On June 26, 2013, Steve Denning writes in Forbes:
No popular idea ever has a single origin. But the idea that the sole purpose of a firm is to make money for its shareholders got going in a major way with an article by Milton Friedman in the New York Times on September 13, 1970.
As the leader of the Chicago school of economics, and the winner of Nobel Prize in Economics in 1976, Friedman has beendescribed by The Economist as “the most influential economist of the second half of the 20th century…possibly of all of it”. The impact of the NYT article contributed to George Will calling him “the most consequential public intellectual of the 20th century.”
Friedman’s article was ferocious. Any business executives who pursued a goal other than making money were, he said, “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.” They were guilty of “analytical looseness and lack of rigor.” They had even turned themselves into “unelected government officials” who were illegally taxing employers and customers.
How did the Nobel-prize winner arrive at these conclusions? It’s curious that a paper which accuses others of “analytical looseness and lack of rigor” assumes its conclusion before it begins. “In a free-enterprise, private-property system,” the article states flatly at the outset as an obvious truth requiring no justification or proof, “a corporate executive is an employee of the owners of the business,” namely the shareholders.
If anyone familiar with even the rudiments of the law were to be asked whether a corporate executive is an employee of the shareholders, the answer would be: clearly not. The executive is an employee of the corporation.
An organization is a mere legal fiction
But in the magical world conjured up in this article, an organization is a mere “legal fiction”, which the article simply ignores in order to prove the pre-determined conclusion. The executive “has direct responsibility to his employers.” i.e. the shareholders. “That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.“
What’s interesting is that while the article jettisons one legal reality—the corporation—as a mere legal fiction, it rests its entire argument on another legal reality—the law of agency—as the foundation for the conclusions. The article thus picks and chooses which parts of legal reality are mere “legal fictions” to be ignored and which parts are “rock-solid foundations” for public policy. The choice depends on the predetermined conclusion that is sought to be proved.
A corporate executive who devotes any money for any general social interest would, the article argues, “be spending someone else’s money… Insofar as his actions in accord with his ‘social responsibility’ reduce returns to stockholders, he is spending their money.”
How did the corporation’s money somehow become the shareholder’s money? Simple. That is the article’s starting assumption. By assuming away the existence of the corporation as a mere “legal fiction”, hey presto! the corporation’s money magically becomes the stockholders’ money.
But the conceptual sleight of hand doesn’t stop there. The article goes on: “Insofar as his actions raise the price to customers, he is spending the customers’ money.” One moment ago, the organization’s money was the stockholder’s money. But suddenly in this phantasmagorical world, the organization’s money has become the customer’s money. With another wave of Professor Friedman’s conceptual wand, the customers have acquired a notional “right” to a product at a certain price and any money over and above that price has magically become “theirs”.
But even then the intellectual fantasy isn’t finished. The article continued: “Insofar as [the executives’] actions lower the wages of some employees, he is spending their money.” Now suddenly, the organization’s money has become, not the stockholder’s money or the customers’ money, but the employees’ money.
Is the money the stockholders’, the customers’ or the employees’? Apparently, it can be any of those possibilities, depending on which argument the article is trying to make. In Professor Friedman’s wondrous world, the money is anyone’s except that of the real legal owner of the money: the organization.
One might think that intellectual nonsense of this sort would have been quickly spotted and denounced as absurd. And perhaps if the article had been written by someone other than the leader of the Chicago school of economics and a front-runner for the Nobel Prize in Economics that was to come in 1976, that would have been the article’s fate. But instead this wild fantasy obtained widespread support as the new gospel of business.
People just wanted to believe…
The success of the article was not because the arguments were sound or powerful, but rather because people desperately wanted to believe. At the time, private sector firms were starting to feel the first pressures of global competition and executives were looking around for ways to increase their returns. The idea of focusing totally on making money, and forgetting about any concerns for employees, customers or society seemed like a promising avenue worth exploring, regardless of the argumentation.
In fact, the argument was so attractive that, six years later, it was dressed up in fancy mathematics to become one of the most famous and widely cited academic business articles of all time. In 1976, Finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester published their paper in the Journal of Financial Economics entitled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”
Underneath impenetrable jargon and abstruse mathematics is the reality that whole intellectual edifice of the famous article rests on the same false assumption as Professor Friedman’s article, namely, that an organization is a legal fiction which doesn’t exist and that the organization’s money is owned by the stockholders.
Even better for executives, the article proposed that, to ensure that the firms would focus solely on making money for the shareholders, firms should turn the executives into major shareholders, by affording them generous compensation in the form of stock. In this way, the alleged tendency of executives to feather their own nests would be mobilized in the interests of the shareholders.
The money took over…
Sadly, as often happens with bad ideas that make some people a lot of money, shareholder value caught on and became the conventional wisdom. Not surprisingly, executives were only too happy to accept the generous stock compensation being offered. In due course, they even came to view it as an entitlement, independent of performance.
Politics also lent support. Ronald Reagan was elected in the US in 1980 with his message that government is “the problem”. In the UK, Margaret Thatcher became Prime Minister in 1979. These leaders preached “economic freedom” and urged a focus on making money as “the solution”. As the Michael Douglas character in the 1987 movie, Wall Street, pithily summarized the philosophy, greed was now good.
Moreover an apparent exemplar of the shareholder value theory emerged: Jack Welch. During his tenure as CEO of General Electric from 1981 to 2001, Jack Welch came to be seen–rightly or wrongly–as the outstanding implementer of the theory, as a result of his capacity to grow shareholder value and hit his numbers almost exactly. When Jack Welch retired, the company had gone from a market value of $14 billion to $484 billion at the time of his retirement, making it, according to the stock market, the most valuable and largest company in the world. In 1999 he was named “Manager of the Century” by Fortune magazine.
The disastrous consequences…
So for a time, it looked as though the magic of shareholder value was working. But once the financial tricks that were used to support it were uncovered, the underlying reality became apparent. The decline that Friedman and other sensed in 1970 turned out to be real and persistent. The rate of return on assets and on invested capital of US firms declined from 1965 to 2009 by three-quarters, as shown by the Shift Index, a study of 20,000 US firms.
The shareholder value theory thus failed even on its own narrow terms: making money. The proponents of shareholder value and stock-based executive compensation hoped that their theories would focus executives on improving the real performance of their companies and thus increasing shareholder value over time. Yet, precisely the opposite occurred. In the period of shareholder capitalism since 1976, executive compensation has exploded while corporate performance declined.
Maximizing shareholder value thus turned out to be the disease of which it purported to be the cure. As Roger Martin in his book,Fixing the Game, noted, “between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.”
Even Jack Welch sees the light…
Moreover in the years since Jack Welch retired from GE in 2001, GE’s stock price has not fared so well: in the decade following Welch’s departure, GE lost around 60 percent of the market capitalization that Welch “created”. It turned out that the fabulous returns of GE during the Welch era were obtained in part by the risky financial leverage of GE Capital, which would have collapsed in 2008 if it had not been for a government bailout.
In due course, Jack Welch himself came to be one of the strongest critics of shareholder value. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”
From shareholder value to hardball…
The supposed management dynamic of maximizing shareholder value was to make money, by whatever means are available. Self-interest reigned supreme. The logic was continued in the perversely enlightening book, Hardball (2004), by George Stalk, Jr. and Rob Lachenauer. Firms should pursue shareholder value to “win” in the marketplace. These firms should be “willing to hurt their rivals”. They should be “ruthless” and “mean”. Exponents of the approach “enjoy watching their competitors squirm”. In an effort to win, they go up to the very edge of illegality or if they go over the line, get off with civil penalties that appear large in absolute terms but meager in relation to the illicit gains that are made.
In such a world, it is therefore hardly surprising, says Roger Martin in his book, Fixing the Game, that the corporate world is plagued by continuing scandals, such as the accounting scandals in 2001-2002 with Enron, WorldCom, Tyco International, Global Crossing, and Adelphia, the options backdating scandals of 2005-2006, and the subprime meltdown of 2007-2008. Banks and others have been gaming the system, both with practices that were shady but not strictly illegal and then with practices that were criminal. They include widespread insider trading, price fixing of LIBOR, abuses in foreclosure, money laundering for drug dealers and terrorists, assisting tax evasion and misleading clients with worthless securities.
Martin writes: “It isn’t just about the money for shareholders, or even the dubious CEO behavior that our theories encourage. It’s much bigger than that. Our theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism. These theories underpin regulatory fixes instituted after each market bubble and crash. Because the fixes begin from the wrong premise, they will be ineffectual; until we change the theories, future crashes are inevitable.”
Peter Drucker got it right…
Not everyone agreed with the shareholder value theory, even in the early years. In 1973, Peter Drucker made a sustained argument against shareholder value in his classic book, Management. In his view, “There is only one valid definition of business purpose: to create a customer. . . . It is the customer who determines what a business is. It is the customer alone whose willingness to pay for a good or for a service converts economic resources into wealth, things into goods. . . . The customer is the foundation of a business and keeps it in existence.”
Similarly in 1979, Quaker Oats president Kenneth Mason, writing inBusiness Week, declared Friedman’s profits-are-everything philosophy “a dreary and demeaning view of the role of business and business leaders in our society… Making a profit is no more the purpose of a corporation than getting enough to eat is the purpose of life. Getting enough to eat is a requirement of life; life’s purpose, one would hope, is somewhat broader and more challenging. Likewise with business and profit.”
The primacy of the customer…
Peter Drucker’s argument about the primacy of the customer didn’t have much effect until globalization and the Internet changed everything. Customers suddenly had real choices, access to instant reliable information and the ability to communicate with each other. Power in the marketplace shifted from seller to buyer. Customers started insisting on “better, cheaper, quicker and smaller,” along with “more convenient, reliable and personalized.” Continuous, even transformational, innovation became requirements for survival.
A whole set of organizations responded by doing things differently and focusing on delighting customers profitably, rather than a sole focus on shareholder value. These firms include Whole Foods [WFM], Apple [AAPL], Salesforce [CRM], Amazon [AMZN], Toyota [TM], Haier Group, Li & Fung and Zara along with thousands of lesser-known firms. The transition is happening not just in high tech, but also in manufacturing, books, music, household appliances, automobiles, groceries and clothing. This different way of managing turned out to be hugely profitable.
The common elements of what all these organizations are doing has now emerged. It’s not merely the application of new technology or a set of fixes or adjustments to hierarchical bureaucracy. It involves basic change in the way people think, talk and act in the workplace. It involves deep changes in attitudes, values, habits and beliefs.
The new management paradigm is capable of achieving both continuous innovation and transformation, along with disciplined execution, while also delighting those for whom the work is done and inspiring those doing the work. Organizations implementing it are moving the production frontier of what is possible.
The replacement for shareholder value is thus now identifiable. A set of books have appeared that spell out the elements of this canon of radically different management.
In effect, shareholder value is obsolete. What we are seeing is a paradigm shift in management, in the strict sense laid down by Thomas Kuhn: a different mental model of how the world works.
And read also:
Corporations are formed by individual in legal association with one another. They are the OWNERS of the corporation’s embodiment in terms of the capital assets owned and controlled by this body of people through their elected and appointed management. Thus, the real legal owner of the earnings is the organization which is owned through private property title in the form of shares by individuals in legal association.
Most businesses, particularly national and multi-national businesses operate as state statute-granted corporations whose essential job is to maximize profits and deliver the highest return possible to its owners, or otherwise fail in an increasingly competative business universe. The key operative is OWNERS and in the case of Market Basket the Demoulas family owns it.
Corporations are an assemblage of both human laborers and non-human capital assets––two independent factors of production. The people factor are labor workers, including the board members, CEOs, management, and workers, who contribute manual, intellectual, creative and entrepreneurial work. Capital assets include land; structures; infrastructure; tools; machines; computer processing; certain intangibles that have the characteristics of property, such as patents and trade or firm names; and the like owned by the individuals who are the registered owners of the corporation. Thus, fundamentally, economic value is created through human and non-human contributions.
The role of physical productive capital is to do ever more of the work, which produces wealth and thus income to those who own productive capital assets. Full employment is not an objective of businesses. Companies strive to keep labor input and other costs at a minimum in order to maximize profits for the owners. They strive to minimize marginal cost, the cost of producing an additional unit of a good, product or service once a business has its fixed costs in place in order to stay competitive with other companies racing to stay competitive through technological innovation. Reducing marginal costs enables businesses to increase profits, offer goods, products and services at a lower price, or both. Increasingly, new technologies are enabling companies to achieve near-zero cost growth without having to hire people. Thus, private sector job creation in numbers that match the pool of people willing and able to work is constantly being eroded by physical productive capital’s ever increasing role. Over the past century there has been an ever-accelerating shift to productive capital––which reflects tectonic shifts in the technologies of production. The mixture of labor worker input and capital asset input has been rapidly changing at an exponential rate of increase for over 235 years. Such tectonic shifts in the technologies of production have and will continue to destroy jobs and devalue the worth of labor.
This reality is now impacting the entire American and global economies as the population majorities are limited systemitically to earning an income SOLELY through a JOB. And when there are no jobs, populations become dependent on coerced tax extraction and promisary national debt to redistribute wealth and provide welfare programs for people who are jobless and propertyless.
Universally, every person desires to earn enough to raise a family, build a modest savings, own a home, and secure their retirement. But because the majority of people have been blinded not to see any other means than a JOB to realize those desires, working people will continue to be limited by earning income solely through their labor worker wages, and they will be left behind by the continued gravitation of economic bounty toward the top 1 percent wealthy ownership class of the people that the system is rigged to benefit. Working people and the middle class will continue to stagnate, resulting in a stagnated consumer economy. More troubling is that this continued stagnation will further dim the economic hopes of America’s youth, no matter what their education level. The result will have profound long-term consequences for the nation’s economic health and further limit equal earning opportunity and spread income inequality. As the need for labor decreases and the power and leverage of productive capital increases, the gap between labor workers and capital owners will increase, which will result in turmoil and upheaval, if not revolution.
This reality is causing more people to question the future of the American corporation––what its purpose is, how it should be run, and whom it should be engineered to benefit. As this article suggests, the argument that maximizing profit and shareholder value is only one way of defining corporate success. Nevertheless it will remain the predominant objective of business in an increasingly competitive global environment.
Still, there is much that can be done to improved the relationship between shareholders and all of the other parties that help account for the success of a company. But the first essential step is to BROADEN OWNERSHIP of companies to include ALL employees and to extend ownership opportunities to customers as well. This can be accomplished through the use of creative financial mechanisms that do no require “past savings” or a denial of consumption in order to purchase ownership shares in growth companies. Such mechanisms would use insured, interest-free, low service cost capital credit loans repayable out of FUTURE earnings of the investment in technological innovation.
We also need to eliminate all tax loopholes and subsidies, encourage corporations to pay out all their profits as taxable personal incomes to avoid paying corporate income taxes and to finance their growth by issuing new full dividend payout shares for broad-based citizen ownership, and eliminate the payroll tax on workers and their employers.
But also a well-run company needs to be managed in a way that benefits not just the investors who own its stock, but a wide range of “stakeholder” constituents––employees, customers, suppliers, and creditors as well as the broader community–– who can now become share owners as well. In such a corporate structure the company’s employees and customers can gain far greater prosperity and contribute to and sustain a company’s success.
At the Center for Economic and Social Justice (www.cesj.org) we advocate Justice-Based Management (JBM) as a leadership philosophy and management system that applies universal principles of economic and social justice within business organizations. The ultimate purpose of JBM is to create and sustain ownership cultures that enhance the dignity and development of every member of the company, and to economically empower each person as an owner and worker.
JBM promotes a company’s long-term profitability within the global marketplace by enabling all worker-owners to serve and provide higher value to the customer. JBM connects every worker’s self-interest to the bottom-line and long-term success of the company, without adding pass-through costs to customers.
The JBM process builds upon a written articulation of the philosophy and principles of the company’s leader (typically the CEO or chairman of the board) and leadership core group, in terms of universal principles and core values of the company. JBM proceeds in stages to build a consensus upon these fundamental shared values and vision of the company within each work area of the company.
These articulated values provide the foundation for enhancing the productiveness of workers in tangent with the significant productiveness of the technological factor and company profitability, and include such structures as employee-monitored economic incentive programs, participation and governance structures, two-way communications and accountability systems, conflict management systems and future planning and renewal programs.
One of the main components of JBM is the “empowerment ESOP.” While the Employee Stock Ownership Plan (ESOP) was originally invented as a means for providing working people with access to capital credit to become owners of corporate equity, most ESOPs are set up as just another employee benefit plan or tax gimmick, or as an employee share accumulation plan (“ESAP”). Most ESOPs today are not designed to treat worker-owners as first-class shareholders. The “empowerment ESOP,” on the other hand, is designed to encourage workers to assume the responsibilities and risks, as well as the full rights, rewards and powers, of co-ownership.
Furthermore, all academic and government studies to date have concluded that ESOPs alone are not enough to affect individual and corporate performance. Within a JBM system, in combination with a regular gainsharing program tied to bottom-line profits, and structured systems of participatory management, the empowerment ESOP stimulates everyone in the company to think and act like entrepreneurs and owners.
Justice-Based Management offers an ethical framework for succeeding in business. JBM balances moral values (treating people with fairness and dignity) with material value (increasing a company’s productiveness and profits while enriching all members of a productive enterprise). JBM’s three basic operating principles are:
- Build the organization on shared ethical values—starting with respect for the dignity and worth of each person (employee, customer and supplier)—that promote the development and empowerment of every member of the group.
- Succeed in the marketplace by delivering maximum value (higher quality at lower prices) to the customer.
- Reward people commensurate with the value they contribute to the company—as individuals and as a team.
Justice-Based Management is guided by the concept of social justice, as articulated by the late social philosopher William Ferree, S.M. Social justice involves the structuring of social organizations or institutions (including business corporations) to promote and develop the full potential of every member.
JBM also embeds within an ownership culture the three principles of economic justice defined by the late lawyer-binary economist Louis Kelso and philosopher Mortimer Adler: (1) “participative justice,” or the right to the means and opportunity to participate in the economic process as an owner as well as a worker; (2) “distributive justice,” or the right to the full, market-determined stream of income from one’s labor and capital contributions; and (3) “social justice,” or the right and responsibility of each person to work in an organized way with others to correct the “social order” or institution when the principles of participative or distributive justice are being violated or blocked.
Within JBM the principles of social and economic justice provide a logical framework for defining “fairness” and structuring the diffusion of power within the corporation.