The European Commission is rightly committed to ensuring that business creates long-term societal value, rather than just short-term profit. Last year, it commissioned EY to conduct a study on directors’ duties and sustainable corporate governance, to identify why companies focus on “short-term shareholder value maximisation rather than the long-term interest of the company” (EY 2020).
The report made various proposals such as legally requiring directors to “properly balance” the interests of employees, customers, the environment, and society alongside shareholders; “making compulsory the inclusion of non-financial [environment, social, and governance] metrics … in executive pay”; and passing “binding rules requiring Member States to introduce mechanisms to incentivise longer shareholder periods.”
It is tempting to believe that radical problems need radical solutions; instead, they need effective solutions. Effectiveness in turn requires both the problem to be diagnosed and the proposed treatments to be based on rigorous evidence, just like in medicine.
In the EY study consultation process, leading academics and practitioners raised several serious concerns with the study, rendering both its diagnosis and suggested treatment unreliable. As a result, Professors Luca Enriques, Jesse Fried, Mark Roe, Steen Thomsen and I have organised a Call for Reflection,1 signed by over 80 elected research members of the European Corporate Governance Institute, urging the Commission to take note of these concerns before taking action. Some of the concerns raised are as follows.
Shareholder value is a long-term concept
The study repeatedly refers to “short-term shareholder value”. This is an oxymoron because shareholder value is an inherently long-term concept. Finance 101 teaches us that shareholder value is the present value of all future cash flows. This is true in practice, not just theory: many of the world’s most valuable companies are priced so high because of their growth opportunities, not their current profits (Roe 2020).
This distinction is far more than semantics. It suggests that, if short-termism is a problem, the remedy is a greater focus on shareholder value rather than less. Evidence indeed indicates that many factors associated with (long-term) shareholder capitalism create long-term value for both shareholders and society. Examples are as follows:
- Shareholder activism: Brav et al. (2015) find that activism by hedge funds – seen as the epitome of short-termism – improves both total factor productivity and labour productivity, and Brav et al. (2018) show that innovation rises. Chu and Zhao (2019) demonstrate that firms targeted by hedge-fund activists reduce toxic chemical emissions, and Jiang (2021) finds that shareholder activism raises gender diversity. Indeed, stepping back from academic research and looking at current events, it is often shareholders who are driving companies to take more action on climate, not the other way around.
- Stock-based pay: Von Lilienfeld-Toal and Ruenzi (2014) show that CEOs that have a large equity stake in their firm outperform those with a small stake by 4–10% per year; this is causation, not just correlation. Flammer and Bansal (2017) find that shareholder proposals to implement long-term pay cause improvements in long-term profitability and innovation and the company’s treatment of the environment, customers, communities, and especially employees. Interestingly, short-term profitability dips, highlighting how the pursuit of long-term shareholder value requires temporary sacrifices.
- Share repurchases: The study argues that share repurchases starve companies of cash for investment, but Brav et al. (2005) find that companies first make their investment decisions and then decide whether to use the spare cash for buybacks. Ikenberry et al. (1995) show that share repurchases are associated with higher long-term stock returns in the US, and Manconi et al. (2018) demonstrate that this result also holds in most countries around the world.
- Shareholder trading: The criticism of ‘short-term’ trading fundamentally confuses the holding period of an investor with orientation. An investor can sell shares in the short-term but base the decision on an analysis of the company’s long-term prospects – such as divesting from a company if it is failing to decarbonise. Indeed, Fang et al. (2009) find that stock liquidity improves firm value, and Bharath et al. (2013) show that this is due to superior governance by large shareholders (blockholders). Edmans et al. (2013) demonstrate that liquidity encourages blockholders to form in the first place.
Surely the frequently voiced concerns about short-termism cannot all be wrong? Indeed they are not. However, the cause is the focus on short-term earnings or the short-term stock price, rather than (long-term) shareholder value. For example, Almeida et al. (2016) find that share repurchases undertaken to meet analyst earnings forecasts lead to a fall in investment and employment. Edmans et al. (2017) show that when CEOs are concerned about the short-term stock price, they cut investment.
Thus, the solution is not to throw the baby out with the bathwater and make managers unaccountable to shareholders. Instead, it is to ensure that managers focus on true shareholder value rather than profits or the stock price, for example through paying them with long-term shares.
Stakeholder value can be a short-term concept
The study also assumes that the pursuit of stakeholder value automatically leads to long-term decisions. But, as I explain in Edmans (2021), companies can take short-term actions to meet sustainability metrics, since they only capture hard (quantitative) information and not soft (qualitative) information (Edmans et al. 2016).
For example, tying CEO pay to the number of new jobs created may cause the CEO to ignore the quality of those jobs. Gantchev et al. (2021) show that mutual funds rush into stocks rated as green to improve their own sustainability ratings, causing these stocks to become overpriced.
Shareholder value is not at the expense of stakeholder value
The policy debate has typically assumed a ‘fixed pie’: that shareholder value is at the expense of stakeholder value and so the former must be reduced for the latter to be increased. However, improvements to stakeholder value typically increase (long-term) shareholder value, such as employee satisfaction (Edmans 2011, 2012), performance on material stakeholder issues (Khan et al. 2016), and shareholders proposing and approving sustainability proposals (Flammer 2015). This explains the evidence cited earlier on how actions to increase accountability for shareholder value typically benefit stakeholders as well as shareholders.
The bigger danger for stakeholder value is not shareholder capitalism but ‘managerial capitalism’, where unaccountable managers shrink the pie for both shareholders and stakeholders. CEOs insulated from shareholder value pursue the quiet life, coasting rather than exerting the effort needed to transform a company (Bertrand and Mullainathan 2003) or taking the risks required for innovation (Atanassov 2013).
In contrast to the ‘fixed pie’ mentality, which assumes that sacrificing shareholder value gives more of the pie to stakeholders, such sloth shrinks the pie for both – the failure of Kodak being a prime example (Edmans 2020). Other CEOs may pursue social objectives, but different ones from what shareholders want. Masulis and Reza (2015) show that some CEOs donate to charities – but those affiliated with the directors who sit on the CEO’s own board. Cai et al. (2021) find that they get a quid pro quo for doing so: they enjoy higher pay and are less likely to be fired for poor performance.
The role of regulators
The idea that regulators force directors to ‘properly balance’ shareholder and stakeholder interests sounds attractive. But it is very difficult to enforce, as it is not clear what a proper balance entails. Even if we ignore shareholders, there are trade-offs between different shareholders – for example, shutting down a polluting plant helps the environment but hurts workers. Are stakeholder interests best balanced by closing down the plant, or not closing it? If both closure and non-closure can be justified, then the CEO can take any decision, which reduces their accountability.
Similarly, the study mentions that directors should “take into account sustainability-related factors”. This again is attractive in theory but unenforceable in practice – how do we know if a company has taken a factor into account? An energy company might take into account the effect of a plant closure on job losses but still close the plant anyway because it believes that decarbonisation is most urgent.
Instead of aiming to reduce managers’ accountability to shareholders, regulation can help in two ways. First, it can ensure that companies focus on true shareholder value rather than short-term earnings. The study’s suggestions to hinder CEOs from selling their shares in the short term, and to discourage quarterly reporting, are thus welcome in this regard.
Second, it can correct market failures that cause shareholder value to deviate from stakeholder value. Examples include prohibiting or taxing negative externalities, subsidising positive externalities, and addressing monopoly power.
Author’s note: The views in this column are those of the author. Please see the Call for Reflection for the views shared by all signatories of that Call.
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