, there is a remarkable lack of persuasive empirical evidence to demonstrate that either corporations, or economies, that are run according to the principles of shareholder value perform better over time than those that are not. Put simply, shareholder value ideology is based on wishful thinking, not reality. As a theory of corporate purpose, it is poised for intellectual collapse.
Part II, What Do Shareholders Really Value?, surveys several promising new alternative theories of the public corporation being offered by today’s experts in law, business, and economics. These new theories have two interesting and important elements in common.
First, as noted earlier, most historical challenges to shareholder primacy have focused on the fear that what is good for shareholders might be bad for other corporate stakeholders (customers, employees, creditors) or for the larger society. The new theories, however, focus on the possibility that shareholder value thinking can harm many shareholders themselves. Indeed, if we think of shareholders as an interest group that persists over time, shareholder value thinking maybe contrary to shareholders’ own collective interests.
Second, the new theories raise this counterintuitive possibility by showing how “the shareholder” is an artificial and highly misleading construct. Most economic interests in stocks are ultimately held by human beings, either directly or indirectly through pension funds and mutual funds. Where “shareholders” are homogeneous, people are diverse. Some plan to own their stock for short periods, and care only about today’s stock price. Others expect to hold their shares for decades, and worry about the company’s long-term future. Investors buying shares in new ventures want their companies to be able to make commitments that attract the loyalty of customers and employees. Investors who buy shares later may want the company to try to profit from reneging on those commitments. Some investors are highly diversified and worry how the company’s actions will affect the value of their other investments and interests. Others are undiversified and unconcerned. Finally, many people are “prosocial,” meaning they are willing to sacrifice at least some profits to allow the company to act in an ethical and socially responsible fashion. Others care only about their own material returns.
Once we recognize the reality that different shareholders have different values and interests, it becomes apparent that one of the most important functions that boards of public companies of necessity must perform is to balance between and mediate among different shareholders’ competing and conflicting demands. Conventional shareholder value thinking wishfully assumes away this difficult task by assuming away any differences among the various human beings who own a company’s stock. In other words, in directing managers to focus only on share price, shareholder value thinking ignores the reality that different shareholders have different values. It blithely assumes that the question of corporate purpose must be viewed solely from the perspective of a hypothetical entity that cares only about the stock price of a single company, today. As UCLA law professor Iman Anabtawi has noted, this approach allows shareholder-primacy theorists to characterize shareholders “as having interests that are fundamentally in harmony with one another.”9 But it also reduces investors to their lowest possible common human (or perhaps subhuman) denominator: impatient, opportunistic, self-destructive, and psychopathically
indifferent to others’ welfare.
This book does not advance a theory of how, exactly, directors should mediate among different shareholders’ demands. Nor does it directly address the question of whether some shareholders’ interests (say, those of long-term or more-diversified investors) should be given greater weight in the balancing process than other shareholders’ interests. These are, of course, critically important questions. But before we can even start to answer them, we must begin by recognizing that conventional shareholder-primacy ideology “solves” the problem of inter-shareholder conflict by simply assuming—without explanation or justification—that the only shareholder whose interests count is the shareholder who is short-sighted, opportunistic, undiversified, and without a conscience. This approach keeps public corporations from doing their best for either their investors or society as a whole.
Why It Matters
It’s time to rethink the wisdom of shareholder value. The stakes are high: for most of the twentieth century, public companies drove the U.S. economy, producing innovative products for consumers, attractive employment opportunities for workers, tax revenues for governments, and impressive investment returns for shareholders and other investors. Corporations were the beating heart of a thriving economic system that served both shareholders and America.
But in recent years the corporate sector has stumbled badly. Americans are beginning to lose faith in business. One recent poll found that where in 2002, 80 percent of Americans strongly supported capitalism and the free-enterprise system, by 2010 that number had fallen to only 59 percent.10 Perhaps understandably, in the wake of each new scandal or disaster, public anger and media attention tend to focus on the sins of individuals: greedy CEOs, inattentive board members, immoral executives. This book argues, however, that many and perhaps most of our corporate problems can be traced not to flawed individuals but to a flawed idea—the idea that corporations are managed well when they are managed to maximize share price.
To help corporations do their best for investors and the rest of us as well, we need to abandon the simplistic mantra of “maximize shareholder value,” and adopt new and better understandings of the legal structure and economic functions of public companies. It’s time to free ourselves from the myth of shareholder value.
PART I
Debunking the
Shareholder Value
Myth
CHAPTER 1
The Rise of Shareholder Value Thinking
The public corporation as we know it today was born in the late 1800s and did not reach its full maturity until the early twentieth century. Before then, most business corporations were “private” or “closely held” companies whose stock was held by a single shareholder or small group of shareholders. These controlling shareholders kept a tight rein on their private companies and were intimately involved in their business affairs.
By the early 1900s, however, a new type of business entity had begun to cast a growing shadow over the economic landscape. The new, “public” corporation issued stock to thousands or even tens of thousands of investors, each of whom owned only a very small fraction of the company’s shares. These many small individual investors, in turn, expected to benefit from the corporation’s profit-making potential, but had little interest in becoming engaged in its activities, and even less ability to effectively do so. By the 1920s, American Telephone and Telegraph (AT&T), General Electric (GE), and the Radio Company of America (RCA) were household names. But their shareholders were uninvolved in and largely ignorant of their daily operations. Real control and authority over public companies was now vested in boards of directors, who in turn hired executives to run firms on a day-to-day basis. The publicly held corporation had arrived.11
The Great Debate over Corporate Purpose: The Early Years
Of all the controversies surrounding this new economic creature, the most fundamental and enduring has proven the debate over its proper purpose.12 Should the publicly held corporation serve only the interests of its atomized and ignorant shareholders, and should directors and executives focus only on maximizing those shareholders’ wealth through dividends and higher share prices? This perspective, which today is called “shareholder primacy” or the “shareholder-oriented model,” may have made sense in the early 1900s to those who viewed public corporations as fundamentally similar to the private companies from which they had evolved. After all, in private companies, the controlling shareholder or shareholder group enjoyed near-absolute power to determine the firm’s future. The question of corporate purpose was easy to answer: the firm’s purpose was whatever the shareholders wanted it to be, and when in doubt, it was assumed the shareholders wanted as much money as possible.
But other observers in the first half of the twentieth century thought differently about the public corporation. To them, these new economic entities seemed strikingly dissimilar, in both structure and function, from the privately held firms that preceded them. The “separation of ownership from control” that allowed the creation of enormous enterprises like AT&T and GE worked a change that was qualitative, not just quantitative. Public corporations seemed to have a broader social purpose that went beyond making money for their shareholders. Properly managed, they also served the interests of stakeholders like customers and employees, and even the society as a whole.
Thus began the Great Debate over the purpose of the public corporation (as it has been dubbed by three influential judges specializing in corporate law).13 The Great Debate was joined in full as early as 1932, when the Harvard Law Review published a high-profile dispute between two leading experts in corporate law, Adolph Berle of Columbia and Harvard law professor Merrick Dodd. Berle was the coauthor of a famous study of public corporations entitled The Modern Corporation and Private Property.14 He took the side of shareholder primacy, arguing that “all powers granted to a corporation or to the management of the corporation … [are] at all times exercisable only for the ratable benefit of the shareholders.”15 Professor Dodd disagreed. He thought that the proper purpose of a public company went beyond making money for shareholders and included providing secure jobs for employees, quality products for consumers, and contributions to the broader society. “The business corporation,” Dodd argued, is “an economic institution which has a social service as well as a profit-making function.”16
To many people today, Dodd’s “managerialist” view of the public corporation as a legal entity created by the state for public benefit and run by professional managers seeking to serve not only shareholders but also “stakeholders” and the public interest, may seem at best quaintly naïve, and at worst a blatant invitation for directors and executives to use corporations to line their own pockets. Yet in the first half of twentieth century, it was the managerialist side of the Great Debate that gained the upper hand. By 1954, Berle himself had abandoned the notion that public corporations should be run according to the principles of shareholder value. “Twenty years ago,” Berle wrote, “the writer had a controversy with the late Professor Merrick E. Dodd, of Harvard Law School, the writer holding that corporate powers were powers held in trust for shareholders, while Professor Dodd argued that these powers were held in trust for the entire community. The argument has been settled (at least for the time being) squarely in favor of Professor Dodd’s contention.”17
The Rise of Shareholder Primacy
But only a few decades after Berle’s surrender to managerialism, shareholder-primacy thinking began to resurface in the halls of academia. The process began in the 1970s with the rise of the so-called Chicago School of free-market economists. Prominent members of the School began to argue that economic analysis could reveal the proper goal of corporate governance quite clearly, and that goal was to make shareholders as wealthy as possible. One of the earliest and most influential examples of this type of argument was an essay Nobel-prize winning economist Milton Friedman published in 1970 in the New York Times Sunday magazine, in which Friedman argued that because shareholders “
own” the corporation, the only “social responsibility of business is to increase its profits.”18
Six years later, economist Michael Jensen and business school dean William Meckling published an even more influential paper in which they described the shareholders in corporations as “principals” who hire corporate directors and executives to act as the shareholders’ “agents.”19 This description—which the next two chapters will show completely mischaracterizes the actual legal and economic relationships among shareholders, directors, and executives in public companies—implied that managers should seek to serve only shareholders’ interests, not those of customers, employees, or the community. Moreover, true to the economists’ creed, Jensen and Meckling assumed that shareholders’ interests were purely financial. This meant that corporate managers’ only legitimate job was to maximize the wealth of the shareholders (supposedly the firm’s only “residual claimants”) by every means possible short of violating the law. According to Jensen and Meckling, corporate managers who pursued any other goal were wayward agents who reduced social wealth by imposing “agency costs.”