The Shareholder Welfare Maximization Corpgov model. Can it work?

Oliver Hart and Luigi Zingales, (Harvard and Chicago) have just published an article (1) in which they promote the idea that Shareholder Value Maximization should be substituted by Shareholder Welfare Maximization as a corporate goal entailing fiduciary duties.

Their first point is examining the case for Shareholder Value Maximization: in a perfectly competitive market, an increase in the value of a firm favors shareholders whose budget restraint moves upwards, without altering other agents´ welfare as prices are not affected; so shareholders necessarily support the SVM model; the same appears to be the case if we consider the firm as a set of contracts that insulate contractors from production decisions: if a change is decided that increases shareholders´value, no stakeholder is negatively affected. Shareholders´value is the total and unique contribution of the firm to society, that is, if it dissappears, this is the value of all welfare lost.

The problems with SVM for Hart & Zingales. They see three major problems:

• Imperfect Competition: shareholders that happen to be employees, or that happen to appropriate part of the monopoly power, would favor diverting from SVM.
• Markets are not complete: in this case profit is a ramdom variable, that can generate a “consumption benefit” for shareholders of a firm if the risk-return profile of the share is different; but competition deters this effect, so this does not really damage the SVM.
• Common Ownership: shareholders may favor non-competitive behavior as they maximize their portfolio value not their individual shares value.
• Externalities exist, and it appears evident in recent times: individuals care for others, are socially responsible. Externalities (even if not corrected) have been neglected when considering the SVM idea; Friedman in 1970 introduced the separation theorem, according to which shareholders favor SVM and in their particular utility function may favor others; but sometimes externalities are not separable from production, (reduce pollution, plastic waste, antibiotics in animal raising activities, and many other actions can harm profit, and shareholders cannot replicate a reduction by the firm). A coalition could bribe firms to act responsibly and compensate the profit lost, but this is difficult to implement; beyond that, shareholders might not be unanimous supporting SVM in these cases, as they may be affected or as they may care for others. Important to note that even if plastic waste is lower than the environmental cost, shareholders would find it difficult to produce the efficient result.

Hart & Zingales explain why in spite of its weaknesses SVM has become the norm.

First, the courts in the US have promoted SVM as they have punished actions diverting firms from pursuing it; the Ford (who had the objective of providing a car to every American) vs Dodge Brothers is an example, (the lattest won); the Ebay vs Craiglist in 2008 also, (even if academics as Stout oppossed to the theory fiercely). Courts seem to think the for-profit corporate form is tied to a fiduciary duty to maximize shareholder value, not to do so being a tax on minority shareholders. This was extended to trusts of investment funds, (1974 Erisa law). The problem appears when an interaction appears between profit and other objectives (that divert from but later on promote profit), as in SpaceX internet support to Ucranians in 2022, or Amazon´s for years focus on growth rather than on profit; funds cannot rely though on this eventual relationship, so that they generaly adhere to SVM in the form of the “best long-term economic interest of investors”.

Second, although complying with the the business judgemet rule requirements protects directors so that they can always state that their actions promote the long-term value of the corporation, lying if it is the case does not establish a sound base for dialogue with shareholders; and certain shields such as the American Law Institute Corpgov principle that directors “can” adopt ethical views if coherent with best practices in business are nonetheless not binding while the SVM is.

The reasons why the SVM has beem predominat are clear.

The case and arguments for Shareholder Welfare Maximization.

Hart & Zingales (4) and Broccardo, (5) model socially responsible shareholders introducing 𝜆 >0 as a weight they grant to others´ interests; every decision results in a cost of “x” for every shareholder if not linked to SVM, and a benefit of “y” for the others, (multiplied by 𝜆is); if the later is greater, a social decision may be adopted; another view is to use the Kaldor-Hicks criteria of whether winners “could” bribe loosers to accept the social decision; this modelling results in shareholders promoting SWM and efficient outcomes if their number is high enough (the costs converges to zero) and a majority of them is socially responsible; the only condition for this efficiency is factual, cost and benefits of the decision should be clearly determined with the help of management, and not affected by biases, media, political factors etc.

Social decisions to be brought to the decision-making body might explode; the modelling shows that SWM is different from SVM when a company has an advantage in promoting a certain objective, so companies should focus only on these cases; when does this comparative advantage appear?  When a company owns a technology that cannot be easily reversed, so that interaction between business and social activities are tied; when a company has some market power, so that it can affect the price and promote or reduce demand, (abortion pills, vaccines, etc); big firms have this advantage when political pressure is needed; these other cases are less general.

In practice, voting occurs through mutual funds usually via the SVM criteria. But shareholders are increasingly desiring to affect the result of votes; this can be promoted if the funds transfer the voting decisions in proportion to the final owners or fund investors; this is impossible for individual and small investors, but via proxy advisors some help emerges; a second way would be for mutual funds to obtain individual preferences and voting according to the aggregation of those; the third way is to offer different funds with different voting orientation so that investors choose; non binary decisions introduce more complexity, but voting systems can be adapted too this anyway.

Would this social orientation flood the General Assemblies with numberless voting proposals? The reality debunks the myth, and moreover, companies are able to block a lot of them on accepted reasons; and there are some filters: the amount of shares owned, the SEC´s acceptance to exclude certain proposals on ground of “ordinary business”, or eventually those that fall out of a comparative advantage as advanced above; thirdly, the proposals are not mandatory if approved.

So as to conclude, the authors highlight the increasing relevance of externalities, and existence of socially concerned investors; a change to the company generally accepted SVM goal is proposed accordingly, and some of the measures they propose are already making their way into reality.

1. Hart, Oliver D. and Zingales, Luigi, The New Corporate Governance (April 25, 2022). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2022-55, Available at SSRN: https://ssrn.com/abstract=4094175 or http://dx.doi.org/10.2139/ssrn.4094175
2. Dodge v. Ford Motor Co., 170 N.W. 668 (Mich. 1919).
3. Stout, Lynn A., 2008, “Why We Should Stop Teaching Dodge v. Ford.” UCLA School of Law, Law‐Econ Research Paper
4. https://scholar.harvard.edu/files/hart/files/108.00000022-hart-vol2no2-jlfa-0022_002.pdf
5. Broccardo, Eleonora and Hart, Oliver D. and Zingales, Luigi, Exit vs. Voice (November 1, 2021). European Corporate Governance Institute – Finance Working Paper No. 694/2020, Available at SSRN: https://ssrn.com/abstract=3671918 or http://dx.doi.org/10.2139/ssrn.3671918