Fishing with dynamite

Whom do CEOs and boards work for? Today’s answer is a given: the shareholder. Their purpose: to maximize shareholder value. Right? Wrong. Here, a leading U.S. lawyer and professor argues that shareholder value thinking is a myth that fuels short-term thinking and hurts companies, communities and investors
By Lynn Stout

Plumes of smoke in Gulf of Mexico from Deepwater Horizon oil spill

The Deepwater Horizon was an oil drilling rig, a massive floating structure that cost more than a third of a billion dollars to build and measured the length of a football field from bottom to top. On the night of April 20, 2010, the Deepwater Horizon was working in the Gulf of Mexico, finishing an exploratory well named Macondo for the corporation BP. Suddenly the rig was rocked by a loud explosion. With minutes the Deepwater Horizon was transformed into a column of fire that burned for nearly two days before collapsing into the depths of the Gulf of Mexico. Meanwhile, the Macondo well had begun vomiting tens of thousands of barrels of oil daily from beneath the sea floor into the Gulf waters. By the time it was capped that September, the blowout was estimated to have caused the largest offshore oil spill in history.

The Deepwater Horizon disaster was tragedy on an epic scale, not only for the rig and the 11 people who died on it, but also for the corporation BP. By June of 2010, BP had suspended paying its regular dividends and BP common stock (trading around $60 before the spill) had plunged to less than $30 per share. The result was a decline in BP’s total stock market value amounting to nearly $100 billion. BP’s shareholders were not the only ones to suffer. The value of BP bonds tanked as BP’s credit rating was cut from a prestigious AA to the near-junk status BBB. Other oil companies working in the Gulf were idled, along with BP, due to a government-imposed moratorium on further deepwater drilling in the Gulf. Business owners and workers in the Gulf fishing and tourism industries struggled to make a living. Finally, the Gulf ecosystem itself suffered enormous damage, the full extent of which remains unknown today.

After months of investigation, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling concluded the Macondo blowout could be traced to multiple decisions by BP employees and contractors to ignore standard safety procedures in the attempt to cut costs. (At the time of the blowout, the Macondo project was more than a month behind schedule and almost $60 million over budget, with each day of delay costing an estimated $1 million.) In trying to save $1 million a day by skimping on safety procedures at the Macondo well, BP cost its shareholders alone a hundred thousand times more, nearly $100 billion.

Why would a sophisticated international corporation make such an enormous and costly mistake? I would argue that the Deepwater Horizon disaster is only one example of a larger problem that afflicts many public corporations today. That problem might be called shareholder value thinking. According to the doctrine of shareholder value, public corporations “belong” to their shareholders and they exist for one purpose only, to maximize shareholders’ wealth. Shareholder wealth, in turn, is typically measured by share price—meaning share price today, not share price next year or next decade.

Shareholder value thinking is endemic in the business world today. Fifty years ago, if you had asked the directors or CEO of a large public company what that company’s purpose was, you might have been told the corporation had many purposes: to provide equity investors with solid returns, but also to build great products, to provide decent livelihoods for employees and to contribute to the community and the nation. Today, you are likely to be told the company has but one purpose, to maximize its shareholders’ wealth. This sort of thinking drives directors and executives to run public firms like BP with a relentless focus on raising stock price. In the quest to “unlock shareholder value” they sell key assets, fire loyal employees and ruthlessly squeeze the workforce that remains; cut back on product support, customer assistance, and research and development; delay replacing worn, outmoded and unsafe equipment; shower CEOs with stock options and expensive pay packages to “incentivize” them; drain cash reserves to pay large dividends and repurchase shares, leveraging firms until they teeter on the brink of insolvency; and lobby regulators and Congress to change the law so they can chase short-term profits speculating in credit default swaps and other high-risk financial derivatives. They do these things even though many individual directors and executives feel uneasy about such strategies, intuiting that a single-minded focus on share price many not serve the interests of society, the company or shareholders themselves.

Any challenge to the doctrine of shareholder value must start by underscoring that shareholder value ideology is just that—an ideology, not a legal requirement or practical necessity of modern business life. United States corporate law does not, and never has, required directors of public corporations to maximize either share price or shareholder wealth. To the contrary, as long as boards do not use their power to enrich themselves, the law gives them a wide range of discretion to run public corporations with other goals in mind, including growing the firm, creating quality products, protecting employees and serving the public interest. Chasing shareholder value is a managerial choice, not a legal requirement.

Nevertheless, in the last 20 years, the idea that corporations should serve only shareholder wealth as reflected in stock price has come to dominate other theories of corporate purpose. Executives, journalists and business school professors alike now embrace the need to maximize shareholder value with near-religious, unquestioning fervour. Legal scholars argue that corporate managers ought to focus only on maximizing the shareholders’ interest in the firm, an approach they somewhat misleading called “shareholder primacy.” (“Shareholder absolutism” or “shareholder dictatorship” would be more accurate.)

Today, questions seem called for. It should be apparent to anyone who reads the newspapers that Corporate America’s mass embrace of shareholder value thinking has not translated into better corporate or economic performance. The past dozen years have seen a daisy chain of costly corporate disasters. Stock market returns have been miserable, raising the question of how aging baby boomers that trusted in stocks for their retirement will be able to support themselves in their golden years. The population of publicly held U.S. companies is shrinking rapidly as former public companies like Dunkin’ Donuts and Toys “R” Us “go private” to escape the pressures of shareholder primacy thinking, and new enterprises decide not to sell shares to outside investors at all.

Even former champions of shareholder primacy are beginning to rethink the wisdom of chasing shareholder value. Iconic CEO Jack Welch, who ran GE with an iron fist from 1981 until his retirement in 2001, was one of the earliest, most vocal and most influential adopters of the shareholder value mantra. But several years after retiring from GE with more than $700 million in estimated personal wealth, Welch observed in a Financial Times interview about the 2008 financial crisis that “strictly speaking, shareholder value is the dumbest idea in the world.”

One does not need to embrace either a stakeholder-oriented model of the firm, or a form of corporate social responsibility theory, to conclude that shareholder value thinking is destructive. The gap between shareholder-primacy ideology as it is practiced today, and stakeholders’ and the public interest, is not only vast but much wider than it either must or should be. If we stop to examine the reality of who “the shareholder” really is—not an abstract creature obsessed with the single goal of raising the share price of a single firm today, but real human beings with the capacity to think for the future and to make binding commitments, with a wide range of investments and interests beyond the shares they happen to hold in any single firm, and with consciences that make most of them concerned, at least a bit, about the fates of others, future generations, and the planet—it soon becomes apparent that conventional shareholder primacy harms not only stakeholders and the public, but most shareholders as well. If we really want corporations to serve the interests of the diverse human beings who ultimately own their shares either directly or through institutions like pension funds and mutual funds, we need to seriously reexamine our ideas about who shareholders are and what they truly value.

OF ALL THE POSSIBLE problems posed when corporations adopt “maximize shareholder value” as their goal, one in particular has captured the attention of the business community. This is the fear that companies whose directors focus on stock price will run firms in ways that raise that price in the short term, but harm firms’ long-term prospects. For example, a company might seek to raise accounting profits by eliminating research and development expenses, or cutting back on customer relations and support in ways that eventually erode consumer trust and brand loyalty. The result is a kind of corporate myopia that reduces long-term returns from stock ownership.

There was a time when people believed share prices always accurately reflect a company’s true value—and so it would be impossible for managers to adopt strategies that harmed the firm’s future without producing an immediate decline in share price. Today, that idea is, if not dead, then at least seriously wounded. But substantial support remains for the claim that—barring unusual circumstances and occasional fits of collective investor irrationality—over the long run, stock prices tend to be reasonably related to actual values. In the words of famed finance professor Fischer Black, many experts might argue that the market is efficient in the sense that “price is within a factor of [two] of value, i.e., the price is more than half of value and less than twice value.”

For many shareholder primacy enthusiasts, this is good enough. They argue that shareholders still benefit when managers look to share price as their guiding star, because even if the market temporarily misvalues companies, mistakes correct themselves over time. Thus, shareholders themselves have reason to try to prevent managerial myopia: they understand that pressuring managers to raise share price through strategies that harm the company’s future will likely end up hurting the value of their own shares.

This view ignores an inconvenient reality. Long-term shareholders fear corporate myopia. Short-term shareholders embrace it—and many powerful shareholders today are short-term shareholders.

To understand just how hyperactive today’s stock markets have become, consider that in 1960, annual share turnover for firms listed on the New York Stock Exchange was only 12%, implying an average holding period of about eight years. By 1987, this figure had risen to 73%. By 2010, the average annual turnover for equities listed on U.S. exchanges reached an astonishing 300% annually, implying an average holding period of only four months.

This is a very odd phenomenon. At the end of the day, most stocks are held either by individuals with long-term investing goals (like saving for retirement or for a child’s college education), or by institutions like pension funds and mutual funds that run portfolios on behalf of these individuals. Even hedge fund clients are typically pension funds, universities, and foundations looking for steady, long-run returns on their endowments.

If most investors want long-term results for themselves or for their clients, why is there so much more short-term trading? Part of the answer lies in the fact that deregulation and advances in information technology have made stock trading much cheaper and faster than it used to be. Once upon a time, high transactions costs discouraged hyperactive trading. Now trading has become so inexpensive that some funds specialize in computerized “flash trading” strategies in which shares are bought and held for mere seconds before being sold again.

Another very important part of the short-term equation is the growing role that institutional investors like mutual funds, pension funds and hedge funds play in the market. As already noted, such funds mostly invest on behalf of individuals with long-term goals. Unfortunately, these individual clients tend to judge the fund managers to whom they have outsourced their investing decisions based on their most recent investing records. This explains why many actively managed mutual funds turn over 100% or more of their equity portfolios annually and why “activist” hedge funds that purport to make long-term investments in improving corporate performance typically hold shares for less than two years. The mutual fund manager whose continued employment depends on her relative performance for the next four quarters finds it hard to resist the temptation to support management strategies that will raise share price just long enough that she can sell and move on to the next stock that might see a short-term bump in its price.

The result is that mutual funds and hedge funds pressure directors and executives to pursue myopic business strategies that don’t add lasting value. For example, the information arbitrage literature suggests that when information is public but not widely available, or is technical and difficult to understand, it filters into market prices relatively slowly. Thus cutting expenses by firing employees or reducing customer support may produce a short-term bump in stock price because the market understands immediately that corporate expenses have been reduced but is slow to see the negative long-term impact of employee disaffection or weakening brand loyalty.

There are also a number of “financial engineering” tricks that short-term investors can push corporate managers to adopt to raise share price without improving long-term performance. For example, practical and legal limits on short selling ensure that the shares of any particular company are typically held, and market price set by, investors who are relatively optimistic about that company’s future. By making a large share repurchase on the open market, the company can shrink its pool of shareholders until price is set only by the wildly optimistic. For similar reasons, a sale of the entire company—which typically requires a buyer to purchase shares not only from the relative realists in the shareholder pool but from the more-optimistic as well—usually demands that the bidder pay a substantial premium over market price. As yet another example, splitting up companies by selling off assets or divisions can create “shareholder value” by allowing different investors to invest only in the particular line of business they favour most.

Once we recognize that stock markets are not perfectly fundamental value efficient and that managers can raise share price without improving real economic performance, we also have to recognize that shareholders with different investing time horizons have conflicting interests. The shareholder who plans to hold her stock for many years wants the company to invest in its employees’ skills, develop new products, build good working relationships with suppliers and take care of customers to build consumer trust and brand loyalty—even if the value of these investments in the future is not immediately reflected in share price. The short-term investor who expects to hold for only a few months or days wants to raise share price today, and favours strategies like cutting expenses, using cash reserves to repurchase shares and selling assets or even the entire company.

This poses a dilemma for the standard shareholder-oriented model. Toward which shareholders is it oriented? If stock prices do not always capture fundamental value, a conflict of interest exists between long-term investors who want directors to invest in the company’s future and short-term investors, especially activist hedge funds, who simply want to raise share price today. In the words of corporate lawyer Martin Lipton, directors must decide “whether the long-term interests of the nation’s corporate system and economy should be jeopardized in order to benefit speculators interested not in the vitality and continued existence of the business enterprises in which they have bought shares, but only in a quick profit on the sale of those shares?”

Lipton’s language makes it clear he’s on the side of the long-term investors, not the short-term speculators. While I share his view, the most important thing is to recognize that long-term investors and short-term activist hedge funds do not compete on a level playing field. Activist hedge funds have a clear advantage, because they concentrate their investment portfolios into just a few securities. This means it is worth their while to spend the time and effort necessary to become involved in a particular firm’s affairs. Diversified retail investors, by contrast, rarely have a big enough stake in any single company to make it sensible to closely monitor what’s going on; they suffer from their own rational apathy. Mutual funds are not much better. Managers mostly vote the shares they hold as directed by RiskMetrics Institutional Shareholder Services (ISS), a proxy advisory service whose ideas about good corporate governance can be criticized for focusing on short-term stock price performance. The end result is that the only shareholders that are likely to engage in any serious way with incumbent management are hedge funds and ISS-shepherded mutual funds, both of which are biased toward the short term.

Finally, in his book Fixing the Game, Rotman School of Management dean Roger Martin has pointed out yet another reason why measuring corporate success by stock price ends up harming long-term shareholders: because it drives directors and executives to focus not on real corporate performance but on what Martin dubs “the expectations market,” wherein “the consensus view of all investors and potential investors as to the expectations of future performance shapes the stock price of a company.”

According to Martin, using the expectations market to gauge performance—especially when this is done by compensating CEOs and other executives primarily with options, stock grants or bonuses tied to share price—puts executives in a terrible bind. Suppose a company is doing well; the firm is operating at peak performance and looks as if it can hum along at peak performance indefinitely. The stock market will incorporate this expectation of optimal future performance into today’s stock price. How then can a CEO raise stock prices any further? Focusing on shareholder value, Martin says, gives managers “a task that is ultimately unachievable, in that it requires that they raise other people’s expectations continuously and forever.”

What’s a CEO to do? If she is a mere mortal, she may decide not to attempt the unachievable but instead to do the achievable: manage expectations, for example by using accounting manipulations (“earnings management”) to produce one disastrous quarter that dramatically lowers and resets the market’s expectations, so she can raise expectations again thereafter. Alternatively, she may elect to avoid the slow, hard, thankless task of developing new products, hiring new employees and increasing sales and profits, and focus instead on cost-cutting or financial engineering (selling off assets, making massive share repurchases) that temporarily raises stock prices without adding real long-term value.

Stock-based compensation schemes thus create an unhealthy alliance between short-term institutional investors who move in and out of stocks, and executives whose compensation plans drive them to focus obsessively on stock market expectations.

This situation wouldn’t be a problem if it allowed executives and short-term speculators to profit without harming anyone else. Unfortunately, long-term investors have to eat the short-termers’ cooking. There are signs the meal is not sitting well. The SEC does not require unregulated hedge funds to publicly disclose their results, so it can be hard to find solid data on hedge fund performance, but there is some evidence activist hedge funds in particular outperform the market. And there is little doubt that stock-based compensation schemes have made executives much wealthier over the past two decades. Meanwhile, average investors’ returns have languished. Even as a laser-like focus on “unlocking shareholder value” has enriched executives and some hedge fund managers, it has done little or nothing to help shareholders as a class.

When long-term and short-term investors’ interests diverge, shareholder value thinking poses the same risks as fishing with dynamite. Some individuals may reap immediate and dramatic returns. But over time and as a whole, investors and the economy lose.

This article is adapted from The Shareholder Value Myth: How putting shareholders first harms investors, corporations and the public, by Lynn Stout, the Marc and Beth Goldberg Distinguished Visiting Professor of Law at Cornell Law School and the Paul Hastings Distinguished Professor of Corporate and Securities Law at the UCLA School of Law. Published by Berrett-Koehler Publishers, San Francisco, May 2012.

Photo: Lee Celano/Reuters

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