The Shareholder Value Myth

by Lynn Stout

  Why Hedge Funds Have the Advantage over Universal Owners

  Undiversified activist hedge funds accordingly pose a special threat to the welfare of universal owners. Of course, an activist hedge fund manager might argue that his interests, and those of his wealthy clients, are just as important and just as worthy of consideration as the interests of more-diversified investors. Similarly, he might argue that even if universal owners are more numerous, this gives them no moral claim to better treatment.

  This may be fair enough. Yet even if we treat activist hedge fund and universal investor interests as on a par, the universal owner concept still undermines the case for shareholder primacy. This is because hedge funds’ interests not only conflict with those of universal owners: shareholder primacy thinking gives activist hedge funds disproportionate power and influence over corporations.

  Activists like Icahn do not suffer from the rational apathy that small retail investors, and even most diversified pension and mutual funds, do. The lack of diversification that puts hedge fund managers’ interests at odds with those of most other investors also gives them an enormous advantage when it comes to influencing boards of directors. By taking relatively large positions in relatively few companies, activist hedge funds position themselves to pressure boards with realistic threats of embarrassing news stories and proxy battles if the directors refuse to undertake massive share repurchases, asset sales, employee reductions, and other strategies designed to “unlock shareholder value.”

  As discussed in Chapter 5, often these hedge fund strategies are nothing more than gimmicks designed to temporarily raise share price without creating lasting wealth. In other cases, schemes to raise share price can be affirmatively destructive to universal investors, destroying value in the other assets in their portfolios. Thus shareholder value thinking becomes especially dangerous to universal investors when hedge funds are added into the mix. Yet many universal investors themselves—retired teachers and firefighters, newly-weds saving to buy a home, parents saving for a child’s college tuition—continue to remain largely unaware of the potential for self-destruction implicit in demanding that corporations seek to “maximize shareholder value.” In the famed words of the cartoon character Pogo, universal investors have met the enemy, and he is us.

  CHAPTER 8

  Making Room for Shareholder Conscience

  Once we abandon the artifice of viewing investors’ interests solely from the perspective of a hypothetical and unrealistic Platonic shareholder, and focus on the reality that human beings who own shares are to at least some degree universal investors, it becomes obvious that conventional shareholder value thinking can be a self-defeating investment strategy for many—if not all—people who happen to own stock. At the same time, the universal investor challenge to shareholder primacy has limits. The category of universal investor is still restricted to those who do in fact hold stocks, whether directly or through a pension or mutual fund.

  Compared to the rest of the world, Americans have a great fondness for stock markets. Although stock ownership has declined somewhat in recent years, it is estimated that about 54 percent of Americans hold stocks directly or indirectly.131 Yet this impressive number still leaves a large number of Americans too poor or too nervous to invest in corporate equities. It also leaves out most of the six billion-plus other people on Earth. It does not include the future generations who will inherit the economy and the planet we leave to them. It does not include animals killed to test cosmetics, endangered species like the spotted owl, or ecologies like the polar ice cap or Amazonian rainforest.

  Even if we approach the question of corporate purpose from the perspective of universal owners rather than nonexistent undiversified “shareholders,” we are still focusing only on the interests of those who belong to the moneyed investing class. What do these investors want? What serves their interests?

  Most People Are Not Psychopaths

  Conventional shareholder value thinking presumes that investors, universal or not, care only about their own material circumstances. Like most of economic theory, it embraces a homo economicus model of human behavior that presumes most people are both rational and selfish. But it is increasingly accepted even among economists that the homo economicus model can be highly inaccurate. This idea provides the basis for a fourth challenge to the shareholder value paradigm: the idea of the prosocial shareholder.

  One problem with homo economicus, observers have pointed out, is that a purely rational and purely selfish person is a functional psychopath. If “Economic Man” cares nothing for ethical boundaries or others’ welfare, he will lie, cheat, steal, even murder, whenever it serves his material interests. Not surprisingly, although homo economicus is alive and well in many economics departments, in recent years a number of prominent theorists have branched out into so-called behavioral economics, which uses data from psychological experiments to see how real people really behave. This experimental data confirms something both important and reassuring. Most of us are not conscienceless psychopaths.

  The scientific data now demonstrates beyond reasonable dispute that the vast majority of human beings are at least to some degree “prosocial.” In the right circumstances, most of us can be counted on to make modest personal sacrifices in order to follow ethical rules and avoid harming others. (The estimated 1 percent to 3 percent who cannot be counted on to do this are indeed psychopaths.) It’s easy enough to doubt pervasive prosociality when reading the daily news. We should remember, however, that cheating, corruption, rape, and murder make the news because they are relatively rare. (No newspaper would run the headlines “Large Man Waits Patiently at Back of Line,” or “Employee Doesn’t Steal, Even When No One’s Looking.”) As the phrase “common decency” suggests, prosocial behavior is so omnipresent we tend not to notice it.

  Nevertheless, the scientific evidence demonstrates that prosociality is endemic. In one common experiment called a “social dilemma,” for example, anonymous subjects are asked to choose between a defection strategy that maximizes their own personal payoffs, and a cooperation strategy in which they individually receive slightly less but the other members of the group receive more. As many as 97 percent of subjects choose to cooperate in some social dilemma games. Similarly, in another experiment called a “dictator game,” subjects are divided into pairs and one subject is given a sum of money and asked whether he or she wants to share the money with the second subject, or not. In some dictator game experiments, 100 percent of the lucky subjects share at least part of their funds. Not surprisingly, researchers have found that the incidence of such behaviors declines as the personal cost of pro-social action rises: we are more likely to be nice when it only takes a little, not a lot, of skin off our own noses. Nevertheless, the evidence overwhelmingly demonstrates that the vast majority of people are willing to make at least small personal sacrifices to follow their conscience.132

  Most Shareholders Are Not Psychopaths, Either

  There is no reason to think investors are less prosocial than others. I suspect most Union Carbide shareholders would have been happy to accept a somewhat lower dividend if this allowed Union Carbide to adopt safety measures that would have prevented the deadly explosion in Bhopal, India, that killed 2,000 and severely injured thousands more. Similarly, I suspect most Exxon shareholders would have preferred to get slightly lower returns on their investment if this could have prevented the Exxon Valdez environmental disaster. In line with these suspicions, one survey has reported that 97 percent of shareholders agree that corporate managers should take some account of nonshareholders’ interests in running firms.133

  Even more direct support for shareholder prosociality can be found in the increasing popularity of socially responsible investment funds (“SRI funds”). SRI funds market themselves to investors by explicitly promising to seek out companies whose practices promote consumer protection, human rights, or environmental sustainability, or to avoid firms that support tobacco, child labor, or weapon
s production. Although the evidence is mixed, at least some studies suggest that socially responsible investment funds may slightly underperform other funds.134 Nevertheless, SRI funds have proven highly attractive to investors, taking in investment funds at a much higher rate than the institutional investing industry as a whole. By 2010, 12 percent of all professionally managed assets were managed by socially responsible funds of one sort or another.135

  Additional evidence of investor prosociality can be found in several states’ passage of laws permitting so-called B Corporations, which are required to publicly report their social and environmental performance, and which allow shareholders to sue the B corporation board for failing to adequately pursue the public good. Finally, public corporations and the SEC have for decades wrestled with shareholder proxy proposals demanding that companies act more responsibly by divesting interests in countries with repressive political systems, promoting greater employee diversity, trying to reduce the company’s carbon output, and so forth.

  But this direct evidence of investor prosociality raises its own problems. Modern science suggests that the vast majority of people are at least to some degree prosocial. Why aren’t even more assets invested in socially responsible funds? Why don’t more shareholders file proposals asking their companies to reduce their carbon footprints? How can we reconcile the empirical evidence on endemic human prosociality, with most investors’ apparent indifference to anything other than stock price?

  Obstacles to Investor Prosociality

  Harvard law professor Einer Elhauge has explored this puzzle in some detail.136 He argues persuasively that for at least two reasons, when otherwise prosocial people put on their shareholder hats, they are likely to make asocial investing decisions that cut against their own prosocial inclinations. First, Elhauge points out, diversified shareholders who are uninvolved in and ignorant of a company’s day-to-day business decisions are in no position to police against, or even know about, antisocial corporate behavior. To the contrary, because the only thing most investors see is stock price, they are likely to pressure corporate directors and executives to adopt strategies that (unbeknownst to prosocial investors) make corporate harms to third parties more likely. And when disaster strikes, uninvolved shareholders are unlikely to feel personally responsible. How many BP shareholders felt responsible for the Deepwater Horizon disaster?

  Second, prosocial investors face a classic collective action problem, another investing Tragedy of the Commons. If socially responsible investment funds provide even slightly lower returns than other funds do, the investor who chooses a socially responsible fund incurs a direct personal cost for his prosociality. At the same time, his individual decision to “put his money where his conscience is” is likely to have little or no marginal impact on the behavior of the corporate sector as a whole. Elhauge concludes that “it is remarkable that many people do invest in socially responsible funds considering that their individual decision to do so has no significant impact on furthering even their most altruistic of motives.”137

  Elhauge’s argument that the nature of modern stock markets discourages prosocial investing behavior is reinforced by the behavioral data. The scientific evidence reveals that, while most people are capable of and even inclined toward prosociality, our prosocial impulses depend greatly on external social cues. In my 2011 book Cultivating Conscience: How Good Laws Make Good People, I label this phenomenon the “Jekyll-Hyde Syndrome.”138 Researchers can dramatically increase the likelihood that experimental subjects will act prosocially by asking them to act prosocially; by leading them to believe other subjects would behave prosocially; and by structuring the experiments so that individuals’ prosocial decisions provide larger, rather than smaller, benefits to the other subjects in the group. Conversely, people act more selfishly when told they should be selfish, when they believe others would act selfishly, and when they think their selfishness imposes only a small cost, or no cost, on others.

  The result is that most people behave as if they have at least two different personalities. When our Mr. Hyde personality is in charge, we try to maximize our own material welfare without worrying about how our decisions affect others. When prosocial Dr. Jekyll holds the reins, we sacrifice for others and follow legal and ethical moral rules, at least as long as it doesn’t cost us too much.139 The same person who donates money to the Sierra Club and World Wildlife Fund might happily hold stock in oil and timber companies that engage in environmentally destructive drilling and clear-cutting.

  Unfortunately, when it comes to investing, shareholder primacy ideology seems almost deliberately designed to bring out our inner Mr. Hydes. The standard shareholder-oriented model of the corporation teaches that it is not only acceptable but morally correct for shareholders to pressure managers to raise share price any way possible, without regard for how the corporation’s actions impact stakeholders, society, or the environment. Shareholder value rhetoric also inevitably signals that most other investors are behaving selfishly. Finally, the standard model teaches that selfish investing, far from harming others, actually benefits them by promoting better corporate performance and greater economic efficiency.

  Thus we should not be surprised if only a minority of investors chose socially responsible funds. As Elhauge points out, we should be surprised that any investors do. The structure of modern stock markets, combined with the rhetoric of shareholder primacy, creates almost insurmountable obstacles to prosocial investing behavior.

  Shareholder Value Thinking Reduces Shareholders to Their Lowest Moral Denominator

  The unhappy result is that even though most of us are not conscienceless psychopaths, when we make investing decisions we often act as if we are. Accordingly, even when corporate executives and directors have perfectly well-tuned moral compasses, shareholder value thinking subjects them to relentless pressure from investors who may act as if they have no moral compass at all. As Einer Elhauge has observed, the situation would be even worse if U.S. corporate law actually required directors to maximize profits: this would “dictate corporate governance by the lowest possible moral denominator … enforcing the very soullessness for which corporations have historically been feared.”140

  This observation casts an interesting light on Joel Bakan’s influential and award-winning 2004 documentary The Corporation. In the film and his accompanying book with the same title, Bakan argued that because corporate managers believe they must maximize shareholder wealth, a corporation is a “psychopathic creature” that “can neither recognize nor act upon moral reasons to refrain from harming others.”141 To the extent this is true, shareholders themselves may be largely to blame. As University of Toronto law professor Ian Lee puts it, “If corporations are in fact ‘pathological’ profit-maximizers, it is not because of corporate law, but because of pressure from shareholders.”142

  Once again, we see the ideology of shareholder value causing corporations to behave in ways contrary to most shareholders’ true interests. Some individual shareholders may in fact be purely self-interested actors—psychopaths—who don’t mind if the companies they invest in exploit child labor, deceive consumers, maim employees, or pollute the environment. But the scientific data indicate the vast majority of us would prefer to tolerate at least somewhat diminished returns to avoid such results. Because most studies find that socially responsible investing erodes investors’ returns only slightly, if at all,143 shareholder psychopathy appears to be neither natural nor inevitable but an artifact, the unfortunate outcome of collective action obstacles combined with shareholder value ideology.

  CONCLUSION

  “Slaves of Some Defunct Economist”

  In the 1933 Supreme Court case of Liggett v. Lee, Justice Louis Brandeis famously called the public corporation a “Frankenstein monster which states have created by their corporation laws.”144 Brandeis was dissenting in Liggett, but his observations about the nature of corporations were right on the mark. In creating the legal institution known as the public co
rporation, state legislatures breathed life into immensely powerful and long-lived entities that interact with human beings on equal legal footing. The corporate whole is much more than the sum of the biological organisms who act as its directors, executives, and employees. It owns property, accumulates wealth, enters contracts, sues and is sued, campaigns for favorable legislation, and reproduces by forming new corporations. We created corporations; now we share the planet with them. The relationship between our two species can be symbiotic or predatory.

  Symbiont or Predator?

  So far, humans and corporations seem mostly symbiotic. Just as we tend to overlook human decency and focus on the relatively few cases where people behave badly, we overlook the enormous benefits the corporate form has given the human race. Thanks to corporations, we have cheap and easy access to a host of medical products that prolong and improve our lives: vaccines to prevent disease, antibiotics to cure infections, contraceptives to prevent unwanted pregnancies. Thanks to corporations, we can fly from one coast of the United States to the other in less than six hours and for less than $1,000. (As uncomfortable and expensive as airline travel maybe, it is a vast improvement over making the journey on foot or by covered wagon.) Corporations provide good livelihoods for many individuals, including shareholders who get dividends, bondholders who earn interest, and employees who receive salaries and health and retirement benefits. They benefit our society and future generations by paying taxes, making scientific discoveries, and designing and producing new technologies. They even, as New York University law professor Cynthia Estlund has pointed out, encourage us to treat each other better, promoting gender and racial equality and cooperation in integrated working environments.145