Is there value in running a public company purely for the benefit of shareholders? Of course there is, you say. But to Lynn Stout, distinguished professor of corporate and business law at the Clarke Business Law Institute of Cornell Law School, the answer is emphatically no.
Stout and several other academics have parted with conventional teachings that preach the doctrine of shareholder primacy, condemning management’s focus on shareholder value as misguided at best and dangerous at worst. As Stout puts it, “It compels myopic short-term earnings tactics, endangering companies, their investors, and even the American public. This reckless behavior often leads to investment disasters, leadership scandals, jaded executives, and bankruptcy.”
Stout recently published a book detailing her criticisms, called The Shareholder Value Myth (Berrett-Kohler Publishers), to some fanfare in the press. (“Down with Shareholder Value” was the headline of a positive notice in The New York Times by columnist Joe Nocera, who wrote, “. . . it feels as if we are at the dawn of a new movement — one aimed at overturning the hegemony of shareholder value.”) She believes that many of the problems that beset American business today — for example, disgraced corporate leaders living large despite their companies’ demise, executive-pay packages enriching those at the top while the rank-and-file slips further behind, the perceived decrease in business innovation — can be blamed on, well, the shareholder-value “myth.”
Whereas conventional wisdom holds that shareholders own the public companies in which they invest, Stout insists this is far from the case. “Shareholders do not own corporations, they own a security commonly called stock,” she insists. “No human being can own a corporation — they are independent legal entities. Consequently, the notion that directors must strive always to maximize shareholder value is wrong.”
She adds, “In fact, the law clearly gives boards the discretion to sacrifice profits and shareholder value to protect the interests of other groups like customers and employees, as well as the company itself.”
Not surprisingly, Stout’s views have generated controversy and criticism. “What [Professor Stout] is saying is nothing new and is actually quite silly,” asserts Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. Elson has publicly debated Stout on the place of shareholder value several times. “If someone asks you to invest [in a company] and you give them money and then they never think about you or talk to you, the cost of that company’s capital will go up, forcing them to rely on debt. Why would anyone invest in something where they’re not considered and have no protections?”
Stout objects to such a characterization of her views. “I would never suggest that managers never think about, or talk to, equity investors,” she says. “Of course they should, and most do. But good managers also think about and talk to other groups as well, including employees, creditors, customers, and suppliers.”
The Dangers of Short-Termism
Stout has support for at least some of her ideas in the business world. Many CFOs agree, for example, that a short-term focus on shareholder value can blur the view of long-term growth. This may explain the rising tide of public companies that have abandoned giving quarterly and even annual earnings guidance to Wall Street, such as Costco Wholesale. (See “Letting Go of Guidance.”)
“The phrase to put in front of ‘shareholder value’ is ‘long-term,’” says Richard Galanti, executive vice president and CFO of Issaquah, Washington-based Costco. “You can do a lot of things to short-term-manage the earnings that may help you this quarter, but if they don’t help you long-term, what’s the point?”
There is no point, agrees Robert Mittelstaedt, dean of the W.P. Carey School of Business at Arizona State University. “A total focus on short-term shareholder returns may starve investment in R&D and capital projects that are crucial to long-term success.” he says. The compulsion to satisfy shareholder expectations by meeting short-term earnings targets is so powerful that executives often engage in “earnings games,” adds Edward Hess, professor of business administration and Batten Executive-in-Residence at the University of Virginia’s Darden Graduate School of Business. “The end result is a series of bad business decisions that harm the fundamentals of the business, ultimately eroding long-term value creation,” says Hess.
In The Shareholder Value Myth, Stout cites a survey done several years ago of 400 CFOs that indicated a full 80% would cut expenses like marketing and product development to hit their quarterly earnings targets, even if they knew it would eventually harm long-term corporate performance. “Is this any way to manage a business?” she asks.
Credit (or Blame) Friedman
Like many others, Stout attributes the shareholder primacy doctrine to Milton Friedman, the Nobel Prize–winning economist who taught at the University of Chicago for three decades. “Friedman published a piece in 1970 arguing that since shareholders ‘own’ the corporation, the ‘social responsibility’ of the board and senior managers is to increase the shareholders’ profits,” Stout explains. “This soon became gospel.”
Six years later, Michael Jensen and William Meckling, an economist and business-school dean, respectively, published an influential paper (“Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”) in which they described shareholders as “principals” who hire directors and executives to act as their “agents.” The concept wasn’t new; Adolf Berle and Gardiner Means discussed it in the 1930s, in their classic work The Modern Corporation and Private Property. But Jensen and Meckling’s work gave rise to the modern doctrine of agency theory, which is now a staple of business-school curriculums.
“The idea that managers should seek to serve only the interests of shareholders — not those of customers, employees, or the community — became ingrained,” Stout says, “even though there are no legal reasons for this primacy. This is something created in the minds of academics that subsequently became rote teaching in business and law schools.”
One skeptic of this dogma is Einer Elhauge, Petrie Professor of Law at Harvard Law School. “I do think the main task of a business is to make profits, but I don’t think this is a restricted duty,” says Elhauge. “There is no real legal requirement for directors and managers to focus 100% on profit maximization. Company conduct must also be regulated through social and moral sanctions.”
As an example, he describes a business’s social/moral contract with its employees — an “implicit deal, where the company is investing in employees and they’re investing in the company,” Elhauge explains. “In a private business, owners would hesitate to cut such people loose simply because things changed in a way that it made it more profitable to let them go. Profit motives are thus tempered by the implicit deal — the notion of mutual trust. In many public companies, this flexibility does not exist.”
Back to Dodd
For her part, Stout wants to put Edwin Merrick Dodd back in the classroom. In 1932, Dodd, a Harvard law professor, wrote in Harvard Business Review that the “proper purpose of a public company went beyond making money for shareholders.” Providing secure jobs for employees, quality products for customers, and contributions to the broader society were just as important, Dodd said. He described the “business corporation” as “an economic institution, which has a social-service as well as a profit-making function.”
Dodd’s theories held sway for four decades until Friedman weighed in. Not coincidentally, maintains Stout, that was a period that produced public companies with far greater long-term value. “From 1933 to 1976, shareholders investing in the S&P 500 enjoyed real compound average annual returns of 7.5%, which fell to 6.5% [through 2011] after the Jensen and Meckling article came out,” she says.
Darden’s Hess also believes that Dodd was on to something. “Numerous studies indicate that over the last 30 years, high-performance companies are those with a multiple-stakeholder theory,” he says. “These companies create value for shareholders, but also provide meaningful benefits to employees, customers, and society.”
Scott Fine, professor of banking and finance at Case Western Reserve University’s Weatherhead School of Management, agrees with these views and cites a tantalizing example. “Look at Ben & Jerry’s ice cream — two guys in Vermont who start a business and want to plow a certain amount of money into good causes, as well as work only with family farms and use only natural ingredients,” Fine says. “The business takes off, they’re bought by Unilever, a giant conglomerate, yet they maintain the same values. I’m sure there are parts of Unilever that don’t subscribe to their philosophy, but the parent knows better than to tinker with a successful strategy.”
Attending only to the interests of shareholders ultimately eats away at an organization’s innovativeness, Stout asserts, since the focus is on the here and now. “In the post-Friedman era, there is some evidence that U.S. corporations are not as dominant in filing patents and are spending relatively less on R&D,” she says. “Public companies are fast disappearing, from 8,823 in 1997 to 5,401 in 2008. We’re losing our innovative edge.”
Pay-for-performance schemes are a big part of the problem, Stout contends. “To feather their nests with their stock-option grants, executives load up on risk, work the numbers, cut back on near-term expenses important for long-term growth, and drain out cash through stock repurchases and dividends — all for the purpose of pumping up the share price temporarily,” she charges.
Mittelstaedt has a similar view: “Companies have figured out how to do extraordinarily well in the short term, filling up with experts who know what to do now, and then compensating them for this short-term performance. What they fail to do is bring in different types of people and acquire different types of companies to address the changing external environment — the company’s long-term challenges, opportunities, and value. They fail this because it’s expensive and hurts short-term results.”
“This is all built on sand,” says Stout. “We’re simply headed in the wrong direction.”
Taking a Longer View
Several CFOs weighed in on the shareholder primacy debate, insofar as how to achieve the right balance between long-term and short-term financial performance. “You can’t obsess about short-term profit maximization and not think about creating opportunities for success in the long term,” says Paul Reilly, executive vice president and CFO of Arrow Electronics, a global provider of electronic components and computer systems. “While we publish quarterly earnings guidance, we also publish long-term goals — the key metrics we believe create future shareholder value, including returns on invested capital, cash flow, and earnings growth.”
As an example of the company’s pursuit of long-term value, Reilly says Arrow made a decision when the financial crisis hit in 2008 to take actions to bolster its future performance. “We made investments to propel us to success whenever we came out of the crisis — investments that had nothing to do with the short term,” he explains. “For instance, we invested in inventory and broadened our sales and engineering to create future revenue streams.”
Even if a decision made for the long term affects short-term value, it may be worth the pain, as was the case at SciQuest. “Last year, we decided that investments in product development, sales, and marketing would expand our market opportunity,” says Rudy Howard, CFO of the publicly traded provider of cloud-based spend-management solutions, which recorded revenues of $53.4 million in 2011. “We indicated to investors that these investments might lower operating margins in 2012, but that we expected them to help increase SciQuest’s revenue growth in 2013 and beyond.”
Howard and other senior executives spent significant time with investors reviewing the investments and opportunity. Thanks to the company’s transparency “about our plans to eventually return to our historical margin levels and drive faster revenue growth in the meantime, investors supported our strategy,” says Howard.
Vastly larger Cisco Systems shares a similar strategy of patient returns. “In our business, we don’t sell to a customer once; we must have long-term engagement,” says Frank Calderoni, executive vice president and CFO of the global networking leader. “Consequently, we strive to design products and solutions for our customers that have long-term value. All our executives are tasked with managing their part of the organization to a three-to-five-year plan.”
At United Parcel Service, the company’s 35,000 managers receive stock rewards that vest over five years, creating an incentive for them to focus on longer-term value. To encourage this further, UPS also tacks on an average extra 3% return to the value of the shares each year. “In effect, our supervisors beat the biggest investment firms [investing in UPS stock] by 3% annually,” says Kurt Kuehn, CFO of the Atlanta-based global shipping company. “Frankly, no one really worries about the daily stock movement here.”
No one worries at Ocean Spray Cranberries either. That’s because the maker of juices and dried fruit is a cranberry cooperative, not a public company. The members of this cooperative are the many farms that grow cranberries for Ocean Spray. Nevertheless, Rick Lees, Ocean Spray senior vice president and CFO, says the overall mission of any corporation “is to generate increasing shareholder value. Future cash-flow stream is real shareholder value. Our strategy embraces social responsibility not as philanthropy, but because the treatment of our employees and member shareholders, and their communities and the environment, ensure this future cash flow and solidify our value.”
He adds, “Quarterly profit is simply what you did the last three months.”
Costco shares this belief, and has taken steps to free the organization from an acute attention on short-term shareholder value. “Almost 30 years ago, our founders articulated our mission: provide the best-quality products at the lowest price to our member customers,” says Galanti. “Their plan for doing this was straightforward: obey the law and not cut corners by taking a little butter out of the butter cookie; take care of customers, not just giving them quality products but also a return policy they could trust; take care of employees; respect but be fair with suppliers; and then take care of shareholders, in that order of priority.”
Why is the shareholder at the end of the list? “Because if we’re doing all these other things right, the shareholder will benefit,” Galanti replies. “That’s what drives long-term value and ensures we’ll be around for the next 20 years.”
For example, Galanti says, “we’d never take a tenth of an ounce out of a hot dog to maximize short-term profits, and we sell 100 million of them with a soda each year for $1.50. Sure, we could sell them at $1.75, make another hundred million quarters and maybe bump up the short-term shares a bit. Instead, we’re trying to see if we can sell them for a buck twenty-five.”
Russ Banham (firstname.lastname@example.org) is a contributing editor of CFO.
Accountable to Whom?
A defense of shareholder primacy
Corporate-governance expert Charles Elson believes that critics of shareholder primacy like Professor Lynn Stout are “old school.” “If there was no value in managing a company for the benefit of shareholders, we never would have seen the rise of shareholder activism in the 1980s,” he says. Until then, he points out, companies viewed shareholders as “irrelevant.” But then they “caught on to the fact that shareholders were, in fact, relevant,” says Elson. “Why? Because this was a period of very poor corporate performance, and the argument was made that it stemmed from a lack of focus on shareholder value. Once this was put in place, company performance improved. To abandon this focus now makes no sense.”
Were companies to relax their focus on shareholder value, we would have a bad case of déjà vu, says Elson — “company performance problems that would put shareholder value front and center again.”
But Elson regards this prospect as highly unlikely. Today, “shareholders are much more active, concerned, and unified,” he explains. As for the contention that companies should also be managed for other constituencies like employees, customers, and the community, Elson responds that when organizations have too many points of accountability, “they end up being accountable to no one.” — R.B.