The shareholder wealth maximization myth

Cite this Article
Todd Henderson, The shareholder wealth maximization myth, Truth on the Market (July 27, 2010),

In a recent speech at the Netroots Nation, Senator Al Franken tried to frighten the crowd by trotting out the corporate bogeyman that greedily makes decisions without regard to anything other than profit. Franken told them: “it is literally malfeasance for a corporation not to do everything it legally can to maximize its profits.” Individuals across the political spectrum share this common canard. Those on the right, like Milton Friedman, argue that the shareholder-wealth-maximization requirement prohibits firms from acting in ways that benefit, say, local communities or the environment, at the expense of the bottom line. Those on the left, like Franken, argue that the duty to shareholders makes corporations untrustworthy and dangerous. They are both wrong.

While the duty to maximize shareholder value may be a useful shorthand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable. The only constraint on board decision making is a pair of duties – the “duty of care” and the “duty of loyalty.” The duty of care requires boards to be well informed and to make deliberate decisions after careful consideration of the issues. Importantly, board members are entitled to rely on experts and corporate officers for their information, can easily comply with duty of care obligations by spending shareholder money on lawyers and process, and, in any event, are routinely indemnified against damages for any breaches of this duty. The duty of loyalty self evidently requires board members to put the interests of the corporation ahead of their own personal interest.

Under this legal regime, it is not malfeasance for boards or corporate chiefs to make decisions that do not maximize shareholder value. Boards are protected by the so-called “business judgment rule” from claims that their decisions were the wrong ones. The business judgment rule protects corporate decisions unless the plaintiffs can show a breach of one of the two duties. In other words, unless there is a plausible story the board’s decision was woefully uninformed or was tainted by self interest, a shareholder challenge to a corporate decision will fail.

The business judgment rule means that decisions that turn out badly for firms are protected. This encourages risk taking and avoids the hindsight bias of litigation in cases where well-meaning and rational decisions do not maximize shareholder value. It also gives boards wiggle room to take more than just profit into consideration when setting corporate policy. As such, firms can tailor their decisions to the demands of the marketplace. One company might believe that employees, customers, and shareholders (the three big constituencies of any firm) prefer a decision to keep open a more expensive factory in Michigan, while another company might believe these stakeholders prefer a decision to move its manufacturing base to Mexico. Both are lawful.

The law lets a thousand flowers bloom, trusting in the markets for labor, products, and investments to determine which of these is optimal for all the individuals involved. A shareholder suit challenging the decision about whether to move the factory would surely lose, even if the decision turns out to be a disastrous one. The shareholder’s alternative to suing is to sell their shares, what is known as the “Wall Street Rule.” This alternative to legal enforcement means there should be innumerable different types of firms catering to the different preferences that exist in the country for work, products, and investments.

To have any other rule would invite costly and inefficient judicial second guessing of business decisions. This would be bad for firms that are trying to maximize profits, since they will inevitably make mistakes, and for firms that are not. Society would be much worse off, since it would put firms in a straight jacket that would limit their ability to meet the needs of their workers, customers, and investors, and it would dramatically raise the costs of risk taking.

Some corporate chiefs may believe they have a duty to maximize shareholder value, but this belief comes from the views of shareholders (that is, all of us) and not the law. Insofar as corporations are too interested in profits, to paraphrase Shakespeare, the fault Senator Franken lies not in the law but in ourselves.