How can long-term shareholder value be achieved?
Academic and business leaders have tried for a long time to define the purpose of a corporation. This pursuit has provoked a fierce debate that pits advocates of the “shareholder theory” against supporters of the “stakeholder theory” of corporate governance.
The shareholder theory asserts that corporate boards have a primary duty to maximise the financial interests of shareholders. However, under the stakeholder theory, managers must balance the interests of all the stakeholders, which include not only shareholders, but also customers and employees, and in some versions of the theory, the community, the environment and even creditors and competitors.
Both sides lament the short-term thinking that pervades corporate management, but the solution may very well sit outside of either framework.
Many stakeholder jurisdictions have legal mechanisms that formally give stakeholders a voice in governance. For example, German law requires employee representation on the supervisory board of a corporation’s two-tiered board system. Under U.S. corporate law (primarily state law), managers owe duties of care, loyalty and good faith to the company and its shareholders. Many states allow investors to form special for-profit “public benefit” corporations, which require their boards to consider the interests of the other stakeholders. But that is the exception. Managers of most corporations are not legally required by corporate law to consider stakeholder interests. Therefore, many deem the U.S. a shareholder theory jurisdiction.
Company managers in the U.S., however, have wide discretion under state law (the business judgment rule) to optimize the outcome for a variety of interest groups. Corporate social responsibility (CSR) initiatives can give the impression of good corporate citizenship, which in turn appeals to certain shareholders, employees and even more customers. But managers who create value for non-shareholder stakeholders as an end – which is what the stakeholder theory requires – may reduce shareholder value. The biggest deterrent against decisions that short change shareholders is a practical one – the potential threat of a shareholder lawsuit.
Criticisms of the theories
Under a stakeholder regime, executives can conceal their true intent by publicly asserting a colourable justification to support an initiative on behalf of another stakeholder. Balancing the interests of all the stakeholders may be impossible. Some commentators have suggested creating computer algorithms to help managers balance the interests of all the stakeholders, but such systems are not immune to hidden personal interests or the “capture” of any interest group by another. Furthermore, laws already exist to protect other classes of stakeholders, for example, consumer protection, environmental, and labour and employment laws.
The main gripe – at least in the current intermediated public company ownership environment – links shareholder primacy to stock buy-backs and other tactics that divert resources to enhance short-term metrics. These are resources that could otherwise be allocated to initiatives like innovation that drive long-term shareholder value. Critics of the shareholder theory also point to the corporate accounting scandals of the early 2000s as evidence of a flawed framework. The shareholder theory, however, requires managers to act “without deception or fraud”.
Incentives outside of corporate governance to create long-term value
If we accept the proposition that the role of a corporation is to promote long-term shareholder value, the question then is whether this can be achieved through prescriptive regulation that compels managers to take the long view or to balance stakeholder interests. An alternative point of view could preserve shareholder primacy and look in regulatory regimes outside of corporate governance altogether for policy and regulatory opportunities to create incentives for long-term thinking.
One potential place to start is patent law. Some technologies, for example, in the energy sector, take much longer to scale than the 20-year protection provided by U.S. patent laws. Current patent reform initiatives are mainly tort reform proposals aimed at patent trolls. A potential approach for policymakers to encourage long-term investment is enhancing the length and quality of patent protection for the owners of inventions that take longer to scale.
Another good place for reform is tax law. U.S. policymakers can incentivize long-term investment by following the UK’s lead and adopting an “innovation box” (or “patent box”). The box would impose significantly lower tax rates on intangible business income (relative to other business income) accruing from patents and other innovations in a way that complies with the OECD’s plan to combat Base Erosion and Profit Shifting (BEPS).
These are just two ways that policymakers can adopt regulatory innovations outside of corporate governance to drive the research and development necessary to maximize long-term shareholder value.
View the story as it originally appeared on The Economist Intelligence Unit.