by Cydney Posner
Are shareholders really the “owners” of corporations? Even though shareholders have no responsibilities to the corporations they “own”? Should corporations be managed for the sole purpose of maximizing shareholder value? Are shareholders even unanimous in that objective? Is shareholder centricity really the right model for good governance of corporations? What changes in corporate governance have been fueled by the shareholder primacy model? Do those changes make sense? What has been the adverse fallout from the current fastidious devotion to shareholder preeminence? These are just some of the issues addressed in this terrific piece by two Harvard Business School professors, Joseph L. Bower and Lynn S. Paine, in the Harvard Business Review. In their view, the “health of the economic system depends on getting the role of shareholders right.” Highly recommend.
The authors contend that the shareholder primacy theory (sometimes referred to as the “shareholder preeminence” or “agency” theory)—the idea that the goal of management and the board should be to maximize shareholder value—is of relatively recent vintage, dating to the Milton Friedman school of economics in the 1970s. The theory is rooted in the idea that shareholders own the corporation and, as owners, they “have ultimate authority over its business and may legitimately demand that its activities be conducted in accordance with their wishes.” To the authors, however, because of the attenuated relationship with, and lack of responsibility for, the corporation that characterizes share ownership, the theory leaves an “accountability vacuum.”
The consequences of this governance model, they maintain, are damage to companies and harm to the broader economy:
“In particular we are concerned about the effects on corporate strategy and resource allocation. Over the past few decades the agency model has provided the rationale for a variety of changes in governance and management practices that, taken together, have increased the power and influence of certain types of shareholders over other types and further elevated the claims of shareholders over those of other important constituencies—without establishing any corresponding responsibility or accountability on the part of shareholders who exercise that power. As a result, managers are under increasing pressure to deliver ever faster and more predictable returns and to curtail riskier investments aimed at meeting future needs and finding creative solutions to the problems facing people around the world.”
In their view, the “model’s extreme version of shareholder centricity is flawed in its assumptions, confused as a matter of law, and damaging in practice. A better model would recognize the critical role of shareholders but also take seriously the idea that corporations are independent entities serving multiple purposes and endowed by law with the potential to endure over time. And it would acknowledge accepted legal principles holding that directors and managers have duties to the corporation as well as to shareholders. In other words, a better model would be more company centered.”
In the article, the authors do not hold back in identifying the defects in the agency model. For example, shareholders, they argue, are beneficiaries of corporations, but they are not really “owners” in any traditional sense: they can’t use the corporation’s property or assets, nor do they have traditional incentives to take care of the corporation; rather, they are typically anonymous holders with a limited set of rights (voting, selling) who can hedge, sell “slices” of their rights or immediately turn their shares over to minimize any long-term risk. (Indeed, with the advent of high-frequency trading, some “shareholders” hold their shares for little more than seconds.) Citing data from the World Bank, the authors show that, over time, the ownership periods have become briefer and briefer: in 1976, the average holding period in the U.S. was 5.1 years; in 2015, it was 7.3 months.
Moreover, shareholders are protected by their limited liability from a traditional feature of “ownership”: responsibility for the corporation and accountability for any harm it inflicts. And, compared to directors, there are few restraints on shareholders’ conduct in self-dealing or other self-interested actions. ‘In a well-ordered economy,” the authors contend, “rights and responsibilities go together. Giving shareholders the rights of ownership while exempting them from the responsibilities opens the door to opportunism, overreach, and misuse of corporate assets,” a risk that is particularly acute when shareholders (especially those of the short-term variety) seek to influence major corporate decisions, change the board or management, or promote various experiments in financial engineering to goose the share price and sell out, “without ever having to answer for their intervention’s impact on the company or other parties.”
SideBar: A recurring demand by hedge funds activists is that the target company return capital to its shareholders by buying back its own stock. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks (which can drive increases in EPS), leaving little for alternative uses of capital, such as long-term strategic investment in productive assets, including investment in R&D. (See this PubCo post, this PubCo post, this PubCo post, and this PubCo post. See also this PubCo post, describing the efforts of hedge fund activists to break up a company and the ripple effects of that effort on the surrounding community.)
Moreover, the presumption that “all shareholders want the company to be run in a way that maximizes their own economic return” is wrong-headed, the authors contend, and overlooks the differences that shareholders may have with regard to investment objectives, risk and time horizons. Agency theory, they argue, “has erased the distinctions among investors and converted all of us into speculators.”
What’s more, the authors believe, the shareholder primacy theory has “provided the intellectual rationale for a variety of changes in practice that, taken together, have enhanced the power of shareholders and given rise to a model of governance and management that is unrelenting in its shareholder centricity.” For example, a corollary of the notion of shareholder centricity is the concept that, to ensure the promotion of shareholders’ interests, management’s interests should be “aligned” with those of shareholders. This concept has given rise to an executive compensation system that relies heavily on equity and “pay for performance,” typically measured by “total shareholder return.”
SideBar: As discussed in this PubCo post, a report by Organizational Capital Partners and the Investor Responsibility Research Center Institute contends that most companies are using the wrong metrics to align executive pay with performance. Rather than using metrics related to creating sustainable, long-term value, the report maintains, companies are tying compensation to short-term market returns – a practice characterized as the “tyranny of TSR.” See also this PubCo post and this PubCo post.
The tenet that shareholders are “owners,” the authors contend, has also led to the increased adoption of measures that give them more power in the nomination and election of directors and in taking other corporate actions, as well as the elimination of measures once considered “shareholder protection measures,” but now viewed as obstacles to the ability of shareholders to vote on takeover offers. Citing data from FactSet and other sources, the authors report that “the proportion of S&P 500 companies with majority voting for directors increased from about 16% in 2006 to 88% in 2015; the proportion with special meeting provisions rose from 41% in 2002 to 61% in 2015; and the proportion giving shareholders proxy access rights increased from less than half a percent in 2013 to some 39% by mid-2016.…From 2002 to 2015, the share of S&P 500 companies with staggered boards dropped from 61% to 10%, and the share with a standing poison pill fell from 60% to 4%.”
According to the authors, the concept of shareholder preeminence has also shaped the attitudes of managements. To illustrate, the authors cite a shift in the stated position of the Business Roundtable from “‘the shareholder must receive a good return but the legitimate concerns of other constituencies also must have the appropriate attention,’” to “’the paramount duty of management and of boards of directors is to the corporation’s stockholders’ and… ‘the principal objective of a business enterprise is to generate economic returns to its owners.’” Similarly, they observe that “many chief financial officers are willing to forgo investments in projects expected to be profitable in the longer term in order to meet analysts’ quarterly earnings estimates.”
SideBar: As noted in a post from The Harvard Law School Forum on Corporate Governance and Financial Regulation, a recent academic study revealed that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.” (See this PubCo post, this PubCo post and this article in The Atlantic).
Similarly, the authors contend that the shareholder primacy theory has “facilitated a rise in investor activism and legitimized the playbook of hedge funds that mobilize capital for the express purpose of buying company shares and using their position as ‘owners’ to effect changes aimed at creating shareholder value…. These investors are intervening more frequently and reshaping how companies allocate resources.” While the authors recognize that “[t]aken individually, a change such as majority voting for directors may have merit,” all of these changes taken together “have helped create an environment in which managers are under increasing pressure to deliver short-term financial results, and boards are being urged to ‘think like activists.’”
SideBar: The American Prosperity Project maintains that our “economic health depends on sustained, long-term investment,” but right now, our “incentive system for long-term investment is broken.” To support its contention, the Project cites the following data:
- The US now ranks 25th in infrastructure quality, per the National Association of Manufacturers, as a result of decades of inadequate investment.
- The US has fallen to 10th in R&D investment relative to GDP, according to the OECD, and China will soon surpass the US in total investment in basic science research.
- Pressure for short-term financial performance has increased recently according to McKinsey, and has also influenced business investment — “fixed capital investment by American corporations is the lowest since 1952 and employer-paid skills training declined 28% between 2001 and 2009.”
- Our tax system and rules and caselaw reinforce short-termism, directly or indirectly through perverse incentives and requirements.
See this PubCo post.
The idea of shareholder preeminence, the authors contend, may lead the corporation to “become so biased toward the narrow interests of its current shareholders that it fails to meet the requirements of its customers or other constituencies.” Rather, they argue, there is a “stark difference” between “managing for the good of the company” and “managing for the good of the stock.” Expense cuts “that eliminate exploratory research aimed at addressing some of society’s most vexing challenges may enhance current earnings,” they note, “but at a cost to society as well as to the company’s prospects for the future.”
In the article, the authors apply the “growth share matrix” to illustrate the strategic implications of a typical activist program on resource allocation and its adverse effect on R&D, capital investments and long-term prospects. According to the authors, “[a]cademic studies have found that a significant proportion of hedge fund interventions involve large increases in leverage and large decreases in investment, particularly in research and development.” Although, certainly, “in some cases activists have played a useful role in waking up a sleepy board or driving a long-overdue change in strategy or management,” and there may be a temporary bump up in stock price, they contend that the change in value is less “value creation” and “more accurately… value transfer” to shareholders —from investments to generate future returns, from the public (aggressive pay-for-performance plans leading to “various misdeeds involving harm to consumers, damage to the environment, and irregularities in accounting and financial reporting”) and even from workers (in diminution of hours and wage stagnation). (See, for example, this Cooley News Brief, this PubCo post, this PubCo post and this PubCo post.)
What does the authors’ alternative—a company-centered model—mean? The authors’ model “would have at its core the health of the enterprise rather than near-term returns to its shareholders” and would acknowledge that managers are “obliged to act in the best interests of the corporation and its shareholders (which is not the same as carrying out the wishes of even a majority of shareholders). This model recognizes the diversity of shareholders’ goals and the varied roles played by corporations in society.” The model would appreciate that, in addition to generating wealth, “corporations also produce goods and services, provide employment, develop technologies, pay taxes, and make other contributions to the communities in which they operate” and “must create value for multiple constituencies.” Rejecting agency theory’s ambivalence toward corporate ethics, they maintain that corporations must also fulfill social responsibilities and observe “ethical standards to guide interactions with all their constituencies, including shareholders and society at large.”
What are the expected practical implications of company-centered governance? The authors suggest the following:
- “greater likelihood of a staggered board to facilitate continuity and the transfer of institutional knowledge
- more board-level attention to succession planning and leadership development
- more board time devoted to strategies for the company’s continuing growth and renewal
- closer links between executive compensation and achieving the company’s strategic goals
- more attention to risk analysis and political and environmental uncertainty
- a strategic (rather than narrowly financial) approach to resource allocation
- a stronger focus on investments in new capabilities and innovation
- more-conservative use of leverage as a cushion against market volatility
- concern with corporate citizenship and ethical issues that goes beyond legal compliance.”
While a “company-centered model of governance would not relieve corporations of the need to provide a return over time that reflected the cost of capital,” corporations “would be open to a wider range of strategic positions and time horizons and would more easily attract investors who shared their goals.” Under a company-centric model that focuses on the long term, the authors anticipate that “speculators would have less opportunity to profit [and the] legitimizing argument for attacks by unaccountable parties with opaque holdings would lose its force.” The authors “also expect to find more support for measures to enhance shareholders’ accountability. For instance, activist shareholders seeking significant influence or control might be treated as fiduciaries for the corporation or restricted in their ability to sell or hedge the value of their shares. Regulators might be inclined to call for greater transparency regarding the beneficial ownership of shares.”