The following was originally published in the Columbia Law School’s Blog on Corporations and the Capital Markets, and was authored by Maria Goranova, Professor of Strategic Management, Lubar College of Business at the University of Wisconsin-Milwaukee, and Lori Verstegen Ryan, Ralph V. Whitworth Chair in Corporate Governance at San Diego State University.
The long-standing debate about corporate purpose has stirred multiple thought-provoking articles across various disciplines. Should companies embrace shareholder value maximization or deal with the fuzziness of the goals of multiple constituencies? Instead of contributing to either side of the shareholders versus stakeholders debate, in our article in the Journal of Management Studies, we critically assess the challenges that contemporary shareholder practices pose for corporate governance and highlight the need for strategic corporate governance, or governance policies and practices that make a priority of the sustainable competitive advantage of the firm.
We focus on three critical assumptions about maximizing shareholder value: that it will (1) maximize the value of the firm, (2) provide appropriate incentives for managers, as shareholders are the only residual claimants among stakeholders, and (3) optimize good governance, as having more than one objective function is a recipe for confusion. If these assumptions hold, then a demand by influential shareholder activist X should: (a) benefit the firm as a whole; (b) optimize management practices and incentives, as shareholder X is a residual-risk bearer and stands to benefit or lose from the corporate actions she influences, and (c) benefit shareholder Y, as shareholders’ interests with respect to the focal firm are assumed to be homogeneous or, at the very least, less heterogeneous than the interests of the firm’s other stakeholders.
If, on the other hand, shareholders have conflicting interests, then a demand by shareholder X could no longer be assured to benefit shareholder Y. Shareholder Y in our case has to extend monitoring resources, rely on the monitoring capabilities of still other shareholders, or depend on corporate officers and directors to serve as gatekeepers in order to protect their interests from the potential infringement demands of shareholder X. As our example illustrates, if traditional underlying shareholder assumptions do not hold, governance mechanisms widely seen as beneficial may instead have unanticipated effects, lead to blind spots, or bring an overall Sisyphean flavor to corporate governance.
What Is Good for Shareholders Is Good for the Firm?
The objective of corporate CEOs has been widely perceived as creating value for their shareholders. But what if shareholders also invest in the firm’s competitors, as is now common? The fraction of U.S. publicly traded firms with a blockholder who has also invested at least 5 percent in a rival firm increased from 10 percent in 1980 to 60 percent in 2014. In 1980, the largest shareholder in the pharmaceutical industry (Lilly Endowment) held shares in only one pharmaceutical firm. By 2015, the largest shareholder in the industry (Vanguard) held shares of 163 publicly traded pharmaceutical firms.
Shareholders with stakes in competing firms not only have an interest in maximizing shareholder portfolio value, but also have a fiduciary duty to do so. Shareholder portfolio value, in turn, need not be highly or even positively correlated with the value of any one firm. Furthermore, holding shares in competing firms in the same industry “incentivizes asset managers to encourage those firms to limit direct competition with each other.” Managers seeking to create shareholder value who are well attuned to the preferences of their shareholders may thus have fewer incentives to compete aggressively, particularly when doing so would undermine their shareholders’ portfolio value. This, in turn, may generate higher profits for the firm in the short term but at a long-term cost, particularly if the firm is at a disadvantage to independently owned competitors.
What If Shareholding Is Decoupled from Residual Risk Bearing?
Shareholders are typically critical players in shareholder value maximization’s goal as “only residual cash flow claimants have the incentive to maximize the total value of the firm.” Ownership intermediation, however, has become widespread, with 80 percent of the ownership of the contemporary American corporation held by institutional investors. While 15 percent of U.S. households invest in equities directly, 53 percent have exposure to publicly traded stocks, particularly through tax-advantaged retirement savings. More than 106 million individuals have investments in mutual funds, ETFs, and other institutional funds. This transformation of corporate ownership has led to a widespread separation of residual-risk bearing from the exercise of shareholding rights, such as voting, trading, and activism.
The $110 trillion global asset and wealth management industry is expected to grow significantly, contributing further to the increasingly complex investment chains and intermediation. An individual with retirement savings in a single pension fund, for example, may be an unwitting participant in an investment chain encompassing mutual funds, hedge funds, or funds of funds, through the investments made by the pension fund itself, as well as the investment companies in which that pension fund invests. Arguments that, as residual-risk bearers, shareholders have a vested interest in maximizing the value of the firm thus predate the question of how investment intermediation affects the incentives of shareholders. This leads to the paradox that institutional investors who are widely seen as at least a partial solution to the agency problems of the firms in which they invest are also prone to agency problems of their own as they invest other people’s money.
Financial intermediation and the elongation of shareholding chains raises the question of potential misalignment of incentives, an issue often neglected in corporate governance research. We believe in the merits of specialization and professionalization, and thus acknowledge that institutional investors facilitate professional investment and help to diversify individual investors’ economic risk. But having agents watching agents could affect corporate governance differently than assumed under traditional, residual-risk bearing models of ownership, particularly if aligning the interests of corporate executives to the interests of money managers prioritizes short-term profitability at a long-term competitive cost.
What If Shareholders Want Different Things?
Michael Jensen famously argued that “purposeful behavior requires a single valued objective function,” as “it is logically impossible to maximize in more than one dimension.” If Jensen is correct that when many masters are served “all end up being shortchanged,” then what are the implications of heterogeneous shareholder interests or conflicting shareholder voices for corporate governance? The shareholder homogeneity assumption is questioned by both scholars and practitioners. In addition to such attributes as family, corporate, foreign, or state ownership, shareholders differ in other ways, such as whether they have a business relationship with the firm, have long-term or short-term investment horizons, use derivatives to decouple voting and economic rights, have a propensity to engage in shareholder activism, or focus on political, corporate social responsibility, or other interests that may not be shared by the firm’s remaining shareholders. Deloitte, for example, posits: “There are many different ownership entities that will take differing points of view on your stock and your strategy.”
While defining CEOs’ job as maximizing shareholder value avoids the problem of managers using the ambiguous goals inherent in the stakeholder framework to serve their own interests, it does not address the challenges of divergent shareholder interests for corporate governance. Heterogeneous shareholder interests, for example, could provide more fertile ground for situations where demands by shareholders with “small financial interest can lead to an outcome that is perverse to the interests of the stockholders in aggregate.” They could thus amplify the paradox that we need to rely on managers to act as gatekeepers to some shareholder demands while serving as agents of other shareholders’ interests. Relying on corporate managers to act as impartial arbiters of conflicting shareholder interests is at odds with the widespread assumption of agency costs, and is furthermore likely to result in higher governance costs. More divergent shareholder interests could make monitoring and evaluating the CEO’s performance more challenging. At the same time, CEOs may find it harder to balance shareholders’ heterogeneous interests and be more tempted to favor shareholders whose interests and risk preferences are more closely aligned with their own, as well as to focus on political, symbolic, and ingratiation behavior.
Is It Time for Strategic Corporate Governance?
Our study points out the limitations of using outdated shareholder assumptions as the foundation for contemporary governance. Our nascent view of Strategic Corporate Governance—a system of governance mechanisms premised on the pursuit of sustainable competitive advantage as the overarching purpose of the firm—offers a more pragmatic approach to dealing with the challenges posed by contemporary shareholder practices than do calls to limit shareholder voting rights or to constrain shareholders’ investment portfolio diversification.
Instead of inferring firm value from shareholder or stakeholder value, we argue that the field requires a strategic approach to corporate governance that makes a priority of building a competitive enterprise. Putting the interests of shareholders (or stakeholders, for that matter) before the interests of the firm as a competitive entity is akin to putting the cart before the horse, particularly when these interests are divergent and dynamic. In turn, we believe that executives and directors who focus on the sustainable competitive advantage of their firms would ultimately create more value for shareholders and stakeholders.
The full study, “The Corporate Objective Revisited: The Shareholder Perspective,” Maria Goranova and Lori Verstegen Ryan, was published in Journal of Management Studies, Vol. 59, Issue 2, March 2022, pp. 526-554.
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