Posted By Kim Ann Curtin
December 24, 2018
Article: The Problem With Putting Shareholders First
Today, we constantly hear about how corporations feel their first responsibility is to their shareholders. However, that myth was debunked in 2012 by Professor Lynn Stout in her excellent book, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. In my own book, Transforming Wall Street, in which I discussed various ways to improve Wall Street and our capitalist system by promoting conscious capitalism, I had the opportunity to interview Professor Stout. During our interview, Professor Stout discussed how businesses’ favorite and most famous mantra, “maximize shareholder value” is in actuality not in their (nor our) best interest and has almost destroyed our economy. Plus, it is based on a misreading of corporate law. In this article, I’ll summarize some of the main points of my interview with Professor Stout and explain why the shareholder value myth is precisely that—a myth.
In Professor Stout’s first book, Cultivating Conscience: How Good Laws Make Good People, she talks about how our conscience needs “breathing room” to work. In other words, we need to feel it’s okay to follow our conscience. In her second book, The Shareholder Value Myth, Professor Stout creates that breathing room by explaining why it’s okay for business executives to do what many of them already intuitively know they should do: take care of their customers, suppliers, and employees, and, in general, be good corporate citizens.
The concept of maximizing shareholder value has been used to override this sense of needing to do the right thing. The term was invented by the Chicago school of economics in the 1970s and gained the support of CEOs in the 1990s when the tax code was changed to tie executive pay to share price performance. However, the idea of shareholder value is not required by law nor consistent with historical business data. It came from people like economist Milton Friedman and a famous paper, called The Theory of the Firm, written in 1976 by economists Mike Jensen and William Meckling. Jensen and Meckling got the law wrong in this paper. They analogized the corporation to a sole proprietorship, and said, therefore, the corporation had to have an owner, who had to be the shareholders. Professor Stout says that’s legally…flatly wrong. Corporations are not owned by shareholders. They own themselves.
Another misconception is that shareholders care only about share price—and, ultimately, profits. However, Professor Stout says such a narrow view equates shareholders with sociopaths. The truth is that shareholders care about more than share price. The rise of economic theory, however, overlooks the human element. It has led to people no longer paying attention to ethics and their consciences and only half-teaching Adam Smith. However, most people in business want to feel good about what they’re doing. They want to feel they are a positive influence on the world. Capitalism is not all about profit, and more and more people on Wall Street are now coming to this realization.
Capitalism flourishes best in a free market, but this myth of shareholder value works in opposition to a free market. Professor Stout states, “If you’re really a free market economist, then you’re going to say, ‘We’re going to let the business world figure out how to do this on their own.’ And instead, what we did was change all the rules to force executives to focus on shareholder value where they hadn’t been doing it before because they didn’t, based on their experience, think that was the best way to run a business. But we changed the law and we changed the rules and made them do it and advised them to do it.”
Finally, Wall Street and economists are waking up to how this myth has distorted our thinking about capitalism. Slowly, but surely, this kind of flawed thinking is changing. When I asked Professor Stout how best to fix the problems this myth has created, she suggested three things:
1. Repeal Section 162(m) of the Tax Code, which requires corporations to tie top executive pay to so-called “objective performance metrics.”
2. Make investors hang on to their shares for a longer period of time, so they care more about the future. Holding time for a stock used to be on average eight years; today, it’s four months. So we need to reduce trading on Wall Street. Basically, tax short-term trading by changing the capital gains rules or enacting a financial transaction tax. Such changes will get the opportunistic short-term traders and the hedge funds out of the market.
3. Educate people so they understand there’s no legal requirement that corporations maximize shareholder value and that doing so is not the best thing for business, society, or investors over the long run.
Hopefully, this article has at least fulfilled the third suggestion: to help educate you. I encourage you to spread this message and work toward making the first two suggestions become a reality. To learn more about the myth of shareholder value and how you can help to promote conscious capitalism, please read Professor Stout’s book The Shareholder Value Myth and my own book Transforming Wall Street.
A better economic world awaits all of us. We can create that better world one investor at a time by spreading the message of conscious capitalism.