CHAPTER 1
The Rise of Shareholder Value Thinking

The public corporation as we know it today was born in the late 1800s and did not reach its full maturity until the early twentieth century. Before then, most business corporations were “private” or “closely held” companies whose stock was held by a single shareholder or small group of shareholders. These controlling shareholders kept a tight rein on their private companies and were intimately involved in their business affairs.

By the early 1900s, however, a new type of business entity had begun to cast a growing shadow over the economic landscape. The new, “public” corporation issued stock to thousands or even tens of thousands of investors, each of whom owned only a very small fraction of the company’s shares. These many small individual investors, in turn, expected to benefit from the corporation’s profit-making potential, but had little interest in becoming engaged in its activities, and even less ability to effectively do so. By the 1920s, American Telephone and Telegraph (AT&T), General Electric (GE), and the Radio Company of America (RCA) were household names. But their shareholders were uninvolved in and largely ignorant of their daily operations. Real control and authority over public companies was now vested in boards of directors, who in turn hired executives to run firms on a day-to-day basis. The publicly held corporation had arrived.¹¹

The Great Debate over Corporate Purpose: The Early Years

Of all the controversies surrounding this new economic creature, the most fundamental and enduring has proven the debate over its proper purpose.¹² Should the publicly held corporation serve only the interests of its atomized and ignorant shareholders, and should directors and executives focus only on maximizing those shareholders’ wealth through dividends and higher share prices? This perspective, which today is called “shareholder primacy” or the “shareholder-oriented model,” may have made sense in the early 1900s to those who viewed public corporations as fundamentally similar to the private companies from which they had evolved. After all, in private companies, the controlling shareholder or shareholder group enjoyed near-absolute power to determine the firm’s future. The question of corporate purpose was easy to answer: the firm’s purpose was whatever the shareholders wanted it to be, and when in doubt, it was assumed the shareholders wanted as much money as possible.

But other observers in the first half of the twentieth century thought differently about the public corporation. To them, these new economic entities seemed strikingly dissimilar, in both structure and function, from the privately held firms that preceded them. The “separation of ownership from control” that allowed the creation of enormous enterprises like AT&T and GE worked a change that was qualitative, not just quantitative. Public corporations seemed to have a broader social purpose that went beyond making money for their shareholders. Properly managed, they also served the interests of stakeholders like customers and employees, and even the society as a whole.

Thus began the Great Debate over the purpose of the public corporation (as it has been dubbed by three influential judges specializing in corporate law).¹³ The Great Debate was joined in full as early as 1932, when the Harvard Law Review published a high-profile dispute between two leading experts in corporate law, Adolph Berle of Columbia and Harvard law professor Merrick Dodd. Berle was the coauthor of a famous study of public corporations entitled The Modern Corporation and Private Property.¹⁴ He took the side of shareholder primacy, arguing that “all powers granted to a corporation or to the management of the corporation … [are] at all times exercisable only for the ratable benefit of the shareholders.”¹⁵ Professor Dodd disagreed. He thought that the proper purpose of a public company went beyond making money for shareholders and included providing secure jobs for employees, quality products for consumers, and contributions to the broader society. “The business corporation,” Dodd argued, is “an economic institution which has a social service as well as a profit-making function.”¹⁶

To many people today, Dodd’s “managerialist” view of the public corporation as a legal entity created by the state for public benefit and run by professional managers seeking to serve not only shareholders but also “stakeholders” and the public interest, may seem at best quaintly naïve, and at worst a blatant invitation for directors and executives to use corporations to line their own pockets. Yet in the first half of twentieth century, it was the managerialist side of the Great Debate that gained the upper hand. By 1954, Berle himself had abandoned the notion that public corporations should be run according to the principles of shareholder value. “Twenty years ago,” Berle wrote, “the writer had a controversy with the late Professor Merrick E. Dodd, of Harvard Law School, the writer holding that corporate powers were powers held in trust for shareholders, while Professor Dodd argued that these powers were held in trust for the entire community. The argument has been settled (at least for the time being) squarely in favor of Professor Dodd’s contention.”¹⁷

The Rise of Shareholder Primacy

But only a few decades after Berle’s surrender to managerialism, shareholder-primacy thinking began to resurface in the halls of academia. The process began in the 1970s with the rise of the so-called Chicago School of free-market economists. Prominent members of the School began to argue that economic analysis could reveal the proper goal of corporate governance quite clearly, and that goal was to make shareholders as wealthy as possible. One of the earliest and most influential examples of this type of argument was an essay Nobel-prize winning economist Milton Friedman published in 1970 in the New York Times Sunday magazine, in which Friedman argued that because shareholders “own” the corporation, the only “social responsibility of business is to increase its profits.”¹⁸

Six years later, economist Michael Jensen and business school dean William Meckling published an even more influential paper in which they described the shareholders in corporations as “principals” who hire corporate directors and executives to act as the shareholders’ “agents.”¹⁹ This description—which the next two chapters will show completely mischaracterizes the actual legal and economic relationships among shareholders, directors, and executives in public companies—implied that managers should seek to serve only shareholders’ interests, not those of customers, employees, or the community. Moreover, true to the economists’ creed, Jensen and Meckling assumed that shareholders’ interests were purely financial. This meant that corporate managers’ only legitimate job was to maximize the wealth of the shareholders (supposedly the firm’s only “residual claimants”) by every means possible short of violating the law. According to Jensen and Meckling, corporate managers who pursued any other goal were wayward agents who reduced social wealth by imposing “agency costs.”

Why Shareholder Value Ideology Appeals

The Chicago School’s approach to understanding corporations proved irresistibly attractive to a number of groups for a number of reasons. To tenure-seeking law professors, the Chicago School’s application of economic theory to corporate law lent an attractive patina of scientific rigor to the shareholder side of the longstanding “shareholders versus society” and “shareholders versus stakeholders” disputes. Thus shareholder value thinking quickly became central to the so-called Law and Economics School of legal jurisprudence, which has been described as “the most successful intellectual movement in the law in the last thirty years.”²⁰ Meanwhile, the idea that corporate performance could be simply and easily measured through the single metric of share price invited a generation of economists and business school professors to produce countless statistical studies of the relationship between stock price and variables like board size, capital structure, merger activity, state of incorporation, and so forth, in a grail-like quest to discover the secret of “optimal corporate governance.”

Shareholder-primacy rhetoric also appealed to the popular press and the business media. First, it gave their readers a simple, easy-to-understand, sound-bite description of what corporations are and what they are supposed to do. Second and perhaps more important, it offered up an obvious suspect for every headline-grabbing corporate failure and scandal: misbehaving corporate “agents.” If a firm ran into trouble, it was because directors and executives were selfishly indulging themselves at the expense of the firm’s shareholders. Managers’ claims that they were acting to preserve the firm’s long-term future, to protect stakeholders like employees and customers, or to run the firm in a socially or environmentally responsible fashion, could be waved away as nothing more than self-serving excuses for self-serving behavior.

Lawmakers, consultants, and would-be reformers also were attracted to the gospel of shareholder value, because it allowed them to suggest obvious solutions to just about every business problem imaginable. The prescription for good corporate governance had three simple ingredients: (1) give boards of directors less power, (2) give shareholders more power, and (3) “incentivize” executives and directors by tying their pay to share price. According to the doctrine of shareholder value, this medicine could be applied to any public corporation, and better performance was sure to follow. This reasoning influenced a number of important developments in corporate law and practice in the 1990s and early 2000s. For example, the Securities Exchange Commission (SEC) changed its shareholder proxy voting rules in 1992 to make it easier for shareholders to work together to challenge incumbent boards; Congress amended the tax code in 1993 to encourage public companies to tie executive pay to objective performance metrics; and, thanks to the protests of shareholder activists, many public corporations in the 1990s and early 2000s abandoned “staggered” board structures that made it difficult for shareholders to remove directors en masse.

Finally, shareholder value thinking came to appeal, through the direct route of self-interest, to the growing ranks of CEOs and other top executives who were being showered, in the name of the shareholders, with options, shares, and bonuses tied to stock performance. In 1984, equity-based compensation accounted for zero percent of the median executive’s compensation at S&P 500 firms; by 2001, this figure had risen to 66 percent.²¹ Whether or not linking “pay to performance” this way actually increased corporate performance, it unquestionably increased the thickness of executives’ wallets. In 1991, just before Congress amended the tax code to encourage stock performance-based pay, the average CEO of a large public company received compensation approximately 140 times that of the average employee. By 2003, the ratio was approximately 500 times.²² The shareholder-primacy inspired shift to stock-based compensation ensured that, by the close of the twentieth century, managers in U.S. companies had stronger personal incentives to run public corporations according to the ideals of shareholder value thinking than at any prior time in American business history.

Shareholder Primacy Reaches Its Zenith

The end result was that, by the close of the millennium, the Chicago School had pretty much won the Great Debate over corporate purpose. Most scholars, regulators and business leaders accepted without question that shareholder wealth maximization was the only proper goal of corporate governance. Shareholder primacy had become dogma, a belief system that was rarely questioned, seldom explicitly justified, and had become so pervasive that many of its followers could not even recall where or how they had first learned of it. A small minority of dissenters concerned with the welfare of stakeholders like employees and customers, or about corporate social and environmental responsibility, continued to argue valiantly for broader visions of corporate purpose. But they were largely ignored and dismissed as sentimental, anti-capitalist leftists whose hearts outweighed their heads. In the words of Professor Jeffrey Gordon of Columbia Law School, “by the end of the 1990s, the triumph of the shareholder value criterion was nearly complete.”²³

The high-water mark for shareholder value thinking was set in 2001, when professors Reinier Kraakman and Henry Hansmann—leading corporate scholars from Harvard and Yale law schools, respectively—published an essay in The Georgetown Law Journal entitled “The End of History for Corporate Law.”²⁴ Echoing the title of Francis Fukayama’s book about the overwhelming triumph of capitalist democracy over communism, Hansmann and Kraakman described how shareholder value thinking similarly had triumphed over other theories of corporate purpose. “[A]cademic, business, and governmental elites,” they wrote, shared a consensus “that ultimate control over the corporation should rest with the shareholder class; the managers of the corporation should be charged with the obligation to manage the corporation in the interests of its shareholders; other corporate constituencies, such as creditors, employees, suppliers, and customers, should have their interests protected by contractual and regulatory means rather than through participation in corporate governance; . . . and the market value of the publicly traded corporation’s shares is the principal measure of the shareholders’ interests.”²⁵ What’s more, Hansmann and Kraakman asserted, this “standard shareholder-oriented model” not only dominated U.S. discussions of corporate purpose, but conversations abroad as well. In their words, “the triumph of the shareholder-oriented model of the corporation is now assured,” not only in the United States, but in the rest of the civilized world.²⁶

There were at least two ironic aspects to the timing of this prediction. First, it was only a few months after Hansmann and Kraakman published their article that Enron—a poster child for maximizing shareholder value and for “good corporate governance” whose managers and employees were famous for their fixation on raising stock price—collapsed under the weight of bad business decisions and a massive accounting fraud.²⁷ Second and more subtly, Hansmann and Kraakman’s argument was primarily descriptive; they were painting a picture of what had become conventional wisdom about the purpose of the firm. Yet even as Hansmann and Kraakman published their essay, a number of leading scholars and researchers (including Hansmann and Kraakman themselves) had begun to question the empirical and theoretical foundations of conventional wisdom.

At least among experts, shareholder value thinking had reached its zenith and was poised for decline. The first sign was a number of articles that began appearing in legal journals in the late 1990s and early 2000s. These articles, mostly written by lawyers, began pointing out a truth the Chicago School economists seemed to have missed: U.S. corporate law does not, and never has, required public corporations to “maximize shareholder value.”