Many elite professionals are deeply upset with US President, Donald Trump’s win. Yet the ideology that he represents is very much in line with the logic of corporate raiders, many of whom, like him, went to Wharton Business School. And many elite professionals, in particular lawyers and consultants, profited handsomely from the adoption of the buccaneer capitalist view of the world and actively enabled much of its questionable thinking and conduct.

From the early days of Naked Capitalism, people have written from time to time about why the “Shareholder value” theory of corporate governance was made up by economists, and has no legal foundation. It has also proven to be destructive in practice, save for CEO and compensation consultants who have got rich from it.

Further confirmation comes from a must-read article in American Prospect by Steven Pearlstein, entitled ‘When Shareholder Capitalism Came to Town’. It recounts how, until the early 1990s, corporations had a much broader set of concerns, most importantly, taking care of customers, as well as having a sense of responsibility for their employees and the communities in which they operated. Equity is a residual economic claim. As was written in 2013:

“Directors and officers, broadly speaking, have a duty of care and duty of loyalty to the corporation. From that flow more specific obligations under federal and state laws. But notice: those responsibilities are to the corporation, not to shareholders in particular…..Equity holders are at the bottom of the obligation chain. Directors do not have a legal foundation for giving them preference over other parties that legitimately have stronger economic interests in the company than shareholders do.

And even in the early 1980s, common shares were regarded as a speculative instrument. And rightly so, since shares are a weak and ambiguous legal promise, “You have a vote that we, the company, can dilute whenever we feel like it. And we might pay you dividends if we make enough money, and are in the mood.”

However, 1900s raiders who got rich by targeting companies that had gotten fat defended their storming of the corporate barricades by arguing that their success rested on giving CEOs incentives to operate in a more entrepreneurial manner. In reality, most of the 1980s deals depended on financial engineering rather than operating improvements. Ironically, it was a form of arbitrage that reversed an earlier arb play in the 1960s. Diversified corporations had become popular in the 1960s as a borderline stock market scam. Companies like Teledyne and ITT, that looked like high-fliers and commanded lofty PE multiples, would buy sleepy unrelated businesses with their highly-valued stock. Bizarrely, the stock market would value the earnings of the companies they acquired at the same elevated PE multiples. You can see how easy it would be to build an empire that way.

The 1970s stagflation hit these companies particularly hard, with the result that the whole was worth less than the sum of the parts. This made for an easy formula for take-over artists: buy a conglomerate with as much debt as possible, break it up and sell off the pieces.

But CEOs recognised how the newly-installed leaders of LBO acquisitions got rich through stock awards or option-type compensation. They wanted a piece of the action.

One of their big props to this campaign was the claim that companies existed to promote shareholder value. This had been a minority view in the academic literature in the 1940s and 1950s. Milton Friedman took it up as an intellectually incoherent New York Times op-ed in 1970. Michael Jensen of Harvard Business School and William Meckling of the University of Rochester argued in 1976 that corporate managers needed to have their incentives better aligned with those of shareholders; and the way to do that was to have most of their pay to be equity-linked. In the late 1980s Jensen, in a seminal Harvard Business Review article, claimed that executives needed to be paid like entrepreneurs. Jensen has since renounced that view.

Why shareholder value theory has no legal foundation

Why do so many corporate boards treat the shareholder value theory as gospel? Aside from the power of ideology and constant repetition in the business press, Pearlstein, drawing on the research of Cornell Law Professor, Lynn Stout, describes how a key decision has been widely misapplied.

Let’s start with the history. The earliest corporations, in fact, were generally chartered, not for private but for public purposes, such as building canals or transit systems. Well into the 1960s, corporations were broadly viewed as owing something in return to the community that provided them with special legal protection, and the economic ecosystem in which they could grow and thrive.

Legally, no statutes require that companies be run to maximise profits or share prices. In most states, corporations can be formed for any lawful purpose. Lynn Stout has been looking for years for a corporate charter that even mentions maximising profits or share price. So far, she hasn’t found one. Companies that put shareholders at the top of their hierarchy do so by choice, Stout writes, not by law.

For many years, much of the jurisprudence coming out of the Delaware courts - where most big corporations have their legal home - were based around the “business judgment” rule, which held that corporate directors have wide discretion in determining a firm’s goals and strategies, even if their decisions reduce profits or share prices. But in 1986, the Delaware Court of Chancery ruled that directors of the cosmetics company, Revlon, had to put the interests of shareholders first and accept the highest price offered for the company. As Lynn had written, and Delaware courts subsequently confirmed, the decision was a narrowly-drawn exception to the business-judgment rule that only applies once a company has decided to put itself up for sale. But it has been widely – and mistakenly – used ever since as a legal rationale for the primacy of shareholder interests and the legitimacy of share-price maximisation.

How shareholder value theory has been destructive

The shareholder value theory has proven to be a bust in practice. Here are some of the reasons: It results in short-termism, underinvestment, and a preoccupation with image management.

As was written in 2005 for the Conference Board Review about how the preoccupation with quarterly earnings led companies to underinvest on a widespread basis. Richard Davies and Andrew Haldane of the Bank of England demonstrated that companies were using unduly high discount rates, which punished long-term investment. But Pearlstein provided more confirmation.

We would be continuing this discourse in the next article.

•Lawrence Nwaodu is a small business expert and enterprise consultant, trained in the United Kingdom and the Netherlands, with an MBA in Entrepreneurship from The Management School, University of Liverpool, United Kingdom, and MSc in Finance and Financial Management Services from Rotterdam School of Management, Erasmus University Netherlands. Mr. Nwaodu is the Lead Consultant at IDEAS Exchange Consulting, Lagos. He can be reached via nwaodu.lawrence@hotmail.co.uk (07066375847).

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