ON DIRECTORSHIP is by PETER TUNJIC.

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 a leading voice in the re-discovery of what corporations are and why they exist.

How Shareholder Value Tied the Invisible Hand : And Why Unilever Wants it Back

Paul Polman, CEO of Unilever NV, considers himself a hardcore capitalist.  A label many in the corporate governance community find hard to believe given his stance against the mantra of maximizing shareholder value - “I don’t think our duty is to put shareholders first. I say the opposite”.

The Dutchman is convinced that something is rotten:

“Capitalism in its current form is broken... The very essence of capitalism is under threat as business is now seen as a personal wealth accumulator…. if you go back to Adam Smith, his thoughts that were that capitalism was intended for the greater good”.

Since 2009, the Anglo-Dutch company has ended quarterly reporting, refused to pander to analysts, doubled capital spending, increased R&D, reduced the number of hedge funds in its shareholder base by half and, according to its CEO treats people, such as their 75,000 small hold tea farmers, fairly.

Polman’s approach puts him at odds with management theorists, and no doubt, many of Unilever's competitors that embrace shareholder primacy as the organizing principle of their corporations and modern capitalism.

To his critics, Unilever has an impostor at the helm.  

According to Bob Monks, pioneering shareholder activist, the “true" capitalist is the shareholder. In a keynote address to the International Corporate Governance Network in Paris on 13 September 2011, Monks passionately argued that shareholder primacy was not a threat to capitalism but its savior.

The overriding first need is for owners to recognize democratic capitalism and all that this means for the strength and prosperity of the world... It is essential that the system of accountability to shareholders be confirmed and re-enforced so that public and private causes can generate sustaining returns traditionally associated with equity investment.

Will the true capitalist stand up.  Is it Polman, who puts Unilever first or Monks, who puts the shareholder first?

Who might Adam Smith give the prize.

The Invisible Hand           

Free market capitalism is loosely based on Smith’s idea that “the invisible hand” of the market will create the best possible outcome for the most people.

Smith formulated the most basic organizing principle of capitalism – In a commercial society “everyman is a merchant” . And the merchant's self interest and freedom dictates everything from price to the nation's progress.

Smith argued that self-interest (but not selfishness) produces the greatest good.  To Smith the “everyman merchant”:

Is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. [...] Nor is it always the worse for the society that it was no part of it.  By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

Smith’s laissez-faire disciples are prone to forget that he was not an economist, but a moral philosopher.  More importantly, they forget that Smith’s morality was based on the virtues of the market as an organizing principle of capitalism and not property rights.  The point of trading and bartering was not just the wealth of individuals but the "Wealth of Nations”.

Democratic Capitalism

Smith described both the virtue of self-interest, and its vice:

The directors of such companies … being the managers rather of other people’s money rather than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which [they would] watch over their own [...] Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Capitalism was powered by self interest but corporations are corrupted by it.  Smith can’t have imagined that his distrust of the human condition would one day inspire the shareholder wealth maximization norm that now dominates modern capitalism.

Under the influence of so called free market leaders, like Nobel Prize winner Milton Friedman, who argued that the only proper goal of business was to maximize profits for the company’s self described owners, public companies have come to be directed and controlled in such a way as to maximize the financial return to shareholders and, increasingly, to ensure shareholders have strategic control of the corporation.

Academics, policy makers and management consultants all celebrate the “virtuous cycle of shareholder value creation”.  The instruction given to company directors is unequivocal.  According to Professor Macey, “all major decisions of the corporation, such as compensation policy, new investments, dividend policy, strategic direction and corporate strategy should be made with only the interests of shareholders in mind”.

In this model of democratic capitalism, the board is primarily an extension or instrument of the shareholder’s business model.  A "man" on the inside responsible for assuring a return on the decision to buy shares.

But unbeknown to Smith, and it seems Friedman and his coterie, the philosopher had introduced a terrible mischief into capitalism by confusing ownership of a share with the ownership of the company.

For the invisible hand to work, everyone must be free to act in their own best interest.  But, under the norms of shareholder primacy, with one very important exception, corporations are not free.  Shareholders are viewed as the owners of corporations, the board of directors and managers are the shareholders agents and finally, the board’s primary role is to minimize the agency costs caused by the so called separation of ownership and control.  This norm of corporate governance is not freedom but a form of corporate servitude that corrupts the free market.

The exception is the corporation that happens to trade shares.  Financial corporations are free to act in their best interest by requiring non-financial corporations to forget theirs.  What believers of shareholder value maximization conveniently forget is that most shareholders are not human beings.  Shareholding describes a relationship, not a person.  In most cases, shareholders are corporations, and shares the commodity they trade.  With apologies to Orwell, all corporations are created equally but, at the moment, some are more equal than others.

This rhetorical trick creates a double standard that twists and ties the invisible hand. 

In a free market system, the needs of the shareholder corporation would be satisfied out of the self-interest of the non-financial corporation.  The shareholder’s share of wealth created by the corporation would be commensurate to the needs of that corporation, not the needs of shareholder.  As Smith reminds us “It is not for the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.

Whatever the elaborate rationalization for shareholder wealth maximization in law, economics or morality, the effect of shareholder primacy is that only financial corporations are free to play by the rules of capitalism laid out by Smith.  Maximizing shareholder value is revolutionary.

The result is a one-handed form of capitalism, in which shareholders convince boards and management to ignore the best interests of their employer.  This is a distorted form of capitalism where one set of corporations are free to act in their own self-interest to build their individual wealth, but other corporations must yield theirs.  This is not free market capitalism it is an institutionalized form of rent seeking that threatens capitalism.  I can only imagine that to Adam Smith, champions of shareholder wealth maximization like Harvard Law Professor Lucian Bebchuk, would be rallied against as a rent seeking apologists rather than lauded as a hero of the free market.

Corporations in Smith's day looked nothing like today's behemoths.  But his basic message remains true.  When the baker ignores their self-interest, the nation suffers.

Commercial Capitalism

What Unilever and its deeply principled leader understand is that it takes two hands to compete in today’s global market.

The Guardian newspaper sums it up well:

Polman is scathing of companies that claim their hands are tied by fiduciary duty to maximise profits for shareholders in the short-term, arguing that this is too narrow a model of Milton Friedman's old thinking. The world has moved on and these people need to broaden their education with the reality of today's world.

But he’s far from alone in demanding change.

Leading the charge to expose the myths of shareholder primacy is Distinguished Professor of Corporate and Business Law at Cornell Law School. Professor Lynn Stout.  According to Stout:   

"What shareholders own are shares, a type of contract between the shareholder and the legal entity that gives shareholders limited legal rights. In this regard, shareholders stand on equal footing with the corporation’s bondholders, suppliers, and employees, all of whom also enter contracts with the firm that give them limited legal rights"

Stout systematically argues that the shareholder value norm is not supported in law or fact.  According to the professor, under the influence of shareholder primacy shareholders are suffering their worst investment returns since the 1920’s; life expectancy of Fortune 500 firms has reduced over the past century from 75 to 15 years and the number of publicly-listed companies has almost halved.

The challenge is that, such is the near universal acceptance of shareholder primacy that an illusion of invulnerability stifles debate.  Stout is more often dismissed by the self-appointed “mind guards” of capitalism as on a quixotic crusade.  Convinced by the inherent morality conferred by share “ownership”, those who don’t believe are the enemy and their arguments unworthy of serious consideration.       

Even the warning signs are dismissed.  Rather than see the global financial as an opportunity to re-evaluate the assumptions of shareholder primacy we have seen a renewed commitment to its dangerous principles.

Amongst those who subscribe to this "group think" masquerading as a paradigm, maximizing shareholder value might not be perfect, but it’s better than no alternative.  Or so the champions of shareholder value maximization think.

Stout’s dismantling of shareholder primacy is softening the ground for the counter-revolution and the return Adam Smith’s invisible hand.  The alternative is not a new form of capitalism but a return to unadulterated capitalism.  But, if you're expecting an argument in favor of the wholesale removal of state intervention in the market, for which Smith is falsely attributed, you’ll be disappointed.

Remove the excessive influence of financial corporations in the affairs of non-financial corporations and capitalism will be restored.

In the new free market capitalism every man, woman and corporation is a merchant and free.

Smith's "Everyman" does not mean every natural person and any corporation that holds a share.  It means every economic actor.  And in today’s global economy there are no bigger economic actors than non-financial corporations who we all depend on to supply us with our needs and wants.  

At the core of the counter revolution is that public corporations are separate and independent legal persons.  And, like their natural person equivalents, corporations owe nothing that they have not promised.  The counter revolution is not economic sedition it’s the forgotten law.  As Stout reminds us, corporations are real persons and their officers owe their duties of loyalty not to the shareholder but to the corporation.

I believe Polman’s call is to for directors and officers to embrace their responsibility to the corporation first.  The goal is to realize the corporation’s strength, resilience and endurance by optimizing the relationship with all stakeholders.  But not out of duty to any shareholder or responsibility to any stakeholder.  The organizing principle of unadulterated commercial capitalism is that the corporation’s actions are guided by a deep and profound understanding of it's self- interest properly understood.  It is not the ethics of duty or responsibility that serves the interests of stakeholders, but the ethics of self interest.

Freed from the distortionary constraints of shareholder primacy, the corporation through its board and management prioritize stakeholders according to their contribution to firm value over the longest time.   

If Polman has a failure as a capitalist, it may be his generosity in sharing the secret of Unilever’s success with its under performing competitors:  

“if you are single-mindedly focused on one value driver you will not be successful.  If you only focus on being sustainable, it would be wrong. If you focused just on shareholder value maximization that would be wrong. The challenge in the new world is to balance it all”.

This is hardcore capitalism because it takes insight, acumen and integrity to make capitalism work:

  • No fixed priorities.  The priority and value exchanged with each stakeholder is based on their contribution to the overall strength resilience and endurance of the corporation.  As circumstances change, the priority of each stakeholder is reconsidered to reflect their importance to the firm’s self-interest.
  • No narrow mindedness.  Stakeholders can’t be mistreated or misused lest they refuse or can’t provide what the corporations needs for its strength, resilience and endurance.  Unilever pays its tea producers fairly not out of benevolence, but because Unilever benefits by ensuring their children are in school and farmers are well trained.
  • No freeloaders allowed.  Unilever’s refusal to bend to the demands of activists and analysts reflects their value to Unilever’s success.  Remember, Smith reviled rent seekers who waste resources trying to extract wealth rather than contributing to its creation through mutually beneficial transactions. 
  • No false opposites.  The opposite of the symptom is rarely the solution to the problem.  Long-termism is not the solution to short-termism.  The solution is to make decisions in the best interest of the corporation.

No argument, however elegant or empirical, in favor of maintaining the status quo of maximizing shareholder comes close to the self-organizing principle of a market in which all its economic agents are free to pursue their interests within the law.

Who is the Capitalist's Capitalist?  

Adam Smith's  simple message to our business leaders is that capitalism is not about putting shareholders first (or second for that matter).  Nor, as Roger Martin and others argue is capitalism about putting customers first.  It’s not even about putting employees, the environment or any other stakeholder first.

The capitalist's capitalist puts their enlightened interest first.  The corporation that trades shares puts their interest first.  The Customer puts their interest first. etc.  But, given the importance of the corporation to capitalism, every director, CEO and other corporate officer must put their corporation’s interest first.  

So who wins - Polman or Monks?

It's a tie.  Monks is right to put the shareholders interest first, and Polman is right to put Unilever first.  The market settles the rest.   

The real impostors are business leaders who agree with Monks and put the shareholder's interest first too.  This is in no one's self interest - even the shareholder.

But don't be too concerned about that return of the managerial bogeyman of the 1970's.  The truth is that he retired years ago and has been working as a director ever since then.  Thankfully, he'll be retiring for good soon.  To be clear commercial capitalism does not mean putting the board and management first. Their promise is to the corporation and the corporation alone.  Remember this and Henry Mintzberg's beige turtle neck will have more chance of making a comeback than managerialism returning to the corporation.

All you need is a little faith in capitalism.  If like Polman (and, I suspect, Steve Jobs), you trust in enlightened self interest, not only have their companies prospered but so to its employees, its customers, the environment and so on.     And if the doubling of Unilever’s share price is any measure or, in the case of Jobs turning a $2 issue price (after splits) into $400 plus, it works for shareholders too.  

# This essay was freshened up in September 2014.

Shareholder Primacy: Paradigm or Groupthink

Governing and Directing : Are They Different? **