More on the Pernicious Effect of "Maximizing Shareholder Value"
By Cydney Posner
Folks at the Washington Post seems to be obsessing about the adverse effects of the concept of maximizing shareholder value. Following on its long piece on the same topic from last week (see my article of 8/30/13), the Post now offers another long piece, this one from business writer Steven Pearlstein, discussing the costs arising out of businesses' focus on maximizing shareholder value. As he introduces his piece, "[i]n the recent history of management ideas, few have had a more profound — or pernicious — effect than the one that says corporations should be run in a manner that ‘maximizes shareholder value.' Indeed, you could argue that much of what Americans perceive to be wrong with the economy these days — the slow growth and rising inequality; the recurring scandals; the wild swings from boom to bust; the inadequate investment in R&D, worker training and public goods — has its roots in this ideology." He concurs with the author of last week's article that "this supposed imperative… has no foundation in history or in law. Nor is there any empirical evidence that it makes the economy or the society better off."
Generally, Pearlstein's history of the evolution of the theory is much the same as the history described in the prior piece: early corporations in the U.S., even continuing into the 1960s, were "widely viewed as owing something in return to a society that provided them with legal protections and an economic ecosystem in which to grow and thrive. In 1953, carmaker Charlie Wilson famously spoke for a generation of chief executives about the link between business and the larger society when he told a Senate committee that ‘what is good for the country is good for General Motors, and vice versa.'"
He also contends that, not only are there "no statutes that put the shareholder at the top of the corporate priority list," but contrary to popular belief, the law does not require "that executives and directors owe a special fiduciary duty to shareholders. The fiduciary duty, in fact, is owed simply to the corporation, which is owned by no one, just as you and I are owned by no one — we are all ‘persons' in the eyes of the law." As he sees it, shareholders have only "a contractual claim to the ‘residual value' of the corporation once all its other obligations have been satisfied — and even then directors are given wide latitude to make whatever use of that residual value they choose, as long they're not stealing it for themselves."
How then, he asks, did "maximizing shareholder value" become such a widely accepted norm of corporate behavior? Pearlstein largely echoes the earlier article in attributing the cause to globalization, deregulation and increased competition, all of which led to the lost decade of the 1970s. The following decade witnessed the threat of hostile takeovers, which "imbued corporate executives and directors with a new focus on profits and share prices, tossing aside old inhibitions against laying off workers, cutting wages, closing plants, spinning off divisions and outsourcing production overseas."
But while the new "market for corporate control" drove the imperative to boost share price, that imperative was reinforced by an "elaborate institutional infrastructure…. This infrastructure includes business schools that indoctrinate students with the shareholder-first ideology and equip them with tools to manipulate quarterly earnings and short-term share prices. It includes corporate lawyers who reflexively advise against any action that might lower the share price and invite shareholder lawsuits, however frivolous. It includes a Wall Street establishment that is thoroughly fixated on quarterly earnings, quarterly investment returns and short-term trading. And most of all, it is reinforced by gluttonous pay packages for top executives that are tied to the short-term performance of the company stock."
As a result, "corporate time horizons have become shorter and shorter. The average holding period for corporate stocks, which for decades was six years, is now down to less than six months. The average tenure of a public company chief executive is down to less than four years. And the willingness of executives to sacrifice short-term profits to make long-term investments is rapidly disappearing." A recent study by consultants "found alarming levels of short-termism in the corporate executive suite. They reported that nearly 80 percent of top executives and directors reported feeling most pressured to demonstrate a strong financial performance over a period of two years or less, with only 7 percent feeling pressure to deliver a strong performance over a period of five years or more. They also found that 55 percent of chief financial officers would forgo an attractive investment project today if it would cause the company to even marginally miss its quarterly earnings target."
Ironically, however, maximizing shareholder value "hasn't, in fact, done much for shareholders." According to academic research, "from 1932 until 1976 — roughly speaking, the era of ‘managerial capitalism' in which managers sought to balance the interest of shareholders with those of employees, customers and the society at large — the total real compound annual return on the stocks of the S&P 500 was 7.6 percent. From 1976 until the present — roughly the period of ‘shareholder capitalism' — the comparable return has been 6.4 percent." At the same time, less of the corporate wealth was going to workers and more to executives: the ratio of CEO comp to corporate profits increased eight-fold between 1980 and 2000, mostly related to stock-based compensation.
One practical problem the author identifies is the diversity of interests among shareholders. Are corporations supposed to optimize the interests of "hedge funds that are buying and selling millions of shares every couple of seconds to earn hedge-fund-like returns? Or mutual funds holding the stock for a couple of years? Or the retired teacher in Dubuque, Iowa, who has held it for decades?"
Even as companies vaunt the shareholder interests, corporate executives and directors, along with the business lobby, "have been doing everything possible to minimize and discourage shareholder involvement in corporate governance," exemplified by the fight against proxy access. In addition, Pearlstein contends, "[f]or too many corporations, ‘maximizing shareholder value' has also provided justification for bamboozling customers, squeezing suppliers and employees, avoiding taxes and leaving communities in the lurch. For any one profit-maximizing company, such behavior may be perfectly rational. But when competition forces all companies to behave in this fashion, it's hardly clear that society is better off. Take the simple example of outsourcing production overseas. Certainly it makes sense for any one company to aggressively pursue such a strategy. But when every company does it, so many American workers wind up losing their jobs or having their pay cut that they can no longer buy even the cheaper goods produced overseas. The companies may also find that government no longer has sufficient tax revenue to educate workers or invest in the roads and ports and airports through which their goods are delivered to market."
Typically, the way to address these unintended spillover effects — euphemistically referred to by economists as "negative externalities"— is through some form of government action. But in the era of shareholder capitalism, taxes and regulations are uniformly opposed by the business community. By this logic, the author argues, "not only must corporations commit themselves to putting shareholders first — society is expected to do so as well."
This attitude may explain in part the "recent slowdown in the pace of innovation and the growth in worker productivity." As one CEO noted in a recent speech, "'If you are the sole proprietor of a business, do you think that you can motivate your employees for maximum performance by encouraging them simply to make more money for you? Of course not. But that is effectively what an enterprise is saying when it states that its purpose is to maximize profit for its investors.'" Likewise, have American workers now lost some motivation knowing "that any benefit from their ingenuity or increased efficiency is destined to go to shareholders and top executives?"
That may also account, to some degree, for the long, slow decline in recent decades in public esteem for corporations and corporate leaders. "One of the rare corporate CEOs lionized on the cover of a newsweekly was the late Steve Jobs of Apple, who as it happened created more wealth for more shareholders than any corporate executive in history by putting shareholders near the bottom of his priorities."
While some CEOs "acknowledge that no enterprise can maximize long-term value for its shareholders without attracting great employees, producing great products and services and doing their part to support effective government and healthy communities…. then by the same logic you could argue that ‘maximizing customer satisfaction' would, over the long term, require taking good care of shareholders, employees and communities. And, indeed, that is precisely the suggestion made long ago by Peter Drucker, the late, great management guru. ‘The purpose of business is to create and keep a customer,' Drucker wrote." Indeed, some academics have shown that "companies that have maintained a strong customer focus…have consistently done better for their shareholders than companies which claim to put shareholders first. The reason is that customer focus minimizes undue risk taking and maximizes reinvestment over the long run, creating a larger pie from which everyone benefits. The truth is that most executives would be thrilled if they could focus on customers rather than shareholders."
Pearlstein suggests a number of possible solutions to try to change this behavioral norm. Some critics of the shareholder value concept have looked to practices such as "socially responsible" investing, which monitors "corporate behavior and publish[es] score cards based on an assessment of how they treat customers, workers, the environment and their communities." The advent of public benefit corporations, which seek to be managed for the benefit of all stakeholders, is another possible solution. (See my articles of 7/16/13 and 5/29/13.) However, many dismiss these ideas as naïve or too ideological, unwilling to recognize that "running a big corporation even for the long term can involve making tough choices such as laying off workers, reducing benefits, closing plants or doing business in places where corruption is rampant or environmental regulations are weak. And as executives are quick to remind, companies that ignore short-term profitability run the risk of never making it to the long term."
But "a consensus is emerging around a number of relatively modest changes in tax and corporate governance laws that could help lengthen time horizons and rebalance the focus of corporate decision-making:
- "The capital gains tax could be recalibrated so that short-term trading profits are taxed the same as wages and salary, while gains from investments held for long periods are taxed more lightly than they are now, or not at all. A small transaction tax could also dampen enthusiasm for short-term trading.
- "The Securities and Exchange Commission could adopt rules that discourage corporations from giving quarterly earnings projections or guidance, while accounting regulators could insist that corporate financial reports better reflect long-term costs and benefits and measure long-term value creation.
- "States could make it easier for corporations to adopt governance rules that give long-term shareholders more power in selecting directors, approving mergers and takeovers and setting executive compensation.
"The point of such reforms would not be to force companies to adopt a different focus or time horizon but to give companies the ability to free themselves from the stranglehold of the short-term stock price. The hope would be that, over time, the corporate ecosystem would become more heterogeneous, with different companies taking different approaches and adopting different priorities. In the end, ‘the market' — not just the stock market, but product markets and labor markets as well — would sort out which worked best."
Pearlstein's hypothesis is that a new generation of employees who "are drawn to work that not only pays well but also has meaning and social value," will finally free "the American corporation from the shareholder-value straightjacket," as companies that are "ruthless maximizers of short-term profits will find themselves on the losing end of the global competition for talent."