The Crazy Assumptions of Stock-Market Ownership

The stock market casts a long shadow over the US economy. Most of the large companies that dominate the marketplace are not owned by their founders or original investors; they are owned by individuals and institutions who buy and sell shares in the public markets. Moreover, many start-up entrepreneurs and private-equity portfolio managers view those markets as the ultimate destination for the companies they control. Take a company public in the right circumstances and you stand to score a big payday.

But there are acute contradictions at the heart of stock-market ownership, as two Harvard Business School professors recently argued in an influential Harvard Business Review article. People who advocate for ESOPs and similar structures need to understand these contradictions, because they provide a powerful rationale for alternative forms of ownership.

The stock market model assumes that shareholders are the owners of the corporation. The company’s board and executives are the shareholders’ agents; they are expected to act in the shareholders’ best interests. Most boards and executives assume that this expectation means maximizing the financial return to shareholders.

All this is pretty much nonsense, say professors Joseph L. Bower and Lynn S. Paine, the article’s authors. For starters, shareholders are not company owners in any traditional sense. They don’t have most of the rights associated with ownership, such as access to the corporation’s premises and records or use of the corporation’s assets. Nor do they have any responsibility or accountability for the corporation’s actions. Their liability is limited to the value of their shares.

Joseph Bower

Nor do they necessarily want maximum short-term financial return. People are different, and have different priorities and objectives. Anyway, how could a corporation ever know what its ostensible owners want? The vast majority of shares in US-listed companies are held by mutual funds and other institutions, which manage them on behalf of beneficiaries such as individuals and organizations. An estimated 75% of the ultimate owners—the beneficiaries—“have instructed their intermediaries not to divulge their identities to the issuing company.”

As for management being an agent of the owners, that’s just wrongheaded. “Managers and directors are fiduciaries rather than agents,” say Bower and Paine—“and not just for shareholders but also for the corporation.” Agents, they explain “are obliged to carry out the wishes of the principal.” A fiduciary’s obligation “is to exercise independent judgment on behalf of a beneficiary.” Legally, directors have a fiduciary duty “to act in the best interests of the corporation, which is very different from simply doing the bidding of shareholders.”

The agency model has pernicious consequences. It focuses managerial attention on short-term gains in the company’s earnings and share price at the expense of other objectives. It frees managers from owners’ oversight as to how they realize this objective, and what they do along the way. It allows them to ignore the social consequences of their decisions—closing a facility in a struggling community, for instance. Essentially, the model creates irresponsible ownership and management.

What’s the alternative? Bower and Paine propose a “company-centered model,” reflecting the fact that corporations are economic and social

Lynn Paine

organisms created by governments to achieve certain objectives. As creatures of the state, which is to say of society, their job is to create value for multiple constituencies. They must acknowledge the fact that they depend on a healthy political and socioeconomic environment. They have interests of their own, “distinct from the interests of any particular shareholder or constituency group.”

The authors don’t spell out the implications of their model for ownership structures, but it’s hard not to conclude that employee ownership through an ESOP would make for far better outcomes. The constituents of an ESOP are interested in the long-term growth and health of a company. They are right there, on site, and their presence is likely to influence management’s behavior even if they have no direct say over day-to-day decisions. (For example, would CEOs of employee-owned companies be as likely to pay themselves many hundreds of times the wage of a front-line employee?) The ESOP trustee has an explicit fiduciary duty to look out for the best interests of plan participants, and can vote the ESOP’s shares accordingly.

“The time has come,” say Bower and Paine, “to challenge the agency-based model of corporate governance.” We might add that the time has also come to challenge the fundamental structure of stock-market ownership. For the vast majority of the American people, it isn’t working.