Companies Should Maximize Shareholder Welfare Not Market Value

Oliver D. Hart is Andrew E. Furer Professor of Economics at Harvard University. This post is based on a recent paper authored by Professor Hart and Luigi Zingales, Robert C. Mccormack Distinguished Service Professor of Entrepreneurship and Finance at University of Chicago Booth School of Business.

There is a big debate in Washington about the attempt in many states to restrict people’s ability to vote in political elections. Yet, there is almost complete silence about a more imminent and no less important form of vote suppression: the attempt to limit shareholder votes introduced in the Financial Choice Act, approved by the House in June. As in all forms of vote suppression, it takes a very technical and even benign form: the Financial Choice Act increases from the current level of $2,000 to 1% the ownership threshold for submitting shareholder proposals to be included in corporate ballots. While $2,000 might be too low to filter out purely frivolous proposals, 1% becomes prohibitive for all but a handful of institutional investors: for example, to make a proposal in Apple you would need over $7 billion in holdings.

The House proposal is the intellectual child of a long tradition in economics and finance, often associated with Milton Friedman, that regards maximization of shareholder value as the sole proper objective of a public company. If maximization of long-term share value is the sole objective, any shareholder vote on other issues is a waste of time and corporate resources.

To be sure, many legal scholars have challenged this tradition. But they have generally done so by arguing that directors owe a duty to other stakeholders (be they employees, the community, or the state). While one can discuss whether this might be desirable, Delaware law does not support it, at least according to Judge Leo Strine. Under Delaware law directors are elected by shareholders and by shareholders alone. They are “elected officials in the republic of equity capital” and they owe their loyalty to those who elect them. If corporations should conduct business according to their shareholders’ desires, Friedman’s conclusion that “the only social responsibility of business is to maximize profits” seems inevitable. Thus, why waste shareholders’ time in voting on social proposals? We can happily disenfranchise them for their own good.

While apparently compelling, this argument is based on two weak assumptions. The first is that people care only about money. Many shareholders buy more-expensive electric cars or they pay more for fair-trade coffee because they care about some social objective: why would they not want the companies they invest in to do the same? In fact, Friedman himself recognizes that the shareholders can have other objectives. Nevertheless, he is able to achieve his famous conclusion because he (implicitly) assumes that the social objective is perfectly separable from the money making objective, i.e. making good is completely independent of making money. This assumption certainly holds in Friedman’s leading example: corporate charity. Shareholders’ donations are as effective as companies’ donations. Therefore, there are no benefits in letting corporate boards allocate profits to charity. It is much better to distribute the profits and let shareholders make this decision. Yet as we argue in our recent paper Companies Should Maximize Shareholder Welfare Not Market Value, this perfect separability assumption is unlikely to hold in general. Consider the recent case, Trinity Wall Street v. Wal-Mart Stores, Inc., where some shareholders wanted to prevent Walmart from selling high-capacity magazines of the sort used in mass killings. If shareholders are concerned about mass killings, transferring profit to shareholders to spend on gun control might not be as efficient as banning the sale of high-capacity magazines in Wall Mart stores in the first place.

Once you drop this separability assumption, then it follows immediately that directors should maximize shareholder welfare, not value. One risk of this alternative goal—anticipated by Friedman– is that it can give too much leeway to corporate managers, leaving them free to pursue their own objectives under the guise of shareholder-desired social objectives. To mitigate this problem, in our paper we argue that companies should ask for more, not fewer, votes from their shareholders to find out what they want.

As we know from the social choice literature, voting is not necessarily a perfect method for aggregating individual tastes into social preferences, but it is the best we have. Furthermore, there is no reason to believe that ignoring shareholders’ social preferences—as the shareholder value maximization movement would have it—dominates voting, with all its limitations.

One could object that forcing shareholders to vote on many issues would produce cognitive overload. In fact, investors could delegate this job to the mutual finds they invest in, as long as these intermediaries either poll them on their social preferences or segment their offerings depending on how they are going to cast the votes on social issues. Imagine a Vanguard—curb gun sales—S&P 500 fund. It will replicate the S&P 500 index, but it will commit to vote in favor of strategies that curb sales of automatic weapons in America.

In fact, the idea is so simple that one might wonder why we do not observe these funds already. While there are a lot of “ethical” funds, which divest from special sectors, we are not aware of any social purpose funds that do not divest, but engage in particular issues. We suspect that the reason is the reluctance of American corporations to let shareholders vote on social issues, a reluctance that the Financial Choice Act would only enshrine. It would be ironic if an act named “Financial Choice” ended up reducing the little power that shareholders still have in America.

The complete paper is available for download here.

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