The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public

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In this radical debunking of pervasive myths about how corporations and investors behave, UCLA professor and legal celebrity Lynn Stout shows how-contrary to entrenched belief-"shareholder primacy" is not mandated by corporate law and actually harms shareholders themselves.

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Chapter One The Rise of Shareholder Value Thinking

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The public corporation as we know it today was born in the late 1800s and did not reach its full maturity until the early twentieth century. Before then, most business corporations were “private” or “closely held” companies whose stock was held by a single shareholder or small group of shareholders. These controlling shareholders kept a tight rein on their private companies and were intimately involved in their business affairs.

By the early 1900s, however, a new type of business entity had begun to cast a growing shadow over the economic landscape. The new, “public” corporation issued stock to thousands or even tens of thousands of investors, each of whom owned only a very small fraction of the company’s shares. These many small individual investors, in turn, expected to benefit from the corporation’s profit-making potential, but had little interest in becoming engaged in its activities, and even less ability to effectively do so. By the 1920s, American Telephone and Telegraph (AT&T), General Electric (GE), and the Radio Company of America (RCA) were household names. But their shareholders were uninvolved in and largely ignorant of their daily operations. Real control and authority over public companies was now vested in boards of directors, who in turn hired executives to run firms on a day-to-day basis. The publicly held corporation had arrived.11

 

Chapter Two How Shareholder Primacy Gets Corporate Law Wrong

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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 shareholder 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.

 

Chapter Three How Shareholder Primacy Gets Corporate Economics Wrong

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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

 

Chapter Four How Shareholder Primacy Gets the Empirical Evidence Wrong

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Chapters 2 and 3 explored how shareholder primacy thinking is neither required by law nor consistent with the real economic structure of public corporations. Nevertheless, the law permits companies to embrace the goal of shareholder value if they elect to do so. A corporation could, for example, mandate shareholder primacy in its charter (although as we have just seen, virtually no public corporation does so).

But as shareholder primacy advocates often point out, there are less-extreme strategies that companies also could adopt to make directors and executives more eager to embrace shareholder value as a goal. For example, a company might encourage its directors to focus more exclusively on shareholder interests by ensuring they are “independent” (that is, not also employed as executives by, or doing business as creditors or suppliers with, the firm). Another strategy that keeps boards attentive to public shareholders’ demands is to make sure the company has only one class of equity shares with equal voting rights, not a “dual class” equity structure where there is a second class of shares, typically held by managers or other insiders, with greater voting power. Yet a third way to give shareholders greater influence over boards is to remove “staggered board” provisions that typically allow shareholders to elect only one-third of the members of the board in any given year, thus making it easier for dissident shareholders to try to replace the entire board in a single proxy voting season. Similarly, removing anti-takeover defenses like “poison pills” makes it harder for the board to fend off a hostile takeover bid at a premium price and so also makes directors more attentive to keeping share price high.

 

Chapter Five Short-Term Speculators versus Long-Term Investors

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Of all the possible problems posed when corporations adopt “maximize shareholder value” as their goal, one in particular has captured the attention of the business community almost from the beginning of the standard model’s ascendance. This is the fear that companies whose directors focus on stock price will run firms in ways that raise that price in the short term, but harm firms’ long-term prospects. For example, a company might seek to raise accounting profits by eliminating research and development expenses, or cutting back on customer relations and support in ways that eventually erode consumer trust and brand loyalty. The result is a kind of corporate myopia that reduces long-term returns from stock ownership.

Until 1987, many finance economists argued that the myopia argument made no sense, because it was impossible for managers to adopt strategies that harmed the firm’s future without producing an immediate decline in share price. This argument was based on widespread embrace of a theory called the “efficient markets hypothesis.”94 Although the literature on the efficient markets hypothesis is both enormous and technical enough to induce narcolepsy, the basic idea can be summarized as follows: stock markets are “fundamental value efficient” when the market price of a company’s stock incorporates all information relevant to its value, producing a share price that reflects the best possible rational estimate of the stock’s likely future risks and returns. In a fundamental value efficient market, there is no need for an investor to stay up late at night trying to figure out what her shares are really worth. She can sleep soundly knowing the market has done her valuation homework for her. Nor is there any fear that today’s stock price might not reflect the firm’s long-run value. Long run and short run merge, because there is only one accurate way to measure a stock’s future risks and returns: by its current market price. Corporate myopia cannot be a problem, because the stock market punishes shortsightedness.

 

Chapter Six Keeping Promises to Build Successful Companies

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We have just seen how, when stock market prices don’t capture fundamental value perfectly, the interests of short-term speculators conflict with those of longer-term investors. This chapter examines an even odder chronological tension: the conflict between shareholders’ initial interest in making commitments to stakeholders and to each other, and their subsequent interest in breaking those commitments later.

To understand the nature of the problem, consider Ulysses’s dilemma when he sailed the Odyssey past the island of the Sirens. The Sirens were beautiful women with compelling voices, but like many beautiful women they followed a strict diet: they used their singing to lure sailors to the island, where the Sirens would promptly kill and eat them. To protect his men from the Sirens’ songs, Ulysses ordered them to stuff their ears with wax as the Odyssey sailed by the island, so they could not hear. But Ulysses himself wanted to experience the Sirens’ music. He left his ears unplugged and ordered his sailors to bind him tightly to the Odyssey’s mast. He also told his sailors not to release him, no matter how he begged and pleaded, until after the Sirens were safely out of sight and sound.

 

Chapter Seven Hedge Funds versus Universal Investors

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To most people, corporations are abstractions. As one old English case famously put it, corporations have “no soul to damn and no body to kick.” By contrast, shareholders seem concrete. When we imagine shareholders, we picture parents saving for a child’s college tuition; retirees waiting for dividend checks; or, sometimes, a wealthy hedge fund baron driving his Ferrari up a long driveway between manicured lawns to the door of his Connecticut mansion.

This view gets it backwards. Corporations may be invisible, but they are quite real. Corporations own real property, enter real contracts, and pay real damages for committing real torts. They can live indefinitely, control more resources than many national governments, and thrive, weed-like, in the harshest locations and climates. By contrast, “the shareholder” is fictional. Shareholders seem more real than corporations because when we think of shareholders, we are not actually thinking of shareholders at all. We are thinking of human beings: fragile biological organisms who may happen to own, among their many different assets, shares of stock.

 

Chapter Eight Making Room for Shareholder Conscience

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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.

 

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