The three primary determinants of economic growth – physical capital growth, human capital growth, and technological innovation – rely on citizens’ confidence that private property rights are secure. Essential to that confidence is the rule of law.
Rule of law is an important catalyst for financial development. It allows for an effective judiciary, which is critical for the enforcement of legal contracts. Shareholders rely on the contractually created limited liability feature of equity to undertake risky, but value-enhancing, investments. That feature is essentially a contract between shareholders and debtholders (and other stakeholders) providing that, when a company’s fortunes sour, shareholders can only be held liable for up to the amount of their investment. An effective judiciary that enforces contracts is critical to shareholder trust and reliance in the limited liability feature of equity.
Contracts between shareholders and debtholders also guarantee important rights to debtholders. These rights provide the debtholders with the confidence and trust in the shareholders to make loans to shareholders. Debtholder rights include (a) the right of first claim on the company’s cash flow up to the amount of the promised payment to the debtholder and (b) the right to force the company into bankruptcy and take over legal ownership of the assets of the company if the company’s cash flow is not sufficient to make the promised payment to the debtholder. In short, debtholder rights and shareholder reliance on limited liability depend on an effective judiciary to enforce contracts. Rule of law is necessary for the existence of an effective judiciary.
This highlights the importance of the rule of law in enabling companies to raise equity and debt financing, leading to financial development. Given this background, we analyze in a new paper the current debate among policymakers, corporate leaders, institutional investors, and social activists on the purpose of the modern corporation.
The modern corporation has been an enormously productive societal and organizational invention. Large corporations have figured prominently in the economic growth of the industrial world over the past century. Core ideas of the corporate construct, including respect for private property rights within the framework of the rule of law, has lifted billions of individuals around the globe in recent decades from poverty toward middle-income and decreased income inequality.
What has guided corporations to enhance growth and well-being? In recent decades, as Milton Friedman argued, the contemporary corporate objective was encapsulated in the shareholder primacy view, which argued for maximizing the company’s long-term shareholder value while conforming to applicable laws and regulations. Fifty years after he articulated it, Friedman’s statement remains a good guide under some broad assumptions. Recently, the Business Roundtable’s Statement on the Purpose of the Corporation committed a board to other stakeholders as well – including customers, employees, suppliers, and communities the company operates in. But importantly, if labor markets and product markets are competitive, the shareholder primacy and stakeholder paradigms would lead to identical corporate policies. When these markets are not competitive, differing time horizons and risk exposures of various stakeholders could lead to differing corporate policies; these are bright lines justifying public policy interventions. But such public policy interventions are a complement to, not a substitute for, long-term shareholder value maximization.
To strengthen the prospects for success of long-term shareholder value maximization, we suggest steps to align shareholder wealth maximization with stakeholder interests. First, antitrust laws should be vigorously enforced to maintain and enhance competition in product markets and labor markets. Second, management and board compensation should be reformed to focus on creating and sustaining long-term shareholder value. Third, the Business Roundtable and other organizations should reconsider their efforts to pressure corporations to focus on non-shareholder priorities. Because public corporations are more susceptible to such pressure, it could persuade them to go private or not go public. Recent evidence suggests fewer public companies leads to more concentrated product markets, which are likely to be less competitive. . Finally, corporations are not well equipped to address many of society’s most serious problems. Climate change, for example, poses significant challenges for societies and businesses. But effectively fighting climate change requires public policy changes in the United States and abroad. Turning more to corporations because the political process seems broken won’t do.
Clear objectives and strong governance facilitate accountability of corporate leaders and boards of directors and shape corporate activities. Pursuing broad or diffuse objectives complicates accountability, limits value creation by businesses, and may dissuade businesses from becoming corporations. Pursuing narrow objectives can lead to conflicts among shareholders and between shareholders and other non-shareholder stakeholders. Corporate focus on long-term shareholder value maximization remains the best way to enhance overall value and corporations’ broader contributions to society.
Where externalities or non-market objectives are important, other mechanisms or public policy interventions can expand or limit the options for value-maximizing corporations, and most externalities require external policy action. Government intervention can also prepare workers and locales for economic shifts prompted by globalization or technological change. But these are government interventions, and political polarization does not make corporate actions the logical alternative. In fact, making the purpose of the corporation anything other than long-term shareholder value maximization risks vagueness that can disrupt the wealth-producing and job-creating power we expect from corporations.
A half-century on, Friedman’s belief in shareholder primacy remains the right place to start, though it is not the entire story.
This post comes to us from professors Sanjai Bhagat at the University of Colorado at Boulder and R. Glenn Hubbard at Columbia Business School. It is based on their recent article, “Rule of Law, and Purpose of the Corporation,” available here.