What Corporate Law’s Emphasis on the Long Term Might Mean

To read influential corporate lawyers, legal academics, and jurists, shareholders are an alarmingly myopic bunch who demand that corporate directors and managers make short-term decisions that sacrifice long-term value. The group receiving the most scolding of late is hedge fund activists. Leo E. Strine, Jr. the chief justice of the Delaware Supreme Court and a commentator on corporate law, says we “must recognize that directors are increasingly vulnerable to pressure from activist investors and shareholder groups with short-term objectives, and that this pressure may logically lead to strategies that sacrifice long-term performance for short-term shareholder wealth.” Delaware corporate law enshrines this view. Directors must maximize the “long run interests of the shareholders” and have no duty (absent a change of control transaction) to  “ best maximize the corporation’s current stock price.” But what is this “long run” interest? The courts never say. It is not a concept from financial economics. Does anyone have a coherent explanation for what it means, in economic terms?

Here is the mystery: There is virtually no evidence that shareholders prefer short-term gains that are smaller than larger (discounted) long-term gains. Harvard Law School’s Mark Roe recently put it this way, “Overall, the evidence that financial markets are excessively short-term is widely believed but not proven, and there is much evidence pointing in the other direction.” It is difficult – if not impossible – in the framework of modern financial economics to generate a logical argument (i.e., a model) for how a short-term gain can be larger than a properly-valued and larger longer term gain that would otherwise be available, keeping constant risk and the like. After all, shareholders, it seems, care about risk-adjusted wealth, and want more of it rather than less. That is why financial economists, as a rule, do not take the short-termism assertion seriously. It assumes a level of investor irrationality that the facts cannot bear. As one reputable financial economist puts it, while there exists the view that “executives have the long-term interest of their corporation at heart, while shareholders, who can trade in and out, are only interested in short term results … I do not know of any empirical support for this view.”

In a recent essay, “The ‘Long Term’ in Corporate Law,” I make a simple claim: The short term/long term rhetoric in corporate law masks the real battle, one between a rational desire by clear-sighted shareholders for shareholder value maximization, on the one hand, and a desire by courts and others for corporate longevityi.e., long-term corporate survival – on the other. Corporate law directs, or at least allows, directors to manage for long-term existence, i.e., a state of sufficient ongoing profitability that allows the corporation to exist for as long as possible, regardless of whether or not that level of profitability is value-maximizing for shareholders. A bias to longevity may benefit others who deal with the corporation, those “stakeholders” who include employees, creditors, suppliers, customers, and even local communities. Part of my claim is that this bias is unstated, but perhaps intentional. This idea is increasingly visible in the writings of our most influential corporate jurists. Very recently, Delaware Chief Justice Strine wrote:

Why can’t we, people ask, have corporations focus on the creation of sustainable wealth, by engaging in fundamentally sound and sustainable business investment and operations? And by doing that, create jobs that investors, their children, and grandchildren can have to live well. By that means, end-user investors will have the main thing they really need, which is a good job. And they will also have a solid investment portfolio to provide for themselves in retirement and to pay for their kids’ education. Wouldn’t we all be a winner, they ask, with this sort of alignment?

But there are problems with masking longevity as a legitimate concern with shareholder welfare.  If Delaware allows corporations to focus on longevity, then that is a goal often at odds with what shareholders want. Empirically, a view of corporations as properly managed to a sustained path of ever-upward profitability ignores the realities of corporate growth and decline. A much under-emphasized empirical fact is that most stocks do poorly in the long run. If the empirical facts teach us anything, it is that pushing off the day of corporate reckoning to the long run often will turn out poorly. “Longevity” is a tough goal, and we need to recognize that fact when setting the rules for directors of for-profit corporations. It may not be as bad for corporations as Keynes said of people, that “in the long run we are all dead,” but for many corporations, it gets pretty grim in the long run. At a minimum, long-run superior performance is quite rare. Shareholders know that.

Logically, it does not follow from the premise that investors want long-term wealth that investors also want or expect any individual corporations in whose stock they invest to seek the prudent preservation of value. For rational investors who are well diversified (index investors, say), what matters is the performance of their portfolio as a whole. Such investors do not value corporate longevity as an independent objective; they value wealth accumulation in the portfolio. Empirical evidence shows that corporations with more-diversified controlling shareholders are more willing to take risks, generally considered by financial economists to be a good thing, since undiversified shareholders are more likely to forgo positive net present value projects. If a corporation in the S&P 500 is more valuable by paying out excess cash flows, and those cash flows are reinvested in the index’s higher growing components, then my kids’ college educations and my retirement benefit from what might otherwise seem to be short termism. With apologies to Neil Young, it can be better for a stock in a diversified portfolio to burn out (profitably) than fade away (unprofitably). We can certainly find examples of corporations that Delaware law protected, only to see the corporation fail in the long run. Polaroid comes to mind. That is not to overlook the human costs of corporate decline. Perhaps we should change corporate law and other laws to deal better with corporate decline. My point here is not otherwise, and I am sympathetic to that line of reasoning. My point is that we should not pretend that smart shareholders (qua shareholders trying to accumulate wealth for consumption) prefer something they don’t – corporate longevity.

These are preliminary thoughts, but there are reasons to explore this idea further. It is surprising in the first place that the long term should have such a privileged position in things so unpredictable as shareholder welfare, business, and the economy. Prediction is hard, in those domains, too.  In any case, the role of the “long run” in corporate law – whether or not it means longevity as I’ve proposed here – deserves more study. Even though no one seems to know what it means, it is having a large impact on current debates about hedge fund activism, for example, and perhaps it is affecting more than notice as well.

This post comes to us from J.B. Heaton, a partner in the law firm of Bartlit Beck Herman Palenchar & Scott LLP. It is based on his recent essay, “The ‘Long Term’ in Corporate Law,” available here. The views expressed in the post are his own and do not necessarily reflect those of the firm or its attorneys or clients.