The Win-Win That Wasn’t: Managing to the Stock Market’s Negative Effects on American Workers and Other Corporate Stakeholders

Aneil Kovvali is Harry A. Bigelow Teaching Fellow & Lecturer in Law at the University of Chicago Law School and Leo E. Strine, Jr. is Michael L. Wachter Distinguished Fellow at the University of Pennsylvania Carey Law School; Senior Fellow, Harvard Program on Corporate Governance; Of Counsel, Wachtell, Lipton, Rosen & Katz; and former Chief Justice and Chancellor, the State of Delaware. This post is based on their recent paper.

The work of Frank Easterbrook and Dan Fischel influenced a generation or more of corporate law scholars and, perhaps more important, powerful players in American corporate governance like institutional investors and government policy makers. It is impossible to consider the path that American corporate governance has taken without acknowledging the impact of their thinking, and the ballast their arguments gave to those who drove policies designed to make American public companies more responsive to the immediate demands of the stock market and to tilt governance towards one that would transmit the desires of stockholders, particularly institutional investors with clout, more consistently and rapidly into corporate policy.

But, in our reflection on their core corporate law scholarship, The Win-Win That Wasn’t: Managing to the Stock Market’s Negative Effects on American Workers and Other Corporate Stakeholders prepared for a festschrift for the inaugural issue of the University of Chicago Business Law Review, we address a claim of Easterbrook and Fischel that in our view has, as a matter of empirical and lived reality, turned out to be false. That assumption was that if corporations were run to maximize the profits of stockholders, and to be highly responsive to their demands, that would benefit all of society. Easterbrook & Fischel explain this perspective in the opening chapter of their 1991 book, The Economic Structure of Corporate Law:

Society must choose whether to conscript the firm’s strength (its tendency to maximize wealth) by changing the prices it confronts or by changing its structure so that it is less apt to maximize wealth. The latter choice will yield less of both good ends than the former. . . . [M]aximizing profits for equity investors assists the other ‘constituencies’ automatically. The participants in the venture play complementary rather than antagonistic roles. In a market economy each party to a transaction is better off.

The concept behind this was that stockholders could only gain if all other stakeholders had their legitimate expectations met, because stockholders were only residual claimants. As a result, it would benefit all if we ran corporations to their direction, because that would grow the value of companies in the maximum way, for the benefit of all stakeholders and society as a whole.

They thus posited a win-win, because there was no zero sum game. Because of their uniquely vulnerable status as residual claimants, without the greater protections of law and contractual precedence other stakeholders had, stockholders supposedly could only win if the other stakeholders did.

But this line of reasoning depends on certain assumptions being true. First of all, it requires the corporation to be surrounded by effective institutions that protect stakeholders, and prevent stockholders from externalizing costs to them. The government must thus enact and diligently enforce rules that set appropriate “prices” on socially dangerous behavior. And corporations themselves must not use the entrusted capital of others to act on the political process and to tilt the rules of the game away from those conditions, and toward ones where the fair costs of doing business are shifted from equity investors to workers, creditors, consumers, the environment, community members, and taxpayers. Workers must be protected against unsafe and overly taxing conditions of employment. Constraints must be set so that employers cannot lowball vulnerable workers by paying poverty-level wages and benefits and workers must be secure in their freedom to join together to bargain and claim their fair share of corporate profits when negotiating employment contracts. Communities and creditors who subsidize corporations must genuinely be made whole before stockholders can harvest. Product markets must ensure robust and healthy competition that encourages corporations to do better by customers, and ensure that products are safe and services are not fraudulent. And financial markets must properly value the contributions and risks generated by corporations, so that share prices reflect and reward sustainable, durable growth, not short-term opportunities for harvest.

On those assumptions, stockholders can only gain if societal interests are respected, because stockholders are only able to harvest if those interests are first satisfied. Stockholders, as residual risk bearers, are the most long-term oriented corporate constituency, and thus focus on creating real social wealth. Running corporations for the benefit of shareholders thus best aligns all interests. In that imagined environment, a corporate governance regime that encouraged ruthless focus on what stockholders at any moment demand would lead to shared prosperity.

But this is another way of saying that Easterbrook and Fischel assumed all of the important problems away. We are told that corporations and those that study them need not do the hard work of finding ways to help society, because we can assume the existence of other tools—other institutions and markets—that will ensure that stockholder wealth generation is aligned with social wealth generation.

Over the past three decades, the benign assumptions Easterbrook and Fischel used to slough off the worry that making corporations more responsive to investor power would hurt other stakeholders have turned out to be untenable. The argued “win-win” has been a win for one constituency—stockholders—and at best another—top management—to the detriment of those most responsible for corporate success: the workers. The investor class—now more powerful and represented through muscular institutional investors—is far more privileged than workers, and the change in gain sharing has driven inequality to levels not seen since before the New Deal. And evidence suggests that gains to stockholders have come at the expense of debt holders, communities of operation, and taxpayers, as corporations had shifted costs to them and bubble behavior has caused the need for repeated societal bailouts of the investor and financial class.

These shifts have been aided by the use of corporate political power to decrease the external protections for corporate stakeholders and society, and to free corporations to cater more to just their stockholder constituency. With the power of that one constituency going way up and the others, particularly workers, going way down, the distributional effects have not been surprising, and are the opposite of the win-win Easterbrook and Fischel predicted.

In this paper, we survey in brief the realities at odds with Easterbrook and Fischel’s win-win prediction, and why there is understandably a demand for rebalancing within corporate governance itself to deal with the actual dangers that a corporate governance system that encourages companies to manage themselves to please the momentary desires of the stock market poses for workers, society, the environment, and other stakeholders, dangers that Easterbrook and Fischel failed to address and anticipate.

The complete paper is available for download here.

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