It’s common practice for shareholders who advocate changes in corporate law to claim that shareholders “own” the corporation and that corporate directors should seek only to “maximize shareholder value.” Whether proposing a change in a company’s bylaws or a major shift in national securities law, their proposals, comment letters, op-eds and speeches are full of ownership language. The media repeats and amplifies their claims.
Web hits prove the point. In early 2010, a web search yielded nearly 4 million hits for the word-for-word phrase: “Shareholders are the owners of the company.” By contrast, the wishful notion that “Osama bin Laden is dead” appeared only 410,000 times, and the happier belief that “Elvis is alive” appeared merely 52,200 times. It’s obvious many people believe shareholders own com-panies. But is that belief correct?
The answer is: No, shareholders do not own the corporation. Rather, they own (or in some cases, temporarily hold) a type of security commonly called stock. Both corporate law and economic reasoning support the limited nature of this ownership, and also undermine the claim that directors should always strive to maximize shareholder value.
The Legal Case
Although it can be difficult for non-lawyers to wrap their heads around the idea, no human being can own a corporation. This is because corporations are legal persons—independent entities with their own rights, including the right to hold property in the corporate name. In effect, corporations, like human beings, own themselves.
As a legal matter, shareholders who purchase shares of stock in a corporation own nothing more than that—shares of stock. Simi-larly, bondholders own only bonds, and executives with employment contracts own their contracts. None of these types of ownership give shareholders, bondholders or executives the right to control the firm. The right to control the firm’s assets and actions rests in the hands of its board of directors, and only when they act as a body and follow proper board procedures.
An important consequence of this governance structure is that shareholders not only have no legal right to control the firm, they also have no legal right to help themselves to the corporation’s assets. In fact, the only time shareholders receive any funds directly from the corporation’s coffers is when they receive a dividend or the corporation repurchases their shares. This only happens when the directors vote to declare a dividend or a corporate repurchase.
In judicial opinions, directors are usually described as owing fiduciary duties “to the corporation and its shareholders”—implying the two are not the same, and that directors’ duties are broader than just duties to shareholders. Even more important, under the doctrine known as the business judgment rule, a shareholder can’t successfully sue a board for failing to maximize shareholder value. To the contrary, directors enjoy wide legal discretion to sacrifice “shareholder value” in order to protect employees, customers, creditors and the community.
This is why fans of shareholder primacy almost always cite the nearly century old case of Dodge v. Ford as their primary legal support for the idea of shareholder primacy. But Dodge v. Ford was really a shareholder-versus-shareholder dispute in a close corporation. Similarly, the second case typically cited—Revlon v. Mac- Andrews & Forbes Holdings, Inc., is also legally irrelevent. In Revlon, the Delaware Supreme Court held that an end-game situation where the directors of a publicly traded firm had decided to sell the company with a controlling shareholder—in effect, terminating the corporation’s existence as a public firm—the board had a duty to maximize shareholder wealth. But subsequent Delaware cases have made it clear that if the directors of the firm decide not to sell at all, or prefer to do a stock-for-stock exchange with another public company, the infamous Revlon doctrine no longer applies. For example, in Paramount Communications, Inc. v. Time, Inc., the Delaware Supreme Court upheld directors’ right to “just say no” to a hostile offer, even though the offer was at a premium over the market price for the company’s stock.
The Economic Case
Paying attention to the realities of corporate law should also put the kibosh on two other sub-legends surrounding the idea of shareholders as owners. The first is the false notion, favored by economists, that shareholders are the “principals” in public corporations and that directors are shareholders’ “agents.” As we have just seen, this agency metaphor misstates the real legal status of shareholders and directors. At law, a principal has a right to control her agent. But shareholders can’t exercise direct control over corporate directors. Moreover, case law describes corporate directors not as “agents” but as fiduciaries with a wide range of discretion, who owe duties not just to shareholders but also to the firm as a whole.
The second mistaken sub-legend is the claim that shareholders are the sole “residual claimants” in the corporation, entitled to each and every penny of profit the firm earns after it pays its expenses. This sub-legend ignores the legal reality that in a public company, the board of directors controls not only whether the shareholders receive dividends out of earnings—the board controls whether the firm has earnings at all. This is because the board controls corporate expenses. If a company is doing extremely well, the directors can pay a dividend, but they can also raise employees’ salaries, improve customer service or work toward a lower debt-equity ratio for creditors.
It is thus wildly misleading to describe shareholders as the sole residual claimants in companies that aren’t actually in bankruptcy.
To the contrary, while shareholders typically share in the wealth when the corporation does well and suffer when the firm does poorly, so do employees, creditors and other “stakeholders.” Many different groups are potential residual claimants and residual risk-bearers in public firms, just as many different groups— not just shareholders—contribute to the firm’s success. Thus, from an economic perspective, it doesn’t make sense to focus only on shareholders. While shareholders are important participants in firms and deserve to be protected, corporations give more value to society when directors look out for the interests of customers, creditors, employees and other stakeholders as well.
This idea is supported by modern options theory. In effect, bondholders own the right to access cash flow but have sold a call to shareholders, while shareholders own the right to access the cash flow but have sold a put to bondholders. Neither shareholders nor bondholders can claim an exclusive right to “own” the company’s cash flow, much less the company.
Why Should Directors Care?
These legal and economic arguments against shareholder primacy have practical importance. Shareholder primacy thinking pressures directors to make business decisions that they know, intuitively, are not in the best interests of their firms. In the mistaken belief that both law and economic efficiency demand they “maximize shareholder value,” directors may fire valuable employees, cut customer support, limit research and development and sell off valuable assets and divisions.
In contrast, once directors understand that shareholders do not in fact own the corporation and that they need not respond to shareholders’ every whim, they can focus instead on getting the best possible corporate performance—on behalf of all stakeholders. In the end, shareholders only stand to benefit.
Lynn A. Stout is professor of law at the University of California Los Angeles School of Law.