One of my pet peeves is the degree to which the notion that corporations exist only to serve the interests of shareholders is accepted as dogma and recited uncritically by the business press. I’m old enough to remember when that was idea would have been considered extreme and reckless. Corporations are a legal structure and are subject to a number of government and contractual obligations and financial claims. Equity holders are the lowest level of financial claim. It’s one thing to make sure they are not cheated, misled, or abused, but quite another to take the position that the last should be first.
If you review any of the numerous guides prepared for directors of corporations prepared by law firms and other experts, you won’t find a stipulation for them to maximize shareholder value on the list of things they are supposed to do. It’s not a legal requirement. And there is a good reason for that.
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…Shareholders are at the very back of the line. They get their piece only after everyone else is satisfied. If you read between the lines of the duties of directors and officers, the implicit “don’t go bankrupt” duty clearly trumps concerns about shareholders…
So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.
One good source for the fact that economists, rather than legal decisions, were the basis for the acceptance of this idea, is a 2005 article by Frank Dobbin and Dirk Zorn, “Corporate Malfeasance and the Myth of Shareholder Value.” This paper looked back to the 1970s, the era of diversified and often underperforming firms (remember the conglomerate discount?). Deregulation, high inflation, and a lax attitude towards anti-trust enforcment stoked a hostile takeover boom. Economists celebrated this development as disciplining chief executives and moving assets into the hands of managers who could operate them more productively. In reality, the success of these early deals depended mainly on asset sales, both of non-core operations and of hidden sources of value, like corporate real estate, as well as leverage and slashing bloated head office staffs (the across-the-company headcount efforts became more prominent in the 1990s).
But I’m now reading an advance copy of terrific book, Private Equity at Work by Elaine Appelbaum and Rosemary Batt, which adds important detail to the Dobbin and Zorn’s account. It’s done a remarkably impressive job of marshaling data about the private equity industry and explaining how it operates, which means debunking its claims about how it adds value. And even its asides are rigorous. For instance, its four page treatment on the origins of the “maximize shareholder value” line of thought showed real mastery of the source material.
Appelbaum and Batt trace the origins of the managerial model of capitalist enterprise to the New Deal securities laws. They helped institutionalize dispersed shareholding, and with it, a separation of ownership and management. From the 1930s onward, there was an active debate between two schools of thought. Adolf Berle and Gardiner Means were concerned that this new approach neglected shareholder interests. By contrast, Harvard law professor Merrick Dodd contended that large-scale corporations had broader social aims, including providing employment and useful goods. By the early 1950s, the Dodd view had clearly prevailed.
Although the writers of that era would never have used this framing, large corporations created reasonably efficient internal markets. Both employers and their workers benefitted from investing in a workforce that was also their main source for supervisors and managers of all levels. Indeed, middle and senior level executives hired in from the outside often found it hard to adapt to these well-established, tightly knit corporate cultures (note that well-established does not necessarily mean “well functioning”). The tendency of companies to promote from within versus the generally lower odds of succeeding in another company meant that most employees’ best prospects were within their current company, which gave them strong incentives to make it successful.
This was also the era when unions had clout. That assured that productivity gains were shared among workers, management, and investors. The fact that labor participated in these improvements helped propel a robust consumer economy, fueling more business growth. These enterprises typically took a long-term view, and used retained earnings to fund investments and research.
This model prevailed until the 1970s. Even though corporate profits as a percent of GDP grew in the 1970s even under stagflation (after the oil shock recession of 1974-5 had passed), return on capital had plunged from 12% in 1965 to 6% in 1979. Appelbaum and Batt describe the rise of the diversified corporation as one of the biggest culprits. They’d 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. Bizarrely, the stock market would valve 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.
But these sprawling conglomerates had lots of managerial downside. Top brass often didn’t understand the operations of these new businesses. They became more dependent on finance staff to impose metrics across businesses to have a handle on what was going on. The formerly virtuous internal labor markets became balkanized and less salutary. And at a higher level, the various businesses were more likely to operate like fiefdoms competing for corporate resources. Finally, because the top executives treated these units as portfolio holdings that could be sold at any time, they were less certain of the necessity and value of investing in them.
So who was the first to insist that the old managerial model needed to be turned upside down and shareholders interests should be paramount? It turns out it was Milton Friedman, in a widely-cited 1970 New York Times op-ed. And Friedman being Friedman, he advocated an extreme form of his thesis. A key excerpt:
The businessmen believe that they are defending free enterprise when they declaim that business is not concerned “merely” with profit but also with promoting desirable “social” ends; that business has a “social conscience” and takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers. In fact they are–or would be if they or anyone else took them seriously–preaching pure and unadulterated socialism. Businessmen who talk this way are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.
The discussions of the “social responsibilities of business” are notable for their analytical looseness and lack of rigor. What does it mean to say that “business” has responsibilities? Only people can have responsibilities. A corporation is an artificial person and in this sense may have artificial responsibilities, but “business” as a whole cannot be said to have responsibilities, even in this vague sense. The first step toward clarity in examining the doctrine of the social responsibility of business is to ask precisely what it implies for whom….
In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom
You can see how incoherent this is. Shareholder are not bosses of corporate executives. They are diffuse and large in number, and if you got them all in a room to tell the corporate executive what to do, you’d be more likely to see fisticuffs than agreement.
Moreover, Friedman simply dismisses the corporate form, when that is precisely what is operative here. You can’t treat shareholders as being remotely the same as owners in a private, closely held business. A share in a public company is a very weak and ambiguous legal claim. You get dividends when the company has enough profits and is in the mood to pay them, and you have a vote on some limited matters, but the company has the right and ability to dilute that too. So Friedman has to utterly misrepresent the fundamental nature of ownership in public corporations to wage his war against big busseses serving broader social aims along with Mammon.
Steve Denning, who called this Friedman article “The Origin of the World’d Dumbest Idea” was even more vituperative:
It’s curious that a paper which accuses others of “analytical looseness and lack of rigor” assumes its conclusion before it begins. “In a free-enterprise, private-property system,” the article states flatly at the outset as an obvious truth requiring no justification or proof, “a corporate executive is an employee of the owners of the business,” namely the shareholders….[I]n the magical world conjured up in this article, an organization is a mere “legal fiction”, which the article simply ignores in order to prove the pre-determined conclusion…. The article thus picks and chooses which parts of legal reality are mere “legal fictions” to be ignored and which parts are “rock-solid foundations” for public policy. The choice depends on the predetermined conclusion that is sought to be proved…
How did the corporation’s money somehow become the shareholder’s money? Simple. That is the article’s starting assumption. By assuming away the existence of the corporation as a mere “legal fiction”, hey presto! the corporation’s money magically becomes the stockholders’ money.
But the conceptual sleight of hand doesn’t stop there. The article goes on: “Insofar as his actions raise the price to customers, he is spending the customers’ money.” One moment ago, the organization’s money was the stockholder’s money. But suddenly in this phantasmagorical world, the organization’s money has become the customer’s money. With another wave of Professor Friedman’s conceptual wand, the customers have acquired a notional “right” to a product at a certain price and any money over and above that price has magically become “theirs”.
But even then the intellectual fantasy isn’t finished. The article continued: “Insofar as [the executives’] actions lower the wages of some employees, he is spending their money.” Now suddenly, the organization’s money has become, not the stockholder’s money or the customers’ money, but the employees’ money.
Is the money the stockholders’, the customers’ or the employees’? Apparently, it can be any of those possibilities, depending on which argument the article is trying to make. In Professor Friedman’s wondrous world, the money is anyone’s except that of the real legal owner of the money: the organization.
But dissatisfaction with large companies was high and only continued to rise as they floundered in a more globalized, less stable world. Friedman’s simplistic, barmy idea found fertile ground. And it became self-reinforcing as executives learned to use it to line their wallets. The long-lived, difficult to displace but not lavishly paid corporate chieftan was over time supplanted by wildly overpaid straight-from-central-casting CEOs. Why worry overmuch about longevity if you can rake it in a 3 to 5 year tenure? And even really disastrous CEOs like Robert Nardelli and Mike Zafirovski find a happy home at private equity firms.
So again, repeat after me: “maximizing shareholder value” is an idea made up and promoted by economists, starting with Milton Friedman and his Chicago School cronies. And like many ideas that came out of the Chicago School, the public as large has suffered from treating a soundbite like a serious policy proposal.