As this is the 50th anniversary of Milton Friedman’s seminal article in The New York Times Sunday Magazine arguing for the notion of shareholder primacy in corporate affairs, and the first anniversary of its repudiation by the Business Roundtable (BRT), some observations are in order. Friedman was not the first to articulate the point. It dated back many years and was most cogently argued by the Michigan Supreme Court in its now legendary 1919 opinion in Dodge v. Ford Motor Company.
Regrettably, the concept of shareholder primacy took a beating in academic and corporate circles during the Great Depression. It was replaced for many years thereafter by the notion that directors are not primarily responsible to shareholders in carrying out their responsibilities, but instead owed equal fidelity to the interests of employees, customers, suppliers and the general community in their decision-making processes. This became known as the stakeholder theory of corporate obligation. While the law itself, mandating shareholder primacy, never changed, for all practical purposes corporations were viewed as having obligations to multiple constituencies. It was this approach that Friedman questioned and attacked in his 1970 article.
Friedman ultimately won the argument with the advent of the modern corporate governance movement, initiated by institutional investors upset with declining corporate performance and consequent lowered equity valuations in the late 1980s. The institutional investors began to argue for the return of shareholder value maximization as the guiding principle of corporate theory.
They were successful in changing popular opinion as to the ultimate value to society of shareholder primacy. Even the BRT abandoned its longstanding support of the stakeholder approach and committed to the notion of shareholder value as the ultimate goal and responsibility of the public corporation, its directors and management.
Lately, however, spurred on by varied political and managerial forces, the cry for a return to a stakeholder objective for corporate purpose intensified dramatically. The BRT responded to this pressure last year by reverting to its earlier support of stakeholder primacy as the appropriate direction for corporations and their boards. This “new” approach is badly misguided. Before examining the problems with stakeholder governance, it is important to state out front that a shareholder primacy model does not mean the diminution of the other stakeholders in a corporation.
There are essentially three problems with the stakeholder theory espoused by the Business Roundtable. First, having a manager accountable equally to multiple constituencies diminishes dramatically a manager’s accountability and performance. If you are accountable to everyone, then you are accountable to no one. The polestar of long-term shareholder value creates an appropriate metric for boards and the public to evaluate a manager’s performance, and this ultimately increases accountability and the odds of a successful, thriving business through which all in society will benefit.
Second, the BRT’s placement of shareholders last on the list of corporate stakeholders is troubling. Shareholders come last in preference in bankruptcy and are protected by fiduciary duties primarily for that reason; placing them last on the Roundtable’s priority list, even if simply symbolic, sends the wrong message. If an equity holder believes they are last in line in corporate priorities, or even one of several equals, they simply will not invest or opt to become a debt holder instead, which would be a deathblow for starting new, risky, but potentially societally valuable, entities. That was the original logic for shareholder primacy.
Finally, the biggest issue involves who the shareholders are today. They are the working men and women of America who have invested in thousands of pension and mutual funds. If the Roundtable’s espousal of stakeholder theory was to protect other “stakes,” they have utterly failed by “deep-sixing” the very holders of those stakes whom they claim to be obligated to protect. And the lack of accountability created by this approach will lead to poor corporate results and the diminution of ordinary people’s ability to retire comfortably.
The lesson for boards is simple. The shareholders elected you, and you are legally obligated to them. Never forget this. I am not arguing for “short-termism” or ignoring the important needs of those various contributors to the corporate entity. For a business to be successful in the long term, the other stakeholders must be focused upon and treated fairly. But to elevate their needs as the corporation’s primary reason for existence will ultimately make us all miserable. And when results flounder and good companies find themselves in troubling straits, the investors — who include all of us — will in the final result hold the directors accountable.