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Lynn Stout's 'The Shareholder Value Myth'

by Robert Teitelman | Published June 29, 2012 at 10:43 AM

'The Shareholder Value Myth'
by Lynn Stout

About halfway through her new book, "The Shareholder Value Myth," Cornell law professor Lynn Stout unleashes Thomas Kuhn and his concept of paradigm shifts. Stout's goal in this short but effective polemic is to shred the theoretical, empirical and ideological arguments that have, over the last half century, made what she calls "shareholder primacy" and what's popularly known as shareholder value the dominant and animating idea in corporate governance. Thus she enlists Kuhn, and his ideas about how scientific paradigms emerge, grow dominant, then resist competitive ideas. Embedded within this scheme is the notion that powerful paradigms actually shape perceptions, resisting anything that might threaten them, until the contrarian evidence grows overwhelming. Kuhn's paradigms, alas, have become a wildly overused metaphor (like revolution, transformation, reinvention or, for that matter, Darwinian) that are bandied about any time someone wants to discuss change of any kind. In this case Stout may be justified in drafting Kuhn. Anyone who has thought about corporate governance over the last 15 years, as shareholder primacy attained its apotheosis in a set of "normative" ideas and institutions -- the term comes from Harvard law professor Reinier Kraakman and his NYU colleague Henry Hansmann's 2000 paper, "The End of History for Corporate Law," and reflects a sort of self-justifying consensus (I wrote about the paper here, and Stout cites it a number of times) -- knows exactly how Quixotic it is to even question the governance paradigm. The normative consensus is stifling; there is no "acceptable" alternatives except a derided past; and contrarian facts are continually explained away by demands for greater shareholder powers. Meanwhile, the evidence piles up: the dot-com bust, the corporate scandals, the financial crisis, the woes of public markets, not to say the complexities of shareholders and their interests. To use an even creakier cliché, it became more and more clear that the emperor has no clothes.

For many, particularly in corporate life, Stout's thin book (the text is a mere 115 pages) may prove unsettling. I recently heard Stout discuss the thesis on a New York City radio interview. The interviewer simply couldn't get his mind around Stout's claim that shareholders aren't really "owners" and that the bogeyman of corporate life was not necessarily entrenched and overpaid managers. Stout was persuasive, but it was hard going. In fact, Stout does not plow any particular new ground here, but she does assemble the anti-shareholder critique with great clarity. This book will not be a bestseller. It's been published by a less-than-powerhouse publisher, Berrett-Koehler, in paperback only (there's a digital version too), and let's face it, this is governance we're talking about. Still, she is performing a valuable service. The book assembles, orders and links the various arguments against the shareholder-primacy model in an accessible way. She provides accepted talking points for shareholder value's critics, many of whom have been outliers over the years. This is an interesting crowd. For example, the list of blurbs praising the book, dominated by business school professors and corporate lawyers, includes Wachtell Lipton's Marty Lipton (no big surprise), but Weill's Ira Millstein (a bit more surprising), Harvard Business School's Jay Lorsch and Toronto's Rotman School of Management Dean Roger Martin.

Stout's critique of shareholder value is straightforward, though she attacks on multiple fronts. She hammers on what she calls "myths": that the notion of shareholders as owners is somehow part of corporate law; that shareholders, from an economic perspective, are principals who hire agents to run corporations, and are thus residual claimants for all profits of the company after contractual obligations are met; and the belief that shareholder primacy has somehow been validated by empirical or market evidence. The latter point is particularly devastating. In real life, as opposed to theory, it's extremely difficult to prove that providing shareholders with increasing powers of oversight and control -- on compensation, poison pills, staggered boards, independent directors, even on political or charitable activities -- has any determinative effect on performance (I've written about some of these papers here, here and here). Indeed, the entire enterprise is a swamp of epistemological and methodological problems, a long way from the simplicity of share prices and Michael Jensen and William Meckling's agency-cost theory, which provided the theoretical underpinnings for shareholder primacy. In real life, corporations are forbiddingly complex. It's impossible, with or without sophisticated math, to separate out a single factor and prove anything. (Why does the psychology always get simpler as the math grows more complex?) Moreover, how do you judge corporate or managerial performance? Even if you accept that the only thing that matters is share performance, on what time frame do you measure that performance? And for whom? Who is your relevant shareholder? Is it the activist hedge fund, the high-frequency trader, the indexer, the mutual or pension fund, the retail investor? How do you extract a kind of common self-interest from this welter of shareholders?

"The result of all these empirical tests?" she writes. "Confusion. For example, one recent paper surveyed the results of nearly a dozen empirical studies of what happens when companies have multiple share classes. It concluded that some studies found the dual class structures have no effect on performance, some found a mild negative effect, and some a mild positive effect. Moreover, at least one study found that multiple share classes greatly improved performance -- exactly the opposite what the standard shareholder primacy model would predict."

Stout goes on to pummel the efficient-markets hypothesis, the rise in short-term trading and the foundational notion that investors are simply members of homo economicus, and thus only interested in their immediate self-interest, that is, maximizing the share price. She dwells on the notion that under the shareholder regime, investors are expected to put their consciences aside and act like psychopaths (this was the subject of an earlier book, "Cultivating Conscience," attacking the law and economics school), and she argues that "universal" investors, that is, those with a broad range of interests (as investors, employees, members of the community, customers), are in actuality both far more common than investors simply fixated on share performance, and vulnerable: The pursuit of share performance, for instance, may undermine their interests as an employee or customer. Narrowly construed share performance may not contribute to the social or corporate good. She believe of the need to return to some variation on the stakeholder model, arguing that for all its ambiguity in terms of who the corporation really is for, that approach is more realistic and more capable of achieving long-term prosperity -- as it did for decades before shareholder primacy arrived in the '70s.

Stout is making an argument about accepting a kind of complexity that cannot simply be dismissed or distilled into a single number. That complexity, of course, is both the weakness of the stakeholder approach and its strength. "When we insist on gauging the performance of the American corporate sector solely by the share price performance of individual companies, we are ignoring the diverse interests and values of different shareholders to focus only on those of a very narrow subset that is particularly short-sighted, opportunistic, indifferent to external costs, and lacking in conscience. Collectively, we might do far better if we are willing to tolerate some ambiguity about what the ultimate purpose of the corporate entity should be. As former Delaware Chancellor William T. Allen has put it, 'It is perhaps too much to expect us, as a people -- or our law -- to have a single view of an institution so large, pervasive and important to our public corporations. Those entities are too important to generate that sort of agreement.' "

To be fair, the same complexity will undermine any attempt to "prove" that the stakeholder model is more effective than the shareholder. It's quite literally a methodological error. Governance, like any political construct, is a set of human arrangements designed to meet multiple goals, not an engineered mechanism. Corporate governance will remain a paradigm, not a provable fact, despite all those busy law review and monograph producers.

But is all this a Quixotic crusade against an overpowering normative reality? Sometimes it can seem so. But while shareholder primacy remains the gospel of business and law schools, the corporate marketplace is changing. The number of public companies has declined steadily since the late '90s. Private equity has boomed, with its focused small ownership groups. The initial public offering market has also waned, as companies such as Facebook delay their public debuts. And for well over a decade, and starting well before the financial crisis, share performance has lagged, and concerns about innovation and competitiveness have mounted. Can all these be attributed to shareholder value and shareholder primacy? Hardly. Again, like everything around the corporations, the reasons behind these developments are tangled. But there are enough disturbing trends to suggest that something fundamental is awry. At the very least, shareholder primacy has not met its promises, and it boggles the imagination that more shareholder input, which shareholders themselves have always resisted (she calls this "rational apathy"), will magically resolve these problems. Only the most committed ideologue, after all, believes that more short-term, speculative trading will create a prudent, prosperous long-term future. The same applies to shareholder value. - Robert Teitelman

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