Elizabeth Warren’s recently proposed Accountable Capitalism Act (“ACA”) has ignited a lot of controversy, with supporters hailing it as the way to save capitalism, while others argue that it will destroy capitalism. In my view, while it is a step in the right direction, there is a better way to solve the problem – more effectively and with less controversy.
But first, let’s take a quick look at what the Accountable Capitalism Act would do. Most significantly, it would require any corporation with over $1 billion in revenue to obtain a charter from a newly-created Office of US Corporations. This charter would expressly require the corporate board of directors to consider the interests of all the corporation’s constituents, including shareholders, customers, employees, and the communities in which they operate.
As our friends over at B Lab have reported, the ACA would essentially require that large corporations become benefit corporations. The benefit corporation is a new type of corporation authorized in recent years by legislation in several states. A benefit corporation is much like a regular corporation except that its management is explicitly empowered to consider the interests of constituencies other than its shareholders, it must provide an annual report to shareholders based on a third-party standard, and its managers are protected from liability when they do consider those other constituencies.
Both of these solutions — the benefit corporation and this proposed new federal corporate charter – are attempts to fix what Forbes describes as a “source code error in the operating system of capitalism” – the notion of shareholder primacy.
Shareholder primacy, sometimes referred to as shareholder value maximization, refers to the idea that a corporation’s sole purpose is to maximize profits for its shareholders. It has been cited as supposedly requiring that a corporation disregard the impacts of its actions on its employees, on the environment, and on the broader community in which it operates if any of those are in conflict with the maximization of profits. And, it is believed, a corporate director or manager who acts in a way that benefits some other constituency but doesn’t maximize profits may be personally liable to shareholders.
It’s easy to see how the notion of shareholder primacy can lead corporations to act in a sociopathic way, with single-minded devotion to profit at the expense of all else. Stock-based compensation to corporate managers incentivizes this myopic focus on shareholder profit, and fear of personal liability for doing otherwise strikes fear into their hearts. Given the enormous wealth and power held by corporations, it is also easy to see how this could cause great harm to all other constituencies, including employees, communities, and the environment.
Not surprisingly, the notion of shareholder primacy has been widely criticized. The late Cornell law professor Lynn Stout, in her 2012 book The Shareholder Value Myth, explains how putting shareholders first not only harms the public, but also harms corporations and their investors. Jack Welch, the former CEO of GE, famously described it as “the dumbest idea in the world.” It is frequently cited as the main reason wages have been stagnant for the past four decades, even as the wealthy have become far wealthier.
So what is the solution? The benefit corporation and Elizabeth Warren’s proposed federal corporate charter both seek to solve the problem by creating a new type of corporation that isn’t saddled with the myth of shareholder supremacy. And yet, while I applaud the good intentions behind both fixes, they share one critical flaw: They implicitly acknowledge that shareholder primacy is the law of the land. But is it?
Those who believe it is the law of the land may be surprised to learn that the notion has never been codified into any statute; and no court has ever ruled that it is the law in any general sense. Quite to the contrary, the well-established business judgment rule explicitly protects managers of a corporation for actions taken in good faith pursuit of the corporation’s best interests – even if those actions don’t necessarily maximize profit for shareholders. It is important to recognize that there are many things that may be in the corporation’s best interests but don’t maximize profits (at least not in the short term), such as R&D, new product development, employee training, community engagement, reductions in environmental footprint, and supporting local charities.
And yet, the notion that a corporate manager’s sole obligation is to maximize profits has become so widespread that it has become the de facto standard for corporations across America since the 1990s. In other words, even though it is not the law, the widespread belief that it is the law has contributed to the concentration of wealth, the impoverishment of workers, and environmental harm – as well as reduced long-term profitability of American corporations, as we’ll see in a moment.
In this context, a solution that implicitly validates this dangerous and destructive myth of shareholder primacy is a solution that just might do more harm than good. A better solution is to explicitly reject the myth altogether, and not just for certain kinds of corporation, but for all corporations.
While this may sound revolutionary, it is not. In fact, the notion of shareholder primacy only gained widespread acceptance in recent decades; it was not always that way.
The corporation as a type of legal entity came into existence as a means of achieving social purposes. The Hudson Bay Company, for example, was chartered in 1670 for the purpose of promoting trade, not for the purpose of enriching shareholders. Early corporations did pay dividends to their shareholders, but that was because investors needed some incentive to invest the capital that corporations needed. The dividend was a means to an end; it was never the primary purpose.
Shareholder primacy as we know it only came into prevalence in the 1980s and 1990s. Milton Friedman, probably its most famous proponent, preached that a narrow focus on maximizing profits would lead to improved corporate performance. And yet, history has shown otherwise. Author and economist James Montier has compared average corporate performance during what he terms the era of managerialism (1940 to 1990 – that is, before shareholder primacy took hold) and the era of shareholder primacy; and he has shown empirically that the single-minded focus on profit in recent decades has led to lower corporate performance. He points to several mechanisms for why this is so, including reduced funding for research and development (because more of a corporation’s profits are paid out to investors), lower employee satisfaction (because compensation is reduced and because their idea of the purpose for why they are there has become confused), and more focus on short-term results rather than long term results (because both corporate lifespans and manager tenures have gone down).
Black Rock, the biggest private asset manager in the world (with over $6 trillion under management), understands this, perhaps better than anyone. Its CEO Larry Fink penned a letter this past January to corporate CEOs explaining that it is time for all companies to make “a positive contribution to society.”
So how do we bring about a repudiation of the myth of shareholder primacy? It would be nice if there was a Supreme Court case confirming that shareholder primacy is not and never was the law of the land. That would lay the matter to rest. But it is unlikely that a case of that sort will work its way through the appellate process and reach the Supreme Court. Another solution would be for state legislatures to amend their corporation laws to explicitly state that managers will not be liable for actions taken in good faith after balancing the interests of all the corporation’s constituencies.
But we should remember that the pickle we are in is not because of bad laws, but because of widespread, albeit mistaken, beliefs about the law. In other words, it is a cultural problem. That being the case, there are ways in which we can all help bring about the demise of the shareholder primacy myth without waiting for any laws to change. We can write about it and speak about it. We can remind corporate managers that they can and should consider the interests of all constituencies. Business owners and managers can ensure that their own businesses adopt a more balanced perspective. We can include an express statement of corporate purpose in charter documents for our legal entities even if they are not formally organized as benefit corporations.
Running a business is never easy, and raising capital is typically even harder – made more so because investors have come to expect that shareholder primacy is the law of the land, and some work hard to insert priority rights to protect the financial investments they manage. While that may lead to quicker short-term profits, it does not lead to a healthy company. Our collective challenge is to help investors and corporate managers to understand that a balance must be struck that honors intellectual capital, human capital, stakeholder capital, and financial capital. When any one of those takes precedence, there are unintended consequences that damage the entire ecosystem of capital.
Circling back to Elizabeth Warren’s Accountable Capitalism Act, I note that it includes some other excellent ideas. For example it would:
- Require that at least 40% of the board of directors of these new US corporations be elected by the corporations’ employees – thus putting more control in the hands of those who care most deeply about the corporation’s purpose.
- Restrict sales of company stock by its directors and officers for three to five years – which is intended to better align their interests with long-term shareholders rather than short-term shareholders.
- Prohibits US corporations from spending any money on lobbying without 75% approval by both its board of directors and its shareholders.
Yet even if the ACA does not actually become law, our hope is that it furthers a very important conversation about the role and purpose of corporations in our economy. We can no longer take bad ideas for granted as simply the way things should be. We need to envision a better way.
Naturally, nothing here should be considered legal, investment, or tax advice. If you would like to like to discuss capital raising or entity structuring with one of us at Cutting Edge Capital, click here