The Future of Shareholder Wealth Maximization: A Response to George Mocsary

In “The Future of Shareholder Wealth Maximization,” Prof. George Mocsary examines two questions: Does corporate law require a corporation’s board of directors to act to maximize shareholder wealth in order to fulfill its fiduciary duties; and if yes (as Prof. Mocsary interprets the cases), should it continue to do so? In this Response, I argue that the law—at least as decided by the Delaware Supreme Court—does not yet clearly articulate shareholder wealth maximizing as the standard of conduct in order for boards to meet their fiduciary obligations, except in the narrow circumstances described as being in “Revlon mode.” That said, the Delaware Chancery Court has articulated the board’s obligations as maximizing shareholder wealth in a number of recent cases, and has effectively invited the Delaware Supreme Court to do so as well. Notwithstanding, I will argue that there are good reasons to reject shareholder primacy.

Shareholder Wealth Maximizing: About what do we disagree?

Before beginning, let me emphasize what I am not arguing: that shareholders have no “pride of place” in corporate law. Of course they do. Shareholders are the only group entitled to vote (although creditors can exert other control rights through their contracts); they are the only group with rights to bring suit derivatively on behalf of the corporation (in the U.S.: in our neighbor to the north a broader range of claimants can bring derivative actions); and the board’s fiduciary duties run “to the corporation and its shareholders.”[1] So the only issue on which Prof. Mocsary and I disagree is whether that duty to shareholders requires “maximizing shareholders’ wealth,” or at least trying to, and whether “maximizing shareholders’ wealth” can be understood as a reasonably accurate description of the corporate purpose.

Shareholder Wealth Maximizing in Delaware

Over the last three decades, primarily in response to the mergers and acquisitions trend beginning in the late 1970s that included hostile tender offers as a mechanism for buying control of a company, the term “shareholder primacy” has become synonymous with the perspective that the purpose of the corporation is to maximize shareholder wealth. Rejecting the socialized view of corporations and their obligations that had developed after World War II, shareholder wealth maximization as the “goal” of corporate law was invoked as a response to the political debates that takeovers were creating in the 1980s.

In an early (1981) articulation of the perspective, University of Chicago assistant professors Daniel Fischel (now professor) and Frank Easterbrook (now Judge on the Seventh Circuit Court of Appeals) relied upon the 1919 Michigan Supreme Court case of Dodge v. Ford[2]– a case in which the controlling shareholder Henry Ford eschewed any obligation to consider the interests of minority shareholders, the Dodge brothers. In famous dicta, the Michigan Supreme Court stated that “there should be no confusion (of which there is evidence) of the duties which Mr. Ford conceives that he and the stockholders owe to the general public and the duties which in law he and his co-directors owe to protesting, minority stockholders. A business corporation is organized and carried on primarily for the profit of the stockholders.”[3]

Yet, this statement must be understood in context: because of the business judgment rule, the Court refused to find that Henry Ford’s plans to pay his employees well, indeed more than the prevailing wage, were wrongful, even though that was one aspect of the Dodge brothers’ challenge. So the Court’s understanding of shareholders’ interests in a for-profit company recognized the company’s legitimate interests in pursuing a longer-term strategy (paying employees well so they could buy more cars), and recognized a balance between the interests of capital providers and labor providers that has been severely undermined by today’s narrower construct of “shareholder wealth maximizing.” Moreover, Henry Ford’s actions at the time were an attempt to “freeze out” minority shareholders by withholding any dividends, Ford having gotten wind of the Dodge brothers’ interest in starting a competing car company.[4] In a freeze-out situation a majority shareholder attempts to deny minority shareholders any financial returns on their shares. And, in a closely-held firm such as the Ford Motor Company was, the shareholders are all capital providers to the company, and their capital is locked in by restrictions on share transfers. The Court’s dicta can be understood as an exhortation to share, fairly, with the minority shareholders, who have no power in the situation (the board being composed of the controlling shareholders’ delegates), but does not provide support for the broader proposition that has been assigned to it—that the duty of directors in a publicly-held company is to “maximize shareholders’ wealth.”

That said, it is clear that the idea that the purpose of the corporation is to maximize shareholder wealth has been accepted by the vast majority of corporate law professors in the United States, and has made serious inroads within the judiciary as well. One recent Delaware Chancery Court case that Prof. Mocsary didn’t mention is Ebay v. Newmark,[5] which involved a struggle between Ebay and craigslist. Craigslist is a closely-held company whose founders and controlling shareholders, Craig Newmark and Jim Buckmaster, specifically, and consistently, rejected monetizing the value of their on-line advertising site. Ebay was able to buy close to a third of craigslist from the one person in the founding triumvirate who was interested in monetizing the value of the site, and then began to put pressure on the owners’ model. Eventually Craig and Jim (as the court referred to them) adopted various defensive measures to freeze Ebay out, and Ebay sued for breach of fiduciary duty. In echoes of Dodge v. Ford, the Delaware Chancery Court rejected the view that Craig and Jim should be permitted to defend the right not to maximize shareholder wealth:

Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders. The “Inc.” after the company name has to mean at least that. Thus, I cannot accept as valid for the purposes of implementing the [defensive measures] a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-profit corporation for the benefit of its stockholders.[6]

In another recent case, Air Products v. Air Gas, the Chancery Court upheld the board’s keeping defensive measures in place in ways that were demonstrably not wealth maximizing and to the frustration of many shareholders—albeit with great reluctance and making clear that it was only because of controlling Delaware Supreme Court precedent.[7] As the Chancery Court recognized, the Delaware Supreme Court had made clear that “directors are not under any per se duty to maximize shareholder value in the short term,”[8] even as the Chancellor Chandler in Air Products invited the Court to reconsider its takeover jurisprudence. This clear invitation to the Delaware Supreme Court to revise the law remains open.

Yet, to date, the Delaware Supreme Court has not required maximizing share value except when the company is in “Revlon mode,” that is, either being broken up or changing control structure—situations that even Prof. Moscary recognizes as a very narrow subset of corporate activity. In Paramount Communications v. Time, a high profile case where the shareholders clearly wanted the company to be sold to maximize their share price, the Court upheld the directors’ power to reject the shareholders’ views and maintain defensive measures.[9] While it might be argued that this simply reflects the Delaware Supreme Court’s recognition that it is directors, not shareholders, who have the statutory power to make fundamental decisions about the company, the board’s actions were demonstrably not shareholder wealth maximizing. If fiduciary principles required shareholder wealth maximizing, the directors’ actions that were upheld in Paramount v. Time and Air Products would not have been permitted. It is for that reason that I disagree with Prof. Moscary’s argument (and most corporate law professors’ view) that “shareholder wealth maximizing is a bedrock principle of corporate law.”

Should Shareholder Wealth Maximizing be Required?

Why might it matter whether a board considers shareholders’ interests (presumably in the long-term success of the company), versus acts to maximize their wealth? It can be the difference, I submit, between being a good landlord with fair terms for one’s tenants and contractors, plenty of heat in the winter, and necessary investments in proactive maintenance of the building for the long-term, versus being a slum lord. We can argue about the analogy, which is admittedly extreme, and try to elide the distinction with appeals to “long-term shareholder interests,” but in today’s world, with diversified capital market participants investing in any number of financial instruments based on computer algorithms on a millisecond-by-millisecond basis, few actual shareholders have long-term interests in specific companies. Most are either diversified mutual fund shareholders, or speculators betting on companies much as currency speculators are betting on Bitcoin today.

Contrary to popular belief, the capital markets are not generally providing capital to companies: most funding of corporate enterprise comes from retained earnings. Indeed, the “net contribution of equity finance to [company] investment projects in the UK and United States has been negative since around 1980s,”[10] given dividends and stock buy-backs from the early 1980s onward. Yet, pressures from capital market participants such as stock analysts, media commentators, and activist investors can cause company managers to act in ways to keep stock prices high, which is consistent with managers’ self-interest as they’ve increasingly been given one-way bets on company stock prices with stock option compensation. Some of these managers’ actions might be productive, such as finding ways to save energy or use fewer inputs, and thus cut costs; but others destroy longer-term value, such as putting off needed maintenance of plant and equipment, delaying marketing campaigns, cutting back on research and development,[11] or even engaging in financial reporting fraud or value-destroying mergers and acquisitions.[12]

Why, given the minimal contributions of today’s shareholders to companies’ projects (outside of initial equity investors, who account for a diminishingly small part of capital market activity), should managers have fiduciary duties to maximize the wealth of today’s shareholders—or this minute’s shareholders? A more productive system, such as we see in Scandinavia, the Netherlands, Germany or Austria, encourages managers and directors to manage their companies well and fairly for the long-term, which will benefit tomorrow’s shareholders in addition to today’s (while not necessary “maximizing” returns today), but which may also give management greater intellectual latitude to consider the positive implications of fair employment policies, high-quality product development, good relationships with suppliers, and so forth? (Intellectual latitude, for as every student of corporate law knows there is much actual latitude for management given the business judgment rule.)

The acceptance of the theory of shareholder wealth maximizing has coincided with an era in which wages for most income groups and professions outside of finance have been stagnant and economic inequality in the U.S. has become extreme.[13] Readers who care about a flourishing free enterprise system, especially one such as that in the United States, where 70% of the economy is based on consumption, should also care that the fruits of economic output are shared fairly enough to continue to fuel that consumption. (Whether any economy can continue free-wheeling consumption under the pressures of population growth and limits to the earth’s carrying capacity is a separate question.)

[1] See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985)(boards obligation is to act in “the best interests of the corporation and its shareholders”); Paramount Communications v. Time, 571 A.2d 1140 (Del. 1989)(same).

[2] 204 Mich. 459, 170 N.W. 668 (1919), cited in Frank H. Easterbrook and Daniel R. Fischel, The Proper Role of a Target’s Management in Responding to a Tender Offer, 94 Harv. L. Rev. 1161 (1981). Easterbrook and Fischel proposed what became known as the “passivity thesis” in that Article, suggesting that target management should not be able to block an above market tender offer to buy control of a company since blocking a tender offer would not maximize shareholder wealth. That thesis has been specifically rejected in Delaware, lending further support to the view that outside very narrow circumstances (“Revlon mode”) Delaware law does not require directors to maximize shareholder wealth. See, e.g., In re: Pure Resources, Inc., 808 A. 2d 421, 440 (Del. Ch. 2002) (recognizing that one of the few aspects of takeover law that is very clear is that the Easterbrook and Fischel thesis has been rejected).

[3] Dodge v. Ford, 204 Mich. 459, 170 N.W. 668 (1919).

[4] For a careful explication of the case in its minority freeze-out context, see D. Gordon Smith, The Shareholder Primacy Norm, 23 J. Corp. L. 277 (1998).

[5] Ebay Domestic Hldgs. Inc. v. Newmark, 16 A.3d 1, 35 (Del. Ch. 2010).

[6] Id. at 35.

[7] Air Products & Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48, 58 (Del. Ch. 2011).

[8] Id.at 98.

[9] Paramount Communications, Inc. v. Time, 571 A.2d 1140, 1154 (Del. 1989)

[10] Simon Deakin, Corporate governance and financial crisis in the long run, in Cynthia A. Williams and Peer Zumbansen, The Embedded Firm: Corporate Governance, Labor, and Finance Capitalism (Cambridge University Press, 2011).

[11] See J.R. Graham, C.R. Harvey & S. Rajgopal, The Economic Implications of Corporate Financial Reporting, 40:1 J. of Accounting and Economics (Dec. 2005).

[12] See Michael Jensen, The Agency Costs of Overvalued Equity, 34:1 Finan. Mngmt. 5-19 (2005).

[13] See Sanford M. Jacoby, Labor and Finance in the United States, in Cynthia A. Williams and Peer Zumbansen, The Embedded Firm: Corporate Governance, Labor, and Finance Capitalism (Cambridge University Press, 2011) (discussing data on both points, including data showing that since 1980 “the top 1 percent doubled its income share in the United States, reaching levels not seen since the early twentieth century.”).