Hedge Funds |
The Trade |
Long-Held Belief in ‘Shareholder Value’
JESSE EISINGER, ProPublica
Heather Ainsworth for The New York Times
Lynn A. Stout, a professor at Cornell Law School, says that the focus on
stock prices has empowered hedge funds that push for short-term
It’s a bedrock principle of our era: Companies
should be run for the sole purpose of increasing their stock prices, or
returning “value” to shareholders, the ultimate “owners.”
To Lynn A. Stout, however, it amounts to nothing
more than a “shareholder dictatorship.”
Ms. Stout, a professor at Cornell Law School, has
written a slim and elegant polemic, “The
Shareholder Value Myth” (Berrett-Koehler Publishers) to explain the
idea’s two problems: It’s worked out horribly and, as a matter of law, it’s
The blame lies with economists and business
professors who have pushed the idea, with generous enabling from the
corporate governance do-gooder movement, Ms. Stout contends. Stocks, as a
result, have become the playthings of hedge funds, warping corporate
motivation and eroding stock market returns.
Economists have promulgated the idea of shareholder
über alles based on what Ms. Stout says is a misreading of corporate law. In
wrote an article for The New York Times Magazine
that contended “the social responsibility of business is to increase its
profits.” Two business professors, Michael C. Jensen and William H. Meckling,
expanded on the idea in their paper “Theory
of the Firm,” arguing that the only obligation corporations had was to
increase profits for their owners, the shareholders.
But the idea that shareholders “own” their companies
isn’t actually so set in the law, Ms. Stout argues. It’s almost as if the
legal world has been keeping a giant secret from the economists, business
schools, investors and journalists.
Instead, as Ms. Stout explains, what the law
actually says is that shareholders are more like contractors, similar to
debtholders, employees and suppliers. Directors are not obligated to give
them any and all profits, but may allocate the money in the best way they
see fit. They may want to pay employees more or invest in research. Courts
allow boards leeway to use their own judgments.
The law gives shareholders special consideration
only during takeovers and in bankruptcy. In bankruptcy, shareholders become
the “residual claimants” who get what’s left over.
That concept has expanded to mean that a corporation
should always be run to maximize the size of shareholders’ claims. But Ms.
Stout, who also serves as a trustee for the
Eaton Vance family of
mutual funds, argues that those special circumstances shouldn’t dominate
how we view the obligations of continuing corporations. A solvent company
has completely different purposes from those of insolvent ones. We don’t
decide what to do with living horses because we turn dead horses into glue,
It’s clear that something is deeply wrong with our
capital markets. Stock market returns have been terrible for well over a
decade. Wall Street investment banks, pushing their stock prices ever
took on risks that blew up the global financial system. In the early
2000s, companies sought to lift their share prices through an epidemic of
The professor’s argument is that as companies have
increasingly focused on their stock prices and given managers more
shareholdings, they have inadvertently empowered hedge funds that push for
short-term solutions. Mutual funds, dependent on winning money from retail
investors, have become myopic as well. The average holding period of a stock
was eight years in 1960; today, it’s four months.
The biggest ill has been to align top executives’
pay with performance, usually measured by the stock price. This has proved
to be “a disaster,” Ms. Stout says. Managers have become obsessed with share
price. By focusing on short-term moves in stock prices, managers are eroding
the long-term value of their franchises.
Here, Ms. Stout also blames the corporate governance
movement, which pushed for such alignment. It has “proven harmful to the
very institutions that it is seeking to benefit,” she says. “Investors are
actually causing corporations to do things that are eroding investor
She calls for a return to “managerialism,” where
executives and directors run companies without being preoccupied with
shareholder value. Companies would be freed up to think about their
customers and their employees and even to start acting more socially
responsible. Shareholders would have a limited “almost safety net” role, Ms.
Stout says. They would be “relatively weak — and that’s a good thing.”
Of course, this is anathema to the corporate
governance advocates. Sure, short-term thinking is bad, but it’s hard to
believe that giving management more power will suddenly result in a wave of
“The era of managerial supremacy was not that
successful then and would be more catastrophic now,” says Nell Minow, a
standard-bearer of the corporate governance movement. “The idea of speaking
of shareholders as owners is absolutely crucial.”
Shareholders need to be active to prevent manager
conflicts of interest and self-dealing. That’s the safeguard to make
managers “as careful with your money as you would be,” Ms. Minow says.
She contends that the idea that shareholders wield
too much power is laughable. Shareholders have increasingly been voting
against directors only to see them reappointed. Recently, shareholders at a
handful of companies have voted the majority of shares against the pay
packages of chief executives — and have been ignored.
Ms. Stout does, in fact, share some goals with the
corporate governance movement. She is also trying to rein in out-of-whack
executive pay, for one. But her idea is to sharply curtail the supposed
alignment that comes from shareholdings. Instead, she calls for directors to
pay executives for after-the-fact performance. Chief executives should get a
salary and then be eligible for a bonus based on good performance.
She also advocates what campaigners have called the
“Robin Hood tax” — a transaction charge on securities trades. A small tax
would curtail zero-sum, socially useless trading and might insulate
Ms. Stout argues that we need less trading: “We need
to lock investors into their own investments so as to not push them into
Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom
that produces investigative journalism in the public interest. Email:
firstname.lastname@example.org. Follow him on Twitter (@Eisingerj).
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