Fall 2000
Vol. 15, No. 3

The $tockholder Myth

by Marjorie Kelly

BOOK EXCERPT: The Divine Right of Capital

Can it be believed that the democracy which has overthrown the feudal system and vanquished kings will retreat before tradesmen and capitalists?

-- Alexis de Tocqueville

     The core problems of capitalism -- bloated CEO pay, sweatshops, and speculative excess to stagnant wages, corporate welfare, and environmental indifference -- all spring from a single source: the mandate to maximize returns to shareholders.

     This mandate amounts to property bias, which is akin to racial or gender bias. It arises from the unconscious belief that property owners, or wealth holders, matter more than others. We call the system upholding this belief "economic aristocracy." We have democratized only government, not economics. Property bias keeps our corporate worldview rooted in the pre-democratic age.

     I co-founded the publication Business Ethics in 1987, in the belief that individual companies, by becoming socially responsible, would transform capitalism. I no longer believe this. I have watched as ethics, employee ownership, family-friendly policies, and other progressive notions have put down only shallow roots -- to be torn out and discarded when they conflict with the mandate to maximize returns to shareholders.

Why the Fuss over Stockholders?
     Where does the wealth of major public corporations come from? To judge by the current arrangement in corporate America, one might suppose capital creates wealth -- which is odd, because a pile of capital just sitting there creates nothing. Yet capital providers (stockholders) lay claim to most of the wealth that public corporations generate. They also claim the more fundamental right to have corporations managed exclusively on their behalf.

     Corporations are believed to exist for one purpose alone: to maximize returns to shareholders. This principle is reinforced by CEOs, the Wall Street Journal, business schools, and the courts. It is the law of the land -- much as the divine right of kings was once the law of the land. Indeed, "maximizing returns to shareholders" is almost universally accepted as a kind of divine, unchallengeable mandate. It is not in the least controversial. Though it should be.

     What do shareholders contribute to justify the extraordinary allegiance they receive? They take risks, we're told. They put their money on the line, so that corporations might grow and prosper. Let's test the truth of this with a little quiz:

     "Stockholders fund major public corporations." -- True or false?

     For the most part, massively false.

     Equity "investments" reach a public corporation only when new common stock is sold, which for major corporations is a rare event. Among the Dow Jones industrials, only a few have sold any new common stock in 30 years. Many have sold little or none in 50 years.

     The stock market works like a used car market, as accounting professor Ralph Estes observes in Tyranny of the Bottom Line. When you buy a 1994 Ford Escort today, the money doesn't go to Ford. It goes to the previous owner. Ford gets the buyer's money only when it sells a new car. Similarly, companies get stockholders' money only when they sell new common stock - which mature companies rarely do. According to figures from the Federal Reserve and the Securities and Exchange Commission, about 99 percent of the stock out there in any given year is "used stock." That is, nearly all "invested" dollars in the US are trading in the purely speculative market and never reach corporations.

     Public corporations sell new stock when they need capital (funds beyond revenue) to operate, for inventory, expansion, and so forth. But they get very little of this capital from shareholders.

     In 1993, according to Federal Reserve figures, corporations raised $555 billion in capital but only four percent came from sales of common stock. An accounting study of the steel industry from 1900 to 1953 found that issues of common stock provided only five percent of the industry's capital -- over the entire first half of the 20th century.

     Equity capital is provided by shareholders when a company goes public and in occasional secondary offerings. But in the life of most major companies, issuance of common stock represents a distant, long-ago source of funds, and a minor one at that. What's odd is that it entitles holders to extract most of the corporation's wealth -- forever.

     Equity investors essentially install a pipeline and dictate that the corporation's sole purpose is to funnel wealth into it. The pipeline is never to be tampered with -- and no one else is to be granted significant access (except executives, whose function is to keep it flowing).

     The productive risk in building businesses is borne by entrepreneurs and their initial venture investors, who do contribute real investing dollars to create real wealth. Those who buy stock at sixth- or seventh-hand -- or at thousandth-hand -- also take a risk, but it is a risk speculators take among themselves, trying to outwit one another like gamblers.

Who Is the Corporation?
     Here is a second oddity: We believe that stockholders are the corporation. When we say "a corporation did well," we mean its shareholders did well. The company's local community might be devastated by plant closings, its groundwater contaminated with pollutants, underpaid employees might be shouldering a crushing workload, and still we will say, "The corporation did well."

     Rising employee income is not seen as a measure of corporate success. Indeed, gains to employees are losses to the corporation. And this betrays an unconscious bias: Employees are not seen as part of the corporation. They have no claim on wealth they create, no say in governance, and no vote for the board of directors. Employees are not citizens of corporate society, but subjects.

     Investors, on the other hand, may never set foot inside "their" companies, may not even know where they're located or what they produce. Corporations exist to enrich investors alone. In the corporate society, only those who own stock can vote. This recalls America before the mid-1800s, when only those who owned land could vote.

     We think of this as the natural law of the free market, but it is more accurately the result of a corporate governance structure that violates free market principles. In a free market, everyone scrambles to get what he or she can, and they keep what they earn. In the construct of the corporation, one group gets what another earns.

     The oddity of it all is veiled by the incantation of a single, magical word: ownership. Because we say stockholders "own" corporations, they are permitted to contribute very little -- and take a lot.

A Built-in Inequity
     Why have the rich gotten richer while employee income has stagnated? Because that's the way the corporation is designed. It is designed to pay shareholders as much as possible and to pay employees as little as possible.

     Why are companies demanding exemptions from property taxes and cutting down 300-year-old forests? Because that's the way the corporation is designed. Corporations are engineered to internalize all possible gains from the community and to externalize all possible costs onto the community.

     "A rising tide lifts all boats," the saying goes. The corporation really functions more like the Panama Canal -- raising the water level in one compartment by lowering it in another.

     The problem is not the free market nor is the problem capitalism. Certainly, free-market capitalism is the most fruitful economic system the world has yet conceived. If we go rummaging through its entire basket of economic ideas -- supply and demand, private property, competition, profit, unconscious regulation, wealth creation, and so forth -- we'll find that most concepts are sturdy and healthy. But we'll also find one concept that is inconsistent with the others. It is these four words: maximizing returns to stockholders.

     When we really look at this notion (as we so rarely do), we will see it is an aristocratic edict. In a competitive free market, this maxim decrees that the interests of one group will be systematically favored over others. In a system based on unconscious regulation, it says corporations will consciously serve one group alone. In a system rewarding hard work, it says members of that group will be served regardless of their productivity.

     Shareholder maximization is a form of entitlement. And entitlement has no place in a free market. It is a form of privilege. And privilege accruing to property ownership is a remnant of the aristocratic past.

Three Pillars of Economic Aristocracy
     In the years just before World War I, kings and emperors sat enthroned atop most nations of the globe. In the twentieth century, governments worldwide crossed a great divide in history -- from aristocracy to democracy. But we have done so only in government. We have yet to democratize economics.

     In its emphasis on individuals getting what they earn, free-market theory points toward democratic outcomes, but in its insistence on stockholder primacy, corporate governance points toward aristocratic outcomes. Corporate governance is antidemocratic.

     The wealth-owning class today is a kind of secular aristocracy, much as dictators were secular monarchs. The core myth -- that shareholder returns must be maximized -- is considered unchallengeable and nearly sacred. It is a myth with the force of law. We might call it our modern version of the divine right of kings.

     I believe that these myths arise not from evil intent but from unconscious prejudice. They serve to uphold a bias favoring those who own property (which today we call financial assets). This is not a bias we hold consciously, because our legal structures hold it for us, as they once held biases favoring men over women, or whites over blacks.

     The first step to changing unconscious bias is to see it. Three sustaining myths support the economic aristocracy of stockholder primacy. They are:

  • Worldview: In the spirit of aristocracy, the corporation discriminates based on property, paying shareholders as much as possible and employees as little as possible.

  • Privilege: Shareholders claim wealth they do little to create, much as nobles claimed privilege they did not earn.

  • Property: Like a feudal estate, a corporation is considered a piece of property -- not a human community -- so it can be owned and sold by the propertied class.

     Like the divine right of kings, it is an increasingly archaic mandate, imposed on an organic system capable of self-governance. It is a stricture that is blocking the natural evolution of capitalism, because it is increasingly out-of-step with the times.

     Today, 51 of the world's 100 largest economies are corporations. Corporations have revenues larger than nation-states yet maintain the guise of being "private" -- much as empires were once viewed as the private property of kings.

     In major public companies today, most shareholders do not manage, fund, or accept liability for "their" corporations. Stockholder function has shrunk to virtually one dimension: extracting wealth.

     For many companies, knowledge is the new source of competitive advantage. To allow shareholders to claim the corporation's increasing wealth when employees play a greater role in creating that wealth, is a misallocation of resources.

     The rules of corporate accounting were written when nature seemed an unlimited reservoir of resources and an unlimited sink for wastes. That is no longer true, but the rules unconsciously retain the old attitudes.

     The word "corporation" appears no-where in the Constitution, because only a handful of American corporations existed when it was written. Washington and Jefferson governed a nation of farmers, in which most nonagricultural businesses were indeed "private," run out of the basement or barn, as part of the private household.

     Public corporations are no longer private. The modern corporation, as Franklin D. Roosevelt observed, "represents private enterprise become a kind of private government which is a power unto itself."

     We fail to see this because we accept the myths that corporations are pieces of private property owned by stockholders, whose primacy is a natural mandate of free markets, just as our ancestors accepted that nations were private kingdoms owned by kings, whose supremacy was a natural mandate of God.

     We live with these myths like buried shells from an old war (the war between Monarchy and Democracy). When these invisible old bombs go off -- in the resurgence of sweatshops, the rise of income inequality, or the increasing demands of corporate welfare -- we ask, "How can the free market go so wrong?" Believing the myth that the system must remain "unfettered," we feel powerless to reach down and defuse the explosive and buried nub of the problem, which in corporate terms is shareholder primacy -- or in a broader sense, property bias.

     We must begin to question things we never thought to question. To see things we never thought to see, though they've always been there -- right in front of our eyes.

Reprinted with permission from Is Maximizing Returns to Shareholders a Legitimate Mandate? by Marjorie Kell. 1999. Published by Berrett-Koehler Communications, Inc., San Francisco, CA 94111-3320. This booklet is part of The Divine Right of Capital, a work-in-progress. The author invites dialog. She can be contacted at MkellyBook@aol.com, or by fax, at (612) 821-9136. For bulk purchases, contact the publisher.