Over the last three decades, public companies have shifted their focus from promoting long-term growth to maximizing “shareholder value” (a euphemism for share price) in the short term. And the federal government has embraced this religion.
In 1993, Congress changed the tax code to require companies to link executive pay to “performance” (typically stock price). The Securities and Exchange Commission over the last two decades has adopted rules to make corporate directors ever more “accountable” to shareholders. And hedge funds have used these rules to harass companies into selling assets, cutting expenses and paying out large dividends to “unlock shareholder value.”
How has this worked out for American investors and the American economy? Not well.
In the name of increasing shareholder value, public companies have sold key assets (Kodak’s patents), outsourced jobs (Apple), cut back on customer service (Sears) and research and development (Motorola), cut safety corners (BP), showered CEOs with stock options (Citibank), lobbied Congress for corporate tax loopholes (GE) and drained cash reserves to repurchase shares until companies teetered on the brink of insolvency (much of the financial industry). Some corporations even used accounting fraud to raise share price (Enron and WorldCom). Public companies employed these strategies even though many executives and directors felt uneasy about them, sensing that a single-minded pursuit of higher share prices did not serve the interests of society, the company or shareholders themselves.
It’s now become clear, however, that a relentless focus on share price can hurt not only employees, taxpayers and society, but shareholders too. Managers who are pressured to raise stock price quickly often resort to tricks — selling assets, cutting payroll and investment, draining cash through dividends and share repurchase programs — to bump up stock price for a year or two. But such strategies often hurt a company’s long-term ability to grow and prosper.
Economists sometimes argue that if this managerial short-termism were really a problem, then the stock market would punish the companies that engage in it with falling stock prices. But the old “efficient markets” theory that stock markets will always price shares appropriately has long been discredited. Shareholder value thinking means short-term thinking in today’s market of high-frequency trading, where the shares of public companies change hands, on average, every four months. This may explain why the approach has produced more than a decade of the worst investor returns since the Great Depression.
But if shareholder value thinking is counterproductive, how did it become so prevalent? Non-experts often assume the approach is rooted in law, and that public companies are legally required to maximize profits and shareholder returns. This is pure myth. Thanks to a legal doctrine called the business judgment rule, corporate directors who refrain from using corporate funds to line their own pockets remain legally free to pursue almost any other objective, including providing secure jobs to employees, quality products for consumers and research and tax revenues to benefit society. The idea that shareholders “own” corporations is another powerful but mistaken myth with no legal basis. Corporations are legal persons that own themselves. Stockholders own only a contract with the company, called a “share of stock,” giving them limited rights under limited circumstances.
In fact, shareholder value ideology is a relatively new concept, one traceable to the rise of the “Chicago School” of free-market economists. (Nobel Prize-winner Milton Friedman once famously claimed in the pages of the New York Times that shareholders “own” corporations and the only proper purpose of business was maximizing these “owners’” profits.) In the 1980s and 1990s, the Chicago School’s views were enthusiastically embraced by several influential interest groups, including academics who wanted to use share price to gauge corporate performance, economists seeking consulting opportunities as governance experts, and executives like GE’s Jack Welch, who recognized that whatever stock-based compensation might do for shareholder wealth, it clearly helped him maximize his own.
But for most of the 20th century, professional managers of public corporations did not view themselves as “agents” whose only purpose was to maximize shareholder wealth. Rather, they viewed themselves as stewards or trustees responsible for steering great social institutions — public corporations — for the benefit not only of shareholders but also employees, customers and the nation. This system of “managerial capitalism” was hardly perfect. But, ironically, it produced better results for investors than the “shareholder primacy” philosophy that dominates public corporations today.
John Maynard Keynes once famously said that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually slaves of some defunct economist.”
It’s time to recognize that the philosophy of “maximize shareholder value” is just such a defunct economist’s idea. Let’s throw off our intellectual chains so our corporate sector can do a better job for shareholders — and the rest of us too.
Lynn Stout is a professor of corporate and business law at the Clarke Business Law Institute at Cornell Law School and the author of “The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.”