The Error at the Heart of Corporate Leadership13 April, 2017 / Articles
In the fall of 2014, the hedge fund activist and Allergan shareholder Bill Ackman became increasingly frustrated with Allergan’s board of directors. In a letter to the board, he took the directors to task for their failure to do (in his words) “what you are paid $400,000 per year to do on behalf of the Company’s owners.” The board’s alleged failure: refusing to negotiate with Valeant Pharmaceuticals about its unsolicited bid to take over Allergan— a bid that Ackman himself had helped engineer in a novel alliance between a hedge fund and a would-be acquirer. In presentations promoting the deal, Ackman praised Valeant for its shareholder-friendly capital allocation, its shareholder-aligned executive compensation, and its avoidance of risky early-stage research. Using the same approach at Allergan, he told analysts, would create significant value for its shareholders. He cited Valeant’s plan to cut Allergan’s research budget by 90% as “really the opportunity.” Valeant CEO Mike Pearson assured analysts that “all we care about is shareholder value.”
These events illustrate a way of thinking about the governance and management of companies that is now pervasive in the financial community and much of the business world. It centers on the idea that management’s objective is, or should be, maximizing value for shareholders, but it addresses a wide range of topics—from performance measurement and executive compensation to shareholder rights, the role of directors, and corporate responsibility. This thought system has been embraced not only by hedge fund activists like Ackman but also by institutional investors more generally, along with many boards, managers, lawyers, academics, and even some regulators and lawmakers. Indeed, its precepts have come to be widely regarded as a model for “good governance” and for the brand of investor activism illustrated by the Allergan story.
Yet the idea that corporate managers should make maximizing shareholder value their goal—and that boards should ensure that they do—is relatively recent. It is rooted in what’s known as agency theory, which was put forth by academic economists in the 1970s. At the theory’s core is the assertion that shareholders own the corporation and, by virtue of their status as owners, have ultimate authority over its business and may legitimately demand that its activities be conducted in accordance with their wishes.
Attributing ownership of the corporation to shareholders sounds natural enough, but a closer look reveals that it is legally confused and, perhaps more important, involves a challenging problem of accountability. Keep in mind that shareholders have no legal duty to protect or serve the companies whose shares they own and are shielded by the doctrine of limited liability from legal responsibility for those companies’ debts and misdeeds. Moreover, they may generally buy and sell shares without restriction and are required to disclose their identities only in certain circumstances. In addition, they tend to be physically and psychologically distant from the activities of the companies they invest in. That is to say, public company shareholders have few incentives to consider, and are not generally viewed as responsible for, the effects of the actions they favor on the corporation, other parties, or society more broadly. Agency theory has yet to grapple with the implications of the accountability vacuum that results from accepting its central—and in our view, faulty—premise that shareholders own the corporation.
The effects of this omission are troubling. We are concerned that the agency-based model of governance and management is being practiced in ways that are weakening companies and—if applied even more widely, as experts predict—could be damaging to the broader economy. In particular we are concerned about the effects on corporate strategy and resource allocation. Over the past few decades the agency model has provided the rationale for a variety of changes in governance and management practices that, taken together, have increased the power and influence of certain types of shareholders over other types and further elevated the claims of shareholders over those of other important constituencies—without establishing any corresponding responsibility or accountability on the part of shareholders who exercise that power. As a result, managers are under increasing pressure to deliver ever faster and more predictable returns and to curtail riskier investments aimed at meeting future needs and finding creative solutions to the problems facing people around the world.
Don’t misunderstand: We are capitalists to the core. We believe that widespread participation in the economy through the ownership of stock in publicly traded companies is important to the social fabric, and that strong protections for shareholders are essential. But the health of the economic system depends on getting the role of shareholders right. The agency model’s extreme version of shareholder centricity is flawed in its assumptions, confused as a matter of law, and damaging in practice. A better model would recognize the critical role of shareholders but also take seriously the idea that corporations are independent entities serving multiple purposes and endowed by law with the potential to endure over time. And it would acknowledge accepted legal principles holding that directors and managers have duties to the corporation as well as to shareholders. In other words, a better model would be more company centered.
Before considering an alternative, let’s take a closer look at the agency-based model.
Foundations of the Model
The ideas underlying the agency-based model can be found in Milton Friedman’s well-known New York Times Magazine article of 1970 denouncing corporate “social responsibility” as a socialist doctrine. Friedman takes shareholders’ ownership of the corporation as a given. He asserts that “the manager is the agent of the individuals who own the corporation” and, further, that the manager’s primary “responsibility is to conduct the business in accordance with [the owners’] desires.” He characterizes the executive as “an agent serving the interests of his principal.”
These ideas were further developed in the 1976 Journal of Financial Economics article “Theory of the Firm,” by Michael Jensen and William Meckling, who set forth the theory’s basic premises:
Shareholders own the corporation and are “principals” with original authority to manage the corporation’s business and affairs.
Managers are delegated decision-making authority by the corporation’s shareholders and are thus “agents” of the shareholders.
As agents of the shareholders, managers are obliged to conduct the corporation’s business in accordance with shareholders’ desires.
Shareholders want business to be conducted in a way that maximizes their own economic returns. (The assumption that shareholders are unanimous in this objective is implicit throughout the article.)
Jensen and Meckling do not discuss shareholders’ wishes regarding the ethical standards that managers should observe in conducting the business, but Friedman offers two views in his Times article. First he writes that shareholders generally want managers “to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” Later he suggests that shareholders simply want managers to use resources and pursue profit by engaging “in open and free competition without deception or fraud.” Jensen and Meckling agree with Friedman that companies should not engage in acts of “social responsibility.”
Much of the academic work on agency theory in the decades since has focused on ensuring that managers seek to maximize shareholder returns—primarily by aligning their interests with those of shareholders. These ideas have been further developed into a theory of organization whereby managers can (and should) instill concern for shareholders’ interests throughout a company by properly delegating “decision rights” and creating appropriate incentives. They have also given rise to a view of boards of directors as an organizational mechanism for controlling what’s known as “agency costs”—the costs to shareholders associated with delegating authority to managers. Hence the notion that a board’s principal role is (or should be) monitoring management, and that boards should design executive compensation to align management’s interests with those of shareholders.