Monday, February 1, 2016

The Shareholder Value Myth

The shareholder value myth was originated by Milton Friedman in a 1970 article in the New York Times.  Michael Jensen picked up on Friedman's idea and co-authored an article that transformed corporate governance, particularly in the US.  There has seldom been an academic idea that has had a similar impact on society.  It was warmly embraced by corporate executives, and by Congress, which passed a law that made it easier for executives to receive the bulk of their compensation in the form of stock options.  Managing the stock price through share buybacks, and increasing dividend payouts to shareholders, has replaced other uses of cash in most of our large corporations.

One of the problems with the notion of shareholder value primacy is that it originated in economics.  Corporations are legal entities which are bound by corporate law.  This article was written by a prominent corporate legal scholar who argues that the shareholder value primacy concept is based upon a serious misunderstanding of corporate law.  More importantly, it argues that shareholders have different reasons for owning shares in corporations.  Many are short term speculators who only care about turning a quick profit; others are long term investors who may be harmed by management decisions that make the corporation less able to compete in the future.  Moreover, shareholders have different values.  Some may worry about the effect of corporate decisions on the broader society,  and others may support corporate behavior that ignores the social consequences of corporate behavior.  Its fairly clear that BP shareholders have suffered from the efforts of management to take safety risks in order to cut costs.  The oil spill in the Gulf also affected suppliers and businesses that depended upon clean water for their livelihood. The recent problems faced by Volkswagen provide another example of the costs to shareholders, and to other stakeholders, of management decisions that were narrowly focused on short term profits and the stock price.

The notion that corporations are owned by their shareholders, and that they are solely entitled to corporate profits, is compelling for many people.  Its easy to confuse a publically held corporation to a private business with a single owner.  Given the importance of the decisions made by our large publically held corporations, and the damages that are being done in the name of shareholder value,  its important to understand the weaknesses of the shareholder value primacy myth.  This article should be required reading in MBA programs.

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