Are Shareholders Hurting Companies?

News Brief
July 2, 2012

By Cydney Posner

Here is an interesting article from Pro Publica, "How Shareholders Are Hurting America," that questions the "bedrock principle" that companies "should be run for the sole purpose of increasing their stock prices, or returning ‘value' to shareholders, the ultimate ‘owners.'"  The article discusses the argument promoted by a Cornell Law professor that the idea that shareholders own the corporations and should be run primarily for their benefit is misguided and has resulted in stocks having "become the playthings of hedge funds, warping corporate motivation and eroding stock market returns."

According to the article, the idea that stockholder value is preeminent has been promulgated by economists such as Milton Friedman, who wrote an article contending that "the social responsibility of business is to increase its profits," and others who expanded on the concept by "arguing that the only obligation corporations had was to increase profits for their owners, the shareholders." That view benefited from "generous enabling from the corporate governance do-gooder movement."

The professor, however, maintains that "the idea that shareholders ‘own' their companies isn't actually so set in the law." Rather, she argues that "shareholders are more like contractors, similar to debtholders, employees and suppliers. Directors are not obligated to give them any and all profits, but may allocate the money in the best way they see fit. They may want to pay employees more or invest in research. Courts allow boards of directors leeway to use their own judgments. The law gives shareholders special consideration only during takeovers and in bankruptcy. In bankruptcy, shareholders become the ‘residual claimants' who get what's left over. That concept has expanded to mean that a corporation should always be run to maximize the size of shareholders' claims."

The problem, as presented by the professor, "is that as companies have increasingly focused on their stock prices, and given managers more shareholdings, they have inadvertently empowered hedge funds that push for short-term solutions. Mutual funds, dependent on winning money from retail investors, have become myopic as well. The average holding period of a stock was eight years in 1960; today, it's four months. The biggest ill has been to align top executives pay with performance, usually measured by the stock price. This has proven to be ‘a disaster,'….. Managers have become share price obsessed. By focusing on short-term stock moves, prices managers are eroding the long-term value of their franchises."

The professor also blames the corporate governance movement for having pushed for this alignment, which, she argues, is "actually causing corporations to do things that are eroding investor returns." Her answer is to return to "managerialism," which would allow executives and boards to operate companies "without being preoccupied with shareholder value. Companies would be freed up to think about their customers, their employees and even start acting more socially responsible."

Of course, the weak role she ascribes to shareholders raises the hackles of corporate governance advocates who view "managerial supremacy" as potentially "catastrophic": "Sure, short-term thinking is bad, but it's hard to believe that giving management more power will suddenly result in a wave of altruism….Shareholders need to be active to prevent manager conflicts of interest and self-dealing." Governance advocates view the idea that shareholders wield too much power as "laughable. Shareholders have increasingly been voting against directors only to see them reappointed. Recently, shareholders at a handful of companies have voted the majority of shares against the pay packages of chief executives — and have been ignored."

While the professor shares with the corporate governance movement the goal of trying to rein in excessive executive pay, her approach is different: "her idea is to radically curtail the supposed alignment that comes from shareholdings. Instead, she calls for directors to pay executives for after-the-fact performance. Chief executives should get a salary and then they would receive a bonus based on good performance."

She also advocates adoption of the so-called "Robin Hood tax," which would impose a small charge on securities trades with the intent of curtailing "zero-sum, socially useless trading": "We need to lock investors into their own investments as to not push them into short-term strategies."