by Lynn Stout
To understand this counterintuitive idea, imagine what you might find if you did an empirical test of the best method for catching fish. On first inspection, one reasonable approach might be to do a statistical analysis of all the individual fishermen who fish in a particular lake, and compare their techniques with the amount of fish they catch. You might find that fishermen who use worms as bait get more fish than those who use minnows and conclude fishing with worms is more efficient.
But what if some fishermen start using dynamite in the lake and simply gather up all the dead fish that float to the surface after a blast? Your statistical analysis would show that individuals who fish with dynamite catch far more fish than those who use either worms or minnows and also that fishermen who switch from baited hooks to dynamite see an initial dramatic improvement in their fishing “performance.” But as many real-world cases illustrate, communities that fish with dynamite typically see long-run declines in the size of the average haul and, eventually, a total collapse of the fish population. Fishing with dynamite is a good strategy for an individual fisherman, for a while. But in the long run, it is very bad for fish and for fishermen collectively. Fishing with dynamite poses the classic conflict between individual greed and group welfare that economists call the “Tragedy of the Commons.”
Part II of this book will explore in some detail several different ways in which shareholder value thinking can create an investor Tragedy of the Commons and prove a bad strategy for investors collectively. Meanwhile, let us stop for a moment to consider what the empirical evidence shows about how the business world’s embrace of the standard shareholder-oriented model seems to be working out for shareholders as a class, as opposed to the shareholders of individual firms. In particular, let us look at what has happened to average shareholder returns in recent years as the business world has embraced the standard model; at modern trends in corporations’ apparent interest in acquiring or retaining public investors; at shareholder behavior in purchasing shares in companies that are more or less shareholder friendly; and at the relative success of jurisdictions whose corporate laws come closer to the shareholder primacy ideal.
Shareholder Value Ideology and Investor Returns
Turning first to the question of average shareholder returns, it is notable that even though American corporate law still does not dictate shareholder primacy, as a practical matter today’s public companies pay far more attention to shareholder value than American firms did two or three decades ago. Although many individual investors still hold stocks directly, in recent decades more have chosen to invest indirectly, by owning interests in institutional investors like pension funds and mutual funds. Pension and mutual funds concentrate the funds of many small investors and so can end up owning large enough stakes in individual companies to overcome the rational apathy described in Chapter 2 and seek to influence companies’ affairs. Another kind of new institutional investor, the hedge fund, is even more likely to concentrate its portfolio in a few holdings, making “rational apathy” even less rational.
Meanwhile, in the name of promoting shareholder democracy, the SEC over the past two decades has adopted several rules designed to encourage boards to pay greater attention to shareholder demands. For example, in 1992 the SEC amended its proxy rules to make it easier for institutional shareholders to communicate and coordinate with each other, and in 2009 it prohibited brokerage firms (which traditionally vote for incumbent directors) from voting the shares held for their clients. Another trend that has been especially important in focusing managerial attention on share price is the use of stock-based compensation. In 1993, Congress amended the tax code to encourage public corporations to tie executive pay to objective “performance” metrics. The percentage of CEO compensation coming from stock option grants then rose from 35 percent in 1994, to over 85 percent by 2001.85 Finally, whether or not directors and executives of U.S. public companies have an enforceable legal duty to maximize shareholder wealth (Chapter 2 shows they do not), today they are far more likely to perceive themselves to have such a duty. In the words of Columbia law professor Jeffrey Gordon, by the 1990s “the maximization of shareholder value as the core test of managerial performance had seeped into managerial culture.”86
If shareholder value thinking was as good for shareholders as its proponents believe it must be, this collective shift toward more shareholder-oriented governance structures and business practices should have greatly improved average investor returns over the past two decades. Yet we have seen exactly the opposite. Business school dean Roger Martin calculates that between 1933 and 1976 (the year Jensen and Meckling published their article on the principal-agent model), shareholders who invested in the S&P 500 enjoyed real compound average annual returns of 7.5 percent. After 1976, this average dropped to 6.5 percent.87 The trend is even more apparent if we look at what has happened to public investors since the early 1990s. After an initial run-up in stock prices from 1992 to 1999—fishing with dynamite produces an initial increase in the fish haul, too—shareholder returns have been dismal.
Of course, other factors—financial deregulation, the 2008 credit crisis, and U.S. political dysfunction—may explain shareholders’ poor returns in the Age of Shareholder Value. (It is worth noting, however, that shareholder value thinking may have contributed to both financial deregulation and the 2008 crisis, which some attribute to the successful deregulation lobbying efforts of share-price-obsessed firms like Enron and Citibank.)88 When we look at such a large phenomenon as economic performance, it can be impossible to single out any single cause, or even to identify with certainty a suite of causes. Nevertheless, at a minimum, the stock market’s recent performance provides no empirical support for the shareholder primacy thesis.
Shareholder Value Ideology and the
Public Company as a Business Form
So let’s consider another kind of big-picture evidence on the wisdom of shareholder primacy: corporations’ willingness to have public investors at all.
Here too, the evidence suggests that shareholder value thinking may not be working out well for public shareholders. A recent study by consulting firm Grant Thornton concluded that from 1997 to 2009, the number of public companies listed on U.S. stock exchanges has declined by 39 percent in absolute terms, and by a whopping 53 percent when adjusted for GDP growth. Formerly public companies like Toys“R”Us and The Gap are going private, buying back outside investors’ shares, and becoming, in effect, closely held companies. Meanwhile private companies, especially start-ups, are reluctant to do initial public offerings (IPOs). According to Grant Thornton, “Small IPOs from all sources—venture capital, private equity and private enterprise—are all nearly extinct and have been for a decade.”89
Again, there are other explanations one could offer for why the public corporation seems to be increasingly an unattractive form for doing business. Many commentators might lay at least part of the blame on excessive regulation, in particular the much-detested Sarbanes-Oxley requirements imposed by Congress on public firms in the wake of the Enron and Worldcom scandals. Nor, it is important to note, does the slow disappearance of publicly listed companies necessarily herald problems for the U.S. corporate sector in and of itself. After all, private firms are just as capable of producing cars, medicines, and software as public companies are. Indeed, in much of the world (Italy, India, and South America) private companies are more the norm than the exception.
But as we shall see in Part II, there is reason to suspect that the rise of shareholder value plays at least some role in the disappearance of publicly listed companies in which average investors can readily buy shares. This disappearance, in turn, harms those average investors, as they find themselves left with fewer and fewer stocks to choose among in investing and fewer and fewer opportunities to participate in the profits that flow from corporate production.
The Lack of Investor Demand for
Shareholder Primacy Rules
As we have already seen, there does not
seem to be any particular investor demand for corporate charters that mandate shareholder primacy. But even more compelling, on the rare occasions when companies do go public today, many adopt dual-class equity structures that concentrate voting power and control in insiders’ hands. Google, LinkedIn, and Zynga are prominent recent examples. This pattern provides still more evidence against shareholder primacy, because it suggest public shareholders themselves do not particularly value shareholder democracy, at least when deciding which firms to buy.
Thanks to the Internet, prospective investors thinking of buying shares in an IPO can easily look to see whether the company’s charter strengthens or weakens shareholder rights. They eagerly buy stock in firms like Google that strip them of power. Meanwhile, charter provisions giving shareholders greater leverage over directors—for example by banning poison pill antitakeover defenses—“are so rare as to be almost nonexistent.”90 If public shareholders thought public shareholder oversight and control was essential to good returns, why don’t corporations going public try to appeal to investors by offering more shareholder-oriented governance?
Evidence from Abroad
Finally, international comparisons provide a fourth source of evidence to raise doubts about the supposed advantages of shareholder primacy. As we have seen, U.S. law and practice departs substantially from the shareholder primacy ideal. In contrast, the United Kingdom seems a shareholder paradise.91 Directors in U.K. companies cannot reject hostile takeover bids; they must sit back and let the shareholders decide if the firm will be sold to the highest bidder. Shareholders in U.K. companies have the power to call meetings, and to summarily remove uncooperative directors. They even get to vote to approve dividends. (Not surprisingly, U.K. companies are more generous with dividends than U.S. companies are.)92
If the standard model is truly superior, and if corporations run according to the standard model were truly more efficient, the United Kingdom should have the world’s best track record in developing successful global public companies. That track record is notably missing. When the average person thinks of great public corporations, the names that come to mind are mostly American, with a few German or Japanese names thrown in: Microsoft, Apple, Walmart, Coca-Cola, Johnson & Johnson, Sony, Toyota, Honda, Canon, Siemens, Bayer, SAP, and Volkswagen.93 Relatively few U.K. companies have a global profile, and those that do are concentrated in banking (HSBC) and commodities extraction (BP). Moreover, in the wake of the oil spill disaster—which seems to have been due in part to BP’s shareholder value obsession—BP’s standing in the ranks of global companies has slipped badly.
We Need a New Paradigm
Of course, there are other factors that could explain why the United Kingdom has failed to become a global corporate powerhouse, just as there are other factors one might offer to explain why shareholder returns have declined in recent years, why companies are increasingly reluctant to go or to stay public, and why shareholders eagerly invest in firms that strip away their rights. Because there are so many variables at work when we look at major trends instead of individual companies or nations, statistical regressions of the type so popular among those who do empirical research on corporations may be of little use. Like the drunk who lost his car keys in the dark parking lot but looks for them under the sidewalk lamppost because that’s where the light is, researchers who look for the secret of good corporate governance in the economic performance of individual companies are unlikely to meet their objective.
Meanwhile, when we start looking in the dark parking lot, we stumble across some disturbing bits of evidence. The standard model predicts that investors’ returns should have improved greatly over the past two decades; that new companies should flock to do business as public corporations; that investors should avoid firms that depart from one-share-one-vote and other shareholder primacy ideals; and that the United States should only now be catching up to the United Kingdom as a leading jurisdiction for global corporations. None of these predictions has been borne out. To the contrary, not only does the big picture fail to support shareholder primacy, it suggests, if anything, that shareholder value thinking may be harmful to shareholders and corporations themselves.
To use the phrase made famous in Thomas Kuhn’s classic book The Structure of Scientific Revolutions, by the close of the twentieth century, the shareholder primacy model had become the “dominant paradigm” of corporate purpose. But it fails, rather dramatically, to explain a number of important empirical anomalies. First, U.S. corporate law does not, and never has, required directors of public corporations to maximize shareholder value. Second, closer inspection of the economic structure of public corporations reveals that shareholders are neither owners, nor principals, nor residual claimants. Third, the empirical evidence does not provide clear support for the proposition that shareholder primacy rules produce superior results. Indeed, once we shift our focus from the performance of individual firms to the performance of the corporate sector as a whole, it suggests the opposite.
As Kuhn famously observed, wherever one finds persistent empirical anomalies that are inconsistent with a dominant theory’s predictions, sooner or later at least a few free-thinking (or foolhardy) souls will want to understand and explain those anomalies. Eventually these free spirits may develop a new, alternative theory. When they do, the real battle begins. Most of the intellectual leaders who built their careers on the original paradigm can be expected to fight tooth and nail to kill off the newcomer. But if the new theory is sound—if it does a better job of explaining what we observe in the real world than the old theory does—it will win hearts and minds and ultimately prevail. Of course, the process may be slow. It has been said that intellectual progress in science is made one funeral at a time.
New Ideas Emerging
There is reason to hope the pace in corporate theory be more brisk. Even as Hansmann and Kraakman were announcing the triumph of the shareholder wealth maximization paradigm in 2000, pioneering thinkers in law, economics, and business (including Hansmann and Kraakman themselves) were busily at work exploring alternative models of corporate structure and purpose that might better explain corporate reality. Today’s literature includes several compelling lines of thought that challenge traditional shareholder primacy.
The next part (Part II) explores some of these emerging theories and shows how they uncover and illuminate the pitfalls of shareholder primacy thinking. In particular, Part II focuses on intellectual challenges to traditional shareholder primacy thinking that have three important characteristics in common.
First, the new theories differ from the traditional stakeholder and corporate social responsibility arguments against maximizing shareholder value, because they focus not on how shareholder primacy hurts stakeholders or society per se, but on how shareholder primacy can hurt shareholders, both individually and immediately, and collectively and over time. This focus on shareholder welfare may not fully satisfy those who believe that directors and executives of public corporations should use their control over corporate resources to promote social justice, employee well-being, or environmental health as goods in and of themselves. But they do suggest, strongly, that the supposed divides between the interests of shareholders and the interests of stakeholders, society, and the environment maybe much narrower than conventional shareholder value thinking admits. Public corporations are more likely to do well for their investors when they do good.
Second, the theories examined in Part II have in common that they pay much more careful attention to the idea of “the shareholder.” Many people think of corporations as fictions and shareholders as real. This perception explains much of the appeal of the principal-agent model, which appears to clear away the fog of corporate identity by focusing on the apparent reality of human agents. Yet corporations are real, at least in legal sense. It is shareholders that are fictional. The standard shareholder-oriented model assumes a hypothetical, homogeneous, abstract shareholder who does not and cannot exist. In his place stand real h
uman beings who happen to own shares of stock. These real human beings have different investing time frames; different liquidity demands; different interests in other assets (including their own human capital); and different attitudes toward whether they should live their lives without regard for others or behave “prosocially.” Recognizing these differences reveals that the idea of a single objectively measurable “shareholder value” is not only quixotic, but intellectually incoherent.
Third and perhaps most important, by recognizing the differences between and among shareholders’ interests, the new models explain empirical anomalies the standard model cannot. The new models are better inductively, meaning they do a better job of predicting the empirical data we observe. They are also better deductively, meaning they explain how and why such “anomalies” persist. In a Kuhnian sense, they are better paradigms for understanding public corporations.
This means that, by demanding that corporations maximize shareholder value, we may indeed be fishing with dynamite. It is not only logically possible, but predictable, that a single-minded focus on maximizing “shareholder wealth” can end up harming shareholders—and stakeholders, corporations, society, and the environment as well.
PART II
What Do Shareholders Really Value?
CHAPTER 5
