Saving Investors from Themselves: How Stockholder Primacy Harms Everyone

Frederick Alexander is Head of Legal Policy at B Lab. This post is based on Mr. Alexander’s recent article, published in the Seattle University Law Review.

Communities around the world face many difficult issues, including poverty, climate change, social and economic inequality, the cost and quality of education and healthcare, stagnant wages, financial market instability, disease, and food security. Despite the existential threat that these concerns may raise, there is no consensus on whether or how to address them through regulation, taxation, or other government policy tools. Private enterprise, however, has tremendous potential to address these issues through technology, wages, supply chain maintenance, green operations, efficient delivery of goods and services, and a myriad of other outputs and outcomes. In the U.S., the potential of the private sector to address these issues dwarfs that of the government. The 2015 federal budget was approximately $2.5 trillion (excluding transfer payments like Social Security), while the 2015 gross domestic product (GDP) was about $18 trillion. While numbers go up and down, total government spending (including state and local) typically accounts for about 20% of GDP when transfer spending is netted out. Consumer and business spending account for the other 80%.

In light of this economic reality, harnessing the assets of the private sector is a critical pathway towards addressing pressing social and environmental issues. However, the structure we use to allocate resources in the private economy actively precludes using assets in this manner. My article describes a critical structural issue—stockholder primacy—and suggests that a new corporate governance model—the benefit corporation—can help to restructure our system of capital allocation. Benefit corporation statutes, adopted in 31 states including Delaware, require directors and managers to consider the interests of all stakeholders as a primary concern, and not merely as a strategy for enhancing stockholder returns.

But reorienting the system for allocating capital in our private markets will require more than an adjustment to governance at the corporate level. The investment channel, from savers at the top, through asset allocators and managers in the middle, to corporations at the bottom, is dominated by Modern Portfolio Theory, which, like stockholder primacy, encourages all participants to focus on “beating the market,” but not on managing the market and the systems in which their investments are embedded. Thus, all participants in the system focus on performance differences among different companies and among different portfolios, but ignore the effect of company actions and portfolio behavior on performance of the market as a whole. This creates commons-grazing effects that threaten the health of the planet’s ecosystem and the stability of markets and communities. One only need to consider the effects of financial companies chasing returns in the run-up to the Financial Crisis to find a ready example.

To address this problem, everyone along the investment chain, from corporate executives and directors, to fund managers and individual investors, needs to add an ethical component to their decision-making. The article does not propose that investors or managers make decisions from an altruistic or moral framework. What it does propose is that there is a better way to invest for private gain—one that will potentially produce a better outcome for all participants in the economy, including investors. The ethical principle is easy to state: investors and managers should not seek gains by simply extracting as much value as possible from the economy, but instead should seek gains by building and sharing value with all stakeholders in their investments.

In other words, we need to reorient our financial system to encourage the investment of private capital in positive sum opportunities. Stockholder primacy and Modern Portfolio Theory have become identified with a pre-governmental pure “free market.” However, there is no free market without rules that are created and enforced by government and social mores, and those rules affect outcomes. The rules in place today pit the interests of investors against those of other stakeholders rather than linking them. This is actually a fairly new construct and not a universal one. Pushing the market in a different direction—one that links the interests of all stakeholders—will return the U.S. to the model of stakeholder capitalism that prevailed after World War II. This model would deliberately allocate capital in order to create value for society as a whole, thereby addressing critical social and environmental issues. It would return U.S. capitalism to a system based on making rather than taking.

Stockholder primacy and Modern Portfolio Theory denies savers the opportunity to build value based on genuine trust and commitment; the rationalization of broad portfolios so that their components are not wasting resources in a negative-sum game; and a portfolio that makes a positive contribution to all aspects of savers’ lives, not just their bank accounts. Benefit corporation law is an excellent start to address these concerns, but much more needs to be done. We must have a public discussion that allows us to establish ethical investment principles enforced by laws and custom.

In order to impose the ethical principle suggested by this article, there must be a commitment at the investor level, similar to the management level in a benefit corporation, to seek out stock value only by building real value. Investors and market participants that play by different rules need to be shunned and shamed. Integrating this ethic into the financial system is a beginning, not an end. Corporate and investment managers, as well as investors themselves, will have to do the hard work of figuring out where the value enhancing opportunities are, even though there will be disagreement on the importance and weight of various stakeholder interests. But, in order to at least get all that capital working in the right direction, we have to change the basic rules. Companies and investors must stop competing to take and start competing to create.

The full article is available here.

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