The primary philosophy driving the modern corporate governance movement and much of U.S. corporate law in recent decades has been investor protection. In modern times, governance reform has centered around changes in corporate structure to create greater accountability of boards and management to shareholders. Implicit in all these movements is the notion of shareholder primacy— the concept that in ordinary circumstances, board directors owe their primary fiduciary duty to shareholders.
Today, this notion of shareholder primacy is under attack from two directions.
The Legislative Attack
First is the legislative attack. The present economic crisis has precipitated a federal governmental response that may be harmful to this philosophy and ultimately results in a scarcity of capital necessary to the success of our system. Regulators have been weakening the alignment of executive pay to stock price performance—a critical component in shareholder primacy. The economic stimulus bill signed into law by President Obama last year included a curb on performance-based pay for the most highly paid executives in firms receiving funds from the Troubled Assets Relief Program (TARP). Such pay cannot be more than one-third of the executive’s total compensation. To be sure, there are exemptions, including one for long-term restricted stock. Still, the law erodes shareholder primacy by weakening the link between executive pay and stock price performance. In doing so, a primary tenet of modern compensation philosophy has been upended—to relate executive pay to corporate performance to effectively align management and shareholder interests to result in ultimate corporate profitability and greater shareholder return. Limiting compensation in this manner suggests that the corporate goal is no longer greater shareholder value and return to the investor, but the preservation of the corporate status quo, ultimately harmful to investor interests.
The Academic Attack
Second is the intellectual attack. There has been some prominent academic support for the notion that corporate directors serve multiple stakeholders to an equivalent degree, rather than shareholders first and foremost. This school of thought says that directors serve the corporation, not its owners, and as such, directors serve multiple constituencies, including employees, customers and communities.
The legislators and scholars who are challenging shareholder primacy offer some intrinsically appealing ideas. One might be tempted to cheer for the legislators’ TARP restrictions, for who would not want to put an end to outrageously excessive compensation during a time of economic depression? And one might be easily drawn to give a sympathetic ear to scholars’ arguments for the stakeholder model of governance. After all, who does not want to honor those who toil for companies or who buy company goods? Who would cavalierly overlook the interests of one’s own hometown?
Why Preserve Primacy?
These attacks may be well armed with attractive arguments, but they are all the more dangerous. In my view as a director and as a shareholder, it is urgently important to preserve the notion of shareholder primacy for five reasons.
1. Shareholder primacy is key to our entire capital system. Simply put, companies have three sources of capital: earnings, debt and equity. Weakening equity as a source of capital will force com-panies to rely increasingly on earnings or debt. Reliance on earnings has its limits, particularly for long-term investment, as earnings can be volatile and have a natural size limit. As for debt, it has its place, but the effects of overleverage can be disastrous. Equity is the answer for many corporations at various points in their life cycles.
2. Unless shareholders are protected, they will not invest and the economy will stagnate, contract, and ultimately grind to a halt. If we didn’t put shareholders’ interests first, investors simply would not invest and we would lose the capital vital to U.S. economic success.
3. The stakeholder system has numerous problems. As a famous corporate commentator used to say, “Even a broken watch gets the time right twice a day.” If boards of directors are responsible to multiple constituencies, directors will make decisions that will always benefit someone, but at the expense of the health of the corporation.
Furthermore, while the other stakeholders can protect themselves contractually, shareholders cannot—that is why we have a board that is elected by the shareholders. Shareholders are indeed the last “residual claimants” and in this lies their primacy from both a legal and economic perspective. Finally, obligations to multiple constituencies lessens managerial accountability, as even a bad decision may please someone— leading to inadequate management and corporate disaster.
4. The argument and conflict between the shareholder primacy and stakeholder theories is more apparent than real. To maximize shareholder value, all of the stakeholders need to be content with corporate direction.
5. We have met the enemy and it is us. The investment class in this country is broad. In today’s world, most taxpayers are investors and every investor is a taxpayer. Most stakeholders are in fact shareholders. The largest owners of many companies are the employees, through their retirement plans.
Significance of Equity Pay
Perhaps the greatest proof of the importance of shareholder primacy comes from the realm of director compensation. Numerous studies have shown a correlation between good corporate performance and the receipt of director pay in stock. This was true two decades ago when I wrote about it in the Boston College Law Review, and it remains true today, as Sanjai Bhagat of the University of Colorado has confirmed with his extensive current studies—notably his December 2008 Columbia Law Review article (with co-authors) on “The Promise and Peril of Corporate Governance Indices.” Professor Bhagat and team ran every commonly measured governance variable and found only one that correlated to financial performance—and that was paying directors in stock. They wrote: “In sum, of all the measures of governance quality evaluated…only the outside directors’ stock ownership measure was related to multiple measures of performance, firms’ future accounting profitability and disciplinary management turnover upon poor performance.”
The image of battle may seem extreme, but much is at stake. Looking back to eras before our own, we see investor protection as a motivating force in much of modern economic history, dating back at least as far as the era of joint stock-trading companies 400 years ago. Without exaggeration, one could say that the new world of America itself was founded on the principles that make equity capital possible. Do we want to cast this vital legacy aside for political expediency or correctness, however well meaning?
Independent, equity-holding boards, accountable first and foremost to investors in free elections, are the ultimate solution to the compensation controversy and the key to effective investor protection. As independent directors elected by shareholders and serving their collective interests, we are both the proof and the prize of shareholder primacy. We must defend and serve this concept vigorously for the good of free enterprise and the future vibrancy of the American economy.
Charles M. Elson is the Edgar S. Woolard Jr. chair in corporate governance and director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. He is a director of HealthSouth Corp.