How CEOs Became Beholden to Shareholders

1970 Milton Friedman’s essay “A Friedman Doctrine—The Social Responsibility of Business Is to Increase Its Profits” appears in the New York Times Magazine.

When Jack Welch came out in 2009 against the concept that the purpose of a corporation is to maximize value for shareholders, it was like the pope attacking Catholicism or Tiger Woods dissing golf. “On the face of it, shareholder value is the dumbest idea in the world,” the former chief executive officer of General Electric told the Financial Times. “It is a dumb idea. The idea that shareholder value is a strategy is insane.”

No CEO was more linked to the shareholder value concept than Welch in his years as chairman and CEO of GE from 1981 through 2001. GE kept its profits on a miraculously even upward trajectory for years. One common technique was to neutralize a big one-time gain that would cause a spike in earnings by arranging to take a one-time loss of about the same size in another business. That didn’t serve any business purpose but did impress Wall Street analysts. All the while, Welch closed down businesses, moved factories abroad, and shifted attention to the money-intensive, worker-light GE Capital operation. His nickname was “Neutron Jack” after neutron weapons, which supposedly killed people while leaving buildings intact.

Applied correctly, shareholder value theory is neither dumb nor insane. American accounting theorists Charles Sprague in 1907 and Henry Hatfield in 1909 developed the idea that a company’s books should be prepared from the perspective of the “proprietors,” which to them included shareholders of corporations. In a 1970 essay for the New York Times Magazine, Milton Friedman, the U.S.’s most famous free-market economist, argued that “the social responsibility of business is to increase its profits.” In 1983 economists Eugene Fama and Michael Jensen wrote about how to make sure that corporate managers act in the best interests of the owners—that is, shareholders.

The idea works fine as long as the shareholders are assumed to be enlightened people who care about long-term returns and (maybe even) good citizenship. It doesn’t work when maximizing shareholder value is taken to mean moving heaven and earth, Jack Welch-style, to beat quarterly earnings estimates.

In any case, shareholder value has lost its cachet in the 21st century. The new buzz phrases are corporate social responsibility, triple-bottom-line accounting, and stakeholder value, all of which make explicit the common-sense notion that companies have a higher purpose than making the numbers.

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