The idea that maximizing shareholder value takes legal and practical precedence above all else first came to prominence in the 1970s. The person who arguably did the most to advance the idea was the business school professor Michael Jensen, who wrote in Harvard Business Review and elsewhere that CEOs pursue their own interests at the expense of shareholders’ interests. Among other things, he argued for stock-based incentives that would neatly align CEO and shareholder interests.
Shareholder primacy rapidly became business orthodoxy. It dramatically changed how and how much executives are compensated. And it arguably distorted capitalism for a generation or more. Critics have long charged that maximizing shareholder value ultimately just encourages CEOs and shareholders to feather their own nests at the expense of everything else: jobs, wages and benefits, communities, and the environment.
The past few years have seen a backlash against shareholder capitalism and the rise of so-called stakeholder capitalism. After reigning supreme for half a century, is shareholder value maximization on its way out?
4 Business Ideas That Changed the World is a special series from HBR IdeaCast. Each week, an HBR editor talks to world-class scholars and experts on the most influential ideas of HBR’s first 100 years, such as disruptive innovation, scientific management, and emotional intelligence.
Discussing shareholder value with HBR editor in chief Adi Ignatius are:
- Lynn Paine, professor at Harvard Business School
- Mihir Desai, professor at Harvard Business School
- Carola Frydman, professor at Kellogg School of Management
Further reading:
- HBR: CEO Incentives—It’s Not How Much You Pay, But How, by Michael C. Jensen and Kevin J. Murphy
- New York Times: A Friedman doctrine‐- The Social Responsibility Of Business Is to Increase Its Profits, by Milton Friedman
- HBR: The Error at the Heart of Corporate Leadership, by Joseph L. Bower and Lynn S. Paine
- U.S. Business Roundtable: Statement on the Purpose of a Corporation, 2019
ADI IGNATIUS: Welcome to 4 Business Ideas That Changed the World, a special series of the HBR IdeaCast. The debate over how much control to give to shareholders has existed for as long as there have been any. The very first firm with publicly traded shares, the Dutch East India Company in the 17th century, pretty quickly fielded complaints from angry stock owners who felt that the company was being run counter to their wishes. And in the ensuing centuries, managers and owners would tussle endlessly over the questions of ownership and control.
Until the 1970s, that is, when the notion of shareholder primacy the idea that maximizing shareholder value takes legal and practical precedence above all else came to prominence. The person who arguably did the most to advance the idea was Michael Jensen, a professor at the University of Rochester Business School and later, a Harvard Business School professor with a coauthor he wrote in Harvard Business Review and elsewhere, he argued for, among other things, stock-based incentives that would neatly align CEO and shareholder interests, maximizing shareholder value became the mantra for every Fortune 500 CEO, achieve it or risk being pushed aside.
Critics have long charged that maximizing shareholder value ultimately just encourages CEOs and shareholders to feather their own nests at the expense of everything else, jobs, wages and benefits, communities, the environment. Now the past few years have seen a backlash against shareholder capitalism and the rise of so-called stakeholder capitalism.
So, in this special series from HBR IdeaCast, we’re exploring 4 Business Ideas That Changed the World. Each week, for four weeks, we’ll be talking to scholars and experts on the most influential ideas of HBR’s first 100 years. This week, it’s shareholder value. With me to discuss the issue are Lynn Paine and Mihir Desai, professors at Harvard Business School, and Carola Frydman, corporate historian at Kellogg School of Management at Northwestern University. I’m Adi Ignatius, editor in chief of Harvard Business Review, and your host for this episode.
Carola, let me start with you, you’re the historian. Let’s say 100 years ago, this is at the time of HBR’s founding, you had a boom in business. There were more businesses, more managers. There were more shareholders. What kind of dynamic was forming then between a firm’s shareholders and its management?
CAROLA FRYDMAN: Well, let me take us a little bit further back to set the stage. So, if you were to drop in the 1850s, in the U.S. economy, what you would have found is every local town had firms producing almost everything, and the owner and the manager of those firms were one on the same. So, what changes, setting the stage up to the 1920s is that the economy gets bigger, and firms get much bigger. The rise of the railroad is a big transformation. And these larger firms need a lot of capital. So, one person just cannot provide all the financing that these firms need, and so we’re starting to see lots of shareholders start funding these firms. So, the structure of firms changes from having one owner be the manager, to having lots and lots of owners and having professional managers.
So, what emerges is what we would call a separation of ownership from control. That those that own the firms that are going to get the cash flows are no longer the same people making the day-to-day decisions for those firms. And that is essentially what’s happening in the 1920s. We see a big rise in the stock market, nothing like what we see today. So, I would say roughly by the late 1920s, probably about 15% of households had one share or more. They actually have very limited rights, and they have very limited information about what the firms are doing. So, we started seeing the tension between shareholders and management emerge. All of this is setting the stage for what’s going to come a little bit later into the mid-20th century.
ADI IGNATIUS: Lynn, so what interests were companies serving then? Was there a philosophy back then as to how to prioritize these interests?
LYNN PAINE: Well, you know, it’s so interesting listening to Carola talk about the history of the rise of the big corporation. Even as early as the 1920s, there was already a growing debate about whose interests this corporation should serve. There was real concern about the power of these large concentrations of capital.
That showed up in print in the early 1930s in a really famous debate between Columbia Professor Adolf Berle and Harvard Law School Professor Merrick Dodd. Berle argued that managers were what he called the attorney for the shareholders. Dodd took the position that, no, managers are trustees, and they’re trustees of the corporate institution, and they have responsibilities to multiple constituencies. We didn’t have the word stakeholder back (laughs) then, of course. He named them constituencies, customers, employees, the shareholders, of course, and the general public.
But then in 1954, Professor Berle wrote a book called The 20th Century Capitalist Revolution, in which he said, the argument had actually been settled in favor of Professor Dodd. That is, that managers were trustees of the institution with multiple responsibilities. But an interesting caveat, he says that the debate has been settled, “at least for the time being.” And it wasn’t very long before that debate was opened up again.
ADI IGNATIUS: That’s really interesting. So, Mihir, you know, as business expands when stock ownership is spread so widely among people and entities, you know, what is happening to the notion of share ownership and the understanding of what power and authority that gives to the shareholders?
MIHIR DESAI: Yeah, I think exactly as Carola and Lynn described, you know, that diffusion of ownership has these great advantages. It enables scale, as Carola suggested. It also enables lots of risk sharing, because you no longer just own your firm and are subject to the whimsies of the firm, you own shares of lots of things. But the primary issue is the one that Carola identified, which is the separation of ownership and control. And that is really a deep problem, and it’s worth just underscoring here.
Which is, the debate now becomes about the degree to which that collective action problem needs to be solved. And by collective action problem, I mean, “Well, now we have diffuse owners. Who’s going to be watching the managers?” And that is the genesis of all this, is there, what we would call a corporate governance problem today now. Which is, how do I make sure that the people who I’ve appointed to do the work will do the work correctly?
And that kind of really becomes manifest, especially in the ’50s and ’60s, which, you know, as Lynn suggested, perhaps got settled, for some. The nature of economic activities started to change and we saw the rise of conglomerates. One of the reactions to the separation of ownership and control and the diffusion of ownership is, in some sense, the rise of managerial power.
And that becomes manifest in these larger entities, which are really remarkable by modern standards. You know, we’ve kind of forgotten about them, but things like ITT, and Gulf and Western, which used that diffusion of ownership to create little empires. ITT would kind of start in a base of telecommunications, but then diversify into Wonder Bread, and rental cars, and hotels. All because the underlying premise being that these managers knew what they were doing, and they had the ability to manage capital broadly for their shareholders, and their shareholders were sufficiently diffuse, to not really be able to stop them. So, that sets the stage for a reaction by people who become worried that shareholders are actually not being served.
ADI IGNATIUS: So, I want to get to that reaction in a second. But Carola, if I can bring you back. You know, there’s this sense, this idealized, maybe, idea that corporations existed, [that] they were more paternal than they would become later. That companies were essentially company towns, and that people thought about stakeholders, again, as Lynn said without using that word, more than they did kind of narrowly about shareholders. Is that even an accurate characterization of, let’s say, the period between you know the 1920s and the 1970s?
CAROLA FRYDMAN: Not fully. There are lots of forces that are changing over the period that put pressure on managers to behave in certain ways, even if their objective is to maximize value. For example, one of the changes that starts putting a lot of pressure on managers are unions, that not only grow larger but become more powerful in the ’30s and ’40s. For a variety of reasons, including, for example, the scarcity of labor during World War II.
And so, there are many firms that have unionized workforces at the time. There are also many firms that don’t. And what you see is in the firms that do not have unionized workforces, they start doing what it’s called, at the time, “welfare capitalism.” Building cities, for example, providing all kinds of benefits to the workforce. They’re not necessarily doing it because they think it’s the right thing to do from a moral standpoint. They’re doing it because by providing those benefits, those social benefits, they’re trying to preempt the workforce from getting unionized in the first place, which they see as a bigger constraint. It’s a larger cost.
When you read business histories of specific companies, the managers are very much mindful that maximizing profits, maximizing value is important. But given the constraints at the time, they need to make investments that, in this particular case, ended up raising wages, giving benefits to other stakeholders.
ADI IGNATIUS: Yeah. All right, well, so let’s fast forward to the 1970s. So, what was happening that set the stage for this, you know, blossoming idea of shareholder value maximization? Mihir, do you want to take the first crack at that?
MIHIR DESAI: Sure. So, you know, for starters, I think there was some disappointment with this notion of conglomerates. And then, of course, in the early 1970s, we have a set of economic shocks, oil shocks, and something that now has become current, again, which is inflation. And in the early 1970s, there were two to three years of very scarring stock returns. You know, 20% down after 25% down. And that I think, really forced people to ask questions about the degree to which were companies in their current form actually serving shareholders and were they generating enough wealth.
At that same time, the ability of pension plans to start to begin allocating capital forces people to say, “Well, wait a second, maybe we as shareholders, we want a different structure.” And in financial thinking, we have a set of ideas about why and how shareholders can diversify themselves. So, why should conglomerates be doing it for them? All of this, I think, gives the seed to, well, wait a second, maybe these things should be dismantled. And maybe we need to take power back from managers in a way that we had ceded during the past 30 to 40 years.
ADI IGNATIUS: Yeah, Lynn?
LYNN PAINE: Yeah, I’ll just jump in there.
ADI IGNATIUS: Please.
LYNN PAINE: Also adding to the story, a couple of other things, you know, we’re starting to see competition from Japan and Germany.
MIHIR DESAI: Right.
LYNN PAINE: And some disappointment with how U.S. companies are responding to that competition. And back in, I think it was 1971 or so when HBS professor Myles Mace published his very influential book, Directors: Myth and Reality. And what he uncovered was some very powerful managers and some very weak boards of directors, little more than rubber stamps for their managers. And then most of the managers were more focused, as Mihir has already pointed out, on building their empires, not serving their shareholders or any other stakeholder for that matter. So, things were pretty, pretty bad at the time.
You know, the other thing I’d add into the mix is, is that was also the era of the beginning of the corporate social responsibility movement.
MIHIR DESAI: Mm-hmm.
LYNN PAINE: And particularly, I don’t know if anybody remembers “Nader’s Raiders,” Ralph Nader, and Campaign GM. Where that was Ralph Nader and some Washington lawyers all trying to get GM to be more focused on auto safety, on pollution, on minority hiring. And I think there was just this sense that things were just kind of collapsing on all fronts. And just remember what the title of Milton Friedman’s article was, it was “The Social Responsibility Of Business Is to Increase Its Profits.” So, I don’t know Milton Friedman. I don’t know his thought processes. But my sense is that he was very worried that all of these other demands coming from society were going to make this ownership and control problem even worse.
ADI IGNATIUS: Yeah, and you’re talking about Milton Friedman’s famous piece in the New York Times that really kind of moved this debate along. So, here we are. So, this is a very dynamic time in American business and global business. Carola, maybe I’ll hand it to you. Can you talk about, then, you know, where these, these ideas, sort of shareholder-first ideas, where they come from and how they take root?
CAROLA FRYDMAN: Well, the ideas were always there in some shape or form. You can open Harvard Business Review articles in the ’30s or in the ’50s that are trying to emphasize how, ultimately, the shareholders and the owners, and what they want is they want to see returns. But those are some voices here and there. What happens with Milton Friedman’s article in the New York Times, and then with Jensen/Meckling’s paper and their articles in a little bit later in the ’70s is that these are very prominent figures. And they really catch fire. They articulate the problems really well. They make the, the problem, crystal clear.
And given all of the context at the time that Mihir and Lynn were describing so well, this gives a clear metric that firms should be maximizing as an objective. So, what’s very interesting is that these ideas become very influential and take hold very, very quickly. So, if you read random articles in the New York Times or in the Wall Street Journal not that long after in the 1980s, for example, it’s not a discussion on whether shareholders’ value maximization should be the objective. It’s a fact. Shareholders’ value maximization is the objective.
MIHIR DESAI: Yeah, and I’d just like to add one more piece of context, because Carola and Lynn already laid out a lot of it. But I, I think it’s also important to remember that politically in the 1980s, there is a resurgence of kind of classical economics. And Friedman and others are arguing, at a time when people are disillusioned with what had been a little bit of a leftward shift in thinking, that we needed to return. And, of course, Reagan is the embodiment of that. So, I don’t think we can abstract away from this background political context of a rightward shift in U.S. politics, and, of course, in the UK as well.
ADI IGNATIUS: Mihir, do you want to talk a little bit more about what, you know, Jensen and his coauthor were trying to fix and what their arguments were exactly?
MIHIR DESAI: Mike Jensen, and his coauthors, and, in particular, in their really remarkable article the Eclipse of the Public Corporation in HBR, really, threw a broadside against managers and against that notion of managerial power. What he does is quite interesting, he basically says, “Public corporations are dead. They are no longer a meaningful way to advance welfare.”
And of course, it’s a very hyperbolic statement. But what he’s getting at is the rise of private equity, the rise of leveraged buyouts, and the ability to say, “Well, wait a second, maybe diffuse ownership isn’t required. Maybe it just won’t be like that anymore.” And it’ll be better, because of exactly the issue that Carola began us on, which is incentive alignment.
It all becomes about incentive alignment, which is we need managers and owners to be back on the same page. And the only way to accomplish that, in this view, is to pay managers with stock, because that creates the incentive alignment. That is really, from their perspective, the core issue in modern capitalism, which is the separation of ownership and control. And again, this comes at a time where rightward shifts in politics, and disappointments with the economic growth of the ’70s serves as very fertile ground for seeding these ideas.
ADI IGNATIUS: Lynn, do you remember when you first heard of this concept and sort of what you thought about this?
LYNN PAINE: Oh, I remember it very well. It was the early 1980s, and I was at a conference. And I was chatting with a graduate student who was very excited about the thesis he was writing. And of course, I asked him to tell me about it, and he said he’s writing a thesis on this hot new idea called agency theory. As I listened to it, I was actually not particularly impressed! Because everything he said was so at odds with what I had learned in law school.
So, you know, for example, he was telling me that managers were the agents of the shareholders. Well, you know, an agent is kind of an order taker, whereas a fiduciary is somebody who’s supposed to exercise independent judgment. And here, judgment on whose behalf? The student was telling me it was on behalf of shareholders. And I had learned that, no, you’re fiduciary for the corporation and the shareholders, not just the shareholders. So, I didn’t think this theory was gonna go anyplace, and (laughs)-
MIHIR DESAI: (laughs)
LYNN PAINE: But I guess I turned out to be wrong.
ADI IGNATIUS: So far.
CAROLA FRYDMAN: Can I, can I briefly jump in?
ADI IGNATIUS: Yes.
CAROLA FRYDMAN: Because the insight that comes out of these papers is really quite simple, but powerful. Which is to say, once we have hired managers, professional managers, on their own, they’re not going to run the form to maximize the firm’s value. Because they’re going to respond to their own personal incentives—unless shareholders are designing the incentives of managers so that they are aligned with whatever the objective is. And that’s important. Because it’s saying, “Well, the manager on its own that’s gonna make the day-to-day decisions, left to her own devices, will think about her own personal benefits or her own preferences. As Jensen and Meckling said very nicely, agency costs are as real as other costs. And they do not disappear depending on what we put as the objective in the maximization function.
ADI IGNATIUS: So, that’s interesting. And I, I mean, it’s a fascinating argument. And you know, Friedman’s argument that look, businesses should just worry about making money, and—that wasn’t totally callous, you know—that other things will be taken care of if they do that. And then, you know, Jensen and Meckling, who, you know, are trying to solve the agency problem.
But what’s interesting to me is, you know, Lynn as a young scholar had problems with it, and yet, it settles into orthodoxy. And for decades, it’s not only like accepted practice, but you talk to CEOs they say, “Hey, I have no choice. The law requires me to maximize shareholder value, or I am abdicating my, you know, legal fiduciary responsibility.” So, more than a fad, it is thought to be the only possible approach that CEOs can responsibly take. How did that happen? And Lynn maybe, maybe I’ll ask you to, to start?
LYNN PAINE: Well, I think the point you make about simplicity is really important. Because the, the fundamental idea that it all starts with is the notion that shareholders own the corporation, even my two-year-old grandson, he knows what he is.
ADI IGNATIUS: (laughs)
MIHIR DESAI: (laughs)
LYNN PAINE: And so, this is a very simple idea. And agency’s a very simple idea. They are the principles, and they delegate authority to their agents to then manage the corporation. But the very premise that shareholders own the corporation, at least from a legal point of view, is very dubious. Shareholders own their shares, but they don’t own the corporation in any traditional sense of ownership.
What I’m really saying is, as a shareholder, you’re not a proprietor of the corporation. You’re not responsible for its debts, its misdeeds. You’re not accountable for any injuries that it imposes on third parties. I mean, I can be a shareholder of say, Apple, but I don’t get the keys to the premises. And I can’t go in and pick up a phone for myself whenever I need one. So, you do own your shares, but it’s a very different concept of ownership from the traditional concept.
MIHIR DESAI: Mm.
LYNN PAINE: But that theory starts with that fundamental premise. We have to also remember in the 1970s and 1980s, institutional shareholding was really picking up—particularly pension funds and government retirement funds—and looking for returns, as Mihir was saying earlier. So, this theory found a ready audience, an audience that said, “Ah, this can help us,” and there was a lot in it for the institutional investors and the fund managers.
MIHIR DESAI: Yeah.
LYNN PAINE: I mean, a good example is CalPERS, which was one of the early companies to get involved in corporate governance issues and shareholder activism in the 1980s. If you go back and look at their materials, you can see that they were pretty directly influenced by this theory. Some of their materials say, “We are owners, we’ve been asleep at the wheel, we need to wake up to that and start asserting our rights.” And institutional investors became a very powerful lobbying force. So, this whole thing is not just about an idea that people globbed onto. There was a movement. There was politics. There was lots of influence. And there was lots of money to be made from this idea by certain groups, and those groups promoted this idea.
MIHIR DESAI: Yeah. Lynn, I just want to pick up on this rise of institutional investors, because I think it’s so important, right? It’s not just pension funds, but it’s an entire change in the way that Americans view savings and the way their retirements get funded. So, if you go back to the ’60s, the GM pension plan, for example, was managed by GM. And then beginning in the early 1970s, they delegated to the nascent private equity firms and nascent venture capital firms that grow up to basically serve to manage assets on their behalf.
So, now you have an industry—the investment management industry—being born, that is crystallizing the idea that, well, our interests need to be served. And then, of course, you have the defined contribution revolution, again, through the late 1970s and early 1980s, that says, “Well, wait a second, the way we do retirement savings should be different, which is it shouldn’t be through firms. We should have portable benefits.” That change makes individuals think of themselves as investors in a way that they never thought of themselves before.
And of course, we have the rise of the mutual fund industry, which again, just explodes in the 1980s and 1970s. And of course, this industry, to Lynn’s point, has every reason to also propagate that idea. Because private equity becomes a major asset class. Venture capital becomes a major asset class. And so, there are a lot of self-interested folks doing lots of things to propagate the idea as well.
ADI IGNATIUS: Carola, how did all this affect executive compensation?
CAROLA FRYDMAN: Well, it’s really a transformative effect on executive compensation. The idea that stock and stock options could be used to align incentives to some extent is not novel. Firms had been using stock and actually stock options before the Great Depression. But all through the ’50s, ’60s, ’70s, the use is relatively minimal.
So, what happens is, Jensen has another really influential paper. In this case, with Kevin Murphy in 1990. That basically says that executives are being paid as bureaucrats. And what they mean by that is that most of their pay is relatively fixed, independent of firm performance. They estimate, essentially, that CEOs get about $3 for each $1,000 in value that they create for their firms. And so, the claim is they get a fixed wage, they have no incentives to work hard or do right by the shareholders.
So, what we see happen through the 1990s is a rapid rise in the levels of CEO pay. But more importantly, a big shift from salaries, relatively fixed bonuses, short-term bonuses, to a very large fraction of the compensation coming through stock options and restricted stock. It’s also aided by a tax reform in 1993, that essentially makes a tax disadvantage for firms to pay executives in relatively fixed forms of pay that are not tied to the performance of firms.
CAROLA FRYDMAN: What we do really see is that the 1990s are the period of the most rapid rise in executive compensation amongst the largest firms, whether we’re looking at averages or medians. And it’s been a lot more stable since, actually. There hasn’t been quite such a sharp increase—some ups and downs, but not the same level of increase—since the early 2000s.
ADI IGNATIUS: So yeah, that 1990 article you mentioned was in HBR: “CEO Incentives—It’s Not How Much You Pay, But How.” Carola, I’m interested, to what extent has this idea of shareholder value maximization actually influenced corporate systems in countries besides the U.S.?
CAROLA FRYDMAN: I think it’s interesting, my perspective is that actually in the last 20, 30 years, we’ve seen a convergence on both sides. Surveys to managers in the early 1990s reflected stark differences in what the objective was across the world. Managers in the U.S., but also the UK or Canada, primarily responded that the one and only objective was shareholders’ value maximization.
Managers in Germany, Japan, for example, were a lot more likely to prioritize stakeholders’ value maximization. And that’s because historically, the governance of firms in Germany and Japan has been very different. There is labor representation mandated in the boards of German corporations.
But what we’ve seen over time is that the significance of shareholders’ value maximization has also influenced other countries. One case in which we see it very clearly is with executive compensation, where the use of equity-based pay was largely non-existent in other countries. And that has changed tremendously as they became aware of the extent to which it was used in the U.S.
ADI IGNATIUS: I mean, this is surely the, the beginning, I guess, of the, the debate over income disparity.
MIHIR DESAI: Yeah.
ADI IGNATIUS: I mean, Peter Drucker’s idea that, you know, the, top earner should not make more than 20 times what, you know, an average-salaried worker makes, obviously seems quaint after this explosion of executive compensation. Coming up after the break, we’re going explore the backlash to shareholder value maximization. Is there a better way? Stay with us.
Welcome back to 4 Business Ideas That Changed the World: shareholder value. I’m Adi Ignatius. So, the idea of shareholder maximization takes hold, it really was an era that lasted for a long time. Mihir, would you be willing to sort of then look at the positives and negatives of this 50 years that we really subscribe to this theory?
MIHIR DESAI: Sure. And I think, you know, my approach to this question is to perhaps quote Churchill.
LYNN PAINE: (laughs)
MIHIR DESAI: Which is, you know, it’s a terrible form of capitalism, but for all the others.
CAROLA FRYDMAN: (laughs)
MIHIR DESAI: You know, which is what Churchill said about democracy. Which is to say there are many problematic aspects to it. You alluded to one, a pretty dramatic rise in income inequality as the ratio of compensation at the top end of the distribution goes to several hundred of those at the bottom of the distribution. I think there was an obliviousness to the central disaster of our time, which is, of course the environmental disaster, and that could have been fostered by this exclusive focus on one metric.
Having said all that, I struggle with what people have been suggesting as alternatives. And you’ll remember Adi, and I’m sure it was in the pages of HBR, which is, “Well, the right way to do this is the Japanese way, you know, we need keiretsu’s, you know, that’s gonna be the solution.” Well, that hasn’t turned out terribly well. The German model turns out to be considerably more idiosyncratic than I think other many people would think of it as. For a while it was, “No, state capitalism as pioneered in China is gonna be the way to do this. That’s going to be the winner.” So, I think these other examples are complicated.
Now, there is concern about income inequality at the national level. But of course, these last three or four decades have seen a remarkable reduction in global income inequality. And I think that’s quite positive. And really remarkable technological accomplishments that have been pioneered by these high-powered incentives. Including in technology that we, you know, laud in venture capital. Which, of course, is predicated on this very idea of incentive alignment that Carola outlined.
So, I think there are many problems. But I don’t think we should, you know, sell short the idea of what it has accomplished for us. And, in particular, in comparison to what alternative models that were heralded during those last 50 years have not delivered.
ADI IGNATIUS: So, that seems fair, but we’re obviously in a moment now where a lot of people are dissatisfied with the shareholder first, the shareholder primacy model. Some of the biggest criticisms of maximizing shareholder value are well-known, but I think it’s worth ticking them off here.
So, I mean, here are a few: short-termism. You know, the sense that CEOs are leading companies to the benefit of the quarterly earnings report, rather than the long-term health of the company. With everything that implies layoffs, reductions in R&D spending, and so on.
Value transfer, as opposed to value creation. That hedge funds, for example, will buy shares, will gain an active role on a board, and then prompt moves to move earnings forward, and then they sell. They’re also not there for long-term growth. So these are some of the most common complaints. But Lynn, you know, what are some other negative and positive impacts that the practice of this idea has had?
LYNN PAINE: That era did bring in more discipline of a certain sort and running the firm or focus on efficiency and more accountability of a certain type. I mean, when I think about the boards that Myles Mace described back in the 1970s, this whole movement certainly woke up a lot of sleeping boards. and they became much more active. So, there were some, definitely some positives to talk about here.
But when you think about maximizing value for shareholders in the U.S. context, you’re really talking about maximizing value for the wealthiest Americans. 90% of U.S. public company equities are held by the wealthiest 10% of Americans. Most Americans get their income, their wealth, from their jobs, from their wages.
ADI IGNATIUS: Mm-hmm.
LYNN PAINE: And if we look at what’s happened to wages in the U.S., and Mihir made the point about global, which I think is also very important. But in the U.S., there’s been very stagnant wages for lower-wage workers and middle-wage workers. Shareholders have done wonderfully over this period. I do feel this problem of income inequality and the kind of divisive times that we live in—it’s going to be hard for us to rebuild the fabric of society unless we think of a better way to share the benefits of this wonderful system that we have.
ADI IGNATIUS: Lynn, how would you define stakeholder capitalism, and you know, where’s this push coming from?
LYNN PAINE: So, we’ve already referred to this as this idea that a company, a corporation should be run for the benefit of all of its stakeholders, and not just for shareholder returns. That’s kind of the core idea. And from a practical point of view, most companies define their core stakeholders as their core constituencies: their employees, their customers, their shareholders, their suppliers, their partners, communities, and the public at large. That’s sort of the set of stakeholders.
The word first appeared in the 1960s, but it was in the mid-1980s, when Professor Ed Freeman, who’s now a professor at the Darden School, wrote his book, Strategic Management: A Stakeholder Approach, that it really kind of put the idea on the map. It really came into the popular imagination over the last decade.
All this is really being driven by an appreciation and awareness of some of these large social and economic problems that we have and the huge environmental crisis that we have. And an understanding that if we just keep on with sort of business as usual—shareholder value maximization—it’s not going to help solve these problems. In fact, it’s probably going to make them worse.
And some of the proponents are—they’re not anti-capitalist—they are experienced business leaders. They are investors. And they’re young people too, looking for how are we going to cope with this world that we’re inheriting? There’s a lot to work out about it. I mean, I don’t think it’s nearly as well-grounded or as well-thought-through as shareholder value maximization.
ADI IGNATIUS: It lacks that simplicity, yeah.
LYNN PAINE: Yeah, it lacks a simplicity. But it also kind of lacks the whole theoretical foundation that’s there. And from a practitioner point of view, I think there’s a lot of confusion, actually, about what it means in practice.
ADI IGNATIUS: I guess one question I have is, whether the shift is real? You know, CEO incentives, I think still tend to be stock-based and, you know, aligned in the same way, as they always were. Active investors are still out there. Carola, the rhetoric has certainly changed. You can’t go to Davos and not talk about stakeholder capitalism, you’ll get booed out of the room. But in practice, are we seeing a change?
CAROLA FRYDMA N: Well, the age comment that Lynn made, I think partly what’s behind this is the younger generation of employees, consumers, and also investors have different preferences. They’re putting more emphasis on climate impact, for example, than the older generation had. And so, in part firms are responding to these concerns, because that’s going to be what’s best for shareholders too.
And in part, because that, as we said before, institutional investors have different preferences. And they express their preferences about environmental and various governance issues in a different way than they did in the past. So, my view [is that] executives are seeing they have to respond to it, because otherwise that’s going to be bad for their firms.
What the impact that’s going to have in practice, I think it’s a little bit early to tell.
MIHIR DESAI: Mm-hmm.
CAROLA FRYDMAN: And it has a, for me, a very big question mark. As Lynn said, shareholders’ value maximization is one very clear metric. It’s easy to quantify and understand. When we think about ESG, or corporate social responsibility, they’re not as easy to measure in a consistent way or we don’t know what the correct measure is. There are lots of different components. Not all of them matter equally. And also, when we think about the diversity of investors of firms, they don’t all have the same preferences.
MIHIR DESAI: Yeah.
CAROLA FRYDMAN: Even if executives are trying to maximize stakeholder value, what does that mean in practice? How do they elicit and weigh the different preferences of all of these stakeholders, and how does that translate into action? And the worry that I have is that it really in a way—that lack of clarity—opens up the room for the agency problem to resurface.
MIHIR DESAI: Mm-hmm. I think that’s super interesting Carola. And it’s real. I think it’s totally real, Adi. Which is compensation is now being linked to ESG metrics. People are thinking hard about it in important ways. I think it’s absolutely real.
My concern is that it’ll, per Carola’s comments, give rise to more agency problems. I mean, I’m reminded of the WeWork filing documents where Adam Neumann said he was going to be saving the world with his company, but was in fact, you know, lining his pockets.
And then the reason I’m really concerned, to go to Lynn’s comments, is that I think it’s a displacement of what are fundamentally political dissatisfactions and political ambitions that are better mediated in the political sphere than in the commercial sphere. You know, if we want to fix the world’s problems—which I do want to—you know, the vehicle for doing that is the political domain. Which may, by the way, include restricting companies from doing things. Somehow we’ve convinced ourselves that the right way to approach this problem—the global problems we face—is to give corporations more latitude to do the things that they think are right. And that seems kind of problematic, and maybe anti-democratic. So, I think it’s a totally real movement. It has enormous potential. But I think there are some real issues about it as well.
ADI IGNATIUS: So, it’s just… it’s a funny period, where we’re looking to companies, we’re looking to CEOs to solve social problems, for better or worse. But I’d love before we’re done to have each of you talk a little bit about, so where are we headed? I mean, I don’t want to say 100 years now, because that’s nonsense. But, you know, if the last 50 years was a sort of Milton Friedman-esque, Reagan-esque, whatever you want to call it, shareholder first, with all the positives and negatives that come from that. Where are we headed? What’s the phase that we’re entering now? Lynn do you want to–
LYNN PAINE: I just feel that we are in a period of experimentation right now. The old paradigm has broken down in various ways. And we don’t have a, you know, a turnkey new one all ready to put in place. And I’m actually kind of encouraged by all of these experiments. That’s kind of the natural process of working through when this old paradigm has broken down, and we’re looking for a new one.
I’m encouraged that some of the advocates and proponents of a shareholder-focused model are rethinking, what is shareholder value? We can find problems with all of these things. But I think it’s good that we’re having this conversation and that there are all of these competing ideas out there, and that we should be working on them.
So, I don’t have a crystal ball. I don’t know what it’s going to look like in 30 or 40 years. But honestly, I don’t think anybody on any side of the debate really wants to go back to the old days, when companies were dumping their pollution into the community water supply in the name of maximizing shareholder value.
ADI IGNATIUS: Mihir?
MIHIR DESAI: I certainly think that’s right. I agree with everything that Lynn said. In fact that we are in this very transitional period, and it’s very exciting, and it’s great to see people coming up with different ideas.
I would be cautious to discount the power of shareholder value maximization as an ongoing bedrock of what we do. In part because of its, I think, some genuine successes. I think it’s really about curbing the excesses of the shareholder value model more than it is about supplanting it with some different notion. Perhaps with legislation. Perhaps with a reinvigorated sense of what the state would do. I think that is the most fruitful way forward.
I don’t know exactly what will happen. But I would not discount that the bedrock will continue to be some form of what we have come to know as shareholder value maximization. But hopefully with more effective curbs on egregious behavior. Hopefully with a more powerful state to counter the force of corporations. I think that would be a good place to end up.
ADI IGNATIUS: And Carola?
CAROLA FRYDMAN: I completely agree with Mihir. What I don’t think is going to happen is, I think we understand the corporate form thankfully is not dead. And the reason for that is that yes, the separation of ownership and control has the agency problem. But we know about it. And we can try to figure out how to address it, not perfectly in some ways.
But the advantage again goes back to what Mihir said before, is the fact that we can diversify risk. And that means firms can take on bigger projects, riskier projects, innovate. And that’s a huge engine for growth.
Now, exactly what we maximize and how we address these problems, I think that’s where we see this constant evolution. With executive compensation, there has been a lot of back and forth. It’s a little bit of a pendulum that slowly moves towards progress. And I think that’s part of what we’re seeing now. It’s going back to take into account the preferences and values of other stakeholders.
But I don’t think that’s going to fully supplant the shareholders’ value as one of the key things that corporations are going to maximize. But it’s a very interesting moment, given what history has taught us. We don’t always get it right. And, in fact, we learn over time, and we try something. It doesn’t work perfectly, we try to fix it. We move one step at a time.
ADI IGNATIUS: I’ve been speaking with Lynn Paine and Mihir Desai of Harvard Business School and Carola Frydman of the Kellogg School of Management.
Next up in our special series 4 Business Ideas That Changed the World will be emotional intelligence. HBR executive editor Alison Beard will talk with three experts about how to identify and manage one’s own emotions, as well as the emotions of others. That is next Thursday right here in the HBR IdeaCast feed after our regular Tuesday episode.
This episode was produced by Curt Nickisch. We get technical help from Rob Eckhardt. Our audio product manager is Ian Fox, and Hannah Bates is our audio production assistant. Special thanks to Maureen Hoch for her help on this project.
Thank you for listening to 4 Business Ideas That Changed the World, a special series of the HBR IdeaCast. I’m Adi Ignatius.
