Stockholders vs Stakeholders

In theory, private corporations are run for the benefit of their stockholders; insofar as the theory is enforced in practice, it is through two different mechanisms. One is the fiduciary obligation of corporate directors, the fact that under U.S. corporate law they are obliged to run the firm in the interest of its stockholders.¹ How much effect that obligation has is not clear, given the obvious difficulties with having a court second guess the decisions of the firm. The second and probably more important mechanism is election of the board of directors by a vote of the stockholders. If holders of a majority of the shares are unhappy with how the corporation is being run they can replace the existing board and so the existing management.

The holder of one share of stock, like an individual voter, knows that his vote is unlikely to change the outcome and so has little incentive to spend time and energy judging how well the firm is being run in order to exercise his voting power. But votes in the corporate context, unlike votes in the political context, are transferable; each is attached to a share of stock and shares can be bought and sold. If a corporation is doing a sufficiently bad job of maximizing stockholder value, someone with the necessary assets and expertise can buy up lots of shares. Since owning lots of shares gives you lots of votes, he can then, perhaps in alliance with other large shareholders, vote out the board, replace management and, when it becomes clear to others that the firm is now doing better for its stockholders, sell his shares at a higher price and go looking for another badly run firm to buy stock in. Takeover bids often get a bad press, possibly due to the efforts of incumbent managers who would prefer not to be replaced. They have been made more difficult both by legal rules and by defensive tactics developed by corporate managers but they still provide people running corporations with a reason not to deviate too far from doing what, in theory, they are supposed to do.²

Some people, including a past colleague of mine whose work first got me interested in the issue, argue that the theory itself is wrong. Decisions made by a corporation affect not only the stockholders but other people as well, most obviously customers and employees. Why not alter the legal rules to give all stakeholders, all people affected by the corporation's decisions, a voice, either by broadening the fiduciary obligation of directors or by expanding the electorate, giving votes to customers, employees, perhaps others, as well as to stockholders.

The reason that is neither necessary nor desirable is that those stakeholders already have protection. A corporation is constrained not only by the legal obligations of the directors and the mechanisms for electing them but by the market on which it sells its outputs and buys its inputs. A customer who finds that its products are more expensive or less desirable than those offered by competitors does not have to intervene in the internal affairs of the corporation to solve the problem, he can simply stop buying what the corporation is selling. An employee who finds that the corporation is offering worse terms than alternative employers can quit. Since the corporation requires customers to provide the money with which it pays dividends to its stockholders and salaries and bonuses to its management and employees to produce the goods and services that it sells to those customers, it has a direct and immediate incentive to produce what customers want to buy and provide employment terms that employees are willing to accept.

Like most mechanisms, this one is imperfect. Customers are not perfectly informed about what they are getting or the alternatives and customers for some goods and services are partly locked in by previous choices. Having spent time and effort learning to use the hardware and software on which I am writing this, I would be willing to switch only if the quality went down quite a lot or the price up quite a lot, so the firms providing the hardware and software have some ability to benefit themselves at my expense without losing my business. Having accepted one job, there would be significant costs to shifting to another, costs of learning my way around a different university, perhaps moving to a different location. Hence my employer as well had some ability to benefit itself at my expense.

But my situation as customer and employee is very much better in this respect than my situation as a stockholder. As a stockholder I have the option of selling my shares of stock, which at first glance looks equivalent to my option as a consumer of not buying a product or as a worker of quitting a job, but the similarity is an illusion. If I choose not to spend forty thousand dollars buying a car from Ford, Ford has one more unsold car and forty thousand dollars less money. If I choose to sell forty thousand dollars of Ford stock, the money I get is not coming from Ford; another investor now owns the stock, leaving Ford itself unaffected. From the standpoint of the firm's incentives it is as if, every time a customer wished to stop buying from a store, he was required to first find a new customer willing to take his place, or as if an employee could only quit if he provided a replacement willing to do the same job at the same pay.

The stockholder's view of the value of the stock directly affects the firm only if it wishes to raise capital by selling a new issue of stock. So far as existing stock is concerned, the shareholder is locked in; if the firm is being run in a way that fails to maximize stockholder value he cannot escape that cost by selling his share, since the price he can sell it for will reflect the expected reduction in future profits.

As a customer of Apple I am to some limited degree locked in; I can switch to hardware and software from another firm but only at a significant cost. The same was true of my situation as an employee of Santa Clara University. In both cases I had born what became sunk costs as a result of my initial decision to buy a product or accept a job. But as a stockholder in Apple I am entirely locked in; all of my cost is sunk. If Tim Cook announces tomorrow that he plans to run Apple entirely for the benefit of its employees and customers, never paying another dividend, the fact that I can respond by selling my stock provides me no protection.

The stockholder is dependent, much more than the other stakeholders, on other ways of getting the firm to act in his interest. That is an argument in favor of the current mechanism for corporate control and the legal rules defining the fiduciary obligation of the directors. More than that, it is an argument for strengthening stockholder control by removing current barriers that make takeover bids more difficult and so make it easier for managers and directors to serve their own interests at the expense of the stockholders.

One example of such a barrier is the rule requiring anyone accumulating stock in order to take over a company to make the fact public as soon as he acquires more than five percent of the outstanding shares of any class. That reduces the incentive to find badly run companies, buy stock in them, replace the management with more competent people and sell the stock at the resulting higher price, since any stock you buy past five percent will be bought at a price reflecting the seller’s knowledge of what you are doing.

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1. Current UK law contains a broader statement of a director’s obligations:

Duty to promote the success of the company

(1)A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a)the likely consequences of any decision in the long term,

(b)the interests of the company's employees,

(c)the need to foster the company's business relationships with suppliers, customers and others,

(d)the impact of the company's operations on the community and the environment,

(e)the desirability of the company maintaining a reputation for high standards of business conduct, and

(f)the need to act fairly as between members of the company

(Companies Act 2006). S172.

2. One economist has proposed applying the same mechanism to political democracy by making citizenship, and the associated vote, marketable.