The Shareholder V. Stakeholder Contrast, a Brief History
Introduction
In a famous 1970 New York Times Article, Milton Friedman postulated that the CEO, as an employee of the shareholder, must strive to provide the highest possible return for all shareholders. Since that article, the United States has embraced this idea as the fundamental philosophy supporting the ultimate purpose of businesses — The Shareholders Come First.
In August of 2019, the Business Roundtable, a group made up of the most influential U.S CEOs, published a letter shifting their stance on the purpose of a corporation. Regardless of whether this piece of paper will actually result in any systematic changes has yet to be seen, however this newly stated purpose of business is a dramatic shift from the position Milton Friedman took in 1970. According to the statement, these corporations will no longer prioritize maximizing profits for shareholders, but instead turn their focus to benefiting all stakeholders — including citizens, customers, suppliers, employees, on par with shareholders.
What has happened over the past 50 years that has led to such a fundamental change in ideology? What has happened to make the CEO’s of America’s largest corporations suddenly change their stance on such a foundational principle of what it means to be an American business?
Since diving into this subject, I have come to find that the “American fundamental principle” of putting shareholders first is one that is actually not all that fundamental. In fact, for a large portion of our nation’s history this ideology was actually seen as the unpopular position.
This post dives into a brief history of these two contrasting ideological viewpoints in an attempt to contextualize the forces behind both sides — specifically, the most recent shift (1970–2019). This basic idea of what is most important; the stakeholder or the shareholder, is the underlying reason as to why many things are the way they are today. A corporation’s priority of shareholder or stakeholder ultimately impacts employee salaries, benefits, quality of life within communities, environmental conditions, even the access to education children can receive. It affects our lives in a breadth and depth of ways and now that corporations may be changing positions (yet again) to focus on a model that prioritizes the stakeholder, it is important to understand why.
Looking forward, if stakeholder priority ends up being the popular position among American businesses, how long will it last for? What could lead to its downfall? And what will managers do to ensure a long term stakeholder-friendly business model?
It is clear to me the reasons that have led to these shifts in ideology are rather nuanced, however I want to highlight a few trends that have had a major impact on businesses changing their priorities while also providing context as to why things have shifted.
The Ascendancy of Shareholder Value
Following the 1929 stock market crash and the Great Depression, stakeholder primacy became the popular perspective within corporate America. Stakeholder primacy is the idea that corporations are to consider a wider group of interested parties (not just shareholders) whose positions need to be taken into consideration by corporate governance. According to this point of view, rather than solely being an agent for shareholders, management’s responsibilities were to be dispersed among all of its constituencies, even if it meant a reduction in shareholder value. This ideology lasted as the dominant position for roughly 40 years, in part due to public opinion and strong views on corporate responsibility, but also through state adoption of stakeholder laws.
By the mid-1970s, falling corporate profitability and stagnant share prices had been the norm for a decade. This poor economic performance influenced a growing concern in the U.S. regarding the perceived divergence between manager and shareholder interest. Many held the position that profits and share prices were suffering as a result of corporation’s increased attention on stakeholder groups.
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This noticeable divergence in interests sparked many academics to focus their research on corporate management’s motivations in decision making regarding their allocation of resources. This branch of research would later be known as agency theory, which focused on the relationship between principals (shareholders) and their agents (management). Research at the time outlined how over the previous decades corporate management had pursued strategies that were not likely to optimize resources from a shareholder’s perspective. These findings were part of a seismic shift of corporate philosophy, changing priority from the stakeholders of a business to the shareholders.
By 1982, the U.S. economy started to recover from a prolonged period of high inflation and low economic growth. This recovery acted as a catalyst for change in many industries, leaving many corporate management teams to struggle in response to these changes. Their business performance suffered as a result. These distressed businesses became targets for a group of new investors…private equity firms.
Private equity (PE) firms primarily buy pieces (equity) of private companies with the goal of selling this equity three to seven years later at a profit. Although these types of firms had existed in the past, with the modern PE firms originating in the mid-1940s, the mid-1970s marked the beginning of a new type of private equity investor. PE firms took advantage of the inability of many corporations to adapt to their changing industries. They turned businesses who were struggling to adapt into profitable, effectively managed corporate entities. This was done through the mechanism of obtaining majority shares in these businesses, substituting equity with debt and forcing much of the cash flow out of the enterprise and back into the shareholders’ hands. This instrument became known as a leveraged buyout, and it created a movement of restructuring in the 1980s that would go on to shape the global perspective on the shareholder v. stakeholder conversation.
What came of this pressure from private equity firms and academics was corporate managers’ new prioritization of shareholder value. The outcomes of the large volume of leveraged buyouts made it clear that outside intervention allocated cash resources in a more economically optimal way, favoring significant increases in shareholder value. A stark contrast to the early 70s which was seen as a time period of inefficient resource allocation.
Why Shareholder Primacy Persisted
A byproduct of this shift in priorities to focus on the shareholder, was a redesign of management incentives. For corporations to more closely align the interests of managers and shareholders, the use of stock options grew substantially as a portion of their pay packages. In addition to the corporate managers, company’s boards of directors also came under increased scrutiny for lack of representation of shareholder interest, resulting in increased stock grant or option packages of non-executive board members.
The popularization of equity did not stop at internal operators and boards, but also expanded to average U.S households. Since the early 1980s growing segments of the population have become shareholders in publicly traded U.S. businesses through the use of mutual funds and retirement funds. According to a study by Gallup, as of April 2019, 55% of Americans reported owning stock either directly, through a retirement account, or mutual fund. This is compared to only 11.9% in 1975.
Changes in the pension system starting back in the 1970s with employers gradually moving from traditional DB plans to DC plans (401ks), has resulted in pension wealth moving from individual firms to the capital markets — in turn increasing the percentage of the population who owns stock.
The original retirement system worked fine as long as there were relatively few retirees in relation to contributing workers, but that hasn’t been the case for decades. When looking at the U.S. Social Security system, there were 41.9 workers to support one retiree in 1945. Over time, this number had shrunk to just 2.9 workers per retiree as of 2012. As a result, retirement funds have been increasing their risk tolerance to generate higher returns in an attempt to reconcile a higher proportion of beneficiaries.
If it wasn’t for the increased reliance on equities, workers would be forced to contribute larger percentages of their pay for the same rewards, retirement ages would likely have increased further, and there is even a chance that the whole Social Security system would have collapsed by now. It is clear that there is a tradeoff between protecting retirees and protecting workers. Considering that contrast, the role of equities is essential in ensuring returns for retirees while also minimizing the financial burden of workers. Today, the U.S. retirement system may be a ticking time bomb, however if the funded pension plans, Social Security plans, and direct contribution plans are to work as expected, companies must be held accountable for generating shareholder value.
During the most recent era of shareholder-focused corporations, unintended consequences of the shareholder primacy philosophy have ultimately led to a revival of a group of thought which places stakeholder value over or at an equal level to shareholder value. This has become a debate that has grown in recent years and recently made headlines with the 2019 Business Round Table statement of changed business purpose. Below outlines some of the major trends that have led the shift in ideology.
The Ascendancy of Stakeholder Value
Economic inequality is one of the most cited consequences as a result of maximizing shareholder value. Between the end of World War II and 1970, economic growth lifted every economic group up at roughly the same rate. This has not been the case for the half century since…
In 2012, the wealth share of the top 0.1% was three times higher than in 1978, and almost as high as in the 1916 and 1929 historical peaks. The wealth of the top 10% of income earners follows a similar trend, in large part due to the heavy influence of the top 1%. Meanwhile, the wealth share of the bottom 90% has fallen from 35% in the mid-1980s to about 23% in 2012. To summarize, more of the wealth generated today is moving to those who already have wealth than to those who don’t. This is something that has been true for much of American history, however today it is happening at levels only last seen in the Jay Gatsby roaring 20s.
A few other statistics that put economic inequality in the U.S into perspective: (Statistics According to the St. Louis Fed)
- In 2016, more than 10% of people had a negative net worth (more debt than assets) up from 7% in 1989.
- In 2016, the top 10% of Americans owned 77% of the wealth “pie” and 50% of the income distribution.
- In 1989, the total household wealth in the U.S. was $32.87 trillion (2016 adjusted dollars) where in 2016, total U.S. household wealth amounted to $86.87 trillion.
The real question that is often asked is why is this bad?
First, it is important to note that wealth and income inequality is not only unavoidable, but at some level it’s actually desirable. As this may be true, there is harm in having extremely high levels of inequality, like that we are seeing today. One of the biggest issues being that it negatively impacts economic growth. A 2014 study by the OECD found that countries with more economic inequality had less economic growth. This is because:
- Less affluent children often have access to less education, putting a limit on their economic potential.
- Public policy faces greater pressure to accommodate “rent seeking elites” and to also provide to the poor, ultimately increasing government intervention and welfare spending.
- The overall performance of the U.S. economy isn’t actually what it seems — it is inflated by the top 1%. Although overall U.S. income growth is higher than many other nations, our 99% base has actually grown slower than many of these countries.
An additional consequence of the alignment of incentives of a corporation’s managers and shareholders, has been the skyrocketing of executive pay. The structure of executive pay packages has changed to the point that there is (generally) a tight link between stock prices and CEO compensation. According to the Economic Policy Institute, CEO compensation rose 1,007.5% from 1978 to 2018. Conversely, the growth of the typical worker’s compensation during this same time period was a painfully slow 11.9%.
A further consequence of the increased alignment of executives and shareholders is the popularization of the stock buyback. A stock buyback, share buyback, share repurchase, whatever you want to call it, is when a company buys its own stock (back) from investors. Buybacks started as a way to prop up share prices during the great depression in 1929. They became highly regulated and (pretty much) illegal from 1934 up until the early 1980s. The arguments against buybacks then were: “They deprived companies of much needed cash; diverted executives away from business problems and toward speculative gyrations of the stock market; and more” all pretty similar to the arguments cited by critics today.
According to government figures, the number of stock buybacks in the U.S. in a given a year has grown (in dollar amounts) from $6.6 billion in 1980 to approximately $200 billion in 2006 and about $1 trillion in 2019.
In a well-run corporation, there is likely to be a formal process by which the allocation of free cash flow to various projects and investments is evaluated. If the company sees no promising investment opportunities, it should either return the capital in the form of a dividend, through a buyback to the shareholders, or conserve cash. Under the shareholder primacy model, businesses are increasing allocations of free cash flow to stock buybacks. Similar to the arguments throughout the mid-1900s, short term stock price gains assumed from buybacks has often come at the cost of structural weaknesses in the underlying businesses and lack of innovation.
In a well-run corporation, there is likely to be a formal process by which the allocation of free cash flow to various projects and investments is evaluated. If the company sees no promising investment opportunities, it should either return the capital in the form of a dividend, through a buyback to the shareholders, or conserve cash. Under the shareholder primacy model, businesses are increasing allocations of free cash flow to stock buybacks. Similar to the arguments throughout the mid-1900s, short term stock price gains assumed from buybacks has often come at the cost of structural weaknesses in the underlying businesses and as lack of innovation.
- In September of 2008, Lehman Brothers declared bankruptcy, yet in 2006 and 2007 spent more than five billion dollars in buybacks.
- From 2010–2019, the top five largest U.S. airlines (Alaska, American, Delta, Southwest, United) spent a combined 96% of their free cash flow on stock buybacks. In 2020, they got a $25 billion government bailout.
- Between 2008 and 2017, the largest pharmaceutical companies spent $300 billion dollars on buybacks and another $290 billion paying dividends. That’s a little more than a 100% of their combined profits.
- Between 2002 and 2019, Cisco spent $129 billion dollars on stock buybacks — more than it spent on research and development.
In the cases of Lehman Brothers, as well as the airlines in 2020, the decision to buy back stock instead of reserve cash or invest back into the business ultimately left these two industries extremely vulnerable in two of the worst economic periods in recent history. In the case of Cisco and pharmaceutical companies like Merk and Pfizer, stock buybacks have come at the expense of corporate innovation in industries that have been historically driven by R&D and innovation. Obviously, it is nearly impossible to have predicted the 2008 mortgage crisis and the coronavirus outbreak of 2020. And it is more than likely that these businesses assumed that they were doing the right thing at the time, however they were doing the right thing in accordance with just shareholder priorities.
Like the mid-1970s when corporate managers were allocating resources in an inefficient way favoring the stakeholder, many believe the same is happening today but with the shareholder.
As academics and private equity firms played a major role in the 1970s shift in position, consumers and investors seem to be the underlying forces of today. Due to a combination of higher ethical standards of consumers and the increased accessibility of information, businesses are held more accountable for their actions and the positions they take than ever before. Accenture Strategy’s Global Consumer Pulse Research, revealed that consumers, across all generations, care about what retailers say and how they act. According to the study, more than six in ten younger consumers closely consider a company’s ethical values and authenticity before buying their products. As this has become more prevalent, companies have increased focus in ESG (Environmental, Social and Corporate Governance). This increased consideration of sustainability and socital impact by corporations has been motivated by consumers but powered by investors.
In 2020, there is quite a bit of evidence that shows companies prioritizing ESG issues actually generate superior long-term financial performance across a range of metrics — including sales growth, return of equity (ROE), return on invested capital (ROIC), and even alpha (market outperformance). According to an analysis on ESG and financial performance that looked at 2,200 studies on ESG, 90% showed either a positive relationship to corporate financial performance (CFP) or at least no-negative relationship. It should come as no suprise that when Harvard Business Review recently interviewed 70 senior executives at some of the largest institutional investing firms, it found that ESG was almost universally top of mind for all of these investors. Clearly, consumers have been the ones to put the pressure on corporations, forcing them to put a greater emphasis on sustainibility and societal impact. Investors support of these priorities has in turn, made stakeholder primacy a new top concern for these corporations.
Conclusion
The narrative has once again, begun to shift. The 50(ish) year cycle of shareholder preference seems to be reverting back to a stakeholder focused outlook. The consequences of shareholder primacy paired with consumer and investor reactions provides an explanation for the Business Roundtable’s redefined purpose of a corporation statement in 2019.
With that being said, this kind of shift is not entirely unique. Life after The Great Depression generated stakeholder support from the public, regulators, investors and led to an era of stakeholder priority that lasted over 40 years. The same reasons that led shareholder primacy to gain traction in the 1970s are likely to occur again towards the end of this stakeholder cycle if things are not done differently. But that is for another article. Until then, it will be very interesting to watch how differently corporations act now that they have publicly committed to prioritize all stakeholders. Only time will tell.
Sources:
Thanks to the books Valuation and The Economists Hour for getting me interested in this. Other sources include:
Jensen and Meckling’s Theory of the firm: Managerial behavior, agency costs and ownership structure (1976)
Wealth Inequality in the United States since 1913: Evidence from Capitalized Income Tax Data, The Quarterly Journal of Economics, Volume 131, Issue 2, Emmanuel Saez, Gabriel Zucman, (2016)
Corporate Governance, Saylor Academy, (2012)
The Investor Revolution, Harvard Business Review, Robert G. Eccles, Svetlana Klimenko(2019)
ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies, Journal of Sustainable Finance & Investment, Volume 5, Issue 4, Gunnar Friede, Timo Busch, Alexandar Bassan(2015)
CEO compensation has grown 940% since 1978, The Economic Policy Institute, Lawrence Mishel and Julia Wolfe, (2019)
What Wealth Inequality in America Looks Like: Key Facts & Figures, St. Louis Federal Reserve, Ana Kent, Lowell Ricketts, and Ray Boshara, (2019)
The Pension System and the Rise of Shareholder Primacy, Seton Hall Law Review, Martin Gelter,(2012)
Public Pension Plans Continue to Shift Into U.S. Stocks, The Wall Street Journal, Heather Gillers, (2019)
What Percentage of Americans Owns Stock?,Gallup, LYDIA SAAD,(2019)
Unemployment Rate by Year Since 1929 Compared to Inflation and GDP, The Balance, KIMBERLY AMADEO, (2020)
