Confessions of a Corporate Shill: Shareholder Primacy Must Prevail
Modern corporate governance is a marvel. Even Adam Smith did not believe that modern corporations could exist profitably because he thought that management would not have enough incentive to serve ownership [1]. The separation of ownership and control in large businesses is fraught with moral hazard: companies are owned by shareholders who may never interact with those who manage the company for the shareholders’ benefit.
But is it true that corporate managers do run – or even should run – their businesses for the exclusive benefit of shareholders rather than stakeholders (defined as all those affected by the business’s decisions)? As a point of law, scholars disagree on whether corporate law as presently constituted actually guarantees shareholder primacy [2,3]. As a political matter, politicians have proposed plans that would sanction and promote stakeholder primacy [4]. Even without legal prodding, 181 CEOs of the largest businesses in America have pledged through the Business Roundtable to incorporate stakeholder demands into their corporate decisions [5].
This trend contradicts commonly accepted principles in corporate law — principles which are commonly accepted for good reasons: without clear goals, honest managers would be left adrift while dishonest managers would be given room to commit fraud. Officers may make it difficult to reallocate investments to other businesses, and investors may fear that they are simply giving their money away. For these reasons, the status quo system of shareholder primacy is superior to one of stakeholder primacy.
First, I will review the evolution of theories around the corporation up to the modern crisis. Second, I will review the legal case for shareholder primacy. Finally, I will make the case that shareholder primacy is normatively preferable.
Evolution of the Theory of the Firm
Corporate charters before the late 18th century were rare. In England, they were issued by the Crown and were limited to ventures within the public interest. Following the American Revolution, however, the United States witnessed an explosion of corporate charters, which could be issued by any state [6]. The Revolution brought with it a new conception of the corporate interest: one which was associated with profit rather than the public good [7]. Courts began to reckon with this phenomenon in the first half of the 19th century in cases such as Trustees of Dartmouth College v. Woodward (1819), in which the Supreme Court ruled that corporate interests expressed in charters are protected from certain kinds of meddling by the state [8].
In the 20th century, economists began to develop new theories regarding business activity. One of the most cited economics papers of all time, “Theory of the Firm,” argued that a firm was nothing more than a nexus of contracts – a legal heuristic for a series of complicated arrangements among employees, owners of capital, creditors, debtors, and customers [9]. The late half of the 20th century was accompanied by movements to make more explicit officers’ obligations to shareholders, which made it easier for shareholders to enforce their contracts with managers. This kind of solution is reflected in the Dodd-Frank Act of 2010, which included, among other provisions, mandatory shareholder votes on certain kinds of executive compensation [10].
The emergence of private equity has raised the question of whether owners ought to extract value from the corporation at the expense of employees. This concern has culminated in the declaration by the Business Roundtable, signed by 181 CEOs, and in Senator Elizabeth Warren’s plan to overhaul corporate governance, which would require directors to fulfill a duty of public benefit – something reminiscent of corporations under the British Crown [11]. Additionally, some institutional investors have begun reading environmental, social, and corporate governance reports to decide how to vote on corporate and investment matters [12].
The Legality of Stakeholder Governance
The political discussion has inspired jurists to re-evaluate the law with respect to shareholder primacy. Jonathan Macey of Yale Law School contends that a number of commonly accepted principles of corporate law are, in fact, myths [13]. Chief among those myths, Macey argues, is that corporate managers have a fiduciary obligation to maximize shareholder value. He explains that this notion is espoused nowhere in controlling law and that support is scant for the assertion that shareholders are “owners” of the corporation in any meaningful way. These myths are told, according to Macey, to protect the interests of the capitalist class.
But is there really no factual basis for shareholder primacy? In Revlon, Inc. v. MacAndrews & Forbes Holdings (1986), shareholders of Revlon sued management for accepting a bid for the company that gave shareholders less value than a competing bid. Management’s justification for accepting the offer was based on the impact to the company’s creditors, who would have incurred a loss under the most shareholder-friendly deal. The Supreme Court of Delaware wrote, “[W]e address for the first time the extent to which a corporation may consider the impact of a takeover threat on constituencies other than shareholders.” The Court ruled in favor of the shareholders and declared that “no defensive measures [to a takeover] can be sustained” on any basis other than “the maximization of shareholder profit” [14]. The rationale for the Revlon decision was later supported in SWT Acquisition Corp. v. TW Services, Inc. (1989), in which Chancellor William T. Allen wrote that boards of directors have a duty to “maximize the long run interests of shareholders” — and nothing else [15]. Precedent in Delaware — the most important state for corporate proceedings — is clear: shareholder primacy rules.
The prevalence of these beliefs, even among courts, does not mean they are correct. Is there any reason besides precedent to accept shareholder primacy? Leo Strine, the former Chief Justice of the Supreme Court of Delaware, presents further arguments in support of shareholder primacy [16]. Chief Justice Strine writes that Delaware General Corporation Law gives “no constituency other than stockholders […] any power” and cites law giving shareholders the rights to vote for directors and to vote on mergers [17]. He argues that any formulation of the law other than the present one would be entirely inconsistent with the structure of the law – the information gleaned from the law’s planted axioms, its format, and the inferences one can make from the relationship between different sections.
In 2013, moreover, the Delaware legislature passed a law that permitted the creation of corporations which placed constituents besides shareholders on equal footing [18]. It would be peculiar for any state legislature to so misunderstand its own laws as to enact one that is entirely redundant. Surely if the interests of stakeholder groups were not subordinated to shareholders’ under previously existing corporate law, the legislature would not have needed to create a new type of corporation in which stakeholders’ rights were explicitly elevated. Even so, peculiarity and correctness are not mutually exclusive. The law is, at the very least, vague at an important juncture: nowhere does the law explicitly state that corporate officers have a responsibility to maximize shareholder welfare, much less shareholder profits. The law can also be changed. How should we interpret it?
Greed and Mismanagement in a Stakeholder System
In addition to distorting capital formation and allocation, a stakeholder approach would render impossible the legal system’s ability to enforce any fiduciary responsibilities of corporate executives, leading to the creation of perverse incentive structures.
Rarely could any material corporate decision fail to have legal justification under the stakeholder theory. The freedom to justify any corporate decision based on its impact on an elusive set of stakeholders leaves certain entities — like corporate executives and environmental, social, and governance (ESG) ratings agencies — with undue power. Suppose, for example, that an officer refuses to accept an acquisition on the grounds that the workforce of the company, including the officer himself, would be displaced. The officer could easily justify the decision on stakeholder grounds even when the magnitude of the benefit for employees is low compared to that for the executive, who would have substantially more trouble finding a comparable position at another firm. Given the abstract tradeoffs involved, the executive could decide in his favor even when the impact of his decision is worse for employees and shareholders on net. In other words, if a variety of corporate decisions could be justified as benefiting some stakeholder, managers could find justification for whichever decisions benefit themselves the most, not which decisions are most just or efficient.
The reliance on ESG scores, which is often necessary under the stakeholder framework, can also have unintended effects. As ESG scores’ cachet has increased, a cottage industry has sprung around improving companies’ scores. Nasdaq, for example, helps clients to “develop” and “share [their] ESG story,” thereby changing the ESG metrics upon which they are judged without improving their scores [19]. Ratings agencies will also need to abide by strict ethics rules – perhaps much stricter than we might expect – in order for the program to work; relationships with the businesses they are rating or with advisory firms seem likely to unfairly influence their work. Synthesizing critical corporate oversight into ESG scores could fail disastrously.
Under the stakeholder framework, companies would be forced to make impossibly complicated tradeoffs between different entities’ welfare. Suppose, for example, that a company chooses to price its product below the market rate for the benefit of its customers – a stakeholder group. Surely this pricing would hurt workers, whose salaries would be suppressed by the decrease in revenue, and shareholders, whose profits would decline. Could the relevant tradeoffs ever be properly defined? Does a 10% increase in consumer welfare – a group potentially encompassing the entire population – outweigh a 10% decrease in shareholder welfare? Not only are those percentages unlikely to be reliably determinable, but the rate at which one group should have its welfare substituted for that of another group is an entirely elusive, normative judgment.
Economic theory prefers to think of corporations as owned by shareholders not only because it explains empirical economic conditions but also because it is most efficient. Principal-agent risk prevents investment, which already impacts businesses whose managers can act in relatively invisible ways to siphon shareholder value for themselves — by over-expensing dinners, for example. With explicit legal sanction under the stakeholder framework, the permissible scope of value transfer from investors to managers could be far greater.
Capital allocation would also suffer without shareholder primacy. Economists have long promoted the benefits of international trade. If certain modes of production (e.g., car manufacturing) could no longer be placed overseas due to pressure from newly empowered unions under the stakeholder theory, American capital and labor power could not be reapportioned to activities at which Americans are best (e.g., computer programming). Furthermore, even intra-U.S. allocation of capital could be stifled if corporations were made unable to move to the parts of the country where they are most productive. Communities would bemoan the loss of jobs and tax revenue and might often succeed in preventing companies from moving. Lastly, if corporations were forced to plowback money into their own businesses rather than permit shareholders to invest elsewhere — a phenomenon at the core of the stakeholder theory — the flow of investment across industries and between firms would stall. There would be an in-built status quo bias, preventing investment across growing sectors of the economy.
Conclusion
Theories of stakeholder value are incompatible with legal precedent, and courts should stay the course. Stakeholder primacy would incapacitate courts’ oversight of corporations and render impossible the oversight of corporate managers more generally. The negative impacts of this misguided framework would be broad: an increase in executive greed, decreased capital formation, and inefficient capital allocation.
Is there any other way in which the government can rein in shareholder irresponsibility? Consider Adam Winkler’s distinction between corporate law and “the law of business” [20]. While general regulations that require corporations to act in the public benefit may only enrich corporate management, certain regulations can address externalities that misalign shareholder interests with public interests without any fundamental change in corporate law – that is, by changing the “law of business.” In the case of pollution, for example, the government can enact Pigouvian taxes or cap-and-trade laws. For example, pollution could be taxed or capped such that corporations emit only the socially optimal level of pollution. Although some believe that shifting to stakeholder primacy would be a panacea for capitalism’s social ills, it would more likely result in a failure to address those problems directly.
References
Hovenkamp, “Neoclassicism and the Separation of Ownership and Control.”
Macey, “The Central Role of Myth in Corporate Law.”
Strine, “The Dangers of Denial.”
Tomlinson et al., “A Participatory Simulation of the Accountable Capitalism Act.”
“Business Roundtable Redefines the Purpose of a Corporation to Promote ‘An Economy That Serves All Americans.’”
Avi-Yonah, “Citizens United and the Corporate Form.”
Avi-Yonah.
17 U.S. 518 (1819).
Jensen and Meckling, “Theory of the Firm.”
12 U.S.C. § 5301.
Tomlinson et al., “A Participatory Simulation of the Accountable Capitalism Act.”
Bailey, Klempner, and Zoffer, “What Institutional Investors Should Do next on ESG.”
Macey, “The Central Role of Myth in Corporate Law.”
506 A.2d 173 (1986).
14 Del. J. Corp. L. 1169 (Del. Ch. 1989).
Strine, “The Dangers of Denial.”
Strine.
8 Del. C. § 103.
“Nasdaq ESG Advisory Program.”
Winkler, “Corporate Law or the Law of Business?: Stakeholders and Corporate Governance at the End of History.”