The Shareholder Value Myth
Page 3
Why Shareholder Value Ideology Appeals
The Chicago School’s approach to understanding corporations proved irresistibly attractive to a number of groups for a number of reasons. To tenure-seeking law professors, the Chicago School’s application of economic theory to corporate law lent an attractive patina of scientific rigor to the shareholder side of the longstanding “shareholders versus society” and “shareholders versus stakeholders” disputes. Thus shareholder value thinking quickly became central to the so-called Law and Economics School of legal jurisprudence, which has been described as “the most successful intellectual movement in the law in the last thirty years.”20 Meanwhile, the idea that corporate performance could be simply and easily measured through the single metric of share price invited a generation of economists and business school professors to produce countless statistical studies of the relationship between stock price and variables like board size, capital structure, merger activity, state of incorporation, and so forth, in a grail-like quest to discover the secret of “optimal corporate governance.”
Shareholder-primacy rhetoric also appealed to the popular press and the business media. First, it gave their readers a simple, easy-to-understand, sound-bite description of what corporations are and what they are supposed to do. Second and perhaps more important, it offered up an obvious suspect for every headline-grabbing corporate failure and scandal: misbehaving corporate “agents.” If a firm ran into trouble, it was because directors and executives were selfishly indulging themselves at the expense of the firm’s shareholders. Managers’ claims that they were acting to preserve the firm’s long-term future, to protect stakeholders like employees and customers, or to run the firm in a socially or environmentally responsible fashion, could be waved away as nothing more than self-serving excuses for self-serving behavior.
Lawmakers, consultants, and would-be reformers also were attracted to the gospel of shareholder value, because it allowed them to suggest obvious solutions to just about every business problem imaginable. The prescription for good corporate governance had three simple ingredients: (1) give boards of directors less power, (2) give shareholders more power, and (3) “incentivize” executives and directors by tying their pay to share price. According to the doctrine of shareholder value, this medicine could be applied to any public corporation, and better performance was sure to follow. This reasoning influenced a number of important developments in corporate law and practice in the 1990s and early 2000s. For example, the Securities Exchange Commission (SEC) changed its shareholder proxy voting rules in 1992 to make it easier for shareholders to work together to challenge incumbent boards; Congress amended the tax code in 1993 to encourage public companies to tie executive pay to objective performance metrics; and, thanks to the protests of shareholder activists, many public corporations in the 1990s and early 2000s abandoned “staggered” board structures that made it difficult for shareholders to remove directors en masse.
Finally, shareholder value thinking came to appeal, through the direct route of self-interest, to the growing ranks of CEOs and other top executives who were being showered, in the name of the shareholders, with options, shares, and bonuses tied to stock performance. In 1984, equity-based compensation accounted for zero percent of the median executive’s compensation at S&P 500 firms; by 2001, this figure had risen to 66 percent.21 Whether or not linking “pay to performance” this way actually increased corporate performance, it unquestionably increased the thickness of executives’ wallets. In 1991, just before Congress amended the tax code to encourage stock performance-based pay, the average CEO of a large public company received compensation approximately 140 times that of the average employee. By 2003, the ratio was approximately 500 times.22 The shareholder-primacy inspired shift to stock-based compensation ensured that, by the close of the twentieth century, managers in U.S. companies had stronger personal incentives to run public corporations according to the ideals of shareholder value thinking than at any prior time in American business history.
Shareholder Primacy Reaches Its Zenith
The end result was that, by the close of the millennium, the Chicago School had pretty much won the Great Debate over corporate purpose. Most scholars, regulators and business leaders accepted without question that shareholder wealth maximization was the only proper goal of corporate governance. Shareholder primacy had become dogma, a belief system that was rarely questioned, seldom explicitly justified, and had become so pervasive that many of its followers could not even recall where or how they had first learned of it. A small minority of dissenters concerned with the welfare of stakeholders like employees and customers, or about corporate social and environmental responsibility, continued to argue valiantly for broader visions of corporate purpose. But they were largely ignored and dismissed as sentimental, anti-capitalist leftists whose hearts outweighed their heads. In the words of Professor Jeffrey Gordon of Columbia Law School, “by the end of the 1990s, the triumph of the shareholder value criterion was nearly complete.”23
The high-water mark for shareholder value thinking was set in 2001, when professors Reinier Kraakman and Henry Hansmann—leading corporate scholars from Harvard and Yale law schools, respectively—published an essay in The Georgetown Law Journal entitled “The End of History for Corporate Law.”24 Echoing the title of Francis Fukayama’s book about the overwhelming triumph of capitalist democracy over communism, Hansmann and Kraakman described how shareholder value thinking similarly had triumphed over other theories of corporate purpose. “[A]cademic, business, and governmental elites,” they wrote, shared a consensus “that ultimate control over the corporation should rest with the shareholder class; the managers of the corporation should be charged with the obligation to manage the corporation in the interests of its shareholders; other corporate constituencies, such as creditors, employees, suppliers, and customers, should have their interests protected by contractual and regulatory means rather than through participation in corporate governance; . . . and the market value of the publicly traded corporation’s shares is the principal measure of the shareholders’ interests.”25 What’s more, Hansmann and Kraakman asserted, this “standard shareholder-oriented model” not only dominated U.S. discussions of corporate purpose, but conversations abroad as well. In their words, “the triumph of the shareholder-oriented model of the corporation is now assured,” not only in the United States, but in the rest of the civilized world.26
There were at least two ironic aspects to the timing of this prediction. First, it was only a few months after Hansmann and Kraakman published their article that Enron—a poster child for maximizing shareholder value and for “good corporate governance” whose managers and employees were famous for their fixation on raising stock price—collapsed under the weight of bad business decisions and a massive accounting fraud.27 Second and more subtly, Hansmann and Kraakman’s argument was primarily descriptive; they were painting a picture of what had become conventional wisdom about the purpose of the firm. Yet even as Hansmann and Kraakman published their essay, a number of leading scholars and researchers (including Hansmann and Kraakman themselves) had begun to question the empirical and theoretical foundations of conventional wisdom.
At least among experts, shareholder value thinking had reached its zenith and was poised for decline. The first sign was a number of articles that began appearing in legal journals in the late 1990s and early 2000s. These articles, mostly written by lawyers, began pointing out a truth the Chicago School economists seemed to have missed: U.S. corporate law does not, and never has, required public corporations to “maximize shareholder value.”
CHAPTER 2
How Shareholder Primacy Gets Corporate Law Wrong
One of the most striking symptoms of how shareholder-primacy thinking has infected modern discussions of corporations is the way it has become routine for journalists, economists, and business observers to claim as undisputed fact that U.S. law legally obligates the directors of corporations to maximize sha
reholder wealth. Business reporters blithely assert that “the law states that the duty of a business’s directors is to maximize profits for shareholders.”28 Similarly, the editor of Business Ethics states that “courts continue to insist that maximizing returns to shareholders is the sole aim of the corporation. And directors who fail to do so can be sued.”29
The widespread perception that corporate directors and executives have a legal duty to maximize shareholder wealth plays a large role in explaining how shareholder value thinking has become so endemic in the business world today. After all, if directors and executives can be held personally liable for failing to maximize shareholder wealth, one can hardly fault them for trying to raise the company’s share price by taking on massive debt, laying off employees, or spending less on research and development. Radicals and reformers can debate whether shareholder wealth maximization is good for society as well as shareholders. (Canadian law professor Joel Bakan has argued that the alleged legal imperative to maximize profits makes corporations act like psychopaths.)30 But making philosophical critiques of the wisdom of American corporate law is well above the pay grade of most directors, executives, and employees in corporations. They reasonably assume that if the law requires them to maximize shareholder value, that’s what they should do.
There is one fatal flaw in their reasoning. The notion that corporate law requires directors, executives, and employees to maximize shareholder wealth simply isn’t true. There is no solid legal support for the claim that directors and executives in U.S. public corporations have an enforceable legal duty to maximize shareholder wealth. The idea is fable. And it is a fable that can be traced in large part to the oversized effects of a single outdated and widely misunderstood judicial opinion, the Michigan Supreme Court’s 1919 decision in Dodge v. Ford Motor Company.31
Why Dodge v. Ford Isn’t Good Law on Corporate Purpose
Industrialist icon Henry Ford was the founder and majority shareholder of the Ford Motor Company, which produced the renowned Model T automobile. Horace and John Dodge were minority shareholders of Ford Motor who had started a rival car manufacturing company, the Dodge Brothers Company. The Dodge brothers wanted money to expand their competing business, and they thought their Ford Motor stock should provide it. (Ford Motor had for years paid its shareholders large dividends.) Henry Ford, well aware of the Dodge brothers’ plans, thought differently. Even though Ford Motor was awash in cash, Henry Ford began withholding dividends. He claimed, with apparent glee in his own altruism, that the company needed to keep its money in order to offer lower prices to consumers and to pay employees higher wages. The Dodge brothers were not amused; they sued. The Michigan Supreme Court sided with Horace and John Dodge, and ordered Ford Motor to cough up a dividend. (It was not as large a dividend as the Dodge brothers had hoped for, and the court allowed Henry Ford to continue with his plan to expand employment and reduce prices.)32
As this description makes clear, Dodge v. Ford was not really a case about a public corporation at all. It was a case about the duty a controlling majority shareholder (Henry Ford) owed to minority shareholders (Horace and John Dodge) in what was functionally a closely held company—a different legal animal altogether. (Shareholders in public corporations, unlike the Dodge brothers, have no legal power to demand dividends.) Nevertheless, while ordering Ford Motor to pay the Dodge brothers a dividend, the Michigan Supreme Court went out of its way to dismiss Henry Ford’s claims of corporate charity with an offhand remark that is still routinely cited today to support the idea that corporate law requires shareholder primacy: “There should be no confusion … a business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.”33
This remark, it is important to emphasize, was what lawyers call “mere dicta”—a tangential observation that the Michigan Supreme Court made in passing, that was unnecessary to reach the court’s chosen outcome or “holding.” It is holdings that matter in law and that create binding precedent for future cases. Dicta is not precedent, and future courts are free to disregard it. It is also worth noting that the Michigan Supreme Court’s remark about the purpose of the corporation was not only dicta but mealy mouthed dicta: note the qualifier “primarily.” Nevertheless, nearly a century later, this language from Dodge v. Ford is routinely offered as Exhibit A in the case for shareholder value thinking. Indeed, Dodge v. Ford is often cited as the only legal authority for the proposition that corporate law requires directors to maximize shareholder value.34
This pattern makes any good corporate lawyer deeply suspicious. Law is a bit like wine. A certain amount of aging adds weight and flavor, but after too many years, law tends to go bad. A legal opinion that is nearly a century old is likely to be an undrinkable vintage. Moreover, Dodge v. Ford hails from Michigan, which has become something of a backwoods of corporate jurisprudence. For historical reasons, the jurisdiction that really counts today on questions of corporate law is Delaware, where more than half of Fortune 500 companies are incorporated. One of the reasons Delaware has become so popular is that Delaware judges (called “chancellors”) are renowned for their expertise on corporate law. And in the past 30 years, the Delaware court has cited Dodge v. Ford exactly once—not on the question of corporate purpose, but on the question of controlling shareholders’ duties to minority shareholders.35
The Real Law on Corporate Purpose
So, Dodge v. Ford’s description of corporate purpose is mere dicta in an antiquated case that did not involve a public corporation, and that has not been validated by today’s Delaware courts. Is there other solid legal authority to support the proposition that the law requires directors of public corporations to maximize shareholder value?
The answer is, no. Corporate law generally can be found in three places: (1) “internal” law (the requirements of a particular corporation’s charter and by-laws); (2) state codes and statutes; and (3) state case law. (Federal securities laws require public corporations to disclose information to investors, but the feds mostly take a “hands-off” approach to internal corporate governance, leaving the rules to be set by the states; this division of labor has been reinforced by court decisions slapping down Securities Exchange Commission (SEC) rules that interfere too directly with state corporate law.)36 None of the three sources of state corporate law requires shareholder primacy.
Let us begin with internal corporate law. Most states allow or require a company’s charter or articles of incorporation—the founding document of every corporation and the equivalent of its constitution—to include an affirmative statement describing and limiting the corporation’s purpose.37 If a company’s founders wanted to, they could easily put a provision in the articles stating (to parrot Dodge v. Ford) that the company’s purpose is “the profit of the stockholders.” Such provisions are as rare as unicorns. The overwhelming majority of corporate charters simply state that the corporation’s purpose is to do anything “lawful.”38
State statutes similarly refuse to mandate shareholder primacy. To start with the most important example, Delaware’s corporate code does not say anything about corporate purpose other than to reaffirm that corporations “can be formed to conduct or promote any lawful business or purposes.”39 A majority of the remaining state corporate statutes contain provisions that reject shareholder primacy by providing that directors may serve the interests not only of shareholders but of other constituencies as well, such as employees, customers, creditors, and the local community.40
Finally, let us turn to the third important source of corporate law, judicial opinions from state courts, like Dodge v. Ford. There are many modern cases in which judges have offhandedly remarked, again in dicta, that directors owe duties to shareholders.41 Most judicial opinions, however, describe directors’ duties as being owed “to the corporation and its shareholders.”42 This formulation clearly implies the two are not the same.43 Moreover, some cases explicitly state that directors can l
ook beyond shareholder wealth in deciding what is best for “the corporation.” For example, in the 1985 opinion Unocal Corp. v. Mesa Petroleum Co., the Delaware Supreme Court stated that in weighing the merits of a business transaction, directors can consider “the impact on ‘constituencies’ other than shareholders (i.e., creditors, customers, employees, and perhaps even the community generally).”44
As in Dodge v. Ford itself, however, such judicial musings remain mere dicta. If we really want to know what the law requires when it comes to corporate purpose, we have to look beyond dicta at holdings—will a court actually hold a board of directors liable for failing to maximize shareholder wealth? Here, to use Sherlock Holmes’s famous analysis, the important legal clue is the dog that is not barking. Judges may say different things about what the public corporation’s purpose should be. But they uniformly refuse to actually impose legal sanctions on directors or executives for failing to pursue one purpose over another. In particular, courts refuse to hold directors of public corporations legally accountable for failing to maximize shareholder wealth.
How “The Business Judgment Rule”
Rules Out Shareholder Primacy
The reason can be found in an important corporate law doctrine called the “business judgment rule.” In brief, the business judgment rule holds that, so long as a board of directors is not tainted by personal conflicts of interest and makes a reasonable effort to become informed, courts will not second-guess the board’s decisions about what is best for the company—even when those decisions seem to harm shareholder value. In one famous case, for example, the corporation that owned the Chicago Cubs refused to hold night games at Wrigley Field. Although holding night games would likely have increased attendance and profits, the president of the corporation, chewing-gum heir Philip K. Wrigley, believed that baseball should be a “daytime sport” and that installing lights would disturb the peace of the surrounding neighborhood. Philip Wrigley also supposedly admitted that he was not particularly interested in the financial consequences for the Cubs. Nevertheless, the court ruled that that under the business judgment rule, it could not disturb the Cubs board’s decision to stick to daytime ball, absent evidence of fraud, illegality, or conflict of interest.45