The toxic side effects of shareholder primacy.

• Author: Stout, Lynn A.
• Position: Response to articles in this issue, p. 1773 and 1907

In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. PA. L. REV. 1773 (2013), and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. PA. L. REV. 1907 (2013).

INTRODUCTION I. SHAREHOLDER PRIMACY AS ACADEMIC CENTRAL PLANNING II. SHAREHOLDER PRIMACY BECOMES DOGMA III. SHAREHOLDER NIRVANA THREATENS CREDITOR WELFARE IV. MORE TOXIC SIDE EFFECTS FROM SHAREHOLDER PRIMACY: DAMAGE TO STAKEHOLDERS OTHER THAN CREDITORS V. STILL MORE TOXIC SIDE EFFECTS: UNLEASHING SHAREHOLDER SHORT-TERMISM CONCLUSION: IS SHAREHOLDER PRIMACY TOO TOXIC? INTRODUCTION

The past two decades have seen a dramatic shift in the corporate landscape. (1) For most of the twentieth century, well into the early 1990s, directors and executives of large U.S. corporations saw themselves as stewards of great economic institutions that should serve not only equity investors but also customers, creditors, employees, suppliers, and the broader society. (2) Today this "managerialist" philosophy is viewed as obsolete and inefficient. Many, and possibly most, public companies now embrace a shareholder-centered vision of good corporate governance that emphasizes "maximizing shareholder value" (typically measured by share price) over all other corporate goals. (3)

What have been the practical results of the shift? The philosophy of "shareholder primacy" overtook managerialism in large part because it was thought to offer a cure for the "agency cost" problem of corporate managers neglecting shareholders' interests in order to serve their own. Today, many argue that the shareholder primacy cure has largely succeeded in eliminating any significant divide between managers' and shareholders' interests. (4) Institutional shareholders in particular enjoy more influence over corporate boards today than at any other time in American business history, and executives are far more focused on keeping share prices high.

Yet there are signs that the shareholder primacy cure has troubling side effects. This concern provides the basis for the two Articles reviewed in this Response: one by Edward Rock and the other by Barry Adler and Marcel Kahan. (5) These Articles point out that increasing shareholders' influence in public companies and driving managers to focus on share price to the exclusion of other considerations can help shareholders by harming corporate creditors. Each Article offers novel and plausible approaches for ameliorating this negative, creditor-damaging side effect of shareholder primacy.

This Response applauds both Articles, but it also suggests that we should further expand the inquiry into shareholder primacy's negative consequences. There is reason to fear that the side effects of the shareholder primacy cure are more toxic than these two Articles suggest. Indeed, they may be threatening the health of the corporate patient.

1. SHAREHOLDER PRIMACY AS ACADEMIC CENTRAL PLANNING

   The public corporation as we know it--that is, the large, publicly listed company with professional management and dispersed shareholders--first emerged at the beginning of the twentieth century. For most of that century, shareholders remained dispersed and passive, exercising little or no influence over boards of directors. In 1932, Adolf Berle and Gardiner Means famously documented this pattern of the "separation of ownership from control." (6) Far from being held under shareholders' collective thumbs, boards of directors in public firms operated as self-selecting and autonomous decisionmaking bodies. They did not privilege shareholders' interests or the idea of "shareholder value" over the interests of other corporate stakeholders, such as customers, creditors, employees, and the local community. While shareholders were treated as an important corporate constituency, they were not the only constituency that mattered. Nor was share price viewed as a reliable proxy for corporate performance.

   Managerialism appears to have first come under attack and the idea of shareholder primacy seems to have first gained traction in academia. This began during the 1970s with the rise of the Chicago school of free-market economics and its intellectual cousin, the "law and economics" movement. (7) In 1970, Milton Friedman published a famous essay in the New York Times Magazine arguing that the only proper goal of business (which he seemed to view as synonymous with large corporations) was the pursuit of profit for the company's owners (which he assumed to be its shareholders). (8) In 1976, Michael Jensen and William Meckling published an influential article on the "theory of the firm," which is still the most frequently cited academic article in the managerial literature today. (9) Jensen and Meckling argued that the main problem in firms was coercing wayward professional managers (whom the authors called agents) to faithfully serve the interests of the firm's owners (so-called principals). Like Friedman, Jensen and Meckling treated the concepts of the "firm" and the "corporation" as synonyms, and they assumed that the shareholders were the corporation's owners and residual claimants. (10)

   Jensen and Meckling's article was eagerly embraced by a rising generation of corporate legal scholars, (11) Yet there are at least two odd aspects to legal scholars' enthusiasm for the "agency cost" approach to understanding the nature of corporate law. First, the classic agency cost model relied on patently inaccurate assumptions about the legal structure of corporations. As a legal matter, directors are not agents subject to shareholders' control; nor do shareholders own corporations, which are legal entities that "own" themselves; nor are shareholders the sole residual claimants of functioning public companies, although they can come close to that status in insolvent firms. (12) Because Friedman, Meckling, and Jensen were economists, and not lawyers, they were perhaps understandably ignorant of the complex web of rights and responsibilities that comprise the modern public company. This ignorance allowed them to assume that large public corporations were simply larger versions of the familiar sole proprietorship or small, closely-held company. (13) But it is curious that scholars with formal legal training (including, for many years, the Author) so easily accepted their views.

   The second odd aspect of the law and economics approach to corporate governance is that it led many emerging corporate scholars to believe that managerialism was outmoded and inefficient and that corporate law and practice needed reform from the outside. (14) In other words, economic analysis led many legal experts to conclude that academics had better insight into how to run businesses than businesspeople themselves; that the voluntary contractual arrangements of atomized individuals were inferior to mandatory governance rules imposed by reformers and regulators; and that uniform, "one size fits all" practices produced better corporate governance than diverse, individualized arrangements. Such beliefs are anathema to free-market economists like Friedrich Hayek, who placed far more faith in voluntary arrangements that evolve naturally from the needs of atomistic individuals in the business world than attempts at the "intelligent design" of institutions by bureaucrats or academics. (15) Nevertheless, embracing economic analysis led many legal scholars to attempt the academic equivalent of bureaucratic central planning in corporate governance.

   Despite the shaky intellectual foundations of shareholder primacy theory, the shareholder primacy theorists had impeccable timing. By the late 1970s and early 1980s, managerialism--which had dominated the business world for more than half a century--had become suddenly and uniquely vulnerable to critique. This vulnerability can be traced to two developments: the 1973-74 bear market, and corporate raiders discovery that the stock market often undervalued the conglomerate business structure that many managerialist boards and executives had favored. (16)

2. SHAREHOLDER PRIMACY BECOMES DOGMA

   It is worth noting that managerialist practices did not cause the 1973-74 bear market, which saw the Dow Jones Industrial Average lose nearly forty percent of its value. Managerialism, after all, had been around for more than half a century. The Arab oil embargo, which quadrupled oil prices, and Richard Nixon's inflation-triggering decision to take the United States off the gold standard were far more plausible causes of the market decline. (17) Still, the stock market's abysmal performance during the early 1970s opened the door to doubts about managerialism's efficacy.

   Similarly, the discovery that the stock market tended to undervalue large conglomerates comprised of many different business divisions, relative to the price the market attached to those business divisions when trading as freestanding entities, provided highly questionable evidence that managerialism was inefficient in any sense other than the very narrow sense of maximizing current share price. (18) The 1980s, however, were the heyday of a particularly extreme version of the "efficient market hypothesis" that held that stock prices always reflected true economic value. (19) Thus, the phenomenon of conglomerate undervaluation was viewed at the time as prima facie evidence that large conglomerates were poorly run. (20) Today, it is widely understood that stock market prices can deviate significantly from underlying value (21) and that shares in diversified conglomerates often trade at a discount that does not necessarily reflect diminished operating performance. (22)

   Whatever the limits of conglomerate discounts and the 1973-74 bear market as evidence of managerialism's supposed inefficiency, by the mid-1980s, many shareholders in public companies had become disillusioned. Some shareholders, such as corporate raiders Carl Icahn, T. Boone Pickens, and Ronald Perelman, saw opportunities to...