TCS Daily

The Importance of the Shareholder Wealth Maximization Standard

By Stephen Bainbridge - February 7, 2006 12:00 AM

There has been a fair bit of ruminating about corporate cowardice lately. Several technology firms have been criticized lately for agreeing to cooperate with authorities in China. Google's decision to censor its Chinese search engine, for example, elicited widespread criticism in the blogosphere (although it also prompted some to speak out in its defense; see here for example). Blogger Mark Kleiman has spotted what he thinks is another example and invites me to reply:

"The weekend Financial Times (behind a paywall; just below the fold on page two of the December 4/5 edition) reports that Nestlé has been swift to advise the Islamic bigots boycotting Danish products that Nestlé is Swiss, not Danish. A rumor had spread in Saudi Arabia that some Nestlé products were of Danish origin. 'We took the trouble to rectify the situation — to give the correct information to consumers,' said a Nestlé spokescoward.

"The implication, of course, is that Danish origin is something to be ashamed of. And the result is to help focus the boycott on the Danes, and thus to increase the pressure on the Danish government to back off from its support of a free press.

"No doubt, if this had been the 1930s, Nestlé would have been equally swift to assure the Nazis that its products were of strictly Aryan origin.

"I'm still waiting for Professor Bainbridge to tell us whether he's prepared to stand behind his theory that the sole duty of corporate managers is to make money for the shareholders when it comes to cases such as this one. Assume, for the moment, what is probably correct: that Nestlé had good reason to think that selling out the Danes would help its bottom line. Is that really any excuse?"

First, the duty of directors is not solely to make money for the shareholders, but rather to do so within the bounds of law. Second, it should be apparent that the duty of directors is not so much to make money as it is to maximize share value. The two are different, because the value of a share of stock is the present discounted value of the stream of dividends the stock will pay in the future. Hence, directorial actions that are inconsistent with short term profit maximization but are consistent with increasing the present discounted value of the future stream of dividends are perfectly appropriate. Suppose, for example, that Nestle management thought confusion over the national origin of its products might endanger employees working in predominately Muslim countries. If so, it would seem both ethical (preservation of life) and profitable (enhanced employee morale) to safeguard the lives and property of those employees through statements such as the ones about which Mark complains.

In some cases, of course, long-term corporate viability may require the entity to take controversial political positions. In particular, as I argued in my paper Catholic Social Teaching and the Corporation, good corporate managers have a very strong stake in supporting democratic capitalism:

"The corporation has proven to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihood depends on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. Because tyranny is far more likely to come from the public sector than the private, those who for selfish reasons strive to maintain both a democratic capitalist society and, of particular relevance to the present argument, a substantial sphere of economic liberty therein serve the public interest."

Both society and their shareholders would have been well-served if German corporate managers had nipped Hitler's rise in the bud instead of facilitating it, for example.

But does all of this mean that corporate fiduciary duty law should require -- or, at least, allow -- corporate directors and officers to behave in ways Kleiman deems brave or responsible when doing so would be inconsistent with shareholder wealth maximization? I think not.

In the first place, requiring directors to maximize shareholder wealth provides the board of directors with a determinate metric for making business decisions. I often use the following example to explain what I mean by that: Suppose Acme's board of directors is considering closing an obsolete plant. The board is advised that closing the plant will cost many long-time workers their job and be devastating for the local community. On the other hand, the board's advisors confirm that closing the existing plant will benefit Acme's shareholders, new employees hired to work at a more modern plant to which the work previously performed at the old plant will be transferred, and the local communities around the modern plant. Assume that the latter groups cannot gain except at the former groups' expense. By what standard should the board make the decision?

Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards. Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.

Worse yet, absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.

In the plant closing example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if the board of directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.

In sum, if you don't like corporate cowardice, the answer is to work for changes that make corporate courage profitable. If you thought Nestle's decision was deplorable, buy American-made Scharfenberger. But don't try changing the basic rules of corporate governance.

The author is Professor at the UCLA School of Law.



Shareholder maximization
Perhaps you discuss this in your longer article on Catholic social teaching-I haven't had time to read it yet as I'm at work. If so, I apologize in advance.

It appears to me that scandal is a potential issue that can affect both ethics and corporate governance. If a director should behave in such a way as to damage the corporations re****tion (decreasing the good will on its balance sheets) it would be acting both unethically in general fashion and also in the more specific sense of not maximizing shareholder value. I think that scandal may cover many of the situations where ordinary ethics appears to conflict with maximizing shareholder value.

I'm not sure that Nestle's actions quite rises to this level. Clearly they would wish to safeguard their employees. all the same, I may feel a little differently the next time I shop for a chocolate bar.

There may also be instances (the entertainment industry comes to mind) where the notoriety from scandal may improve the bottom line. I think that this is ethically difficult-as a very minor shareholder in Pixar (soon to be Disney)there are limits to how far I would want an entertainment company to go in order to stoke the bottom line. Still, I do like to make money.

Thanks for an interesting and thought provoking article.

Under the law, a corporation is a person with the same legal rights and obligations as any natural person (in most cases). Yet many people expect corporations to follow a higher standard of conduct than they themsleves are willing follow, and they even assign to corporations a heavier social burden than they assign to themselves. This is self-serving hypocrisy.

I'm no Dane, and if I come under threat of financial ruin due to the Dane's foolish cartoons, I'll say so loud and clear. If Danish foolishness threatens to land me in the poorhouse, then SCREW DENMARK! Moreover, since this would be my individual response, why should I expect Nestlé to respond any differently? Or Nestlé's shareholders?

Judge not lest you be judged, for you'll be judged by the very same measure whereby you judge others. Moreover, do to others as you would have them do to you. I didn't get these gems from the Catholics, but they're the only standards I need when assessing the actions of others, including corporations.

Shareholder maximization
It's interesting that part of my first comment got blanked out by the censor. The word that was partially deleted was spelled rep_u_t_ation (we'll see if it gets past the censor. If not, reasonable synonyms might be renown or public esteem).

On further reflection, I do think shareholder maximization should be the ethical gold standard by which directors base their decisions about corporate governance. If a director feels ethically conflicted between personal ethics and shareholder interests, he should resign if he feels unable to represent the shareholders.

Mr. Bennett's letter gave me pause for thought. "Screw Denmark" makes me quite uncomfortable. Nestle's actions have certainly made the company's esteem fall in my eyes. I'm not a direct shareholder, but do own some shares through a mutual fund. I'm not sure the directors acted in my best interest by showing such cowardice. As an Iraq War veteran, I admire courage. I like to feel good about the companies I invest in-I consider that part of my return.

My wife used to work for Curtiss Candy -Baby Ruth, Butterfinger- that are now made by Nestle. She's not happy about this. We may not buy any of our favoite bars for a month or two to show our displeasure. I don't feel strongly enough to sell the mutual fund, which has 3% of its funds in Nestle. If I owned Nestle outright, I would probably sell.

As I said before, shareholder maximization is a reasonable gold standard. However, it's easier to say it than to get there. The public esteem of a company, which can relate to its ethical behavior in the larger world is surely one of the factors that a wise director considers as one of the vectors leading to maximization of value.

Ethics, utility maximization and free market justice
Ethics are tricky because the interests of many parties who share an interest in any given choice and act will inevitably conflict.

Let's take Nestlé's disavowal of Denmark as an example. It tends to serve the shareholders' interest to the extent that it prevents boycotts leading to share price depreciation in anticipation of falling sales, declining revenues, plant closures and layoffs. Consequently, it also tends to serve the interests of Nestlé's employees, management, and board members. In sum, disavowing Denmark maximizes utility all around, particularly for those most intimately interested in Nestlé's well-being, a group to which Denmark does not belong.

However, if certain crusade-minded Nestlé shareholders or customers take offence at Nestlé's perceived perfidy, then they are free to punish Nestlé by boycotting its products and selling off its shares. This is free market justice, and it´s exactly the same kind of justice Muslim consumers and shareholders would have exacted had Nestlé not set the record straight.

Now pay close attention, because here comes the irony: By disavowing Denmark, Nestlé bet on the Western version of free market justice, for having seen the recent news reports out of the Middle East, it knew that Westerners are possessed of much cooler, much more rational heads.

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