Milton Friedman’s shareholder credo is simple and catchy but has shaky foundations. Corporate directors and officers are not agents of shareholders and have no legal obligation to focus solely on enhancing share value. Business corporations are legal devices invented centuries ago by states to govern group ventures, to hold property used in the venture, and delegate decision making about the venture to boards of directors. They were intended to provide benefits to communities and customers, as well as to investors and managers.
Editor’s note: To mark the 50-year anniversary of Milton Friedman’s influential NYT piece on the social responsibility of business, we are launching a series of articles on the shareholder-stakeholder debate. Read previous installments here.
Investors, corporate board members, and corporate managers are suddenly hearing from all sides that corporations should have a social “purpose” that addresses societal needs and takes into account the impact of their activities on communities, the environment, their workers, and the distribution of wealth and income, both within the US and globally.
According to this line of thinking, corporations should be providing solutions to the world’s problems—from containing pandemics to ending racism to reversing global warming. These new expectations come after decades of shareholders and leaders of corporations being told that they should focus their attention solely on “maximizing share value,” as instructed by University of Chicago economist Milton Friedman in 1970.
Friedman’s pronouncement about maximizing shareholder value has always had shaky foundations. But it carried the day in many policy arenas because it is simple, catchy, and has served the interests of the wealthy and powerful.
There are at least five different types of arguments made by defenders of shareholder value maximization: 1) those supposedly based on property law; 2) those based on a claim about who is bearing what risks; 3) those supposedly based on corporate law; 4) those based on the structure of incentives in corporations; and finally, 5) those based on the difficulty of holding corporate executives accountable for any goal other than maximizing share value.
Each of these arguments has gaping holes in it. Even collectively, they do not add up to a compelling case for a preference for share value maximization to the exclusion of other corporate goals.
The property law argument asserts that shareholders in corporations are the “owners” of those corporations. This is the basis of Milton Friedman’s claims about corporations. “A corporate executive is an employee of the owners of the business,” he wrote. If this were true, it might follow that corporate officers and directors are “agents” of shareholders and should do what shareholders want them to do, as hundreds of law professors and business school professors have claimed in recent decades. But the claim is false on both counts: Shareholders are not “owners” of corporations in any normal sense of that word, and directors of corporations are not the “agents” of shareholders. Although equity shares in a corporation are a species of property, like any other security issued by a corporation, the corporation itself is not a piece of property.
The corporation is a legal construct, created by an act of a state, which construes a group of individuals acting collectively as a single entity, for the purposes of holding property and entering into contracts.
The entity created by a corporate charter is legally distinct from the shareholders, the managers, the directors, and of any other participants in the activities of the corporation. It has an indefinite life (by default, though the parties who seek the charter, or the state that grants it, can impose limits), and its assets and obligations remain those of the corporation even as the individuals involved change. This has enormous advantages for the participants in any corporation because it makes it possible for the corporation to make long-term commitments to enterprises that require substantial resources that are highly specific to an enterprise (e.g., railroad tracks, or factories) over an extended period of time.
Thus, the corporation can hold property, like an individual, but the corporation is not, itself, a piece of property. Moreover, under the law, executives and officers of corporations are agents of the corporation, but are not agents of shareholders. Corporate directors are fiduciaries for the corporation, but, again, not agents of shareholders.
The risk-bearing argument starts by conceding that shareholders are not, technically, owners of corporations, but, nonetheless, they are said to be the bearers of the residual risk associated with corporate activities. Other participants, or “stakeholders,” are all supposedly compensated by complete contracts, but the shareholders are compensated by a residual contract that says they get what is left over after all the others have been compensated. Because shareholders are the residual risk bearers, the argument goes, social value is maximized when the value of that residual claim is maximized.
This is clever, but still doesn’t work as a defense of shareholder value maximization because it is not factually correct. When corporations are taken over and restructured, employees often find that the value they expected from a long-term relationship with the corporation—such as their pension plan—is destroyed. The current pandemic makes it clear that employees and communities bear substantial risks related to the performance of corporations.
The financial crisis of 2008-2009 made it clear beyond dispute that, when corporations compete by trying to maximize share value, they frequently do so by foisting risk off to governments and to society at large. Even in bankruptcy, which is the only context in which shareholders, by law, are supposed to get the residual, shareholders often participate in distributions of assets even while some creditors and claimants, such as employee pension funds and tort claimants, do not get paid in full.
The corporate law arguments are also problematic. Despite what Milton Friedman said, there is no statutory requirement anywhere, in any state, that says that corporate officers and directors must maximize share value. Corporate laws typically say something like “the board of directors of a corporation shall exercise all corporate powers.” The fiduciary duties of corporate directors and officers require only that they are informed, that they exercise care in their decisions, and that they not act in their own personal interest.
There are a handful of court cases in which a simplified reading would seem to suggest that courts require shareholder value maximization. Upon closer examination, these cases involve one of two situations: either a controlling interest in the corporation is going to be sold, and existing corporate shareholders are going to be bought out, in which case courts have said directors must try to get the highest buyout price they can; or, the issue at stake is whether a controlling shareholder in a closely held corporation can use corporate assets, or cause the corporation to pursue strategies that divert value to the controlling shareholder at the expense of minority shareholders.
In those limited cases, courts have required the majority shareholders to refrain from actions that siphon value out to themselves and instead direct them to take actions that create value on a pro-rata basis for all of the shareholders, not just for the subset of shareholders that control the entity. The instructions that courts give in these cases sometimes use share value maximization language, but courts have not attempted to apply a share value maximization rule broadly across all of the decisions boards and managers make.
In recent years, some advocates of share value maximization have argued that the incentive structures in corporations will push corporate actors toward the maximization of share value. This is partly a product of several decades of business school education that has told managers they should structure compensation packages to reward corporate executives if the share price goes up. These compensation packages are choices of the existing management and boards. They could, in principle, be structured to encourage corporate officers to reduce the firm’s carbon footprint, or improve their record of on-time delivery to customers, or to improve training and safety protocols for employees.
In the process of negotiating share-price based compensation packages stuffed with stock options, perverse incentives have emerged. Corporate executives often have an incentive to report bad news to the markets a few days before the issue date of new option awards so that the exercise price of the options might be lower than it otherwise would be. It is also well known that corporate executives often accelerate the recognition of revenues, or slow the charging of costs, or delay investment expenses so that the corporation seems to meet reported net income targets. While it might seem like a good idea to incentivize corporate executives to take actions that lead to better stock price performance, actions that manipulate the short-term share price may undermine the actual long-term performance of the corporation.
Perhaps the most important argument in favor of share value maximization is that share value is a readily observed metric, while other sources of value that corporations provide to society (or costs they impose) can be extremely difficult to measure. It is also difficult to determine causal links between performance in various measurable dimensions, and the social value of the corporation. So, the argument goes, we should evaluate and incentivize corporate leaders to focus on share value because that’s a metric we can measure with precision! But that’s sort of like saying that we don’t really know or understand all the factors that lead to good health, so let’s just measure how much a person weighs and let weight serve as a proxy for the overall good health of the person. We should, instead, put our energy into finding better measures of social value, rather than finding better ways to create incentives to deliver a false or incomplete proxy for social value.
Even if social value is hard to measure, it may be possible to encourage the creation of social value if we focus on fair and efficient systems and processes for creating and distributing wealth. The Chicago School of economics has emphasized property and contract rights as essential for wealth creation, for example. But another type of institution that economists have given much less attention to are mechanisms for resolving disputes, which can facilitate cooperation and production by groups or teams.
Corporations are, by nature, group enterprises. Some of the earliest business corporations were invented as tools for the self-governance of groups of traders, or skilled workers, or other business people, who believed they could be more productive if they pooled their resources and worked together. Other early corporations were formed to hold assets necessary for the construction and maintenance of some important piece of public infrastructure, such as a canal or a bridge or a cathedral. The king, or parliament, or, in the new United States, state legislatures, would grant charters that prescribed a governance structure for these organizations, such as a board of governors or board of directors, so that disputes among the participants could mostly be settled internally and kept out of the courts. It wasn’t until the mid-20th century that the law even allowed single persons, acting alone, to form business corporations (and corporations could not form other corporations).
Seen this way, corporate executives and directors should understand that a big part of their role is to keep the participants in the corporate enterprise working together in a productive way. This involves assuring adequate rewards to investors such as shareholders and creditors, but also recognizing that other participants, including employees (from key creative people to rank and file workers), suppliers, customers, and communities, also have assets at risk in the enterprise, and all need to prosper and be treated fairly over time.
The law understands this broader function of executives and directors, which helps explain why the law requires corporations to be governed by boards of directors with all corporate powers, rather than by individual founders or CEOs. That is also why the law says that the fiduciary duties of directors and officers run to the corporation, and not directly to any individuals who are involved in the corporation, including any individual shareholder.
It is complicated, uncertain, and sometimes hazardous to one’s health to try to govern an institution that involves a lot of competing interests, especially one in which a number of different parties have made investments and commitments in the enterprise, and all want to be sure their interests are taken into account. This is why kings and parliaments and legislatures have tried to keep as much as possible of the decision-making about the internal operation of corporations out of the courts. It is also why the law delegates governance to boards of directors and does not designate in advance, and from outside of the enterprise, which interests should prevail in any given situation.
What does all this mean for the debate about corporate “purpose”? Corporations are legal devices, not pieces of property. Their original function was to provide for the governance of joint enterprises, developments, and projects that require the participation of a variety of different types of investors and other participants, and are expected to provide benefits for many different customers, clients, and communities. All hope to gain some advantage from interacting with the corporation. In this way, there can be no single corporate purpose. Likewise, no one metric can measure the full costs and benefits provided by the activities of the corporation. The law deals with this by delegating decision-making to boards of directors and places no obligation on them to focus only on rewarding shareholders.