Debating “The Shareholder Value Myth”

Many thanks to Larry and the Concurring Opinions folks for inviting me to blog this month. This is my first time blogging and I’m glad to finally try it out.

On Wednesday, I attended an event promoting Lynn Stout’s book The Shareholder Value Myth, sponsored by the Federalist Society and the American Enterprise Institute. The event was structured as a debate of Stout’s thesis with Jonathan Macey (who wrote this review of the book) taking the opposing position. In her book, Stout argued that the widely accepted norm that corporations are owned by shareholders and exist to maximize shareholder wealth is a destructive myth. Instead, Stout claimed, corporations own themselves and in running corporations, managers can and should pursue any lawful purpose.

It is a real credit to Lynn that there was such a lively, thought-provoking debate about the topic. That corporate managers have an obligation to work on behalf of shareholders to maximize shareholder wealth may be the most basic tenet of corporate law and policy. Options theory aside, many think of shareholders as the “owners” of the corporation and even those who question whether shareholders technically own the corporation do not doubt that the corporation should be operated in such a way as to maximize shareholder value. This unwritten “norm” has dominated corporate law, policy, scholarship, and, indeed, management for a long time (for precisely how long, Stout and Macey disagreed).  It is extremely impressive that Stout has been able to provoke a debate about the viability of this fundamental norm.

Wednesday’s debate was the second time I’d seen Stout present at a Federalist Society event. Both times, she began her presentation by arguing that hers was the truly conservative position. It seems an unlikely claim that surprises the audience given what her conclusions are, but I think it highlights what Stout does so well – she reaches her audience with their priors in mind in order to really draw them into her ideas where they might be tempted to dismiss her arguments out of hand. Her presentation was not about good corporate behavior or environmentalism, themes she touched upon in the book, but rather about how debunking the shareholder value myth would allow corporate law to favor state law over federal regulation, to prefer common law rules to statutory regulation, to enhance private ordering, and to honor the lessons of history.

Stout claimed that academics created the shareholder value myth based on a mistaken belief that shareholders are the firm’s owners. Stout argued that corporations own themselves because corporations, through their managers, decide how to allocate profits. She rejected the notion that shareholders are a corporation’s residual claimant. Because, according to Stout, shareholders have no more of a readily exercisable claim to the firm’s assets than any other corporate constituent, their interests should not be pursued above all others when determining what is best for the corporation. The corporation’s interests may include a broader range of outcomes than simply shareholder wealth maximization.

Macey disagreed with Stout’s premise that shareholders are not the residual claimants. He pointed out that the understanding of absolute priority that leads us to call shareholders residual claimants is not just applicable to dying companies, but defines how we value shares in living companies. He also noted that shareholders are the only corporate constituency with the ability to vote on corporate decisions and elect the board. The law gives shareholders special powers because of their position as residual claimants.

In every other form of property ownership I’m aware of, the owner of the equity interest is considered the owner of the property. Even if one does not accept that shareholders are owners of corporations (I agree that it might be theoretically useful at times not to use the term “owner” to define their interest and role in the firm), they do not fail to be “owners” simply because they are not able to unilaterally dispose of corporate property. Ownership interests are often encumbered by the rights of others, as shareholders’ interests in corporate assets are encumbered by the rights of corporate creditors and the interests of other shareholders in delegating control over the assets to managers. Indeed, managers may make decisions to spend corporate assets in various ways that will affect the amount of equity attributable to the “residual claim.” The fact that shareholders agree to take their shares subject to certain restrictions does not mean that they do not have a claim to the value corporation’s equity in certain circumstances. This claim against the firm’s equity (however limited or hypothetical) forms the basis of considerable and real value shareholders are able to trade on and profit from and thereby enjoy personally.

It seems to me that the residual claim is a common, helpful way of understanding the value of the equity interest in a firm, even when the firm’s equity has no value. Indeed, when there is no equity in the firm and only some creditors can be repaid, we say that the junior-most claimants who could be paid from corporate assets are the residual claimants and, in bankruptcy, we give those creditors of the insolvent company many of the rights we would afford shareholders. The rights over the firm’s management and assets that we associate with ownership of a business follow the residual claim, whether it belongs to shareholders or not. So, even where a corporation may not be maximizing shareholder value because shareholder value no longer remains, management should be working to maximize the value of the residual claim, to create as much value as possible from the use of the firm’s assets. One need not be able to cash out her proportional share of the residual claim on demand in order for an understanding of the residual claim to be a valuable guide to managerial decision making.

The interesting question, and one Stout confronted head on, is how to maximize the value of the firm’s assets. Stout is adamant that managers cannot maximize the value of the firm by focusing solely on maximizing shareholder value as measured by current stock price. Will the firm work to increase the value of its assets in the short term or will it seek long term growth and viability? What outcomes really are in the best interests of the corporation? How do managers balance the competing rights and interests of various constituents in doing what they believe is “best” for the corporation? I will return to these issues in a future post.

Stout has written a book that is accessible to many audiences while seriously questioning deeply held assumptions about corporate law and policy. In corporate law scholarship, that is a rare combination. Work that forces us to question the premises of our thinking and policy-making is extremely valuable and Stout does an impressive and thought-provoking job in The Shareholder Value Myth.

 

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17 Responses

  1. Brett Bellmore says:

    “Instead, Stout claimed, corporations own themselves and in running corporations, managers can and should pursue any lawful purpose.”

    How convenient for those managers, suddenly pursuing their own ends with funds entrusted to them based on the earlier, “maximize shareholder value” norm. But that’s a trick you can only pull off once, and then people will find other things to do with their money than become shareholders.

    A lot of norms are like that: Somebody stands to profit from overturning them, but only once, because you can only betray a trust once, and then nobody trusts you.

  2. PrometheeFeu says:

    That is a fascinating perspective. Thank you for bringing it up here.

    Perhaps we are simply conceiving of ownership in the wrong way, or wrongly defining the unit that is the corporation. Let me explain myself. I am the owner of a wide variety of things which could be said to “act” independently of my will and interests. My computer for instance has on some occasions deleted things I did not wish to see deleted.

    Perhaps the actions of managers should be seen in the same way. When a manager acts, it is merely the corporation that is acting. Shareholders are free to act “upon” that which they own, but they cannot dictate their actions to managers any more than the law comes to my rescue when a program misbehaves.

  3. Shag from Brookline says:

    Brett’s:

    ” … but only once, because you can only betray a trust once, and then nobody trusts you.”

    apparently didn’t apply to Georg W. Bush in 2004. (Fool me once, shame on you; fool me twice, shame on me.)

  4. Brett Bellmore says:

    Oh, my! I never realized Shag had trusted Bush, and voted for him twice! How remarkably gullible! Unlike me, who only expected him to be the lesser evil. (Though I still got disappointed, I expected a bit more “lesser”.)

    Were there no other place than stock shares where people could put their money, corporations might be similarly situated to politicians, one of whom is going to be elected even if you rationally distrust both. And so they get voted for even though the rational voter knows they’re being lied to.

    But they’re not similarly situated: Should corporations, already in possession of funds given them under a norm of shareholder maximization, suddenly switch to a norm of shareholder screwing over, there ARE other places people can put their money. Commodities. Personal property. Heck, at today’s interest rates, mattresses are competitive with savings accounts, and perhaps safer.

    And so, we can rationally expect that, were corporations to take the above advice, they would suddenly find it remarkably more difficult to raise money. As well as facing considerable political pressure to change laws in order to formally reinstate the norm, only with serious penalties.

    Corporations are in possession of huge sums of other people’s money, and those other people should not be expected to be indifferent to the proposed change of norms.

    Again I say, you can profit from betraying trust, but only once. Make no mistake, that’s what is proposed here, a betrayal.

  5. Shag from Brookline says:

    Brett apparently is unaware of Bernie Madoff, who made off with other peoples’ monies (invested and reinvested) for a long, long time (for which he will be doing long, long time).

    No, Brett, I never trusted Bush, especially after reading a “favorable” biography “First Son, George W. Bush and the Bush Family Dynasty” by Bill Minutaglio, published in anticipation of his run in 2000. And I never voted for him. But you apparently have no shame.

    Regarding shareholder value, consider the tax benefits to shareholders for unearned income in the form of dividends and and long term capital gains that came about with the Bush tax cuts.

    In any event, there was no lesser evil than Bush/Cheney.

    As for corporations, in their roles as “people” per Citizens United, Burt Neuborne’s “Of ‘Singles’ Without Baseball: Corporations As Frozen Relational Moments” available at:

    http://ssrn.com/abstract=2255094

    provides an astute and short (24 pages) history of corporate “personality” in America. Citizens United makes a myth of the diversity of shareholders in a large corporation in spending corporate funds for political purposes without shareholder approvals.

  6. Lawrence Cunningham says:

    Kelli:

    Great post.

    Sitting here in Omaha this morning at the start of the Berkshire Hathaway annual shareholders’ meeting, it is amazing to hear Lynn Stout deny that shareholders own corporations. The idea of shareholders as owners as at the heart of Warren Buffett’s investment and management philosophy.

    It’s funny that Lynn participated in our symposium on Buffett’s letters 17 years ago and I don’t recall her raising any question about this proposition. Perhaps later this month when you and I and others do the on-line symposium about Buffett’s letters we can get into that fundamental idea.

    Meanwhile, again, great post.

    –Larry

  7. Shag from Brookline says:

    If more corporate CEO/Chairmen were of the caliber of Warren Buffett, there might not be a myth. (I provide no services to either Buffett or Berkshire Hathaway, nor am I a stockholder, just a fan.)

  8. Joe says:

    “Citizens United makes a myth of the diversity of shareholders in a large corporation in spending corporate funds for political purposes without shareholder approvals.”

    I recently read a biography (written when Shag was but a babe) of Justice Wayne [“James Moore Wayne, Southern unionist”] and the position of corporation as a “citizen” or “person” for limited purposes was familiar back then. That is the 1840s.

    So, I find it more helpful to address things such as shareholder approvals. Cf. how unions are treated, multiple opinions concerned about unwilling workers be forced to have their money spent for union causes.

  9. Urska says:

    Thank you for writing this post, Kelli.

    Stout is obviously right that shareholders can’t tell managers for a share of the profits that the firm generated in any given year. And so is Macey when he says that shareholders are residual claimants (even if they are not the “only” residual claimants). But they disagree about the implications of their positions – to which I suspect you will get in your next posts.

    Why does it matter that we call shareholders owners rather than something else? A lawful owner of a bald or golden eagle feather can’t even give it away, let alone sell.

  10. Kelli says:

    Thanks, Larry. I think one of Lynn’s main objectives is to move managers away from prioritizing short term profits. She and Warren Buffett would agree on that point. The short term/long term debate is what I’d like to discuss in my next post, so I won’t write all of my thoughts on the matter here, but I think Lynn thinks we get away from short-termism by de-emphasizing the interests of short-term shareholders and she thinks a way to do that is to relieve managers of the obligation to prioritize the interests of shareholders at all.

    Urska — I agree with you that whether we call shareholders “owners” may not matter much as long as we understand their rights and role within the firm. I think Lynn’s point was that she thinks shareholder value thinking is destructive and it is often justified by the understanding (which she thinks is mistaken) that shareholders are the true owners of the firm. Considering the shareholders owners leads managers to believe they are required to make decisions that will maximize shareholder value and that thinking is what Lynn finds troubling.

  11. Shag from Brookline says:

    Adam Liptak’s NYTimes column (5/4/13) “Corporations Find a Friend in the Supreme Court” seems to confirm the myth.

  12. Douglas Levene says:

    As Prof. Bainbridge has pointed out repeatedly, it is a mistake to think of shareholders in a widely held public corporation as the “owners” of the corporation. They are the owners of a claim to the residual interest in the corporation. Because the contract between the corporation and the residual interest holders is necessarily incomplete, the law fills the gap in that contract by giving shareholders a vote for directors and mandating a duty of directors to act loyally in the shareholders’ interests. This is all elementary and, I thought, widely understood.

    If you eliminate the fiduciary duty to act loyally in the shareholders’ interest, then one of two things will happen. Either the residual interest holders will figure out how to draft much more explicit contracts binding the directors to act in their interests, or they will require much higher returns to compensate them for the increased risk to the residual interest. The only thing such a change would not do is discourage the directors from focusing on short-term profits, which in any event is not required by the law of fiduciary duty but rather by market forces.

  13. Lawrence Cunningham says:

    @Douglas 12:

    I’d say what you think is “elementary” and “widely-understood” are a set of assertions that are better described as “over-simplifications” and “widely-debated.”

    For instance, there is no “contract” between the corporation and the “residual interest holders”; that is just a simplifying image. Similarly, the “residual interest holder” is not a legal or business concept but a theoretical idea or heuristic from economics.

    More broadly, shareholders “own” many rights other than the “claim to a residual interest,” including as you note to elect directors as well as to: (a) remove and replace directors; (b) vote on dissolution, charter amendments, mergers and substantial asset sales; (c) amend bylaws; (d) inspect books and records; (e) call, attend, participate in and vote at special shareholders’ meetings; (f) initiate derivative lawsuits; and (g) freely transfer those and a bundle of other rights to others. Controlling shareholders, moreover, even have duties to the corporation and the other shareholders.

    Given this complexity, it is as sensible to say that shareholders own the corporation (the traditional view) as it is to say they own the residual interest (the contemporary law-and-economic theory view), as both are imprecise short-hands for a complex set of ideas. But to say that the view you seem to have adopted is “elementary and widely-understood” seems off. Instead, exactly how to classify shareholders in the corporation is a complex question on which there is a vast history, tradition, criticism, literature and range of highly-contested positions.

  14. Douglas Levene says:

    Point well taken. I summarized the bundle of rights that shareholders have (which is, as you point out, a combination of contractual and legal rights), as do those who describe shareholders as the “owners” of the corporation. In any event, the elements I omitted did not seem particularly relevant to the question whether describing shareholders as “owners” or “residual rights claimants” makes a difference in terms of the directors’ focus on short-term profits. I also don’t disagree with you that there is still an ongoing debate about the nature of the corporation, even within the law and economics tradition (e.g., compare Macey with Bainbridge on the market for corporate control), and that Prof. Stout always has something challenging and interesting to add to that debate. The law and economics analysis seems far more powerful to me, though.

    Query: do you disagree with my claim about what the result would be of eliminating the duty of directors to act loyally in the interests of shareholders?

  15. Jennifer Taub says:

    Kelli,

    Excellent post. Wondering if there was a video or transcript of the event. It would be useful to watch/read the debate between Stout and Macey.

    JT

  16. Jennifer Taub says:

    Thank you!