Friday November 28, 2014

Shareholders as Owners: Legal Reality Or Urban Legend?

Shareholder primacy thinking is mistaken, says this legal scholar.

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.

Comments on “Shareholders as Owners: Legal Reality Or Urban Legend?”

  • Choong WK says:

    Can shareholders be considered as owners of the company if they have the majority share and they are also seated in the board of directors?

  • foo bar says:

    Is it not typical that a shareholder super-majority can remove/fire board members? Or are board members afforded a permanent seat contractually because of investment deals? Can the board itself not remove a rouge board member?

  • deonsta says:

    So who then owns the company? Is it the founder of the company or shareholders

    • TJ says:

      Who owns you?

      A corporation is a person.

  • Gary Spaulding says:

    A Corporation is not a Human Being and will never be one. Sorry, that is a Lawyer’s lie. A Corporation is Created by Law and never in birth. That law is granted to the States by the Federal Government under the (I believe)Constitution (Commerce Clause). Each State has a Secretary of State that is elected by the people of that State, and as such is responsible to the People of that State. A Corporation is formed when a group of ‘Real Humans” petitions the Secretary of State to form a new legal entity at law as a Corporation (This is not done at birth). That Corporation is owned not only by the individuals forming the entity, but also by the Secretary of State, and the Citizens of that State that are represented by that office.

    When ever that Corporation, or those offices in the Corporation, NO LONGER SERVE THE BEST INTRUSTS OF THE CITIZENS O0F THAT STATE, then the Secretary of State has the authority, and the responsibility, to close the Corporation down and file charges against the offices, and anyone else it deems guilty, of crimes against either the State, the stock holders, employees, or any others it deems as harmed by their actions. It may also claim all the assets of that corporation and liquidate them as it sees fit in accordance with the law of that State.

    Now, who did you say owns a Corporation???

  • Robert says:

    Ugh, why do occupy-types who know nothing of law or finance always end up commenting on these articles? Shareholders are a subset of stakeholders. If a company declares bankruptcy, it’s workers -if they have pensions or other benefits- are entitled to “first dibs” on the liquidation of any assets the firm possesses. Corporations are governed by by laws which detail the election of board members and directors as well as their rights an responsibilities. These vary widely depending on the corporation. …I know “Main Street” likes to portray institutional shareholders as greedy Wall Street robber Barron’s looking to squeeze every nickel out of businesses by laying off workers and sending their jobs to China but that is not the case. At the firm I used to work at, the majority of OUR shareholders were public pension funds and charitable foundations. In other words, we were long on most of everything we bought. This is why the shareholder value model is THE ONLY model as far as most people who work in this industry are concerned. We manage your pensions an have a fudicial responsibility to see that companies are successful. If more people buy into the market, this makes the process even more efficient and better able to benefit everyone. As more and more people started investing in the early 1970s there was a wonderful paper published called “The coming of the zero hour work week”. The title is a huge exaggeration obviously but the premise was that up to that time, American wealth pretty much across the entire spectrum of income was growing at a rate such that if it were to continue they would be able to not work an simply live off ther investments (remember, obviously an exaggeration). This came to an end however when the dollar was devalued by the Nixion administration by ending the Brenton Woods system and making it ILLEGAL for persons to hold gold bullion. This was done to pay for the huge costs of the cold war which was being exacerbated by conflict in southeast Asia (Vietnam). Inflation began to rise while wages remained stagnant. It was not until Reagan that things began to change and taxes were lowered and regulations on financial services were lazed. Even worse ones were eventually implemented under the Clinton administration however in 1993 which caused the financial crisis as well as te explosion in CEO pay and conflicts of interest. As part of the changes to the tax code, the government defined “unreasonable compensation” to pay somebody over $1,000,000. A rediculously low number when we are talking about large multinational billion dollar institutions. We needed a way to adequately compensate the people we were entrusting YOUR money to to make sure they do a good job so we advised boards to load up contracts with stock options. This caused management to adopt short term mindsets where they would only focus on stock price and ignore the health of the firm. The only solution to this was to introduce a backstop in the form of lump sum payments if the CEO or execs were fired by the board. The most recent legislation passed (the Dodd-Frank reform) makes matters even worse and will probably sometime in the not too distant future cause another financial crisis -the exact thin it is intended to prevent. So I beg anyone who reads this, please please please, with sugar on top, vote for Mitt Romney.

  • Glaw says:

    It would really blow these peoples mind to know that even if you “own” shares, they aint even in your name! The brokerage has them in street name in c/o your name. Sooo when the brokerage goes belly up, you are pretty much last in line to try to get anything back. Who says they even purchased those shares when you actually placed the buy order? Your just an entry in their system. Just remember what uncle Gerald Celente sings – “Its not your money if its not in your pocket!” Direct registration or certificates are the closest thing to owning as your going to get.

  • katherine says:

    Are the stockholders/shareholders of the corporation considered as the creditor of the corporation?

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