The Myth of Maximizing Shareholder Value

Yves here. This is a subject near and dear to my heart. So many of the assertions made about “maximizing shareholder value” are false that they should be assumed to be a lie until proven otherwise. The first is that board and managements are somehow obligated to “maximize shareholder value” is patently false. Legally, shareholders’ equity is a residual claim, inferior to all other obligations. Boards and management are required to satisfy all of the company’s commitments, which include payments to vendors (including employees), satisfying product warranties, paying various creditors, paying taxes, and meeting various regulatory requirements (including workplace and product safety rules and environmental regulations). As we wrote last year:

If you review any of the numerous guides prepared for directors of corporations prepared by law firms and other experts, you won’t find a stipulation for them to maximize shareholder value on the list of things they are supposed to do. It’s not a legal requirement. And there is a good reason for that.

Directors and officers, broadly speaking, have a duty of care and duty of loyalty to the corporation. From that flow more specific obligations under Federal and state law. But notice: those responsibilities are to the corporation, not to shareholders in particular…Shareholders are at the very back of the line. They get their piece only after everyone else is satisfied. If you read between the lines of the duties of directors and officers, the implicit “don’t go bankrupt” duty clearly trumps concerns about shareholders…

So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.

And as John Kay has stressed, when companies try to “maximize shareholder value,” they don’t succeed:

Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.

Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them…

Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations…in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

So what is this propagandizing really about? As this post from INET discusses, it’s a justification for extractive capitalism. I encourage you to make the time to watch the video, which is very accessible and lends itself to sharing with friends and colleagues.

In 2010, the 500 largest companies in the United States, otherwise known as The Fortune 500, generated $10.7 trillion in sales, reaped a whopping $702 billion in profits, and employed 24.9 million people around the world.

Historically this has been good news. After all, when these corporations have invested in the productive capabilities of their U.S. employees, Americans have typically enjoyed plentiful well paying and stable jobs. That was the case a half century ago.

Unfortunately, as Bill Lazonick points out in the interview below, it’s not the case today.

Originally published at the Institute for New Economic Thinking blog

For the past three decades, top executives have been rewarding themselves with mega-million dollar compensation packages while American workers have suffered an unrelenting disappearance of middle-class jobs. Since the 1990s, this hollowing out of the middle-class has even affected people with lots of education and work experience.

As the Occupy Wall Street movement correctly recognized, the concentration of income and wealth of the economic top “one percent” of society has left the rest of us largely high and dry. Corporate profits are increasingly going to share buybacks or dividend distribution, but very little is going back into research and development efforts, capital reinvestment, and employment.

Corporations, in other words, are devoting increasing amounts of their considerable and growing financial resources to redistribution rather than innovation. And they are doing so based on the justification of 
“increasing shareholder value.”

However, as Lazonick points out, when the shareholder-value mantra becomes the main focus for companies executives usually concentrate on avoiding taxes for the sake of higher profits and don’t think twice about permanently axing workers. They also increase distributions of corporate cash to shareholders in the form of dividends and, even more prominently, stock buybacks.

When a corporation becomes financialized in this way, the top executives no longer concern themselves with investing in the productive capabilities of employees, the foundation for rising living standards. Instead they become focused on generating financial profits that can justify ever higher stock prices – in large part because, through their stock-based compensation, high stock prices translate into megabucks for these corporate executives themselves.

It’s not a pretty state of affairs. Lazonick discusses how we evolved from a society in which corporate interests were largely aligned with those of broader public purpose into a state where crony capitalism, accounting fraud, and corporate predation are predominant characteristics.

Lazonick makes a very powerful case that the ideology of “maximizing shareholder value” primarily works to the benefit of the very corporate executives who make corporate resource allocation decisions, and who derive high levels of remuneration from munificent stock option awards. As for the rest of us, we’re left to fight over the crumbs.