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Today, you’re going to hear my interview with Lynn Stout. Now, Lynn Stout is a rock star, and I’m not saying that…you know, everybody calls people rock stars…she really is a rock star. She’s a professor of corporate law – but she’s not boring. She’s a professor of corporate law, so to me, she’s like the keeper of all the secrets to everything that is good and important in the universe. But look, there are a lot of corporate lawyers and a lot of professors of corporate law out there who are just sort of horrible. She’s not. She wrote a book that had a profound influence on me, and that book is called, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations and the Public, and in this book she confirmed a lot of things that I deeply suspected about the way the world works in finance and investments. What Professor Stout has to say is earth-shattering. It ought to rock the foundations of skyscrapers all across the country. What she says is that the whole world of big business and big investments is being run badly. Now, she doesn’t say it like that. I’m saying it like that because I want you to understand it, and that is, in the end, what she’s saying – not in those words. But, let me explain.
Here’s something you may not know – people with extra cash invest that cash. They take that money and they buy something with it that’s going to increase in value, and maybe every once in awhile – maybe every year – pay them a little bit of money. Money makes more money. See, if you’ve never had extra money you don’t know this, but money is just like labor. It’s just like your time. If you do the right things with it, it will make money. Just like you. Just like you go get a job, or just like you go to the office, or maybe you sell yourself an hour at a time… It’s the same thing with dollars. You take your dollars and you put them somewhere and somebody else gets to use them while you’re not using them. And then, whatever they do with that money grows in value, hopefully, and you get that money back at some point. And along the way, you might get some payments. That’s investing. Now, if you’ve never had extra money, you don’t know this. If you have had extra money and you’ve invested it, then you do understand it.
You can invest some of your money by buying ownership in a company – buying stock in a company. You can also leave money in a savings account. The bank will use that money while it sits in the savings account, and, in exchange, you get interest. Now, because the interest rates right now are so low, you don’t get very much interest. Or, you can invest in real estate. You can buy a building. You can buy a lot. You can buy an apartment. And then, you can either live in it, or you can fix it up and sell it or you can rent it out. You can also loan someone money either through buying a bond or just loaning somebody money and taking back interest in a right to repayment. So, those are really the four kinds of ways to invest your money. One is to put it in the bank, which does the very least. One is to invest in companies by buying stock. One is to invest in real estate. And, one is to loan people money.
Now, the best investments over time are investing in stocks or investing in real estate. But, you can also invests in groups of companies, groups of real estate, groups of bonds, and you do that by investing in funds. So people – usually men, unfortunately – will go out and they will start these companies and they will create funds. Funds, in this case, is like group purchasing. They get people to give them money and they take that money and they go buy stock in companies, or they buy bonds, or the buy interests in real estate, or they might buy a whole bunch of pieces of real estate and put that in and then you can come along and give them money and either buy a right to the fund, or you provide the capital that they actually use to go out and buy the investments in the first place. Those are funds.
For the most part – 99 percent – of any investments you’re going to do, you’re going to do what’s called “in public”. You’re going to invest in big national or international markets. And those big a national and international markets are called the capital markets. Those capital markets are the what’s supposed to drive the economy. When people say the economy is doing well, how those markets are doing – how many people are buying into the markets and at what rate, at what price – determines the health of the market or the sickness of the market. And in the United States, if you have extra cash, 99% of the time you have got to put that money into something that’s big and public. You cannot go and invest in some little store on main street that’s going to make your community look good for a whole lot of legal reasons that we’re not going to talk about today. But that’s the thing you have to understand.
Think about these markets as a funnel. If you’ve got extra money sitting in the bank you really should put it somewhere (and there are limited places to put it), so you’ve got to go through that big capital markets funnel. You’ve got to drop your money into the funnel and pick where it ought to come out. If you have a 401k at your work, it’s the same thing. If you invest the money or if you have someone else invest it for you, they’re taking that money and dropping it into that great big funnel and it’s coming out wherever they say it should go.
Pension plans, which control billions and billions and billions of dollars, take all that money and they drop it into that great big funnel and it comes out. We are all dependent on that money being invested wisely because we need all those people and all those people need that money invested wisely and we need all those people to be self sufficient. So we need their pensions to do well so they stay around and generate enough cash to pay their benefits. I hope this isn’t getting too complicated, but this is the way it works.
Now, here’s the problem: when we drop our money through that big funnel and it trickles down and goes into where we said it’s got to go, we are dependent on the people who either run the funds that buy the companies or run the companies that were investing in to do a good job. We need them to do a good job because if they don’t do a good job we don’t make as much money as we should, or we don’t make any money, or we lose money, or we lose all the money. That happens. That’s risk. We need management to do well. We need them to care about how their company does.
The market declares winners and losers every day. But the problem is, when you run a business everything is not a today problem. Every investment is not about what things look like today. It’s like if you’ve got a house and you look at it from the outside and it looks great, even though you know that your plumbing is deteriorating and you’ve got some water leaks and maybe you’ve got a busted pipe. You don’t worry about it. As long as everything looks great on the outside today, the world’s impressed. That’s what it’s like today on Wall Street. That’s what it’s like in the capital markets. And, that’s what Professor Stout is saying in her book. This short-termism is driven by this idea in corporate law that the duty of the corporation and the duty of directors and managers who run the corporation is to maximize returns for the shareholders. There are a lot of people who say that’s the law and that’s the duty, but it’s not true. She spends some time in her book talking about how it’s not true and how that idea has warped and perverted our approach to companies and to the duties that the people who run companies owe. But more importantly, that idea that the duty is to maximize returns for shareholders focuses only on the short-term return and not the better, long-term, consistent investment that buying a stock ought to be.
My grandmother was a great investor. She bought stock in Microsoft and MCI at their IPOs. She held on to those stocks for years and made a fortune. Almost at the end of her life, she sat me down to talk to me about investing to tell me what she learned. Here’s what she said: “I pick companies that I believe in – that have smart, careful and innovative management. I buy their stocks or I buy their bonds, and I hold on to them for years. And those stocks or bonds will pay me a little bit of money every year. But, I buy enough companies so that those little bits of money I piece together into something really valuable, and I hold on to that stock as long as I can; as long as I think it’s smart. Until I see the company really start to mess up and I don’t see that they’re going to correct, I hold on to that stock. And I almost never lose money.” This is what she said. She also said to me that there is no such thing as a get rich quick investment. Very few of us – I can’t do it, you can’t do it, most people can’t do it – very few of us can invest in a company and expect a giant return quickly and then to get out and know when they should get out. You have to invest for the long term. This is what my grandmother told me. I still think that my grandmother’s advice about what is prudent as an investor is to manage companies for the long term prosperity.
But, here’s the problem: today, the only measure of success is how stuff looks today; how the house looks today. Management gets paid based on its stock price – its current stock price. Not its future prospects. Not its research and development. Not investments that it’s made into the future. Only on what its stock is today. So it does a bunch of things to goose up the stock price today. And those things are not good for the company, they’re not good for the investor and they’re not good for the country. Laying people off. Cutting research and development. Cutting expenses to the bone. Stock buybacks, where a company goes out into the world and gives money to its stockholders to buy back their stock. That just inflates the price of the stock. These are all bullshit, stupid things that you do with a company when you’re just trying to goose up the stock price for management’s personal bank account, or to please the market and the fund managers who are also dependent on that short term thinking. And what is lost are the solid business principles that make great companies. Innovation, efficiency, a well-trained and engaged workforce, and happy, repeating customers. That’s a great business. But instead, the capital markets are now jerry rigged to inflate the compensation of the fund managers who buy their stock and top management that plays to them. This is a serious, serious, serious problem in the capital markets across the nation. When you have capital markets hellbent on extracting every dollar now, nothing means anything. There is no pride, there’s no sense of innovation or creativity. Nobody is building anything.
When the only currency is currency and not legacy or creation or invention, then you get the kinds of days like we’re having today. When five major, major banks plead guilty to fixing the markets. See, it doesn’t matter. They’re part of the capital markets. When nothing means anything other than cash now, we’re in trouble.
Now, Professor Stout is too sober, too careful, too prudent to say that. I’ll say it. I’ll say the truth. This short-term thinking that plagues the capital markets – this absence of decency, of respect for rules and people and life – is plundering our present and our future. That’s why this book that she’s written is so important. See, most people who teach corporate law – most people who are in this environment at all – are apologists for the greed firsts; are apologists for the people who see nothing wrong and everything good about grabbing at the most amount of dollars now. Professor Stout sees the bigger picture. She sees how it all fits together, and understands that the rules that companies play by are also statements of morality and ethics and inclusiveness.
So, after the break, please enjoy my conversation with Professor Lynn Stout, Distinguished Professor of Corporate and Business Law at Cornell Law School.
CS: I’m here with Lynn Stout, the Distinguished Professor of Corporate and Business Law at Cornell Law School. Her book, The Shareholder Value Myth: How Putting Shareholders first Harms Investors, Corporations and the Public, was published in 2012 and was named the 2012 Governance Book of the Year. Professor Stout has an enormous CV. She serves on the board of governors of the CFA Institute on the Financial Research Advisory Committee to the U.S. Treasury. She’s a member of the Board of Advisors for the Aspen Institute’s Business and Society Program. She serves as Executive Adviser to the Brookings Institution Project on Corporate Purpose. And, she is a research fellow for the Gruter Institute for Law and Behavioral Research. She’s got a B.A. and a Master’s from Princeton, and she got her J.D. from Yale Law School. So, she’s got some game. She’s also really nice, which you don’t expect in a corporate law professor. Professor, welcome.
LS: Oh, thank you, Coco. That’s really kind and appreciated.
CS: I want to set the stage. I love business. I love commerce. I love entrepreneurs. But, there is something that has gone fundamentally wrong in American business today, and I want to talk to you about that. So, first, you wrote this phenomenal book that’s had a real influence on me called, “The Shareholder Value Myth”. In that book, you lay out the case as to why the idea that companies are there to maximize profits for shareholders is not only wrong but it’s also bad for the economy and it’s bad for that company. Did I say that right?
LS: Yes, and bad in the long-run for shareholders themselves.
CS: But just about everybody in the world would say you’re wrong. They would say, “But this is capitalism. This is how business works. We maximize profit.” I was hoping you’d speak to that.
LS: Yeah, um, in fact, I would say that that view – even though people think that that’s the dominant economic view – it’s actually fairly new. It doesn’t really show up on the intellectual landscape until the 1970s, and it’s based on arguments by the Free Market School of Chicago Economists, in particular some arguments advanced by Milton Friedman. The problem with those arguments is that Milton Friedman and the economists who were writing with him literally did not know what corporations were. They had never been to law school. A corporation is created by law – as the Supreme Court has reminded us, it is a legal person – and when the economists started writing about what corporations are and what they should do, they didn’t know what a corporation was, so they just compared it in their own minds to a gigantic sole proprietorship. That’s the only thing they could think of, that it was the equivalent of a business owned by somebody. But, that’s not what corporations are, and it’s not their primary function. Corporations are legal entities. They own themselves, and a lot of non-lawyers have a hard time getting their heads around that concept. It takes a couple years of law school before you become comfortable with this thing we call a “legal entity”, but it’s actually really critical for understanding what corporations are supposed to do. They are creatures of the state. They are created by law. They are not the property of anyone, and they’re particularly not the property of shareholders. There’s a lot of evidence that the primary reason why legal systems created corporations was not only to benefit shareholders, but to pursue long-term economic projects that created benefits for a large number of different kinds of interests, including, not only shareholders, but also employees, customers and the nation-state that created the corporation. It’s hard if you haven’t been to law school and you’re not comfortable with this notion of a legal person, and so it’s easy when people say things like “shareholders own corporations”. That makes sense to people even though it’s one-hundred percent wrong. It’s simply not correct. But the problem is, these mistaken ideas have now been taught to a generation of business leaders and others who just take it for granted that this must be true because so many people have said it.
CS: Well, I’ve gotta tell you, at the risk of really getting out ahead of my skis, I think one of the problems is the description of a corporation as a legal person, because when you say a legal person, you can embody it with actual human characteristics that make it very confusing and make it seem like corporations should be able to do everything that humans do, including contribute to political campaigns.
LS: Right, and that’s a very scary notion that we’d create these Frankenstein monsters that would then compete with us. But that’s not actually what “legal person” means. In the eyes of the law, “legal person” only has the rights that the human beings want to give the “legal person”. The primary rights that a corporation has, and, indeed, has to have to perform the valuable functions that they can perform for society, is the right to own property and the right to enter contracts. But other personal and political liberties, like the right to exercise religion or the right to contribute to campaign contributions don’t necessarily have to go along with it. We shouldn’t confuse a “legal person” with a human being.
CS: But what’s happened? Because now, even at the Supreme Court they don’t get the concept of a corporation’s limited right.
LS: Yeah, they’ve been wrestling with it, and we see in cases like Hobby Lobby and Citizens United that there is an urge to expand the right of “legal persons” so that they are the same as the rights of natural persons. And there’s nothing in the law that says you have to do that. There are rights that institutions like corporations need to have to exist, but they don’t necessarily include rights to political freedom.
CS: I mean, as an aside, I do have to say that I really do think that we can do a whole lot better if we redefine a corporation – not as a legal person, maybe as a synthetic person, or something that maybe doesn’t include the term “person.” And, I understand the roots of person, but it’s confusing to people, apparently including Supreme Court Justices.
LS: Yes, I think that’s absolutely right. It would be much better if we came up with another term, but, unfortunately, because of the concern that corporate personhood would be confused with being a human being, what we get instead is this very mistaken notion of the corporation as something that belongs to shareholders and that exists only to serve the monetary interests of the current crop of shareholders. And that idea, in its own way, has been extremely destructive, and is causing our corporations to be run in a way that’s not only harming employees and customers and the nation-state, but it’s actually harming the long-term interests of most shareholders themselves.
CS: So, if I’m starting a business, what’s the point? What’s the point of my business?
LS: Well, we need to distinguish between you starting a business and someone creating a corporation. If you start a business, the point of the business is, by the way, whatever you want it to be. And there are lots of businesses that are owned by human beings who run those businesses with a view to taking care of, not only themselves, but also their employees and their customers. I mean, if you actually look at private businesses, you’ll often find that a lot of the people who run them are very responsible for their employees, very responsible to their customers, view themselves as good citizens. But a corporation, once you create this legal person, at that point the business exists because the state made it possible to create it. The purpose of the corporation should be whatever the purposes are of the people who created that legal institution. I think there are a lot of good arguments that if you look across history, nation-states didn’t create the corporate form so that a few people could become fabulously wealthy. They created corporations to pursue projects that were going to benefit society as a whole. To develop colonies, to build canals and railroads and bridges… They have a much broader social purpose than just allowing two or three people to make a lot of money.
CS: Yeah, and I always think of a corporation as a bargain; as an exchange. I do actually think of a business and a corporation as, in some way, very related to the people who started it or own it, whichever is most applicable. And, I know that, in your book, I saw several times that you make an attempt to divorce those two concepts, and I think that legally, that’s appropriate. From a different perspective, though, where people actually try and understand this, I think of it as a bargain, in that if you want to start a business, we want you to start that business, because you’re going to do all kinds of things when you do it, for yourself and for your customers and for your employees and for your community. And, because we want you to start that business, we don’t want everything you do to be a life or death decision, so we’re going to wrap you in a nice little shell.
LS: Limited liability!
CS: Right, and that shell is going to keep you safe as long as you don’t act maliciously. But, in exchange, you can’t act maliciously, and you’ve got to tell the whole world that you’re doing business behind this shell. So, to me, that’s the bargain, and that bargain is completely lost. Now, a corporation is nothing more than an instrument of personal greed.
LS: Right, and that’s not what they were intended to do. The other thing that goes into the corporate form that’s very important to bear in mind is, not only does it give limited liability to its shareholders (and, by the way it also gives limited liability to its directors, employees and creditors. I mean, the corporate entity is responsible for its own debt, and none of the human beings associated with it – shareholders or not – are responsible for the corporation’s debts), but the other thing you get is a legal form that can own property and can exist in perpetuity. I think this is the element of the corporation that a lot of people have missed. They’re not there just to serve the current generation of shareholders. These are legal forms – institutions – that are designed to serve multiple generations, and I think that’s part of the problem. When we say that we need to take care of the shareholders, we’re thinking only of the people who own the shares today. But, the fact is, those shareholders come and go. The purpose of the corporation is to pursue long-term projects that generate long-term benefits, and that’s hard when you allow the people who own the shares today to do things like force the corporation to cough up cash or to sell off parts of itself. The original corporations – the first corporate entities – were universities and townships and monasteries. Basically, institutions that were supposed to pursue projects that would go on for centuries, and that’s what the largest companies can do, but not if they’re run with a fashion that focuses on raising the share price today, and go hang the future.
CS: Right, so what’s the connection between this shareholder value myth, this short term profiteering, and the increasing stock buybacks that Nick Hanauer wrote about?
LS: Yeah. Well, what’s going on is that when we talk about maximizing shareholder value, what that translates to in practice is getting the share price up as quickly as possible. We know there are all sorts of financial tricks you can play that have a good chance of getting the stock price up. We know that if you do a share buyback, that tends to drive up the price. If you pay out a big dividend, that tends to drive up the price. If you fire some employees, cut back on research and development so it looks like you have more accounting profits, that will temporarily drive up the price. If you sell off a couple of divisions, that will probably drive up the price. The problem is, these are all short-term strategies – financial tricks – that don’t actually improve the operation of the business over time, and, in fact, may even harm the company’s ability to make long-term profits because it makes it impossible for companies to pursue long-term investment plans.
CS: Who does that hurt?
LS: Oh, that hurts all of us! In the 1950s, large companies devoted 60% of their profits to research and development. That’s how we got the computer, the Internet, the transistor, a lot of our pharmaceuticals. Today, thanks to shareholder value thinking, public companies invest less than 10% of their profits in research. So, what we’re getting is declining corporate innovation, declining economic growth, and never mind all the problems that come from companies trying to fire employees in order to bump up their accounting profits. I mean, when all the companies are firing their employees, guess what? There’s nobody out there with the income to buy the corporation’s products.
CS: Right, right, right. So, umm, what about the stockholders? So, most stockholders, well, I don’t know, you’ll have to tell me this… There are some stockholders – like me – I invest personally in comparatively small amounts, and then there are these institutional investors, but that’s actually holding insurance companies and pensions, right? And university endowments. So, who gets hurt, or who gets helped by this?
LS: Well, what’s going on is actually that shareholders, collectively, are pushing for companies to do things that hurt shareholders, collectively. And to help that make a little sense, imagine that you were a fisherman, and you lived in a village with a bunch of other fishermen on the shores of a lake. One of the fishermen figures out that instead of using lines and bait, she could get a lot more fish by just using dynamite. Now, that’s a situation where every individual fisherman looks at him- or herself and says, “You know what? If I switch over to dynamite, I’m going to get more fish.” But, if they all do that, what is going to happen? The fish catch is going to go down for everybody. So everyone pursuing the best thing for them produces a collective result that’s bad for everybody. We’re seeing something similar to this in investing behavior. We’re seeing pension funds and mutual funds and endowments take a position in a few companies and say, “We’re going to push these companies to do these financial tricks to get the share price up, because then we’re going to sell and go buy another company.” But, what we’re seeing is, with everybody doing that, the number of corporations is shrinking, the life expectancy of corporations is shrinking and the returns from owning stock in corporations is going down.
CS: Professor, I think that analogy about fishing with bait and a pole versus dynamite epitomizes what’s happening in business today, but what do you say to the person who is holding the stick of dynamite and a match?
LS: Don’t do it!
Well, there are three things we can do. We’ll start with the hardest one. If we could get an effective federal government, we could fix this problem very quickly. A lot of the problem comes, frankly, from the tax code, which gives capital gains favorable tax treatment to people who hold shares for only a year – I should think it should be more like 10 years – and also that requires companies to tie executive pay to objective metrics, which tends to be stock price. So we’re actually paying executives to raise the stock price in the short-term. So we can fix a lot of things in the tax code.
You could also fix things at the level of corporations themselves. Corporations can do things to discourage very short-term investors – particularly to discourage the activist hedge funds who are behind a lot of this fishing with dynamite. That’s their specialty. So the companies themselves can do those things but the companies can do those things best when they have support from the broader shareholder base. And, here, we run into the problem that so many people do own their stocks, not directly, but through pension funds and mutual funds. And so what’s needed is a way to get the people who really own these shares – you know, the mom and pop investors – to tell their pension fund trustees and their mutual fund portfolio managers that we don’t want you to fish with dynamite. We want you to let corporations be run for the long-term. That’s a tougher problem, but in the meantime, at least, as an investor, you could go out and look for the companies that are already thinking long-term and trying to protect themselves from the short-termers.
CS: How do you figure out who those companies are?
LS: Well, oftentimes, they’re very public about it. So, you look at companies like Starbucks or Costco that are run by CEOs who have made it very clear that they’re focusing on the long-term and on their employees and their customers, and they’ll often be very public about that.
CS: Yeah, that’s excellent advice. Alright, so I have one more question, and this one is very near and dear to my heart. What do you think is the law firm, or the lawyer’s – the legal profession’s – role in pushing back against this short-term profiteering?
LS: Well, you know, interestingly enough, the lawyers are in a position to be the heroes on this one, and the best way for them to do it is for them to be very clear that this notion that there’s some sort of legal duty to “maximize shareholder value” is a myth. Directors are free to run companies in the fashion that they think is in the best long-term interests of the corporate entity, including, not only its shareholders, but its other stakeholders. And the clearer lawyers can be about that, the more they can help reduce some of the confusion and some of the mistaken beliefs out there, the better off we will all be.
CS: Agreed. Agreed. Our profession is going to have to get a lot more backbone to do that, but I think that it is possible, and I think that you’re a national treasure, and I hope you just keep writing and teaching and speaking and just keep going.
LS: Well, thank you so much, Coco. And thank you for the work you’re doing as well.
CS: Well, thank you, professor, and I hope you’ll come back again.
LS: Oh, I’d be happy to.
CS: Okay. Thank you, professor.
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