Toppling the Idol of 'Shareholder Value'
"Maximizing shareholder value" is one of those concepts that falls under the adage, "Be careful what you wish for." I know this because, a long time ago, I was one of those wishing for it.
It seemed like such a good idea at the time, back in the late 1970s and 1980s. For too long, the compensation of top executives was disconnected from any performance criteria, including whether they made money for shareholders. CEOs did pretty much whatever they wanted, with no fear of consequences. Thus, companies that needed to slim down, wouldn't. Companies that needed to deploy capital more intelligently, didn't. Executives who should have been fired, weren't.
Back then, I was hanging around with T. Boone Pickens, the famous "corporate raider" and one of the first to espouse the primacy of the shareholder. His refrain was that shareholders were the real owners of companies, and that corporate executives worked for the shareholders. It was a novel idea then, and in time it spread well beyond takeover artists to academics, Wall Street types and finally corporate executives, especially once they discovered that hitching their pay to the stock price could make them rich. "Corporate raiders" became "shareholder activists."
The shareholder-value movement did some good, especially in those early years. It became de rigeur for boards to create performance criteria that executives had to meet to get bonuses and stock options. And it was a means of imposing discipline.
But the pendulum has swung too far, and today the ethos embodied by the phrase "maximizing shareholder value" does more harm than good. It has widened income inequality. It has rewarded short-term "make-the-quarter" thinking over long-term value creation. It is the reason companies take on too much debt and perform feats of useless — but stock-price enhancing — financial engineering. It explains why so few companies subsidize the local symphony or art museum anymore. It is why drug prices have risen so obscenely, why airlines have made flying such a miserable experience and why wages have remained stagnant even as profits have soared. When shareholders matter more than employees or customers or communities, some people do very well, but the purpose of a corporation becomes warped and society loses.
What prompts these thoughts are two articles I saw late last week. The first was a story on BuzzFeed that crystallized for me just how far astray the "shareholder value" craze has led us. It concerned the decision by American Airlines to give its workers raises worth about $1 billion over three years, even though its labor contracts weren't up for another two years. Chief executive Doug Parker explained that the raises would lead to better service and hence higher revenue. In other words, he made the kind of decision that might hurt in the short term but was likely to have long-term benefits.
How did Wall Street react? With fury. The stock was pummeled. One analyst, Kevin Crissey of Citigroup, complained to his clients: "This is frustrating. Labor is being paid first again. Shareholders get leftovers." One would be hard-pressed to find a better example of how "maximizing shareholder value" can blind people to more important goals and values.
The second article is in in the latest issue of Harvard Business Review. Entitled "The Error at the Heart of Corporate Leadership," and written by two Harvard Business School professors, it is nothing less than an all-out assault on the primacy of shareholder value. (Academia calls it "the agency model.") The "agency model," write Lynn Paine and Joseph Bower, can warp "corporate strategy and resource allocation" — and potentially damage the larger economy. They go on to say:
The agency model's extreme version of shareholder centricity is flawed in its assumptions, confused as a matter of law, and damaging in practice. A better model would recognize the critical role of shareholders but also take seriously the idea that corporations are independent entities serving multiple purposes and endowed by law with the potential to endure over time. And it would acknowledge accepted legal principles holding that directors and managers have duties to the corporation as well as to shareholders. In other words, a better model would be more company centered.
Then they proceed to pick apart the various rationales for "shareholder value." Many board members think they have no choice but to find ways to maximize it — especially when an activist comes calling — because they are legally bound to do so. Not so, say Paine and Bower; under the law, directors are fiduciaries for the corporation, not agents for the shareholders, and they have every right to make decisions that take into account a company's other constituents.
They write that a shareholder-centric model is "rife with moral hazard" because "shareholders are not accountable as owners for the company's activities, nor do they have the responsibilities that officers and directors do to protect the company's interests." And shareholders "do not all have the same objectives and cannot be treated as a single 'owner.'"
As for "value creation," Paine and Bower are brutal in their appraisal:
It is important to note that much of what activists call value creation is more accurately described as value transfer. When cash is paid out to shareholders rather than used to fund research, launch new ventures, or grow existing businesses, value has not been created. Nothing has been created. Rather, cash that would have been invested to generate future returns is simply being paid out to current shareholders. The lag time between when such decisions are taken and when their effect on earnings is evident exceeds the time frames of standard financial models, so the potential for damage to the company and future shareholders, not to mention society more broadly, can easily go unnoticed.
When I spoke to Adi Ignatius, the editor of the Harvard Business Review, about what wanted the article to accomplish, he said that he hoped it would spark a rethinking of shareholder-value dogma. So far, it seems to be getting a fair amount of attention. Bower said that he has gotten positive reactions from a number of chief executives. Martin Lipton, the corporate lawyer who has railed against the shareholder-value creed for decades, called it a "brilliant, must-read article" in a note to clients. It's been picked up by Alan Murray at Fortune and Steve Denning at Forbes.
But it's one thing to show the failings of the shareholder-value model, and another to come up with ways to fix the problem. One reason the doctrine was so appealing is that it offered a simple way to quantify a chief executive's performance. We certainly don't want to go back to the days when there were no performance metrics and potentate CEOs weren't answerable to anyone.
Paine and Bower suggest a more company-centric model in which shareholders are an important constituency but not the only one. Their plan is pretty vague — they forthrightly acknowledge that their model "has yet to be fully developed" — and it's a little hard to envision how it would work in practice. In another article on the Harvard Business Review website, Roger Martin of the University of Toronto's Rotman School of Management — and a long-time critic of "short-termism" — proposes that a shareholder's voting rights be increased according to how long he or she has owned the stock. That has promise, but I doubt it would fix things entirely.
The essential problem with the over-reliance on shareholder value as the only metric of success is that it creates the wrong incentives. Although the backlash against it is gaining momentum, nothing will change until its critics find new and better incentives. That's the next step. It can't come soon enough.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story:
Joe Nocera at firstname.lastname@example.org
To contact the editor responsible for this story:
Jonathan Landman at email@example.com