The Primacy of Shareholder value: Reflections on the roles of Milton Friedman and Michael Jensen Andrew Cornford

The debate over the appropriate role of shareholder value in corporate governance throws interesting light on fluctuations of intellectual fashion in financial economics. The debate was triggered by the statement of Milton Friedman that “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engage in open and free competition without deception or fraud.” This apparently simple statement actually conceals several difficulties concerning prevalent practices in markets, and their relation to the prevailing legal regime within which a profit-maximising enterprise pursues its objectives. Moreover the statement appears to accept that the rules of the game are an exogenous feature of this regime rather than one over which enterprises themselves have significant influence through their lobbying power – influence which generally increases with the success of their pursuit of profits. The statement unsurprisingly generated opposition amongst the natural critics of enterprise behaviour and market power. But it also began a debate within the intellectual and practical world of finance concerning the relation between managerial incentives and enterprise performance. A lucid account – on which this note draws – of major features of the debate and of the role in it of the influential financial economist, Michael Jensen, is contained in the 2009 book by Justin Fox, The Myth of the Rational Market A History of Risk, Reward, and Delusion on Wall Street.

Friedman’s statement reflected his conviction that the assumption of open competition in markets is a sufficiently reasonable approximation of reality to serve as the basis of both economic analysis and policy design. This conviction was in contradiction with a long tradition of work on the structure and performance of significant parts of industry in the United States which stressed the frequency with which market power and distance impeded open competition. This work drew on monographic and annalistic coverage of the functioning of many markets in the late nineteenth and early twentieth centuries which influenced major legislation such as the Sherman Antitrust Act, the Federal Trade Commission Act and the Clayton Act. During the period from the 1930s onwards there was further research on industrial structure, market power and market functioning of which a particularly extensive example was the study by the National Resources Committee, The Structure of the American Economy. The Initiatives of the United States in this area have strongly influenced work on business behaviour elsewhere, for example, that of the European Union.

Perhaps unsurprisingly defence of the Friedman thesis concerning the social responsibility of business did not focus on its reliance on the existence of competitive markets. Such a defence would have embroiled it in the long-running controversies over the interpretation of the extensive empirical data concerning actual enterprise behaviour in the markets for goods and services – controversies in which professors at Friedman’s own university, Chicago, were mostly convinced supporters of free-market ideas that were far from commanding an intellectual consensus. Instead debate on the social responsibility of business took as its central issues corporate governance and its relation to new theories of finance. Paradoxically a key work on a central issue in this debate, the separation of ownership and control in large corporations, had received its first major treatment by two progressive thinkers, Adolf Berle and Gardiner Means, in their celebrated treatise of 1932, The Modern Corporation and Private Property. The problem cited by these authors was the absence of a guarantee that the controllers of a business would not pursue motives at variance with the interests of its owners.

This issue was addressed in a 1971 article of Michael Jensen and William Meckling, academics at the small (but also wealthy) University of Rochester. The solution which they proposed, which would not require government intervention, depended on market efficiency. According to this doctrine the stock market could be relied on to “fully reflect all available information” as well as some that was not readily available. The linking of shareholder value and the efficient-market hypothesis was an idea which took some time to take off. Until the 1980s the primacy of shareholder value as a management objective remained an idea promoted by some consultants and with implications discussed only in parts of academe.

But in the 1980s this changed, and with the change came one in the standing of Jensen. Key features of the background of this change were the more favourable attitude towards mergers and acquisitions of the Reagan administration, reductions in taxes on high incomes, and closer relations between executives and the money managers of the funds controlled by institutional investment firms. As executive remuneration was increasingly linked to performance and performance was increasingly linked to an enterprise’s stock price, executives’ focus on the stock price was also increased. An article by Jensen in The Harvard Business Review in 1990 summarised his influential role in this process: “so many CEOs [currently] act like bureaucrats rather than the value-maximising entrepreneurs companies need to enhance their standing in world markets”.

Jensen’s fame had led to his hiring in 1985 by the Harvard Business School, which at the time was searching for ways to recover its standing amongst the country’s élite institutions. In this position he had already expressed his support for the takeover movement that gathered force in the 1980s. Debt, crisis and management turnover associated with this movement, he argued, performed the useful function of “making remarkable gains in operating efficiency, employee productivity, and shareholder value”. The picture was actually a mixed one. Efficiency gains were not absent and the arranging investment banks were paid large fees. But the takeovers often involved increased leverage. One vehicle which attracted much attention in this context was the leveraged buyout (LBO). Here a new shareholder group, which might even be the management of the target firm, acquired the shares of the old shareholder group with debt (or sometimes with shares in the reconstituted firm), in this way raising the rate of return on equity but also saddling the firm with increased interest obligations.

One problem of linking stock prices to management performance was the choice of time period to which the link applied. According to the theory of efficient markets investors weigh the evidence linking the present price to different determinants of an enterprise’s performance sufficiently continuously for this price to serve as the best available gauge of managerial performance. It could be argued that over the longer term the stock price might indeed serve as a useful gauge of such performance but as a continuous gauge this role for the stock price was implausible. Even over the longer term such a use of the stock price is subject to major qualifications due to the influence of changing short-term considerations and follow-the-leader trading behaviour.  Against the efficient-markets hypothesis should be set the verdict of the celebrated investor in and writer about the stock market, Benjamin Graham: “The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers”. This statement appears in the first 1934 edition of the classic Security Analysis by Graham and his collaborator and co-author, David Dodd. The verdict was repeated in subsequent editions.

The glowing role attributed to shareholder value and efficient markets by Jensen and much of the financial economics profession was inevitably affected by the downward pressure on stock prices themselves at the end of the 1990s after a period during which they had trended upwards. Jensen now supplemented his theory with inclusion of the importance of integrity, defined as honouring your word and acknowledging failures. Considered on its own this is a reasonable argument. But, as Fox notes, Jensen, who “had been the  most influential exponent of the notion that financial markets knew best, and that financial-market-based incentives were the ticket to a more efficient, more prosperous world…was acknowledging that these incentives weren’t enough. If market participants failed to follow a particular non-market-determined norm – integrity – markets would not work. The market could not govern itself.”

But the setback to share prices was also accompanied by more fundamental questions than that addressed by Jensen. Accounting scandals raised questions as to the reliability of the information on which investors were supposed to value shares and as to the integrity of key participants in financial markets whose actions were covered by this information. Of these scandals perhaps the most publicised was the case of the trading company Enron. In The New Forensics Investigating Corporate Fraud and the Theft of Intellectual Property Joe Anastasi of Deloitte and Touche’s Forensic Investigations practice describes how Enron parked highly risky (often loss-making) investments in of-balance-sheet special purpose entities (SPEs) or partnerships. Provided its investment in these SPEs remained below a low threshold Enron was not legally obliged to include the results of their investments and borrowing in its own annual financial reports. Lenders to these SPEs were kept at bay by the issuance to the SPEs of new Enron stock so long as its price was rising. But eventually, owing to miscalculations of Enron’s management concerning other developments affecting its trading business and the ending of the Internet Bubble, Enron’s stock price began to slide and the true level of Enron’s losses was revealed. Insolvency and exhaustive investigations of Enron’s practices and of those of its auditors and lenders followed. The scandals and others during this period were serious blows to a theory linking managerial performance and remuneration to data which could be misleading and was not necessarily subject to scrutiny serious enough to justify such a link.

Outsider critics might also add several more general points concerning the role of shareholder value in the governance of stock markets.

Eventual recognition by shareholder value’s promoters of the inadequacy of heavy reliance on price-based incentives in this governance was not accompanied by acknowledgement of the need for expanded government regulation of the markets’ functioning – regulation to the contraction of which the intellectual dominance of efficient-markets theory during a long period of buoyant stock prices had contributed.

There was also no acknowledgement that, under the heading of governance not only of stock markets but also of financial markets more generally, not only the determinants of their functioning narrowly understood should be open to question but also how far these markets now contribute to the social and economic objectives which they were historically developed to serve.

(Andrew Cornford, a former senior economist at UNCTAD and now with the Geneva Finance Observatory.)