For CdM: On Shareholder Value

[Sheilbh]

How the cult of shareholder value wrecked American business
By Steven Pearlstein, Published: September 9 at 12:20 pm

In the recent history of management ideas, few have had a more profound — or pernicious — effect than the one that says corporations should be run in a manner that "maximizes shareholder value."

Indeed, you could argue that much of what Americans perceive to be wrong with the economy these days — the slow growth and rising inequality; the recurring scandals; the wild swings from boom to bust; the inadequate investment in R&D, worker training and public goods — has its roots in this ideology.

The funny thing is that this supposed imperative to "maximize" a company's share price has no foundation in history or in law. Nor is there any empirical evidence that it makes the economy or the society better off. What began in the 1970s and '80s as a useful corrective to self-satisfied managerial mediocrity has become a corrupting, self-interested dogma peddled by finance professors, money managers and over-compensated corporate executives.

Let's start with some history.

The earliest American corporations were generally chartered for public purposes, such as building canals or transit systems, and well into the 1960s were widely viewed as owing something in return to a society that provided them with legal protections and an economic ecosystem in which to grow and thrive. In 1953, carmaker Charlie Wilson famously spoke for a generation of chief executives about the link between business and the larger society when he told a Senate committee that "what is good for the country is good for General Motors, and vice versa."

There are no statutes that put the shareholder at the top of the corporate priority list. In most states, corporations can be formed for any lawful purpose. Cornell University law professor Lynn Stout has been looking for years for a corporate charter that even mentions maximizing profits or share price. She hasn't found one.

Nor does the law require, as many believe, that executives and directors owe a special fiduciary duty to shareholders. The fiduciary duty, in fact, is owed simply to the corporation, which is owned by no one, just as you and I are owned by no one — we are all "persons" in the eyes of the law. Shareholders, however, have a contractual claim to the "residual value" of the corporation once all its other obligations have been satisfied — and even then directors are given wide latitude to make whatever use of that residual value they choose, as long they're not stealing it for themselves.

It is true that only shareholders have the power to select a corporation's directors. But it requires the peculiar imagination of a corporate lawyer to leap from that to a broad mandate that those directors have a duty to put the interests of shareholders above all others.

Becoming the norm

How then did "maximizing shareholder value" evolve into such a widely accepted norm of corporate behavior?

The most likely explanations for this transformation are two broad structural changes — globalization and deregulation — which together conspired to rob many major American corporations of the outsize profits they had earned during the "golden" decades after World War II. Those profits were so generous that there was enough to satisfy nearly all the corporate stakeholders. But in the 1970s, when increased competition started to squeeze out profits, it was easier for executives to disappoint shareholders than their workers or communities. The result was a lost decade for investors.

No surprise, then, that by the mid-1980s, companies with lagging stock prices found themselves targets for hostile takeovers by rivals or corporate raiders using newfangled "junk" bonds to finance their purchases. Disgruntled shareholders were only too willing to sell. And so it developed that the mere threat of a possible takeover imbued corporate executives and directors with a new focus on profits and share prices, tossing aside old inhibitions against laying off workers, cutting wages, closing plants, spinning off divisions and outsourcing production overseas. Today's "activist investor" hedge funds, which have amassed war chests of tens of billions of dollars to take on the likes of Microsoft, Procter & Gamble, PepsiCo and Apple, are the direct descendants of these 1980s corporate raiders.

While it was this new "market for corporate control," as economists like to call it, that created the imperative to boost near-term profits and share prices, an elaborate institutional infrastructure has grown up to reinforce it.

This infrastructure includes business schools that indoctrinate students with the shareholder-first ideology and equip them with tools to manipulate quarterly earnings and short-term share prices.

It includes corporate lawyers who reflexively advise against any action that might lower the share price and invite shareholder lawsuits, however frivolous.

It includes a Wall Street establishment that is thoroughly fixated on quarterly earnings, quarterly investment returns and short-term trading.

And most of all, it is reinforced by gluttonous pay packages for top executives that are tied to the short-term performance of the company stock.

The result is a self-reinforcing cycle in which corporate time horizons have become shorter and shorter. The average holding periods for corporate stocks, which for decades was six years, is now down to less than six months. The average tenure of a public company chief executive is down to less than four years. And the willingness of executives to sacrifice short-term profits to make long-term investments is rapidly disappearing.

A recent study by the consultants at McKinsey & Co. and Canada's public pension board found alarming levels of short-termism in the corporate executive suite. They reported that nearly 80 percent of top executives and directors reported feeling most pressured to demonstrate a strong financial performance over a period of two years or less, with only 7 percent feeling pressure to deliver a strong performance over a period of five years or more. They 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.

The real irony surrounding this focus on maximizing shareholder value is that it hasn't, in fact, done much for shareholders.
Roger Martin, the outgoing dean of the Rotman School of Management at the University of Toronto, calculates that from 1932 until 1976 — roughly speaking, the era of "managerial capitalism" in which managers sought to balance the interest of shareholders with those of employees, customers and the society at large — the total real compound annual return on the stocks of the S&P 500 was 7.6 percent. From 1976 until the present — roughly the period of "shareholder capitalism" — the comparable return has been 6.4 percent.

Obviously, a lot of other things happened during those two periods that could have affected returns to shareholders. One thing we know is that less and less of the wealth generated by the corporate sector was going to frontline workers. Another is that more and more of it was going to top executives. According to Martin, the ratio of chief executive compensation to corporate profits increased eight-fold between 1980 and 2000. Almost all of that increase came from stock-based compensation.

Shareholder involvement

One practical problem is that it's not clear which shareholders it is whose interests the corporation is supposed to optimize. Should it be the hedge funds that are buying and selling millions of shares every couple of seconds to earn hedge-fund-like returns? Or mutual funds holding the stock for a couple of years? Or the retired teacher in Dubuque, Iowa, who has held it for decades?

Companies might try to answer this question by giving shareholders more of a voice in how the companies are run. But it turns out that even as they proclaim their unwavering dedication to the interest of shareholders, corporate executives and directors have been doing everything possible to minimize and discourage shareholder involvement in corporate governance. This blatant hypocrisy is most recently revealed in the all-out effort by the business lobby to prevent shareholders from voting on executive pay or having the right to nominate a competing slate of directors.

For too many corporations, "maximizing shareholder value" has also provided justification for bamboozling customers, squeezing suppliers and employees, avoiding taxes and leaving communities in the lurch. For any one profit-maximizing company, such behavior may be perfectly rational. But when competition forces all companies to behave in this fashion, it's hardly clear that society is better off.

Take the simple example of outsourcing production overseas. Certainly it makes sense for any one company to aggressively pursue such a strategy. But when every company does it, so many American workers wind up losing their jobs or having their pay cut that they can no longer buy even the cheaper goods produced overseas. The companies may also find that government no longer has sufficient tax revenue to educate workers or invest in the roads and ports and airports through which their goods are delivered to market.

Economists have a name for such unintended spillover effects — negative externalities — and normally the right fix is some form of government action. But one of the hallmarks of the era of shareholder capitalism is that every tax and every regulation is reflexively opposed by the business community as an assault on profits and shareholder value. By this logic, not only must corporations commit themselves to putting shareholders first — society is expected to do so as well.

Perhaps the most ridiculous aspect of "shareholder uber alles" is how at odds it is with every modern theory about managing people. David Langstaff, chief executive of TASC, a Chantilly-based government contracting firm, put it this way in a wonderful speech he gave at a recent conference in Chicago hosted by the Aspen Institute and 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? Of course not. But that is effectively what an enterprise is saying when it states that its purpose is to maximize profit for its investors."

These days, in fact, economies have been scrambling to explain the recent slowdown in the pace of innovation and the growth in worker productivity. Is it possible it might have something to do with the fact that American workers now know that any benefit from their ingenuity or increased efficiency is destined to go to shareholders and top executives?

Customers first?

The public, certainly, isn't buying the shareholder-first ideology. Polls by the Gallup Organization show that people's trust and respect in big corporations has been on a long, slow decline in recent decades — only Congress and health maintenance organizations are held in lower esteem. One of the rare corporate CEOs lionized on the cover of a newsweekly was the late Steve Jobs of Apple, who as it happened created more wealth for more shareholders than any corporate executive in history by putting shareholders near the bottom of his priorities.

The defense you usually hear of "maximizing shareholder value" from chief executives is that most of them don't make the mistake of confusing this week's stock price with shareholder value. They are quick to acknowledge that no enterprise can maximize long-term value for its shareholders without attracting great employees, producing great products and services and doing their part to support effective government and healthy communities. In short, they argue, over the long term there is no inherent conflict between the interests of shareholders and those of other stakeholders.

But if optimizing shareholder value requires taking care of customers, employees and communities, then by the same logic you could argue that "maximizing customer satisfaction" would, over the long term, require taking good care of shareholders, employees and communities. And, indeed, that is precisely the suggestion made long ago by Peter Drucker, the late, great management guru. "The purpose of business is to create and keep a customer," Drucker wrote.

Martin argues it is no coincidence that companies that have maintained a strong customer focus — think Apple, Johnson & Johnson and Procter & Gamble — have consistently done better for their shareholders than companies which claim to put shareholders first. The reason is that customer focus minimizes undue risk taking and maximizes reinvestment over the long run, creating a larger pie from which everyone benefits.

The truth is that most executives would be thrilled if they could focus on customers rather than shareholders. In private, they chafe under the quarterly earnings regime forced on them by asset managers and the financial press. They fear and loathe "activist" investors who threaten them with takeovers. And they are disheartened by their low public esteem.

Possible solutions

If it were simply the law that was at fault, that would be relatively easy to change. Changing a behavioral norm — particularly one reinforced by so much supporting infrastructure — turns out to be much harder.

Not that people aren't trying.

A small and growing universe of "socially responsible" investing is made up of mutual funds, public and union pension funds and research organizations that monitor corporate behavior and publish score cards based on an assessment of how they treat customers, workers, the environment and their communities.

And a dozen states, including Virginia and Maryland, and the District, have recently established a new kind of corporate charter — the benefit corporation — that explicitly commits companies to be managed for the benefit of all stakeholders. The hope is that someday there will be a sufficient number of these "B-Corps" that they can be traded on their own exchange.

The big challenge facing the "corporate social responsibility" movement, however, is that it exhibits an unmistakable liberal bias that makes it easy for academics, investment managers and corporate executives to dismiss it as ideological and naïve.

As executives see it, running a big corporation even for the long term can involve making tough choices such as laying off workers, reducing benefits, closing plants or doing business in places where corruption is rampant or environmental regulations are weak. And as executives are quick to remind, companies that ignore short-term profitability run the risk of never making it to the long term.

Among the growing chorus of critics of "shareholder value," however, a consensus is emerging around a number of relatively modest changes in tax and corporate governance laws that could help lengthen time horizons and rebalance the focus of corporate decision-making:

●The capital gains tax could be recalibrated so that short-term trading profits are taxed the same as wages and salary, while gains from investments held for long periods are taxed more lightly than they are now, or not at all. A small transaction tax could also dampen enthusiasm for short-term trading.

●The Securities and Exchange Commission could adopt rules that discourage corporations from giving quarterly earnings projections or guidance, while accounting regulators could insist that corporate financial reports better reflect long-term costs and benefits and measure long-term value creation.

●States could make it easier for corporations to adopt governance rules that give long-term shareholders more power in selecting directors, approving mergers and takeovers and setting executive compensation.

The point of such reforms would not be to force companies to adopt a different focus or time horizon but to give companies the ability to free themselves from the stranglehold of the short-term stock price. The hope would be that, over time, the corporate ecosystem would become more heterogeneous, with different companies taking different approaches and adopting different priorities. In the end, "the market" — not just the stock market, but product markets and labor markets as well — would sort out which worked best.

My guess is that it will be a new generation of employees that finally frees the American corporation from the ­shareholder-value straightjacket. Young people — particularly those with skills that are in high demand — today are drawn to work that not only pays well but also has meaning and social value. As the economy improves and the baby boom generation retires, companies that have reputations as ruthless maximizers of short-term profits will find themselves on the losing end of the global competition for talent. In an era of plentiful capital, it will be skills, knowledge, creativity and experience that will be in short supply, with those who have it setting the norms of corporate behavior.

Who knows? It could even get to the point where executives, hedge fund managers and financial columnists start agitating to free the economy from the tyranny of "maximizing employee satisfaction."

For further reading: Check out Jia Lynn Yang's piece on how the mantra of 'shareholder value' took over Corporate America.

[crazy canuck]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation and it may well not be in the best interests of the corporation to simply maximize shareholder value depending on how that term might be defined.

For example if shareholder value is defined in the size of dividend distributions then there is obviously a potential conflict of interest of the company and that of the shareholder.  If it is defined as maximizing the stock value so the shareholder can realize a taxable gain then that can cause the corporation to make short sighted decisions.  Also, and perhaps more importantly.  Why should a corporation care about people who know longer wish to own its stock.

Really the only time the share value of a shareholder or potential share holder should matter to the corporation is when the corporation wishes to raised more capital.  But this is a fairly rare occurrance.  What is really going on here is that executives are not worrying so much about shareholder value as they are about the value of their own stock options and it is being dressed up as concern for mom and pop shareholder.

This is not to say, of course, that shareholders shouldnt have rights against directors or executives who are not performing properly.  But that is another issue.

[alfred russel]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation

A corporation is a filing sitting in a secretary of state's office...I understand owing a fiduciary obligation to the owners of the corporation, but then those are the shareholders.

I understand that there are sometimes fiduciary responsibilities to other stakeholders. But as an owner, I want the directors to focus on my interest rather than those of other stakeholders (while still operating in legal and ethical boundaries).

[DGuller]

I think that there are three possibly criticisms to the shareholder value dogma, and they're all somewhat different in nature:

1)  The problem is with the very goal of maximizing shareholder value.  Something else should be the goal, shareholder value is just a number on a stock ticker.
2)  The problem is that what is considered "shareholder value" is just a short term profit-taking, and investors are too stupid to price in the long-term damage appropriately.
3)  Maximizing shareholder value is not the only purpose, since corporation as an entity was entrusted with limited liability in exchange for some measure of social responsibility.

[alfred russel]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation and it may well not be in the best interests of the corporation to simply maximize shareholder value depending on how that term might be defined.

For example if shareholder value is defined in the size of dividend distributions then there is obviously a potential conflict of interest of the company and that of the shareholder.  If it is defined as maximizing the stock value so the shareholder can realize a taxable gain then that can cause the corporation to make short sighted decisions.  Also, and perhaps more importantly.  Why should a corporation care about people who know longer wish to own its stock.

Well, the general method is reasonably standard, although there are differences. It is the risk adjusted present value of estimated future cash flows of the enterprise, calculated on a per share basis. Adjustments need to be made for things like dividends and repurchases and typically other financing and investing activities.

[crazy canuck]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation

A corporation is a filing sitting in a secretary of state's office...I understand owing a fiduciary obligation to the owners of the corporation, but then those are the shareholders.

No.  That would be impossible at law.  For example, if you owed a fiduciary obligation to all the shareholders of a widely held coroporation you would have to speak to each and every one of them to make sure that they were fully informed, fully understood and fully agreed with what you are doing.

It is a fundamental misunderstanding of the legal duties involved to suggest that anyone owes a fidiciary duty to the shareholders.  Indeed the Company Acts in most jurisdictions give shareholders very limited rights.  Something which is fundamentally at odds with the statement that it is the shareholder to whom a fidiciary duty is owed.

[alfred russel]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation

A corporation is a filing sitting in a secretary of state's office...I understand owing a fiduciary obligation to the owners of the corporation, but then those are the shareholders.

No.  That would be impossible at law.  For example, if you owed a fiduciary obligation to all the shareholders of a widely held coroporation you would have to speak to each and every one of them to make sure that they were fully informed, fully understood and fully agreed with what you are doing.

It is a fundamental misunderstanding of the legal duties involved to suggest that anyone owes a fidiciary duty to the shareholders.  Indeed the Company Acts in most jurisdictions give shareholders very limited rights.  Something which is fundamentally at odds with the statement that it is the shareholder to whom a fidiciary duty is owed.

In any case, there are relatively generally accepted methodologies to estimate shareholder value, and those are applied to major decisions that companies make. Any time you hear of a major acquisition, divestiture, plant expansion, etc, you can be confident that there is an excel file in the company with a financial model showing that action provided improved shareholder value.

If the decision needs shareholder approval, then you just put it up for a vote and it gets approved like 99% of the management proposals to shareholders.

[CountDeMoney]

Excellent article, Shiv.

[crazy canuck]

When I was in law school the sole goal of maximizing shareholder value as the predominant interest of the Directors was relegated to the lunatic fringe since the directors owe a fiduciary obligation to the corporation

A corporation is a filing sitting in a secretary of state's office...I understand owing a fiduciary obligation to the owners of the corporation, but then those are the shareholders.

No.  That would be impossible at law.  For example, if you owed a fiduciary obligation to all the shareholders of a widely held coroporation you would have to speak to each and every one of them to make sure that they were fully informed, fully understood and fully agreed with what you are doing.

It is a fundamental misunderstanding of the legal duties involved to suggest that anyone owes a fidiciary duty to the shareholders.  Indeed the Company Acts in most jurisdictions give shareholders very limited rights.  Something which is fundamentally at odds with the statement that it is the shareholder to whom a fidiciary duty is owed.

In any case, there are relatively generally accepted methodologies to estimate shareholder value, and those are applied to major decisions that companies make. Any time you hear of a major acquisition, divestiture, plant expansion, etc, you can be confident that there is an excel file in the company with a financial model showing that action provided improved shareholder value.

If the decision needs shareholder approval, then you just put it up for a vote and it gets approved like 99% of the management proposals to shareholders.

Well at least you are backing away from your first observation that the fidiciary duty is owed to the shareholders rather than the corporation.  As I said, that used to be considered lunatic fringe type stuff because there are so many problems with that view. 

[alfred russel]

Well at least you are backing away from your first observation that the fidiciary duty is owed to the shareholders rather than the corporation.  As I said, that used to be considered lunatic fringe type stuff because there are so many problems with that view.

I'm not backing away from it--I'm letting it go because you missed the point I was trying to make (perhaps because it wasn't clear). Everything that is ascribed to a corporation--including things like duties to perform, profits, and losses--are going to be allocated to other parties: depending on the case they could be shareowners, bondholders, customers, employees, the general public (through the government), etc. Certainly the interests of the ultimate parties are considered during decision making.

I think a fiduciary duty is owed to shareholders in any case, but I could be wrong...I'd defer to a lawyer on that.

[The Minsky Moment]

In most relevant US contexts (i.e. Delaware and New York) both Alfred and CC are partially correct.  The directors of a corp due owe fiduciary duties to the entity.  However this is interpreted and understood as an obligation to act as loyal and competent custodians for shareholders, and is commonly expressed as a fiduciary duty to shareholders.  Thus shareholders - and only shareholders - can assert derivative claims against the directors for disloyalty or carelessness.  Other stakeholders can't.  Shareholders also have the right to make direct fiduciary duty claims against directors in certain circumstances, and in the context of a sale of the company the directors assume "Revlon" duties to get the best price for the stockholders.   In contrast, employees, suppliers, customers, creditors, etc. generally have no rights other than what they contractually bargain for, barring very special circumstances (ex. creditors in the "zone of insolvency").

The OP is correct that Delaware (and AFAIK no other state) does not recognize a broad directorial duty to pursue "shareholder value" or maximize stock price or even profits.  The directors have to be loyal, act with care and good faith, and not waste corporate assets.  Beyond that the courts tend to defer to the board's business judgment.

[crazy canuck]

Thus shareholders - and only shareholders - can assert derivative claims against the directors for disloyalty or carelessness. 

Exactly so.  It is important to note for those who are not familiar with derivative claims that it is a claim of the company asserted by the shareholders.  ie the shareholders claim on behalf of the company that the company has been wronged.  If the duty was owed directly to the shareholders then there would be no need for them to bring a derivative action.  They could simply sue in their own name directly against the directors.  Not a small distinction as obtaining court approval to launch a derivative action is often quite expensive.  The other duties you mentioned are offshoots of this concept.

Derivative actions are a very good illustration of why the concept that directors owe fidiciary duties directly to shareholders is at best questionable. 

[The Minsky Moment]

How the cult of shareholder value wrecked American business
By Steven Pearlstein, Published: September 9 at 12:20 pm
Nor does the law require, as many believe, that executives and directors owe a special fiduciary duty to shareholders. The fiduciary duty, in fact, is owed simply to the corporation, which is owned by no one, just as you and I are owned by no one — we are all "persons" in the eyes of the law. Shareholders, however, have a contractual claim to the "residual value" of the corporation once all its other obligations have been satisfied — and even then directors are given wide latitude to make whatever use of that residual value they choose, as long they're not stealing it for themselves.

This is at best confusing and misleading.  As to fiduciary duty, the directors do owe that duty to shareholders - I don't know what "special" was supposed to mean, but the Delaware courts have distinguished shareholders from all other stakeholders for decades now in terms of directorial fiduciary duties.

As to the ownership question, the shareholders are the owners in any meaningful sense of the word, at least until insolvency occurs.  The OP seems to be adopting an extreme view of corporate personhood in the vein of Citizens United but the 13th amendment does not apply to entities.  The shareholder claim to residual value is not contractual in nature as the OP in effect concedes what after stating that.  Pretty much everything in this paragraph is wrong, misleading, or incomplete in some way.

[crazy canuck]

This is at best confusing and misleading.  As to fiduciary duty, the directors do owe that duty to shareholders -

Then why must shareholders bring claims by way of a derivative action rather than in their own name?

[The Minsky Moment]

Thus shareholders - and only shareholders - can assert derivative claims against the directors for disloyalty or carelessness. 

Exactly so.  It is important to note for those who are not familiar with derivative claims that it is a claim of the company asserted by the shareholders.  ie the shareholders claim on behalf of the company that the company has been wronged.  If the duty was owed directly to the shareholders then there would be no need for them to bring a derivative action.  They could simply sue in their own name directly against the directors.  Not a small distinction as obtaining court approval to launch a derivative action is often quite expensive.  The other duties you mentioned are offshoots of this concept.

Derivative actions are a very good illustration of why the concept that directors owe fidiciary duties directly to shareholders is at best questionable.

The distinction is important but the conclusion doesn't really follow.  The touchstone to determining whether the corporation's interests are harmed is the impact on the shareholder interest.  Thus the Delaware courts commonly describe the duties as duties owed to both the coporation and the shareholders.