Does focusing on shareholder value hurt shareholder value?
Shareholders own the corporation, so managers should maximize returns for shareholders, right? Corporate law expert Lynn Stout says that there are problems with this argument, starting with the fact that legally shareholders don't own a corporation. On top of that, she says, prioritization of shareholder value harms returns in the long run.
Q: From society's perspective, what is a corporation for?
Corporations are social and economic institutions that serve many different groups. They have made enormous contributions to human welfare. The evidence suggests that the primary purpose was as a vehicle for locking in financial capital, so that corporations could pursue projects that required enormous amounts of specific investment, such as building railroads, canals, or manufacturing plants; developing brand names; or producing patents or patentable processes.
They serve a vital economic function, and to do that, they need various inputs, not just financial capital from shareholders and creditors, but human capital inputs from executives and rank and file.
Q: Has the view of the function of corporations changed over time?
For most of the 20th century, large public corporations were managed according to a philosophy that was called managerial capitalism. According to managerial capitalism, the directors of the company were not mere agents, and they certainly were not mere agents beholden only to shareholders. They viewed themselves as trustees or stewards, who were supposed to steer these great institutions in a direction that would keep the institutions alive, and in the process, serve the interests of a wide range of stakeholders.
If you look at business history, you'll see that managerialist firms turned in excellent results—investors got significantly higher returns in the days of managerial capitalism than they're getting today—while simultaneously offering secure employment to their employees and playing a positive role in the nation state and the political system. They weren't perfect. I'm not suggesting that. I'm just suggesting that the great corporations of the managerialist era arguably were doing a better job for their constituencies than our modern corporations are today. That all changed—rather quickly, in a historical sense—in the 1970s.
Q: What happened?
As best as I can tell, the change from a managerialist philosophy to today's dominant philosophy of shareholder value was actually not the result of any bottom-up demand from the business world. It was instead an attempt at top-down reform that began with academic theory. Of course, we should always be nervous when we try to change a system that evolved naturally on the basis of academic theory.
If I had to finger a single individual who got us started in what I regard as the wrong direction, it has to be poor old Milton Friedman, who wrote a very famous article in the New York Times Magazine in 1970 in which he argued that shareholders own corporations, and that corporations have a single purpose—to maximize profits for shareholders.
What's interesting about this to a legal scholar is that Milton Friedman was, in a way, making a legal claim and he was dead wrong about it.
Shareholders do not own corporations. Corporations are legal entities that own themselves. That's important because it's essential to their performing their function of aggregating specific investments. If shareholders owned corporations, they could yank those specific investments out any time they wanted to.
Milton Friedman's claim that corporations are run well when they are run to maximize profits for shareholders is also not based in law. According to a doctrine called the Business Judgment Rule, there is no obligation for the directors of public corporations to maximize profits.
Q: What is the argument for shareholder value as a legal requirement?
If you ask advocates of the idea for any legal support, they almost invariably cite a single case: Dodge v. Ford. But no good lawyer would ever rely on that case in today's world. It's not a case from Delaware, which is the jurisdiction that really counts in American corporate law. The case is almost 100 years old, which makes it ancient by legal standards. On top of that, it was not in fact a case about public corporations. It was a case about a dispute over the obligations of a majority shareholder to minority shareholders in a closely held corporation.
In Dodge v. Ford, Henry Ford controlled the Ford Motor Company. He was denying dividends to the Dodge brothers so they couldn't use the money to compete with him. The Michigan Supreme Court found that Ford did have to pay a special dividend, but the case should be understood to be about controlling shareholders' duties not to oppress minority shareholders. The one Delaware opinion that cited Dodge v. Ford in the last 30 years cites only that. The part of Dodge v. Ford that shareholder value advocates cite is what lawyers call "dicta"—a very carefully qualified offhand remark by the court that didn't play into the legal grounds for the decision.
If you look at Delaware, what you see are cases like the recent case of Air Products v. Air Gas, where the court says the board of directors is "not under any per se duty to maximize shareholder value in the short term, even in the context of a takeover."
As far as Delaware is concerned, directors are completely free to adopt any goal, which could include maximizing share price or taking care of employees, being responsible to creditors and suppliers, or being a good corporate citizen. That's true even when they receive a takeover bid. The Air Gas board of directors refused to sell the company for $70 a share, even though it had been trading for $40 or $50 a share, and the court said that's all right—you don't have to sell the company, even at a higher price.
Q: Why did the shareholder value approach take over?
This very narrow economic theory, which started with Milton Friedman—and eventually got taken up by William Meckling and Michael Jensen, in 1976, with a famous article called "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,"—ended up being very appealing to a number of influential interest groups.
One was academics themselves. It allowed empirical scholars to claim to have a perfect metric for measuring corporate performance. It allowed economists to give opinions on what was good corporate management, even if they didn't have any particular background in the business world, or any detailed legal understanding of how corporations operate. And it offered a very simple story about what corporations are and what they're supposed to do that is much easier to teach in the classroom than the messy reality of what is essentially a quasi-political system in which there are many stakeholders that make economic investments and have various kinds of soft and hard rights. That search for simplicity and the exact right answer has a lot of sway. It's a siren song for academics.
Two other main groups had a financial interest in pushing this idea: hedge funds and corporate executives.
Hedge funds, which really got going in the late 1980s and 1990s, found shareholder value ideology very profitable, because it allowed them to take stakes in companies, push the directors to do things that pump up the share price in the short term, and then sell. This gave them the mantle of being the defenders of good corporate governance, even though, in fact, most of the time the strategies that activist hedge funds push for end up harming long-term results.
A change in the tax code in 1993 gave many executives an enormous economic stake in embracing this idea, too. Congress changed the tax laws to require public corporations to tie the pay of their top executives to so-called objective performance metrics in order for that compensation to be a tax-deductible business expense. That put executives in a position where they, too, could profit from strategies that bumped up share price in the short term, even if those strategies ended up harming employees, customers, society, and shareholders in the long term.
One of the most ironic things about shareholder value ideology is that there is so little empirical evidence to support the idea that it works for most shareholders, and there is so much empirical evidence to suggest that it does not.
When there's an absolute focus on profits, we see, over and over, that companies cut back on expenses, including payroll and research and development. They do massive dividends and share repurchases, which drain the companies of cash, thus making them less prepared to deal with problems that arise. They sell off key assets and even the company itself. None of those things are good for long-term returns.
Q: What's the role of the shareholder?
One of the reasons why shareholder value ideology has become so persuasive, or at least such a dominant force in today's modern business world, is because of the change in the nature of who owns shares. If you go back to the heyday of managerialism, a very large portion of shares were held directly by individuals—so-called mom-and-pop shareholders—and they traded very infrequently. Even as late as 1960, the average holding period for a share of stock in an American public corporation was eight years.
Since then, increasingly, individuals choose not to hold shares in their own names, but instead to invest indirectly, through mutual funds and pension funds, which now collectively control nearly half of all shares. And although there are many advantages to that, one of the downsides has been that it has promoted a culture in which shares are traded much more frequently.
If you look at how frequently shares are traded now, the average holding period is down to four months. Some of that is due to flash trading, but a lot of it is simply due to the fact that your typical mutual fund portfolio manager cannot afford to think for the long term, because if he doesn't get good short-term results, he's likely to lose his job.
Q: What would help?
We could do many things to make our corporate sector work better for investors and for everyone else. If I were to pick a single silver bullet we should go after first, we should put a stock transaction tax in place again.
The idea is to get rid of this frenetic hamster-wheel, short-term flipping of shares and encourage institutional investors as well as individuals to hold shares for longer periods of time.
Q: What should happen with pay for performance?
We could try to improve the performance measures. I think, after 20 years of trying to perfect the idea of so-called objective performance metrics, we still haven't gotten it down. I'm fond of the bad old days when we gave CEOs a million dollars and an executive jet. It cost less and it seems to have produced better results.
Q: The business landscape has changed dramatically since the 1970s. Is there still a place for managerialism? Being globally competitive requires the capacity for quick reaction. Is there room for a long-term perspective?
One of the wonderful roles that corporations can play for society is that, as entities that, theoretically, can have an infinite life, they actually have the capacity to plan for the future better than most humans do. The insurance industry, right now, is planning and strategizing over what to do about climate change, which puts it considerably ahead of, say, the average politician or voter.
But, another consequence of shareholder value ideology is that corporations are having more and more difficulty taking that long view because their life expectancy is declining. Stephen Denning at Forbes reported that the life expectancy of Fortune 500 companies, which at one point was an average of 75 years, is now down to 15 years. And that's because our corporations are disappearing—they're blowing up in scandals and disasters, they're being acquired by other firms, they're being taken private.
The number of public companies is declining severely. In 1997, there were 8,823 companies listed on U.S. exchanges. By 2008, that number was down to 5,401. That is an almost 40% decline in the population of public companies. If public companies were a species, we would call them endangered.
Public corporations once played very important roles in planning for the future. Remember the days when IBM, Xerox, Bell Labs, and DuPont all did an enormous amount of pure research, which is the ultimate investment in the future? Those firms can no longer play that role. If a company is going to plan for the future, it's going to have to become privately held and escape shareholder-primacy pressures.
The public corporation is becoming increasingly dysfunctional, so there's a shift to the private corporation. That's where we see the beginnings of what could be labeled managerialism 2.0. Companies that do go public are, increasingly, what I call private companies that are in the closet. They're using dual-class share structures, where the founders and the management keep all the voting power, and public shareholders are essentially disenfranchised. We see this with all the tech companies—Google, LinkedIn, Facebook. We see this with the private equity companies that have gone public.
Q: Is that going to hurt shareholders?
Investors are lining up to buy shares in the dual-class companies, which might be going too far in the direction of leaving public shareholders powerless. My thesis is that what might be better for shareholders is to go back to some version of managerialism, where you basically say to shareholders, look, you're pretty much along for the ride. You're only going to exercise a governance function in extreme cases where something has gone terribly wrong and you're willing to incur the high cost of removing the incumbent board of directors.
In other words, we need a bit less shareholder democracy. The country that comes closest to a perfect world of shareholder democracy and shareholder-value ideology is the United Kingdom. And it has a notably poor track record in terms of generating great global companies that serve their investors. Of the top 30 global firms, only one is in the UK, and that's BP. And BP's record recently is not that impressive. By contrast, the nations that have a long record of creating successful global companies—Japan, France, Germany, and, at least until recently, the United States—all give shareholders notably limited rights and influence in corporations.
Q: Are you seeing different behavior from management in private companies?
Management behaves entirely differently in privately held companies. One pattern we see: they take better care of their employees. They're much less likely to fire them because they need to make their numbers for the quarter. They pay their executives less. And this is sort of a soft factor, but they are much more likely to publicly express a willingness to sacrifice today's profits for the benefit of a larger social good.
Google's unofficial motto, quite famously, is "Don't be evil." Now, one can argue that they don't always live up to that motto. But I think they couldn't even have it as a motto if they didn't have their dual-class structure. So there you go. That's what I'm talking about when I'm taking about managerialism 2.0.
Q: You describe this system arising out of academia. What's the role for academia now?
At the top of the to-do list for us academics is changing the way we teach corporate law and corporate theory. One of the key reasons why shareholder-value ideology has been embraced by the business world, according to a recent study by the Brookings Institution, is that that's what today's generation of business leaders have been taught.
If the professor tells students in business school that they have one job, and that's to maximize shareholder value, we really can't be too upset when that's what they turn around and try and do when they go out into the business world. But we shouldn't be in the business of imparting fables to our students, no matter how charming the fables might be. We need to roll up our sleeves and embrace the messy reality of corporations as social and economic institutions.
For more on this, see Lynn Stout's book The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.
Interview conducted and edited by Ted O'Callahan.