What is the purpose of a firm? Given we have so many firms and business schools are such a sizable chunk of many universities, you might think that we all agree what firms are for. You would be wrong. There is a surprising amount of disagreement as to the purpose of firms. What are they for? What must they do? Lynn Stout addressed what is likely the biggest question. Must Firms Maximize Shareholder Value? (An idea that is often called shareholder primacy). “No” was the very clear answer she came to.
I Want To Believe
There is always a danger when you read something you want to be true. The fact that maximizing shareholder value seems a bit of an intellectual dead-end to me doesn’t mean it isn’t currently law. As such, I wondered about how Stout would make her argument. Given the caveats that a) I wanted to believe and b) have no idea about US (or any other type of) law l found what she said was clearly argued. Her points seemed to make a lot of sense. She mentioned some key cases I had seen referenced as baldly stating that managers had a legal duty to maximize shareholder value. Stout then detailed why they say no such thing.
Ford Versus Dodge
I have seen it argued that Ford versus Dodge is the legal basis for firms having to maximize shareholder wealth. Stout tackles why this doesn’t make sense. She argues that Ford versus Dodge wasn’t a case about a public corporation. Instead, it was a case of a majority shareholder, Henry Ford, looking to abuse his position against minority shareholders, the Dodge brothers. Ford was a closely held company. The company structure facing Ford was different to most companies we discuss today. Indeed, the case seemed to involve Ford trying to underhandedly undercut his rivals. It wasn’t a case about a large-scale revolt of shareholders with small stakes in the company attacking a manager paying too much to the workers.
The judge did say that firms are primarily for the profit of the stockholders. Stout argues that this was more of an offhand comment. It was never designed to be the key comment defining US corporate law. What is more ‘primarily’ is quite different from exclusively. Even if US law were to say that a firm had to primarily focus on shareholders this isn’t the same as saying they can’t worry about other stakeholders.
Revlon
A second commonly cited case is Revlon. The Revlon board planned to go private and was told by a judge that they needed to do the best they could financially for the shareholders. Stout notes that the case is not about a continuing company undergoing normal operations. The managers couldn’t appeal to the long-term interests of the corporation to justify helping other stakeholders because, according to the management plans, there was no long-term interest to appeal to. Again this was about a specific narrow situation and not widely applicable.
The Short-Term And Long-Term
One of the challenges with maximizing shareholder value is that you never know if you are doing it. It would be a problem if the law said managers must maximize shareholder value. This is because it isn’t clear what actions should be taken to achieve this. A law people don’t know whether they are following is a really problematic law.
A challenge discussed in the book is well-known to marketers.
…the fear that companies whose directors focus on stock price will run firms in ways that raise that price in the short term, but harm firm’s long-term prospects.
Stout, 2012, page 63
What is good for the shareholders in the long-term is not provable at the time that decisions are taken. Furthermore, there is another problem unless we are willing to assume perfect financial markets. (By a perfect financial market I mean one where the current share price perfectly captures all future prospects — i.e., it predicts the future). There is a potential conflict between shareholders whenever markets aren’t perfectly miraculous. Some shareholders will care about the long-term while other shareholders will plan to flip their shares. For the flippers, short-term unsustainable gimmicks to raise the share price will be fine, but not so for the long-term focused. This means the idea that there is a single ‘shareholder’ whose interests must be followed is an unsupportable fiction.
Corporations Are People (Apparently)
One of the most surprising parts of the book is Stout’s reliance on the idea that corporations are people. Ironically, right-wing people in the US tend to rely on the twin ideas of corporations as people and shareholder primacy. The left, conversely, tends to neither accept corporate personhood nor shareholder primacy. Stout uses the idea that corporations are people, which infuriates the left, to attack another popular right-wing idea, that of shareholder primacy.
If firms are people then they logically can’t be beholden to someone else for their choices. Firms can have their own objectives (personalities even). The world seemed pretty upside down by this point. The idea of firms being people still weirds me out a little but I can see the value in the case Stout makes. If firms are people then let these corporate people make their own choices.
Must Firms Maximize Shareholder Value?
The idea that firms must maximize shareholder value seems to be on debatable legal grounds.
The problem is that widespread belief in legally required shareholder primacy — what Stout calls the Shareholder Value Myth — can by itself influence behavior. Managers might act as though the law dictates that they must maximize shareholder value, even if the law doesn’t. The challenge here is that the belief becomes self-fulfilling. People believe a dubious legal claim. Then they act on this belief. This means the claim is further perceived to be true; after all, everyone is acting as though it were true.
This was a really interesting book. It helped me think about company law and supplies arguments to push back on shareholder primacy. Still, I wouldn’t advise anyone to put me on the Supreme Court after I have just read this book alone. (Although the free all-expenses-paid vacations Supreme Court members get from wealthy ‘friends’ sound very nice).
For more on stakeholder focussed management see here, here, here, here, here, and here.
Read: Lynn Stout (2012) The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public, Berrett-Koehler