CHAPTER 3

Shareholder Primacy and Capitalism Model

Executive Summary

The classic profit-maximizing model of publicly traded companies has shaped the role and responsibilities of business organizations in creating value for shareholders. According to this model, a public firm’s shareholders elect the board of directors and the board then appoints managers to maximize the firm’s profits, and thus maximize the firm’s value and shareholders’ wealth. The trends emerging in the past few decades, including the focus on protecting the interests of all stakeholders, have raised questions about whether the classic model is still applicable and relevant. According to the shareholder primacy and capitalism model, the primary function of business entities is to maximize shareholder wealth through continuous sustainable economic performance. This chapter addresses the shareholder primacy and capitalism model of business organizations.

Introduction

The goal of companies has evolved from profit maximization, to shareholder wealth enhancement, to creation of shared value for all stakeholders. Traditionally, public companies in the United States have operated under the corporate model known as “shareholder primacy and shareholder capitalism model.” This corporate governance model posits that the primary purpose of a corporation is to generate returns for shareholders, and thus managerial decisions and actions should be focused on creating shareholder value. This shareholder primacy model has served investors well in maximizing wealth for them but is being criticized for focusing on generating short-term profits at the expense of long-term sustainability performance innovation, growth, and the social and environmental impacts of corporations. The focus on shareholder wealth creation may not benefit other stakeholders, such as employees, customers, creditors, suppliers, government, society, and the environment. Companies are given rights to operate and generate profits for their shareholders, but with these rights come public interests and societal responsibilities. This chapter presents the shareholder capitalism primacy model and its corporate governance mechanisms and measures.

Shareholder Primacy and Shareholder Capitalism

Corporations as legal entities are incorporated under state law with many privileges, enabling them to raise public capital and create wealth for their owners. Prioritization of shareholder wealth maximization has contributed to wealth inequity and populism in the nation to the extent that the nature, extent, and value of capitalism are being questioned. Policy makers and regulators worldwide also promote the move toward a more balanced-purpose model for public companies. As mentioned previously, Senator Elizabeth Warren introduced the Accountable Capitalism Act in 2018, which if enacted would require public companies in the United States with more than $1 billion in revenues to obtain a federal charter stating the company’s “purpose of creating a general public benefit,” defined as “a material positive impact on society resulting from the business and operations” of the company.¹ Among the requirements is the mandate that at least 40 percent of the directors of public companies in the United States be elected by employees, and that directors consider the interests of all corporate stakeholders, including customers, suppliers, employees, investors, and the communities in which the corporation operates. Some Democratic congresspersons elected in 2019 advocate social responsibility for corporations. These initiatives by policy makers reflect the larger debate regarding the role of corporations in society that calls into question the fiduciary model of shareholder primacy and advocates move toward stakeholder primacy.

There is less doubt that the capitalism system in the United States has contributed to the economic growth and prosperity for the nation. However, like any other system, it has its own challenges as many may believe that the capitalism system has not benefited the entire society. Recent focus on environmental and social issues worldwide, many business organizations and their board of directors are paying attention to the growing interest and demand by socially responsible investors, regulators to focus on sustainability factors of performance, risk, and disclosure, and take them into consideration in their pressure to factor into their business and strategic decision making. Profit-oriented business organizations and their board of directors address these sustainability factors in many of their corporate decisions including financial economic sustainability performance and nonfinancial environmental, ethical, social, and governance sustainability performance, their relationships with current or potential employees, customers, and suppliers, their ability to attract capital and investor interests, and to recruit, develop, and retain a talented and motivated workforce. Business organizations should prepare for new sustainability strategic planning to effectively respond to the request from stakeholders for improvement in nonfinancial environmental, social, and governance (ESG) activities and performance as well as the demand by shareholders for improving financial economic sustainability performance in terms of total shareholder return (TSR).

Shareholder Governance

The shareholder aspect of corporate governance is based on the premise that shareholders provide capital to the corporation, which exists for their benefit. It supports the agency theory that the fiduciary duties of corporate directors and executives are to shareholders who have a residual claim on the company’s residual assets and cash flows. Shareholders (principals) provide capital to the company, which is run by management (agents). The principal–agent problem exists because corporations are separate entities from their owners—management needs physical capital (investment funds) and investors need skilled human capital (management) to run the company. According to the principal–agent theory, also called the shareholder model of corporate governance, the primary objective of the company is to maximize shareholder wealth and, thus, the role of corporate governance is to ensure the enhancement of shareholder wealth and to align the interests of management with those of the shareholders. The principal–agent problem arises from two factors: the separation of ownership and control, and, most importantly, incomplete contracts or costly enforceable contracts between the agents and principals, known as agency costs. A growing debate in corporate governance is whether corporate gatekeepers including directors and top management team should consider only the interests and wealth of shareholders or should also consider the interests and welfare of all stakeholders such as employees, customers, suppliers, the environment, and local communities when making business decisions. While the corporate governance and agency theory suggest the primary fiduciary duty of corporate gatekeepers is to shareholders, stakeholder governance and stake holder theory advocate corporate gatekeepers’ responsibility is to all stakeholders in creating shared value for them. Stakeholder governance has made significant progress in recent years as an alternative to shareholder governance to place more emphasis on impact investing of achieving a desirable rate of returns on investment for shareholders, while generating social and environmental impacts.

The New Paradigm is a roadmap, which is a guide for implicit corporate governance and stewardship partnership between corporations and investors and asset managers to achieve sustainable long-term investment and growth. The premise is based on a defense to attacks from short-term financial activists that impedes long-term financial and economic growth. It is composed of three factors: governance, engagement, and stewardship. Governance relates to the company and its shareholders, and the relationship between them. It also deals with the company’s management and board of directors, and the principles in place to create genuine relationships with their shareholders. This can be seen through the company’s commitment to long-term business goals as well as effective board oversight. The second factor, engagement, deals with the effective communication and exchange of information between a company and its shareholders. Companies show that they are responsive to shareholder concerns and preferences in an effort to develop the long-term relationship. Finally, stewardship is the accountability of the shareholders, also referred to as the investors and asset managers, to wisely invest the money that supports long-term wealth creation, rather than just meeting short-term goals. These three factors will help management focus on the company, rather than just meeting earnings marks and will benefit the long-term sustainability of a company.

The corporate governance structure should consist of mechanisms (internal and external) designed to effectively align the behavior of management (agents) and its interests with the desires of the principals (shareholders). The agency problem exists when the interests of management and shareholders are not in accord and when there are difficulties in verifying management activities. Agency costs also arise where there is an “information asymmetry” between management and shareholders as well as when the company’s board of directors fails to fulfill its fiduciary duties of effectively carrying out its assigned oversight role.

In the real world, the agency problem can never be perfectly solved, and agency costs cannot be eliminated. If complete contracts were feasible and efficiently enforceable, there would be no agency costs, in the sense that investors would have known exactly what management was doing with their funds, and management would know investors’ expectations. However, complete contracts are neither feasible nor enforceable, which results in the occurrence of “residual contract rights” of making decisions based on the rights not specified in the contract or based on unforeseen circumstances. The residual contract rights may cause asymmetric information problems as management possesses information that is not disclosed or available to investors, which may result in management entrenchment. Under the shareholder aspect, corporate governance is designed to reduce the agency costs and align the interests of management with those of investors through: (1) providing incentives and opportunities for management to carry out its function effectively, and to maximize shareholder wealth by providing executive compensation plans, ownerships, or stock options; (2) strengthening shareholder rights to monitor, control, and discipline management through enforceable contracts or legal protection; (3) promoting shareholder democracy; (4) improving the vigilance of the board’s oversight function; (5) holding directors accountable and liable for the fulfillment of their fiduciary duties; and (6) improving the effectiveness of both internal corporate governance mechanisms (board of directors and internal controls) and external corporate governance mechanisms (external audit, monitoring, and regulatory functions).

Shareholders as owners of public companies should be attentive and protect their investment by attending shareholders annual meetings (in person and/or virtual) to vote on corporate governance issues as reflected in management and shareholders resolutions. The 2019 proxy paper issued by the advisory firm Glass Lewis identifies many shareholder corporate governance initiatives that are addressed in all chapters in this module.² Shareholders play a crucial role in corporate governance through their voting right and engagements in meetings and discussions with the board of directors and management. These engagements enable shareholders to submit their governance proposals at the annual meetings. In the United States, shareholders need to own at least 1 percent or $2,000 of a company’s share to submit a proposal for inclusion in proxy statements.³

The shareholder-driven aspect of corporate governance is based on agency theory and the shareholder primacy model. Under this aspect of corporate governance, the main focus is on maximizing shareholder wealth and as such all corporate governance measures and reforms are aimed at protecting interests of investors regardless of the impacts of business operations on the well-being of other stakeholders, such as employees, customers, creditors, suppliers, government, society, and the environment. Shareholder-driven corporate governance will draw the attention of directors and management to maximizing profit and creating value for shareholders but may not serve the purpose of creating shared value for all stakeholders. Corporations and their directors and officers typically focus primarily on maximizing shareholder wealth in the short term by engaging in earnings management in beating analysts’ forecast expectations at the expense of long-term sustainable performance and protecting interests of employees, suppliers, customers, society, and the environment.

Shareholder primacy is an owner-centric form of corporate governance that focuses on maximization of shareholder wealth before considering the interests of other stakeholders, such as employees, customers, society, community, consumers, and the environment. The debate between a shareholder primacy and a stakeholder primacy has been extensive, long-lasting, and inconclusive. Proponents of shareholder primacy suggest that corporations should focus on shareholder wealth maximization, while advocates of stakeholder primacy indicate the importance of corporations in generating shared value for all stakeholders. Some of the shortcomings of shareholder primacy are given as follows:

The shareholder model of corporate governance is considered to be an impediment to corporate social responsibility (CSR) and sustainability. Under the shareholder model, management is commonly constrained from taking CSR initiatives and expenditures that may be viewed as inconsistent with the economic interests of shareholders. Shareholder-driven corporate governance suggests that shareholders are attentive in looking after their investments by governing the corporation that they own and by protecting their interests while also involving in the governance of the company. Shareholder-driven governance captures both actual and potential governance strategies to: (1) minimize the concerns relating to management and board entrenchment; and (2) respond to the shift in the balance of power within public corporations between the board of directors, management, and investors, particularly investor activism. The Dodd Frank “say-on-pay” reforms of 2010 are a prime example of an increased move toward shareholder-driven governance in influencing executive compensation and in separating the roles of board chair and chief executive officer (CEO). However, the extent of shareholder-driven governance depends on the sizes and types of shareholders. It is expected that institutional investors (pension funds, mutual funds, and hedge funds) engage more in corporate governance than individual retail investors because of the level of their sophistication and resources.

Shareholders play an important role in corporate governance by electing directors who appoint management to make day-to-day business decisions for public companies. In addition, shareholders vote on many important issues that can create value for them. Generally, at annual shareholder meetings, shareholders vote for or against candidates for director positions, obtain detail information regarding executive compensation plans, put forth proposals for consideration by other shareholders, and attend special shareholder meetings to vote on important corporate structure matters (mergers and acquisitions). Shareholders have options of casting their votes at the meetings in person or “by proxy” including online, by mail, or by phone. Shareholders play an important role in corporate governance by exercising their voting rights and engaging in meetings and discussions with the board and management. This engagement has become increasingly crucial when shareholders submit their own proposals at the companies’ annual meetings. Proactive participation and monitoring by shareholders in the company they own is an important component of effective corporate governance. The shareholder theory of corporate governance is derived from the agency aspect of corporations and is based on the concept that the primary objective of corporations is to create shareholder value, and thus the purpose of corporate governance is to align management interests with those of shareholders. According to the agency theory, shareholders (principals) hire management (agent) to manage the corporation for the benefit of owners. There may be conflicts of interest between management and shareholders. Thus, the corporate governance structure and measures are designed to focus on the process of directing and managing the business and affairs of the corporation to achieve its objective of creating shareholder value. The shareholder theory of corporate governance concentrates on role of the board of directors and management to manage corporate activities in achieving financial performance that maximize shareholder wealth.

Agency/shareholder theory focuses on risk sharing and agency problems between shareholders and management by suggesting that the interests of principals (owners) and their agents (executives) are often not aligned. Thus, in the context of agency theory, the role of corporate governance is to align interests of management with those of shareholders. Moral hazards can occur in the presence of information asymmetry where the agent (management) acting on behalf of the principal (shareholders) knows more about its actions and/or intentions than the principal does due to a lack of effective corporate governance in properly monitoring management. The implications of agency/shareholder theory for corporate governance are that management incentives and activities often focus on short-term earnings targets and self-serving of maximizing executive compensation rather than improving long-term performance in creating shareholder value. Thus, corporate governance measures should be in place to ensure management focus on creating shareholder value.

Director Fiduciary Duties

Directors have fiduciary duties of care and loyalty that they must uphold. These duties require the directors to use informed, deliberate decision-making and to act on a disinterested and independent basis when making decisions. They are required to use good faith and judgement to act in the best interest of the company and the stockholders they represent. A “Roadmap” to satisfying fiduciary duties should be followed. With it, directors should be well-advised and properly informed, using all material information available to them. They must be comfortable with all processes, keep confidential information confidential, be able to weigh out risks and rewards and compare them to alternatives, and be able to respond appropriately to all issues. Finally, they must ultimately act in good faith and make decisions on what they believe is in the best interest for the company.

A big responsibility that directors must deal with is effective oversight over the company and its risk management. Protocols to monitor and avoid risk, as well as comply with laws and regulations must be put in place to avoid a breach in fiduciary duties. To do this, a good board process must be established. Having a good board process in place creates an appropriate framework for any situation, while also recording how situations were handled and serving as evidence for the director’s completion of the fiduciary duties. This is all very important because if director is sent to court, the burden is now on the plaintiff to provide evidence of gross negligence regarding a director’s fiduciary duties, due to the business judgment rule. This rule, along with reliance with company records, indemnification and expense advancement, exculpation of certain personal liabilities, and directors and officers (D&O) liability insurance are provisions that help directors satisfy their fiduciary duties and protect that from possible accusations of breach.

The World Economic Forum recommends business organizations to move from the traditional model of corporate governance and shareholder capitalism to the model of stakeholder governance and stakeholder capitalism.⁴ Under the stakeholder governance model, the fiduciary duty of the board of directors is extended to all stakeholders including shareholders, employees, customers, suppliers, communities, society, and the environment. The stakeholder governance will be examined in the next chapter.

Conclusion

The shareholder aspect of corporate governance implies that shareholders, by virtue of their ownership investment in the company, are entitled to direct and monitor the company’s business and affairs. Shareholders influence corporate governance by exercising their right to elect directors, who then appoint management to run the company. Directors and officers, as agents of the company, act as trustees on behalf of shareholders, and their primary responsibilities and fiduciary duties are to shareholders. While directors’ and officers’ legal fiduciary duties are only extended to shareholders who invested in the company, they may have many nonfiduciary duties to other stakeholders, who may have various interests and claims to the company’s welfare. Shareholders’ rights, including the right to elect, the right to put propositions before the annual shareholder meetings, and the right to reliable and accurate financial information, are legally enforceable, and offending directors and officers can be brought to justice through the courts. Corporate purpose is now changing as there are more support for stakeholder governance and stakeholder theory in creating shared value for all stakeholders and in maximizing stakeholder welfare than just creating shareholder value and in maximizing shareholder wealth.

Chapter Takeaways