“New” Approaches to Corporate Governance— Why the Shareholder Wealth Maximization Norm Makes

Sense JAMES R. COPLAND Senior Fellow and Director, Legal Policy Manhattan Institute for Policy Research April 12, 2018 OECD

The Manhattan Institute for Policy Research was founded in New York in 1977, through funding principally raised by British businessman Sir Antony Fisher. The Manhattan Institute is a non-profit, non-governmental organization funded wholly through private sources. The mission of the Manhattan Institute is to develop and disseminate new ideas that foster greater economic choice and individual responsibility.

ABOUT THE MANHATTAN INSTITUTE

Our scholars’ research and opinions are their own; the Institute does not take organizational stances on matters of public affairs.

Educated in economics, business, and law at the University of North Carolina, the London School of Economics, and Yale.

Have led the Manhattan Institute’s legal policy research efforts since 2003.

On multiple occasions, named to the Directorship 100, designating the individuals most influential over U.S. corporate governance, by the National Association of Corporate Directors.

ABOUT ME

This debate is NOT “new”

Points of agreement

Ownership and market costs

A ROADMAP

Points of distinction and clarification

Market allocation of capital

Social investing activism in practice

“A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.” —Dodge v. Ford (1919)

THIS DEBATE IS NOT “NEW”

Ford Model T Henry Ford John Francis Dodge

THIS DEBATE IS NOT “NEW”

Columbia law professor Adolph Berle attacked Dodd’s notion, arguing that if “the fiduciary obligation of the corporate management and ‘control’ to stockholders is weakened or eliminated, the management and ‘control’ become for all practical purposes absolute.” —For Whom Corporate Managers Are Trustees: A Note 45 Harvard Law Review 1365 (1932)

During the Great Depression, Harvard professor Merrick Dodd called for “a view of the business corporation as an economic institution which has a social service as well as a profit-making function.” —For Whom are Corporate Managers Trustees? 45 Harvard Law Review 1145 (1932)

THIS DEBATE IS NOT “NEW”

The modern push for “corporate social responsibility” generally traces to a pair of 1970s books: —Where the Law Ends, by Christopher Stone (1975) —Taming the Giant Corporation, by Ralph Nader, Mark Green & Joel Seligman (1976)

Ralph Nader

“Any mandatory governance reforms intended to spur more corporate altruism are almost sure to have general institutional costs within the corporate system itself. . . . But the proponents of ‘more’ corporate social responsibility have never bothered to analyze or examine, from any clearly defined starting point, even just the benefits they anticipate from reform.” —David L. Engel, An Approach to Corporate Social Responsibility 32 Stanford Law Review 1 (1979)

Shareholder wealth maximization and the profit motive are NOT the sole, or even principal, objectives of political economy.

There is significant scope for corporate boards and managers to exercise discretion in their business judgment.

POINTS OF AGREEMENT

Corporate decisions affect numerous stakeholders other than the owners of equity shares.

The principal purposes of publicly traded stock markets are about ownership and control: • Enabling founding entrepreneurs to give up day-to-

day control of corporate operations to managers without large inside ownership stakes, and to enable they and their financiers to liquidate their wealth creation and diversify their investments

POINTS OF AGREEMENT

Publicly traded corporations in the United States regularly return capital to shareholders, rather than reinvesting earnings in new investments and research.

POINTS OF AGREEMENT

Since the 1970s, the return of corporate earnings to shareholders on the part of publicly traded corporations, including through share buybacks, has increased.

Since the 1970s, publicly traded corporations have generally been more aligned with shareholder wealth maximization than in the earlier postwar period—including through executive compensation plans that grant managers interests in share-price returns.

It is not wholly accurate to think of corporations as “owned” by shareholders. The more appropriate conception is to view corporations as a “nexus of contracts.”

Armen A. Alchian & Harold Demsetz Production, Information Costs, and Economic Organization 62 American Economic Review 777 (1972) Michael C. Jensen & William H. Meckling Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 Journal of Financial Economics 305 (1976)

POINTS OF DISTINCTION AND CLARIFICATION

Among those stakeholders in contract with the corporation, equity shareholders are unique:

—Suppliers, customers, employees, retirees, lenders, and borrowers all have contractual protections entitling them to precise shares of corporate earnings —Equity shareholders are entitled only to a corporation’s “residual earnings”

POINTS OF DISTINCTION AND CLARIFICATION

Equity ownership is vital to capital formation, precisely because it allows entrepreneurs to defer regular payments to investors without receiving any regular, near-term payoff.

To protect their interests, equity shareholders have three principal mechanisms:

—Corporate-law fiduciary duties of loyalty and care —Voting rights —The ability to sell their shares (at least in publicly traded companies)

POINTS OF DISTINCTION AND CLARIFICATION

The shareholder wealth maximization norm is embedded in the fiduciary duty of care

—This is a concept of corporate law (applied to all ordinary corporations), not securities law (applied, in the U.S. context, to publicly traded securities).

POINTS OF DISTINCTION AND CLARIFICATION

In modern-day corporate law in the United States, courts afford business leaders significant leeway in enforcing the duty of care under the business judgment rule.

The duty of care is most relevant in change of control situations in which boards of directors have to consider tender offers for companies’ shares.

Corporations in the United States—and many other developed countries—do not have to accept a shareholder wealth maximization norm.

OWNERSHIP AND MARKET COSTS

Nor do business organizations have to vest voting control with equity shareholders. In fact, business entities in the United States are commonly:

—Employee-owned —Customer-owned —Supplier-owned

In addition, non-profit corporations (like the Manhattan Institute) and private clubs, lacking any profit orientation, are commonplace.

BUT…

OWNERSHIP AND MARKET COSTS

“Most large-scale enterprise in the United States is organized in the form of the conventional business corporation, in which the firm is owned collectively by investors of capital.” —Henry Hansmann, Ownership of the Firm Journal of Law, Economics and Organization (1988)

This is true even though shareholder companies have high agency costs relative to alternative ownership forms.

The predominance of this ownership form ought to make us highly dubious about altering the traditional form of equity ownership shareholder wealth maximization norm.

OWNERSHIP AND MARKET COSTS

“In determining whether the costs of ownership are manageable for a given class of patrons, homogeneity of interest appears to be an especially important consideration. In particular, it is evidently a significant factor in the widespread success of the modern investor-owned business corporation, and it may be among the best explanations for the relative paucity of worker-owned firms, which otherwise have some significant efficiency advantages.” —Hansmann, Ownership of the Firm Alignment of shareholder interests around a single variable—shareholder wealth maximization—is thus perhaps the central reason why equity ownership predominates in the market.

OWNERSHIP AND MARKET COSTS

This makes sense in light of public choice theory.

Marquis de Condorcet

Kenneth Arrow

Vs.

OWNERSHIP AND MARKET COSTS

Arrow’s Theorem in a nutshell: When voters have three or more distinct options, no ranked voting electoral system can convert the ranked preferences of individuals into a community-wide ranking.

OWNERSHIP AND MARKET COSTS

American voters, for instance, have many different issues upon which they disagree:

Tax policy Welfare-state spending Military and foreign policy Trade policy Immigration policy Gun rights Abortion rights Gay rights

Most voters support candidates for office who disagree with them on one or more of these issues.

This is why politics is messy!

OWNERSHIP AND MARKET COSTS

This is why politics is messy!

OWNERSHIP AND MARKET COSTS

The same principles apply to corporate control—which is precisely why traditional corporate law orients control to a single class of stakeholder with interests aligned around a single variable of interest.

If a board of directors faces a choice weighing multiple factors—shareholder wealth maximization, employee impact, community impact, broader social goals like the environment:

How exactly should a decision be made? And how exactly should a court review a decision?

OWNERSHIP AND MARKET COSTS

Given the business judgment rule, the duty of care most commonly is applied in “change of control” or takeover situations. A multi-factor standard governing the duty of care would greatly inhibit the ability of courts to stop incumbent directors and managers from blocking value-creating bids on corporate control. This would effectively lock in equity capital—increasing the cost of capital to fund new ventures. “The empirical evidence is most consistent with value-maximizing, efficiency-based explanations of takeovers.” Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation, 9 Yale Journal on Regulation 119 (1992)

MARKET ALLOCATION OF CAPITAL

“[T]he process of industrial mutation . . . incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.”

—Joseph Schumpeter Capitalism, Socialism and Democracy (1942)

Schumpeter rightly understood that finance is the vehicle of creative destruction—for allocating capital to its most efficient use.

MARKET ALLOCATION OF CAPITAL

The return of capital to shareholders—more than 70% of which are institutional investors that reallocate capital—is the most efficient way to shift societal resources to highest-value use.

Three of the six of the most valuable companies in the United States did not exist at the time Professor Lazonick began criticizing traditional corporate governance in the late 1980s.

The market’s reallocation of capital to its most efficient uses is working!

MARKET ALLOCATION OF CAPITAL

How exactly should the director of a textile manufacturing company in the United States reinvest company earnings?

The Belgian company Picanol has made significant advances in air-jet loom technologies. But its products can be purchased by manufacturers worldwide.

It is hard to see how reinvesting earnings internally for a U.S. textile company in 1997—as opposed to distributing them to shareholders able to invest funds in Google or Amazon—would not be value destroying!

MARKET ALLOCATION OF CAPITAL

There is NO fundamental distinction between returning corporate earnings to shareholders in the form of dividends as opposed to in the form of share buybacks.

—In the United States, there can be tax advantages to share buybacks—which are treated as capital gains—as opposed to dividends. —Sometimes, this has been in terms of tax rates. —It is always the case for tax timing. —In addition, buybacks allow companies to distribute earnings irregularly, as opposed to dividends, which can be harder to vary widely.

SOCIAL INVESTING ACTIVISM IN PRACTICE

Under U.S. securities regulations, any shareholder with $2,000 of a company’s stock, held for one year, can file a shareholder proposal for inclusion on a company’s proxy ballot.

In 1976, the U.S. Securities and Exchange Commission issued an interpretive release stating that shareholder proposals if they involved substantial policy considerations.

This affords us the ability to market test “corporate social responsibility” concepts in practice—understanding that most institutional investors, who dominate shareholder voting, vote their shares consistent with a shareholder wealth maximization norm.

SOCIAL INVESTING ACTIVISM IN PRACTICE

Shareholder-Proposal Subject Matter (%) (2017)

In 2017, as in 2016, a majority of all shareholder proposals involved social or environmental concerns, as opposed to classic questions of corporate governance or executive compensation.

SOCIAL INVESTING ACTIVISM IN PRACTICE

Shareholder-Proposal Sponsors by Type (%) (2017)

Only 1% of shareholder proposals were sponsored by institutional investors without a social-investing orientation or a tie to public- or private labor unions.

SOCIAL INVESTING ACTIVISM IN PRACTICE

From 2006 through 2017, the 250 largest publicly traded U.S. companies (by revenues) faced 1,674 shareholder proposals related to environmental, social, or policy concerns.

Only 5 of these 1,674 socially oriented shareholder proposals received majority shareholder support over board opposition.

“Ownership by public pension funds engaged in social-issue shareholder-proposal activism is negatively related to firm value.” Tracie Woidtke, Public Pension Fund Activism and Firm Value (Manhattan Institute, 2015)

CONCLUSION

Elected officials can and should consider more than economic efficiency and profits in setting policy agendas.

There is little reason to delegate this important public choices to the leaders of publicly traded corporations.

Attempting to reorient corporate purposes strikes at the very core of the reasons why equity ownership has assumed its role as the preeminent form of organizing large commercial enterprises. This form of corporate organization has generated tremendous wealth since these debates began nearly a century ago—lifting billions worldwide out of absolute poverty.