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March|April 2006
A Watchdog That Didn't Bark By Norman Ornstein
Shareholders Unplugged By Lynn A. Stout
Overprivileged By Francisco Ferreiro

Shareholders Unplugged

Power to the investor is the favored cure-all for corporate mismanagement, but it's bad for public companies and the people who work for them.

By Lynn A. Stout

CARL ICAHN, THE ONE-TIME CORPORATE RAIDER and present-day hedge-fund manager, portrays himself as a champion of the average investor. His latest Robin Hood maneuver is an attack on the media giant Time Warner and its share price, which has been stagnant for the past three years.

In partnership with some outside hedge funds, Icahn has acquired 3.1 percent of Time Warner's stock. With the advice of the investment bank Lazard, he is using this stake to try to pressure Time Warner's board into (in Icahn's words) "maximizing shareholder value."

In particular, Icahn wants the company to sell some of its key business lines, including, perhaps, America Online, and to buy back $20 billion of its $79 billion of outstanding stock, all to drive up the price of company shares.

Would Icahn's plan actually benefit the average investor? He does not have a track record of rescuing troubled companies through his salvaging of investments gone bad. To the contrary, he has left a fair amount of wreckage in his wake, including a bankrupt TWA. Yet while Icahn has never shown a talent for keeping a company healthy over the long term, there is one trick he knows very well: how to "restructure" firms to boost share price long enough for him to make money.

Icahn's actions go to the heart of a long-running debate over public corporations and their proper purpose. One side, the so-called "shareholder primacy" view, argues that boosting share price is exactly what good corporate governance is about, and that the job of corporate boards and the directors who sit on them is essentially to do what shareholders want them to. The other argues that, for a corporation's long-term health, its directors must consider the interests of shareholders but also of other important corporate stakeholders like employees, consumers, and the communities where the company does business.

The shareholder-primacy view originated not in corporate law or practice but in economic theory, particularly the "Chicago School" of thinking, which emphasized a free-market approach that is now treated as a basis for laissez-faire monetary policies. The Chicago School first weighed in publicly on the subject of corporate purpose in 1970, when the economist Milton Friedman argued that because shareholders "own" corporations, the only "social responsibility of business is to increase its profits." Few directors or executives actually ran companies this way. Friedman's argument nevertheless gained traction among academics, especially after the publication in 1976 of an influential paper, "Theory of the Firm," by the economists Michael Jensen and William Meckling. According to the authors, shareholders are "principals" who hire directors as their agents in managing corporations, and the job of these directors is to increase shareholder wealth—through every means possible, short of violating the law.

This paper, and the ideology behind it, led to the rise of a "principal-agent" model of the public corporation, which turned out to have a broad appeal. To law professors, the application of economic theory lent an attractive patina of scientific rigor to the shareholder-primacy side of the debate over corporate purpose. To the press, shareholder primacy offered a good sound bite about what corporations are and what they are supposed to do. To business reformers seeking a way to distinguish between "good" and "bad" governance practices, the approach promised a single, easily read measure of corporate performance in the form of share price. The principal-agent model seeped into the curriculum at law and business schools. By the mid-1990s, most regulators and many scholars had come to accept the maximization of shareholder wealth as the only goal of corporate governance. Meanwhile, in the business world, directors and executives continued to quietly run companies with a broader view of corporate purpose. They felt increasingly uneasy, however, about doing what their business sense told them to do. The ideology of shareholder primacy prevailed, even if it didn't dictate corporate practice.

YET EVEN AS SHAREHOLDER PRIMACY has gained widespread ideological acceptance, the theory underlying it is being questioned by a new generation of corporate scholars. They suspect that the principal-agent model reflects both a mistaken view of corporate law, and a mistaken view of corporate economics.

Starting with corporate law, it is worth noting that the principal-agent model was devised by economists—not by lawyers. This may explain why it fails to account for the legal structure of the corporation. According to corporate law, shareholders are neither owners of nor principals in corporations. Nor are directors agents. Legally speaking, corporations "own" themselves, and they are controlled not by shareholders but by directors, who are supposed to represent the best interests of the firm as a whole—not just its shareholders.

Shareholders do have some influence. They can sell their shares in a corporation if they don't like the direction in which it's headed, or they can keep their shares and exercise the voting rights that come with them, which in theory allow shareholders to oust a sitting board. In most public companies, however, defenses have been put in place to block any type of shareholder-led hostile takeover, and shareholders are so widely dispersed and apathetic that their voting rights have limited practical value.

Nor does corporate law require directors to build up shareholder wealth. To the contrary, there's a long-established legal standard—the "business judgment rule"—that insulates directors from liability for almost anything short of outright theft. In practice, this makes it impossible for shareholders to sue directors who sacrifice share price to benefit employees, customers, or other corporate constituencies.

The result, as experienced corporate lawyers know, is that public companies in the United States are controlled by their directors and not by their shareholders. And while boards care about share price, they often care about other things as well. For example, they care about the complaints they receive from employees, creditors, or communities harmed by corporate action. They also care about the firm's long-run survival. (No firm, no board.) Corporate law gives them room to take account of such concerns. This director-oriented governance system departs dramatically from the shareholder-primacy ideal, but it has served shareholders themselves remarkably well. American public corporations, for all their flaws, have the best long-run performance record in the world.

Turning to economics, recent scholarship on corporate governance suggests that control by directors works because it helps solve three distinct problems that public corporations commonly face. The first is that most shareholders don't have the time, skill, or inclination to pay attention to what's going on inside the firm. Most of them care only about share price, which isn't always a true reflection of the economic health of the company. By contrast, directors have a better knowledge of their corporation, and they are much more likely to have a realistic conception of the true value of their company and its shares. (Twenty years ago, the idea that share price might not reflect value was controversial. Today, however after the bursting of the tech-stock bubble in 2000, even finance economists have largely abandoned the idea of an "efficient" stock market where prices always capture value. One of the hottest areas in finance theory today is something called "heterogenous beliefs" modeling, an approach to understanding stock prices that explains why share repurchases of the sort being pushed by Icahn raise price without doing a thing to improve underlying corporate performance.)

The second economic problem boards help solve arises from the fact that, in public firms, different groups of shareholders very often have different interests. The principal-agent model of the corporation glosses over this inconvenient fact, assuming shareholders are one big happy family with a common interest in raising share price. But the reality is more complicated. For example, conflicts arise between short-term and long-term investors, because strategies that pump up prices short-term (cutting research, repurchasing shares, even engaging in accounting fraud) often harm shareholders in for the long haul, typically mom-and-pop investors and those who buy index funds.

Shareholders are riven by other conflicts as well. In the Time Warner example, a diversified investor who owns stock in that corporation is likely also to own stock in companies that are candidates to buy Time Warner's business lines. As Icahn knows well, bidders often overpay in such situations. A diversified investor would not want Time Warner to raise its share price by selling assets at inflated prices to other companies the investor also owns. Undiversified shareholders, however, don't care about the negative effects of playing musical chairs with corporate assets. And because undiversified shareholders—which these days are most likely to be hedge funds—usually have larger individual stakes in a company than diversified shareholders do, they are far more likely to wield influence in a system that relies on "shareholder democracy."

Finally, director governance serves another useful purpose. While keeping shareholders from exploiting each other, it also keeps shareholders from exploiting employees, customers, and other important stakeholders. This idea is explored in the growing literature on the "team production" model of the corporation, which I developed with Margaret Blair, a professor of law at Vanderbilt University. Team-production analysis starts by recognizing that, in addition to needing shareholders to supply capital, healthy corporations often need executives, employees, communities, and other groups to make what economists call "specific investments" in the company (meaning investments of time, money, or expertise that bear fruit only if the corporation survives and thrives). For example, a typical start-up needs an entrepreneur to provide an idea, equity investors to provide cash to fund initial operations, and executives to provide loyalty, dedication, and long hours implementing the idea. Each contribution is essential to the business's success. And each contributor risks losing his stake if the firm goes under.

ACCORDING TO THE PRINCIPAL-AGENT MODEL, directors shouldn't worry about nonshareholders' specific investments, because employees, customers, and other corporate team members have formal contracts to protect them. But a variety of contributions people make to a corporation aren't covered by formal contracts. Consider the executive who skips vacations and works weekends because she cares about her work and believes the company won't fire her without good reason, or the customer who buys and learns to use a software product assuming the company will support it, or the community that builds roads and schools to serve factory employees in the belief the factory will stay open. Shareholders have no interest in protecting these sorts of investments by nonshareholders. In fact, they might be tempted to exploit the investments by threatening to destroy their value unless given concessions that raise share price. ("Cut the property taxes due on our factory, or we'll close it—rendering the roads and schools you've built useless.")

But directors, unlike shareholders, cannot personally profit from exploiting the groups that make up the corporate team, at least not in their role as directors. The board's primary interest is keeping the company alive and healthy, so the directors keep their jobs. Board governance offers what Martin Lipton, a dean of the corporate bar, has described as the promise of "business continuity," which attracts important investments from nonshareholders. These investments contribute to corporate profits. As a result, board governance promotes team production in a fashion that serves shareholders' future overall interests even if it sometimes frustrates their attempts to raise share price (at other team members' expense), at a particular moment in time.

Corporate experts alert to the problems of market inefficiency, conflict among shareholders with differing interests, and the potential for exploitation of a corporation by its shareholders frown on boards that always do what shareholders ask them to—especially when shareholders are asking a board to do everything possible to raise share price. Despite its imperfections, the traditional U.S. system of corporate governance by a board with the freedom to consider long-term results and nonshareholder interests may be better than a system that requires directors to bow to a large shareholder's demands.

If this view is correct, we should worry about the extent to which the ideology of shareholder primacy is influencing the way corporate directors and executives view their own roles. Most experienced managers still reject the notion that they should always increase share price, no matter what the cost to stakeholders or the company's own future. Nevertheless, the idea that shareholders "own" corporations and that directors are merely "agents" is becoming more widely accepted among business leaders and in the business press. Carl Icahn has plenty of company in his effort to compel a big corporation into raising its stock price, with activist investors working to force similar changes at Wendy's, Knight Ridder, and other corporations.

The principal-agent model is gaining influence among practitioners as it loses support among theorists. And it is practitioners, including corporate lawyers, investor advisory services, and directors and executives themselves, who determine whether and to what extent the ideology of shareholder primacy, although not required by corporate law, becomes internalized to the point that it influences actual business decisions.

These developments make it more important than ever that business people in the trenches understand the weaknesses of shareholder primacy and the principal-agent model of the corporation. They should pay attention to what they know, rather than following the simplistic recommendations of economists whose theories have little to do with the realities of corporate law and practice. There's more to a public company than "shareholder value." If we lose sight of that, customers, employees, and communities will pay the price—and so will long-term investors.

Lynn A. Stout is a professor at UCLA School of Law and Principal Investigator for the UCLA-Sloan Research Program on Business Organization.

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