Corporate Governance - What do shareholders really value? (LECTURE ONLY)

[Music] I've always I'm glad to come to Australia and Sydney in particular which is just a delightful city to visit but more than that there are lots of exciting things going on here in terms of business and thinking about business and so it's always nice for me to be exposed to the new ideas that are coming out from different parts of the world especially Australia so I want to warn you today that the topic I'm about to discuss is one that when I go in that direction a lot of people tend to assume that I'm some sort of a communist nothing could be further from the truth I adore business I'm deeply attached to it I do not believe that successful societies can exist without a thriving business sector at the same time I also understand that free market is an oxymoron a free market is a place where the biggest strongest person bops you over the head and takes what they want markets cannot exist without law and business cannot exist without law and in order to understand what makes business contribute to social welfare because of course in my view that's what business is about it's about improving our lives and by the way it's brilliant at that when it's structured properly but it has to be structured properly and to do that we need to be very realistic and very informed about what business really is and my thesis today is that collectively we may have made a dreadful mistake over the past 20 30 years in misunderstanding what business really is and especially what the public corporation really is and I want to give you an example I think of how that mistake has actually impeded the ability of business to make our lives better and the example is BP you probably remember that on April 20th and 2000 a oil well that BP was drilling in the Gulf of Mexico suddenly exploded and the oil rig the Deepwater Horizon went up in a column of fire that burned for two days before it finally collapsed into the depths of the Gulf of Mexico killing 11 people and beginning the worst oil spill in I believe the history of humanity this was a disaster on a scale that's very hard to imagine but it was especially a disaster for BP shareholders themselves BP shares had been trading around $60 a share us before the Deepwater Horizon explosion and within a month or so afterwards they had been halved to $30 a share a loss in bp's market capitalization of 100 billion dollars of course the calamity was by no means confined to reductions in the value of BP shares BP bonds were also severely damaged as they were downgraded to almost junk bond status other oil companies shares were harmed because in the wake of the spill President Obama imposed a moratorium on all drilling in the Gulf which of course is bad for all the other corporations that were seeking oil in the Gulf it was bad for corporations that were in the tourism industry in the Gulf it was bad for the fishing industry in the Gulf it was bad for individuals who owned real estate in the area of the Gulf it was bad for individuals who were employed in the fishing and the tourism industries in the Gulf it was bad for people who like to eat fish from the Gulf and it was bad for anyone who wanted to enjoy the recreational facilities of the Gulf ecosystem and finally was obviously very bad for the Gulf ecosystem itself how could a disaster happen on such a massive scale the United States government organized a commission to investigate and what they concluded was that the ultimate cause of the disaster was bp's desire to cut safety corners in order to save money each day that BP was drilling without putting the well into full operation was costing them 1 million dollars so in order to save 1 million dollars a day they ended up sacrificing a hundred billion dollars in shareholder wealth alone no matter how you do the math this was an enormous mistake how could it have been made my hypothesis is that one of the ultimate causes of the BP oil spill was what I call shareholder value thinking and shareholder value thinking possesses the business world today especially publicly listed companies and it drives executives and directors to focus relentlessly on trying to get their share price up not 10 years from now not even five years from now three months from now tomorrow if possible and in the quest to raise share price we see companies do what BP did they cut safety corners they reduce workplace safety they make other poor decisions they cut back on customer support they reduce expenditures on research and development at a consulting firm in the United States published the results of a survey last year in which they interviewed chief financial officers of listed companies and said would you undertake a an investment in a project that would produce net present value positive net present value over three to five years if you thought it would harm your quarterly earnings and 85% of the CFOs said no we would not make that long-term investment if it harmed our short-term ability to meet our earnings estimates not only do companies resist long term investments they fail to take adequate care of their customers they fail to take adequate care of and to invest in their employees they take on risks and we've certainly seen this in the US financial center set sector they leverage up their firms in the hopes that if things go well they'll produce an enormous profit and with the assurance that if things go very poorly indeed much of the loss will be borne by their bondholders by their customers by their employees but not ultimately by the shareholders themselves finally in the u.s. in particular in the quest to raise share price they actually manipulate the law itself there's a story that has not been told enough in the United States I think which is that in many ways we can trace the 2008 credit crisis to to changes in US law that were driven by Enron and Citibank respectively Citibank lobbied to eliminate restrictions on banks abilities to speculate through proprietary trading divisions and Enron lobbied to change the futures regulations laws so that for the first time in American business history purely speculating off of an exchange became legal and that was the origin of a six hundred trillion dollar derivatives market so if we look at what this focus on share price has done I think there's lots of reason to suspect it is actually preventing corporations from doing their best not only for communities for their employees for their customers but also possibly for investors as a class over time so how did we get to shareholder value thinking so this is really how I came to this project I am a law professor I study the law and when I first went off teaching law one of the things that drove me crazy was of course I liked probably virtually everyone in this room had been taught that the purpose of the corporation is to maximize shareholder wealth that shareholders are the ultimate owners of the corporation and that ultimately they ought to exercise control and if the boards of directors don't do what the shareholders want then the shareholders ought to be able to step in and remove the boards I mean I this was this was as we say in America mom apple pie and shareholder value and I had no reason to doubt it when my professors taught it to me it seemed sensible enough here's the problem the more I taught law the more I realized that's not what the law says and indeed 50 years ago it's not what people in the business world believed so let's step back in a time machine and go back to the 1940s and 1950s if you were to interview the director of public company in the 1940s or 1950s in America and I don't can't speak for Australia but certainly this would be true for the large public corporations they're the AT&T is the General Electric's and you were to ask directors what's the purpose of the corporation they would have said something like that's a very complicated question we serve many different interests we want to develop a large successful firm and that means we have to take care of our customers we have to take care of our employees we have to take care of our suppliers we certainly have to take care of our investors and we have to be good corporate citizens fast forward getting your time machine go to the year 2000 and if you were to ask most directors they would say oh no we have one goal maximizing shareholder wealth how did that happen it seems to have been the influence of an idea or more specifically an ideology that as best I can trace it came out of the University of Chicago in the 1970s and was led by among others the famed economist Milton Friedman and there's this interesting intellectual history it starts with Milton Friedman who was a Nobel Prize winning economist but I'll tell you was no lawyer saying that shareholders owned corporations now how many people in the room are lawyers I suspect we've got more than a few here all right then please back me up on this shareholders don't own corporations corporations are independent legal entities that own themselves just like you own yourself what do shareholders own well the name tells you they own shares and what is a share it's a contract between the shareholder and the corporation that gives shareholders very limited rights just like bondholders enter a contract with the corporation that gives them limited rights and employees enter contracts with corporations that give them limited rights so from a legal perspective Milton Friedman's claim that shareholders own corporations was wrong from the get-go yet somehow this notion turned out to have tremendous it had tremendous appeal to economists because it gave them a simple story that also gave them a metric for measuring corporate performance if you think that shareholders are the owners or as more sophisticated economists would put it the residual claimants then you have an easily measurable corporate objective the idea is as long as you maximize the share value of the firm you've maximized the social contributions that the firm makes because everyone else according to economic theory gets only what their contracts provide them bondholders get interest payments employees get their salaries but they're not entitled to and they shouldn't receive anything else shareholders as owners should get every penny that's of profit that's left over after the firm has paid off the fixed claims of its other participants and if you're an economist you say this is brilliant all we have to do to make recommendations about the best way to govern firms is to figure out what you can do that can raise the share price at firms and we've got ourselves a titled tiny little business and economic consulting so the consultants the economists and the economic consultants loved this idea and business journalists and a lot of professors love the idea too because it makes corporations very easy to understand it almost analogizes them to a sole proprietorship and anyone can understand a sole proprietorship so if you talk about corporations as if they're owned by shareholders as if shareholders are the residual claimants as if shareholders are principals who hire agents then suddenly a very complex institution that I personally think of as being more comparable to a nation-state suddenly gets reduced to something that you can explain in a paragraph to your students to your readers if you're a journalists to your business school students if you're a business school professor the problem is and and this is what I found so frustrating when I began to teach and to a more limited extent as a member of a Board of Trustees which is the equivalent of a board of directors I began to experience it in the business world it's simply didn't describe the reality that I saw so what was the reality that I saw well the first thing I've already mentioned which is that as a legal matter it is completely misleading to describe shareholders as owners of firms they're not they are people who enter contracts with firms just as bondholders employees suppliers enter contracts with firms what about this notion that shareholders are entitled to all the profits left over after other firm participants have been paid or as an economist would put it that shareholders are the residual claimants well it turns out that's only an accurate description of dead firms that are being liquidated it's not an accurate description of living firms at all what happens in living firms well actually shareholders do not get a penny unless the directors decide to declare a dividend they're not in any realistic sense entitled to take all of the profits they have to wait for the directors to give it to them now at this point I always get a very sensible finance student who puts up her hand and says Oh professor stout but it doesn't matter if the directors don't declare dividends as you men as you may know in the u.s. they frequently don't dividends are a much bigger part of business life in the UK and in Australia than they are in the States but my students would say it doesn't matter if the directors don't declare dividends because of course then the earnings will be retained by the firm and the value of the shares will rise so at the end of the day the shareholders get the benefit anyway at which point I turn to my student I say very good I'm glad you've taken finance now you need to go take an accounting course because if you take accounting you'll very quickly learn that retained earnings is an accounting concept and of course earnings are nothing more than revenues minus expenses oh and by the way who controls the expenses it's not the shareholders it is again the Board of Directors so there's only profits for the shareholders if the directors want there to be and if instead if the firm's got tons of revenues rolling in and the directors say but we want to give some of this money to the employees in the form of arrays and we want to give our executives access to a Learjet by the way if you want I'm perfectly happy to defend the executive jet to anyone it's much cheaper than giving them stock options give them a jet if it makes them happy and they even get more work done that way so so I don't understand this anti jet thing even though I myself like coach and I'm envious as the rest of you but really it jets are not so bad in any case the directors can say we're going to build up a cash cushion which by the way benefits the creditors along with the shareholders they say we can donate money to the community so what happens in reality in successful corporations is that when the corporation is doing very well there are lots of groups that benefit along with shareholders and by the way when the corporation is doing poorly there are lots of groups that have to bear the cost so when you've got a bad year you say sorry executives the Jets go on your flying coach you tell the employees your health benefits are gonna be cut back no more dental insurance for you you cut back on your philanthropic contributions and the equity cushion gets worn thin and the creditors suffer that's the way living firms operate I think it's a tremendous mistake to judge the role of shareholders by what happens in dead firms that are being liquidated that's like judging the use of a horse by what happens to dead horses right live horses are athletes and pets dead horses are pet food don't confuse the two functions all right and live corporations are different from dead corporations so finally let's get to this notion that is very common among economists that shareholders are principals who control directors as their agents again the lawyers in the room this is legally completely wrong in law principles are people who want to accomplish something who hire agents to do the job for them subject to their control now this is very interesting because it presumes that the principle comes before the agent and it presumes that the principle controls the agent that's not the way corporations come first as a matter of law the corporation and the board of directors appears before there's a shareholder on the horizon you have to incorporate the firm and you have to select a board of directors before there's anyone in position to enter a contract with shareholders and sell shares how can you possibly have a principle that's created after the agents created it's the other way around and of course boards of directors are not controlled by shareholders in a typical publicly listed firm now here I must mention that the arguments that I'm making applied primarily to publicly listed firms and not to privately listed firms with controlling shareholders firms with controlling shareholders which are of course the model in most of the world especially outside the United States are quite a different animal and in a sense you can say that if you've got a controlling shareholder you're moving closer to this notion of shareholder ownership because that controlling shareholder has much more influence over the board through the power to remove them relatively easily however interestingly enough the data shows that these privately managed or privately controlled firms actually ironically tend to make decisions that are more long-term and more socially responsible than the publicly listed firms and I'm going to explain why in a few minutes now let's go back to these publicly listed firms where there's this enormous pressure that we're placing on directors not coming from the law but coming actually from our ideology of what we think directors should do these enormous pressures to maximize shareholder value um well it turns out that that pressure has got no basis in corporate law itself because if you look at the rules of corporate law although you can find dicta in some cases where judges have offhandedly said things like oh well directors owe duty to shareholders I could also show you plenty of cases that say directors also owe duties to this entity called the firm and in the United States I can give you cases that say oh and while they're looking after the firm directors have the discretion to look after other constituencies employ suppliers consumers but the key point from a legal perspective is that this is all dicta or as we legal types call it near dicta meaning it's not binding in any way in law what matters is not dicta not the offhand remark in law what matters is what we call the holding what the judge makes you do at the end of the day and in both the US and Australia at the end of the day judges don't make directors maximize shareholder value instead they defer to something called the business judgment rule that says as long as directors are not using their powers to line their own pockets as long as they're not stealing from the firm it's up to the board to decide what the corporation ought to do and this pattern by the way is reflected in corporate charters themselves another source of corporate law in quotes that I think isn't very neglected is what the corporate charter says about corporate purpose and in most states in the United States there's actually a requirement that you describe the corporate purpose in the Charter I have never seen a charter that says the purpose of this corporation is to maximize shareholder value it may exist out there but after years of looking at charters I've never seen it what you do see over and over is the following the purpose of the corporation is to do anything lawful so both in the internal law of corporate charters and the external law of case law what we see is that corporate law has evolved to preserve enormous discretion on the part of directors to choose purposes other than maximizing shareholder value it is a mistaken view that many directors have and I think we can attribute this view to I do think we academics get much of the blame because since the days of Milton Friedman we've been teaching our students in law schools and business schools that they need to maximize shareholder value but that's not in fact what the law says and it doesn't seem to be working out all that well the more business goes in the direction of convincing our directors we need to maximize shareholder value let's just say there's no evidence that's I'm you know when I'm feeling ambitious I may go further and say you know I can't prove it I but I suspect it's hurting but let me talk about the evidence we've got because of this embrace of shareholder value thinking we have a generation of economists and legal scholars who thought well this is a lovely theory let's go out and prove it's true and boy have they tried they have tortured the data until it screamed and yet there is a remarkable lack of any reliable replicated evidence that corporations that are run according to the principles of shareholder value actually produce better results for shareholders nevermind anybody else so one of my favorite examples is in the United States about I think it's now seven or eight percent of firms have what we call dual class shares where you've got the founders of the company who have one class of shares that have ten times the voting power of the public shareholders now if you believe in conventional shareholder primacy theory you would say that's a dreadful situation because the 10% of the shareholders who control all the votes often tend to be the executives and the top managers of the corporation you'd say that should be a dreadful system they should produce dreadful returns for shareholders well there's no evidence that that's true and there's actually some evidence that firms that have dual class capitalization outperform firms with one share one vote if you look at long-term results and if you look at their ability to avoid collapsing firms that have one share one vote are more fragile and tend to run into trouble more often and also don't tend to have as good long-term operating results but more broadly I think that by looking at the performance of individual companies we're actually looking at the wrong phenomenon I call this the problem of fishing with dynamite so let me give you an allergy suppose you wanted to figure out the best fishing technique and you might go out and say oh there are fishermen who use bait before they use you know they use I don't know worms for bait and there are fishermen who use lures for bait and if we want to find out the best way to fish what we're going to do was run an empirical study to see if you get more fish by fishing with worms or fishing with lures and at first that seems like a very sensible way to test what's the best way to fish right but what is one of the fisherman figures out that he can fish with dynamite well what are your empirical studies going to show they're going to show that anyone who switches from fishing to worms to fishing with dynamite gets lots more fish and you're also going to see that the overall fish catch goes up dramatically in the short term but what's going to happen to fishing in the long term well we've tried this in lots of communities and we know what tends to happen when you let people fish with dynamite is eventually you run out of fish and my concern is that something very similar may be going on in the business world by embracing the ideology of shareholder value and encouraging corporate directors and corporate executives to do something anything to raise share price at a particular firm tomorrow we are actually making it harder and harder for the corporate sector as a whole to produce long term returns for investors and you know as I will be the first person to admit there's no way I can prove that the dreadful returns that US investors in particular have suffered in the last ten years which by the way we now call the Lost Decade in the United States investor returns have been almost flat I can't prove that shareholder value thinking is a direct cause because there's so many other possible causes but the logical connection is there if the short term pursuit pursuit of a higher share price harms long term returns both for the shareholders of that company and for the shareholders of other companies and for the economy as a whole you would expect to see what we have seen which is that the increasing embrace of shareholder thinking especially as reflected in executive compensation plans has produced a flattening of economic growth investment and share returns along with it all right so where do we stand intellectually where we stand intellectually oh my gosh I'm almost done how did that happen all right I'm going to leave to the chase I've done the most important part where we stand intellectually I think is it's time for us as people who believe in business to sit back and say we believe in business but we also believe in reality and if we look at the reality our theories of what makes business work don't seem to be working there's something wrong with the theory we need a new theory well I was going to spend a lot of time talking about possible new theories but I see I've run out of time but I'll just hint at the one I think I have found a useful wedge to get people started thinking and that is why is shareholder value going wrong my working hypothesis is we don't understand what shareholders are shareholder is a fiction I actually of a review a lot of people think that corporations are fictions and shareholders are real I think that's backwards corporations are real they may be invisible but any lawyer will tell you as legal entities they're very real they own property they commit torts they enter contracts the shareholder is a fiction shareholders are human beings the idea that there's some mythical shareholder there that cares only about the price of Qantas stock and nothing else is a mistake hedge fund managers come close but the rest of us have lots of interests and they include we're not just interested in what happens to Qantas stock tomorrow we're interested in what happens to Qantas stock 10 years from now because if you're saving for retirement if it's your super I guess you call it here it's that long term you're thinking about we're not just interested in Qantas ability to get a short term rise in share price by pressing down wages we're also interested in making sure that Qantas has a good positive long-term relationship with labour now it may be Labor in another part of the world but if you're interested in Qantas is long-term success and in the sess of other businesses you need to keep labour and suppliers and other constituencies at the table contributing to firms we're interested not just in the price of Qantas stock but if you're a diversified shareholder you care about all the other Australian firms whose businesses were disrupted when Qantas stopped flying so Qantas stock went up and everybody else's stock went down because they're business executives couldn't get what they were going and their supplies and their products couldn't get where they were going and finally and I love this part if you want to talk about this I'd be delighted delighted to talk about this another area that I do research in is moral behavior and as you may have gathered I actually think successful business and moral behavior are deeply related and in my study of moral behavior I have good news for you most of us aren't psychopaths because of course Homo economicus is the rare entity that truly cares about nothing but his or her own material gain is technically called a psychopath and I'm pleased to report that most of us actually would prefer to get slightly reduced shareholder returns as say shareholders of Union Carbide if our companies would avoid blowing up an Indian village and killing 2,000 and maiming 10,000 more so the reality is if you look at the data there's every reason to think that shareholders as human beings also want their corporations to be socially responsible but that's not something shareholders can do I'm sorry that's not something corporations can do when you relentlessly press them to raise share price at any cost okay have I caused enough trouble Justin I hope so but I think I'll simply close by saying I think the moral of the story is that ideas matter and john maynard keynes actually told us about this many years ago where he wrote that practical men who believed themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist I fear we have our loud ourselves and by ourselves I mean the business community the investing community and the community community to become slaves of funked economic idea that it's well past time to revisit so thank you very much [Applause]

Channel: UNSW

Views: 118,320

Rating: 4.8875675 out of 5

Keywords: UNSW, Law, corporate, governance, Lynn, Stout, UCLA, Justin, O'Brian, CLMR, market, reform, shareholders, Greg, Medcraft, John, Colvin, Seumas, Miller, Morgan, Business, Lecture, University, of, New, University Of New South Wales, Australia

Id: s5Eoy988728

Length: 31min 32sec (1892 seconds)

Published: Mon Dec 12 2011