Business School’s Worst Idea: Why the “Maximize Shareholder Value” Theory Is Bogus

Short-termism, underinvestment, and a preoccupation with image management.

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By Yves Smith

From the early days of Naked Capitalism, we’ve written from time to time about why the “shareholder value” theory of corporate governance was made up by economists and has no legal foundation. It has also proven to be destructive in practice, save for CEO and compensation consultants who have gotten rich from it.

Further confirmation comes from a must-read article in American Prospect by Steven Pearlstein, When Shareholder Capitalism Came to Town. It recounts how until the early 1990s, corporations had a much broader set of concerns, most importantly, taking care of customers, as well as having a sense of responsibility for their employees and the communities in which they operated. Equity is a residual economic claim. As we wrote in 2013:

Directors and officers, broadly speaking, have a duty of care and duty of loyalty to the corporation. From that flow more specific obligations under Federal and state law. But notice: those responsibilities are to the corporation, not to shareholders in particular…..Equity holders are at the bottom of the obligation chain. Directors do not have a legal foundation for given them preference over other parties that legitimately have stronger economic interests in the company than shareholders do.

And even in the early 1980s, common shares were regarded as a speculative instrument. And rightly so, since shares are a weak and ambiguous legal promise: “You have a vote that we the company can dilute whenever we feel like it. And we might pay you dividends if we make enough money and are in the mood.”

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However, 1900s raiders who got rich by targeting companies that had gotten fat, defended their storming of the corporate barricades by arguing that their success rested on giving CEOs incentives to operate in a more entrepreneurial manner. In reality, most of the 1980s deals depended on financial engineering rather than operating improvements. Ironically, it was a form of arbitrage that reversed an earlier arb play in the 1960s. Diversified corporations had become popular in the 1960s as a borderline stock market scam. Companies like Teledyne and ITT, that looked like high-fliers and commanded lofty PE multiples, would buy sleepy unrelated businesses with their highly-valued stock. Bizarrely, the stock market would value the earnings of the companies they acquired at the same elevated PE multiples. You can see how easy it would be to build an empire that way.

The 1970s stagflation hit these companies particularly hard, with the result that the whole was worth less than the sum of the parts. This made for an easy formula for takeover artists: buy a conglomerate with as much debt as possible, break it up and sell off the pieces.

But CEOs recognized how the newly-installed leaders of LBO acquisitions got rich through stock awards or option-type compensation. They wanted a piece of the action.

One of their big props to this campaign was the claim that companies existed to promote shareholder value. This had been a minority view in the academic literature in the 1940s and 1950s. Milton Friedman took it up an intellectually incoherent New York Times op-ed in 1970. Michael Jensen of Harvard Business School and William Meckling of the University of Rochester argued in 1976 that corporate managers needed to have their incentives better aligned with those of shareholders, and the way to do that was to have most of their pay be equity-linked. In the late 1980s, Jensen in a seminal Harvard Business Review article, claimed that executives needed to be paid like entrepreneurs. Jensen has since renounced that view.

Why The Shareholder Value Theory Has No Legal Foundation

Why do so many corporate boards treat the shareholder value theory as gospel? Aside from the power of ideology and constant repetition in the business press, Pearlstein, drawing on the research of Cornell law professor Lynn Stout, describes how a key decision has been widely misapplied:

Let’s start with the history. The earliest corporations, in fact, were generally chartered not for private but for public purposes, such as building canals or transit systems. Well into the 1960s, corporations were broadly viewed as owing something in return to the community that provided them with special legal protections and the economic ecosystem in which they could grow and thrive.

Legally, no statutes require that companies be run to maximize profits or share prices. In most states, corporations can be formed for any lawful purpose. Lynn Stout, a Cornell law professor, has been looking for years for a corporate charter that even mentions maximizing profits or share price. So far, she hasn’t found one. Companies that put shareholders at the top of their hierarchy do so by choice, Stout writes, not by law…

For many years, much of the jurisprudence coming out of the Delaware courts—where most big corporations have their legal home—was based around the “business judgment” rule, which held that corporate directors have wide discretion in determining a firm’s goals and strategies, even if their decisions reduce profits or share prices. But in 1986, the Delaware Court of Chancery ruled that directors of the cosmetics company Revlon had to put the interests of shareholders first and accept the highest price offered for the company. As Lynn Stout has written, and the Delaware courts subsequently confirmed, the decision was a narrowly drawn exception to the business–judgment rule that only applies once a company has decided to put itself up for sale. But it has been widely—and mistakenly—used ever since as a legal rationale for the primacy of shareholder interests and the legitimacy of share-price maximization.

How the Shareholder Value Theory Has Been Destructive

The shareholder value theory has proven to be a bust in practice. Here are some of the reasons:

It produces short-termism, underinvestment, and a preoccupation with image management. We wrote in 2005 for the Conference Board Review about how the preoccupation with quarterly earnings led companies to underinvest on a widespread basis. Richard Davies and Andrew Haldane of the Bank of England demonstrated that companies were using unduly high discount rates, which punished long-term investment. Pearlstein provides more confirmation:

A recent study by McKinsey & Company, the blue-chip consulting firm, and Canada’s public pension board found alarming levels of short-termism in the corporate executive suite. According
to the study, nearly 80 percent of top executives and directors reported feeling the most pressure to demonstrate a strong financial performance over a period of two years or less, with only 7 percent feeling considerable pressure to deliver strong performance over a period of five years or more. It also found that 55 percent of chief financial officers would forgo an attractive investment project today if it would cause the company to even marginally miss its quarterly-earnings target.

As we’ve stated before, we’ve been hearing this sort of thing from McKinsey contacts for more than a decade. And the “55 percent” figure likely understates the amount of short-termism. First, even in a presumably anonymous survey, some CFOs might be loath to admit that. Second, for any project big enough to impact quarterly earnings, the CFO is almost certain not to have the final say. So even if his team approves it, it could be nixed by the CEO out of concern for earnings impact.

It empirically produces worse results. We’ve written from time to time about the concept of obliquity, that in a complex system that is affected by interactions with it, it is impossible to map out a simple path to a goal. As a result, other approaches are typically more successful. From a 2007 Financial Times article by John Kay, who later wrote a book about the concept:

Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.

Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck (“We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been”) with that of John McKeen of Pfizer (“So far as humanly possible, we aim to get profit out of everything we do”).

Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

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Some more commonly-cited reasons for why a focus on shareholder value hurts performance is that it dampens innovation. Pearlstein describes another, how it demotivates workers:

Perhaps the most ridiculous aspect of shareholder–über-alles is how at odds it is with every modern theory about managing people. David Langstaff, then–chief executive of TASC, a Virginia–based government-contracting firm, put it this way in a recent speech at a conference hosted by the Aspen Institute and the business school at Northwestern University: “If you are the sole proprietor of a business, do you think that you can motivate your employees for maximum performance by encouraging them simply to make more money for you?” Langstaff asked rhetorically. “That is effectively what an enterprise is saying when it states that its purpose is to maximize profit for its investors.”

And on a societal level, it erodes social capital and trust, which are the foundations for commerce:

It is our social capital that is now badly depleted. This erosion manifests in the weakened norms of behavior that once restrained the most selfish impulses of economic actors and provided an ethical basis for modern capitalism. A capitalism in which Wall Street bankers and traders think peddling dangerous loans or worthless securities to unsuspecting customers is just “part of the game,” a capitalism in which top executives believe it is economically necessary that they earn 350 times what their front-line workers do, a capitalism that thinks of employees as expendable inputs, a capitalism in which corporations perceive it as both their fiduciary duty to evade taxes and their constitutional right to use unlimited amounts of corporate funds to purchase control of the political system—that is a capitalism whose trust deficit is every bit as corrosive as budget and trade deficits.

As economist Luigi Zingales of the University of Chicago concludes in his recent book, A Capitalism for the People, American capitalism has become a victim of its own success. In the years after the demise of communism, “the intellectual hegemony of capitalism, however, led to complacency and extremism: complacency through the degeneration of the system, extremism in the application of its ideological premises,” he writes. “‘Greed is good’ became the norm rather than the frowned-upon exception. Capitalism lost its moral higher ground.”

Many elite professionals are deeply upset with Trump’s win. Yet the ideology that he represents is very much in line with the logic of corporate raiders, many of whom, like him, went to Wharton Business School. And many elite professionals, in particular lawyers and consultants, profited handsomely from the adoption of the buccaneer capitalist view of the world and actively enabled much of its questionable thinking and conduct. As CEO pay rose, so to did the pay of top advisers. They couldn’t be all that good, after all, if they were in a wildy different income strata.

So as Lambert has warned, unless we hear a different economic and social vision from The Resistance, which looks troubling to have more failed Democratic party influence behind it than either of us like, the best we are likely to get is a restoration. And if you remember the French Revolution, strongman Napoleon was succeeded by the Bourbon Restoration, which then led to the Second Empire under his nephew. So if we want better outcomes, status quo ante is not good enough.

Originally published at Naked Capitalism.

2017 February 5

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  • Rick Alexander

    Couldn’t agree more with craziness of shareholder value maximization; it is truly incoherent, as it simply ignores that corporations have multiple outputs, not just financial– so shareholder primacy awards negative sum activity is long as the negatives are external. This means a corporation can emit GHG, and create severe inequality and instability, but claim it “created value,” because it made a profit doing so. Insane. However, I am afraid that Professor Stout’s analysis of Revlon and its progeny, though insightful and well-reasoned, does not face the fact that, however crazy it is, maximization has become the law in Delaware– that is why 33 states adopted “constituency” statutes in order to avoid the same outcome decision (Delaware corporate law being persuasive in all US jurisdictions). But don’t believe me: here is what the Chief Justice of the Delaware Supreme Court says in a recent law review article:

    The understanding in Delaware is that Revlon could not have been more clear that directors of a for-profit corporation must at all times pursue the best interests of the corporation’s stockholders, and that it highlighted the instrumental nature of other constituencies and interests. Non-stockholder constituencies and interests can be considered, but only instrumentally, in other words, when giving consideration to them can be justified as benefiting the stockholders.

    The Article was titled “The Dangers of Denial,” and I could not agree more. Eliminating the shareholder value maximization mandate (both at companies and at the portfolio level, where it is manifested through Modern Portfolio Theory) is on the critical path to saving the planet. Professor Stout’s The Shareholder Value Myth is perhaps the best explanation of why that is.) But hope is not a strategy, and we need to work to take steps to eliminate it, not pretend it doesn’t exist. Pressuring corporations to become benefit corporations, which do mandate stakeholder values, is a good start.

  • laura mezzanotte

    Only problem, by now, is to convince a bunch of greedy executives who have spoilt shareholders to take another road.
    History teaches us that very seldom the powerful give up power voluntarily.
    We must expect a violent backlash.

  • GaryReber

    A corporation can be a single person conducting business by selling products or services. Or a corporation can be an assemblage of two or more individuals conducting business by selling products or services. In both cases incorporation is a legal protection against personal liability and lawsuits.

    In both cases, the business of selling products and services is about earning income or profit, which is dependent on consumer wants, needs, and satisfaction with the product or service being sold. Without satisfaction, “customers with money” will not purchase or return purchasing the product or service, and thus there will be no sustainability, profit or growth.

    So there is a correlation between quality of product and service and profit (the difference between what it cost to produce a product or service and what the sales price is) to be earned. Investors are people who actually invest “past savings” into the money flow of a corporation, versus speculators who gamble by purchasing previously owned (secondhand) shares of a corporation’s stock, betting that the stock value will increase. Thus, while legally, no statutes require that companies be run to maximize profits or share prices, it is self-evident that business corporations, not non-profit corporations, are created to generate profits for their owners.

    In order to maximize profits for the owners of a business corporation operating in competitive national and local markets, as well as markets that stretch globally, our scientists, engineers, and executive managers and the work force under their direction, who are not owners themselves, except for those in the highest employed positions, are encouraged to work to destroy employment by making the owner(s) of the business more productive by substituting human labor with non-human means of production (called physical capital). How much employment can be destroyed by substituting machines for people is a measure of their success – always focused on producing at the lowest cost. Only the people who already own the business corporation(s) and the productive capital assets of the corporation(s) are the beneficiaries of their work, as they systematically concentrate more and more capital ownership in their stationary 1 percent ranks. Because capital ownership is extremely concentrated among less than 10 percent of the population with the vast majority fundamentally playing the role of industrial sharecroppers who work for somebody else and have no other source of income, extreme economic inequality has resulted. The problem is that the 5 percent are not the people who do the overwhelming consuming. The result is the consumer populous is increasingly not able to get the money to buy the products and services produced as a result of substituting machines for people. And yet you can’t have mass production without mass human consumption made possible by “customers with money.”

    Economic inequality will worsen if the system is not reformed. Solution have tended to focus on job creation in spite of the reality that full employment is not an objective of businesses. Companies strive to keep labor input and other costs at a minimum in order to maximize profits for the owners. They strive to minimize marginal costs, the cost of producing an additional unit of a good, product or service once a business has its fixed costs in place, in order to stay competitive with other companies racing to stay competitive through technological innovation. Reducing marginal costs enables businesses to increase profits, offer goods, products and services at a lower price (which people as consumers seek), or both. Increasingly, new technologies are enabling companies to achieve near-zero cost growth without having to hire people. Thus, private sector job creation in numbers that match the pool of people willing and able to work is constantly being eroded by physical productive capital’s ever increasing role.

    Thus, what this article does not address is the exponential disassociation of production and consumption that is the problem in the United States economy, and the reason that ordinary citizens must gain access to productive capital ownership to improve their economic well-being. Such access means that business corporations would become more democratic as they become broadly owned.

    And as the role of physical productive capital is to do ever more of the work, which produces wealth and thus income to those who own productive capital assets, it is critical that legislation is enacted to facilitate the broadening of capital ownership simultaneously with the growth of the economy.

    Because our financial institutions base business development and growth on the prerequisite of “past savings” whenever capital credit loans are approved for business investment in new viable productive capital formation projects, ONLY the wealthy capital ownership class has the required savings to pledge as security collateral in the event the investment does not generate its own earnings sufficient to repay the capital credit loan.

    The other form of finance is for business corporations to retain earnings from which to investment in new viable productive capital formation projects. Thus, retaining earnings means that the earnings are not fully paid out to the owners of the business corporation.

    Neither of the above financial mechanisms create any new capital asset owners.

    What can be done to broaden the ownership of productive capital simultaneously with the growth of the economy, without taking from those who already own?

    Starting with the business corporation, a legal entity created and sanctioned by state and federal government and judicial law, the government should provide tax incentives for full-dividend payouts to its stockholders, or alternatively dictate that from now on 100 percent of all profits be paid out fully as dividend payments to stockholders (thus, eliminating the corporate income tax), who would be subject to progressive individual taxation rates during the short term until a flat tax, after an exemption of $100,000 for a family of four to meet their ordinary living needs, can be instituted. This would effectively prohibit retained earnings financing of new productive capital formation (reinvesting the corporate earnings already earned). The government could also limit debt financing by imposing some ratio formula to annual revenue under which a corporation could debt finance new productive capital formation with borrowed monies. Both retained earnings and debt financing only enhance the ownership holding value of the existing corporate ownership class and do nothing to create new owners. Thus, the rich get richer systematically and capital ownership concentration is furthered, facilitated by financing further productive capital acquisition out of the earnings of existing productive capital (past savings).

    In place of retained earnings and debt financing, the government should require business corporations to issue and sell full-voting, full-dividend payout stock to more people to underwrite new productive capital formation, with the purpose of providing opportunity for new owners, both employees of corporations and non-employees, to participate in a growing economy by purchasing the newly issued stock using insured, interest-free “pure credit” repayable out of the full earnings generated by the earnings produced by the actual future capital assets. Of course, there needs to be a financial mechanism put in place that will guarantee loan risks; otherwise banks and lending institutions will not make the loans, and the system will continue to limit access to capital acquisition to those who already own capital — the rich. This is because “poor” people have no security or collateral, or sufficient income resulting in savings to pledge against the loan as security, and/or are disqualified on the grounds of either unproven unreliability or proven unreliability.

    Criteria must be created to qualify the corporations, both new start-ups and established ones, subject to this policy and those corporations that qualify overseen so as to insure that their executives exercise prudent fiduciary responsibility to generate loan payback. Once the guaranteed loans are paid back to the lending entity, the new capital formation will continue to produce income for existing and future owners.

    While tax and investment stimulus incentives (such as government contracts, grants and loans) are tools to strengthen economic growth, without the requirement that productive capital ownership is broadened simultaneously, the result will continue to further concentrate productive capital ownership among those who already own, and further create dependency on redistribution policies and programs to sustain purchasing power on the part of the 99 percent of the population who are dependent on their labor worker earnings or welfare to sustain their livelihood. By stimulating economic growth tied to broadened productive capital ownership the benefits are two-fold: one is that over time the 99 percenters will be enabled to acquire productive capital assets that are paid for out of the future earnings of the investments and gain greater access to job opportunities that a growth economy generates.

    Capital acquisition takes place on the logic of self-financing and asset-backed credit for productive uses. People invest in capital ownership on the basis that the investment will pay for itself. The basis for the commitment of loan guarantees is the fact that nobody who knows what he or she is doing buys a physical capital asset or an interest in one unless he or she is first assured, on the basis of the best advice one can get, that the asset in operation will pay for itself within a reasonable period of time — 5 to 7 or, in a worst case scenario, 10 years (given the current depressive state of the economy). And after it pays for itself within a reasonable capital cost recovery period, it is expected to go on producing income indefinitely with proper maintenance and with restoration in the technical sense through research and development.

    Still, there is at least a theoretical chance, and sometimes a very real chance, that the investment might not pay for itself, or it might not pay for itself in the projected time period. So, there is a business risk. This is why: using the example of Employee Stock Ownership Plan (ESOP) financing, the lender has no reason to loan to the ESOP trust unless it has two sources of repayment. In addition to determining that the investment is viable and that the business corporation is credit worthy and reliably expected to make loan repayments, there needs to be security against default. Thus, for the lender to make the loan the corporation must provide the security.

    Binary economist Louis Kelso was the architect and pioneer of the Employee Stock Ownership Plan, which Kelso invented to enable working people without savings to buy stock in their employer company and pay for it out of its future dividend yield — on the promise of the capital investment’s future income.

    The ESOP provides access by employees to capital credit to buy company stock and pay for it in pre-tax dollars out of what the assets underneath that stock yield. Bank loans are made to the ESOP trust that represents employees, instead of to the company (current owners). The trust gives the lender a note and with the borrowed monies makes the investment in the company stock. The company then issues stock to the ESOP trust. The company now has the money, which otherwise could have been borrowed directly without the ESOP (benefiting current owners), to make the planned investment and repay the loan from pre-tax forecasted future capital earnings. The company promises the bank to make pre-tax full-dividend payments to the ESOP trust to enable the trust to replay the lender. Assuming that it would take five years for that capital investment to pay for itself, at the end of five years the employees now own the full stock value in the expanded company.

    Companies can use the ESOP as the credit mechanism to create employee ownership in ratios up to a 100 percent leverage buyout. Nothing has been taken away from the existing owners. However, using the ESOP, the existing owners will surrender the exclusive right to acquire more ownership in the company and have a smaller percentage of ownership in the total company, but they have not been prevented from making a fair rate of return on their thus-far accumulated ownership shares because the company earns a rate of return throughout the process. After the loan has been paid off with pre-tax earnings, the employees will have more earnings from capital and they will have more consumer power to purchase products and services. Multiply this by tens of thousands of employee-owned companies and the economy revs up to grow dramatically.

    There are now over 11,000 profitable ESOP companies, of which 1,500 of those companies are worker majority owned, with workers paying for their stock shares out of future corporate profits, not by reducing their take-home labor worker incomes.

    ESOPs work as designed and optimized when the workers receive the full property rights as owners, including full voting rights, not simply treated as beneficial owners with power concentrated at the top of the company, without any accountability or transparency. Unfortunately, some ESOPs have been structured so that the rights, powers, and benefits of ownership remain concentrated in a small non-accountable elite controlling corporate and financial governance. When all of the employees are owners, dependent on their income from the company’s bottom line rather than through ordinary labor wages and benefits, the workers’ economic interests are more invested to see that their company succeeds. In this way, each person in the company is empowered as a labor worker and as a capital worker (owner) and inspired to work together as a team to make better operational decisions to serve and maximize value to their customers.

    Under our current financial system, the security (collateral) necessary to secure an ESOP loan must come from the company, and therein the current owners are providing the security to broaden employee capital ownership with the benefit that expanded capital ownership drives expanded consumer power to purchase products and services. (This is somewhat akin to Henry Ford’s policy to pay workers sufficient wages to enable them to purchase the automobiles they manufacture.)

    Under this scenario the company owners are “insuring” the risk without a benefit, which can be recompensated by paying the employees less labor wages, reduced pension benefits, and receiving government tax forgiveness benefits, which are written into the Internal Revenue Code.

    With the ESOP, employees can acquire capital ownership with the earnings of capital. ESOPs have thus far only provided part of the solution, and the stock acquisition is limited to the employer company and to those employed by a for-profit business corporation.

    Robert Ashford, Professor of Law at the Syracuse University College of Law (New York) and a former lawyer in Kelso’s San Francisco law firm, specializes in the teaching of binary economics. He has expanded the ESOP trust into what he terms the “Super ESOP,” which includes multiple company diversification facilitated with private capital credit insurance or a government reinsurance agency (ala the Federal Housing Administration concept). Under Ashford’s plan, the promissory note can be offset to the government’s central Federal Reserve Bank in return for the cash equivalent of the amount of the loan, less an administrative fee. The only cost to the direct lending bank in making a loan to the corporation would be the administrative fee, or about 2 percent of the loan’s principal and then another 2 percent for capital credit insurance, with an additional quarter of a percent paid to the Federal Reserve Bank to monetize the loan and give the lender the same cash as it would have had if it had actually loaned money to the corporation. The lender’s cash loaned to the ESOP trust is replenished with the Federal Reserve Bank cash. When the company pays the ESOP trust enough money to enable the trust to repay the lender, the lender has to retrieve the note and pay back the Federal Reserve Bank. Thus, the loan cost would be essentially not more than 5 percent to allow ownership broadening financial capital to be in­vested in ownership broadening ESOP trusts to create new capitalists. Thus, national capital credit insurance replaces the requirement for the current corporate owners to pledge security.

    And then there is the provision of the proposed Capital Homestead Act (aka Economic Democracy Act), which would empower EVERY citizen, regardless of being employed or not, to acquire through an annual Capital Homestead Account (CHA) ownership stakes in new productive capital formation investments, using insured capital credit loans, repayable out of the future earnings of the investments, without the requirement of past savings.

    CHAs, ESOPs and other Kelsonian plans avoid the gambling trade and Wall Street firms that play with your money. The CHA and ESOP circumvent that. In a single transaction, you finance tools for the employer and ownership for the employees through ESOPs and ownership for EVERY citizen through CHAs. The pre-tax yield of corporate assets of prosperous companies varies from 25 to 60 percent. The yield on secondhand securities is around five or six percent. Sure, as Kelso has stated, “with capital gains, you can get a little more, but don’t forget, that’s a zero-sum game; for every gainer, there’s a loser. Wall Street doesn’t fly any airplanes or raise any corn or do anything else in the way of producing products and services. It just plays games with your dough. And when you take it out in pensions, you’re going to get less than the company put in for you. You have to; that’s the dynamics of it.”

    To learn more on how to democratize business corporation and broaden the ownership of future wealth-creating, income-producing capital formation projects see the following:

    Monetary Justice at

    The Capital Homestead Act (aka Economic Democracy Act) at,, and