From stakeholder values to shareholder values

Here are an excerpt from the 2010 book
The Betrayal of American Prosperity:
Free Market Delusions, America's Decline,
and How We Must Compete in the Post-Dollar Era

by Clyde Prestowitz.
Emphasis is added.
This excerpt also appears in my post dedicated to that book,
but is broken out here in a special post dedicated just to
the topic specified in the post title.

Chapter 7
Companies Without a Country

A corporation must consider
the impact of its actions on all,
from the shareholders to the society at large.

— Business Roundtable, 1981

Few trends could so much undermine our free society
as the acceptance by corporate executives
of social responsibility.

— Milton Friedman, 1970

[This thirty-page chapter is full of good insights,
but to save [my] time I only excerpt a few parts of it.]

[A 1981 speech by GE CEO Jack Welch at New York’s Pierre Hotel]
heralded a radically new philosophy or perhaps a return to an old one
for American business.
Under the new doctrine, the central concern of CEOs became
the steady accumulation of strong quarterly results in order to
increase the value of a company’s stock.
The notion that a CEO’s core responsibility is to the shareholders
has by now become such widely accepted wisdom
that it may seem always to have been the American business creed.
But that is not the case.
The view that had prevailed in America since the Great Depression was that
a CEO is responsible to the many people, businesses, and services
that have a stake in his or her corporation’s welfare—
to the society, that is, in which the corporation is embedded.

At about the same time as Welch’s speech,
in a manifesto on corporate governance,
the Business Roundtable, a group of CEOs of America’s major corporations,
perfectly expressed what has become know as the stakeholder theory:
“A corporation’s responsibilities include
how the whole business is conducted every day.
It must be a thoughtful institution which rises above the bottom line
to consider the impact of its actions on all,
from the shareholders to the society at large.

Its business activities must make social sense.”
According to this theory
the stakeholders in a company are defined broadly as
its employees, customers, and suppliers
along with the community in which it operates and the larger society.
But the Roundtable’s statement was a lagging indicator.
Welch had caught the new wave.
And the fealty to that new creed of shareholder value above all else
has by now been taken to such lengths that
a host of the most powerful American companies—
the companies most crucial to our economic well-being—
increasingly do not consider that they have obligations to America
or even that they are American.
Nor is this attitude limited to American CEOs.
The same could be said, although to a lesser degree, of many European CEOs,
and to a much lesser degree of some Asian CEOs.
The problem with this creed, as we have seen in the recent crisis, is that
when a company gets in trouble,
it turns to its domestic stakeholders, and especially to the U.S. government,
to bail it out.

Section 7.2
The Harvard Business School Creed

At the founding of the Harvard Business School in 1908,
Dean Edwin Gay said the purpose of the school
was to teach business leaders how to
“make a decent profit by doing decent business.”
That was McCabe’s creed
[Thomas McCabe had been head of Scott Paper and a mentor to Clyde Prestowitz]
and what thousands of future business leaders
learned at Harvard for many years.
But in 1970,
the University of Chicago’s Milton Friedman sounded a different note.
Said he,
“Few trends could so much undermine our free society as
the acceptance by corporate executives of social responsibility other than
to make as much money for shareholders as possible.”

This tune was quickly picked up and elaborated upon
by Harvard’s professors and especially by professor Michael Jensen,
who became the dominant American voice on corporate architecture
and the proper role of a board of directors and a CEO.

In a hugely influential 1976 paper and subsequently,
Jensen propagated Friedman’s doctrine as the sole purpose of the CEO.
His argument was grounded in the view that
the shareholder is the corporation’s final risk bearer
and therefore also its final claimant.
He added the notion that, as agents of the shareholders,
the corporation’s managers do not necessarily share
the interests of the shareholders.
Indeed, the managers and the shareholders may be at war
because the way for the CEO to maximize his/her private gain
may be at odds with maximizing shareholder gains.
For instance,
a CEO may like corporate jets or want to be part of the society scene,
but the costs of such indulgence may be a burden to shareholders.
Thus, the central problem is
how to align the interests of managers and shareholders
and to establish a monitoring mechanism that easily indicates
whether the managers are acting properly on behalf of the shareholders.

Jensen’s solution was to grant gobs of stock options to CEOs
and to evaluate their job performance by focusing on
the progression of quarterly earnings.
This is a single, readily available, objective number
upon which
a CEO can concentrate all [his] attention and which
the shareholder can readily use to determine
whether a CEO is working for him.
Jensen emphatically rejected stakeholder theories on the grounds that
giving a CEO multiple objectives would be confusing, distracting,
and make it impossible in the end to measure performance.

Of course, there were many counterarguments.
Is it true that shareholders are the residual risk bearers and claimants?
The shareholder does not own a corporation in the same way
he owns his house.
He owns only a right to the residual cash flow.
He doesn’t own the actual assets or business or a corporation,
which is itself a legal person.
Indeed, owning it would not be compatible with
the limited liability concept on which a corporation is founded.
Further, the value produced by a corporation
is produced by a combination of resources.
In addition to those of the shareholders,
there are also the workers, suppliers, customers,
public infrastructure and services,
the legal system,
and the society at large represented by the government.
So why should the distribution of value favor only shareholders?
Moreover, it is not clear that the shareholder bears more risk
than do other stakeholders.

Indeed, simply by selling shares
the shareholder can divest himself of risk more easily
than can any stakeholder.
Workers, suppliers, and communities
cannot so easily extract themselves from failing corporations.
Take the case of the recent bankruptcy of General Motors.
Many shareholders were able to sell out with relatively small losses
when they realized the company was in deep trouble.
But GM’s independent dealers, for example, weren’t so lucky.
With employees and cars in their showrooms,
suddenly they were told they were being cast off.
Or take the communities where plants are being closed.
Maybe the GM workers will get
some kind of reasonable severance and even a pension,
but the people who work in the coffee shops, machine shops, and other shops
that depended on that now closed plant
are all pretty much just out of luck.
Further, several empirical studies and examples have indicated that
stakeholder-oriented companies do better in crises and over the long term
than do those narrowly and intensely focused on shareholder return.
In a 1992 study,
John Knox and James Heskelt showed that
stakeholder companies had grown four times faster than
shareholder-driven firms.

But none of the objections stopped the momentum
that quickly developed behind the shareholder value theory.
The popularity of the new thinking was probably due in large part to
the fact that the focus on short-term earnings
made it so easy to quantify performance.
It also rationalized a lot more Wall Street merger and acquisition activity
and facilitated the quantification of business management theory
and the building of models
so that business professors could, like their economist colleagues,
present their discipline as a science.
The emphasis on the primacy of the CEO
was also, for obvious reasons, quite popular with CEOs,
and led eventually to the apotheosis of the CEO
as a godlike figure in American business,
credited with achieving near miraculous feats singlehandledly.
For example, the 1997-04-15 issue of Fortune magazine stated that
“in four years CEO Lew Gerstner had added $40 billion to IBM’s market value.”
Really? Did Lew do that all by himself?

In 1997, the Business Roundtable reversed its earlier views and pronounced:
“In the Business Roundtable’s view,
the paramount duty of management and of boards of directors
is to the corporation’s stockholders…
The notion that the board
must somehow balance the interests of stockholders
against the interests of other stakeholders
fundamentally misconstrues the role of directors.
It is moreover, an unworkable notion because
it would leave the board with no criterion for resolving conflicts
between interests of stockholders and other stakeholders
or among different groups of stakeholders.”
So fixed did this view become that eleven years later,
despite the intervening debacles of
Enron, WorlCom, Tyco, and Long-Term Cap[ital Management,
Jack Welch could still threaten his handpicked successor, Jeffrey Immelt,
with mayhem for missing his quarterly earnings target.
Said Welch in April 2008:
“Here’s the screw-up.
He promised he would deliver and now he misses three weeks later.
Jeff has a credibility issue.
He’s getting his ass kicked.
If it happens again, I will get a gun and shoot him.”

What Welch may not have realized is that
his stockholder value/quarterly earnings fetish had become a big gun
shooting a large hole in the competitiveness
both of corporations and of the United States.

The focus on short-term profits led to the slashing of R&D
and of investment in longer-term, more risky projects.
In short, companies were increasingly showing good short-term results
while eating their seed corn.

Miscellaneous Articles

Maximizing shareholder value: The goal that changed corporate America
By Jia Lynn Yang
Washington Post, 2013-08-27

[A very good article, which echoes many of the facts and shifts
pointed out by Clyde Prestowitz in his 2010 book.
It would have been nice to see that book cited,
and some current quotes from Mr. Prestowitz on how he has updated his views,
if he has.
He certainly has earned some degree of priority of place on this subject.]

Labels: , , ,