ABA Section of Business Law

It all comes down to money

Face it: A board's main goal is corporate profits

Sommer is counsel at Morgan, Lewis & Bockius in Washington.

Do boards of directors have a greater purpose than simply the pursuit of profit? No, this isn't a trick question. And surprisingly, the answer isn't tricky at all.

Ever since the invention of the modern corporation, there has been controversy concerning its purpose and responsibilities. The earliest corporations were set up for specific public purposes, generally to do a public good, for instance, operate a toll bridge or construct some other public facility; of course, the entrepreneurs expected to make a profit from the enterprise. As the general purpose corporation became commonplace and the organizers could organize for any legal purpose whether it served a public need or not, it became possible for corporations to be organized solely for the enrichment of their organizers.

As these corporations grew in size and influence, and it became apparent they could wield significant economic power, social reformers began to insist that this power should be marshaled for the common good. These demands were particularly strong during times of economic distress. Thus during the depression of the '30s the debate was vigorous. Its intellectual manifestation was most clearly seen in the pages of the Harvard Law Review and the Columbia Law Review where E. Merrick Dodd and Adolf A. Berle, professors respectively at Harvard and Columbia, stated opposing viewpoints. Dodd insisted that the corporation had a purpose that transcended simply making money for shareholders; Berle took the opposite point of view.

The battle was renewed during the '80s, not because of economic misfortune, but because of the onset of the hostile tender offer. The traditional view that the directors had a fiduciary responsibility that ran solely to shareholders, save in extraordinary circumstances, seemed to many to require directors to reach for the highest offer for the company regardless of other considerations, such as effect on employees and communities.

To remove the strait jacket in which they found themselves, corporations prevailed on the legislatures in some 30 states to adopt legislation that would permit directors to take into account in their decision making constituencies and considerations beyond the shareholders. They could, for instance, take into account the interests of employees, suppliers, customers, communities, long-term interests of shareholders as well as short-terin interests, the interests of the state and so on. With the exception of Connecticut, there was no obligation on directors to a take into account these interests.

Some have expressed concern as to whether the privilege accorded by the statutes to take into account other interests transcends the fiduciary obligation of directors to shareholders except for the few states that made sure action favoring constituencies other than shareholders would be upheld.

Many contended that the directors had an obligation to the "corporation," which they interpreted to mean that the directors could, even without special legislation, take into account the variety of interests connoted by that term. To some extent, they found solace in the fact that the Delaware Supreme and Chancery Courts, as well as courts in other states, used "shareholders" and "corporation" interchangeably and spoke of directors having an obligation to either or both. In the United Kingdom, the Companies Act makes clear the duty of directors is to shareholders alone.

Notwithstanding the ambiguity in its use of "shareholders" and "corporation," the Delaware Supreme Court on several occasions has indicated clearly the primacy of shareholders. Most notably, in Mills Acquisition Co. v. Macmillan Inc. (559 A. 2d 1261, 1282, n. 29 [Del. 1989]), it stated that a board in deciding whether to accept an offer may consider "the impact of both the bid and the potential acquisition on other constituencies, provided that it bears some relationship to general shareholder interests."

During the time that the debate was continuing with regard to "other constituencies" statutes, the American Law Institute, perhaps the preeminent body of judges, lawyers and academics concerned with the progress of American law, was considering the principles of corporate governance. In Section 2.01 of the final product of the project, Principles of Corporate Governance: Analysis and Recommendations, it stated that, with certain limited exceptions for ethical and eleemosynary considerations, "...a corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain."

ALI members deliberated with regard to the conduct of directors in connection with takeovers. The advocates of a broader perspective prevailed to some extent, so that the Principles provide that in any action to forestall an unsolicited tender offer, the directors may "take into account all factors relevant to the best interests of the corporation and shareholders [and] may ... have regard for interests or groups (other than shareholders) with respect to which the corporation has a legitimate concern if to do so would not significantly disfavor the long-term interests of shareholders."

Even in this formulation, there is recognition that whenever action on behalf of nonshareholder interests is taken, the primacy of shareholder interests must be ever in mind.

The fact of the matter is that American courts, American lawyers, American executives and American directors do put the interests of shareholders first in their thinking. This has been amply seen in recent years in which directors, often acting in response to shareholder rebellion, have ousted management. It is not customers or suppliers or communities or even employees who insisted on the dismissal of executives, but rather directors dissatisfied with the performance of management on behalf of the shareholders. To the extent that other factors like dissatisfaction of employees play a role, it is concern with the impact of those factors on the bottom line that moves them to action.

Increasingly, with more and more Americans dependent on equities for their retirement (and that number will multiply enormously if some of the proposals for Social Security reform prevail) shareholder value and corporate performance mean more and more to more Americans.

One of the clearest difficulties of suggesting that directors should take into account a variety of interests is the simple problem of monitoring and evaluating director and executive performance. What may appear as poor performance from the standpoint of shareholders may on the other hand be roundly applauded by the community or suppliers or employees. The simplest measure, and the one that economic America is most accustomed to dealing with, is simply, "How well has the corporation served investors?" It is this by which the professional analysts, investors, the sources of capital and ordinary shareholders judge the performance of the corporation and determine whether its shares are an appropriate investment.

The problem of the corporation serving varied interests and directors being compelled to make difficult allocation judgments has been well stated by the Nobel Prize-winning economist, Milton Friedman. He said, "A single, objective goal like profit maximization is far more easily monitored than a multiple, vaguely defined goal like the fair and reasonable accommodation of all affected interests. It is easier, for example, to tell if a corporate manager is doing what she is supposed to do than to tell if a university president is doing what she is supposed to do." In fact, if corporate directors were to allocate the resources among the many claimants on the basis of their judgment of the merits of each claimant, or group of claimants, they would in effect be making political decisions.

From time to time, proposals have been made to develop a means of "social accounting" whereby a corporation's performance might be judged by measures other than solely economic performance. For instance, a value might be given to its employee relations, community attitude, relations with customers and suppliers, environmental policies and safety and health of employees. All efforts have focused on the question of how to measure the other elements of the equation.

Even if such a series of measures might be developed, the next problem is acceptance of them by those who have capital to invest. So far, there has been no indication whatsoever that there are significant numbers of investors who would be influenced by these considerations.

The primacy of shareholder value is no longer a unique American phenomenon. Increasingly, foreign companies are shifting their focus from the concept of corporations as "social entities" and seeing them more as "profit-making entities" that must gain investor confidence; otherwise they will lag in the struggle for capital essential to survival in today's economic world.

The most recent evidence of the increasing world transcendence of the primacy of shareholder value is seen in the April 1998 report to the Organi-zation for Economic Co-operation and Development (OECD), an organization of 29, for the most part, developed countries, by a blue-ribbon advisory group on corporate governance. Under the caption "The Primary Corporate Objective," the report states: Most industrialized societies recognize that generating long-term economic profit (a measure based on net revenues that takes into account the cost of capital) is the corporation's primary objective. In the long run, the generation of economic profit to enhance shareholder value, through the pursuit of sustained competitive advantage, is necessary to attract the capital required for prudent growth and perpetuation.

No one can read with equanimity about massive layoffs with all of the human suffering that entails reductions in standards of living, economic hardship, family dislocations and a whole range of other undesirable consequences. One cannot be indifferent to the fate of communities that have come to rely over the years on a corporate presence. However, this has been the history of capitalism what Joseph Schumpeter, the great economist, has described as the "creative destruction of capitalism." Out of the destructive dimension of capitalism has come creativity that carried society to new levels of well being.

This has been seen on both a macro and a micro level. On the micro level, a good example is seen in the development of the transportation industry in this country. Once river barges and stage coaches provided the principal means of hauling freight and people. These were succeeded by the railroads, and those who were running the barges and stage coaches had to seek other employment and undoubtedly in the course of the transition businesses failed and many communities that depended on business generated by the barges and stage coaches suffered major setbacks.

On a macro basis, the industrial revolution is a good example. History records that this resulted in huge dislocations and a virtual revolution in the structure of society as countries industrialized. Many of the enterprises engaged in the old ways of production undoubtedly failed with sizable financial losses to their owners. Their employees and their crafts were made obsolete and had to seek other, usually less fulfilling and less remunerative employment, but the new order brought immeasurable wealth and prosperity to their progeny and to society as a whole.

Today, we are witnessing another "macro" example of "creative destruction." As industry throughout the world refashions to take advantage of the computer-information revolution, we see many of the same dislocations that the industrial revolution brought about.

Often the rewards of this "creative destruction" are unevenly distributed, with those in the vanguard of change reaping what appears to many (and with good reason in many cases) to be excessive benefits. Witness the compensation levels and the wealth generated for the owners and managers of computer-related enterprises as we make the transition from an industrial economy into an information-oriented economy.

No one can doubt that the emphasis by American management on shareholder value driven by foreign competition, the threat of takeovers, shareholder pressure and activist boards has been the key ingredient of the continued phenomenal success of American industry in this decade. Enterprises that lagged in their return to shareholders soon found themselves under awesome pressure to improve performance, and if they failed, they were often absorbed by other enterprises or fell by the wayside.

The struggle for capital is now worldwide, with enterprises in every country, in every region, along with American enterprises, all seeking to tap the same wells of capital. In every case, the suppliers of capital want the highest possible return commensurate with risk. If the expected return from an investment in an enterprise will be inadequate in relation to other opportunities, then capital will go where the promise of return is the greatest and no amount of largesse to employees, communities, suppliers or customers is going to make a difference.

In the final analysis, of course, managements are not indifferent to other constituencies. Their commitment to shareholder value demands that they be sensitive to their workforce, its training, its quality, its morale, and to the relationships with customers and suppliers, and with the community. A deficiency in the relationship with any of these can adversely affect return on capital. So the question is not whether management and directors should favor other constituencies over shareholders, but how well they can use those relationships to advance the interests of shareholders.

During the height of the tender offer phenomenon in the '80s, the question was often asked whether directors and management should be concerned with the short-term interests of shareholders or their long-term interests. The issue was framed in terms of a huge premium upfront to buy a company versus the prospect of greater gains over the long run if the enterprise remained independent. Some court rulings suggested that directors had as much responsibility to the short-term speculators as to the long-term investors. With some encouragement from the Delaware Supreme Court, it is fair to say that that issue has been resolved and most commentators, executives, directors, analysts and others would say that the primary responsibility of the management and directors of an enterprise is the long-term value of the enterprise.

The concept of the primacy of shareholder value strikes many and not just academics as heartless and unfair, ignoring the "investment" made by employees who commit years of service to a company, communities that build facilities to accommodate employees and their families, suppliers who depend on a particular enterprise. Unfortunate as the consequences of adherence to shareholder value as the goal of corporate enterprise often may be, there is ample evidence that this commitment has served society at large well.

It has provided a meaningful measure of the manner in which society's resources owned by corporations are used, and has provided the incentive for the maximization of their use. Moreover, other constituencies have available, and have used, various means to protect themselves from adversities brought on by the effort to maximize shareholder value. As an example, labor enters into contracts, suppliers cultivate multiple customers, communities attract other enterprises to avoid dependence on a single employer.

In short, management and directors who seek to maximize shareholder return create wealth that benefits the entire community. Experience teaches that, and throughout the world that experience is leading to new opportunities and the promise of better days.