How Putting Shareholders First Harms Investors, Corporations, and the Public

The evolution, ecology, and nature of firms

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By David Sloan Wilson and Lynn Stout

A bedrock assumption of economics is that firms become well adapted by competing against each other. If so, then consider a study that I reported upon earlier, which monitored the survival of 136 firms starting from the time they initiated their public offering on the US Stock Market. Five years later, the survivors—by a wide margin—were the firms that did best by their employees.

If only the fittest firms survive, then doing well by employees would have become the prevailing business practice a long time ago. That hasn’t happened, so something is wrong with the simple idea that best business practices evolve by between-firm selection. That “something” is multilevel selection, which is well known to evolutionary biologists and needs to become better known among economists and the business community.

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Multilevel selection theory is based on the fact that competition can take place at all levels of a multi-tier hierarchy of units—not only among firms, but also among individuals and subunits within firms. The practices that evolve (culturally in addition to genetically) by lower-level selection are often cancerous for the welfare of the higher-level unit. By the same token, if selection did operate exclusively at the level of firms, then the outcome would often be cancerous for the multi-firm economy. When it comes to the cancerous effects of lower-level selection, there is no invisible hand to save the day.

The kind of firm selection imagined by economists, along with the invisible hand assumption that lower-level selection is robustly beneficial for the higher-level common good, would be called “naïve group selectionism” by evolutionary biologists. Its biological counterpart was roundly criticized during the 1960’s and has had a half century to mature. Modern multilevel selection theory is not naïve and has much to teach the economics profession and business community.

stout_cornllThat is the topic of my interview with Lynn Stout, who knows a thing or two about firms. She is Distinguished Professor of Corporate and Business Law at the Cornell Law School and author of Cultivating Conscience: How Good Laws Make Good People and The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.

DSW: Hello, Lynn, and welcome to, which has already featured your work.

LS: Thank you for inviting me to have a conversation. I think the evolutionary approach offers a lot of insights into the workings of corporations.

DSW: Let me begin by making sure that I haven’t constructed a straw man. Am I correct that between-firm selection is a bedrock assumption of economics? I have in mind Milton Freeman’s classic 1953 essay in which he invokes between-firm selection to explain why people behave as if the assumptions of neoclassical economics are true (go here for more).

LS: It’s a pretty fair claim. Although a lot of people never make the assumption explicit, the bedrock of many debates in corporate governance today is the often unspoken-belief that corporations have to maximize profits and “shareholder value” in order to survive, and the companies that sometimes sacrifice these goals in order to take care of their employees, suppliers, customers or communities are at a disadvantage and will be selected out.

DSW: Right! From your own perspective, why are these beliefs a “myth” as you put it in the title of your most recent book?

LS: Corporations are complex systems that bring together intellectual capital, physical capital, the human capital of employees and executives, and financial capital from equity and debt investors. These different elements work together over time to produce a number of important social benefits, including not only dividends and share price appreciation for stockholders, but also interest payments to bondholders, salaries for employees and executives, useful goods and services for consumers, tax revenues for taxing governments, and technological innovations for future generations. The shareholding system (that is, the system within the corporation by which shareholders contribute financial capital on the rare occasions when companies issue stock) is only one of the important subsystems that corporations need to function. Unfortunately, the modern cult of “shareholder value” privileges the interests of the shareholding subsystem over the interests of the corporate entity as a whole. The result has been an obsessive focus on raising share price in many public companies that may be threatening their ability to survive. If you look back at the last quarter-century, with the rise shareholder value ideology –now hardwired into a number of federal securities regulations and tax code rules –you will also see declining numbers of public companies, dramatically reduced corporate life expectancy, and reduced long-term returns for shareholders themselves.

DSW: OK, that’s a cancerous social process if ever there was one! Why isn’t it easily diagnosed as life threatening for the body politic? The power of narrative to trump reality and elites benefitting at the expense of the common good are two reasons that spring to mind, but I am eager to hear your diagnosis.

LS: You’ve identified the combination of factors that has made shareholder value thinking so influential. Talking about corporations as if they are owned by shareholders is a very simple, reductionist story that makes life easy for professors and journalists who are either unaware of, or don’t want to go into, the essential but messy legal details of what corporate legal personality really means. And unfortunately, this reductionist narrative has proven extremely useful for short-term investors who use it as a basis for claiming managers should “unlock shareholder value.” They’ve even been able to push through federal rule changes, like tax code rules that pressure companies into tying executive pay to shareholder returns, that drive companies to focus even more on short term results for shareholders.

DSW: Biology offers the example of cancer, which eats multi-cellular organisms from within. In addition, even when multi-cellular organisms are cancer-free, they often interact with each other in ways that are highly dysfunctional at the level of single-species social groups and multi-species ecosystems. Special conditions are required for higher-level units to function as “super-organisms”. During our get-together, you told me about some business practices that are highly predatory and no more desirable for an economic ecosystem than the crown of thorns starfish destroying coral reef ecosystems. Could you elaborate on that here?

LS: There’s no better example of corporate predators than activist hedge funds. These are investment funds catering to wealthy individuals and institutions that typically target companies, take a modest stock position, then use the threat of an embarrassing proxy contest to pressure managers into “unlocking value” by selling assets, taking on leverage, or cutting accounting costs like payroll and R&D to make the company looked more profitable. These strategies have a good chance of raising the share price in the short term, which is all the activists care about as they’re planning to sell as soon as the price rises. Unfortunately, this kind of “financial engineering” often ends up harming companies in the long run, along with their employees, customers, and remaining investors. The predatory nature of activist funds is well captured in the slang business term for a group of hedge funds working together to target a company: a “wolf pack.”

If activists targeted only weaker companies, it could be argued that they play a useful role in the corporate ecosystem. Unfortunately, shareholder activism creates a destructive feedback loop. As activists earn profits from damaging companies, they become wealthier, allowing them to target more companies, become still wealthier, and so forth. Of course eventually they will run out of companies to target. We’ve already seen the population of U.S. public companies drop by 50%, as new corporations avoid activists by remaining privately held and declining to go public in the first place. But when corporations stay private, the wealth generated by corporate production remains concentrated in the hands of the very wealthy. Meanwhile, the ongoing destruction of U.S. public companies produces negative consequences for employees, customers, long-term investors, and the nation.

DSW: Wow. Companies staying private to avoid getting attacked by hedge fund wolf packs is so similar to biological examples of prey remaining in refuges to avoid getting attacked by predators, even though they would do much better leaving their refuges in the absence of the predators. I’m also reminded of the predatory nature of high frequency trading, as recounted by Michael Lewis in his book Flash Boys, which I interpret from a game theoretic perspective here. Here is how Lewis describes the emotionally numb view of one of the book’s characters, Don Bollerman:

Don wasn’t shocked or even all that disturbed by what had happened, or, if he was, he disguised his feelings. The facts of Wall Street life were inherently brutal, in his view. There was nothing he couldn’t imagine someone on Wall Street doing. He was fully aware that the high-frequency traders were preying on investors, and that the exchanges and brokers were being paid to help them to do it. He refused to feel morally outraged or self-righteous about any of it. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ “ he said.   “We have a boom in carcasses on the savannah.  So what? It’s not their fault. The opportunity is there.”  To Don’s way of thinking, you were never going to change human nature—though you might alter the environment in which it expressed itself.

The more I learn about theories of economics and business, the more I realize how far they lag behind theories of evolution, ecology, and behavior, which are my home disciplines. The idea that ecosystems achieve some sort of benign balance by themselves, which is best left undisturbed by human intervention, no longer has any basis in theory [go here for more]. Special conditions are required for multi-agent systems to function well as systems. Multi-level selection theory begins to spell out the conditions for both natural and human systems (e.g., here and here). From your own legal perspective, what is required for multi-agent corporate ecosystems to function well as systems?

LS. The first and absolutely necessary step is to recognize that the business sector is indeed a system. If we want it to work well, we need to treat it as such. That includes looking out for potential problems like decreasing diversity, lack of resilience, runaway feedback loops, and so forth. Ironically, one of the most dangerous feedback loops is the ability of wealthy individuals and institutions to buy the legislation and regulation they want through campaign contributions and lobbying. Left to its own devices, the business sector is pretty good at finding efficient and stable solutions–as long as the law doesn’t get in the way too much.

DSW: What is the role of the government in regulating corporate ecosystems? Is it possible for corporations to regulate themselves and are there any examples?

LS. Business corporations need governments to provide and enforce basic rules against theft, fraud, and obvious market failures like monopolies and pollution. Beyond that, government tinkering often does more harm than good, as our current campaign finance system allows powerful interests to hijack regulation and bend it in their favor. For example, if we’re worried about pollution and climate change, a simple carbon tax is a great solution compared to attempts to micromanage through investment tax credits, carbon markets, performance standards, and so forth. Similarly, back in the days when corporate law was mostly state law and mostly “enabling,” meaning business people could choose their own firm structures and objectives, US corporations were more resilient and profitable, and did a better job for their employees and other stakeholders, than today. Tinkering with the business sector raises many of the same problems as tinkering with an ecological system; you never know what the unintended consequences of your actions are going to be.

DSW: That’s the challenge of managing complex systems. Central planning won’t work. Lack of regulations won’t work. Something in between is required, which David Colander and Roland Kupers call “Activist Laissez-faire”. Thanks very much for your insights!

2016 May 19

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