What Comes After Shareholder Primacy? Employee Empowerment

In corporate law, the U.S. academic elite stubbornly clings to shareholder primacy as the foundational principle of the field. The concept is simple, even elegant: Shareholders should be given ultimate control of the corporation because they are entitled to the residual – the leftover profits after all other contractual constituents have been paid – and they therefore have the proper incentives to maximize the overall value of the firm.

At an earlier time, shareholder primacy was more of a call to arms. As Berle and Means first identified, dispersed shareholders in the early 20th century were subject to the predations of management, who felt no real governance pressure to cater to their interests. Later academics such as Manne, Friedman, and Easterbrook & Fischel gave the world a more robust and exacting theory of shareholder primacy, which granted corporate players full license to restructure the corporate landscape. The idea (and ideal) of shareholder wealth maximization not only took over the fields of finance, economics, and corporate law – it also became the lodestar for boardrooms, activist shareholders, and even union pension funds. But the result of giving all governance power to these corporate participants has been predictable. Corporate profits and stock buybacks have risen, while employees’ wages have stagnated and their share of GDP has dropped.

Within recent corporate law scholarship, the debate has not been whether the corporation should seek to maximize shareholder utility, but how. Shareholder-rights advocates push to interject the will of shareholders into governance by giving them access to the company’s proxy ballot, eliminating dual-class shares, and restricting common ownership. Despite their grounding in academic theory, these policy proposals have engendered a fair amount of controversy. Google, Facebook, and Snap have dual-class share structures in which common shareholders have weakened voting rights – or none at all. And many academics have begun to question whether shareholders — be they dispersed small-time day-traders, activist hedge funds, or one of the Big Three Index Funds — deserve the governance obeisance required by shareholder primacy.

Advocates of stakeholder theory have provided the consistent yin to the yang of shareholder primacy; or perhaps, more accurately, have played the Generals to shareholder primacy’s Globetrotters. They reject the idea that the corporation should maximize shareholder wealth; it should instead promote the interests of all corporate participants: shareholders, customers, employees, suppliers, and communities alike. The Business Roundtable recently advanced this vision, proclaiming that all stakeholders are “essential” and committing to “deliver value to all of them, for the future success of our companies, our communities and our country.” But turning stakeholder theory into governance reality has long proven to be an intractable puzzle. In practice, stakeholder theorists have tended to hand absolute power over to the board and the C-Suite and hope for the best, which makes the Business Roundtable’s proposal look a little less radical (and a little more self-serving).

The problems of income inequality, short-term time horizons, and inattention to social and environmental harms are all exacerbated by shareholder primacy. We need to reconsider the basic structures of corporate governance. In our paper, “Reconstructing the Corporation: A Mutual-Control Model of Corporate Governance,” we argue that the exclusive shareholder franchise is at the root of our economic pathologies and needs to give way to new models. We then provide a new model supported by both traditional economic theory and a new theory of democratic participation.

As we have detailed in past work, the theoretical framework for shareholder primacy has largely disintegrated. In particular, the law-and-economics justifications for the exclusive shareholder franchise rest on flawed assumptions and misapplied social choice theory, and often run counter to the fundamental principles of standard economics they purport to rely upon. One of the justifications, for example, provides that shareholders have a homogeneous interest in wealth maximization, a premise that’s undercut by recent revelations that real shareholders have complex sets of intersecting desires and agendas that belie any claim of uniformity. An argument based on Arrow’s theorem misreads and misapplies the lessons of the theorem; indeed, if anything, the looming specter of voting cycles is made more likely by restricting the corporate electorate to shareholders alone. The argument that the corporation is merely a nexus of contracts is based on a proposition that is both factually and legal incorrect and, therefore, a misguided justification for mandatory and default shareholder governance rights. And, more broadly, the inverse fortunes of shareholders and employees over the last half century demonstrate that shareholders do not mop up whatever’s left after other stakeholders have been satisfied; instead, corporate leaders have rewarded shareholders with dividends and buybacks while they push down labor costs through stagnant wages, subcontracting, and outsourcing.

The answer to our difficulties with shareholder primacy is not to hand over unaccountable authority to corporate boards. Board primacy theorists would have us rely on the good graces of board members (described variously as “Platonic guardians” and “mediating hierarchs”) to look after all corporate constituents rather than just the ones who elect them. But it’s not enough to ask companies to voluntarily look after their employees, their customers, and the environment. Instead, the basic governance structure of the corporation must be changed to provide the necessary checks and balances against both unfettered managerial control and overweening shareholder desires.

There are both economic and political reasons to believe that employees are best positioned to provide this counterbalance. The concept of employment is critical to the economic theory of the firm. As Ronald Coase contended in The Nature of the Firm, “We can best approach the question of what constitutes a firm in practice by considering the legal relationship normally called that of ‘master and servant’ or ‘employer and employee’.” By taking employment inside the firm, Coase argued, businesses reduce transaction costs by replacing a market for labor with a hierarchical relationship. Employees also participate in the Alchian & Demsetz model of team production, in which several types of resources are combined to produce goods or services, and these joint products are not easily divisible according to their inputs. The facilitation of joint production is the purpose of the firm, and employees are central participants in the firm.

The basic political theories about how to best aggregate preferences also help explain which corporate constituents should have corporate voting rights (and, just as importantly, which should not). We usually extend governance rights to groups with a stake in an enterprise so long as there is some manageable way to pick them out, some marker of that interest. Both shareholding and employment are the kind of accurate and manageable markers of interest that counsel in favor of extending voting rights to those groups; other corporate constituents are not so situated. Thus, this theory of democratic participation also counsels in favor of extending voting rights to employees in ordinary corporate governance situations.

Change may be coming. In the past year, Senators Warren and Baldwin have each introduced legislation that would provide workers with significant minority representation on corporate boards. The German model of codetermination, long dismissed as an aberration by many corporate law scholars, has received important empirical validation for its stability in crises and its long-term value creation. And as growing populist unrest calls into question the effects of the global capitalist revolution, we are searching for new responses to income inequality, reckless corporate behavior, and a sense of structural economic disengagement. Employee representation addresses these problems.

Shareholder primacy should no longer dominate the conversation surrounding corporate law and governance. The flaws in the theory are too apparent. As we begin to unpack the theory from its foundational mythologies, we must focus on the purpose of firms and the importance of people to economic production. Bringing employees into the governance structure will balance the system, improve information flows, and facilitate long-term sustainable economic success.

This post comes to us from Professor Grant Hayden of SMU-Dedman School of Law and Professor Matthew Bodie of Saint Louis University School of Law.  It is based on their recent article, “Reconstructing the Corporation: A Mutual-Control Model of Corporate Governance,” available here.

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