by Lynn Stout
Such games of corporate musical chairs would not be a problem if they allowed executives and short-term speculators to profit without harming anyone else. Unfortunately, long-term investors have to eat the short-termers’ cooking. There are signs the meal is not sitting well. The SEC does not require unregulated hedge funds to publicly disclose their results, so it can be hard to find solid data on hedge fund performance, but there is some evidence activist hedge funds in particular outperform the market.113 And there is little doubt that stock-based compensation schemes have made executives much wealthier over the past two decades. Meanwhile, average investors’ returns have languished. Even as a laserlike focus on “unlocking shareholder value” has enriched executives and some hedge fund managers, it has done little or nothing to help shareholders as a class.
When long-term and short-term investors’ interests diverge, shareholder value thinking poses the same risks as fishing with dynamite. Some individuals may reap immediate and dramatic returns. But over time and as a whole, investors and the economy lose.
CHAPTER 6
Keeping Promises to Build Successful Companies
We have just seen how, when stock market prices don’t capture fundamental value perfectly, the interests of short-term speculators conflict with those of longer-term investors. This chapter examines an even odder chronological tension: the conflict between shareholders’ initial interest in making commitments to stakeholders and to each other, and their subsequent interest in breaking those commitments later.
To understand the nature of the problem, consider Ulysses’s dilemma when he sailed the Odyssey past the island of the Sirens. The Sirens were beautiful women with compelling voices, but like many beautiful women they followed a strict diet: they used their singing to lure sailors to the island, where the Sirens would promptly kill and eat them. To protect his men from the Sirens’ songs, Ulysses ordered them to stuff their ears with wax as the Odyssey sailed by the island, so they could not hear. But Ulysses himself wanted to experience the Sirens’ music. He left his ears unplugged and ordered his sailors to bind him tightly to the Odyssey’s mast. He also told his sailors not to release him, no matter how he begged and pleaded, until after the Sirens were safely out of sight and sound.
Before approaching the Sirens’ island—“ex ante,” as academics put it—Ulysses wanted above all to make sure that he escaped the Siren’s clutches. “Ex post,” while actually listening to the Sirens’ music, Ulysses wanted nothing more than to jump overboard, swim to the island, and present himself as that day’s entrée. Luckily, ex ante Ulysses figured out a way to make sure ex post Ulysses did not succumb to the Sirens’ charms. He had himself “bound to the mast” (as we say today, “tied his own hands”) to protect himself from his own future behavior.
The Shareholder as Ulysses
Shareholders do much the same when they buy stock in public corporations. When equity investors buy stock in the “primary market” where companies raise capital by selling shares, the investors’ money instantly becomes the corporation’s money. All the equity investor owns now is a contract with the corporate entity, called “a share of stock.” This contract does not entitle the stockholder to get her money back. She may or may not get dividends, depending on what the directors decide; she may or may not find another investor willing to purchase her contract in the “secondary market” where investors buy from and sell stock to each other. But her initial capital contribution is, to use the words of influential corporate scholar Margaret Blair at Vanderbilt, “locked in” to the corporate entity. Shareholders have no legal right to demand their money back, in whole or in part. Corporations aren’t like partnerships, where a partner at any time can leave the partnership and get back her proportionate share of the partnership’s assets.
For most of the twentieth century, the phenomenon of capital lock-in received little scholarly attention. Business and law school professors routinely taught their students that corporations were attractive ways to do business primarily because they offered shareholders four characteristics: (1) limited personal liability, (2) centralized management, (3) indefinite legal life, and (in the case of public corporations) (4) liquid stock markets where investors could sell their shares. This fourth characteristic, in particular, obscured the reality of capital lock-in by creating an illusion that equity investments in public corporations were liquid and could be easily withdrawn. But stocks are only liquid on the margin. Should all a firm’s shareholders decide to sell at once—say, because the CEO is indicted, or the company is struggling—the liquidity illusion quickly disappears. Shareholders discover to their horror a fifth characteristic of corporations: their money is locked in and inaccessible.
So why would any sane investor buy stock in a public corporation? Why not stick to partnerships and other business forms that allow you to get your cash back whenever you demand it?
Some Advantages of Tying Your Hands
This question was perhaps first raised in print by UCLA economist Harold Demsetz, who noted in 1995 that a “largely unrecognized” condition of share ownership in public companies was “the inability of investors to force the firm to disgorge assets purchased with funds secured for the initial sale of stock.”114 Demsetz then observed:
It is impractical from the perspective of being able to make business commitments to allow shareholders to reclaim their share of the firm’s assets in the typical case. The corporation makes commitments to purchase materials and plant, as well as to provide goods and services. If these commitments are to be treated as reliable, the firm must have control of the asset it has secured through the sale of stock or bonds. It cannot be in continual jeopardy of losing assets to its disappointed shareholders. The typical corporation must be organized in a way that bars investors from reclaiming their fraction of the firm’s assets in other than exceptional circumstances. The firm is, therefore, granted a life that is in important ways distinct from the lives and desires of those who supply it with capital and other inputs.115
Other scholars have expanded on Demsetz’s insight in ways that cut directly against shareholder value thinking. They have shown how shareholder-oriented governance rules that allow shareholders to withdraw their funds—including rules that make it easier for shareholders to pressure boards to pay dividends or implement share repurchase programs—can actually reduce shareholder wealth by discouraging other financial and nonfinancial investors from making important “firm-specific” contributions to corporate production.
For example, in her 2003 historical analysis of the rise of the corporate form, Margaret Blair described how capital lock-in protects shareholders from the impecuniousness and opportunism of their fellow shareholders.116 Suppose you want to build a canal or a factory. The project requires more funds than any single investor could, or would want, to put up, so several investors agree to contribute together. If they organize as a partnership, they face a serious problem. What if one of the investors wants his money back, perhaps because he has fallen on hard times? What if a partner dies and her heirs don’t want to take her place in the business, but instead cash in their inheritance? You can’t sell off pieces of a canal or factory without destroying much of its value. Factories and canals are “firm-specific” investments, resources that can’t be easily withdrawn from the firm without destroying at least part of their value.
A partnership is no way to build a canal or factory. But if our four investors incorporate, the firm-specific canal or factory will now belong to the corporate entity itself. No single shareholder can demand back her share of the company’s assets. This protects the four investors from each other’s possible future poverty. It also protects the four investors from the siren song of opportunism.
More Advantages: Discouraging Opportunism
To see how lock-in protects against opportunism, suppose the four investors agreed to form a partnership to build the canal or factory, and also agreed each partner would receive 25 percent of any future profits. After the
canal or factory is built, one of the four might demand that, unless the partnership agreement was amended to give her 50 percent of profits, she would withdraw from the partnership and take her one-fourth of the canal or factory with her. The threat is self-destructive but effective, like a bank robber’s threat to blow up himself and the bank unless the teller follows his instructions.
The incentive to attempt such holdups is greatly reduced if the four investors incorporate their business. Now, the canal or factory is owned by, and locked into, the corporate entity. No single shareholder can threaten to withdraw her capital and unilaterally blow up the business. The corporation’s board of directors decides when and if shareholders will receive any dividends, and it would take three of the four shareholders to replace the board.
The need to discourage investor opportunism becomes even more obvious when we look at the role of bondholders and other creditors. If bondholders could demand their money back from the corporation at any time, no firm could safely use borrowed money to make long-term investments. Conversely, if shareholders were free to withdraw capital from the corporation at any time, no sensible creditor would ever lend to a corporation, for fear the shareholders would simply use the borrowed money to pay themselves a massive dividend, leaving the firm insolvent and the creditor holding the bag. Moreover, even if the shareholders are by law or contract constrained in paying themselves dividends (as they generally are), without capital lock-in, the corporation’s creditors still have to worry about shareholders’ creditors, and the possibility that a bankrupt shareholder’s creditors might try to recover from the corporation itself the value of the shareholder’s interest in the firm.
This last point was explored in some detail by Hansmann and Kraakman in an article they published in 2000, just before their influential “End of History” essay proclaimed the triumph of shareholder primacy ideology. Hansmann and Kraakman examined what they call corporate asset shielding, the corporation’s ability to protect its assets from the claims of shareholders and shareholders’ creditors. They argued that asset shielding is essential in business projects where “partial or complete liquidation of the firm’s assets could destroy some or all of the firm’s going concern value,” because “a [shareholder’s] personal creditor with the right to foreclose on firm assets might well threaten to exercise that right and destroy substantial going concern value—even if he could realize little or nothing thereby because the firm lacks sufficient net worth—simply to hold up the firm (or its owners or creditors) for a sum larger than his claim on the firm would receive if he actually foreclosed.”117
Blair’s discussion of capital lock-in, and Hansmann’s and Kraakman’s work on asset shielding, both illustrate how conventional shareholder primacy rules that may seem to benefit shareholders ex post by allowing them to “unlock” their financial capital from the corporation, can actually harm them ex ante by making it harder for business enterprises to get started in the first place. Only when financial capital can be made secure from the demands of shareholders and creditors alike, can it be safely used to make firm-specific investments in complex, uncertain, long-range projects—constructing railroads, canals, and factories, developing new drugs, software and technologies, building trusted brand names.
Still More Advantages: Encouraging Stakeholder Investment
But a corporation’s need for firm-specific investment is not limited to financial capital. In a 1999 article, Margaret Blair and I developed a more general theory of the role of firm-specific investments in corporate governance that we call the team production theory.118 Economists say a project requires “team production” whenever two or more actors must make specific contributions that are essential to the project’s success, and that can’t be withdrawn from the project without losing much of their value. Moving a large sofa is a classic example of team production. Two or more people are needed, and if one quits in the middle, the “sofa-moving specific” efforts of all are wasted.
Many successful corporate projects require team production with stakeholders, meaning they demand not only locked-in capital from financial investors (whose money becomes firm-specific after being spent on salaries, specialized equipment, and other nonrecoverable expenses) but also specific investment from employees, customers, and even the community. For example, a railroad needs more than a set of tracks and some empty railroad cars. It also needs employees with specialized skills (engineering, conducting) who live in the area; commuting customers who have decided to live and work along the railroad line; and local communities to build and maintain roads, parking lots, schools, power grids, and other vital infrastructure along the line. None of these essential stakeholders would make such firm-specific investments if they thought the railroad might disappear tomorrow—as it might, if creditors or shareholders could easily and unilaterally withdraw their financial contributions.
As Blair and I discuss at length in our 1999 article, this insight explains a host of otherwise-puzzling anomalies in American corporate law that can’t be explained by the standard shareholder-oriented model, including the rules of derivative suit procedure, the nature of fiduciary duties, and shareholders’ extremely limited voting rights. Most important, it explains the peculiar institution of the board of directors. Economists since Adam Smith have wondered why sane investors would cede control over their hard-earned cash to strangers. (This is exactly what happens when you buy stock in a public corporation.) The answer, Blair and I suggest, is not that investors expect boards to run corporations perfectly, or even particularly well. But they do expect directors to run the public company well enough to keep the firm on its feet, else they would lose their own board positions. They also expect directors not to steal corporate assets: corporate law’s duty of loyalty has real teeth, and severely limits directors’ discretion to use their corporate powers to enrich themselves. Meanwhile, by relinquishing control of corporate assets to boards, financial investors get a valuable consolation prize. Board control allows directors to act as “mediating hierarchs” who can balance the ex post demands of shareholders against the interests of other stakeholders—customers, suppliers, employees, the community—that make essential contributions to firms. This reassures stakeholders and makes it safer for them to make their own firm-specific investments, which in turn allows the firm to pursue profitable projects it otherwise could not.
Some Evidence of Investor Hands-Tying
The corporation’s need to encourage firm-specific investments from employees and other stakeholders explains an interesting empirical puzzle that is impossible to reconcile with conventional shareholder primacy. This puzzle is the contrast between investors’ apparent willingness to buy stock in firms with governance rules that reduce shareholder power, while complaining about similar rules at other firms in which they own shares. Why would the same mutual fund manager buy shares in a company with a staggered board, while dutifully voting with ISS to try to de-stagger the boards of other companies in the manager’s portfolio?119 Why not just avoid buying stock in companies that limit shareholder power in the first place?
Ulysses’s tale suggests an answer. When corporations pursue complex, long-term projects with uncertain results —building brand names, inventing new technologies, developing new drugs or software—they often depend critically on their employees’ creativity, dedication, and passion. Unfortunately, it’s hard to draft employment contracts that guarantee creativity, dedication, and passion. Instead, corporations can encourage employee firm-specific investment by trying to reassure employees their investments will be respected and protected. Placing control of the project and its profits in the hands of a board that cannot personally profit from withdrawing financial capital or opportunistically threatening stakeholders (as shareholders can) helps provide that reassurance. Staggered board provisions and dual-class equity schemes that make it harder for an opportunistic shareholder to oust the board provide additional protection. Thus, governance provisions like staggered boards or dual classes
of shares make some kinds of corporate projects more likely to succeed, in turn making corporations with those governance structures more attractive investments.
Of course, when listening to the Sirens, Ulysses wanted his hands unbound. Similarly, once a corporation’s stakeholders have made essential firm-specific investments in the company’s success, its shareholders might want to exploit that stakeholder trust and vulnerability. For example, a firm might try to raise profits by threatening to outsource manufacturing to China or India unless its employees accept lower wages and the local community provides larger tax breaks.
In contrast, the duty of loyalty prevents directors from reaping personal profits by exploiting stakeholders. With no reason to try to exploit stakeholders, the board may resist shareholder demands to behave opportunistically. But what if the shareholders can easily remove the board, perhaps by selling en masse to a takeover bidder who would become a majority shareholder who did not suffer from collective action problems? Now, shareholders are in a much better position to demand the board try to profit from exploiting employees’ specific investments. (Economists Andrei Shleifer and Lawrence Summers estimated that after Carl Icahn acquired TWA in a takeover that earned TWA shareholders a premium of about $300 to $400 million, TWA’s unionized employees lost about $800 million in future wages.)120 This explains why the development of an active hostile takeover market in the 1980s was accompanied by labor force reductions (which hurt employees) and increased leverage (which harmed creditors).