Debunking ‘Shareholder Primacy Theory’

The great neoliberal economist Milton Friedman once made the famous assertion that “there is one and only social responsibility of business – to use its resources and engage in activities designed to increase its profits.” Regrettably, this statement has been adopted as an almost infallible cornerstone of business management by educators and companies alike since the 1970s, and it has undoubtedly played a notable part in the collapse of national economies in western nations plagued by rampant corruption, nepotism, and barely fathomable scales of fraud. Fortunately, corporate bosses – and perhaps more importantly investors – are waking up to the reality that shareholder primacy theory is neither a positive catalyst for economic prosperity, nor a socially responsible approach to finance on the whole.

Naturally as with any theory – scientific, economic, political, or otherwise – the notion of shareholder primacy has its fair share of supporters and detractors. Charles Elson,  a distinguished expert and academic in the field of corporate governance, and a regular contributor to a blog hosted by the National Association of Corporate Directors, presents a five-pronged argument in supporter of shareholder primacy with the underlying message that the “failure to put shareholders’ interests first would drive away investors and capital.”  Elson provides the following points in favour of Friedman’s treatise (these points are found in his blog located here):

1. Shareholder primacy is key to our entire capital system.
2. Unless shareholders are protected, they will not invest…and we would lose the capital vital to US economic success.
3. The stakeholder system has numerous problems. If board directors are responsible to multiple constituencies, directors will make decisions that will always benefit someone, but at the expense of the health of the corporation.
4. To maximize shareholder value, all of the stakeholders need to be content with corporate direction.
5. Most stakeholders are shareholders. For example, the largest owners of many companies are the employees, through their retirement plans.

On the other end, Paul Polman – CEO of the global consumer goods conglomerate Unilever – is one of those executives who is relentless and calculated in his attack on what he calls “Milton Friedman’s old thinking” and says that he believes “if we focus our company on improving the lives of the world’s citizens and come up with genuine sustainable solutions, we are more in synch with consumers and society and ultimately this will result in good shareholder returns.” Accordingly, the very real urgency of developing sustainable solutions in business and government policy is not a threat to the capital system that Elson sets out to protect, but rather a new layer of added protection for economies which have relied too long on unsustainable practices to deliver on consumer needs (e.g. reliance on dirty fossils fuels).

Professor Lynn Stout of Cornell Law School is another vocal voice arguing against Friedman’s economics on the lecture circuit and it’s no wonder that her new book “The Shareholder Value Myth” is turning corporate governance policy on its head. Not one to mince words, the main crux of Stout’s thesis against shareholder primacy is that there is actually no legally binding corporate law which supports the notion that the shareholders are the owners of a company. Jesse Eisinger of ProPublica says that in a nutshell what Professor Stout is arguing is that “shareholders are more like contractors, similar to debtholders, employees and suppliers…directors are not obligated to give them any and all profits, but may allocate the money in the best way they see fit.” The logic behind this argument is sound when viewing the state of the global financial economy, and particularly the American economy, through the lens that Professor Stout is advocating.

Short-termism – a word used to describe when companies take major risks to drive up stock prices in a limited window of time – is one of the main culprits behind the collapse of the global financial system according to Stout. An even bigger aberration of corporate law stemming from shareholder primacy theory is the widely-accepted practice of rewarding top-performing corporate execs with gigantic cash windfalls and bonuses. According to Stout, corporate bosses became obsessed with share prices due to a widely accepted practice which sees executive compensation linked to share value; however, “by focusing on short-term stock moves, price managers are eroding the long-term value of their franchises.” Sheila Bair – Chairman of the Federal Deposit Insurance Corporation (FDIC) – also notes the dangers of short-termism in her blog at Harvard Law stating that it “grows out of the institutional rules that govern our behavior…when executive compensation varies according to current-year earnings or stock prices, it creates incentives to maximize short-term results even at the expense of long-term considerations.”

At the end of the day, if not for any other reason, Professor Stout finds that the “very idea of a single ‘shareholder value’ is fundamentally flawed because different shareholders value different things” – the gulf between the needs of a short-term speculator and an investor looking to grow the money in his children’s college fund is an ideal analogy. Hence, the adoption of such a fundamentally flawed idea to govern the business practices of corporations has been debunked as being either socially responsible or financially viable, and the global financial crisis is simply a reflection of both genuine strategic missteps by corporate managers, as well as intentional deceit on the part of the more corrupt business oligarchs (i.e. the Bernie Madoffs of the world).

Suffice it to say that as we move towards a new global order where social responsibility and the adoption of ESG policies is becoming more widespread on a daily basis, the old neoliberal economic ideas are simultaneously coming unwound, and thank heavens for that. The crisis state of international economics has shown that companies have many more issues to consider if they want to be perceived as socially responsible enterprises, than just the dollar value of their shares and the financial well-being of corporate bosses.