It has been a business maxim for years: Shareholder value trumps all when it comes to measuring corporate success. But by overrating shareholder value, management could focus too much on short-term stock price measures, given that outsized executive compensation often is fueled by stock options. And focusing too much on the short term can hurt a business over the long run, says Eric W. Orts, a Wharton professor of legal studies and business ethics. There are better measures of corporate success, he points out in an interview with Knowledge at Wharton about his new book, Business Persons: A Legal Theory of the Firm.
An edited transcript of the conversation follows.
Knowledge at Wharton: Eric, you take issue with the idea that shareholders and executives are too often viewed as if they are the only entities in the corporation that matter. No one else is really important to the process. That’s reinforced by this concept of shareholder value and the idea that executives are the ones who create the shareholder value — and it’s just these two things that matter. Would you discuss why you think that’s a limited view?
Eric W. Orts: I think you need to start from the view of how businesses are constructed from a legal vantage point — and that’s the main argument of the book. There is a bottom-up process by which people come together into teams that represent capital [in] a company — labor — [and] there’s organization governing expertise, which is management. It’s a very complex process if you look at this historically and legally over time. Business firms themselves — and this is why we have business schools that study this and try to teach managers the complexities that are involved in this — are very intricate organizations. You can have very small start-ups that are only one person. But very quickly in most businesses you get economies of scale and economies of scope that mean you have very large enterprises that are putting together lots of moving parts.
Those moving parts are reduced in economic theories that say shareholders are the only group that matters. There are advantages to looking at share price, and I’m not saying that shareholders don’t matter. Shareholders vote, and they ultimately have authority over who is voted onto the corporate board, and that means authority to determine who the CEO is. But in most circumstances, shareholders aren’t exercising that role. I think that the shareholder-value arguments — that managers only should be looking to shareholder value — have gotten us into trouble.
There are examples in the news — all the series of corporate frauds that we continue to have, accounting frauds and other kinds of frauds, insider trading scandals, etc. But the corporate fraud issue, especially with respect to some accounting issues, partly has to do with incentives that are created by asking managers to only manage [with regard to] short-term shareholder value. The theory is … that managers should manage [in a way that increases] shareholder value. If shareholder value increases, then everybody will be better off … and then managers should be compensated more.
In practice, though, what happens sometimes is that when you are using short-term options or other mechanisms to pay managers only in terms of their share-price performance, you create perverse incentives for them to commit fraud. I think that this is something that people did not think about when they adopted economic theories. Basically, in the economic jargon this is called “principal agent theory.” Principal agent theory was invented and advocated beginning about 20 or 30 years ago. That’s now seized the day with respect to executive compensation debates, where you basically see managers as the agents of shareholders, and that’s the only relationship that matters.
“Economic models that have driven this idea that managers should only manage to [increase] share price, particularly in the short term, are wrong.”
What I argue in the book is that there are a number of other considerations that matter. Employees matter, and how they are motivated [matters]. That really is not taken into account in a simple principal agent theory. The other group that matters [includes] other creditors, bond holders and other capital providers of the enterprise. The role of retained earnings in a firm is really under-appreciated in the principal agent models. So, a main argument is that these economic models that have driven this idea that managers should only manage to [increase] share price, particularly in the short term, are wrong. They’re the product of economic theories that I think at this point have been shown to be wrong.
And one of the arguments in my book is to say, “Look, here’s another theory — namely, traditional legal understandings of how firms are created and how they are formed and run over time that are different than the standard economic theories.”
Knowledge at Wharton: You have this idea of shareholder value being central and prominent and almost overriding, and you then have executives whose compensation is based on shareholder value, i.e., the stock price. And so, naturally, they are incented to make sure that the stock price is as high as possible, which generally is a good thing. But in practice, as you say, there’s this critique that they’re managing for the short term because most of their compensation is based on stock options directly related to the share price. So, they want that next quarter’s — or certainly the next year’s — financial results to maximize the stock price, which could undermine the long-term soundness of the firm. If they dump all the assets and resources into trying to make [the price] go up short term, they miss opportunities.
There are companies that do it the other way, like Amazon, that invest for the long term. They’ll take losses in certain areas in the short term in order to invest and guarantee that they succeed in the long term. So, this is another part of it, this economic argument, isn’t it? In addition to the fact that you’re saying it can lead to fraud.
Orts: I think that’s exactly right. And in some ways, that’s even more important. One problem you have is that you might increase fraud. You increase the dysfunctionality of the system…. You want to have long-term sustainable growth that is going to raise everyone’s boats, create more wealth, help to make everybody better off. If we don’t have systems in place — and part of this is about economic theories that we’re adopting and part of it is about law listening to the economic theories and following those economic theories — we’re going to be in some trouble.
I think you identify a very big issue. What is the purpose of an enterprise, and how do you provide the right incentives, both legally and economically, for long-term economic growth? One example I use in my book is Google. Specifically, when Google went public, it opted out of this traditional pattern of being governed only by shareholders…. And Delaware had a famous case that was decided in the 1980s — called “Revlon” — where [the court] said that in some circumstances, we’re going to demand that you get the highest price for the company if you’re selling the company or if you’re in a sales situation.
There are some complexities around that. The argument here is: Well, why would we expect that [benefit] to be only for shareholders? Why would we only want to take one share price right now and say that is the intrinsic value of the company? There could be all kinds of reasons that share price is either up or down [at a given moment]. And to put so much weight on the artifact of share price, I think, has been a mistake over time. Google has been a successful company in bucking that trend, where they said, “No, we’re going to basically hold control….”
“What is the purpose of an enterprise, and how do you provide the right incentives, both legally and economically, for long-term economic growth?”
Another example historically that seems to be pretty successful this way is Ford Motor Company. It has done the same thing, which indicates that maybe shareholder value in a broadly held market is not the only model for a company. Also, for long-term sustainable growth, we need to have a more complex understanding of incentives in enterprises and provide for lots of different experiments for how businesses should work, rather than, as some economists have tried to argue, put a template of an economic theory on the world and say that everybody has to manage to this shareholder maximizing model….
[There are a lot of] other examples out there where companies are not behaving that way, and they are actually doing better than companies that are being trained to just look at short-term returns.
Knowledge at Wharton: When people talk about maximizing shareholder value, it tends to mean “in the short term,” as you point out. You’ll sometimes hear that executives have a fiduciary responsibility to do so. But you seem to be arguing that there are other responsibilities. And, in fact, you could be irresponsible by not investing for the long term. By giving out too many dividends in the short term, you then don’t have money in retained earnings to invest for that next new product that’s going to give growth for the long term.
Orts: Yes, I think there has been a lot of misinformation sent out — sometimes I’m afraid in business schools, but it also sometimes happens in law schools — of what the fiduciary duty of directors actually is in the United States. In fact, the business judgment rule has allowed [for] a lot of the discretion that directors have in the United States…. Now, we have had some changes that have moved us toward a shareholder-maximization model. The Revlon case I mentioned is one of those changes. And there have been [other] Delaware law cases that go in that direction.
There also have been Delaware cases and other legal developments that have said, “Wait, companies don’t have to manage in that way.” One of the interesting experiments that I also talk about in the book is something I call hybrid social enterprises. Delaware enacted a benefit corporation statute which explicitly says you can have two different objectives. One is making money, but another is an environmental objective, let’s say, or some specified social objective of trying to alleviate sanitation problems in a particular country. What those experiments show — and one of the main arguments that I give in the book — is that purposes of businesses are actually quite diverse.
“One of the virtues of modern Western societies is that we have this framework of law that allows individuals … to be entrepreneurs … [and] come up with new ways of structuring enterprises that are either going to work or not work.”
You can have a business, and it can be just maximizing shareholder value. I’m not saying we shouldn’t have businesses that are organized in that way. There are lots of other kinds of models, not only in the United States but in the world, of different kinds of companies that are looking at different kinds of objectives…. We’re in a better circumstance if we allow a diversity of different companies like that.
An argument in the book is that one of the virtues of modern Western societies is that we have this framework of law that allows individuals from the bottom up to be entrepreneurs, to come together, to come up with new ideas, to come up with new ways of structuring enterprises that are either going to work or not work. And we allow general markets of supply and demand to determine that. But we don’t mandate some particular way in which every business has to be managed. And I think that that’s a good thing and one that I hope to encourage by writing this book.
Knowledge at Wharton: A point you made that may be surprising to some is that shareholders, although they have an equity stake, are not the main providers of financing for companies. That [mistaken idea] might be one reason that people would think shareholders should have such prominence. There might be a conception that they are the primary financiers of the corporation. But, in fact, you’re saying that that’s not the case on average.
Orts: The finance literature has now become pretty clear that the main area in which companies get money and property — from which they decide to allocate new capital to new projects — is retained earnings. Colin Mayer at Oxford was one of the main proponents and authors of empirical research that shows that this is true, not only in the United States, but in many other countries. It shows that the shareholder value idea that capital comes from the shareholders — and therefore you owe an exclusive duty only to the shareholders — is wrong.
It’s also true that you get a lot of capital provided to companies through credit and debt financing. Usually those are interpreted as contractual relationships. And they are contractual relationships. But it’s also true that at the edges, there are duties that can sometimes be owed to those capital providers as well. That’s an example of how the property relationships within firms — and I go into this in more detail in the book — are actually a lot more complicated, and ownership is much more fragmented, than this simplistic idea of managers and shareholders [presents].
Whenever you have a simple way of describing something, sometimes people grab onto that and they think that’s a hammer that you should then hammer into any problem that comes up. [For example], they use that principal agent model of shareholder managers. And [to them,] that’s the answer. I think that’s fundamentally wrong.
It’s not that I’m saying shareholders are not important. They are primary, as I said. They elect directors. There’s an important corporate role that shareholders play. But the idea that that’s all there is, and that managers should only think about that to the exclusion of strategic considerations of research and development — how you are motivating your employees, how you’re relating to different governments that you’re dealing with, all those other kinds of issues — I think really underplays the important role that managers have. And … it makes the idea of the task a little bit too easy.
So, that’s my answer: That shareholder value matters. It’s one measure of how firms are doing well or not doing well, but it’s not the only measure. And we really have to think about these broader concerns.