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2.4 The Primacy of Shareholder Interests: A Historical Perspective

During the first part of the 19th century, the corporation was viewed as a social instrument for the state to carry out its public policy goals, and each instance of incorporation required a special act of the state legislature. The function of the law was to protect stakeholders by making sure corporations would not pursue activities beyond their original charter or state of incorporation. By the end of the 19th century, states began to allow general incorporation, which fueled an explosive growth in the creation of companies for private business purposes. In its aftermath, concern for stakeholder welfare gave way to the concept of managing the corporation for shareholders’ profits.This section draws on Sundaram and Inkpen (2004).

In 1919 the primacy of shareholder value maximizationA doctrine that holds that a company’s ultimate success can be measured by the extent to which shareholders’ wealth and stock value are increased. was affirmed in a ruling by the Michigan State Supreme Court in Dodge vs. Ford Motor Company. Henry Ford wanted to invest Ford Motor Company’s considerable retained earnings in the company rather than distribute it to shareholders. The Dodge brothers, minority shareholders in Ford Motor Company, brought suit against Ford, alleging that his intention to benefit employees and consumers was at the expense of shareholders. In their ruling, the Michigan court agreed with the Dodge brothers:

A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the non-distribution of profits among stockholders in order to devote them to other purposes.Dodge v. Ford Motor Co. (1919).

In The Modern Corporation and Private Property, published in 1932, Adolph Berle and Gardiner Means provided important intellectual support for the shareholder value norm. In this now classic book, the authors called attention to a new phenomenon affecting corporations in the United States at the time. They noted that ownership of capital had become widely dispersed among many small shareholders, yet control was concentrated in the hands of just a few managers. Berle and Means warned that the separation of ownership and control would destroy the very foundation of the existing economic order and argued that managing on behalf of the shareholders was the sine qua non of managerial decision making because shareholders were property owners.

Following the 1929 stock market crash and the Great Depression, stakeholder concerns were being voiced once again. If the corporation is an entity separate from its shareholders, it was argued, it has citizenship responsibilities.Dodd (1932), pp. 1145–1163. According to this point of view, rather than being an agent for shareholders, the role of managementExecutives who act in a trustee manner toward a corporation’s nonshareholders, including labor, consumers, and the environment. is that of a trustee with citizenship responsibilities on behalf of all constituencies, even if it means a reduction in shareholder value. In the following years, states adopted a number of stakeholder statutes reflecting this new sense of corporate responsibility toward nonshareholding constituencies, such as labor, consumers, and the natural environment.

By the end of the 20th century, however, despite state-level legislative efforts to the contrary, American-style market-driven capitalism had prevailed and the pendulum swung back to the shareholder. Friedman’s view that the “sole social responsibility of business is to increase profits” energized a push back on corporate social responsibility.Friedman (1970). In the meantime, agency theoryA theory that attempts to reconcile the relationship between shareholders and the agent of the shareholders (for example, the corporation’s managers). For agency theory, see, for example, Alchian and Demsetz (1972); and Jensen and Meckling (1976); and Fama and Jensen (1983a). Agency theory is directed at the dilemma in which one party (the shareholder as the principal) delegates work to another (management as the agent) who performs that work. Agency theory is concerned with resolving two problems that can occur in such a relationship. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing. The issue here is that the principal cannot verify that the agent has behaved appropriately. The second is the problem of risk sharing that arises when the principal and agent have different attitudes toward risk. In this situation, the principle and the agent may prefer different actions because of the different risk preferences. and the concept of the corporation as a nexus of contractsEasterbrook and Fischel (1991). Nexus of contracts theory views the firm not as an entity but as an aggregate of various inputs brought together to produce goods or services. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm’s inputs. The firm is seen as simply a web of explicit and implicit contracts establishing rights and obligations among the various inputs making up the firm. had become influential doctrines in finance and economics.

To protect the interests of other stakeholders, 30 states in the United States enacted stakeholder statutes that allowed directors to consider the interests of nonshareholder constituencies in corporate decisions. Thus, the law gave boards latitude in determining what is in the best long-term interests of the corporation and how to take the interests of other stakeholders into account. Nevertheless, the mainstream of U.S. corporate law remains committed to the principle of shareholder wealth maximization.See the notes for Bainbridge (1993) “In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green.”