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Wharton Professor Sees Misinformation on What Fiduciary Duty Really Means for U.S. Companies

It has been a business maxim for years: Shareholder value trumps all when it comes to measuring corporate success. But by overrating shareholder value, management could focus too much on short-term stock price measures, given that outsized executive compensation often is fueled by stock options. And focusing too much on the short term can hurt a business over the long run, says Eric W. Orts, a Wharton professor of legal studies and business ethics. There are better measures of corporate success, he points out in an interview with Knowledge@Wharton about his new book, Business Persons: A Legal Theory of the Firm.

An excerpt of the conversation follows.

K@W: You have this idea of shareholder value being central and prominent and almost overriding, and you then have executives whose compensation is based on shareholder value, i.e., the stock price. And so, naturally, they are incented to make sure that the stock price is as high as possible, which generally is a good thing. But in practice, as you say, there’s this critique that they’re managing for the short term because most of their compensation is based on stock options directly related to the share price. So, they want that next quarter’s — or certainly the next year’s — financial results to maximize the stock price, which could undermine the long-term soundness of the firm. If they dump all the assets and resources into trying to make [the price] go up short term, they miss opportunities.

There are companies that do it the other way, like Amazon, that invest for the long term. They’ll take losses in certain areas in the short term in order to invest and guarantee that they succeed in the long term. So, this is another part of it, this economic argument, isn’t it? In addition to the fact that you’re saying it can lead to fraud.

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Orts: I think that’s exactly right. And in some ways, that’s even more important. One problem you have is that you might increase fraud. You increase the dysfunctionality of the system…. You want to have long-term sustainable growth that is going to raise everyone’s boats, create more wealth, help to make everybody better off. If we don’t have systems in place — and part of this is about economic theories that we’re adopting and part of it is about law listening to the economic theories and following those economic theories — we’re going to be in some trouble.

I think you identify a very big issue. What is the purpose of an enterprise, and how do you provide the right incentives, both legally and economically, for long-term economic growth? One example I use in my book is Google. Specifically, when Google went public, it opted out of this traditional pattern of being governed only by shareholders…. And Delaware had a famous case that was decided in the 1980s — called “Revlon” — where [the court] said that in some circumstances, we’re going to demand that you get the highest price for the company if you’re selling the company or if you’re in a sales situation.

There are some complexities around that. The argument here is: Well, why would we expect that [benefit] to be only for shareholders? Why would we only want to take one share price right now and say that is the intrinsic value of the company? There could be all kinds of reasons that share price is either up or down [at a given moment]. And to put so much weight on the artifact of share price, I think, has been a mistake over time. Google has been a successful company in bucking that trend, where they said, “No, we’re going to basically hold control….”

“What is the purpose of an enterprise, and how do you provide the right incentives, both legally and economically, for long-term economic growth?”

Another example historically that seems to be pretty successful this way is Ford Motor Company. It has done the same thing, which indicates that maybe shareholder value in a broadly held market is not the only model for a company. Also, for long-term sustainable growth, we need to have a more complex understanding of incentives in enterprises and provide for lots of different experiments for how businesses should work, rather than, as some economists have tried to argue, put a template of an economic theory on the world and say that everybody has to manage to this shareholder maximizing model….

[There are a lot of] other examples out there where companies are not behaving that way, and they are actually doing better than companies that are being trained to just look at short-term returns.

K@W: When people talk about maximizing shareholder value, it tends to mean “in the short term,” as you point out. You’ll sometimes hear that executives have a fiduciary responsibility to do so. But you seem to be arguing that there are other responsibilities. And, in fact, you could be irresponsible by not investing for the long term. By giving out too many dividends in the short term, you then don’t have money in retained earnings to invest for that next new product that’s going to give growth for the long term.

Orts: Yes, I think there has been a lot of misinformation sent out — sometimes I’m afraid in business schools, but it also sometimes happens in law schools — of what the fiduciary duty of directors actually is in the United States. In fact, the business judgment rule has allowed [for] a lot of the discretion that directors have in the United States…. Now, we have had some changes that have moved us toward a shareholder-maximization model. The Revlon case I mentioned is one of those changes. And there have been [other] Delaware law cases that go in that direction.

“There has been a lot of misinformation sent out — sometimes I’m afraid in business schools, but it also sometimes happens in law schools — of what the fiduciary duty of directors actually is in the United States. In fact, the business judgment rule has allowed [for] a lot of the discretion…”

There also have been Delaware cases and other legal developments that have said, “Wait, companies don’t have to manage in that way.” One of the interesting experiments that I also talk about in the book is something I call hybrid social enterprises. Delaware enacted a benefit corporation statute which explicitly says you can have two different objectives. One is making money, but another is an environmental objective, let’s say, or some specified social objective of trying to alleviate sanitation problems in a particular country. What those experiments show — and one of the main arguments that I give in the book — is that purposes of businesses are actually quite diverse.

You can have a business, and it can be just maximizing shareholder value. I’m not saying we shouldn’t have businesses that are organized in that way. There are lots of other kinds of models, not only in the United States but in the world, of different kinds of companies that are looking at different kinds of objectives…. We’re in a better circumstance if we allow a diversity of different companies like that.

An argument in the book is that one of the virtues of modern Western societies is that we have this framework of law that allows individuals from the bottom up to be entrepreneurs, to come together, to come up with new ideas, to come up with new ways of structuring enterprises that are either going to work or not work. And we allow general markets of supply and demand to determine that. But we don’t mandate some particular way in which every business has to be managed. And I think that that’s a good thing and one that I hope to encourage by writing this book.


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