by Lynn Stout
An even more important example of how the business judgment rule gives directors discretion to pursue goals other than shareholder value can be found in the recent Delaware case of Air Products Inc. v. Airgas, Inc. Airgas’ stock had been trading in the $40s and $50s. Nevertheless, the directors of Airgas refused the amorous takeover advances of Air Products, which wanted to purchase Airgas by paying its shareholders $70 a share. Many of the Airgas’ shareholders supported the sale as an easy opportunity to increase their wealth. But the Delaware court held that, so long as Airgas’ directors wanted Airgas to remain a public company, the Airgas board was “not under any per se duty to maximize shareholder value in the short term, even in the context of a takeover.”46 Disinterested and informed directors were free to ignore today’s stock price in favor of looking to the “long term”—and also free to decide what was in “the corporation’s” long-term interests.
Indeed, there is only one significant modern case—the 1986 case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.47—where a Delaware court has held an unconflicted board of directors liable for failing to maximize shareholder value. (In addition to the dusty Dodge v. Ford, Revlon is the second case shareholder primacy advocates typically cite in support of shareholder wealth maximization.) A closer look at the unique facts of Revlon shows it is the exception that proves the rule. The directors of Revlon had decided that Revlon, a public corporation, would be sold off to a private group of shareholders, thus becoming a private company. In other words, Revlon’s board planned to “go private,” and require the public shareholders of Revlon to give up their interests in the company and receive cash or other securities in return for their Revlon shares. That meant there would be no public corporation whose long-term interests the board might consider. The Delaware Supreme Court held that, under the circumstances, the business judgment rule did not apply and Revlon’s directors had a duty to get the public shareholders (soon to be ex-shareholders) the best possible price for their shares.
In other words, it is only when a public corporation is about to stop being a public corporation that directors lose the protection of the business judgment rule and must embrace shareholder wealth as their only goal. Subsequent Delaware cases have made clear that, so long as a public corporation intends to stay public, its directors have no Revlon duty to maximize shareholder wealth.48 This is why the Airgas board, which did not want to take the company private, was able to claim the protection of the business judgment rule and reject Air Products’ offer to buy Airgas at a premium that would have substantially increased Airgas shareholders’ wealth.
The business judgment rule thus allows directors in public corporations that plan to stay public to enjoy a remarkably wide range of autonomy in deciding what to do with the corporation’s earnings and assets. As long as they do not take those assets for themselves, they can give them to charity; spend them on raises and health care for employees; refuse to pay dividends so as to build up a cash cushion that benefits creditors; and pursue low-profit projects that benefit the community, society, or the environment. They can do all these things even if the result is to decrease—not increase—shareholder value.
If Not Shareholder Value, Then What?
It is time to exorcise the ghost of Dodge v. Ford from contemporary discussions of corporate purpose. Contrary to the conventional wisdom, American corporate law (case law, statutes, and corporate charters) fiercely protects directors’ power to sacrifice shareholder value in the pursuit of other corporate goals. So long as a board can claim its members honestly believe that what they’re doing is best for “the corporation in the long run,” courts will not interfere with a disinterested board’s decisions—even decisions that reduce share price today.
As far as the law is concerned, maximizing shareholder value is not a requirement; it is just one possible corporate objective out of many. Directors and executives can run corporations to maximize shareholder value, but unless the corporate charter provides otherwise, they are free to pursue any other lawful purpose as well. Maximizing shareholder value is not a managerial obligation, it is a managerial choice.
But might it be the best choice? Even if the law doesn’t require directors and executives to maximize shareholder value, could pursuing that objective be the best way to serve the interests of shareholders, and possibly society as a whole?
The next chapter looks at the normative case for shareholder value thinking. That is, it looks at the claim that whatever the law may require, maximizing shareholder value remains the best philosophy of corporate management because it ultimately is the best way to maximize corporations’ economic contributions to society. As we shall see, there is every reason to believe this belief also is mistaken, for it rests in turn on a fundamentally mistaken idea in economic theory: the “principal-agent” model of the corporation.
CHAPTER 3
How Shareholder Primacy Gets Corporate Economics Wrong
The idea of shareholder primacy has gained enormous traction among laymen, journalists, economists, and business leaders. But as we have just seen, American law does not actually mandate shareholder primacy. Many legal experts acknowledge this misfit.49 For example, Hansmann and Kraakman recognized the yawning gap between shareholder value ideology and the actual rules of corporate law in their influential “End of History” essay when they suggested that shareholder value thinking would lead to the eventual “reform” of corporate law, implicitly conceding that the law in its current “unreformed” state falls far from the shareholder primacy ideal.50
Nevertheless, many legal scholars today passionately embrace shareholder value as a normative goal. They believe that even though the law does not require managers to maximize shareholder wealth, it ought to. The perceived superiority of the shareholder-oriented model has inspired a generation of would-be reformers to work tirelessly at thinking up new ways to “improve” corporate governance so that managers will focus more on shareholder value. For example, there is now a small academic cottage industry in churning out proposals for tying directors’ and executives’ compensation to share price performance.51 Another popular argument is that corporations should be forced to abandon anti-takeover defenses like “staggered boards” and “poison pills,” which help directors of firms like Airgas to fend off a hostile takeover bidder offering a premium price.52 Yet another idea in fashion is that public corporations need more “shareholder democracy,” and should be forced to eliminate classified share structures that give some shareholders superior voting rights, or even give dissident shareholders access to corporate funds to mount proxy contests to remove incumbent directors.53
Intellectual Origins of Shareholder Primacy:
The Principal-Agent Model
Where did the notion that American corporate governance is defective come from? How did maximizing shareholder value get elevated to the level of Mom and apple pie as an American ideal? Shareholder value thinking cannot be explained as a reaction to recent corporate scandals and disasters, as it dates back much earlier, at least to Milton Freidman’s 1970 ode to shareholders in the pages of Sunday New York Times.54 The assumption that corporations should maximize shareholder wealth was already widespread in economic and legal circles by the early 1980s, well before Enron and AIG became household names. Rather than being driven by recent business scandals, the shift to the shareholder-oriented model occurred much earlier, and seems to have been inspired not by experience or evidence but by the seductive appeal of an idea: the principal-agent model of the corporation.
The principal-agent model of the corporation is associated with a classic Journal of Finance article published in 1976 by business school dean William Meckling and finance economist Michael Jensen. Ambitiously titled “The Theory of the Firm,” the article described the economic problem that arises when the owner of a business or “firm” (the principal) hires someone else (the agent) to manage the business on a day-today basis. Because the agent/manager does all the work while the owner/principa
l gets all the profits from the business, a self-interested agent/manager can be expected to shirk, or even steal, at the owner’s expense. The result is a separation of ownership from control that creates “agency costs.”
Jensen’s and Meckling’s article, the most frequently cited article in business academia today,55 assumed without discussion that shareholders in corporations played the role of principal/owner, while “managers” (directors and executives) are the shareholder’s agents. Yet Jensen and Meckling were economists, not businessmen or corporate lawyers. We shall soon see how their article failed to capture the real economic structure of public companies with directors, executives, shareholders, debtholders, and other stakeholders. Nevertheless, the principal-agent model was enthusiastically embraced by the emerging Law and Economics school as the perfect way to bring the rigor of economic theory to the messy business of corporate law. As early as 1980, Richard Posner of Chicago Law School and Kenneth Scott of Stanford Law School published and edited a volume called The Economics of Corporate Law and Securities Regulation that included Jensen’s and Meckling’s work.56 The principle-agent model embedded itself still more deeply into scholarly thought in 1991, when Frank Easterbrook and Daniel Fischel (also both from Chicago Law School) published the The Economic Structure of Corporate Law, an influential primer still in use today.57 By 2001, Hansmann and Kraakman were ready to declare that the standard shareholder-oriented model of the corporation had achieved “ideological hegemony.”58
Basic Assumptions Underlying the
Principal-Agent Approach
The “standard” principal-agent model is associated with three core assumptions about the economic structure of corporations. These are:
1. Shareholders own corporations;
2. Shareholders are the residual claimants in corporations, meaning they receive all profits left over after the company’s contractual obligations to its creditors, employees, customers, and suppliers have been satisfied;
3. Shareholders are principals who hire directors and executives to act as their agents.
These three assumptions reveal a basic problem with the standard principal-agent model of the corporation. Put bluntly, the model is wrong. Not wrong in an ethical or moral sense: there’s nothing objectionable about a principal hiring an agent. But it’s patently and demonstrably wrong, as a descriptive matter, to claim that Jensen’s and Meckling’s simple model captures the economic reality of a public corporation with thousands of shareholders, scores of executives, and a dozen or more directors. The standard model may describe some kinds of “firms,” especially sole proprietorships, or closely held corporations with a single shareholder and no debt. But it grossly misstates the economic structure of public corporations. To see why, let’s revisit each of the model’s core assumptions.
The First Mistaken Assumption:
Shareholders Own Corporations
Laypersons and journalists, and even the occasional economist like Milton Friedman, often casually assert that shareholders “own” corporations. Sometimes even law professors—who know better—find themselves reflexively repeating the phrase. But from a legal perspective, shareholders do not, and cannot, own corporations. Corporations are independent legal entities that own themselves, just as human beings own themselves.
Adult humans can hold property in their own names, bind themselves to perform contracts, and be held liable for committing torts. Corporations can do all these things, too. Nonlawyers may find it hard to wrap their heads around the notion that an intangible and abstract institution like a corporation is a “juridical person.” But law has long been used to create—to make “corporate”—institutions that interact on equal legal footing with natural persons. Examples include not only business corporations, but also nonprofit entities like universities, trusts, towns and municipalities, and the Roman Catholic Church. (Each of these legal entities, it is worth pointing out, manages to function despite lacking shareholders.)
What, then, do shareholders own? The labels “shareholder” and “stockholder” give the answer. Shareholders own shares of stock. A share of stock, in turn, is simply a contract between the shareholder and the corporation, a contract that gives the shareholder very limited rights under limited circumstances. (Owning shares in Apple doesn’t entitle you to help yourself to the wares in the Apple store.) In this sense stockholders are no different from bondholders, suppliers, and employees. All have contractual relationships with the corporate entity. None “owns” the company itself.
Indeed, once we recognize that corporations and shareholders contract with each other, the “ownership” argument for shareholder primacy disintegrates in the face of economic theory itself. Only three years after Milton Friedman championed the idea of shareholder ownership in the New York Times, Nobel-prize winners Fischer Black and Myron Scholes published their famous paper on options pricing, which provides the foundation for modern options theory.59 Black and Scholes proved that once a corporation issues debt, one can just as correctly say the debtholder has purchased the right to the corporation’s future profits from the corporation while also selling a call option (the right to any increase in the company’s value above a certain point) to the shareholders, as say the shareholders purchased the right to the corporation’s profits from the company but have also bought a put option (the right to avoid any loss in the company’s value below a certain point) from the debtholders. In other words, from an options theory perspective, shareholders and debtholders alike have equal—and equally fallacious—claims to corporate “ownership.”
How, then, can one describe corporations—especially public corporations that issue debt—as being owned by shareholders? One cannot and should not. Corporations own themselves, and enter contracts with shareholders exactly as they contract with debtholders, employees, and suppliers.
The Second Mistaken Assumption:
Shareholders Are the Residual Claimants
A second common idea that has persuaded many experts that shareholder primacy is normatively desirable is the idea that shareholders are the “residual claimants” in corporations. In economics, a residual claimant is the party that is entitled to keep all the residual profits left over after a business has met its basic legal obligations (e.g., paying interest due to creditors, contract wages due to employees, and taxes due to governments). According to shareholder primacy theory, shareholders are the only residual claimants in public corporations. Other stakeholders, like employees, customers, creditors, or suppliers, are entitled to receive from the corporation only the minimum the law and their formal contracts require. Shareholders and only shareholders (or so it is assumed) get everything left over after these legal and contractual obligations have been met.
The belief that shareholders are the residual claimants in corporations leads naturally to the belief that maximizing shareholder wealth will maximize overall social wealth as well. After all, if the interests of other stakeholders in the corporation are fixed and predetermined, the only way to increase the value of the shareholders’ residual interest is to increase the value of the corporation itself.60 Conversely, when the value of the shareholders’ interests decreases, this must mean the value of the company has declined.
The idea is elegant, appealing—and wrong. To understand why, it’s useful to start by recognizing that the “shareholders are the residual claimants” idea has its roots in bankruptcy law, where courts distributing the assets of liquidated companies are assumed to pay stockholders last, and only after the claims of employees, debtholders, and other creditors have been paid in full. But even in bankruptcies, influential UCLA scholar Lynn LoPucki has shown, courts often require creditors to share in equity holders’ losses to some extent.61 More important, we should not judge the function of a living, profit-generating corporation by the way we treat a company being liquidated in bankruptcy court. Living corporations are different entities with fundamentally different purposes than dead corporations, just as living horses (which we employ as
competitive athletes and family pets) have fundamentally different purposes from dead horses (which we use, if at all, for glue and pet food).
If we focus on successful, operating companies, it quickly becomes apparent that as a descriptive matter, the claim that shareholders are corporations’ residual claimants is simply incorrect.62 Outside the bankruptcy context, it is grossly misleading to suggest that shareholders are somehow entitled to—much less actually receive—everything left over after a company’s legal obligations have been met. To the contrary, shareholders cannot get any money out of a functioning public corporation unless two conditions are satisfied. First, under the standard rules of corporate law, a company’s board of directors only has legal authority to declare dividends to shareholders when the company is doing well enough financially, as measured by whether it has (in accounting terms) sufficient “retained earnings” or “operating profits.”63 Second, no dividends can be paid unless the board decides to actually exercise its authority by declaring a dividend.64
