Management: Shareholder Wealth Optimization

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Table of Contents

Introduction
A Case against Shareholder Primacy
Arguments in Favour of Shareholder Primacy
Conclusion
References

Introduction

In 1970, the distinguished economics professor Milton Friedman wrote an essay in which he argued that the sole social responsibility of a company is to generate profit for its shareholders. Bejou (2011) notes that the core message that Friedman was advancing through his argument was that the primary responsibility of managers was to the owners or investors of the company.

This outlook is regarded as the traditional shareholder primacy theory and its main argument is that the primary task of management is to maximise shareholders wealth. The school of thought further on proposed that organizations should not be concerned with solving social problems since this the responsibility of other actors such as the government. Friedman’s defence of managers’ duties to shareholders continues to be the prominent concept dominating corporate governance.

In line with this reasoning, many top managers of public corporations today seek ways to increase the profits of their shareholders. This begs the question what is should the primary role of management in public corporations be. This paper will argue that management should expand its role and responsibilities to cater to the needs of other stakeholders in addition to the shareholders and owners of the company.

Increasing the wealth of shareholders and owners should not be the core objective of management. To provide a balanced view on the subject, the paper will also review some of the arguments made in support of shareholder wealth optimization by management and offer counterarguments to the same.

A Case against Shareholder Primacy

Corporations cannot exist on their own; they need the input of other groups such as creditors, employees, and the government (Stout 2002). As such, the shareholders alone cannot make, much less sustain a corporation. For this reason, the other contributors to the existence of the corporation also need to be considered by management. Stout (2002) elaborates that the non-shareholder groups who contribute to the welfare of the corporation also need to be compensated in accordance to some explicit and/or implicit contracts.

For example, the employees will engage in operations on behalf of the organization in return for a salary, favourable work conditions, and prospects of career advancement. If management’s only concern is shareholder wealth, they organization will not be sustainable and it will fail therefore hurting the shareholders and all the other stakeholders. Management that is focused only on maximizing the wealth of shareholders will damage the firm’s economic interests.

Stout (2002) states that such management will be inclined to take wealth and resources from other corporate constituencies such as employees, creditors, and governments in order to increase shareholder wealth. Management therefore needs to consider the other groups who make a contribution to the corporation’s survival.

Emphasis on increasing the wealth of shareholders and owners will reduce the productivity of the firm since it might lead to lower employee motivation (Kellerman 2007). Motivation is a highly desirable attribute in employees since motivated employees are integral to the success of the business.

Kellerman (2007) explains that job satisfaction plays a significant role in creating motivated employees who in return direct their energies to meeting organizational goals. If management only considers the profit interest of the shareholders, they are going to sell the corporation to the highest bidder without considering the losses that may arise to the employees and the local community.

Employee motivation will be diminished if the workers believe that the management will sell the company to the highest bidder even if such a move will negatively affect them. Such employees are unlikely to commit their careers or give their loyalty to the corporation. This will result in reduced productivity for the company and this will reduce returns to shareholders.

Shareholder primacy has led to risky financial undertakings by management in their question to increase shareholder value (Bergstresse & Philippon 2006).

Many organizations have tied the pay received by top managers to the share price in an effort to incentivize them to increase company performance. Managers therefore have a vested interest in the increased profitability of the organization and they are motivated to ensure that shareholder interests are met.

Bergstresse and Philippon (2006) confirms that many bit US corporations are in the habit of offering extravagant pay packages to their top executives as a means to align the upper management interests with those of shareholders. When the self-interest of managers is tied to the wealth of the shareholders, they are likely to make decisions that are only aimed at short term gains by the organization.

Such an approach might have dire consequences for the organization and the society at large. For example, the financial crisis of 2008 which led to a global recession has been blamed on top managers allowing self-interest to prevail over any other concern. Emphasis on increasing shareholder wealth can cause risky behaviour by management and this might damage the corporation.

The best interest of the shareholder group is not always served by profit maximization by management and therefore, the shareholder value ideology can lead to negative impacts on the well-being of the company and its investors (Stout 2012).

Stout elaborates that an organization has various classes of shareholders and their needs and interests vary depending on their degree of investment and interests. While some may be concerned in the short-term earnings of the company, others might be interested in the long-term performance of the organization.

The view that management should only seek to increase shareholders wealth is based on the wrong assumption that increase in share price is proof of greater economic efficiency by the company in question. Stout (2012) forcefully asserts that the performance of a business cannot be measured through any one single metric. By focussing on share price and ignoring other variables such as capitalization, board structures, and equity to name but a few, a wrong assessment of the company is bound to be made.

Focussing on increasing profitability might discourage investment and innovation therefore harming the employees and the customers of the organization. Holmstron and Kaplan (2001) declare that managers who view themselves as representatives of the corporation and not the shareholders are likely to maintain a long-term vision of the company and therefore take steps to ensure its growth and stability.

Management needs to avoid being obsessed with increasing the wealth of shareholders and owners in order to serve the best interest of the shareholder group.

Focus on shareholder profitability will cause an organization to ignore the needs of the non-shareholder entities and this might be detrimental to the organization’s future. Organizations are affected by factors that are internal and external to them. Albright (2008) highlights the importance of the organization to have a good understanding and demonstrate sensitivity to the needs of its environment.

There is a strong interdependence between the corporation and stakeholders such as customers, suppliers, creditors, the media, and activists. Management is therefore forced to balance the interest of shareholders with those of the other stakeholders in order to create a win-win situation from which everybody can benefit.

Shareholder wealth maximization will negatively affect the economy of a country since it might lead to reduction in production and the raising of prices by managers in a bid to increase profits (Solo 2000).

This is especially the case if the organization holds a monopoly in the industry. As a monopoly, the corporation has the discretion to restrict production and raise prices without fear that the competitive forces will oblige it to react to the demand-supply forces.

If the management in such a monopolistic organization holds strong shareholder-primacy view, his only concern will be to increase profitability. This will be achieved by lowering production in order to create excess demand and then raising prices.

The manager could also lower the employment in order to reduce the production cost incurred by the company. All these factors will hurt the economy of the nation since it will lead to reduced production. The expansion of the company will also be deterred if the managers are only concerned with increased profitability. Emphasis on profits has led to many layoffs and mergers, which have driven the stock prices of company’s up at a considerable social cost.

The American workforce has been the worst affected by the shareholder primacy norm practiced by many top executives. Grossman (2005) reveals that in the past two decades, over 45million Americans have been laid off as corporations downsize in order to increase their profitability by raising stock prices. Stout (2012) observes that managers who have weak shareholder wealth maximization norms are more likely to concentrate in increasing sales and industry expansion instead of aggressively trying to increase profitability.

The manager whose primary objective is not to increase the shareholders wealth will invest in larger firms and build new factories in order to increase the production capacity of the organization. This will result in an increase in social wealth. Emphasis on shareholder wealth maximization will be detrimental to the economic well-being of the society.

The purpose of the organization is not only to make money for the business owners but also to fulfil other social functions which include ” secure jobs for employees, better quality products for consumers, and greater contributions to the welfare of the community as a whole” (Stout 2002, p.1989).

This is in line with Dood’s assertion that the business corporation is “an economic institution which has a social service as well as a profit-making function” (Stout 2002, p. 1989). If management is only concerned with shareholder interests, they will not make an effort to fulfil the obligations of the organizations to the society.

Green (1993) explains that when the primary objective of management is confined to increasing shareholders and owners’ wealth, they cannot dedicate resources or managerial time to worthy causes since this will be deemed as embezzlement of organization resources. Shareholder primacy therefore makes it impossible for management to fulfil other social functions and therefore ensure business success.

A more prudent approach would be for management to try to maximize the “sum of all the returns enjoyed by all of the groups that participate in firms” (Stout 2000, p.1198). Such an approach would stop managers from taking actions that result in the maximization of wealth of shareholders in the short run while negatively affecting all the other participates in the firm.

The shareholder wealth maximization norm is outdated since it refuses to acknowledge the importance of adopting socially responsible practices for the welfare of the business (Grossman 2005). Focus on shareholder profit maximization will lead to the removal of social factors that might reduce shareholder wealth. In today’s business environment, the financial performance of an organization is increasingly interconnected with its social performance.

While organizations could in the past ignore the needs of the non-shareholders and still survive, the current environment is forcing companies to align their interests with those of the society order to ensure their future survival.

The last few decades has witnessed an increase in the importance attributed to Corporate Social Responsibility (CRS). CRS. Stout (2012) observes that an emphasis on CRS by European companies has enabled them to compete favourably with the American multinationals that have dominated the global market for decades.

Adopting the shareholder primacy theory will therefore hurt the overall performance of the business since management will fail to satisfy social interests. Grossman (2005) best articulates this by stating that “in order to truly maximize profits a company must engage with social interests” (p.575). Managers should seek to not only produce good returns for investors but also provide good work conditions for the workforce and serve the community by making quality products and being a good corporate citizen.

Management has a moral and ethical obligation to consider the interests of all stakeholders in their decision making (Boatright 2006). These obligations include a guarantee to honour agreements and contracts, honesty, and legitimacy in conducting business to name but a few. Shareholder primacy might cause management to ignore its moral obligations when they do not contribute to an increase in the profitability of the corporation. Managers can ignore ethical obligations that and agreements that are not codified in laws.

The public confidence in corporations is significantly lowered by the culture of profit at all costs (Jenster & Hussey 2001). For an organization to function effectively, it needs to gain the confidence of the market. This confidence will increase the chances that people will be willing to invest in the corporation or endorse its products.

Arguments in Favour of Shareholder Primacy

The major reason given by advocates of shareholder primacy is that the corporation belongs to its shareholders and due to this ownership; their interests should be put first (Holmstron & Kaplan 2001). Friedman best advocated this school of thought in his 1970 essay where he noted that managers are agents who have promised to serve the shareholders who have entrusted them with their property (Green 1993).

Management is therefore bound to act diligently in the best interest of the owners. Stout (2002) reveals that this argument is flawed since shareholders do not in actual fact own the corporation but rather own stocks which means that they their ownership is limited. Boatright (2006) agrees with this by noting that shareholders do not own the corporation in the same way that a person could own a house or a vehicle. The alleged ownership refers to the bundle of rights that these group has.

Shareholder primacy is based on the premise that more profits will lead to the creation of wealth for individuals that will in turn benefit society (Husted & de Jesus 2006). This argument holds true since creating wealth for individuals makes the community dynamic and people are able to engage in more economically productive endeavours.

A look at the prominent economic systems of the world supports this since the capitalistic ideology which favours the capital contributors in the society is the most successful and vibrant system in the world. Placing emphasis on profits leads to strong performance by the corporation. Husted and de Jesus (2006) observe that strong industrial performance is beneficial to the society.

Proponents of shareholder primacy argue that profit seeking will result in more efficient utilization of resources by management in order to increase productivity and in the end, offers the greatest benefits to the society as a whole. While it is true that shareholder primacy will result in higher returns, this wealth is not distributed to a large number of society members.

Instead, it is concentrated within a few disproportionately wealthy members of the society. The argument that shareholder primacy will benefit society by creating wealth for many individuals in the society is therefore not entirely true. With this consideration, Grossman (2005) suggests that corporations owe an obligation to society to at least be good corporate citizens and provide some social services even if these might decrease their profits.

Social responsibilities imposed on business may hamper business growth and render it unable to operate (Husted, BW & de Jesus 2006). Friedman argued that management “possess neither the authority nor the moral right to divert shareholders’ profits for the welfare of the general public” since they are merely agents of the stockholders (Grossman 2005, p.574). Advocates of shareholder primacy reinforce this argument by asserting that it is not right for the society to impose welfare obligations on the corporation.

If individual stockholders choose to use their profit for worthy causes, they can do this but the choice should not be made by managers who have been appointed to run the company. While market forces should be the main determinant of how the corporation reacts, the corporation has an obligation to the society. Businesses have to conform to the basic rules of the society and avoid seeking only profits.

Stakeholders assume significant risk by investing their resources to the firm and for this reason, their financial interests should be the primary objective of management. Individuals who invest in corporations do this in the hope of achieving greater returns in business than they would if they engage in business activities independently.

Boatright (2006) states that the prospect of significant financial benefits is what makes individuals with economic assets voluntarily agree to contribute their assets to production in an organization. Shareholders are likely to suffer from personal losses if the corporation fails. This is because they are the people who have invested money into the organization.

Since shareholders agree to take up significant risk in investing in the corporation, it is appropriate for the managers to work towards ensuring that these risk takers obtain high levels of profit from their shares. Risk taking does not give the stakeholders all the power over the corporation. While the other stakeholders might not take the risk, their involvement facilitates the profitability of the organization. Their concerns should therefore also be addressed.

Conclusion

This paper set out to dispute the accepted financial axiom that the primary objective of management is to increase the wealth of shareholders and owners. The paper has demonstrated that the shareholder wealth maximization concept does not serve the best interests of the society as a whole. It has shown that the assumption that shareholder primacy and other party’s interests coincide since the maximization of stockholder wealth improves the welfare of society is wrong.

It has revealed that the view that companies with rising share prices are economically efficient is flawed since business performance should not be measured through a single metric. Weak shareholder wealth maximization norms have also been observed to be healthier for the economy of a nation since they can have the impact of increasing national wealth through increased production.

Voices have over the last two decades been raised against the shareholder primacy model advocated by Friedman. Corporate managers are increasingly required by the society to consider the interests of more than just the shareholders and owners of the company. This paper has demonstrated that corporations are faced with expectations not only from their shareholders but also from their employees and the society.

They must therefore act in a manner that takes into consideration the needs of non-shareholder actors. A corporation that addresses societal needs has a greater chance of succeeding and therefore increasing the value for its stakeholders. Management should therefore overcome its predisposition to only focus on the needs of the shareholders and make decisions that appeal to the needs of all the relevant stakeholders.

References

Albright, SK 2008, ‘Environmental scanning: radar for success’, The Information Management Journal, vol. 12 no. 2, pp. 38-45.

Bejou, D 2011, ‘Compassion as the New Philosophy of Business’, Journal of Relationship Marketing, vol. 10 no. 1, pp. 1-6.

Boatright, J 2006, ‘What’s Wrong – and What’s Right – with Stakeholder Management’, Journal of Private Enterprise, vol. 11 no. 2, pp. 106-130.

Green, R 1993, ‘Shareholders as Stakeholders: Changing metaphors of Corporate Governance’, Washington and Lee Law Review, vol. 50 no. 4, pp. 1409-1421

Grossman, A 2005, ‘Refining the role of the corporation: the impact of corporate social responsibility on shareholder primacy theory’, Deakin Law Review, vol. 10 no. 2, pp. 572-596.

Holmstron, B & Kaplan, NS 2001, ‘Corporate Governance and Takeovers in the U.S.: Making Sense of the ’80s and ’90s’, Journal of Economic Perspectives, vol. 22 no.2, pp.121-144.

Husted, BW & de Jesus Salazar, J 2006, ‘Taking Friedman Seriously: Maximising Profits and Social Performance’, Journal of Management Studies, vol. 43 no. 1, pp 76-91.

Jenster, P & Hussey, D 2001, Company Analysis: Determining Strategic Capability, Wiley, New Jersey.

Kellerman, B. (2007) ‘What Every Leader needs to know About Followers.’ Harvard Business Review 85,(12) 84-91.

Solo, A 2000, Economic Organizations and Social System, University of Michigan Press, Michigan.

Stout, L 2002, ‘Bad and not-so-bad arguments for shareholder primacy’, Southern California Law Review, vol. 75 no. 1, pp. 1989-1210.

Stout, L 2012, ‘The problem of corporate purpose’, Issues in Governance Studies, vol. 48 no. 3, pp. 1-14.

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