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The Corporate Objective Debate

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Ought corporations be run for shareholders only?

Public corporations that perform well inject huge amounts of wealth into the modern economy. They have been described as ‘the crucial actors in a capitalist economy’. Ever since the formation of the limited liability company in the nineteenth century, a debate has raged about how these corporations should be managed. The conventional answer is that corporations should be run solely for the wealth and welfare of shareholders. This idea has persisted and is largely accepted as the correct position for directors to adopt in managing a company. However, the aim of this paper is to illuminate the many theoretical and practical deficiencies with this shareholder primacy norm. As we shall explore, the theoretical justifications for the model rest upon weak foundations. Furthermore, compelling evidence exists that shareholder primacy simply is not working on a practical level: shareholder returns are down, the number of public corporations is dwindling and public corporations have been involved in some of the worst corporate scandals in recent history. This leads to an unimpeachable conclusion that corporations should not be run for the sole benefit of shareholders.

From the outset, it is important to identify the boundaries of this paper. Firstly, this paper deals with the public corporation only. These are the ‘large companies with real economic power’ and are the most influential in wealth generation across the globe. Secondly, this paper has a narrow focus in that it will deal with the sole issue of shareholder primacy. In answering the question ‘Ought corporations be run solely for the benefit of shareholders?’ in the negative, the sole purpose of this paper is to provide convincing reasons why this model is not suitable as the primary corporate objective. An alternative to shareholder primacy is not offered in this paper, however, reference will be made to other corporate objectives in order to illuminate the analysis of shareholder primacy.

Part I of this paper will briefly introduce the corporate objective debate and briefly sketch out the shareholder primacy norm. Part II will involve an in-depth analysis of the theoretical justifications for pursuing shareholder primacy. Ultimately, these justifications will be rejected.

i. The Debate on the Corporate Objective

Keay submits that all purposeful activity needs an objective, and the work of the public corporation is no different. This sentiment is echoed by Parsons who suggests that the defining characteristic of any corporation is ‘the attainment of a specific goal or purpose’. While the construction of a clear objective is important on a theoretical level, it also represents one of the most important practical issues facing the modern corporation. For example, identifying the corporate objective will help furnish directors with guidance on how they should exercise their powers. The debate concerning the proper objective of the public corporation is well rehearsed. It is usually traced to an exchange between Adolph Berle and E. Merrick Dodd. Berle contended that managers of a company held the property of a company on trust for the benefit of shareholders and should act in order to maximise shareholder wealth. This is termed the shareholder primacy norm. Under this model of governance, stakeholders such as suppliers, customers and creditors must negotiate their portion of the company profits ex ante, but after that, the remaining residual interest belongs to the shareholders. Considerations of corporate philanthropy and any socially responsible activity are not encouraged under this model as this would divert the company from its overriding objective – securing maximum shareholder profit for its shareholders.

This single-minded emphasis on creating wealth for shareholders has been maligned by many commentators as negatively impacting on the long-term stability of the firm and diverting attention away from broader social welfare issues. On the other side of the corporate objective debate, Dodd launched a robust rebuttal of Berle’s ideas, offering ‘a view of the corporation as an economic institution which has a social service as well as a profit-making function.’ This is termed the stakeholder theory of the corporation. Stakeholder theory is premised on the idea that groups other than shareholders have claims on a corporation’s assets and income as it is these groups that contribute to the company’s capital. Put simply, this theory dictates that the corporate objective involves benefitting all of those entities that can be identified as stakeholders.

While the ‘battle lines in the debate wax and wane’ over time, the shareholder primacy has become largely accepted as the proper objective of the public corporation. Indeed, Hansmann and Kraackman trumpet that the dominance of shareholder primacy has ushered in the end of history for corporate law as ‘the dominant corporate ideology of shareholder primacy is unlikely to be undone.’ This extravagant assertion is supported by Matheson and Olson who suggest that ‘the fundamental goal of corporate law is so theoretically and historically obvious that it does not need to be explicated: the goal is to maximize corporate – and thus shareholder – welfare.’ The dominance of the shareholder primacy norm in corporate thinking is a fact that is difficult to defeat – the justifications upon which the theory rests are not.

ii. Justifications for Shareholder Primacy

The literature on the proper objective of the corporation reveals a myriad of reasons for maintaining shareholder primacy as the preferred corporate objective. However, one theme that ties most of these arguments together is efficiency, indeed, it is argued in some circles that shareholder primacy itself is based on efficiency. As we shall now explore, the majority of arguments supporting shareholder primacy are ‘bad arguments’ in that they are ‘inaccurate, incorrect, and unpersuasive to the careful and neutral observer’. We now turn to explore four specific theoretical justifications for pursuing shareholder primacy: that shareholders are owners of the corporation, that shareholder primacy enhances shareholder returns and promotes aggregate social welfare, that managers are the agents of shareholders, and finally, that shareholders are the only risk-bearing residual claimants.

Shareholders as Owners

A small body of legal scholarship and judicial pronouncements endorses the idea that shareholders are owners of corporations. Horrigan, opines that ‘much of the conventional economic, contract-based and business thinking in support of shareholder primacy is predicated on the idea that those who invest in a company are its true owners’. The courts have on occasion endorsed such an approach. In Malone v. Brincat the Court held that ‘the board of directors has the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners.’ Similarly, in Stahl v. Apple Bancorp Inc. the Court concluded that the traditional model of the corporation sees shareholders as “owners”. Furthermore, in the UK, The Cadbury Committee declared in 1992 that ‘the shareholders as owners of the company elect the directors to run the business on their behalf and hold them accountable for its progress.’

The concept of shareholders as owners, rests upon a property model which considers the company in a proprietary fashion. This property-based model is a rights-based model where the ownership comes from capital contributions to the company. As a result, the shareholders enjoy a right to the firm’s residual income and share of surplus assets – it is these rights, along with the rights to control the board and have the board removed that gives shareholders this “badge of ownership”. On this construction, the shareholders have the right to have the company run solely for their benefit, and failure to do so, violates the rights of private property, which requires that property be used solely in the interests of property owners.

Some commentators have urged a reimagining of the concept of “property” in order to explain shareholders as owners. One argument advanced is that ownership does not require absolute ownership: property scholars have for some time rejected the absolutist view of property rights, insisting that property can be divisible, shared and contingent. For example, life interests, remainder interests, and easements are considered to be property rights and not contractual rights, despite the fact that they lack some of the elements of ownership. If we apply these rules, it is of course conceivable that shareholders could be considered owners.

While some evidence can be found to support the notion that shareholders are owners of the company, these represent isolated examples. Conversely, the arguments indicating that shareholders are not owners are plentiful, coherent and conclusive.

The assumption that shareholders are owners of the corporation has been the subject of trenchant criticism, with Stout suggesting that it is ‘the worst…of the standard arguments for shareholder primacy.’ Ireland opines that at the beginning of the twentieth century, those observing the corporate shareholder’s lack of traditional ownership rights, began to challenge the notion that shareholders were “owners” of the companies in which they held shares. Ireland further adds that shareholders were better conceived of as bondholders, sitting outside the company and being owed from the company, as opposed to owning the company. This approach is supported by Wood who suggests that the average stockholder in a large corporation ‘regards himself more as a security holder than in any sense a responsible managing partner in the corporate enterprise’, and as a result the distinction between bondholders and stockholders was ‘fast becoming a distinction unwarranted by the actual situation’.

The contention that shareholders are not owners is undoubtedly a strong one. Firstly, from a legal perspective, shareholders do not ‘own’ the company, but are merely owners of stock. This gives them claims to certain control and financial rights but not direct control over the firm. These rights do not extend to helping themselves to the firm’s earnings: shareholders only receive payment directly from the corporation when they receive a dividend, and this is at the behest of the directors. Furthermore, shareholders do not enjoy any direct access to the firm’s assets: any influence is indirect through the control they exert over directors. What control they do have over the board, is diluted even further by the fact that in public corporations share ownership is heavily dispersed. In addition, some commentators suggest that on a practical level, shareholders do not resemble traditional owners in that they are a ‘fluid and fluctuating group of investors, many of whom only hold short-term interests’ and most importantly ‘they do not exercise the control associated with traditional property rights’. The argument goes that by surrendering this control and responsibility of property, they surrender their right to have the corporation operated for their sole interest.

Parkinson suggests that while shareholders may not be considered owners of the corporation on a strict application of the law, they are in substance owners based on their contribution to the company’s capital. This argument is ripe for challenge. The argument assumes, using agency theory as its foundation, that the corporation does not have a separate autonomous existence, and tries to bridge the gap between the corporate assets (the capital) and the shares (owned by shareholders) by conflating the two. This approach is emphatically rejected by Mumford, who concludes that ‘much of a company’s capital is self-owned…that much of its capital comes from its own earnings, and that most of the “reserves” represent the proceeds of its own endeavours.’ Therefore, the argument that shareholders are owners of the corporation through capital contributions is exposed as a ‘fiction…that has little merit.’

The net effect of these findings has led some commentators to conclude that ‘where once shareholders stood at the centre of the corporate universe, with the undisputed right to control the management and direction of the company and to have it run for their exclusive benefit, this century shareholders have become little more than bystanders. While the ownership argument is supported by a smattering of support in the case law and commentary, the arguments against this idea are more convincing and plentiful. Perhaps, it is time to ‘lead the “shareholder ownership” argument…to the back of the barn, and to put it out of its misery.’
Shareholder Promotes Shareholder and Aggregate Social Welfare

By definition, the shareholder wealth maximisation norm serves to increase the pot for shareholders. In addition, it is asserted that in mandating shareholder primacy, and increasing wealth for shareholders, this will in turn increase overall social wealth. We now turn to consider the first issue: does shareholder value necessarily lead to increased shareholder returns?

Thus far we have examined the theoretical justifications for shareholder primacy and attempted to illuminate the weaknesses with such arguments. Of course, if something is lacking a firm theoretical foundation, this does not automatically mean it is wrong. However, when we add in the fact that shareholder primacy simply does not deliver on its promise of generating shareholder wealth, and has actually damaged corporations, then this model of governance becomes almost impossible to defend.

Stout suggests that the real effect of pursuing shareholder primacy has yielded ‘disappointing results’, and that in the last twenty years, under this model, the ‘business sector has stumbled’. It is difficult to argue with this conclusion. The last twenty years has seen an exponential increase in corporate failures, from the collapse of Enron to the banking crisis of 2008. Corporate failures have always been a fact of corporate life, but their frequency has grown at breakneck speed in the recent past, often with catastrophic economic and social results.

However, moving away from these corporate failings, when we examine the returns to investors over the last two decades, the defence of the shareholder value loses any modicum of legitimacy. Under the shareholder primacy model, the traditional approach is to equate increased shareholder value with increased share value, defined as the present discounted value of the stream of dividends the share will pay in the indefinite future. As the share price is considered a measure of a company’s performance and the stock market is the only objective assessor of management performance, the share price is considered a measure of whether directors have fulfilled the corporate objective. In increasing the share price, the corporation is likely to increase its dividend pay out to shareholders. However, the return to investors has been disappointing recently. Investors in the S&P 500 enjoyed real compound average annual returns of 7.5% between 1932 and 1976. This return had dropped to 6.5% in 1976 and after 2000 the decrease became even more pronounced. Some observers have even concluded that the return on bonds is outperforming the return to stockholders for the first time in over 150 years. In addition, despite being the ‘locomotives of capitalism since they were invented in the mid-19th century’ the number of US public companies has decreased considerably, from 8,823 in 1997 to 5,401 in 2009. In addition, the life expectancy of the public company in the S&P 500 has plummeted from up to seventy-five years in the middle of the twentieth century to only fifteen years today.

We now turn to the second limb of this argument: does the pursuit of shareholder value promote aggregate social welfare? The mechanics of this argument dictate that maximising value for shareholders is equivalent to maximising the social value of companies – therefore it is socially optimal to assign control rights to shareholders so that share value is maximised. Similarly, Jensen opines that ‘two hundred years of work in economics and finance implies that in the absence of externalities and monopoly…social welfare is maximized when each firm in an economy maximizes its total market value.’ This assertion is further supported by empirical evidence by Copeland et al who suggest that ‘winning companies seem to create relatively greater values for all stakeholders’. The authors found that ‘shareholders are the only stakeholders of a corporation who simultaneously maximise everyone’s claim in maximising their own.’

However, it is submitted that there fundamental flaws with this argument. This argument, according to Lorderer et al, rests on the First Fundamental Welfare Theorem, which states that a competitive equilibrium – where firms maximise profits and consumers maximise utility – is Pareto efficient. Pareto efficiency is achieved when no change can make someone better-off without making someone else worse-off. It is submitted that this theory rests upon assumptions that simply do not operate in the real world as the theory suggests. For example, the theory assumes that transaction and information costs in the market are zero, however, transaction costs are rarely ever zero, implying that conflicts of interest cannot always be prevented. Under these conditions, approaches other than shareholder wealth maximisation can lead to higher firm value and social welfare.

Several commentators have further suggested that shareholder primacy produces a short-term focus and in doing so reduces the ability to enhance aggregate social welfare. The herculean rise of the institutional investor, with their myopic focus on current share price, has meant that stockholders have little incentive to behave like traditional owners by working towards the long-term operating success of the corporation. In blindly pursuing short-term gains over sustainable long-term development, corporations fail to follow a path that would be the ‘most beneficial to the greatest number of corporate constituents, including stockholders, and to our economy and society as a whole.’ This short-term approach is not congruous with the more holistic approach required in order to generate aggregate social welfare.

One of the consequences of shareholder value has been an increase in income inequality within the company itself. As noted by Froud et al increases in remuneration for senior managers and top executives in large corporations does not tend to be shared with other employees. Dore suggests that this inequality gap can be directly linked to the rise of shareholder primacy. The author adds that measures of income inequality are rising faster in the most financialized economies of the world, and that in these economies, median incomes stagnate while the top earners make incredible gains. The distribution of these earnings are also problematic, in that the highest incomes gravitate towards the financial services at the expense of everyone else.

The pursuit of shareholder value has also had an impact at the level of the firm. Williams concludes that shareholder value, in its current form, has led to ‘an intensification of all forms of restructuring such as horizontal merger, divestment and downsizing, which…reduce the capital base and sweat out labour for usually transitory gains’. This idea is supported by Lazonick and O’Sullivan who conclude that the pursuit of shareholder value in the United States ushered in a shift in corporate strategy from one of “retain and reinvest” to one of “downsize and distribute”. Under the “retain and invest” model, companies retain the money earned and the people they employ, and focus on reinvesting in physical capital and human resources. Conversely, the “downsize and distribute” model mandates top managers to downsize the companies they control including the labour pool in an effort to increase the returns on equity. This approach was replicated in the UK, where dividend growth outstripped investment growth by nearly 3:1 between 1987 and 1997. This programme of downsizing, which occurred in the era of shareholder primacy, has negative societal and economic outcomes. This radical restructuring of the labour pool has resulted in a dearth of stable and well-paid jobs and led to a dramatic growth in job loss figures, especially in corporations employing more than ten thousand employees.

Agency Theory

A wealth of academic opinion supports the idea of agency theory as a justification for pursuing shareholder primacy. The theory operates under the assumption that directors are agents of the shareholders and are employed to run the company’s business for their benefit, as shareholders do not have the time or expertise to do so themselves. The concept of agency theory was formalised by the work of Jensen and Mackling. In essence, the shareholders, who elect the directors, are considered the bosses of the managers. If there was no shareholder primacy, this may lead to directors engaging in opportunistic behaviour and would result in “agency costs” through the necessity to monitor the work of the directors to ensure they are not abusing their positions. Similarly, Erturk et al conclude that any form of discretionary management is incompatible with maintaining the financial interests of the owner-shareholders.

Keay suggests two weaknesses with agency theory as outlined. Firstly, managers have no express contract with shareholders and arguably there is no implied contract either. Shareholders buy shares from existing shareholders and in this situation it is not possible to imply a contract between the managers and the new shareholders. If shares are bought from the company then there is no real contract beyond the share prospectus. Moreover, the lack of any face-to-face dealings between both parties and the lack of any specific representations by managers during the purchase makes it even more difficult to imply a contract.

The second point is that from a legal viewpoint, the managers cannot be considered agents of the shareholders. Managers are employed by the company and not the shareholders, and they make contracts on behalf of the corporate entity. Furthermore, managers are not able to enter into any relationship that will modify the relations that shareholders have with third parties. In addition, principles of agency dictate that the principal can control the agent, however, managers and executives are empowered to manage the company and cannot be ordered what to do by shareholders in the general meeting. The directors are agents of the company, and not the shareholders, and therefore the responsibilities to shareholders are considered ‘secondary and indirect’. We can therefore conclude that the agency theory of the corporation is not entirely conclusive.

Shareholders as Residual Claimants

One of the most enduring justifications for employing shareholder primacy is the residual claimant argument. Shareholders, as equity investors, are the only participants in the corporation for whom returns may be classified as ‘”residual”. In economics, a residual claimant is a party that is entitled to keep all residual profits once a business has met all of its legal obligations – for example, paying government taxes, wages and interest due to creditors. As residual claimants, the shareholders bear the risk of the company making a profit or loss, and therefore have an interest in having resources allocated so as to make the residual as large as possible. Conversely, the returns to all other contributors who provide resources to the firm, including customers, suppliers and creditors are not residual, but derived from contractual claims.

The “residual claimants” justification has been met with fierce opposition. Shareholder primacy operates on the assumption that shareholders are the only residual claimants in a public corporation. It is submitted that this argument is inherently flawed. Other stakeholders could be considered residual claimants also. Unsecured creditors can only expect partial payment, if at all, should a corporation enter into an insolvency regime. Furthermore, employees often develop skills that are firm-specific which are not transferable should an employee be made redundant. Those who have ongoing contracts with the corporations, directors and employees who receive bonuses rather than fixed salaries and customers who receive price cuts and loyalty discounts all have ongoing claims to the surplus. Zhao concludes that ‘Even in the absence of an explicit contractual claim to the firm's surplus, stakeholders apart from shareholders can clearly be regarded as residual claimants since they enjoy extra-contractual benefits when the corporation performs well.’

Two points fall to be considered in assessing the actual level of risk that is incurred by shareholders. First – it could plausibly be argued that shareholders incur less risk than other stakeholders in certain circumstances. For example, it is not fanciful to suggest that employees are in a more risky position than shareholders, as shareholder risk is limited and known in advance, while the employee’s risk is often unknown and unforeseeable. Furthermore, the liquidity of the stock market means that shareholders can diversify and transfer their risk by selling their shares, a luxury that is not available to employees and other stakeholders.

A more radical argument is proffered by Hill who explores the idea that the “residual claimants” argument is compromised by innovations in financial instruments. While traditional instruments continue to be the building blocks of recent financial engineering, the process of disaggregation and recombination have facilitated a move towards new forms of financial contract. Disaggregation involves bonds and stocks being separated out into their constituent parts – these parts are then marketed separately. The disaggregated parts are recombined into new financial products. These new products allow the control and risk of the share to be separated out, therefore it is not ‘axiomatic that the shareholder is the only residual claimant and risk bearer in the corporation.’

We can therefore see that the claim that shareholders are the only residual claimants does not rest upon a strong foundation. Not only do other residual claimants exist, but it could be plausibly argued that other stakeholders incur a higher degree of risk than shareholders.

The debate on the corporate objective has fixated scholars, economists and other commentators for over a century. However, the debate is not only of academic significance. As we have investigated in this paper, the choice of corporate objective has real and tangible outcomes. When we choose to prefer shareholder primacy, we opt for negative outcomes for corporations and society as a whole. Proponents of shareholder primacy justify running the company for the benefit of shareholders, based on precarious theoretical foundations, while ignoring the reality that shareholder primacy simply does not deliver what is asked of it. The often-cited mantra that shareholder primacy is the proper objective of the modern corporation has cunningly weaved its way into the fabric of the modern corporate consciousness. Until corporations insist on departing from this theory, we will continue to experience the drawbacks that accompany loyalty to the shareholder primacy norm.



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Article published 25/05/2017

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