Public Corporations and Investors: Theory vs. Reality

It's conventional knowledge, in the business world at least, that a corporation's primary purpose is to maximize shareholder value.  A corporation can only hope to maximize benefits to everyone through maximizing shareholder value. This idea is often presented as a law of the universe as immutable as the laws of physics.  In The Shareholder Value Myth by Lynn Stout makes a persuasive case that maximizing shareholder value is not always the best for the corporation, the market, or society.  Stout is a law professor at Cornell specializing in corporate governance law.  She argues that corporations are not legally required to maximize shareholder value at the exclusion of other goals.  Furthermore, the focus on stock price leads corporations to destroy fundamental value in favor of short-term gains, which is against the long-term interests of many shareholders as well.  Instead, corporations should invest in their employees and their communities to maximize long-term benefits.

I recommend anyone who is interested in corporate governance, business management, economics, finance, or social entrepreneurship to read this.  It is a fairly short and quick read, but since many people still won't read it, I will summarize the main points here.




        Shareholder primacy is the principle that the corporation's sole purpose is to increase shareholder value because this maximizes the welfare of the corporation as well as society at the same time.  This means that a corporation's performance is based completely on one number, and that is the stock price.  Yes, it is very conceptually elegant, not to mention convenient, if this were true.  This idea became popular in the 1980's coinciding with the rise of neoclassical economic theory.  (Although there is nothing wrong with neoclassical theory itself, it is often misapplied.  More on this later).  Since then, conviction in shareholder primacy became so strong that everyone believes that corporations have a fiduciary duty to maximize shareholder primacy and that this duty is enforced legally.

It's Not Legally Required
        Lynn Stout's first point is that shareholder primacy is actually not a legal requirement.  The case that is typically cited to demonstrate legal fiduciary duty to shareholders is Dodge v. Ford 1916 where Dodge was a minority shareholder in Ford Motor Company.  The court ruled that Henry Ford could not reduce the dividends to shareholders such as the Dodge brothers to build more plants and pay his employees more while profit was increasing.  Stout argues that the ruling is outdated as well as irrelevant because

1. Ford was not a public corporation.  It was a closely held corporation where the majority shareholder (Henry Ford) had a duty to look out for the interests of minority shareholders (Dodge).  
2. The comment that supports shareholder primacy, "a business corporation is organized and carried on primarily for the profit of the stockholders" was a "dicta."  In other words, it was not part of the legal rationale for the decision and therefore does not set legal precedent.
3. It is an old ruling. 
4. It was a ruling from the Michigan Supreme Court, which is not considered an authoritative source for corporate law compared to Delaware, where many more companies are incorporated.

        Instead, directors of public corporations have protection under the "business judgment rule," where corporations can do anything as long as it is lawful and directors do not have personal conflicts of interest.

The Theory is Flawed
        Stout's second and perhaps more interesting point is that economic theory is being misapplied to corporate governance.  The theory behind shareholder primacy is that shareholders are the owners and thus residual claimants of a corporation's profits.  They are the principals while directors are the agents and therefore if the agents maximize the welfare of the principals, welfare should be maximized overall.  This idea was popularized by Milton Friedman, a prominent neoclassical economist.  However, Stout argues that the principal-agent relationship isn't really descriptive of the relationship between the shareholder and corporation because

1. Shareholders do not legally or practically own corporations.  In fact corporations own themselves.  Shareholders own a share, which is a contract with some limited rights.
2. Shareholders are not the residual claimants.  The idea that they are comes from bankruptcy law, where the shareholders get whatever is left over after other contractual obligations are fulfilled as a company is being liquidated.  However, a company being liquidated is completely different from a living company, which has to plan for the future.
3. Shareholders are not principals.  Corporations are created before there are shareholders, but principals should exist before agents.  
4. The share price alone (probably) cannot be used to measure the worth of a company.  First of all, it doesn't really make sense to use something that fluctuates constantly.  Second of all, because of frictions that come with doing business in real life, a corporation can cause many externalities (public harm) while privatizing the benefits.  These externalities ultimately lower the quality of life of the public, including shareholders.  Stout claims that externalities can and do harm the private sector as well, stunting the growth of the market overall.

Justifying Myopic Behavior in the Finance Industry
        Another very rich topic that Stout digs into is how the realities of the finance industry interact with shareholder primacy to encourage myopic behavior in corporations and investors.  Short-term investing has been increasing.  By 2010, public stock is held for four months on average compared to eight years in 1960.  Therefore, even though investors should theoretically be primarily interested in long-term corporate performance, clearly many are profiting from short term gains.  An investor who only plans on holding a stock for a short time can and do lobby for actions that increase the stock price in the short term, after which the investor sells, thus relinquishing her interest in the long-term success of the corporation.  In fact, it would be good for these investors if the stock price subsequently went down so that she can invest again and start the cycle over.  Myopic behaviors include cutting back on R&D or marketing or laying off employees to boost quarterly earnings reports.  They also include splitting up the company, selling off assets, and getting acquired.
       These things happen because shareholders (and thus investors) are heterogeneous in their expertise as well as incentives.  Also, information is expensive and time consuming, especially more qualitative information as opposed to prices.  Long-term investors profit from the overall performance of the market.  They will hold diversified assets in order to reduce risk.  As a result, they "suffer" from rational apathy.  There is too much information and their stake in each company is so small that it is not worth it to investigate whether a company's earnings went up because of myopic behavior or because of a particularly successful new product or operational improvements.  In contrast, shareholders who are more involved in corporate governance are usually short-term investors who profit from buying and selling.  They will hold relatively large stakes in a small number of companies, and it is in their interest to create "news" that will change expectations one way or another.  Yes, the market eventually "corrects itself," but the profits and losses from the error and subsequent correction are real.  Misallocation of financial capital, hurting employee morale, losing talent, slower innovation, lower quality products, reduced customer loyalty are sometimes also tangible and lasting effects.  Another dynamic that exacerbates the prevalence of these behaviors is that long-term investors such as institutional investors, who invest on behalf of pensioners for example, hire active managers to manage large portions of their assets.  These active managers are judged by their quarterly performance.  As a result, they are often short-term investors because those strategies are more reliable as well as profitable.


Recommendations
        Ok, that sounds like a hairy mess.  Stout's recommendations aren't as crisp as her analysis of the situation.  Even so, there are four potential solutions that stood out to me.

1. Stop promoting shareholder democracy and giving shareholders more power.  This is one of Stout's main recommendations.  Shareholders do not act like responsible principals and cannot be counted on for effective corporate governance.  For example, even after the Great Recession and subsequent bailout, shareholders opted not to diffuse the power of the CEO and chairman of JPMorgan Jamie Dimon, much less fire him. 
2. Her second recommendation is to encourage companies to maximize stakeholder value.  She introduces the concept of team production, which expands on maximizing stakeholder value as a more descriptive theory of how corporations create value.  Basically, value is created as corporations build trust and commitment among employees, creditors, managers, consumers, and the community.
3. Institutional investors should change how they evaluate active managers.  Stout did not focus on this probably because she does not think that institutional investors have enough incentive to reform this.
4. Make information cheaper for long-term investors.  Stout also does not focus on this possibly because it is unclear if it is technically feasible.  However, I am personally very interested in this kind of solution.

Talkin About the Issues

Thomas Piketty is talking about the issue of inequality in a book, Capital in the 21st Century.  Apparently it is popular, and there have been many articles written about it.

I wonder why this one has gotten so popular, and I wonder if it will help to change the dominant point of view that inequality is ok because the rising tide of capitalism raises all boats.  Definitely adding this one to my (imaginary) summer reading list.

http://www.slate.com/articles/technology/technology/2014/04/thomas_piketty_capital_in_the_twenty_first_century_surprisingly_entertaining.html

International Financial Crisis Seminar

I'm taking a seminar this semester on the International Financial Crisis with University of Michigan Professor Emeritus Robert Stern. We are reading Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan. Some of his arguments are very persuasive. I like how he presents the problems in the global economy in terms of systemic tensions. Although he doesn't exactly say it this way, my conclusions after reading some of his book is that no country in the world really knows how to shift to an economy where low-skilled labor is no longer really needed. In other words, in a world where you only need a few highly skilled people to produce the majority of goods, how do you still distribute the goods? Maybe finally, this is where communism comes in.

At the same time, perhaps the case is overstated. Clearly we still have plenty of things to do for low-skilled labor on farms and perhaps cleaning the environment. But there is much more money for skilled labor perhaps because there is not enough supply of skilled labor. At the same time, I'm not sure if this is correct because there is plenty of unemployed skilled labor as well as unskilled labor in Europe.

In Fault Lines, Rajan talks about how many financial crisis such as the Great Depression and Great Recession were related to expansions of credit for housing. Because housing itself is a necessity and that the education system in the US is funded by local taxes, housing is particularly important in the US for social mobility and neighborhood stability. It made me think about how many people make money from investments, but because of the transaction costs, it only makes sense if you have a certain amount of income. Perhaps there is a way to lower the entry costs so that there is more of a cushion for lower income households.

Where do we go from here? Unclear. I suppose we continue to muddle through.

The Only Economics Class

Many people agree that it would be good for everyone to take an economics course in high school or in college. Usually, introductory economics courses only cover microeconomics, though. I have just gone through the core of the Macroeconomics textbook used in 14.02 (Principles of Macroeconomics at MIT). I think it would be more useful for the first economics course that people take to cover primarily macroeconomics, especially if it's going to be the only course in economics they ever take. The topics in microeconomics that should be covered are the supply and demand curves, the concept of marginal utility, and the production function. The rest of the course should be about macroeconomics. Macroeconomics would help people to better understand fiscal and monetary policy and how they impact unemployment and inflation. This would help people have a better understanding of current events and be informed voters.

The problem when people only take microeconomics is that people try to use the very simplistic results to make policy decision. For example, people conclude that markets are the most efficient methods to allocate resources so there should be fewer regulations. Price ceilings and floors always add deadweight loss so those should never be used either. Theoretical and empirical results from macroeconomics are much more directly applicable to explaining everyday events and informing policy decisions.

MIT Macroeconomics Symposium

I'm watching this video from the MIT 150 Economics Symposium back in January about the development of macroeconomics. It helps to watch it several times as I learn more about macroeconomics from reading and talking to friends who are economists. I get a little bit more out of it each time. I'm looking for guidance and inspiration for possible research topics or other projects.

Expect More Inequality But Less Poverty?

Not very many Americans seem to be bothered by the growing inequality of wealth in the United States. This is partly because logically there doesn't seem to be a reason why some people might not have been more productive or more creative than others. It would not seem to be fair to set a maximum limit on how much a person can make, and it's hard to see why there would be any physical limit.

At the same time, if this idea is extended globally, then that implies that Americans and the developed world might always be more wealthy than developing nations. But one of the arguments for globalization is that developing nations will develop and the standard of living will improve for everyone even if GDP per capita continues to be higher in developed nations. The mental image of a nation like China once it has developed, though, is that the citizens' standard of living will eventually equal the standard of living of Americans. Is there a contradiction? People usually think of South Korea or Japan as developing nations that successfully became developed nations. Some food for thought.