Testing Shareholder Primacy

A response to The Shareholder Value Myth

Sean Moore 8/1/2012

INTRODUCTION
Lynn Stouts book The Shareholder Value Myth is devoted to undermining the ruling ideology of shareholder primacy that the only suitable corporate purpose is to maximize shareholder wealth. The argument behind shareholder primacy, first put forth by Berle and Means in 1932, is that since shareholders own corporations, the maximization of shareholder value should be the sole purpose of the corporation.1 Thus, in corporate governance theory, shareholders are seen as principals of a corporation, and managers are seen as agents who are hired to carry out the shareholders main desire maximize wealth.2 This paper will focus on Stouts arguments against shareholder primacy, put forth in part one of her book. Overall, each of the three parts of her argument against shareholder primacy is either untenable or immaterial. Moreover, on many occasions Stout makes significant factual and theoretical errors, further undermining the validity of her claims. Thus, this paper will go through each part of Stouts three-part argument against shareholder primacy, and provide a brief discussion on the suitability of shareholder primacy. To be clear, the goal of this paper is not to defend the shareholder primacy ideology. Instead the goal is to show that Stouts arguments against shareholder primacy mischaracterize the ideology and suggest the basis for a more meaningful attack on shareholder primacy.

BOOK OVERVIEW
Stouts book is divided into two parts. The first is devoted to undermining the shareholder primacy vision of corporate purpose, and the second proposes alternative views of corporate purpose and governance. Stouts motivation for challenging shareholder primacy is that she believes the ideology is to blame for many recent corporate scandals. She attempts to undermine
Berle, Adolf and Gardiner Means. The Modern Corporation and Public Property. New York: Macmilla, 1932. Accessed through Heinonline on July 27 2012. 2 Jensen, Michael C. and William Meckling. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics. October 1976, V. 3, No. 4 pp. 305-360.
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shareholder primacy ideology in a three-part argument. First, Stout contends that there is no legal basis for the idea that corporations are legally required to maximize shareholder value. In her view, this idea is a myth based on the misinterpretation of a few American cases. Second, Stout argues that the principal-agent model, as it is applied to industrial organization, is wrong. This framework was put forth by Michael Jensen and William Meckling in 1976, who aimed to show optimal ownership structure and objective function of firms. Stout believes principal-agent theory is wrong because it is based on faulty assumptions that misrepresent the true economic nature of the modern corporation. Finally, Stout attempts to undermine shareholder primacy with empirical evidence. The second part of The Shareholder Value Myth provides alternative frameworks for corporate purpose and governance. Here Stout advances the stakeholder view of corporate purpose articulated by Merrick Dodd in 1932. Under this view, corporations are accountable not just to shareholders, but to creditors, employees, consumers, and society as a whole. Stout also advances a team production theory of corporate law, which uses the stakeholder vision to put forth a more holistic vision of corporate purpose in the legal realm. As mentioned, only the first part of the book is discussed in this essay.

ARGUMENT 1: CORPORATE PURPOSE & SHAREHOLDER VALUE

Stout devotes chapter two of The Shareholder Value Myth to expose the myth that corporations are legally required to act in the shareholders best interests. In showing that there is no legal basis for shareholder primacy, Stout undermines the shareholder primacy ideology. However, in order to completely discredit shareholder primacy, Stout must also show that shareholder primacy is not the most optimal corporate purpose. She attempts to argue this point in chapter three. Still, if Stout is unable to prove that maximizing shareholder value is not an optimal corporate purpose, the fact that corporations do not have this legal mandate is immaterial. Legality

is neither a necessary nor a sufficient condition for the optimality of a given strategy, given that no part of that strategy is illegal. Stout argues that the misunderstanding of the laws treatment of corporate purpose is based on a poor interpretation of two American cases. The first is the Michigan Supreme Courts 1919 Dodge v. Ford Motor Company decision, and the second is the Delaware courts 1986 decision on Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. Dodge is often cited as the legal basis for shareholder maximization as the presiding judge clearly supported the shareholder primacy ideology in his judgment. Specifically, he stated the following: There should be no confusion a business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.3 This statement is often held up as the legal basis of shareholder ideology. Stout, however, notes that this statement was not a ratio decidendi but an obiter dictum. In courts a ratio decidendi is the rationale for a judges decision, or the legal principal which a case establishes.4 An obiter dictum, rather, is a statement made in passing and not a material part of the judges rationale behind his or her decision.5 Thus, the judges statement in Dodge has no legal weight, and cannot be used as legal support for shareholder primacy. Under the Revlon case, directors of Revlon decided that a going-private transaction would best benefit the company. Shareholders of Revlon sued the board of directors for not reaching the best sale price possible for the company, thereby failing to maximize shareholder value. The judge in Revlon ruled in the shareholders favour, seemingly providing a legal basis for shareholder primacy. However, as Stout argues, this decision is made under very specific circumstances and really only shows that the court decided that a board of directors can be sued for treating a group of

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Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 26. Ratio Decidendi Definition. Duhaime.org. <http://www.duhaime.org/LegalDictionary/R/RatioDecidendi.aspx> Accessed July 29, 2012. 5 Obiter Dictum Definition. Duhaime.org. <http://www.duhaime.org/LegalDictionary/O/ObiterDictum.aspx> Accessed July 29, 2012.

shareholders unfairly in a buyout. This does not mean that directors are, under any circumstances, required to maximize shareholder value.6 Beyond these two cases, Stout shows that the legal treatment of corporate purpose vis--vis shareholders is minimalistic. The corporate law doctrine, the business judgment rule holds that courts cannot, under most circumstances, hold directors liable for business judgments they make. So long as the board maintains its fiduciary duty to act in the best interests of shareholders, and maintains its duty of care, loyalty and faith, it is free to pursue any lawful corporate purpose.7 Furthermore, with regards to corporate purpose, the Delaware Supreme Court has stated that the court "will not substitute its own notions of what is or is not sound business judgment" in legal decisions.8 Given that there is no legal support for shareholder primacy, the basis for the ideology must lie in economic theory, else the ideology is groundless. Similarly, if Stout is unable to undermine the theoretical basis for shareholder primacy, her attack against the ideology will fall short.

ARGUMENT 2: PRINCIPAL-AGENT MODEL IS WRONG

Under the framework advanced by Jensen and Meckling in 1976, shareholders are principals and managers are agents hired to maximize shareholders utility. In order to maximize utility, managers must maximize shareholder wealth, which in turn requires maximizing firm value. This insight has since shaped the theoretical understanding of optimal ownership structures, capital structures and several other features of the modern firm. Accordingly, Stout correctly identifies Jensen and Mecklings 1976 paper Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure as the theoretical basis for shareholder primacy. Stout, however, holds that this model is inaccurate and is based on three faulty assumptions. First, she claims that

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Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 30-31. Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 29. 8 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). Via Reflections on the Revlon Doctrine at www.law.upenn.edu, accessed July 29.

shareholders do not own corporations. Second, Stout argues shareholders are not, as is commonly believed, residual claimants. Finally, Stout attempts to undermine the idea that shareholders are principals in corporations, and managers are agents. Given the above claims, Stout then argues that principal-agent theory is wrong, and shareholder primacy ideology is unsubstantiated. In each of the three supporting points, Stout makes very poor arguments, undermining her overarching point. Before treating each supporting argument, it is necessary to make an important theoretical note about the nature and purpose of economic models. Most standard introductory microeconomic textbooks begin with a chapter on this subject. They all usually state one important fact: models are abstractions based on simplifications of economic reality. Without exception, these assumptions create a world that bears little resemblance to reality. The point of abstraction is to isolate particular problems so as to generate meaningful conclusions. Abstraction is required for all scientific discoveries. For instance, most hypotheses in Newtonian physics assume a frictionless world. Does this make the conclusions drawn from these abstractions wrong? No. The conclusions hold under very specific conditions. Neither is the model wrong it is simply an arrangement of abstractions and assumptions. Still, Stout says: Put bluntly, the model is wrong its patently and demonstrably wrong to claim that Jensens and Mecklings simple model captures the economic reality of a public corporation with thousands of shareholders, scores of executives, and a dozen or more directors (authors emphasis).9 This quote underscores the authors misunderstanding of the nature and purpose of economic models. Furthermore, Jensen and Meckling never claim that their stylized world reflects reality. Of course the model does not take into account how many shareholders, executives or directors the firm has such facts are irrelevant to the purpose of the model. As the first part of her argument, Stout attacks Jensen and Mecklings assumption that shareholders own corporations and claims that under American law, this is not the case. She states that corporations are independent legal entities that own themselves. Just as no one can own a
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Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 36

person, no one can own a corporation. Instead shareholders own shares of stock, which is a contract between the shareholder and corporation granting the shareholder some limited rights.10 Stout argues that if corporations are not owned by shareholders, then managers should not strive to maximize shareholder wealth. This argument is simplistic on two levels. First, the limited rights granted to shareholders include the right to vote, sue and sell shares, and can dramatically affect the strategy and success of a corporation.11 In a later section, Stout undermines the right to vote, arguing that shareholders rational apathy is an important obstacle to meaningful collective shareholder action.12 However, the fact that shareholders do not take their voting rights seriously does not mean that the voting rights are meaningless. Stout also argues that shareholders can only sue directors on a very narrow range of issues, as the business judgment rule clears directors of any responsibility for poor business decisions.13 This may be true, but it does not undermine the fact that shareholders are collectively an important decision-making group within a corporation. Finally, Stout argues that because shares are not negotiable instruments they carry very little economic importance.14 This argument is very misleading. If corporations act as poor stewards of its investors capital, shareholders will sell their shares, driving down the firm value. When the corporation issues more stock to raise capital, it will do so at a depressed price, impacting the range of capital investments available to it. Thus, the right to sell shares is very meaningful as are the other two rights granted to shareholders. Second, although it may be true that shareholders do not own shares, they are still residual claimants. As residual claimants shareholders as a collective have the strongest interest, of all stakeholders, in maximizing firm value. This leads to Stouts criticism of Jensen and Mecklings second supposed mistaken assumption: that shareholders are not residual claimants. Here, Stout

Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 37 Revised Model Business Corporation Act 7.20. 12 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 43 13 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 43 14 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 44
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uses particularly troublesome tactics to prove her questionable claim. The idea of shareholders as residual claimants is rooted in bankruptcy court. Citing a study by influential legal scholar Lynn LoPucki, Stout states that even in bankruptcies courts often require creditors to share in equity holders losses to some extent.15 Stout never expands upon this point. A quick skim through LoPuckis paper The Myth of the Residual Owner reveals that Stout committed a severe error of misattribution. The purpose of LoPuckis paper is to argue that bankruptcy courts are necessary for orderly bankruptcy proceedings. The paper only shows that it is very difficult to identify a residual claimant ex ante. This is because the value of a bankrupt firm may not be high enough to satisfy the full value of a debt holders claim.16 In this way, the debt holder may be considered a residual claimant ex post. However, this is the case only after the corporation has gone bankrupt. In all other states, the debt holder is a fixed claimant and the equity holder is a residual claimant. Stout also states that living corporations are different entities with fundamentally different purposes than dead corporations, and that we should not judge a company by how it is treated in bankruptcy court.17 This interpretation completely misses the point of classifying the shareholder as a residual claimant. Debt holders claims are secured against assets, or at least senior to equity holders, meaning that they bear less risk than equity holders. Because the idea of residual claimancy deals primarily with the riskiness of the equity holders investment, bankruptcy is an extremely important consideration.18 Risk only exists if there is a possibility that an investment will destroy wealth. In order to judge the equity holders risk against the debt holders risk we must consider the relative extent to which both parties are exposed to losses the case of bankruptcy. Thus, residual claimants or equity holders bear more risk than debt holders. Accordingly, they have the strongest interest in maximizing firm value, as doing so minimizes risk and maximizes

Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 39 LoPucki, Lynn M. The Myth of the Residual Owner: An Empirical Study. 82 Wash. U. L. Q. 1341 (2004) 17 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 39 18 Fama, Eugene F. and Michael C. Jensen. Agency Problems and Residual Claims. Journal of Law and Economics, 1983, Vol. 26, No. 2, pp. 327-349.
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return. In this way, one can argue that maximizing shareholder value leads directly to the maximization of firm value. Finally, Stout argues that shareholders are not principals and managers are not agents. Her argument here rests upon the legal definition of principals and agents. Under the law, a principal refers to someone who hires another person to serve his or her interests. Stout argues that Both the corporation itself and its board of directors (the supposed agents) must exist prior to, and independent of, the stockholders (the supposed principals).19 This argument is not only weak, it is demonstrably false. At least under Canadian law, a corporation can only exist if it has at least one shareholder. Thus, the corporation and shareholder come into existence simultaneously. Furthermore, the claim that a principal must exist prior to an agent is completely irrelevant. In fact, temporality is completely missing from all definitions of the principal-agent relationship. For instance Kathleen Eisenhardt of Stanford defines the relationship as one in which one party (the principal) delegates work to another (the agent), who performs that work.20 One can claim that directors are not accountable to shareholders, however such an assertion runs counter to legal fact and economic theory. As discussed earlier, shareholders have very particular rights providing control over the election of directors, and thus the appointment of management. Directors are no less principals to shareholders than the President is to American citizens. Stouts claim that shareholders are not principals and directors are not agents is completely fallacious and is a misrepresentation of the roles of both parties, and agency theory in general.

ARGUMENT 3: EMPIRICAL EVIDENCE

As a final argument against shareholder primacy, Stout provides five pieces of empirical evidence against the ideology. First, she references several event and cross-sectional studies that show that methods to enhance shareholder primacy, like staggered boards and poison pill defenses,
Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 42 Eisenhardt, Kathleen. Agency Theory: An Assessment and Review. Academy of Management Review, 1989, Vol. 14, No. 1, pp. 57-74.
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have not enhanced corporate performance or share price performance.21 Each of the studies are published in peer reviewed journals and appear to prove legitimate claims. Second, Stout states that average annual returns on the S&P 500 from 1933 to 1976 (the date of Jensen and Mecklings publication) were 7.5%, and were only 6.5% after 1976.22 This evidence is extremely tenuous. Numerous factors drive index performance over a period of months, and considerably more over a period of decades. One cannot say, definitively that shareholder primacy has caused this decline in returns. Third, Stout cites the declining importance of public corporations in the past decade as evidence that shareholder primacy is a suboptimal ideology.23 Again, several factors explain the drop in the number of public corporations. Most significantly the introduction of Sarbanes-Oxley in 2002 increased the cost of public accounting significantly, to the point that the economics behind remaining public were no longer viable for many corporations.24 Fourth, Stout claims that shareholders have little demand for shareholder primacy rules.25 She cites the rise of high-tech public companies like Zynga, LinkedIn and Google, none of which have strong shareholder primacy rules. Once again, several reasons can explain why these companies do not such rules. The strongest of those reasons is that these companies, Google especially, can command such stellar fundamental and market performance that the demand for the rules is weak. Finally, Stout draws on international evidence in support of her argument. Once again the evidence is far from conclusive. Stout argues that the UK is among the most shareholder-friendly jurisdiction in the world, but has relatively few commanding multinational corporations.26 Stout may have a point here, but without conclusive evidence for this claim, the point is moot. Of Stouts five pieces of empirical evidence only the first holds up to any sort of scrutiny.

Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 48 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 53 23 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 54 24 Engel, Ellen, Rachel Hayes and Xue Wang. The Sarbanes-Oxley Act and firms going-private decisions. Journal of Accounting and Economics, 2007, Vol. 44, No. 1, pp. 116-145. 25 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 55 26 Stout, Lynn. The Shareholder Value Myth. Berrett-Koehler: San Franciso, 2012. pp. 56
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DISCUSSION
Stouts argument against shareholder primacy is very poorly crafted. This, however, does not vindicate shareholder primacy as a universally legitimate corporate purpose. Its true that in reality maximizing firm value should maximize shareholder value. However, its questionable whether or not this result is commutative. In practice managers can employ various methods of corporate accounting to maximize shareholder value in the short-term while undermining longterm value. Furthermore, depending on the level to which one accepts the efficient markets hypothesis, it may be accepted that maximizing value in the short-term does not necessarily lead to long-term maximization. In this way, shareholder value thinking can breed short-termism, which can lead to underinvestment, asset stripping and underutilization all in the name of short-term profit. Thus as former GE CEO Jack Welch stated, pursuit of shareholder value is not a strategy. Shareholder value is a result of a well-formulated and effective implementation of corporate strategy. While it may be a truism to say that firm value is maximized through building a good firm, it certainly benefits all of a firms stakeholders.