Naked Capitalism | February 03 2017
From the early days of this website, we’ve written from time to time about why the “shareholder value” theory of corporate governance was made up by economists and has no legal foundation. It has also proven to be destructive in practice, save for CEO and compensation consultants who have gotten rich from it.
Further confirmation comes from a must-read article in American Prospect by Steven Pearlstein, When Shareholder Capitalism Came to Town. It recounts how until the early 1990s, corporations had a much broader set of concerns, most importantly, taking care of customers, as well as having a sense of responsibility for their employees and the communities in which they operated. Equity is a residual economic claim. As we wrote in 2013:
Directors and officers, broadly speaking, have a duty of care and duty of loyalty to the corporation. From that flow more specific obligations under Federal and state law. But notice: those responsibilities are to the corporation, not to shareholders in particular…..Equity holders are at the bottom of the obligation chain. Directors do not have a legal foundation for given them preference over other parties that legitimately have stronger economic interests in the company than shareholders do.
And even in the early 1980s, common shares were regarded as a speculative instrument. And rightly so, since shares are a weak and ambiguous legal promise: “You have a vote that we the company can dilute whenever we feel like it. And we might pay you dividends if we make enough money and are in the mood.”
However, 1900s raiders who got rich by targeting companies that had gotten fat, defended their storming of the corporate barricades by arguing that their success rested on giving CEOs incentives to operate in a more entrepreneurial manner. In reality, most of the 1980s deals depended on financial engineering rather than operating improvements. Ironically, it was a form of arbitrage that reversed an earlier arb play in the 1960s. Diversified corporations had become popular in the 1960s as a borderline stock market scam. Companies like Teledyne and ITT, that looked like high-fliers and commanded lofty PE multiples, would buy sleepy unrelated businesses with their highly-valued stock. Bizzarely, the stock market would value the earnings of the companies they acquired at the same elevated PE multiples. You can see how easy it would be to build an empire that way.
The 1970s stagflation hit these companies particularly hard, with the result that the whole was worth less than the sum of the parts. This made for an easy formula for takeover artists: buy a conglomerate with as much debt as possible, break it up and sell off the pieces.
But CEOs recognized how the newly-installed leaders of LBO acquisitions got rich through stock awards or option-type compensation. They wanted a piece of the action.
One of their big props to this campaign was the claim that companies existed to promote shareholder value. This had been a minority view in the academic literature in the 1940s and 1950s. Milton Friedman took it up an intellectually incoherent New York Times op-ed in 1970. Michael Jensen of Harvard Business School and William Meckling of the University of Rochester argued in 1976 that corporate managers needed to have their incentives better aligned with those of shareholders, and the way to do that was to have most of their pay be equity-linked. In the late 1980s, Jensen in a seminal Harvard Business Review article, claimed that executives needed to be paid like entrepreneurs. Jensen has since renounced that view.
Why The Shareholder Value Theory Has No Legal Foundation
Why do so many corporate boards treat the shareholder value theory as gospel? Aside from the power of ideology and constant repetition in the business press, Pearlstein, drawing on the research of Cornell law professor Lynn Stout, describes how a key decision has been widely misapplied:
Let’s start with the history. The earliest corporations, in fact, were generally chartered not for private but for public purposes, such as building canals or transit systems. Well into the 1960s, corporations were broadly viewed as owing something in return to the community that provided them with special legal protections and the economic ecosystem in which they could grow and thrive.
Legally, no statutes require that companies be run to maximize profits or share prices. In most states, corporations can be formed for any lawful purpose. Lynn Stout, a Cornell law professor, has been looking for years for a corporate charter that even mentions maximizing profits or share price. So far, she hasn’t found one. Companies that put shareholders at the top of their hierarchy do so by choice, Stout writes, not by law…
For many years, much of the jurisprudence coming out of the Delaware courts—where most big corporations have their legal home—was based around the “business judgment” rule, which held that corporate directors have wide discretion in determining a firm’s goals and strategies, even if their decisions reduce profits or share prices. But in 1986, the Delaware Court of Chancery ruled that directors of the cosmetics company Revlon had to put the interests of shareholders first and accept the highest price offered for the company. As Lynn Stout has written, and the Delaware courts subsequently confirmed, the decision was a narrowly drawn exception to the business–judgment rule that only applies once a company has decided to put itself up for sale. But it has been widely—and mistakenly—used ever since as a legal rationale for the primacy of shareholder interests and the legitimacy of share-price maximization.
How the Shareholder Value Theory Has Been Destructive
The shareholder value theory has proven to be a bust in practice. Here are some of the reasons:
It produces short-termism, underinvestment, and a preoccupation with image management. We wrote in 2005 for the Conference Board Review about how the preoccupation with quarterly earnings led companies to underinvest on a widespread basis. Richard Davies and Andrew Haldane of the Bank of England demonstrated that companies were using unduly high discount rates, which punished long-term investment. Pearlstein provides more confirmation:
A recent study by McKinsey & Company, the blue-chip consulting firm, and Canada’s public pension board found alarming levels of short-termism in the corporate executive suite. According to the study, nearly 80 percent of top executives and directors reported feeling the most pressure to demonstrate a strong financial performance over a period of two years or less, with only 7 percent feeling considerable pressure to deliver strong performance over a period of five years or more. It also found that 55 percent of chief financial officers would forgo an attractive investment project today if it would cause the company to even marginally miss its quarterly-earnings target.
As we’ve stated before, we’ve been hearing this sort of thing from McKinsey contacts for more than a decade. And the “55 percent” figure likely understates the amount of short-termism. First, even in a presumably anonymous survey, some CFOs might be loath to admit that. Second, for any project big enough to impact quarterly earnings, the CFO is almost certain not to have the final say. So even if his team approves it, it could be nixed by the CEO out of concern for earnings impact.
It empirically produces worse results. We’ve written from time to time about the concept of obliquity, that in a complex system that is affected by interactions with it, it is impossible to map out a simple path to a goal. As a result, other approaches are typically more successful. From a 2007 Financial Times article by John Kay, who later wrote a book about the concept:
Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.
Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck (“We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been”) with that of John McKeen of Pfizer (“So far as humanly possible, we aim to get profit out of everything we do”).
Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.
Some more commonly-cited reasons for why a focus on shareholder value hurts performance is that it dampens innovation. Pearlstein describes another, how it demotivates workers:
Perhaps the most ridiculous aspect of shareholder–über-alles is how at odds it is with every modern theory about managing people. David Langstaff, then–chief executive of TASC, a Virginia–based government-contracting firm, put it this way in a recent speech at a conference hosted by the Aspen Institute and the business school at Northwestern University: “If you are the sole proprietor of a business, do you think that you can motivate your employees for maximum performance by encouraging them simply to make more money for you?” Langstaff asked rhetorically. “That is effectively what an enterprise is saying when it states that its purpose is to maximize profit for its investors.”
And on a societal level, it erodes social capital and trust, which are the foundations for commerce:
It is our social capital that is now badly depleted. This erosion manifests in the weakened norms of behavior that once restrained the most selfish impulses of economic actors and provided an ethical basis for modern capitalism. A capitalism in which Wall Street bankers and traders think peddling dangerous loans or worthless securities to unsuspecting customers is just “part of the game,” a capitalism in which top executives believe it is economically necessary that they earn 350 times what their front-line workers do, a capitalism that thinks of employees as expendable inputs, a capitalism in which corporations perceive it as both their fiduciary duty to evade taxes and their constitutional right to use unlimited amounts of corporate funds to purchase control of the political system—that is a capitalism whose trust deficit is every bit as corrosive as budget and trade deficits.
As economist Luigi Zingales of the University of Chicago concludes in his recent book, A Capitalism for the People, American capitalism has become a victim of its own success. In the years after the demise of communism, “the intellectual hegemony of capitalism, however, led to complacency and extremism: complacency through the degeneration of the system, extremism in the application of its ideological premises,” he writes. “‘Greed is good’ became the norm rather than the frowned-upon exception. Capitalism lost its moral higher ground.”
Many elite professionals are deeply upset with Trump’s win. Yet the ideology that he represents is very much in line with the logic of corporate raiders, many of whom, like him, went to Wharton Business School. And many elite professionals, in particular lawyers and consultants, profited handsomely from the adoption of the buccaneer capitalist view of the world and actively enabled much of its questionable thinking and conduct. As CEO pay rose, so to did the pay of top advisers. They couldn’t be all that good, after all, if they were in a wildy different income strata.
So as Lambert has warned, unless we hear a different economic and social vision from The Resistance, which looks troubling to have more failed Democratic party influence behind it than either of us like, the best we are likely to get is a restoration. And if you remember the French Revolution, strongman Napoleon was succeeded by the Bourbon Restoration, which then led to the Second Empire under his nephew. So if we want better outcomes, status quo ante is not good enough.