Do Shareholders "Own" a Corporation?

Early in her novel Atlas Shrugged, Ayn Rand presents us with a scene aboard a train that is entering Philadelphia. “An office building appeared, close to the tracks. The big neon sign on its roof lighted the interiors of the coaches as they went by. It said: Rearden Steel. A passenger, who was . . .

a journalist, made a note for future use in his column: ‘Hank Rearden is the kind of man who sticks his name on everything he touches. You may, from this, form your own opinion about the character of Hank Rearden.’”Of course, the journalist means to impugn Rearden, but Rand means to praise him. Thus, throughout Atlas Shrugged , we find that the companies run by heroes generally bear the name of their founder: Taggart Transcontinental, d’Anconia Copper, Wyatt Oil. By employing this symbol, Rand was not merely extolling the virtue of pride. She was raising a much deeper issue: What is the relationship between the soul of that artificial person called a corporation and the soul of the person who runs it?

Ralph Waldo Emerson wrote in “Self-Reliance” that “an institution is the lengthened shadow of one man,” adding that “all history resolves itself very easily into the biography of a few stout and earnest persons.” For proof, Emerson cited the monastic movement initiated by St. Anthony, the Reformation begun by Martin Luther, and the evangelical approach to religion promoted by John Wesley. By naming her heroes’ corporations after their founders, Rand was saying that a great corporation is the lengthened shadow of one businessman, and that the main narrative of business history thus also resolves easily into biography.

Can an individualist understanding of business and businessmen be reconciled with the wealth-maximization rule?

Unfortunately, that viewpoint will seem eccentric to anyone who reads contemporary accounts of business, even (or perhaps especially) accounts written by pro-business journalists and scholars. A corporation, these authors tell us, belongs not to its executives but to an ever-shifting group of anonymous shareholders. And the business must be run by its directors and executives for one and only one purpose: maximizing shareholder wealth. Whatever actions are demanded by consumers’ dollars, those actions must be performed by the men running a company. St. Anthony? Martin Luther? John Wesley? Corporations are about profits, not prophets.

DO SHAREHOLDERS OWN A CORPORATION?

In 1970, Milton Friedman gave the classic statement of the view that shareholders are the true owners of the corporation and executives are merely their employees. He wrote:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society.

Predictably, after the world’s most prominent pro-capitalist economist proclaimed corporate executives to be mere servants, muckraking journalists found much to damn in their behavior. They found business executives to be arrogant, presumptuous, impudent, insolent, procacious, and just plain uppity. In her column of December 3, 2006, New York Times business journalist Gretchen Morgenson wrote:

Corporate executives, and those who carry their water, dismiss shareholder activists these days as promoters of hidden agendas that have no place in the financial markets. Stockholders interested in making executives more accountable to their owners, the shills say, are really pushing labor union participation or kooky environmental issues and are generally to be ignored. Never mind that many activists have the sole goal of pressuring me-first executives to remember that they are hired help and are supposed to be working for their bosses (also known as shareholders).

There you have it. “Shareholders are owners. Executives are servants. Shut up and listen to your masters.”My first suspicion that something was amiss in this account of corporate structure came from Robert Hessen’s splendid 1979 book In Defense of the Corporation. (See also his excellent article on corporations in the Concise Encyclopedia of Economics, available online at http://www.econlib.org/library/Enc/Corporations.html.) In his book, Hessen wrote:

Critics frequently denounce the separation of ownership and control in giant corporations; yet it merely represents a widening specialization of function or division of labor. There is no reason why a shareholder must personally manage his own money. . . . [And] just as most investors do not seek to exercise managerial authority, so too, when a business goes public, the founding officers and their successors do not intend to relinquish their decision-making powers. For example, when Walt Disney, Edwin Land, and Thomas J. Watson sold stock in their companies to outsiders, they were seeking capital, not advice on how to produce cartoons, cameras, and computers.

All very true. Yet I was not quite satisfied. Obviously, the division of labor between investors and managers makes sense. And obviously no third party has a complaint if both parties are happy with that division of labor. But if shareholders really are owners, I wondered, why should it be so extremely difficult for them to oust the incumbent managers of their money and install new ones? When we see how hard it is for European managers to fire their employees, we rightly call their system rigid and sclerotic. Why, then, shouldn’t the same be said of the public corporation, if it is nearly impossible for the corporation’s owners to fire their employees, the board of directors?

A NEW UNDERSTANDING

Recently, I have found, a growing number of legal scholars challenge the whole idea of shareholders as the owners of the corporation, at least in any commonly understood sense of ownership. One of these scholars, Professor Lynn A. Stout of UCLA Law School, points out in “New Thinking on ‘Shareholder Primacy’” that the shareholders’ “ownership” role is largely limited to electing the board of directors and that even these elections seem “a mere ceremony,” as it is extremely difficult to defeat the board’s own slate of candidates. Surely, if investors were true owners, who were merely delegating the management of their money to others, they would want some say in selecting the single most important manager of their money: the CEO. But that is not part of their power. Or again, Stout observes that shareholders are unable to demand the corporation pay them a dividend. Why? If they really were the owners, delegating the management of their money to others, wouldn’t they be able to determine when their managers gave back to them a little of the money that had been made on their behalf?

A growing number of legal scholars challenge the idea of shareholders as the owners of the corporation.

In short, it seems that the Chicago School of Economics, and Milton Friedman in particular, may have been wrong as a matter of law when they perpetuated the view that shareholders own a corporation.

The alternative view has been called the “contractarian” or “director primacy” concept of the corporation, and its most prominent proponent is Professor Stephen Bainbridge (also of UCLA Law School), a conservative theorist in the Burkean mold, an œnophile, and a popular blogger (www.professorbainbridge.com). In a famous essay called “Director Primacy: The Means and Ends of Corporate Governance,” Bainbridge wrote, “Contractarians reject the idea that the firm is a thing capable of being owned.” Instead, “director primacy treats the corporation as a vehicle by which the board of directors hires various factors of production. The board of directors thus is not a mere agent of the shareholders but rather is a sui generis body.”

THE WEALTH-MAXIMIZATION RULE

If we can dispense with the idea that a corporation is owned by its shareholders, perhaps a more individualist conception of business and businessmen may emerge. But there is one major hurdle. Even if corporate executives are not the employees of shareholders, doesn’t Friedman’s larger point remain? Executives are bound by a fiduciary duty to serve a single goal: maximizing shareholder wealth, and that would seem to preclude them from running a business that serves their ideals and vision. For an individualist, who believes commerce is an activity no less creative than the fine arts, this is not a happy conclusion.

Bainbridge asserts (though Stout denies) that the fiduciary duty of corporate managers to maximize shareholder wealth does indeed remain under the theory of director primacy. He writes: “In rejecting [the shareholder primacy] model, director primacy does not throw out the baby with the bath water. The eponymous shareholder wealth maximization norm charges directors with managing the corporation so as to maximize shareholder wealth.”

The question, then, is this: Can an individualist understanding of business and businessmen be reconciled with the wealth-maximization rule? Consider what Ludwig von Mises had to say in Human Action about the role of businessmen in the free market:

The direction of all economic affairs is, in the market society, a task of the entrepreneurs. Theirs is the control of production. They are at the helm and steer the ship. A superficial observer would believe that they are supreme. But they are not. They are bound to obey unconditionally the captain's orders. The captain is the consumer. Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt, and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.

Does this passage imply that idealists are bad capitalists and are properly driven into bankruptcy? Does it imply that successful functioning in the free market belongs to amoral and ethically bankrupt managers who will do anything legal for a buck? Even more to the point: Does the duty of maximizing shareholder wealth imply that, if consumers so demand, a manager is legally obligated either to behave in an immoral fashion or quit?

Let me pose the difficulty by recalling a memorable passage in Rand’s Fountainhead: The modernist architect Howard Roark is offered a commission to build a Tudor-style home but refuses it. His would-be customer is perplexed. Roark is an architect. She is offering him a commission. People in business are supposed to respond to demand. That is how the market works. What’s up?

Of course, in the novel, Roark’s firm is not a publicly held corporation, and although individual proprietorships are supposed to maximize their profits according to free-market theory, they are not obliged to. However, if Roark’s firm had been a publicly held corporation, that would have added a legal aspect to the economic puzzle. Would Roark’s fiduciary duty to maximize stockholder wealth have obligated him, legally, to accept the commission for a Tudor home?

I confess that this scene long perplexed me. How can Roark’s behavior be reconciled to what capitalist economists like Mises tell us about the free market? And how could similar behavior by the idealistic CEOs of publicly held corporations, such as the heroes of Atlas Shrugged, be reconciled to their wealth-maximization duty?

A POSSIBLE SOLUTION

I think the closest statement to my own current view of the matter was the one put forward by John Mackey, the CEO of Whole Foods, in the course of his 2005 Reason debate with Milton Friedman. This is perhaps not surprising. Mackey gave a speech at the 2004 FreedomFest in which he said: “Atlas Shrugged remains one of the five greatest novels I have ever read. Who can ever forget characters like Dagny Taggart, Hank Rearden, Francisco d’Anconia, from Atlas Shrugged, as well as Howard Roark in The Fountainhead. These characters all demonstrated tremendous passions and drive, backed by high self-esteem. Each one inspired this young entrepreneur. I wanted to be just like those heroic characters in Atlas Shrugged.”

At any rate, in his debate with Friedman, Mackey rejected the view of the executive as the shareholders’ servant and laid down this formulation:

I believe the entrepreneurs, not the current investors in stock, have the right and responsibility to define the purpose of the company. It is the entrepreneurs who create a company, who bring all the factors together and coordinate it into [a] viable business. It is the entrepreneurs who set the company strategy and who negotiate the terms of trade with all of the voluntarily cooperating stakeholders—including the investors. At Whole Foods, we ‘hired’ our original investors. They didn’t hire us.

Although there is much in Mackey’s “stakeholder” philosophy of business that I reject, the point he is making here leads me to formulate this suggestion: The long-term goal of a company is to maximize wealth for its shareholders. But it is obliged to do that only through its particular line of work. And that line of work is not defined by the general type of good or service it provides. Rather, as Mackey says, a company’s purpose is defined by a corporate vision, set down by its board or CEO. Adherence to the corporate vision is what gives a company its integrity, and the primary duty of the man running the company is to ensure it adheres to that vision. In this way, the corporation does indeed become his lengthened shadow.

A company’s purpose is defined by a corporate vision, set down by its board or CEO.

Clearly, Roark’s business is his lengthened shadow. The work of his firm is defined by his vision of architecture, and his vision excludes the production of Tudor homes. That is just not the business he is in. To produce Tudor homes would be to enter a new line of business and thus to violate his company’s integrity. Contra Mises, then, there is no prima facie reason to suppose that Roark’s firm will produce a Tudor home, however high the demand for them may go.

Roark may succeed in his vision-defined line of work, or he may fail. But this much at least can be said: If Roark’s architectural firm were a public corporation, his rejection of the commission for a Tudor home would not be a failure to maximize shareholder wealth. It would merely be a refusal to enter an alien line of work, for the very sound reason that to do so would destroy the corporation’s soul, as well as Roark’s own

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