The Myth of Maximizing Shareholder Value

By the end of the 20^th century, a broad consensus had emerged in the Anglo-American business world that corporations should be governed according to the philosophy often called shareholder primacy. Shareholder primacy theory taught that corporations were owned by their shareholders; that directors and executives should do what the company's owners/shareholders wanted them to do; and that what shareholders generally wanted managers to do was to maximize "shareholder value," measured by share price.

Today this consensus is crumbling. As just one example, in the past year no fewer than three prominent New York Times columnists have published articles questioning shareholder value thinking.¹ Shareholder primacy theory is suffering a crisis of confidence. This is happening in large part because it is becoming clear that shareholder value thinking doesn't seem to work, even for most shareholders.

Consider the example of the United States. The idea that corporations should be managed to maximize shareholder value has led over the past two decades to dramatic shifts in U.S. corporate law and practice. Executive compensation rules, governance practices, and federal securities laws, have all been "reformed" to give shareholders more influence over boards and to make managers more attentive to share price.² The results are disappointing at best. Shareholders are suffering their worst investment returns since the Great Depression;³ the population of publicly-listed companies has declined by 40%;⁴ and the life expectancy of Fortune 500 firms has plunged from 75 years in the early 20th century to only 15 years today.⁵

Correlation does not prove causation, of course. But in my book The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public,⁶ I explore the logical connections between the rise of shareholder value thinking and subsequent declines in investor returns, numbers of public companies, and corporate life expectancy. I also show that shareholder primacy is an abstract economic theory that lacks support from history, law, or the empirical evidence. In fact, the idea of a single shareholder value is intellectually incoherent. No wonder the shift to shareholder value thinking doesn't seem to be turning out well -- especially for shareholders.

Debunking the Shareholder Value Myth: History

Although many contemporary business experts take shareholder primacy as a given, the rise of shareholder primacy as dominant business philosophy is a relatively recent phenomenon. For most of the twentieth century, large public companies followed a philosophy called managerial capitalism. Boards of directors in managerial companies operated largely as self-selecting and autonomous decision-making bodies, with dispersed shareholders playing a passive role. What's more, directors viewed themselves not as shareholders' servants, but as trustees for great institutions that should serve not only shareholders but other corporate stakeholders as well, including customers, creditors, employees, and the community. Equity investors were treated as an important corporate constituency, but not the only constituency that mattered. Nor was share price assumed to be the best proxy for corporate performance.⁷

Go back further, to the very beginnings of business corporations, and we see even greater deviations from shareholder primacy. Many corporations formed in the late eighteenth and early nineteenth centuries were created specifically to develop large commercial ventures like roads, canals, railroads, and banks. Investors in these early corporations were usually also customers. They structured their companies to make sure the business would provide good service at a reasonable price -- not to maximize investment returns.⁸

So where did the idea that corporations exist only to maximize shareholder value come from? Originally, it seems, from free-market economists. In 1970, Nobel Prize winner Milton Friedman published a famous essay in the New York Times arguing that the only proper goal of business was to maximize profits for the company's owners, whom Friedman assumed (incorrectly, we shall see) to be the company's shareholders.⁹ Even more influential was a 1976 article by Michael Jensen and William Meckling titled the "Theory of the Firm."¹⁰ This article, still the most frequently cited in the business literature,¹¹ repeated Friedman's mistake by assuming that shareholders owned corporations and were corporation's residual claimants. From this assumption, Jensen and Meckling argued that a key problem in corporations was getting wayward directors and executives to focus on maximizing the wealth of the corporations' shareholders.

Jensen and Meckling's approach was eagerly embraced by a rising generation of scholars eager to bring the "science" of economics to the messy business of corporate law and practice. Shareholder primacy theory led many to conclude that managerialism must be inefficient and outmoded, and that corporations needed to be "reformed" from the outside. (There is great irony here: free-market economist Friedrich Hayak would have warned against such academic attempts at economic central planning.)¹²Shareholder primacy rhetoric also appealed to powerful interest groups. These included activist corporate raiders; institutional investors; and eventually, CEOs whose pay was tied to stock price performance. As a result, shareholder primacy rose from arcane academic theory in the 1970s to dominant business practice today.¹³

Debunking the Shareholder Value Myth: Law

Yet it is important to note that shareholder primacy theory was first advanced by economists, not lawyers. This may explain why the idea that corporations should be managed to maximize shareholder value is based on factually mistaken claims about the law.

Consider first Friedman's erroneous belief that shareholders "own" corporations. Although laymen sometimes have difficulty understanding the point, corporations are legal entities that own themselves, just as human entities own themselves. What shareholders own are shares, a type of contact between the shareholder and the legal entity that gives shareholders limited legal rights. In this regard, shareholders stand on equal footing with the corporation's bondholders, suppliers, and employees, all of whom also enter contracts with the firm that give them limited legal rights.¹⁴

A more sophisticated but equally mistaken claim is the residual claimants argument. According to this argument, shareholders are legally entitled to all corporate profits after the fixed contractual claims of creditors, employees, suppliers, etc., have been paid. If true, this would imply that maximizing the value of the shareholders' residual interest in the company is the same thing as maximizing the value of the company itself, which usually benefits society. But the residual claimants argument is also legally erroneous. Shareholders are residual claimants only when failed companies are being liquidated in bankruptcy. The law applies different rules to healthy companies, where the legal entity is its own residual claimant, meaning the entity is entitled to keep its profits and to use them as its board of directors sees fit. The board may choose to distribute some profits as dividends to shareholders. But it can also choose instead to raise employee salaries; invest in marketing or research and development; or make charitable contributions.¹⁵

Which leads to the third legal error underlying shareholder primacy: the common but misleading claim that directors and executives are shareholders' "agents." At law, a fundamental characteristic of any principal/agent relationship is the principal's right to control the agent's behavior. But shareholders lack the legal authority to control directors or executives. Traditionally, shareholders' governance rights in public companies are limited and indirect, including primarily their right to vote on who sits on the board, and their right to bring lawsuits for breach of fiduciary duty. As a practical matter, neither gives shareholders much leverage. Even today it remains very difficult for dispersed shareholders in a public corporation to remove an incumbent board.¹⁶ And shareholders are only likely to recover damages from directors in lawsuits involving breach of the duty of loyalty, meaning the directors were essentially stealing from the firm. Provided directors don't use their corporate powers to enrich themselves, a key legal doctrine called the "business judgment rule" otherwise protects them from liability.¹⁷