Lynn Stout, professor of business law at Cornell University, is concerned with how markets contribute to the peace and prosperity of nations. But the ideas set forth in her book, “The Myth of Shareholder Value,” are anything but peaceful: they are more like dynamite set at the foundations of modern corporate governance.
That’s not to say you would find Stout at an Occupy Wall Street rally. “I’m a capitalist to the bone,” she says. “That’s because the moral defense of capitalism is that it makes people better off. I want to make it work as it should, not as it’s been hijacked by an ideology.”
The ideology that Stout opposes is the influential idea — often seen as a bedrock principle — that corporations exist for the benefit of their shareholders. Stout argues that the shareholders are not even, legally speaking, the owners of public companies, and that running a company to only maximize shareholder value is ultimately short-sighted and self-destructive.
Stout will speak at dinner meeting of the Human Resources Management Association of Princeton Monday, May 12, from 5:30 to 8 p.m. at the Hyatt Regency. She will present her views alongside Frank Werner, associate professor of finance and business economics at Fordham University. Tickets are $50 for non HRMA members. For more information, visit hrma-nj.shrm.org.
In Stout’s view, there are two major schools of thought when it comes to how public companies should be run. The first is the “managerial capitalist” philosophy that predominated for most of the 20th century. In this paradigm, corporate directors were responsible to the shareholders, but also saw themselves as stewards of institutions. Instead of trying to maximize share prices in the short term, corporate directors sought to build companies that could thrive in the long run, and that meant taking care of customers, employees, the community in which the corporation was located, and even contributing to the nation as a whole. Stout argues that this philosophy began to change in 1970 when the economist Milton Friedman began arguing that companies should be run to maximize profits because shareholders were the owners of the businesses.
Friedman was dead wrong about that, Stout says.
“Milton Friedman never went to law school, and he actually didn’t understand what a corporation was,” she says. “Shareholders do not own corporations. He was thinking a corporation was a giant sole proprietorship, and that’s not what they are.”
Stout argues that a corporation is something far more abstract. “As the Supreme Court reminded us in Citizens United, a corporation is an independent legal entity,” she says. Because of the legal “personhood” of corporations, buying a share in a corporation is like making a contract with the legal “person” that is the company, which is different from buying the company.
Further, she argues, the charters of corporations call for the directors to run them for the benefit of “the corporate entity and the shareholder,” and never just the shareholder.
Stout has long been interested in corporate governance and moral behavior. She grew up outside of Albany, New York, where her parents were public servants. “I went to a high school where there was corn growing outside the window,” she says. She earned a bachelor’s degree at Princeton, graduating in 1979, and a master’s of public administration, also at Princeton, before studying law at Yale. She was an attorney for several years before becoming a law professor and writer. The whole time, she was fascinated with how corporations affected society. “There really is nothing like ethical, well-organized capitalism to contribute to progress in the world,” she says. “It really captures my attention when I see capitalism being misused, not to lead to progress, but to just enrich a few people.”
As one might expect from a law professor, she supports her argument with many legal justifications, but Stout’s main argument against shareholder primacy is a practical and moral one. After looking at the history of the economy, she has come to the conclusion that shareholder primacy leads managers to make bad decisions. In seeking to pump up share prices, companies have paid huge cash dividends, launched share repurchase programs, cut research and development, employee development, and marketing, and sold off parts of companies to raise cash. “These strategies are reasonably effective at raising the price of stock temporarily, but history suggests they are bad for the ability of corporations to generate long term profits,” she says.
These short-sighted decisions have far-reaching consequences. With fewer people working, and less wages going out to the workforce, the marketplace for goods and services shrinks. “When companies are all simultaneously firing people, there’s nobody left to buy the products that companies generate,” she says.
Stout likes to cite Motorola as an example of the folly of short-term thinking. The cell phone maker was once a vaunted technology company. Founded in Illinois in 1928, Motorola created the first car radios, the first walkie-talkies, and was a pioneer in the development of cell phones. But in the late 1990s and early 2000s, the company faced pressure to report high quarterly earnings. “They stopped doing basic R&D,” Stout says. “Instead they devoted their efforts to tweaking the phones and marketing different colors and different shapes. As a result, they were not prepared when Apple came out with the iPhone and touch-screen.”
Motorola’s cellphone division is now owned by Google, which, Stout says, is its Motorola. Google has a multi-class corporate structure that gives management more say over the direction of the company. When Google went public in 2004, it sold Class B shares to the public, which had the same value but less voting power than the Class A shares the founders owned. In 2012 it added Class C shares, which have no voting power at all. In Stout’s view, this allows Google to resist hedge funds and activist shareholders who would seek to pump up short-term profits at the expense of long-term activities like research and development.
The last two decades have seen more Motorolas than Googles on the corporate landscape. Stout notes that the number of publicly owned corporations has fallen by 40 percent since 1993. That same time period has been characterized by stagnant wages for workers, more unemployment, and lower returns for investors, particularly long-term, diversified investors.
Stout picked 1993 as a turning point to study because that was the year that congress passed a law, in an effort to reduce out-of-control CEO pay, that required executive compensation to be tied to objective performance metrics — meaning stock prices. It was that year, she believes, that shareholder value thinking really took off.
Astronomical CEO pay, which in some companies is thousands of times the salary of the average worker, has been blamed for economic inequality. But Stout doesn’t think high executive pay is the root of the problem. “I think they’re being paid for the wrong thing,” she says.
Stout believes companies would be better off if they focused on goals other than share price. Share price, she says, is only one measure of a company’s success among many.
“We have to get used to the idea of measuring across several different metrics,” she says. “There is what I view as a somewhat crazy idea floating around that you have to have a single metric of measuring performance or else the world will stop spinning on its axis. People balance competing objectives all the time. If you go out to lunch, you are going to have multiple objectives: to get enough calories, but not too many, getting nutrients, enjoying the taste of lunch. If a human being doesn’t have a single objective in eating lunch, why would you ever say an institution as complex as a corporation should have a single objective?”
In the managerialist era, CEOs had lower pay, workers had higher pay, companies were more innovative, and stockholders got better returns, all because companies were not so monomaniacally focused on share prices.
Stout’s call to detonate the foundations of shareholder primacy have been surprisingly well received in the business community, she says. “People inside the business community actually see this,” she says. “They see the way the pressure to keep stock price up all the time is preventing them from running companies for the long term, in the responsible and profitable way they’d like to run them.”