List of symposium papers
“New Thinking on “Shareholder Primacy”” by Lynn Stout DOI 10.1515/2152-2820.1037
“Myths about Shareholder Value” by Faith Stevelman DOI 10.1515/ael-2013-0005
“Deconstructing the Mythodology of Shareholder Value: A Comment on Lynn Stout’s “The Shareholder Value Myth”” by Thomas Clarke DOI 10.1515/ael-2013-0006
“The Shareholder Model of the Corporation, Between Mythology and Reality” by Olivier Weinstein DOI 10.1515/ael-2013-0032
“The Troubling Question of Corporate Purpose” by Lynn Stout DOI 10.1515/ael-2013-0042
The mythology of shareholder value has proved one of the most debilitating ideologies of modern times. The pursuit of shareholder value has damaged and shrunk corporations, distracted and weakened managers, diverted and undermined economies, and, most paradoxically, neglected the long-term interests of shareholders. All of these unintended consequences of the unremitting pursuit of shareholder value in the last 30 years of Anglo-American corporate governance, is presented with marvellous lucidity and graphical intellectual force in the wonderful little book by Lynn Stout, The Shareholder Value Myth.1
An unfortunate lacuna in corporate law was filled by the simplistic tenets of agency theory, which has promulgated enduring myths of shareholder primacy that have been misconstrued as authentic legal interpretations of directors’ duties, and often guided directors with increasingly narrow and damaging corporate objectives. The tenets of shareholder value are portrayed as eternal, universal and unarguable. Lynn Stout resoundingly and convincingly exposes the multiple fallacies of each of these claims concerning shareholder value.
Corporate law in many jurisdictions states simply that directors and officers must exercise their powers and discharge their duties “in good faith and in the best interests of the corporation.” As the corporation is an intangible legal creation, the ongoing debate is whether it should be meant to serve narrowly the owners of the corporation (the shareholders) or more widely to encompass the interests of all stakeholders. There have been no court cases that clarify this issue definitively in many jurisdictions and therefore the phrase is still open to subjective interpretation, though in the United States a number of states recognize the legitimacy of directors taking stakeholder interests into account. The view in many jurisdictions is that the law permits flexibility and this is seen as a good thing. The common legal view is that it is the role of the directors to determine what is in the best interests of the company, unless no reasonable director could have reached the decision. The contribution of Lynn Stout’s book is to clearly analyse and explain how such common-sense views of the world were replaced by the narrow and constricting dictum of shareholder value.
This review article seeks to celebrate the deconstruction of the mythology of shareholder value inspired by Lynn Stout, and to dismantle the hegemony of agency theory, which originated the concepts of shareholder value and shareholder primacy. In order to offer a contextualized, historical critique of the intellectual forces that created agency theory and the concept of shareholder value, the analysis presents a broad consideration of the financialization of the Anglo-American corporation in the later decades of the twentieth century. It was in this period that the Anglo-American corporation was crudely translated from a wealth creating vehicle for the wider community of stakeholders and whole economy, into a bundle of assets with the sole purpose of benefiting shareholder interests. This analysis traces some of the historical critique of corporate purpose, and the wider implications of the critique for corporate activity. The article goes on to analyse the interpretations of corporate purpose emerging in modern company law reform. Finally, the article considers the implications of the growing international corporate social responsibility movement for directors’ duties, which is arguably in contradiction to many of the fundamental beliefs of shareholder value, and recasts the direction of corporations towards more responsible and sustainable value creation.
As the corporate responsibility movement has become stronger, international standards are fast proliferating for corporate social and environmental responsibility, filling the lacuna left by the law. Directors are developing an understanding of the broad aims of corporate responsibility, but what it means in practice across different industries and different corporate structures is less clear (Klettner & Clarke, 2011). The passive stance taken by Anglo-American governments and legal systems has left the issue open to a contest between the narrow strictures of shareholder value, and the burgeoning values of corporate social responsibility. Directors are caught in the grip of what appear to be contradictory orientations and require greater clarity on what is expected of them. There is much evidence to suggest that however great the ideological weight of the shareholder value movement might have been in recent decades, many directors in practice have maintained a more balanced sense of corporate purpose.
2 The financialization of Anglo-American corporations
The origins of agency theory and shareholder value lie within the deeper development of the financialization of the Anglo-American corporation in the later decades of the twentieth century. The modern corporation that had emerged in the early part of last century was typified by Berle and Means as manifesting a separation of ownership and control, where professional managers were in a position to determine the direction of the enterprise, and shareholders had “surrendered a set of definite rights for a set of indefinite expectations” (Berle & Means, 1933, p. 244). After the New Deal and the end of the Second World War, many US corporations in the 1950s and 1960s grew massively in scale and market domination, achieving pre-eminent positions in world markets.
A new managerial and corporate mode of coordination of enterprise based on organization and planning had arrived as analysed by Coase (1937) and later by Chandler (1977), transcending the market. This was an era celebrated in Galbraith’s New Industrial State (1967) in which corporate growth and brand prestige apparently had displaced profit maximization as the ultimate goals of technocratic managers, as planning and administration in close cooperation with government had displaced market relations as the primary corporate dynamic (Henwood, 1998, p. 259). In this technocratic milieu shareholders were “passive and functionless, remarkable only in his capacity to share without effort or even without appreciable risk, the gains from growth by which the technostructure measures its success” (Galbraith, 1967, p. 356).
The Galbraithian idyll began to disintegrate with the severe recession of 1973–1975, the incapacity of US corporations to compete effectively with Japanese and European products in key consumer market sectors, and the push towards conglomerate formation by Wall Street, which was interested in managing multiple businesses by financial performance. Subsequently, in successive waves, US corporations were subjected to further financial imperatives: tight monetary and fiscal policy suppressed growth; wages were constrained to raise profits; and competition facilitated by international de-regulation (Henwood, 1998). As Doug Henwood graphically and extensively portrays, “Over time purely financial interests have increasingly asserted their influence over hybridized giant corporations” (1998, p. 262).
A fertile scene was set for Michael Jensen, his colleagues in the Business and Law Schools at Harvard, and the Chicago school of economics, to develop a finance-based theory of corporate governance that was to envelop Anglo-American policy and practice. While agency theory and shareholder value were the most enduring principles of the Jensen legacy, they were preceded and accompanied by other financial innovations that disrupted the stability and often damaged the substance of corporate America. The series of wrecking-balls of leveraged buyouts (LBOs), junk bonds and free cash flow directed at US corporations were impelled by the frequent enthusiastic exhortations of Jensen (Henwood, 1998; Lazonick, 1992, 2012).
Jensen was an early convert to the leveraged buyout in which a group of investors, and incumbent senior management would take a company private by going deeply into debt: “The discipline of debt and the potential vast rewards from holding the stock would inspire managers to heroic feats of accumulation” (1989). In this new market for corporate control alternative managerial teams compete for the rights to manage corporate resources (Jensen & Ruback, 1983). However, it is clear that the resources the new management teams were particularly focused upon were the cash flow of the corporations concerned. Jensen neatly translated this investor avariciousness into “disgorging free cash flow,” which he defined as
Free cash flow in excess of that required to fund all projects that have net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial cash flow. The problem is how to motivate managers to disgorge the cash rather than investing at below the cost of capital or wasting it on organization inefficiencies. (1986)
Yet, as Henwood persuasively argues,
Jensen’s definition sounds more precise than it really is, while cash flow and cost of capital are possible to figure out, though different analysts will come up with different measures for each, it is judging future projects that is difficult. It assumes firms know how much money a project can earn. Of course they never can. In practice, one can do little more than extrapolate from the past, but that’s not really the same thing. (1998, p. 260)
For Jensen “the stock market is always axiomatically the ultimate arbiter of social good” (Henwood, 1998, p. 269). However, the result of eliminating the free cash flow of companies in leveraged buyouts (which disappeared in fees to investment banks and lawyers, and in huge incentives paid to management and former shareholders), and in loading up companies with debt, while facing increasing interest rates in the inflationary times of the 1970s and 1980s, was to leave US companies without capital to invest in research and development at a time of increasing competition from overseas companies engaged in continuous product development (Blair, 1993). Meanwhile Jensen was more impressed by the financial innovation of boutique LBO firms such as KKR, and the inventor of the low-rated/high-risk/high-return junk bonds Drexel Burnham Lambert, suggesting these financial engineers could readily replace corporate entrepreneurs: “With all its vast increase in data, talent and technology, Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. KKR’s New York offices and Irwin Jacobs’ Minneapolis base are direct substitutes for corporate headquarters” (Jensen, 1989).
This amounted to the eclipse of the public corporation to Jensen, which he announced in a celebrated Harvard Business Review article and received a robust response. Peter Róna, head of Schroder Bank in New York, maintained that by exclusively privileging shareholder interests Jensen pre-empted “thoughtful analysis of the very question that is at the heart of the issue – what should be the rights and privileges of shareholders?” Róna questioned Jensen’s assumption that shareholders are better judges of capital projects than managers and corporate boards as “an ideologically inspired assertion that lacks empirical support” (1989).
Extensive evidence assembled by Henwood suggests that Jensen’s confidence was unfounded that “all-knowing financial markets will guide real investment decisions towards their optimum, and with the proper set of incentives, owner-managers will follow this guidance without reservation” (1998, p. 276). The impact of the restructuring of assets in the increasingly aggressive market for corporate control in the 1970s and 1980s was not primarily efficiency-enhancing as Jensen maintained, and there is little support for the “inefficient management displacement hypothesis” (Ravenscraft & Scherer, 1989). While acquisitions may benefit some private interests, there is little productivity gain and frequent losses from mergers (Caves, 1989). Any returns from hostile acquisitions came from other sources including reductions in employment, tax savings, cuts in investment, and possibly, with mergers within industries, increasing their market power to control prices. Moreover, management buyouts and hostile takeovers were not a new permanent organizational form, but a temporary reallocation of assets, before they were transferred back to large public corporations (Bhagat et al., 1990). In this process the large US corporation was not eclipsed, but was usually badly bruised and often left eviscerated.
The 1980s ended with disillusionment in the role of LBO firms to serve other than their own interests (Bartlett, 1991), with an extensive series of defaults by over-leveraged firms amounting to the largest insolvency boom since the 1930s, and with the imprisonment of Michael Milken of Drexel Burnham for fraud. Those who wished to discipline corporations needed to find a more pliable tool than the market for corporate control in order to do so. The organization of shareholder activism provided a new form of investor assertiveness. Ironically among the most influential of the new shareholder activists was T. Boone Pickens, an oil industry corporate raider. He organized the United Shareholders Association (USA):
From its 1986 founding to its 1993 dissolution, USA tracked the performance of large public corporations and compiled a Target 50 list of losers. The USA would try to negotiate with the underperformers, urging them to slim down, undo anti-takeover provisions, and just deliver their shareholders more “value.” If satisfaction wasn’t forthcoming, USA would ask its 65,000 members to sponsor shareholder resolutions to change governance structures. USA-inspired resolutions were often co-sponsored by groups like the California Public Employees Retirement System (Calpers), the College Retirement Equities Fund (CREF), and the New York City Employees Retirement System (Nycers). (Henwood, 1998, p. 289)
In 1995 a new organization Relational Investors was founded to invest to act as a “catalyst for change” with similar backing from a number of large institutional investors. These were pension funds of public sector workers, adopting an anti-management rhetoric aimed at big business, though focusing on governance reforms such as more independent directors, and linking executive pay to stock performance (Useem, 1996). Unfortunately these performance improvements would often be achieved by downsizing and investment cutbacks, and heralded an increasing short-termism in the obsession with quarterly results. The rationale for these interventions was that higher share prices benefited society at large; however, the loss of growth and employment through reduced investment involved considerable social costs, and the benefits in share price gains were distributed to a much narrower section of the community with the extreme concentration of all forms of shareholdings, including pension funds investing in equities, since all forms of superannuation are themselves highly unequally distributed (Henwood, 1998, p. 291).
It was in this hollowing-out of the social responsibility of business that the US business corporation emerged as primarily a financial instrument. In this new financialized, de-materialized and de-humanized corporate world agency theory could be purveyed as the primary theoretical explanation, and shareholder value as the ultimate objective with impunity. In turn these new conceptions of the theory and objective of the firm became vital ingredients in the further financialization of corporations, markets and economies (Weinstein, 2012).
3 Dismantling the hegemony of agency theory
Agency theory has become “a cornerstone of … corporate governance” (Lan & Heracleous, 2010). Agency theory is often regarded not only as the dominant current interpretation, but as an eternal and universal explanation of corporate governance. In fact agency theory is of recent origin, and is very much a product of the Anglo-American world. Rooted in finance and economics, it has somehow managed to penetrate not only policy and practice but the essential understanding of corporate law regarding directors’ duties. In classical agency theory the central role of the board of directors is to monitor managers (the agents) to ensure that their interests do not diverge substantially from those of the principals (the shareholders), and to devote the company to maximizing principals’ returns (Fama, 1980; Fama & Jensen, 1983a, 1983b; Jensen & Meckling, 1976). Yet, despite its pre-eminence, agency theory is not only profoundly simplistic, but deeply flawed:
Agency theory focuses on an oversimplification of complex financial and business reality.
Agency theory damagingly insists upon the single corporate objective of shareholder value.
Agency theory misconceives the motivations of managers.
Agency theory ignores the diversity of investment institutions and interests.
Agency theory debilitates managers and corporations, and ultimately weakens economies.
Agency achieves the opposite of its intended effect.
As Didlier Cossin, professor of finance at the International Institute for Management Development (IMD), Switzerland, has recently observed:
Most financial models taught today rely on false mathematical assumptions that create a sense of security even as failure approaches… The list of flawed theories (including agency theory).are all finance models based on over-simplifying complex choices. This pretence that mathematical models are the solution for human problems is dangerous and is not only at the core of finance theory but is also in the heads of many corporate and financial managers. Given the tremendous changes in financial systems, these theories must be scrutinised and then abandoned as models for the future. (Financial Times 5 September 2011)
Not only does agency theory dangerously over-simplify the complexities of business relationships and decisions, but it damagingly demands a focus on a single objective. Agency theory asserts shareholder value as the ultimate corporate objective that managers are incentivized and impelled to pursue: “The crisis has shown that managers are often incapable of resisting pressure from shareholders. In their management decisions, the short-term market value counts more than the long-term health of the firm” (Segrestin & Hatchuel, 2011).
Agency theory daring not to enter the “black box” of the firm itself, from a distance hopelessly misconceives the motivations of managers, reducing their complex existence to a de-humanized stimulus/response mechanism:
The idea that all managers are self-interested agents who do not bear the full financial effects of their decisions (Jensen & Meckling, 1976) has provided an extraordinary edifice around which three decades of agency research has been built, even though these assumptions are simplistic and lead to a reductionist view of business, that is, comprising two participants – managers (agents) and shareholders (principals). (Pye & Pettigrew, 2005)
Agency theory tends to ignore the diversity of investment institutions and interests, and their variety of objectives and beneficiaries. As Lazonick (1992) has argued institutional investors are not monolithic and different types of institutional investors have different investment strategies and time horizons. Corporate governance becomes less of a concern if a shareholding is a very transitory price based transaction, and much share trading today is computer generated, with rapid activity generated by abstract formulas. While life insurance and pension funds do have longer term horizons, and often look to equity investments to offer durable and stable returns, the behaviour of other market participants is often focused on the shorter term, and more interested in immediate fluctuations in stock prices than in the implications of corporate governance for the future prospects of a company:
Pension fund managers can generally take a longer-term perspective on the returns to their portfolios than can the mutual-fund managers. Nevertheless even the pension funds (or insurance companies) are loath to pass up the gains that, in a speculative financial era, can be made by taking quick capital gains, and their managers may feel under personal pressure to match the performance of more speculative institutional investors. The more the institutional investors focus on the high returns to their financial portfolios needed to attract household savings and on the constant restructuring of their portfolios to maximize yields, the more their goals represent the antithesis of financial commitment. Driven by the need to compete for the public’s savings by showing superior returns, portfolio managers who invest for the long term may find themselves looking for new jobs in the short term. (Lazonick, 1992)
US information technology companies, which led the world in the 1990s innovation (Microsoft, IBM, Cisco, Intel, Hewlett-Packard), “spent more (much more except Intel) on stock buybacks than they spent on R & D in 2000–2009” (Lazonick, 2012). In the 2007–2008 global financial crisis,
many major US financial firms (including Citigroup, Merrill Lynch, Lehman Brothers, Wachovia, Washington Mutual, Fannie Mae), many of whom subsequently failed, had previously used up precious reserves in order to fund stock buybacks, which in turn made already over-compensated executives even wealthier.
Lazonick asks why did senior executives willingly diminish the financial strength and resilience of major corporations in this reckless way?
The ideology of maximizing shareholder value is an ideology through which corporate executives have been able to enrich themselves. The economists’ and corporate executives’ mantra from 1980 until the 2007–2008 meltdown of shareholder value and the need to “disgorge … free cash flow” (Jensen, 1986, p. 323) translated into executive option grants and stock buybacks, and resulted in increasing dramatically those executive options’ value. (Lazonick, 2012)
The self-interest and irresponsibility inherent in the practice of pursuing shareholder value reached its zenith with the reckless excesses of the global financial crisis. William Bratton and Michael Wachter relate the activities of financial sector firms in the years and months leading to the financial crisis of 2007−2008:
For a management dedicated to maximizing shareholder value, the instruction manual was clear: get with the program by generating more risky loans and doing so with more leverage. Any bank whose managers failed to implement the [high risk strategy] got stuck with a low stock price…. Unsurprisingly, its managers labored under considerable pressure to follow the strategies of competing banks. (Bratton & Wachter 2010)
This behaviour has been widely recognized in post-crisis inquiry reports, and regulatory reforms across most jurisdictions now recommend that executive remuneration systems should be redesigned to take into account risk strategy and promote long-term performance and responsibility (Blair, 2012).
In the latest manifestation of the reckless pursuit of self-interest at the (Mina, et al., 2012) heart of shareholder value, the dangers of massive high-frequency trading are becoming increasingly clear in equity markets. Regulators around the world are very concerned about the systemic risk in high-frequency trading. Already we have experienced a flash crash on the New York Stock Exchange on 6 May 2010 when $1 trillion dollars was wiped off share values in a matter of minutes only to be largely restored later in the afternoon (SEC, 2010), and the bail-out of Knight Capital hedge fund due to a high-frequency trading algorithm that went wrong leading to a $440 million trading loss, but there have been frequent incidents in other major markets as well. Algorithmic and high-frequency trading is sometimes manipulative or illegal, but it is often simply predatory on other investors. In response there is the proposal to make computer “kill” switches mandatory that stop trades that appear to be out of control. In addition, regulators are concerned about the increase in trading taking place in “dark pools” and are encouraging trades back out on to Exchanges.
There is an intense irony in the huge divide between the sage call for long-termism in investment horizons by the representatives of the institutional investors, and the acute explanation of the increasing prevalence of high-frequency trading (HFT) provided by the trading arms of investment banks, which starkly highlights the complexities of contemporary finance markets. The immense divide between the 20-year time frame of fund managers to provide retirement benefits to the public, and the frantic high-velocity trading, in which micro-seconds are critical, demands further investigation.
First, there is a profound distinction between investing and trading. These are very different activities and deserve to be regulated, supervised and taxed in different ways. The Kay Review of UK Equity Markets and Long-Term Decision Making published in July 2012 analysed this distinction. High-frequency traders are driven by short-term market trends, and turn their portfolios over rapidly. The underlying performance is of less interest than immediate opportunity. In contrast, investors intent on holding assets for the long-term will analyse a companies’ prospects and the underlying performance. Kay concludes, “Equity markets work effectively for the corporate sector when they encourage, and do not impede, decisions which enhances the long-term competitive capabilities of the business.” The concern is that the short-term emphasis of equity markets may have encouraged unproductive value extraction at the expense of sustainable value creation.
Advances in financial, computing and communications technologies have facilitated the dramatic reduction of the average holding period of equity: on the NYSE this has diminished from 7 years in the 1950s to 6 months today. More worryingly, as much as 70% of trading volume on the NYSE is measured now in milliseconds, and other exchanges are similarly overwhelmed:
Over the past decade, trading in financial markets has undergone a technological revolution. The frontier of this revolution is defined by speed. A decade ago, trade execution times were measured in seconds. A few years ago, they were measured in milliseconds. Today, they are measured in microseconds. Tomorrow, it will be nano-seconds or pico-seconds. For technologists, this is a “race to zero” – the promised land of zero latency where execution times converge on the speed of light. For social scientists, this is a financial arms race, a sub-second game of leapfrog. In their quest for speed, a number of firms are also engaged in a positional race… Accompanying this shift in speed has been a dramatic change in the composition of trading and market-making. During this decade, so-called High Frequency Trading (HFT) has come to dominate. It now accounts for anywhere between a half and three-quarters of trading volume on the world’s major equity markets and a rising share of futures and other derivative markets. In some markets, HFT firms have become the de-facto liquidity providers or market-makers. Historically, designated market-makers were often granted privileges in return for agreeing to ensure trade and price continuity. No longer: the sleek have inherited the earth. (Haldane, 2012, p. 4)
The more impact short-term traders have on the market, the more volatile prices will be as these become less rooted in the fundamentals of the value of corporations traded, as Andrew Haldane of the Bank of England has documented, citing a Chartered Financial Analyst (CFA) 2006 Symposium, which concluded that “The obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, decreasing market efficiency, reducing investment returns, and impeding efforts to strengthen corporate governance” (Haldane, 2011, p. 3).
Present financial wisdom, and the securities regulation that has been developed within the same paradigm, suggests that there is no such thing as too much liquidity, too much volatility or too much trading, as Fox and Lorsch argue in the August 2012 issue of the Harvard Business Review. Yet this creates very hazardous financial seas in which to navigate any corporate vessel. Michael Porter once warned the US Council on Competitiveness of the problems for business created by a too fluid capital market.
More recently, the consequences for corporate America in 2012 were revealed by Bill Lazonick of the University of Massachusetts: US corporations have hoarded trillions of dollars, and they will only spend money on dividends, share buy backs and executive options – all designed to enhance their share price. Disastrously, investment in innovation, product and skill development has collapsed in US industry (with the large corporation exceptions of Apple and Google). Last year America had a US$60 billion trade deficit in high-tech goods, according to the US Department of Commerce (2012). Business innovation is fuelled by investment. Innovation trajectories are shaped not simply by new knowledge and technical capability, but also by the rates and criteria by which financial markets and institutions will allocate resources to innovative business enterprise. Long-term innovation and investment performance requires attention to more than short-term financial metrics to satisfy the most transient of shareholders.
4 The myths of shareholder primacy
Yet the concept of shareholder primacy, and the concomitant insistence that the only real purpose of the corporation is to deliver shareholder value has become an almost universal principle of corporate governance, and often goes unchallenged. This self-interested, tenacious and simplistic belief is corrosive of any effort to realize the deeper values companies are built upon, the wider purposes they serve and the broader set of relationships they depend upon for their success (Clarke, 2007). The obsessive emphasis on shareholder value is an ideology that is constricting (Blair and Stout, 1999; Mitchell, et al., 2005; Lazonick, 2009) and misleading in business enterprise, and is intended to crowd out other relevant and viable strategies for business success:
The idea that shareholders alone are the raison d’être of the corporation has come to dominate contemporary discussion of corporate governance, both outside and (in many cases) inside the boardroom. Yet the “shareholder primacy” claim seems at odds with a variety of important characteristics of US corporate law. Despite the emphasis legal theorists have given shareholder primacy in recent years, corporate law itself does not obligate directors to do what the shareholders tell them to do. Nor does it compel the board to maximize share value. To the contrary, directors of public corporations enjoy a remarkable degree of freedom from shareholder command and control. Similarly, the law grants them wide discretion to consider the interests of other corporate participants in their decision-making – even when this adversely affects the value of the stockholders’ shares. (Blair & Stout, 2001)
From the mid-1980s a majority of states in the United States (but not in Delaware, the seat of incorporation of many major US corporations) amended their corporate law statutes to permit (but, typically, not to require) directors to take into account in decision-making the interests of other stakeholder constituencies and community interests beyond shareholders. Approximately, half of these constituency statutes (as they are called) grant the licence only in the context of a hostile takeover or other corporate control transaction; indeed, the licence has principally been invoked by directors in response to an unsolicited takeover bid. Generally, the statutes do not give non-shareholder stakeholders standing to take enforcement action against directors and they make no provision for representation in governance of non-shareholder interests (CAMAC, 2006; Hale, 2003).
Lynn Stout (2012) explains how the Chicago economists strongly (Parsons, 1967) influenced the debate over shareholder primacy to the point where, in the 1990s most scholars and regulators accepted shareholder wealth maximization as the proper goal of corporate governance. Hansmann and Kraakman’s 2000 paper, “The End of History for Corporate Law” marked the peak of this theory. Stout’s view is that this was the zenith of the shareholder primacy view which is now “poised for decline”. She explains very clearly that furthering shareholder value is only one interpretation of directors’ duties, “American law does not actually mandate shareholder primacy” (Stout, 2012, p. 35).
Despite these developments, the primacy traditionally accorded to shareholder interests is most often justified on the basis that it is the means by which corporate law can most effectively secure aggregate social welfare (Hansmann & Kraakman 2001, p. 19). This view was perhaps most clearly and familiarly expressed by the economist Milton Friedman (1970) that “the social responsibility of business is to increase its profits.”2 However, the question of whose interests should shape corporate operations and strategy has become contested under the corporate social responsibility movement. Is it, and should it be, the collective interest of shareholders exclusively or should it also include other interests and wider social claims in their own right?
Lynn Stout argues that the debate is not a simple contest between shareholders and stakeholders but that the idea of shareholder value as a stand-alone concept does not make any sense. Indeed she comments that “a relentless focus on raising the share price of individual firms may be not only misguided but harmful to investors” (2012, p. 7).
If we stop to examine the reality of who “the shareholder” really is – not an abstract creature obsessed with the single goal of raising the share price of a single firm today, but real human beings with the capacity to think for the future and to make binding commitments, with a wide range of investments and interests beyond the shares they happen to hold in any single firm, and with consciences that make most of them concerned, at least a bit, about the fates of others, future generations, and the planet… (Stout, 2012, p. 6).
She argues convincingly that each of the basic assumptions behind shareholder primacy are false and that shareholders do not own the company: “Corporations own themselves, and enter contracts with shareholders exactly as they contract with debt holders, employees, and suppliers” (Stout, 2012). Once it is conceded that directors are allowed to pursue the success of the company in meeting all of its contractual relationships, and that they are not required to simply maximize the value of the corporation’s shares, the question then becomes what ultimate objectives should they pursue? (Blair, 2012). If the answer to this question is the corporate objective is to pursue a long-run goal to satisfy wider corporate interests, it is difficult to implement this prescription without adopting a more explicitly stakeholder orientation in practice, as even Michael Jensen the arch-priest of agency theory has conceded:
In order to maximize value, corporate managers must not only satisfy, but enlist the support of, all corporate stakeholders – customers, employees, managers, suppliers, and local communities. Top management plays a critical role in this function through its leadership and effectiveness in creating, projecting, and sustaining the company’s strategic vision …. Enlightened value maximization uses much of the structure of stakeholder theory but accepts maximization of the long-run value of the firm as the criterion for making the requisite tradeoffs among its stakeholders. (Jensen (2002, p. 67).3
As Margaret Blair contends, in the US directors have both the authority and the responsibility, without any change in corporate law, to consider the interests of all of the participants in the corporate enterprise in order to try to find the outcome that creates value for all parties (2012, p. 69).
5 Modern company law reform
Historically, since the origins of contemporary capitalism, the wider purposes and interests of the corporation were recognized and valued. Berle and Means were the first to fully explore the structural and strategic implications of the separation of ownership and control (Weinstein, 2012). Berle wrote in the preface to The Modern Corporation and Private Property (1932) that “it was apparent to any thoughtful observer that the American corporation had ceased to be a private business device and had become an institution.” In their monumental work, Berle and Means searched for a new conception of the corporation that embraced the wide constituency of corporate interests and responsibilities (a concern tragically abandoned by most contemporary financial economists):
Neither the claims of ownership nor those of control can stand against the paramount interest of the community… It remains only for the claims of the community to be put forward with clarity and force. Rigid enforcement of property rights as a temporary protection against plundering by control would not stand in the way of the modification of these rights in the interests of other groups. When a convincing system for community obligations is worked out and is generally accepted, in that moment the passive property right of today must yield before the larger interests of society. Should corporate leaders, for example, set forth a program comprising fair wages, security to employees, reasonable service to the their public and stabilization of business, all of which would divert a portion of the profits from the owners of passive property and would the community generally accept such a scheme as a logical and human solution of industrial difficulties, the interests of passive property owners would have to give way. Courts would almost of necessity be forced to recognize the result, justifying it by whatever of the many legal theories they might choose. It is conceivable, indeed it is almost essential if the corporate system is to survive, that the “control” of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community and assigning to each a portion of the income streams on the basis of public policy rather than private cupidity. (1933, p. 312)
As Olivier Weinstein authoritatively sets out, the clear features of the new form of corporate enterprise advanced by Berle and Means “underlying its capacity to serve as a support to the accumulation of capital and to an unprecedented concentration of material, human and financial resources” included three essential dimensions:
The separation between investors and the enterprise, the status of the corporation making the corporation an autonomous entity, involving the strict separation between the assets of the enterprise and the assets of the investors;
Incorporation required governance rules legally separating business decision-making from the contribution of finance capital, and giving discretionary powers to directors and officers, recognizing their managerial rights to allocate corporate resources (Blair, 2004);
The freedom in a public corporation for shareholders to sell their stock with the development of capital markets. This signified a radical change in the relationship of the investors and the enterprise (2012, pp. 5–6).
These dimensions are integral to the investment, operation and development of corporations, and the workings of capital markets, and are the foundation on which Berle and Means built their theory of the implications of the separation of ownership and control. Integral to this theorization is a realization that there is a distinction between the corporation as a legal entity and the firm as a real organization. The corporation is both a legal entity, and a collective, economic set of activities, that cannot be simply reduced to a series of contracts. It is this latter existence that gives the corporation an existence independent from the changing shareholders (Weinstein, 2012, p. 13). This gives rise to the enduring question of in whose interests should the corporation be managed?
Berle and Means could never have imagined that 80 years later corporations, managers, shareholders and lawyers would remain mired in the controversial issues raised by their ideals. And however undermined and marginalized the idealism of Berle and Means became in the work of financial economists in the later twentieth century who reasserted shareholder primacy with a purity and intensity not witnessed since the early nineteenth century origins of industrial capitalism, yet the resonances of good sense of the original Berle and Means statement continued in the minds and actions of practical managers and corporations. Indeed the arrival of the new knowledge-based economy added a powerful boost to the early conceptions of the essentially social basis of industry, as Charles Handy highlighted:
The old language of property and ownership no longer serves us in the modern world because it no longer describes what a company really is. The old language suggests the wrong priorities, lead to inappropriate policies and screens out new possibilities. The idea of a corporation as the property of the current holders of shares is confusing because it does not make clear where power lies. As such, the notion is an affront to natural justice because it gives inadequate recognition to the people who work in the corporation, and who are, increasingly, its principal assets. (1997)
Ironically during the 1990s explosion of the knowledge economy, the Anglo-Saxon shareholder value based approach to corporate governance became reinvigorated in the United States, the United Kingdom, Australia, New Zealand and other countries that adopted this model. This model also began to have a strong influence on European and Asian economies that formerly sustained more stakeholder or collective conceptions of corporate governance. In the context of global competition, international investment patterns, and the aggressive growth of international mergers and acquisitions, assuming the primary objective of releasing shareholder value often seemed the only sure way not only for international business success, but for corporate survival itself.
The shareholder value view upholds a property conception of the company (Biondi, 2012). In its most extreme form, as developed by the Chicago School of law and economics, the company is treated as a nexus of contracts through which the various parties arrange to transact with each other. This theory claims the assets of the company are the property of the shareholders, and managers and boards of directors are viewed as the agents of the shareholders with all of the difficulties of enforcement associated with agency relationships. Though the shareholder value orientation is assumed to be an eternal belief, firmly rooted in law, with strong historical foundations, none of this is anything more than a recent ideological convenience. Shareholder value in its current manifestation was a construct of financial economists in the 1980s, and meant to deal with the lack of shareholder value orientation widely apparent in US industry at the time.
Historically, American corporations have demonstrated a broad conception of the orientation towards a wide constituency of stakeholders necessary in order to build the enterprise. Over time and with the increasing market power of large corporations, managements’ sense of accountability might have become overwhelmed by complacency and self-interest. However, to attempt to replace self-interested managers, with managers keenly focused entirely upon delivering value to shareholders, is to replace one form of self-interest with another. Any broadening of the social obligations of the company was dangerous according to the shareholder value school of thought, “Few trends could so thoroughly undermine the foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible” (Friedman, 1970, p. 113).
The difficulty is whether in trying to represent the interests of all stakeholders, company directors simply slip the leash of the one truly effective restraint that regulates their behaviour – their relationship with shareholders. These views were expressed with vigour by liberal economists, and enjoyed the support of leading business leaders and senior politicians. More practically, such views reflected how US and UK companies were driven in the (Baxt, 2011) period of the 1980s and 1990s, with an emphasis upon sustaining share price and dividend payments at all costs, and freely using merger and takeover activity to discipline managers who failed in their responsibility to enhance shareholder value. It was the economic instability and insecurity created by this approach that was criticized in the report by Porter (1992).
Meanwhile efforts were made to clarify the law on directors’ duties. In 1979 the UK company legislation was amended to provide that the matters (Redmond, 1992; 2012) to which directors “are to have regard in the performance of their functions include the interests of the company’s employees in general, as well as the interests of its members.” The duty is owed to “the company (and the company alone) and enforceable in the same way as any other fiduciary duty owed to a company by its directors” (s 309(2)). These issues were extensively considered for several years in the deliberations of the United Kingdom Modern Company Law Review (1998–2000). Two approaches were considered:
A pluralist approach under which directors’ duties would be reformulated to permit directors to further the interests of other stakeholders even if they were to the detriment of shareholders;
An enlightened shareholder value approach allowing directors greater flexibility to take into account longer term considerations and interests of various stakeholders in advancing shareholder value.
In considering these approaches, the essential questions of what is the corporation, and what interests it should represent are exposed to light, as Davies eloquently argues:
The crucial question is what the statutory statement says about the interests which the directors should promote when exercising their discretionary powers. The common law mantra that the duties of directors are owed to the company has long obscured the answer to this question. Although that is a statement of the utmost importance when it comes to the enforcement of duties and their associated remedies, it tells one nothing about the answer to our question, whose interests should the directors promote? This is because the company, as an artificial person, can have no interests separate from the interests of those who are associated with it, whether as shareholders, creditors, employers, suppliers, customers or in some other way. So, the crucial question is, when we refer to the company, to the interests of which of those sets of natural persons are we referring? (Davies, 2005)4
6 Options for change
What should be the legal rule with respect to directors’ duties? Should company law require directors and senior managers to act by reference to the interests of all stakeholders in the corporate enterprise, according primacy to no particular interests including those of shareholders (mandatory pluralism)? Or should company law permit (but not require) directors and senior managers to act by reference to the interests of all stakeholders, according primacy to no particular interests including those of shareholders (discretionary pluralism)?
The most radical of these models is the mandatory pluralist model creating a multi-fiduciary duty requiring directors and managers to run the company in the interest of all those with a stake in its success, balancing the claims of shareholders, employees, suppliers, the community and other stakeholders. The claims of each stakeholder are recognized as valuable in their own right and no priority is accorded shareholders in this adjustment; their interest may be sacrificed to that of other stakeholders. (Stakeholders are variously defined as those with an interest in or dependence relationship with the company or, alternatively, as those upon whom it depends for its survival). The discretionary pluralist model would permit, but not require, directors to sacrifice shareholder interests to those of other stakeholders. Either of these models would formalize earlier managerialist practice that has been displaced by the current shareholder value culture. As a member of the Corporate Law Review Steering Group, Davies goes on to defend the enlightened shareholder value view suggesting the pluralist approach produces a formula which is unenforceable, and paradoxically gives management more freedom of action than they previously enjoyed (Davies, 2005). However, John Parkinson another member of the Corporate Law Review Steering Group argued strongly for the viability of a pluralist conception that maintained a broader sense of corporate purpose, but sadly Parkinson died during the period the steering group was meeting (Parkinson, 1993).
The UK Company Law Review Steering Group (2000) following its comprehensive review of company law recommended a recasting of directors’ duties to give effect to its notion of “enlightened shareholder value” ultimately contained in the Companies Bill 2006 (UK) which received Royal Assent on 8 November 2006.
Section 172(1) of the Companies Act 2006 imposes a duty upon a director to act in the way he or she considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to (a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct and (f) the need to act fairly as between members of the company.
In short, we are at a stage where directors are permitted to take different stakeholder interests into account but only to the point that this can be argued to be good for long-term shareholder wealth. It would be hard for directors to make decisions that treat the well-being of employees or the environment as the primary cause for action (unless based on other legal obligations under employment or environmental law). As Marshall and Ramsay state, “the extension of duties of directors has not been attended by the extension of rights for stakeholders” (2009, p. 16).
7 The international advance of corporate social responsibility
Yet the movement for the exercise of greater corporate social responsibility has continued to attract considerable interest world-wide in recent years (CAMAC, 2005, 2006). However challenging the prospects, there are growing indications of large (McBarnet, et al., 2007) corporations taking their social and environmental responsibilities more seriously, and of these issues becoming more critical in the business agenda, and being taken up as part of the duties of company directors. This is a consequence of several factors: technological advances such as the internet make it much easier to find out about companies and broadcast any misdemeanours; maintaining a good reputation is therefore an important marketing asset for many companies; civil society groups have become more vocal regarding companies’ public responsibilities; and some of the protections offered by law have been eroded (for example industrial relations law) (Marshall & Ramsay, 2009). Whether the driving force for corporate responsibility is genuine concern or a desire to present a favourable front, the substance of company reports is changing, from purely environmental reporting up until about 1999, to sustainability reporting (social, environmental and economic), which has become the mainstream approach of global companies (KPMG, 2011).
Though some of the expressed concern may be part of the discourse of political correctness, there does appear to be a significant shifting of opinion among executives. At the confluence of these multiple emerging initiatives and trends towards greater corporate social and environmental responsibility, there is emerging a dynamic stakeholder model for driving enlightened shareholder value (or more expansively, stakeholder values) (Mays, 2003; SustainAbility, 2005). This “enlightened shareholder value” approach posits that there can be a win-win situation whereby a company will benefit financially in the long term if it behaves responsibly towards its employees, the environment, customers, suppliers etc. The obvious manifestations of this are reputational benefits, reduced costs from more efficient use of natural resources and the support of local communities (the licence to operate). Critics of this view maintain that there will be circumstances where the win-win scenario is simply not possibly or too costly: not all companies are concerned with reputation and the benefits from bad behaviour can be all too tempting. A business case for corporate responsibility may exist for some companies but not for all, indeed Vogel in discussing the limits of CSR comments that it should be understood as “a niche rather than a generic strategy” (Vogel, 2005).
However, many advances in corporate social responsibility and sustainability international policy and practice have occurred in recent years. The further development of the UNEP Financial Initiative with the report ESG Show me the money: linking environmental, social and governance issues to company value (UNEP FI, 2006) has persuasively argued the relationship between sustainability and valuation; the UNEP FI Principles of Responsible Investment (2012) has recruited 915 investment institutions as signatories of the principles, with assets under management of approximately US$30 trillion; the Global Reporting Initiative (GRI) have been adopted world-wide as a means of integrated reporting. Together with many other international, national and private sector initiatives the knowledge and practice of sustainability and corporate social responsibility has gained global significance. However, the proliferating range of sustainability standards and initiatives themselves poses challenges even for corporations committed to performing well.
In fact corporations and governments are struggling with an “almost bewildering array of international CSR initiatives” (Calder & Culverwell, 2005; McKague & Cragg, 2005). Reviewing the efforts to develop CSR following the World Summit on Sustainable Development, a survey of stakeholders by the Royal Institute for International Affairs identified a range of significant weaknesses in current approaches to promoting CSR that governments should seek to address:
An over-proliferation of CSR initiatives at the international level and lack of clarity about how these initiatives relate to each other in a coherent way;
An excessive focus on getting businesses to make commitments to CSR and not enough focus on enabling them to implement them effectively;
An absence of credible monitoring and verification processes of CSR initiatives;
A lack of effective mechanisms of redress for communities affected by companies that flout national or international norms on sustainable development or human rights (Calder & Culverwell, 2005, p. 7).
The rapidly developing interest in sustainability and corporate social and environmental responsibility has resulted in a plethora of overlapping definitions and interpretations of the two concepts from international agencies, consultancies and practitioners. A difficulty is that the most commonly employed acronym, CSR, refers to corporate social responsibility, though in most interpretations is meant to include environmental responsibility also. The use of the simpler term corporate responsibility and acronym CR is not widespread, though it would more readily embrace all corporate responsibilities. The UN’s recent adoption of the environmental, social and governance (ESG) acronym may become influential, since it explicitly links governance to social and environmental responsibility.
8 Directors’ understanding in practice
With the current situation placing wide discretion on directors, what we really need to know is how they are interpreting their duties in practice. Marshall and Ramsay (2009, p. 48) conducted a survey of Australian directors which did not support the view that directors adhere to a “shareholder primacy” understanding of their responsibilities. In fact, no directors believed they had to act in the short-term interests of shareholders only and most had a “stakeholder” understanding of their obligations.
Recent research supports this view, revealing that many large Australian companies have a board sub-committee dedicated to considering issues of corporate responsibility/sustainability (Klettner & Clarke, 2009). They have formal processes for engaging with their stakeholders and systems (Jordi, 2010) for ensuring that stakeholder interests are taken into account at the highest levels of decision-making. Formal governance structures are being put in place to ensure that sustainability initiatives are integrated into core business strategy. This is further evidence supporting the view that directors currently uphold a stakeholder view of their duties.
Of course, the fact that a process exists for taking different interests into account does not tell us how those interests are prioritized. It may be that shareholder value remains at the top of the list. Marshall and Ramsay (2009) found that 44% of directors ranked shareholders as their number one priority and 40% the company, employees tended to come third. Certainly there is evidence to suggest that boards are not as narrowly focused on maximizing share value as they may have been in the past. In interviews conducted in 2007, Klettner, Clarke, and Adam (2010) found that boards were warming to the idea of corporate responsibility on the basis of it being an exercise of increasing efficiency – cost savings can be made through staff training and retention as well as through minimizing wastage of natural resources:
The development of corporate responsibility practices has occurred in a piecemeal fashion in response to the specific demands of stakeholders. Companies have now reached the stage where they need to consolidate and integrate those practices into their overall business strategy. (Klettner & Clarke, 2011)
There remains much work to be done in embedding sustainability business strategies and practices. Traditionally the focus of corporate performance measures have almost entirely been concerned with economic and financial performance, and it was possible to consider social and environmental impact as “externalities.” Today there is a growing realization that social and environmental impact must be internalized as part of business performance. Both investors and corporations are becoming aware of the importance of environmental, social and governance (EDG) factors in the estimation of corporate value.
ESG factors can have long-term consequences on a company’s financial performance, either for better or for worse. ESG factors are now at the core of business. However, the depth and breadth of ESG factors are not fully valued by investors and company management. Companies believe that mainstream asset managers currently under or overvalue the long-term intrinsic value of companies because they fail to routinely integrate ESG factors into their investment analysis and decision-making. (UNEP FI, 2006; UNEP FI/WBCSD, 2010, p. 7)
The task of directors integrating sustainability into the business models of corporations is an important objective: “Sustainability should not be a separate policy but integrated in the entity’s strategy and business model” (FEE, 2011, p. 5). For example, recent controversies regarding major banks’ policies on interest (Benn and Dunphy, 2007) rates and employment security indicate an apparent dissonance between their social commitments and commercial instincts. Recognition of the materiality of sustainability would cover matters such as fees and charges, investment and lending, customer service, job security, financial inclusion, economic contribution and security with regard to customers, employees and the wider community.
Nevertheless share price continues to be seen as the vital indicator of firm performance and certain stakeholders in the firm do care greatly about share value – fund managers tend to be judged (and paid) on the basis of the value of their portfolio, and many senior executives have a large portion of their bonus dependent on share performance. An important question in our recent work with Catalyst Australia was to investigate whether large corporations are now including sustainability performance in their remuneration systems. Unless executives are rewarded for improving a firm’s long-term sustainability as well as its short-term share price, sustainability will tend to come second. A positive finding was that most of the twelve firms included in the study did include some aspect of sustainability in their short-term incentive schemes, most commonly occupational health and safety. It was very unclear exactly what proportion of remuneration might be dependent on safety performance and how it would vary, however, it was encouraging to see the link being made.
9 Conclusions: directors’ duties and corporate responsibility
It may well be the case that further legislative and regulatory intervention will be required to ensure all corporations fully respond to the growing public demand that they recognize their wider social and environmental responsibilities. In an assessment of the arguments in favour of voluntary and mandatory standards of sustainability reporting, UNEP, in a report prepared by KPMG, states:
Suggested prerequisites for balanced regulation highlight the importance of a publicly recognized set of performance indicators (of which the Global Reporting Initiative provides a global reference framework), independent verification, stakeholder engagement, the role of government in enforcing a level playing field and the importance of incentives. The conclusions also highlight the importance of international cooperation and collective action, avoiding a proliferation and fragmentation of national level guidelines. (UNEP FI, 2006)
However, it is useful to examine how far corporate social responsibility objectives can be achieved within existing law and regulation. If there is substantial evidence of leading corporations demonstrating it is possible to voluntarily commit to social and environmental performance and to achieve commercial success – perhaps because of, rather than in spite of, ethical commitments – then it will be more straightforward to press for the legislative changes necessary to deal with corporations that refuse to acknowledge their wider responsibilities, as well as finding appropriate legislative support for the directors of companies that wish to develop further their corporate social and environmental responsibility commitments.
This is all a long way from the simplistic tenets of shareholder value, and the narrow objective it focused upon, often to the detriment of corporations, shareholders, stakeholders and the wider economy and environment. Hopefully we can now spend more time addressing the possibilities and limitations of corporate social and environmental responsibility, free of the dead weight of the mythology of shareholder primacy. If shareholder value in future is not regarded with the deadly seriousness it was in the recent past, in no small part it will be due to the brilliant polemic of Lynn Stout manifest in her 2012 book.
Stout, Lynn. 2012. The Shareholder Value Myth. San Francisco, CA: Berrett-Koehler; cf Stout, Lynn. 2012. “New Thinking on ‘Shareholder Primacy’.” Accounting, Economics and Law: A Convivium 2(2). doi:http://dx.doi.org/10.1515/2152-2820.1037
Robe (2012) mounts a sustained challenge to Friedman’s polemic.
For a different view of value creation and distribution see, Sunder, Shyam. 2009. “Extensive Income and Value of the Firm: Who Gets What?” CLPE Research Paper No. 20/2009. Available at SSRN: http://ssrn.com/abstract=1440886; Biondi, Yuri. 2011. “The Problem of Social Income: The Entity View of the Cathedral (May 28, 2011).” Seattle University Law Review 34(4):1025. Available at SSRN: http://ssrn.com/abstract=1854803
In contrast, according to Biondi, this problem occurs only because Davies considers the company as a subject of law (i.e. a legal person), not an object. If the company is an institution and an object of law, it can be considered as a collective agency, and be organised consequently as other institutions are (in a Republican order), see Biondi, Yuri. 2009. “The Governance and Disclosure of the Firm as an Enterprise Entity (July 29, 2009).” CLPE Research Paper No. 21/2009. Available at SSRN: http://ssrn.com/abstract=1440871; Revised and augmented version forthcoming with Seattle U Law Review
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