Whenever I go into serious thinking mode I tousle my hair, scratch my beard, adjust my glasses because I hope I get better focus \u2014 it’s actually true, my eye doctor explained it to me \u2014 it’s physics, look it up. Then I turn to my blackboard and start to scribble like a mad scientist. Eleven posts in and the list keeps growing \u2014 create institutional decision-making frameworks, solve systemic and structural issues in organizations, enable cultural change through organizational learning, work on ideals not on pretty pictures, design workplaces that give identity not just employment, experiment and find enabling ways of working not cheap prisons, ensure healthy and safe workplaces, understand that motivation comes from meaningful work and not money, invest in the managerial profession, design processes that include customers, build companies that fulfill their economic and social role simultaneously.<\/p>\n\n\n\n
White chalk, smeared a bit here and there. But it looks right, reasonable, no utopia. This comes from practical observation and some intelligent books. I can nod at this. I bet a lot of you can, too. So why is this not happening at scale? Because \u2014 at least in my experience \u2014 things like this often land on the cutting floor of the corpo movie. Or you run into some invisible wall when trying to implement it. The movie, the wall have a name. And a date. And of course since it is a movie also an author.<\/p>\n\n\n\n
\nThe Board Room Version: In 1970 an economist wrote a 3,500-word editorial. It had no legal foundation, no empirical support, and failed on its own terms. It restructured global capitalism anyway. Friedman claimed that managers’ sole responsibility is to maximize profits for shareholders. Six years later Jensen and Meckling argued that managers may pursue their own interests at investors’ expense, so they should be aligned with shareholders through ownership and incentives. In 1999 this was all institutionalized by the OECD and made into a global corporate governance principle. The whole thing was wrong from the beginning. A corporation cannot be reduced to contracts serving shareholders. The facts were wrong: managers did not systematically destroy shareholder returns, and stock-based incentives did not improve long-term operating performance. It is legally wrong: shareholders own shares, not corporations. And the outcome was wrong: exuberant executive pay, short-termism and inequality rose while shareholders received no promised golden age. Between 1933 and 1976 the S&P 500 returned 7.5 percent annually. After shareholder primacy became doctrine, it returned 6.5 percent. The alternative was always there: stakeholder hierarchy with a decision rule. In good business, shareholder value is a consequence, not an objective. The doctrine that claimed to answer the question of corporate purpose was never legally required and produced worse outcomes than the system it replaced.<\/em><\/p>\n<\/blockquote>\n\n\n\n
September 13, 1970. Milton Friedman. New York Times Magazine.<\/p>\n\n\n\n
The movie is called Shareholder Primacy, just in case you were wondering. Friedman was not the big bad villain. He was part of what is called the Chicago School of economics. His ideas influenced heads of state like Ronald Reagan and Margaret Thatcher. And it’s all about the idea of shareholder value being the most important thing in business. Ah, I see some shoulders dropping in the room. Yeah, the reason your team was reduced by 10% last year. The reason your project had to be finished in six months instead of the planned nine.<\/p>\n\n\n\n
In 1970 Friedman wrote an essay ‘The Social Responsibility of Business Is to Increase Its Profits.’ It basically said top management are agents of shareholders, sort of the employees of shareholders. Sounds right? We will see. Friedman explained that spending shareholder money on social goals is taxation without representation. So top management is not allowed to just spend company, sorry shareholder money in any way they see fit. The only social responsibility of business is to increase its profits. It’s a short editorial \u2014 3,500 words \u2014 that tried to fight against unnecessary spending by top management. Problem is that at the time the corporate payout ratio to shareholders was in an absolutely stable era, had been for years. So, what was he on about? Be patient.<\/p>\n\n\n\n
Six years later economists Michael Jensen and William Meckling published a paper ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ in the Journal of Financial Economics and it was the foundation for what is called agency theory. First of all, companies are something that is basically made out of a nexus of contracts. That’s what they are. And shareholders are on the receiving end of these contracts. They are the head honchos. They hire directors as agents. And then there is something called agency costs. And that comes from managers not serving the shareholders’ interest. Wait, what? Yes, sometimes top management does other stuff than working for the profit of the shareholder like buying private jets or expensive offices or also when they just run a business sometimes. This costs money and that is a problem to the shareholder because it cuts into his profits. How to make all that bothersome spending of money go away? Stock-based compensation is the answer because this aligns management with shareholders’ interests. Jensen and Meckling’s paper gave Friedman’s initial idea the mathematical and academic legitimacy.<\/p>\n\n\n\n
After that, the idea kind of exploded and the confetti of shareholder value landed everywhere and I mean everywhere \u2014 business, academia, media and politics. Even the voice of reason in international business, the OECD, made it clear in 1999: it had placed shareholder rights at the centre of its global governance principles, although it still explicitly recognised employees, creditors, suppliers and other stakeholders. The little idea out of a short op-ed in a Sunday newspaper had become the global governance consensus. Why? There must have been tons of studies done on the subject with a lot of evidence supporting the idea. Funnily enough, not. It just became the dominant idea. Academia said it made sense and we all know that scientists just have to say so, no proof needed. The media found a simple story to tell. You know, the poor shareholder gets robbed by overspending CEOs. Consultants could easily sell the idea and product: returns to shareholder maximization \u2014 cut costs, hype companies. And the major stock exchanges had a trading machine that needed to make stocks the center of the business world. It was the perfect combo of a simple idea and all the institutional actors that had something to gain from it. <\/p>\n\n\n\n
In 2001 two leading corporate-law scholars from Yale and Harvard announced \u201cThe End of History for Corporate Law\u201d, beating the same drum. The debate was permanently settled. For eleven months. Then Enron happened.<\/p>\n\n\n\n
Of course Friedman didn’t cause Enron directly, he didn’t tell Enron’s top management to commit the fraud that caused the bankruptcy. Friedman only supplied the moral argument: managers have to work for the shareholders. Jensen and Meckling supplied the machinery behind it. Managers are agents whose interests must be aligned with those of shareholders. So give managers shares to connect them to shareholders. Managers will then drive up the share price. <\/p>\n\n\n\n
Well, at least that’s good for shareholders \u2014 and managers. Even on its own promised outcome, the record was hardly impressive. Between 1933 and 1976 the annual return of the S&P 500 had been 7.5 percent; after 1976 until 2011 it was 6.5 percent. So shareholders got less. What we got was Enron, WorldCom, Xerox, HealthSouth, Lehman Brothers, Wirecard, Wells Fargo \u2014 financial fraud cases because managing the stock price became more important than running the real business. But it’s not all accounting stuff. Volkswagen engineered software to fake emissions tests to avoid the cost of genuine regulatory compliance. And one of the most tragic cases was Deepwater Horizon. When engineering and process safety were ignored to reduce schedule and cost \u2014 a pattern the National Commission on the BP Deepwater Horizon Oil Spill documented in detail, finding that the industry’s knowledge and experience in deep-water safety had been decreasing for years \u2014 causing a disaster that killed 11 workers and released 134 million gallons of oil into the Gulf of Mexico. These disasters had different immediate causes, but they shared a dangerous governing logic: measurable financial performance and stock price repeatedly outranked the health of the underlying system.<\/p>\n\n\n\n
It all comes back to Deming: when you impose a numerical target, people will try to improve only that specific number, not the system behind it.<\/p>\n\n\n\n
And it’s not as if any of these failures ended the doctrine. Laws passed did little to prevent the next crash. If anything, each crash produced more of the same over more than 25 years. That is not a theory being tested but an ideology being administered.<\/p>\n\n\n\n
So if it turned out so catastrophically, at least the initial idea must have been brainy and great. Actually not. The discussion Friedman reopened had already been settled. In 1954 the leading corporate law scholar Adolf Berle had conceded the debate \u2014 in favor of the other side. It always amazes me that shareholder primacy is one of those theories where you see the cracks immediately. <\/p>\n\n\n\n
Friedman had that whole spiel about how managers, if not laser focused on shareholders and profit, were spending the company’s money on other stuff, like corporate social responsibility. That would be like a tax the company and shareholders would have to pay. And Friedman said that would be taxation without representation, without legitimization \u2014 like in some communist dictatorship. He did say that, but you know, 1970 and cold war. The thing is that in a company managers always had very direct legitimization. If you want to use Friedman’s metaphor for the company as a political system \u2014 which is odd because he was the deregulation guy \u2014 then the actual legitimization is there without any changes needed. The shareholders elect the board, the board hires or fires the managers. Perfect. What Friedman was asking for was already there.<\/p>\n\n\n\n
But he goes on about all this social spending and says these are only things not demanded by law and things that do not make sense for the business. But what about everything companies already do because the law requires it \u2014 social security contributions, safety standards, labor protections \u2014 or because it simply makes business sense, like paying decent wages so people don’t quit on you? Eventually most things a manager could do would fall into either of these categories. So what is left? The 100 dollar donation to WWF?<\/p>\n\n\n\n
So what was Friedman on about? Maybe it was the time \u2014 maybe managers during that time were ruining shareholders. We already saw that they were not. William Lazonick and Mary O’Sullivan’s empirical analysis of US corporate governance documents what Friedman chose not to examine. Real returns were stable. The payout ratio had been consistent for the last three decades: 40-45 percent. Lazonick and O’Sullivan’s 2000 paper ‘Maximizing Shareholder Value: A New Ideology for Corporate Governance’ is the empirical source for most of the numbers in this essay. Friedman described a solution to a problem that did not exist.<\/p>\n\n\n\n
But then Jensen and Meckling had to be on to something. They came up with agency theory that is still recognized today. And it’s true \u2014 nothing to complain about here: when managers control resources they don’t fully own, costs occur. Well done. Actually, if anything, they didn’t go far enough. Because it’s not just costs that have to be paid by the shareholders. Managers or shareholders can also create costs for employees \u2014 reduce staffing, freeze wages \u2014, customers \u2014 overselling \u2014, suppliers \u2014 extending payment terms \u2014, communities \u2014 tax concessions \u2014, the state \u2014 bailout costs \u2014 or the environment \u2014 pollution. But their agency theory just named the shareholder as the only possible victim \u2014 sorry, principal. <\/p>\n\n\n\n
Even beside this little oversight, the whole idea doesn’t have a firm grounding. The principal-agent model rests on three factual claims that are all wrong. Firstly, it says that shareholders own corporations. But companies are in a legal sense a person. Nobody owns one like an asset \u2014 shareholders have rights and duties \u2014 but that is not the same as owning it. Jensen and Meckling described the corporation as a nexus of contracts. That is like saying a person is just a collection of organs and bones and muscle and whatever. The corporation is not what its contracts say it is. It is what the law says it is \u2014 a legal person with rights and duties that exist independently of any agreement between shareholders, managers, employees or anyone else. Those rights and duties were given by law, not negotiated. You cannot contract your way out of them. Jensen and Meckling looked through the legal person and saw only the contracts underneath. What disappeared from view was everything the law put there that no contract could replace.<\/p>\n\n\n\n
Well, that is all legal talk \u2014 what about the real world? Good question. The answer is, it’s exactly the same. In the real world the company is still a legal person, since its only reason for existing is that a legal system has given it its founding status. It is in the real world a person. Funny? Yeah, but that was the whole idea of the corporation. What Jensen and Meckling describe is not a corporation but a simple ownership or partnership. And they should know better \u2014 they are the experts. In my first year of private law I learned that shareholders are not the only group that has obligation towards the corporation. Employees have deferred compensation claims, career-specific investments, pension promises. Suppliers have relationship-specific investments. Communities have infrastructure built around the company. All have a stake in the corporate game. That’s why we call them stakeholders. The workers who lost jobs and pensions in the 2008 financial crisis were residual risk-bearers. The shareholders who got bailed out were arguably less residual than them.<\/p>\n\n\n\n
Plus, it is also not really true that shareholders hire the board. A board is elected through a governance process established and secured by law. The board is then supposed to exercise independent fiduciary judgment. They are the voice of reason in the game \u2014 the White Council, so to speak, although we know how that turned out. But they are not there to just execute shareholders’ instructions.<\/p>\n\n\n\n
The next thing is just a practical thinking trap \u2014 the compensation problem. Stock options were supposed to align management with shareholders, to make real good-old business decisions. Problem is, stock prices became the metric and that is not about good business performance. It is what people are willing to pay for a stock on a market. Therefore what is considered is the expectation. Now, managing a company for real performance and for expectations are different things. Legendary economist Keynes called it almost a hundred years ago a beauty contest. And he saw that it is not only about expectations \u2014 it’s about what you think other people are expecting. And you have just taken one more step away from the real business. <\/p>\n\n\n\n
Researchers have never established that the enormous expansion of stock-based compensation reliably improves long-term operating performance. What it unquestionably improved was executive compensation. Their compensation doubled in the 80s and quadrupled in the 90s. In 1965 a CEO earned 44 times the average factory worker’s salary. By 1998 it was 419 times. Wait \u2014 but that means those agency costs were rising. Yes, they were. The agency problem was real. The implemented solution made it worse.<\/p>\n\n\n\n
But the best is yet to come: the people the whole thing was designed for \u2014 the shareholders. They didn’t even exist. Friedman, Jensen and Meckling all assumed the shareholder was an opportunistic, selfish actor indifferent to others’ wellbeing \u2014 sort of the lowest human denominator elevated as the governance body of business. OK, so who is the typical shareholder then? He doesn’t exist. Approximately half of them are institutional investors, everything from hedge funds to pension funds. So there are people somewhere behind it, but they are so removed from the actual share ownership they are invisible and powerless. Like me \u2014 I am part of a pension fund but I have no idea nor any real control over what that fund owns. But there is a fund manager somewhere who has some control, but he doesn’t own it either. In addition there are some very wealthy people directly owning stocks. And it is not just the diverse nature of shareholders \u2014 it’s also the length of time shares are held. In 1960 average shareholders of companies at the NYSE stayed with an investment for more than 8 years calculated from trading activity. By 2010 the average shareholder was gone in four months. Meaning each quarter you are faced with a new set of shareholders. Different shareholders have completely incompatible interests \u2014 the hedge fund and the pension fund own the same shares and want opposite things. Maximizing shareholder value means privileging the most aggressive, most short-term, least diversified shareholders over the long-term interests of most real investors.<\/p>\n\n\n\n
Managing shareholder value means playing the expectations game \u2014 not creating actual value. If you beat the analyst estimate the stock goes up; miss it and the stock goes down. In 1983 US companies met earnings expectations about 50 percent of the time \u2014 that is what you would expect from a random system. By 1997 they beat it 70 percent of the time. Management didn’t get better at running businesses in that time \u2014 they just got better at playing a game.<\/p>\n\n\n\n
You may say that this all sounds like business black magic, but what did it mean in reality? You know it already. What happens when companies are streamlined and made to look pretty? People are fired, even when companies are doing well. 1983 to 1987 were boom years. 4.6 million US workers lost their jobs. 35 percent remained unemployed two years later, with permanent wage reductions for those who found work. And more and more profits were going out the door of companies in the form of dividends and share buybacks \u2014 81 percent by 1989. That is money that used to be reinvested in the business. Now it disappeared. But wait \u2014 that was the rise of Silicon Valley. All that new technology must have come from R&D. Yes, from the investments that had been made decades before, not at the time. You know, minor stuff like the internet and GPS. The new doctrine just harvested. The only thing that was rising was management compensation \u2014 419 times a worker’s salary. <\/p>\n\n\n\n
But still, accepting the shareholder as the top dog sounds right somehow, doesn’t it? This is how it is supposed to work. It’s the way the system was set up. If you mean the law by system, that is not true. Corporate law generally does not require managers to maximize today’s share price \u2014 not US, not UK, not EU, not CH. Even in Asia where corporate law is very different, you will not find it. If the different national laws state anything on the purpose of a firm it is a very diverse range of things: growing the company, creating quality products, protecting employees, serving the public interest. As long as the board and management do not abuse their power to enrich themselves they can take any direction.<\/p>\n\n\n\n
Maximizing shareholder value is not an obligation for management. It is one of several options. Friedman made it a must. And it was further developed into a de facto law by people who benefited from it. The costs are paid by the people who could not write an op-ed in the New York Times.<\/p>\n\n\n\n
Alternatives had already existed for decades. Drucker had it in 1942. Deming in the 1950s. Japan went another way. Their most important principles had always been company continuity and long-term relationships with employees, suppliers and customers. Continental Europe had the tradition of both shareholders and employees having participatory power. Both regions slowly shifted towards shareholder primacy through privatization, institutional investors, executive share incentives, financialization and pressure for higher returns. The voices and examples for alternatives have always been there. The problem was never a lack of knowledge.<\/p>\n\n\n\n
Shareholders are of course very important to business. But they are not the only important group. The needs of all stakeholders have to be considered, because without their input the business cannot grow. Yeah, yeah, all are important. We have all of them in our strategy, they are on our posters, sometimes even in our slogans. But it’s not that simple. As long as you just list all of the groups, it will not tell anybody how to make decisions. Because superficially stakeholders have contradictory demands: I want more profit, I want more salary, I want more taxes. So how do you solve the issue? Well, the concept is easy \u2014 it’s called stakeholder hierarchy. It gives managers a decision rule when stakeholder interests conflict. Customer first means when resources are scarce you know where they go. Employee second means you know what comes next. Shareholder last doesn’t mean shareholder unimportant \u2014 it means shareholder as consequence of doing the other things well. The hierarchy matters \u2014 without it you have organizational personality disorder, competing goals with no decision rule. With it you have a governing principle that produces better shareholder returns than shareholder primacy did.<\/p>\n\n\n\n
A word of caution: stakeholder hierarchy has been misused before. Trickle-down economics claimed that enriching corporations and the wealthy would eventually benefit everyone. There is no convincing empirical evidence that it does. Stakeholder hierarchy has to be founded on real performance, not on promises.<\/p>\n\n\n\n
The real market \u2014 actual business performance \u2014 should be the ultimate objective of corporations. The real market creates value through products, services and relationships. The stock market translates expectations about that value into prices. The danger begins when management starts producing expectations for the stock market instead of value for the real market. Seems like reality is the better game to play. Who would have thought?<\/p>\n\n\n\n
But why does shareholder value remain the dominant idea? We have seen what harm it can do. There is a known and tested alternative. And it’s no secret. Even the big promoters of shareholder primacy have distanced themselves from their claims. Jensen retreated from short-term, share-price-driven shareholder primacy \u2014 co-authoring ‘Just Say No to Wall Street’ in 2002. More damning still \u2014 the poster child of shareholder primacy, GE’s Jack Welch, said in an interview with the Financial Times in 2009, after his retirement: ‘Shareholder value is a result, not a strategy. Your main constituencies are your employees, your customers and your products.’<\/p>\n\n\n\n
I guess there is more to explore.<\/p>\n\n\n\n