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Source: New York Times DealBook, June 27, 2012 article


Hedge Funds | The Trade | June 27, 2012, 12:00 pm

Challenging the Long-Held Belief in ‘Shareholder Value’


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 solutions

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 solutions.

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 not true.

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 1970, Milton Friedman 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, she says.

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 higher, 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 accounting fraud.

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 returns.”

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 altruism.

“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 corporations.

Ms. Stout argues that we need less trading: “We need to lock investors into their own investments so as to not push them into short-term strategies.”

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Email: Follow him on Twitter (@Eisingerj).

Copyright 2012 The New York Times Company




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