When policy pundits and politicians are frustrated with corporate America, their typical foil is the “shareholder culture.” By that they mean that shareholders compel managers to serve shareholder interests at the expense of other stakeholders, including employees, customers, suppliers, and the community at large.
For example, last November, NYT columnist David Leonhardt wrote that in the 1970s managers decided to adopt shareholder value maximization as a corporate mission and as a result all kinds of bad things followed after that. The truth is that in the 1960s managers had engaged in a value-destroying spree of corporate acquisitions in the belief that conglomeration was a more profitable strategy than focusing in a few related business lines. Academic research, both theoretical and empirical, has shown ever since that the “empire building” strategy actually destroys economic value for shareholders and the society at large. Educated by these findings active shareholders pushed executives to pay more attention to value. They have done this by selling off shares of underperforming firms and/or bidding for equity stakes large enough to enable them to exert enough influence over or even to oust directors and executives that waste resources.
Last week, another NYT columnist, David Brooks, wrote “But these days corporations see themselves as serving one purpose and one stakeholder – maximizing shareholder value.” First, we should have the courage – no matter how difficult and controversial it has become these days – to say that there is nothing wrong (given certain caveats) with creating value for shareholder. Unless the buyers of corporate equity (stock) are not compensated for the time value of money (i.e., the interest rate that they could otherwise receive on bank deposits) and the risk they take by investing in businesses with uncertain payoffs, there would be no equity capital to fund firms. Neither financial theory nor best practices in corporate management teach or support that the interests of the shareholders are in conflict with the interests of other stakeholders. Corporations (as all firms) generate more value by producing good products and services and expanding their markets. They can undermine both if they try to shortchange their employees, creditors, customers, suppliers and their communities. A firm can serve well all these stakeholders and still pursue value maximization through economic efficiency and successfully meeting the needs of consumers. We have numerous examples of corporations that ran afoul of the law or the trust of customers and other stakeholders and saw their reputation and value suffer.
The more important question to ask is: Do corporations pursue value maximization objectives in order to meet the expectations of shareholder while treating fairly the other stakeholders? To answer this question, we need to look at the structure of the modern corporation. The shareholders as contributors and owners of the equity capital are given the right to run the firm. The shareholders elect a board of directors, which then appoint the CEO. Both the directors and the CEO act as agents, that is, as representatives of the shareholders and, by law, they have the fiduciary responsibility to act in the interests of shareholders. In practice, this structure gives directors and managers effective control to run the corporation in ways that may not always be consistent with value creation. Why is this so? Because no one shareholder can monitor the actions of the CEO and hold him/her fully accountable. To do so it takes significant resources, expertise, and time. Someone like Warren Buffet can do it; but not you or I. In practice, the rest of us rely on our pension funds, mutual funds, and activist investors to ensure managers and boards protect our interests as shareholders. This separation between ownership and control has been recognized by Berle and Means since the 1930s.
Why do we need protection from CEOs? Because if they only receive a base salary, they have a personal interest to also accumulate various expensive perks (like a private plane, generous car and travel allowances, etc.) with the cost of these perks coming out of the shareholders’ pockets. More importantly, CEOs may avoid business decisions that could create value but could also threaten the CEO’s tenure or compensation. The solution to this so-called “agency problem” is to give CEOs (as well as directors) shares of the corporation or options to buy such shares so that their financial interests are better aligned with the pay-offs of the shareholders, which are dividends and stock value appreciation. This trend started in earnest after the 1980s and with the aggressive push of executive compensation consultants has led to the astronomical executive compensation packages of our days. There is no credible theoretical or empirical support as to whether the extravagant CEO compensation packages are truly warranted, which speaks to the power of top executives.
One source of this power is the influence American CEOs have in the selection of the individuals who serve on the board of directors. Furthermore, American CEOs almost invariably serve as chairs of their boards. Thus, they control both the agenda and the dynamics of board deliberations. It takes a lot of courage and conviction and often a lot of CEO malfeasance for an individual director to go against a failing CEO. And even when CEOs are let go, they go with outrageous financial packages as a severance consolation even when they deserve to be fired. Think about it. In what other job, employees demand extra compensation in order to do their work as warranted by the employment contract? As a British executive compensation expert once quipped, only in America executive income is called “compensation” instead of the English term remuneration as if American executives are told to do such thankless work for which they have to be compensated!
The truth of the matter is that American CEOs consistently resist rules that give shareholders a stronger voice and restore their right to act as full owners. If corporate America needs improvement in its corporate governance is in regards to making corporate decisions more democratic rather than to diluting shareholder rights vs. those of managers. Although there is more to this story, condemnation of the “shareholder culture” while ignoring the powerful role and lack of full accountability of executives fails to steer us toward the truly relevant issues.
Note: Part II will address some of these issues.
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