The Future of Shareholder Wealth Maximization

Right on its 20-year schedule,[1] the old debate over the proper purpose of the corporation has recently been revivified in books, articles, and blog posts in as dire a tone as ever. The spectacular corporate failures on the part of firms like Enron, Lehman Brothers, and the quasi-governmental Fannie Mae, accompanied by equally spectacular government bailouts of failed firms, have fueled the recent uproar. A sense that someone has somehow wronged the rest of us characterizes the zeitgeist of the post-bailout era.

It is textbook law that a corporation’s board of directors must act in good faith to maximize for its shareholders the value of the firm under its charge. This essay considers the future of this bedrock principle of corporate law—shareholder wealth maximization—from practical and aspirational viewpoints. It first addresses the assertion that corporate law in fact does not require directors to maximize the wealth of their shareholder principals, and concludes that this claim is indefensible when viewed in proper context. It then asks to what extent shareholder wealth maximization ought to be the norm, and offers a libertarian, shareholder-driven take on corporate purpose.

Shareholder Wealth Maximization is the Norm

Shareholder wealth maximization deniers argue that directors do not, and never had to, maximize the wealth of a corporation’s shareholders. Their first argument is based on the observation that directors are regularly exculpated from liability despite having lost money for their firms. But this misses the point. Shareholder wealth maximization, as courts adjudicate it via the business judgment rule, is a standard of conduct, not a legal rule requiring a particular financial result. That is, directors incur no liability for an injury to the corporation resulting from an action that they pursued in good faith and with appropriate care. Managers must attempt to maximize shareholder value, but are not required to succeed.

The business judgment rule is thus the standard against which adherence to the shareholder wealth maximization norm is reviewed. It protects many actions that, in hindsight, did not increase, much less maximize, shareholder wealth. This includes manager decisions that appear to have favored the interests of nonshareholder stakeholders at shareholder expense. Courts do not second guess business decisions that plausibly could have furthered long-term shareholder wealth.

This perhaps odd combination of a strict wealth maximization principle and a low standard of review is a result of an implicit contract between shareholders and managers: Shareholders would not invest in a company if managers could whimsically deploy their investment to serve other interests. At the same time, managers would not work for a firm if their acceptance of employment meant that they had to guarantee optimal financial returns.

The second argument is grounded in language in some judicial opinions that, when viewed in isolation, can be read to suggest that shareholder wealth maximization is optional. For example, the Delaware[2] case of Air Prods. & Chems. v. Airgas,[3] says that a firm has no “per se duty to maximize shareholder value in the short term.” But for several pages thereafter, it reinforces the rule that a firm cannot neglect its long-term responsibilities to its shareholders. An honest reading of the case, especially in the context of the common law in which it is couched, establishes that the long-run interest to be considered ultimately comes back to that of the shareholder. Two older but famous cases, A.P. Smith Manufacturing v. Barlow[4] and Shlensky v. Wrigley,[5] are likewise cited for the proposition that maximizing shareholder wealth is discretionary. The former, in refraining from interfering with a corporate charitable donation, said that ‘‘[t]he general intent and end of all civil incorporations is for better government’’ and that “modern conditions require that corporations acknowledge and discharge social as well as private responsibilities as members of the communities within which they operate.”[6] In the latter case, the court did not intervene when the Chicago Cubs’ owner refused to install lights in Wrigley Field because “baseball is a daytime sport and . . . the installation of lights and night baseball games [would] have a deteriorating effect upon the surrounding neighborhood.”[7] Yet both decisions ultimately recognized that such seemingly nonshareholder-serving actions were actually investments in long-term business reputation and health, wholly consistent with maximizing shareholder wealth.[8]

As suggested, in the short run, the business judgment rule[9] only demands loose adherence to shareholder wealth maximization. Where there is no inevitable sale of the company, or transfer of control that would subject shareholders to the risks and consequences borne by holders of minority shares, managers may forego short-run gains in exchange for long-term ones.[10] It is only at the “Revlon moment” when managers must maximize the price that shareholders obtain in the short term. The Revlon moment occurs either when a company is certain to be sold,[11] or when a transaction causes control to shift from a diffuse set of shareholders to a concentrated block.[12] Short-term shareholder wealth maximization is required in these situations because they are the last opportunities for shareholders to maximize their return in their investment or for minority shareholders to be paid for their control premiums, respectively. At this Revlon moment, a board of directors may only collaterally—essentially accidentally because the board’s single-minded goal must be maximizing the price obtained for shareholders’ stock—protect nonshareholder interests if those interests create equivalent or greater value for shareholders.[13]

A third objection is that the current rule is invalid because the 1919 case of Dodge v. Ford[14]has been improperly interpreted to create it. This is a non sequitur. The current legal rule, reaffirmed multiple times just this year,[15] lacks no clarity in requiring managers to maximize shareholder wealth in today’s for-profit corporations.

A fourth objection is that a majority of states (but not Delaware) have enacted so-called “constituency statutes” that purportedly allow corporate boards to consider the interests of nonshareholder constituencies in their decision-making. If interpreted liberally, they may be understood to allow (but not require) boards to serve nonshareholder interests without tying their decisions to shareholder wealth. On another view, these statutes acknowledge and codify Delaware’s permissive approach to allowing boards to consider nonstakeholder interests in the short-term provided that there is a long-term connection to shareholder value. The most narrow view suggests that these statutes merely codify the common-law business judgment rule. Absent any meaningful judicial interpretation of these statutes despite decades since most were enacted, it would be reckless not to assume that legislatures would have been more explicit had they intended to be so revolutionary as to overturn such a longstanding precept of common law. The most reasonable understanding at this point is that these statutes officially import Delaware’s approach into their states.

A final contention—and one which this essay agrees would promote economic freedom—is that under Delaware law, a corporation may be organized for “any lawful business or purposes”[16] that need not include the promotion of shareholder wealth. (There are similar provisions in other states.) But Delaware courts, which interpret Delaware law, generally disagree unless the corporation is of a special type, like the very recently allowed “public benefit corporation” discussed below. If a corporate charter actually says that a corporation is to be run for a purpose other than maximizing shareholder value, a court may allow it (though this is not at all certain), but the run-of-the-mill business corporation is not set up this way, and the courts impute their aim to be maximizing shareholder value.

Corporate law is, for now at least, still very firmly in the shareholder wealth maximization camp.

A Libertarian Take on Corporate Purpose

Despite its solid footing in corporate law, it is difficult to say that long-term shareholder wealth maximization is taking place in today’s corporations in any strong form. Despite expanded shareholder ability to participate in corporate management (e.g., through more permissive proxy-access rules and the consolidation of holdings into blocks that are large enough to overcome shareholders’ rational apathy toward corporate elections) the board of directors controls the firm: boards act, shareholders react (at most) to board decisions.

Shareholder wealth maximization is based on agency theory, which holds that the incentives of managers are at odds with those of their shareholder principals. As a result, managers will run firms in a way that will maximize their own wealth rather than that of the shareholders whose investment enabled the enterprise. Because shareholders risked their wealth to finance the firm, they are entitled to a “residual” claim on whatever is left over after the firm’s contractual obligations have been fulfilled. A problem with allowing managers to serve multiple stakeholders is that, with any given decision, they will pick the stakeholder whose interests are most aligned with their own. This misalignment of incentives causes the firm to be run inefficiently—in a way that creates less overall value—with the resulting loss of value termed “agency costs.” To minimize agency costs managers should be required to exert their best efforts to maximize shareholder wealth. With this corporate goal in mind, the theory goes, nonshareholder stakeholders—managers, employees, customers, creditors, communities, and others—can contract ex ante for their fair share of the value created by the corporation.

Unfortunately, any method for enforcing the shareholder-value norm, with its attendant metrics, can be gamed by crafty managers who may very well be more familiar with their firms, and thus better positioned to extract wealth from them, than their shareholder principals. For example, a modern problem with attempting to induce shareholder-wealth-maximizing behavior among managers is an oversupply of short-term, and a dearth of long-term, incentive compensation based on share prices. A given year’s or quarter’s results are relatively easy for willing managers, “80 percent of [whom] report [that] they would sacrifice future economic value to manage short-term earnings to meet investor expectations,”[17] to manipulate. But like most chicaneries, they tend to be harmful in the long run, and in the extreme cases can result in catastrophic collapses, a la Enron.

It is harder to support the assertion that running firms to maximize long-term share price is per se improper. Indeed, long-term thinking about improving and perfecting the firm’s products and services that translates into sustainably increased future cash flows on the whole benefits all stakeholders. It is axiomatic that, say, a car company that exerts its energy on building ever-better cars will provide both its shareholders and its other stakeholders with greater value in the long term: Customers will be happier with better cars, and will buy them in the future and tell their friends to do the same. Robust sales will translate into employees with more secure and better paying jobs, more secure creditors, and communities with better employment opportunities and a greater tax base. And the longer-run residual benefit to shareholders is obvious: A company with greater and more stable cash flows will pay greater and more reliable dividends. Assuming that markets function more-or-less properly, some of that cash flow will be capitalized into current share prices.[18] Put another way, a firm’s doing well does in fact do good for the rest of us. But it is easy to see how managers compensated on short-term results would have incentive to put the firm’s cash into a bank account or far riskier investments if that would yield greater short-term returns than research and development.

All this said, and even assuming that such an enlightened form of shareholder wealth maximization were implementable and enforceable, some shareholders may desire to sacrifice financial returns to achieve other objectives. For example, some retail outlets like Hobby Lobby and Chick-fil-A do not open on Sundays both to make a religious statement and to give their employees a chance to go to church. If founding shareholders are unanimous in their wishes, and future shareholders have proper notice (say, in the firm’s certificate of incorporation) about the uses to which the firm in which they are about to invest will put their investment, a departure from the shareholder wealth maximization norm should be unproblematic.[19]

Many states have also taken a direct step toward expanded shareholder freedom by passing benefit corporation statutes. In Delaware, a “public benefit corporation” is a for-profit firm that nonetheless intends to produce enumerated public benefit(s) and that “shall be managed in a manner that balances the stockholders’ pecuniary interests, the best interests of those materially affected by the corporation’s conduct, and the public benefit or public benefits identified in its certificate of incorporation.”[20] Shareholders who form or invest in such a company may go beyond the wealth-maximization norm to both serve specific public benefits and consider the interests of other stakeholders. Still, it is unclear whether these new corporations may be managed so as to achieve private nonpecuniary benefits, or to consider only the enumerated and shareholder-wealth interests (as opposed to the interests of all “materially affected” parties). Relatedly, it is worth remembering that not-for-profit corporations, which may have members instead of stockholders, are prohibited from making a profit.

The corporate form is essential to the prosperity of modern economies. One of its many benefits is that, when properly employed, it allows investors to voluntarily tie up capital with each other in a way that facilitates a long-term view. Even if one shareholder decides to escape a corporation by selling, it must find another to take its place; it is unable to cripple the enterprise by withdrawing its investment on a whim. The shareholder wealth maximization norm provides a basic assurance that money locked into a firm is not entirely lost. The norm is here to stay and will continue to be the default rule. Properly incentivized, it is socially beneficial and should even be encouraged.

Yet corporate law is a field of complex questions requiring complex and creative, rather than one-size-fits-all, solutions. Shareholders who risk their resources on a firm ought to be given the freedom to decide both how to control their directors and to what end they should be working. Some owners may indeed want to be wealthy, and thus want their directors to think only of their long-run financial gain. Others may want to become rich, but believe that the best path to wealth is indirect, via service to other interests. Still others may have little interest in making money and genuinely want to run a corporation for some other mission. The law should not impose either end upon an owner who desires another. As long as shareholders know what they’re getting into, they should indeed be allowed to pursue “any lawful . . . purpose” with their firms.

[1] Stephen M. Bainbridge, In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green, 50 Wash. & Lee L. Rev. 1423, 1435 n.42 (1994).

[2] Delaware is the de facto leader in corporate law which other jurisdictions regularly imitate. The focus herein is thus primarily, but not exclusively, on its laws and jurisprudence.

[3] 16 A.3d 48, 98 (Del. Ch. 2011).

[4] 98 A.2d 581 (N.J. 1953).

[5] 237 N.E.2d 776 (Ill. App. 1968).

[6]Barlow, 98 A.2d at 583, 586.

[7]Shlensky, 237 N.E.2d at 778 (internal quotation marks omitted).

[8]Id. at 180-81; Barlow, 98 A.2d at 585.

[9] Corporate boards enjoy less deference in the takeover context than the business judgment affords in nearly every other context. The analysis for present purposes is functionally the same in that managers wrong decisions are not questioned, but only their self-interested ones. Airgas, Time, QVC Network, Unocal, and Revlon, discussed infra, are takeover cases.

[10] Air Prods. & Chems. v. Airgas, 16 A.3d 48 (Del. Ch. 2011); Paramount Communications v. Time, 571 A.2d 1140 (Del. 1989); see also Paramount Communications v. QVC Network, 637 A.2d 34 (Del. 1993); Unocal v. Mesa Petroleum, 493 A.2d 946 (1985).

[11] Revlon v. MacAndrews & Forbes Holdings, 506 A.2d 173, 184 (Del. 1986).

[12]QVC Network, 637 A.2d 34.

[13]Revlon, 506 A.2d 182, 185.

[14] 170 N.W. 668 (Mich. 1919).

[15]E.g.:In re Trados Inc. Shareholder Litigation, 73 A.3d 17, 37 (Del. Ch. 2013)(“In terms of the standard of conduct, the duty of loyalty therefore mandates that directors maximize the value of the corporation over the long-term for the benefit of the providers of equity capital, as warranted for an entity with perpetual life in which the residual claimants have locked in their investment.”); In re Trados Incorporated Shareholder Litigation, 2013 WL 4511262, at *1 Del Ch. (Aug. 16, 2013) (“Directors of a Delaware corporation owe fiduciary duties to the corporation and its stockholders which require that they strive prudently and in good faith to maximize the value of the corporation for the benefit of its residual claimants.”); In re Novell, Inc. Shareholder Litigation, 2013 WL 322560, at *7 Del Ch. (May 1, 2013) (“There is no single path that a board must follow in order to maximize stockholder value, but directors must follow a path of reasonableness which leads toward that end.”).

[16] 8 Del.C. §§ 101(b), 102(a)(3).

[17] Keith L. Johnson & Frank Jan De Graaf, Modernizing pension fund legal standards for the twenty-first century (quoting Chairman Alan Greenspan), in The Embedded Firm: Corporate Governance, Labor, and Finance Capitalism 459, 464 (Cynthia A. Williams & Peer Zumbansen eds. 2011).

[18] Some economists believe that today’s stock price is always an accurate measure of today’s best estimate of future value creation because it reflects the present value of all future cash flows. Inasmuch as this reflects an investor’s view, it is correct. However, a given instance of, say, earnings manipulation is almost by definition unknown to investors.

[19] Corporate law already allows this in the area of shareholder agreements that would otherwise impermissibly restrict the board’s management authority. E.g., 805 Ill. Comp. Stat. §§ 5/7.70-71; N.Y. Bus. Corp. Law § 620(b); Chapin v. Benwood Foundation, 402 A.2d 1205 (Del. Ch. 1979); Clark v. Dodge, 199 N.E. 641, 642 (1936).

[20] 8 Del.C. § 362(a).