Like the Economics of Good and Evil by Tomas Sedlacek, Lynn Stout’s The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public is an exploration into the history and sociology of knowledge. While Sedlacek ambitiously tackles several myths at the core of economics, Stout focuses laserlike on the misconception that corporations are required to “maximize shareholder value.”
Most will take an hour or two to read this slim volume but will think about its implications for years to come. Like the design of Apple’s iproducts, Stout’s central argument is simple and compelling:
- U.S. corporate law does not, and never has, required directors of public corporations to maximize shareholder value. Most are formed “to conduct or promote any lawful business or purposes.”
- Shareholders are neither owners, nor principals, nor residual claimants. Directors have primacy. The “business judgement” rule gives them tremendous latitude with regard to claims on the corporation, including decisions that reduce share price.
- Shareholder primacy rules do not produce superior results. They lead to short-termism, externalization of costs and a tragedy of the commons.
- In 1993, Congress amended the tax code to tie executive pay to “performance” metrics. In 1991, average CEO pay at large public firms was 140 times that of average employees. By 2003, it was approximately 500 times. Whereas equity-based compensation at such firms was zero percent in 1984, it climbed to 66% by 2001. The percentage of CEO pay from stock option grants rose from 35% in 1994, to 85% by 2001.
- Decades ago high transaction costs (fixed commissions and transfer taxes) “discouraged hyperactive trading.” When such costs were drastically reduced, annual share turnover for firms on the NYSE went from 12% in 1960 to 73% by 1987. “By 2010, the average annual turnover for equities listed on U.S. exchanges reached an astonishing 300% annually, implying an average holding period of only four months.”
CEO’s are increasingly tempted by pay incentives, shareowner demands, and other constraints to manage earnings by producing one disastrous quarter that resets market expectations so that several future quarters are bound to look better. Rewards come quicker through cost-cutting (firing employees, reducing R&D) or financial engineering than by developing new products, training staff or increasing sales.
Stout cites Thomas Kuhn’s The Structure of Scientific Revolutions with a discussion around the need for a new paradigm, which seems a bit odd, given her argument that U.S. laws have never required companies to maximize shareholder value. In some respects Stout seems happy with the current paradigm.
Board control allows directors to act as ‘mediating hierarchs’ who can balance the ex post demands of shareholders against the interests of other stakeholders−customers, suppliers, employees, the community−that make essential contributions to firms.
There is increasing recognition that shareowners are not a monolithic group. Stout is certainly critical of efforts to bring democracy to corporate governance, since measures to de-stagger boards, link pay to performance (frequently measured by share price), and to adopt majority votes standards for director elections all limit board discretion and can accelerate demands and practices which emphasize maximizing share value in the short term. They empower short-term hedge funds as much or more than long-term investors.
There is no reason to think that continuing to promote “shareholder democracy” through even more rules, like the SEC’s controversial proxy access proposal, will do a better job of serving shareholders’ collective welfare.
Stout is happy with our legal framework but unhappy with a wide-spread cultural misperception… a new norm that has become pervasive in U.S culture, even seeping into law school class discussions at Cornell where Stout recently accepted the well deserved position, Distinguished Professor of Corporate and Business Law.
I wish she had done more with her chapter Making Room for Shareholder Conscience. She says SRI funds have “proven highly attractive,” with 12% of all professionally managed assets managed by such funds. She also brings in a discussion from her 2011 book, Cultivating Conscience: How Good Laws Make Good People:
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 crux of the problem is that corporations and CEOs are seen by many in our society to be obligated to act selfishly. That expectation reinforces behavior. It doesn’t have to be that way. Stout has, paraphrasing Martin Luther King, Jr., been to the top of the mountain and has glimpsed the promised land but isn’t sure how to get there. She quotes Ian B. Lee,
If corporations are in fact ‘pathological’ profit-maximizers, it is not because of corporate law, but because of pressure from shareholders.
But didn’t changes in law tie executive pay to performance and reduce transaction costs help turn stock market investing into casino gambling? Investors probably had a role in shaping and passing these laws but can’t more enlightened investors and citizens reverse them, now that we know how damaging they are? And don’t corporate managers share in the blame?
“Although short-termism may be fueled by investor pressure, it’s equally true that investors select companies for their time frames,” according to recent research by Francois Brochet, George Serafeim, and Maria Loumioti published in the Harvard Business Review.
Short-Termism: Don’t Blame Investors, examined the transcripts of 70,042 earnings conference calls held by 3,613 firms from 2002 to 2008. Their analysis of words and phrases suggesting a short-term emphasis (“next quarter” and “the latter half of this year,” for example) versus those pointing to a long-term view (“years” and “long run”), suggests that short-termism is rooted in a company’s culture and its directors.
Companies emphasizing the short-term were more likely than others to manage earnings, have volatile stock prices, and had costs of capital 0.42% higher than average.
Managers can take actions and structure their communications to offset them [short-term tendencies]. They should be aware that to a large degree, they are setting the tone. The language a company uses when talking to investors is a meaningful indicator of its orientation—and the investors listening in on calls that emphasize a short-term approach are a largely self-selecting group who like what they hear.
There is plenty of blame to go around but Stout seems reluctant to admit that oligarchic rule by entrenched boards may contribute significantly to selfish short-term thinking.
…the objective of any particular corporation may be best determined not by regulators, judges or professors, or even by any individual shareholder or group of shareholders, but by a board of directors.
Accountability is central to creating better corporate governance. Stout is right in her fundamental analysis that maximizing shareholder value is a mantra that has generally contributed to short-term thinking. However, the solution isn’t to terminate the move towards more democratic corporate governance and rely on the beneficence of directors.
Wouldn’t it be better to enlarge the domain of mutual influence in corporate governance? Instead of aligning corporate governance theory to reflect the dismal reality that businesses involve an apathetic majority and rule by a self-selecting minority elite in the form of directors, wouldn’t it be better to increase the political efficacy of the majority?
The real challenge is to construct democratic decision-making structures which encourage investment of firm specific capital of both the financial and human varieties from all the various stakeholders. Investment funds need to do a better job of protecting the interest of investors not only in their role of investors but also as customers, employees, homeowners and biological organisms dependent on their environment. Stout begins to explore such possibilities but stops short.
…the idea that a pension or mutual fund might protect not only its beneficiaries’ financial interests in the fund’s portfolio, but also their outside interests in such matters as continued employment, adequate health care, lower taxes, and a clean environment, is−to put it mildly−legally untested.
Don’t give up so easily. Reverse the tax code changes with regard to pay for performance, especially pay linked to stock performance. Place transaction taxes on stock and derivative trades to slow the pace of turnover and raise substantial taxes. Fight to change the prudent man standard of ERISA, the “lemmings rule,” which requires fiduciaries to act like other fiduciaries, even where that isn’t prosocial.
How, for example, do funds get away with continuing to hold stock in companies that everyone knows are headed for bankruptcy without taking any action? They can do it because of the myth of efficient markets and because indexing is the ultimate defense of lemmings.
In 1994 there was a 3rd Restatement of Trust Law drafted by the National Conference of Commissioners on Uniform State Laws. This is basically the current standard fiduciaries should be following. Section 2 is the heart of it, setting out the Standard of Care; Portfolio Strategy; Risk and Return Objectives. Subdivision (c) sets out a list of usual considerations, such as economic conditions, tax consequences, expected total return, needs for liquidity, etc. The interesting consideration that pension funds have largely failed to incorporate into practice is that of subdivision (c)(8):
an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries
What “special value” does any specific investment have to one or more of the beneficiaries? We’re not just looking at money, not just the pension itself, but other benefits that fiduciaries are obligated to consider and to provide. These could be clean air, clean water, inexpensive living quarters, healthy food, efficient public transportation, convenient places to exercise, continuing education, a healthy local economy to grow old in, or the lower taxes that Stout’s list includes. Wouldn’t it be a good idea for pension funds to at least survey beneficiaries and taxpayers (in the case of public pension funds) to get some sense of these other priorities?
The Shareholder Value Myth makes a strong argument that a corporate focus on one goal, maximizing shareholder value, is a ruinous path. However, I’d like to hear more from Stout on what should be done to incorporate prosocial needs into corporate governance. Don’t tell me self-selecting directors are blessed with a divine right to rule.
Explore this topic further through the following books:
- Participation and Democratic Theory
- Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century
- Entrepreneurs and Democracy: A Political Theory of Corporate Governance
- Ideas, Artifacts and Facilities: Information as a Common-Pool Resource
- How to Govern Corporations So They Serve the Public Good: A Theory of Corporate Governance Emergence
- Shareholder Democracies?: Corporate Governance in Britain and Ireland before 1850
- The Corporate Objective
- Governance Reimagined: Organizational Design, Risk, and Value Creation
Also, don’t miss this event and paper at the Brookings Institute: The Modern Shareholder: How a Short-Term Focus is Harming U.S. Corporations.
2019 update: See The Myth of Shareholder Primacy.