The decline of shareholder value

This is part of a text that I have written on the duty of disclosure present in US Securities Law which I will share in the near future.

 

Shareholder value has been  for long accepted as the most relevant corporate strategies. Certainly, the primacy of shareholder value is also the result of economic and ideological perspectives from a historical process. The historical context of shareholder value can be traced back to the emergence of management capitalism to the decisive triumph of capitalism over socialism in the late years of 1980 decade’[1]s.

Before the shareholder value perspective the prevalent managerial trend was managerial capitalism[2]. According to this conception of management was in large measure influenced by the presence and regulation of large public Institutions, the Directors had a fiduciary liaison with the Institution and the shareholder’s value was just one of the collectives which fell inside of Director’s responsibilities[3]. Other sectors included in the Directors and the Managers responsibilities with other stakeholders such as customers, creditors, employees and the community[4]. The triumph of neoliberal views over state interventionism set the stage for a period of market liberalism characterized by strong deregulation and the strengthening of corporations[5]. Certainly, academic´s work had a vital influence in the consolidation of the neoliberal views of the best known intellectuals such as Milton Friedman famous essay on shareholder value in which the author argued that a corporation’s only goal was to maximize its profits[6].

The work which captured the ideas of profit maximization and developed the idea of shareholder value was the paper elaborated by Jansen Michael and Meckling William entitled “”the theory of the firm[7]. Both essays are known for arguing in favor of profit maximization as the main or only objective of corporations. The work of these authors had enormous impact in the creation of the shareholder value concept.  The article integrates three diffent conceptions: the theory of property rights, the agency cost theory and ownership structure theory. Of central importance to the paper is the explanation given regarding the relation of agency between the managers and the firms.

The authors explain that there are several sources of conflict such as the natural tendency of the manager to appropriate the resources of the firm or the problem which can arise if the manager does not employ the necessary effort/ our diligence in his activity. By describing these problems, the authors looked to demote the activity of managers and to favor the shareholder value criteria. By centering all the efforts in the shareholder value the interests of the shareholders or the corporation will be saved. Following Roger Martin  the argument of these authors consisted in the fact that “The the owners were getting short shrift from professional managers who enhanced their own financial well being rather than that of the shareholders. This was bad for shareholders and wasteful for the economy, Jensen and Meckling argued, the managers were squandering corporate and societal resources to  feather their own nests[8].

The notion of shareholder value is thus the result of a specific historical process and until present day it is still a frequently used reference for Managers[9]. The concept has been used as a mean to get efficient results or to maximize profits. The first impression is that it could be a successful mechanism for profit maximization and as mentioned reflects the neoliberal ideas which consolidated during the end of the 1980’s. The theory of shareholder value has been finally elaborated around the notion of the agency contract where shareholder/owners hire directors and these act on their behalf. This concept of shareholder value allows to explain with more detail how the relationship between the stockholders and managers of a corporation fits the definition of a pure agency relationship.

Despite the enormous reception of shareholder value, there is evidence which suggests that the strategy is not the only, the best or even the desired strategy for desirable results[10]. As Denning, Steve suggests, shareholder value encourages hierarchical bureaucracy, it destroys employee morale, it is antisocial in nature, gives business a bad reputation and it cripples job growth[11].

Another argument against the notion of shareholder value consists in that it is a theory which does not take into consideration the long term results of the firm[12]. According to this last critique shareholder value is an overly narrow theory. It is also a measure which does not take into account the full scope of the financial and economic activity, the sense that it ignores that there is a plurality of interest and persons who work around the notion of the firm[13].

The intellectual backbone of shareholder value reflected the economic thinking of an era which did not take into account the role of shareholders in the corporation and of manager’s consumers and other entities involved in the corporate activity.

Moreover, and the following the narrow economic vision of shareholder value from which it was created did not take into consideration that an understanding of the main problem is incomplete without a legal study of the problem. As Lynn A. Stout points out, shareholder value does not take into consideration the notion of “legal entity.”

According to law, the shareholders are not owners of the corporation as the economist Milton Friedman might have argued; there is a contractual relation of the shareholders with the shares. This is of great importance as it shows that the subject regarding shareholders, shares and corporations has necessarily a legal dimension which has to be taken into account. Moreover and as equally important it is a legal entity which gives shareholders limited legal rights.

Alternatives to shareholder value: Stake holder value and Consumer Capitalism

The purpose of describing alternative theoretical approaches to the firm consists in demonstrating that the concept of shareholder value is currently being challenged by other strategies. These new theories of the firm (the stakeholder theory and consumer capitalism) have in common with the Duty of Disclosure exactly the fact that they are all the results of policies or conceptions of the firm which move away from the notion of only recognizing profit maximization as the main objective of the firm.

One of the possible alternatives to shareholder which has already been indicated is the replacement of shareholder value by the concept of stakeholder value[14]. This option would allow to explain the structure and the operations of a corporation in a way that allows to include relevant market participants and issues into the decision making sphere[15]. This would be the case of public institutions, investors, or labor interests. This strategy would allow as well the integration among these concepts. In this case several group interests which have gained enormous importance in the present day and which were completely ignored by shareholder value such as costumers[16].

More over this alternative would certainly be a better option for corporations in the long run than shareholder value[17] criteria. Despite of these evident advantages, the stakeholder value conception has also important inconvenients. For example, as Denning, Steve argues, including a multitude of interests necessarily leads to the existence of different Directors who might have different interests. This situation can certainly lead to conflicts between Managers and Directors, a matter which makes this issue unpractical[18].

 An alternative to stakeholder value is a theory which is gaining now important momentum is the notion of customer value. The advantages of this conception of the firm over the one proposed by share value defenders consists in the fact that it is a theory of the firm which would benefit both shareholders as costumers. It is also a theory which offers as oppose to share holder value, long term solutions as one of its primary objectives consists in creating stable relation with customers. It is also a theory which as it targets or addresses customers offers a high profitability.  Moreover it is a theory which doesn´t necessarily enter into conflict with stakeholder theory or sustainable growth. The reason behind this assertion is that good policies on corporate social responsibilities generally have a positive impact on costumer value.

A corporation with good CSR reputation will enjoy from investor and consumer confidence. The consumer value also serves as a parameter for measuring the successes of corporate social responsibility measures. Following a research by Peloza, John and Shang, Jingzhi, CSR leads to outcomes such as increased customer loyalty, willingness to pay premium prices and lower reputational risks in times of crisis. Moreover, according to the research each of these measures has the potential to support increased profitability[19].


[1] An excellent article on the historical context of shareholder value is the one elaborated by Mizruchi Mark S. and Kimeldor Howard in The Historical Context of Shareholder Value Capitalism ,( Political Power and Social Theory, volume 17, 213-221) According to these authors this facet was characterized by the following institutional conditions: First, most corporations had come to accept the existence of labor unions. Second, the emergence and expansion of a more activist state. In third place, there was a change in social organization and growing activism within corporations. The second stage is the failure of the State to adequately address mainly the economic issues of America and its replacement with the neoliberal policies introduced by Reagan. The final stage coincides with the retreat of the state, labor and the banks from control of corporations and the rise of institutional investors and financial analysts.

[2] The rise of managerial capitalism in the United States is very well explained by Lazonick, William in “Organizational Capabilities in American Industry: The rise and Decline of Managerial Capitalism”. The author relates the rise of  managerial capitalism with the arising of organizational capabilities in American Industry, which were means to coordinate, integrate and plan divisions of labor to organize goals. According to the author managerial capitalism was both a cause and effect of the growth of American or the growing and technical and social complexity of the specialized divisions of labor are explanations of the emergence of managerial capitalism (p1.),

[3] Lynn A. Stout: The shareholder value Myth: Cornell Law school-Jack G. Clarke Business Law Institute. April 1, 2013. European Financial Review, April-May 2013.

[4] Ibid. Page 2.

[5] As Mizruchi, Mark S. and Kumeldorf, Howard point out, in the period of 1980´s American presidency, “by freeing up markets and implementing fiscal and tax policies designed to encourage investment americans would enjoy a level of personal freedom never before experienced under the shadow of big government. (p 6)   

[6] Friedman, Milton “The social responsibility of business is to increase its profits, New York Times Magazine, September 13, 1970.

[7]  C. Jensen, Michael, Meckling William H. The Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economic 3. Received January 1976.

[8] Martin, Roger. The age of customer capitalism. The magazine January 2010. Harvard Business Review

[9] Despite recent publication which severly critique shareholder  value ( see Jesse Eisinger, “Challenging The Long-Held Belief in ‘Shareholder Value’”, New York Times, (June 27, 2012); Joe Nocera, “Down With Shareholder Value,” New York Times (August 10,2012); Andrew Ross Sorkin, “Shareholder Democracy Can Mask Abuses,” New York Times, shareholder value theory is still a used criteria and is still defended by many authors ( see Why is shareholder value still matters. Hansell, Gerry and Olsen, Eric. Bloomberg Business week. Companies & Industries. March 23, 2010. http://www.businessweek.com

 

[10] According to Stout, Lynn points out the only empirical finding that has been replicated “ is that when governance changes cause directors to sell a company, the buyer pays a premium over market price. Cornell Law school- Jack G. Clarke Business Law Institute. April 1, 2013. European Financial Review, April-May 2013.

[11] Denning, Steve. Can the dumbest Idea in the world be saved? http://www.forbes.com/sites/stevedenning/2012/11/27/  last accessed 25/08/2013.

[12] As Stout, Lynn A. points out there is strong evidence which demonstrates that the shareholder value is not an adequate strategy especially for policymakers. According to the author “shareholder value-increasing strategies that are profitable for one shareholder in one period of time can be bad news for shareholders collectively over a longer period of time.”(p4).

[13] The article Corporate Governance: Stakeholder Value Versus Shareholder Value Charreauz, Gerard and Desbrieres, Philippe propose the replacement of the concept of shareholder value by the notion of stakeholder value. According to the authors, stakeholder value is a more suitable definition as it permits the formation of the pluralist view of the firm and stakeholder value. Charreaux, Gerard and Desbrieres Philippe. Corporate Governance: Stakeholder Value Versus shareholder value. Journal of Management and Governance 5: 107-128, 2001.

[14] Following Freeman, R. Edward “Stakeholer theory of the modern corporation” stakeholders are groups, individuals who benefit from or are harmed by, and whose rights are violated or respect by corporate actions.

[15] A good explanation of the stakeholder theory can be found in Donaldson Thomas and Preston Lee E. “The stakeholder theory of the Corporation: Concepts, Evidence, and implications” According to the author the theory of stakeholder value can be understood according to three different views: the descriptive, the instrumental and the normative aspects.

In synthesis, the descriptive point of view of the author argues that stakeholder theory is used to describe and to explain, specific corporate characteristics and behaviors. According to the author, the instrumental perspectives uses of stakeholder theory to make a connection between stakeholder approaches and commonly desired objectives such as profitability (p7) finally the normative theory tries to interpret the idea of investor owned corporation on the basis of philosophical doctrines. Another issue of great relevance to understand the concept of stakeholder value dealt by the author consists on the issue regarding the justification problem or why is this theory relevant or better than other theories. Source: The academy of Management Review, Vol. 20, No 1 (Jan., 1995), pp.65-91. Published by Academy of Management. Stable URL: www.jstor.org/stable/258887

[16] A close idea to stakeholder value is presented by   Rebernak Kathee. In this case the author argues that idea of integrating sustainable principles into corporate strategy and implementing them in operations would generate business value. As the author expresses this would demonstrate that shareholder value does not suffer in the pursuit of “sharevalue”.

(Source: Framework strategies for sustainable advantage, 2012. From www.framework-llc.com last accessed 25/08/2013) 

[17] Ibid. In this article the authors stand out that corporate governance as a crucial criteria for value creation. The authors intend to give a definition of  stakeholder value in accordance to a pluralist view of the firm( p 108)

[18] Denning, Steve “Is the Tyranny of shareholder value finally ending?  The risk of return to garbage organizations. According to the author the problem of the concept of stakeholder value is that it  has the danger of going back to “garbage organizations” characterized by “ a variety of inconsistent and ill defined preferences.”  8/29/2012 (Source www.forbes.com last accessed 26/08/2013 p).

[19] Peloza, John and Shang Jingzhi “Sustainability and Customer Value. Sustainability Matters. Why and how Corporate Boards should become involved. The conference Board Center for Sustainability. www.conferenceboard.org/sustainability.  The main hypothesis of this article is that CSR activities have the potential different forms of value for the customers. (p53)

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