Gabriella Quesada
Edited by Sahith Mocharla, Jia Lin, and Paras Patel
In 1919, the Michigan Supreme Court forever changed the course of corporate America with the Dodge v. Ford ruling. [1] Three years prior, the Ford Motor Company sought to lower their vehicles’ prices while raising their workers' salaries. This would drastically decrease the business’s dividends: the portion of profit and retained earnings paid to investors. Therefore, Henry Ford faced resistance to this direction of his company, most notably from his minority shareholders, the Dodge brothers. John and Horace Dodge kept track of the company’s struggling financials and felt Ford’s direction would position the company as a charity. However, Ford declared that these compensations were not a main consideration in his decision and went forward with his initial intentions. This resulted in the Dodge brothers’ lawsuit against Ford Motor Company, which prompted the court to consider whether minority shareholders could restrict Ford's ability to run his company. Eventually, the court upheld shareholder primacy: a business is designed and carried on primarily for the stockholder’s profits. [9] This profit-minded decision reverberated for years and has been the standard at almost every office in the U.S. Although this mentality has dominated for years, it has not gone unopposed. Numerous drawbacks have led to a movement towards a more holistic approach: stakeholder primacy. Stakeholder primacy considers other factors of a company, such as its employees, the environment, and consumers, before yet not in the absence of its shareholders. In analyzing the decision in the Dodge case, one could consider a corporate transition straying away from the current model of shareholder primacy. Through this shift, companies can practice more ethical behavior, sustainable practices, and economic longevity.
Shareholder primacy is the embodiment of Friedman’s Free Market Economic Vision – developed as the Shareholder Preeminence Theory at the Chicago School of Economics in the 1970s – arguing the primary purpose of a business is to maximize its revenue along with its returns to its shareholders. [2] All other factors, including social responsibilities, are not obligations of a company and are only done if the shareholders decide to do so. This theory may seem drastically focused on one subset of people, but Friedman did this purposefully, believing that valuing shareholders rules business. While multiple court cases have challenged this common law, shareholder primacy has typically been seen as a “norm” or even a “dogma” in the status quo. Therefore, Friedman’s theory, centered around businesses having no social responsibility, enabled a more concrete way of identifying this common behavior. In the 1980s, Friedman’s ideals were supported through reengineering, a concept where companies began restructuring, with expert help, to elevate their efficiency in generating revenue to increase shareholder profits. [3] As enterprises were reorganized, exclusively prioritizing profits began integrating itself into countless corporate laws. For instance, the Model Business Corporation Act (MBCA) was created in 1950 by the American Bar Association to uniform corporate affairs across the states. [4] Within the guidelines offered by the act lie the rights of shareholders: the right to vote, transfer ownership, claim dividends, inspect corporate documents, and sue for wrongful acts. Although shareholder primacy is not formal legislation, its presence is prevalent within the existing statutes of business conduct. Companies sought to follow Friedman’s principles as a response to the assurance it provided for maximizing profits. To better grasp this economic revolution, one can examine specific companies directly affected.
In the 1970s, leaders of the Dow Jones Industrial Average (DJIA – one of the oldest and most followed equity indexes) faced difficulties as the diffusion of their operations resulted in weak corporate accountability to their shareholders. This trend was prevalent in American corporations from the nineteenth to the twentieth centuries. Before the global expansion of corporate structures, entrepreneurs bore the brunt of responsibility for their failures. While the consequences were risky, it enabled them to have greater liberties in their business decisions. However, as businesses began to experience exponential growth, the role of investors – previously negligible – became critical. With the addition of investors came a new network of people responsible, and that required a rebalancing of power amongst the investors and CEO. This shift in control led to an internal struggle between the business owners and shareholders, causing DJIA to enter a long-term slump in profitability. However, the Friedman Doctrine seemed to offer a solution.
Moving into the 1980s, DJIA showcased the immediate effects of the decade’s wave of restructuring of corporate America to conform to Friedman’s principles. [5] As Friedman prioritized the shareholder’s value, DJIA reorganized to concentrate its equity ownership. Rather than having multiple modest shareholders, whose investments would not equate to a large say in the company, DJIA concentrated the power amongst the top investors, granting them greater leverage with the company’s board of directors. [6] This not only created a more streamlined method of communication but also enabled the company's profitability to correlate with the shareholders’ best interests. From 1976 to 1990, DJIA doubled its equity from $1.4 to $3 trillion, and shareholders gained $750 billion. Friedman’s principles in practice proved to align directors’ fiduciary duty with shareholder interests. [5] This is certainly a remarkable influx of profits, yet, with the fluctuating U.S. economy in mind, it would be inadequate to try to similarly apply these outcomes nearly four decades later to modern businesses. Therefore, it is critical to analyze how companies like DJIA laid the groundwork for modern companies to follow.
In current business structures, American corporations have quantified shareholder-centricity through Total Shareholder Return (TSR), the primary way the world measures corporate performance, executive compensation, and the role of directors. Indicating businesses’ success by the total amount investors reap from their investments essentially narrows companies’ vision to become equivalent to shareholder returns. [7] Wall Street, the hub of stock market trading, has perpetuated this narrow view through their dependable updates of the TSR, essentially showing the fluctuations of a shareholder’s investment. Companies will go to great lengths to strategically elevate outstanding stock prices, solidifying the high ranking of their company’s success. For example, as of March 2022, Target’s board of directors approved a $15 billion share-repurchase program. Rather than granting its shareholders dividends, Target’s buybacks preserved its stock prices, granted selling shareholders their monetary compensation, and consolidated the ownership of the remaining shareholders – a clear practice of shareholder primacy. [7] Since Dodge v. Ford and the transformation undergone by DJIA, shareholder primacy has laid the groundwork for how businesses today grow to be successful. While corporations vary greatly, this shared priority creates a common outlook that can lead to consequential sacrifices for shareholder profits.
In light of environmental issues, income inequality, and the undervaluing of workers, shareholder primacy can have detrimental consequences. Most notably, the 2008 financial crisis spurred an examination of shareholder primacy’s disadvantages. [8] After examining excessively risky investment strategies that led to the worst economic downturn since the Great Depression, shareholder primacy seemed to be the culprit. The intense focus on profits blindsided and influenced managers to pursue unnecessarily high-risk avenues to increase shareholder profits rather than sustainable business models. [9] This mentality is further intensified by the emphasis on short-termism: the focus of companies on quick results regardless of long-term results. [10] Shareholder primacy ultimately rewards this kind of thinking and is displayed by businesses’ prioritization of quarterly reports, stemming from investors wanting immediate affirmations on the outcomes of investments. Therefore, the norm of shareholder primacy pushes companies to comply with their investors’ desires, encouraging a short-term perspective. While the benefits of shareholder primacy exist, it is critical to understand that these advantages are short-term. Enron Corporation, prior to 2001, was known for being highly successful due to its high stock price. However, the managers were soon revealed to be illegally hiding debt in conjunction with criminal accounting practices – defrauding investors by appearing to be profitable despite heavy losses. [11] Once praised for its accumulation of $350 billion in trades, the company filed for bankruptcy, with its head executives being sent to jail for corporate crimes. While this is an extreme scenario, Enron displays the level of desperation for the sake of shareholder returns this system of priority creates.
These long-term effects can materialize in many different forms. To start, the crisis of increasing global temperatures has led to societal pressures for energy companies to start considering the sustainability of their practices. Using Friedman’s principles, committees such as one for sustainability would only be viewed as a drain for profits to go down. Yet, large corporations that have added this governing body have offset their short-term consequences with long-term growth. For instance, the cost of recyclable materials may be higher, but their products gain popularity with consumers as their ethical practicality ensures a longer company lifespan. [12] While Friedman would disapprove of the extra costs being fronted in the beginning, the long-term impacts enable environmentally conscious companies to gain better media traction amongst more educated consumers, who are known to have higher levels of income.
Secondly, educated consumers bring forth more knowledge about the wealth gap currently expanding in the country. Shareholder primacy has been shown to exacerbate this issue through its results of appropriating 93% of all corporate profits from the Standard and Poor’s (S&P) 500 to shareholders. This extreme concentration of wealth comes not only from the priority given to shareholders but, more importantly, from the concentration of investment, as equity is more influential in greater quantities. CFOs and CEOs are incentivized to practice business this way, as the ones who have the formal power to challenge their business decisions are the shareholders themselves; therefore, decisions must be made with shareholder interests rather than the company’s. [12] The corporate structure enables the investors to increase their income and threatens the managers if they go against their best financial interests. Essentially, Friedman influenced a never-ending cycle of wealth concentration with long-term consequences, to which only investors are immune.
Concerning these consequences, the greatest threat to a business's long-term growth lies in the undervaluing of employees. Target’s shareholder buybacks had a knock-on effect, leading to the long-term consequences of massive worker lay-offs. By investing 50% more of their profits in investors rather than the workforce, Target’s payment towards improving job training created a harder level of employment and facilitated older employees being let go for their inability to fulfill higher standards. [7] Other high-profile companies followed Target’s example, such as Amazon, which was seen investing in their stockholders 20 to 1 compared to their employees, amidst a unionizing plan by Amazon workers at the Alabama plant. [7] Effectively granting $10 billion to its investors, Amazon sent a message of indifference to its workers in Alabama, which Friedman would uphold through his principles, affirming a company’s lack of obligation to social responsibility.
In recent times, companies have notably begun to push back on Friedman’s principles; however, the ingraining of shareholder primacy into corporate structures has limited their opposition. In the tech sector, shareholder primacy has created a common practice of replacing employees with contract labor. The latter has less job security, lower wages, and close to no employee benefits – all of which are cheaper for the company in the short term. [7] Google, as of 2022, had more contracted labor than employees on the payroll. In 2011, Google announced its intent to create 1,600 new jobs. Shareholders were against this goal, as it would increase expenses. [7] Consequently, the stock price fell 5% within 24 hours. Workers who are under contract, with limited opportunities for advancement in the company, have decreased motivation to go above and beyond their job description and make meaningful changes for the business. Ultimately, shareholder primacy encourages short-term benefits in the face of long-term drawbacks and, more importantly, restricts business managers from trying to overcome its constraints.
In general, the critique of this sustained corporate precedent is that the shareholders’ interests trump all others. When layoffs and pollution start to become the keys to profit, it is time to start questioning the social efficacy of this business norm. The preeminent alternative theory to shareholder primacy is stakeholder primacy, exemplified by the family business model. In 1984, R. Edward Freeman developed the Stakeholder Theory, arguing that businesses do have moral responsibilities that are best served by considering all stakeholders, such as consumers, employees, and communities. [13] While Freeman is not advocating for ignoring investors, he argues their disproportionate value to the rest of the stakeholders disrupts a company’s long-term success. Since the 1980s, economists have used Freeman’s principles to challenge the consequences of shareholder primacy, and family businesses showcase his theory in practice. For instance, Jack Stack, a family business owner, utilized “open book” management that effectively turned his failing business around. [3] This style of management included employees’ input in the business’s finances to encourage efficiency. As the numbers were right in front of them, the employees were not only motivated to help but also felt valued for their efforts. Financial transparency is in direct line with Freeman's principles since Stack was able to make his company successful by creating stronger inter-company ties. In Freeman’s model, the workers are investments, not a cost to be minimized. This key difference creates a more stable company better equipped to achieve maximum productivity. This practice also functions beyond the scope of family businesses. One can find this theory in practice within private companies such as The Corporate Coalition of Chicago: an alliance of corporations working to combat racial and economic inequalities through their business practices. [14] Their annual stakeholder reports continue to hold company managers accountable to their employees and the public. The corporations utilize these reports to communicate directly with their stakeholders and make their progress transparent. Through Freeman's principles, corporations shift their focus from shareholder profit to their own moral and internal financial outcomes, engendering dependable employees with corporate longevity rather than short-term benefits.
However, the practicalities of switching to Freeman from Friedman are challenging. While shareholder and stakeholder primacy are not laws, court cases and corporate statutes underscoring the former create legal difficulties for companies to change. From the earliest case, Dodge v. Ford, to the current American Bar Association, shareholder primacy has deeply embedded itself into the pillars of corporate America. Yet strides are still being made. For example, in 2019, the Business Roundtable, a nonprofit association of CEOs of 200 major U.S. companies, made a rousing declaration with the release of the Statement on the Purpose of a Corporation. [15] In describing the economy that Americans deserve, it wasn’t until the 250th word out of 300 that “shareholder” was written. The companies definitively stated they “share a fundamental commitment to all of their stakeholders.” Listing out their responsibilities to their customers, employees, and suppliers, shareholders were the last on the list and clarified their commitment was to the company’s “long-term” benefit.
While this was a powerful step in a new direction, corporate action has yet to indicate measurable change. Researchers from Harvard Law School, Lucian Bebchuk and Roberto Tallarita, argue the statement was “mostly for show” after its second anniversary had passed with no perceptible change. [16] In 2021, a Business Roundtable spokeswoman opened up, explaining that the statement was more of a concession to the fact that the short-term gains of shareholder primacy are not enough to sustain a company, but the switch to stakeholder primacy can’t practically happen without formal changes to bylaws, governance guidelines, and corporate policies.
Therefore, the enforceability of Friedman’s dogma remains questionable. Societal and corporate interests are not mutually exclusive; therefore, shareholder primacy trying to separate these intertwined ideals only promotes more harm to society and propagates corporate practices that stray away from consumer benefit. The federal government has intervened multiple times through federal regulation – whether on a case-by-case basis or for entire industries – federal regulations have been used to promote the public health, safety, welfare, and morals of their constituents. [17] The tension between the federal government’s use of regulations effectively challenged the Supreme Court’s original ruling in Dodge v. Ford, which made shareholder primacy a business norm. While this legal complexity is ongoing, companies remain tied to their shareholders because managers still functionally require a majority of investors to agree to pursue broader economic interests for the sake of maximizing shareholder returns. This short leash inhibits ethical behavior, sustainable practices, and economic longevity.
The U.S. economy remains ever-changing and the longevity of current business practices remains in question. However, undoubtedly Friedman and Freeman have opened the corporate world to a mix of interpretations of what businesses should prioritize. While the dogma of shareholder primacy remains at the forefront, Henry Ford’s intentions to spread his industrial system’s benefits to his community have yet to be forgotten over a century later.
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[2] Cydney Posner, So long to shareholder primacy The Harvard Law School Forum on Corporate Governance (2019), https://corpgov.law.harvard.edu/2019/08/22/so-long-to-shareholder-primacy/#:~:text=The%20shift%20to%20shareholder%20primacy,increase%20its%20profits.%E2%80%9D%20Subsequently%2C (last visited Nov 6, 2023).
[3] Dennis Jaffe, From shareholder primacy to stakeholder primacy: How family businesses lead the way Forbes (2021), https://www.forbes.com/sites/dennisjaffe/2021/02/24/from-shareholder-primacy-to-stakeholder-primacy-how-family-businesses-lead-the-way/?sh=79c269ed21ed (last visited Nov 6, 2023).
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[7] Alexa Wahl, The impact of shareholder primacy: What it means to put the stock price first The Aspen Institute (2022), https://www.aspeninstitute.org/of-interest/the-impact-of-shareholder-primacy-what-it-means-to-put-the-stock-price-first-2/ (last visited Nov 6, 2023).
[8] Brian Duignan, Financial crisis of 2007–08 Encyclopædia Britannica (2019), https://www.britannica.com/money/topic/financial-crisis-of-2007-2008 (last visited Nov 6, 2023).
[9] David Million, Shareholder Primacy in the Classroom After the Financial Crisis Journal of Business & Technology Law (2013), https://core.ac.uk/download/pdf/56355522.pdf (last visited 2023).
[10] Short-termism: Causes and disadvantages of short-termism - 2023, MasterClass (2023), https://www.masterclass.com/articles/short-termism (last visited Nov 6, 2023).
[11] Troy Segal, Enron scandal: The fall of a wall street darling Investopedia (2023), https://www.investopedia.com/updates/enron-scandal-summary/ (last visited 2023).
[12] IncNow, What is shareholder primacy? IncNow (2022), https://www.incnow.com/blog/2022/01/05/what-is-shareholder-primacy/#:~:text=The%20disadvantage%2C%20or%20critique%2C%20of,of%20all%20other%20stakeholder%20interests (last visited Nov 6, 2023).
[13] About the Stakeholder Theory, Alt Text, http://stakeholdertheory.org/about/#:~:text=About%20the%20Stakeholder%20Theory&text=The%20theory%20argues%20that%20a,values%20in%20managing%20an%20organization (last visited Nov 6, 2023).
[14] Corporate coalition of Chicago, Corporate Coalition of Chicago, https://www.corpcoalition.org/ (last visited Nov 6, 2023).
[15] Statement on the Purpose of a Corporation, Business Roundtable (2019), https://www.businessroundtable.org.
[16] Geoff Colvin, America’s top CEOS didn’t live up to their promises, research says Fortune (2021), https://fortune.com/2021/08/05/business-roundtable-letter-statement-on-the-purpose-of-a-corporation-stakeholder-capitalism-american-ceos/ (last visited Nov 6, 2023).
[17] Kyle Bernal, 5 examples of government regulation of businesses Executive Gov (2022), https://executivegov.com/articles/5-examples-of-government-regulation-of-businesses/#:~:text=Federal%20regulations%20and%20laws%20can,and%20morals%20of%20its%20constituents (last visited Nov 6, 2023).