Bad and Not-so-Bad Arguments for Shareholder Primacy

Abstract

Since the public corporation first evolved as a business form, there has been a lively debate over whether its proper purpose always is to maximize shareholder wealth, or whether directors sometimes can consider the interests of creditors, employees, and other corporate stakeholders. This article reviews why two of the arguments traditionally used to justify strict shareholder primacy - that shareholders own the corporation, and that shareholders are the sole residual claimants of corporations - are bad arguments, in the sense that they are demonstrably incorrect from both an economic and a legal perspective. The article then explores a third and better argument for shareholder primacy: that requiring corporate directors to serve only shareholders is the best way to keep directors from imposing excessive agency costs on firms. This agency cost argument recognizes that in an ideal world, directors would take account of the interests of both shareholders and other stakeholders. Indeed, allowing this can provide ex ante benefits to shareholders by encouraging nonshareholder groups to make firm-specific commitments to corporate team production. Nevertheless (the argument goes), a rule of strict shareholder primacy remains preferable, because it permits corporations to monitor and reward director performance according to a single easily-observed metric: stock price. While plausible in theory, the agency cost argument for strict shareholder primacy suffers from a serious weakness. In practice, the business world displays a strong revealed preference for corporate governance rules that grant directors discretion to serve stakeholder groups, even at shareholders' ex post expense. What's more, this pattern is observed when firms are first incorporated and brought public, a time when corporate promoters have every incentive to cater to shareholder interests. Such observations suggest that business participants believe the ex ante benefits of allowing directors to consider stakeholder interests outweigh the ex post harms in terms of greater agency costs. They also raise serious questions about the empirical strength of the agency cost argument for ex post shareholder primacy.