The Shareholder Value Myth: How putting shareholders first harms investors, corporations, and the public
by Lynn Stout
Business schools and law schools teach that the purpose of a corporation is to maximize shareholder wealth. “Shareholder wealth, in turn, is typically measured by share price—meaning share price today, not share price next year or next decade.” Lynn Stout (1957-2018), who was a business law professor at Cornell, makes the case that this is both untrue and harmful.
“United States corporate law does not, and never has, required directors of public corporations to maximize either share price or shareholder wealth… State statutes similarly refuse to mandate shareholder primacy… As long as boards do not use their power to enrich themselves, the [business judgment rule] gives them a wide range of discretion to run public corporations with other goals in mind, including growing the firm, creating quality products, protecting employees, and serving the public interest. Chasing shareholder value is a managerial choice, not a legal requirement.”
SHORT-TERM SPECULATORS VERSUS LONG-TERM INVESTORS
“Toward which shareholders is it oriented? … Long-term shareholders fear corporate myopia. Short-term shareholders embrace it—and many powerful shareholders today are short-term shareholders.”
“The shareholder who plans to hold her stock for many years wants the company to invest in its employees’ skills, develop new products, build good working relationships with suppliers, and take care of customers to build consumer trust and brand loyalty—even if the value of these investments in the future is not immediately reflected in share price.”
“The short-term investor who expects to hold for only a few months or days wants to raise share [price] today, and favors strategies like cutting expenses, using cash reserves to repurchase shares, and selling assets or even the entire company.”
“In the words of corporate lawyer Martin Lipton, directors must decide ‘whether the long-term interests of the nation’s corporate system and economy should be jeopardized in order to benefit speculators interested not in the vitality and continued existence of the business enterprises in which they have bought shares, but only in a quick profit on the sale of those shares?’”
“To understand just how hyperactive today’s stock markets have become, consider that in 1960, annual share turnover for firms listed on the New York Stock Exchange (NYSE) was only 12 percent, implying an average holding period of about eight years. By 1987, this figure had risen to 73 percent. By 2010, the average annual turnover for equities listed on U.S. exchanges reached an astonishing 300 percent annually, implying an average holding period of only four months.”
“When long-term and short-term investors’ interests diverge, shareholder value thinking poses the same risks as fishing with dynamite. Some individuals may reap immediate and dramatic returns. But over time and as a whole, investors and the economy lose.” Economists call this Tragedy of the Commons.
MUTUAL FUNDS AND HEDGE FUNDS
“The mutual fund manager whose continued employment depends on her relative performance for the next four quarters finds it hard to resist the temptation to support management strategies that will raise share price just long enough that she can sell and move on to the next stock that might see a short-term bump in its stock. As mutual fund guru and Vanguard Funds founder Jack Bogle puts it, the mutual fund industry has become a ‘rent-a-stock’ industry.”
“Diversified retail investors, by contrast, rarely have a big enough stake in any single company to make it sensible to closely monitor what’s going on; they suffer form their own rational apathy.” Surprisingly, the author puts diversified pension plans in the rational apathy category as well.
“Mutual fund managers mostly vote the shares they hold as directed by RiskMetric’s Institutional Shareholder Service (ISS), a ‘proxy advisory service’ whose ideas about good corporate governance can be criticized for focusing on short-term stock price performance. The end result is that the only shareholders that are likely to engage in any serious way with incumbent management are hedge funds and ISS-shepherded funds, both of which are biased toward the short term.”
“Consider, for example, the standard ‘investing’ strategy of activist hedge fund manager Carl Icahn. Icahn is famous for acquiring a substantial position in a particular stock, then using his new shareholder status to demand the company’s board put the firm on the auction block and sell it off to the highest bidder (at which point Icahn becomes an ex-shareholder). Among other triumphs, he recently succeeded in pressuring Motorola to sell itself to Google. But on the rare occasion when Icahn has found himself owning stock in a company that wanted to make its own acquisitions—that is, when he is a shareholder in the bidding company that pays a premium, not the target that receives it—he has protested mightily, and worked to block the sale. Clearly, Icahn does not believe the mergers and acquisitions merry-go-round benefits investors as a class. But he is not interested in the wealth of investors as a class. He is interested only in his own wealth.”
“One study has calculated that the net results, for shareholders as a class, of all corporate mergers from 1980 to 2001 was an overall loss in stock market value of $78 billion. Thus a hyperactive merger market may benefit undiversified shareholders who hold stock only in targets, while destroying value for universal owners.”
Skyrocketing CEO compensation is directly linked to shareholder primacy. “In 1993, Congress amended the tax code to encourage public corporations to tie executive pay to objective ‘performance’ metrics. The percentage of CEO compensation coming from stock grants then rose from 35 percent in 1994, to over 85 percent by 2001.” CEO compensation surged from 140 times that of the average employee in 1991 to 500 times in 2003. As recently as 1984, “equity-based compensation accounted for zero percent of the median executive’s compensation at S&P 500 firms.”
CORPORATIONS OWN THEMSELVES?
Stout asserts that shareholders do not own the corporation. “Laypersons and journalists, and even the occasional economist like Milton Friedman, often casually assert that shareholders ‘own’ corporations. Sometimes even law professors—who know better—find themselves reflexively repeating the phrase. But from a legal perspective, shareholders do not, and cannot, own corporations. Corporations are independent legal entities that own themselves, just as human beings own themselves… All the equity investor owns now is a contract with the corporate entity, called a ‘share of stock.’”
This unconvincing statement is an unnecessary distraction from her main thesis about the dysfunction of management’s myopic focus on short-term share price. Companies can be acquired by buying all of the outstanding shares from stockholders, i.e. the owners. The author even acknowledges this: “A sale of the entire company—which typically requires a buyer to purchase shares not only from the relative realists in the shareholder pool but from the more-optimistic as well—usually demands that the bidder pay a substantial premium over market price.”
“Owning shares in Apple doesn’t entitle you to help yourself to the wares in the Apple store. In this sense stockholders are no different from bondholders, suppliers, and employees. All have contractual relationships with the corporate entity.”
Obviously, fractional owners do not individually control management and cannot help themselves to merchandise. Collectively, shareholders elect a board of directors to govern the corporation. (At least in theory. In practice, it seems like CEOs often hand-pick their bosses, which is a dysfunction that Stout does not address.)
“Corporations own themselves, and enter contracts with shareholders exactly as they contract with debtholders, employees, and suppliers.” This statement ignores consideration, an essential element of an enforceable contract. Stout already stated that boards are under no obligation to pay dividends, and many corporations never do. So what consideration are investors offered in this contract in exchange for their capital? Clearly they are offered a share of ownership in the corporation, proportionate to the number of shares outstanding.
Stout explains that dual classes of stock diminish shareholder primacy. “On the rare occasions when companies do go public today, many adopt dual-class equity structures that concentrate voting power and control in insider’s hands. Google, LinkedIn, and Zynga are prominent recent examples.” Is this really a good thing? Dual-classes of stock which ensure control of insiders like Mark Zuckerberg make a mockery of corporate governance. A person who controls the voting rights can elect a new board, should they become uncooperative.
The makeup of boards also influences the direction of governance. “A company might encourage its directors to focus more exclusively on shareholder interests by ensuring they are ‘independent’ (that is, not also employed as executives by, or doing business as creditors or suppliers with, the firm).” I would note Germany leans in the opposite direction; its Co-determination Act of 1976 (Mitbestimmung) allows workers in companies with more than 2000 employees to elect half of the board members.
The author points out that United Kingdom law differs from U.S. Law. “Shareholders in U.K. companies have the power to call meetings, and to summarily remove uncooperative directors. They even get to vote to approve dividends. (Not surprisingly, U.K. companies are more generous with dividends than U.S. companies are.)”
Two years after this book was published, France enacted the 2014 Florange Act, automatically granting double voting rights to shares held for at least two years, although corporations may amend their bylaws to opt out.
The book mentions B Corporations as an alternative paradigm.
Stout concludes, “Directors and executives do a disservice to their firms and their investors if they use share price as their only guiding star. To build enduring value, managers must focus on the long term as well as tomorrow’s stock quotes, and must sometimes make credible if informal commitments to customers, suppliers, employees, and other stakeholders whose specific investments contribute to the firm’s success.”
Overall this is an excellent book about an important topic. However, at times I feel the author’s dogma overshadows her logic, as noted above.
Stout, Lynn. The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. Oakland, CA: Berrett-Koehler, 2012. Buy from Amazon.com
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