Shareholder primacy will remain the default setting unless meaningful policy action is taken.
October 2, 2019
With Responses From
Oct 2, 2019
6 Min read time
Shareholder primacy will be the default unless serious policy action is taken.
Lenore Palladino has written a concise and compelling critique of the theory of shareholder primacy. The merits of this critique (and the work Palladino draws upon) are demonstrated by the fact that it is no longer especially controversial. Even the Business Roundtable, a group of America’s largest corporations, recently renounced its commitment to shareholder primacy and pledged to serve “all of our stakeholders.” These statements may be merely cosmetic, but it is nevertheless significant that Milton Friedman’s original arguments for shareholder primacy, formerly mainstream in academia as well as the business world, are now openly embraced only by a libertarian fringe.
Nevertheless, American business has operated under the principle of shareholder primacy for decades, and it will remain the default setting unless meaningful policy action is taken. In the second part of her article, Palladino outlines such a program: she seeks to empower other stakeholders by altering corporate charters, changing the composition of boards, and—similar to a UK Labour Party plan—granting employees of large public companies a 10 percent ownership stake. To be sure, such policies are unlikely to be endorsed by the Business Roundtable any time soon, and they raise a number of practical and theoretical questions. Still, Palladino’s program deserves serious consideration and, upon closer examination, is actually less radical than either its supporters or critics may assume.
Palladino’s program is actually less radical than either its supporters or critics may assume.
First, an immediate concern: Palladino’s plan applies only to publicly traded companies. But in an era of massive private equity firms and growing alternatives for monetizing investments outside of public markets, limiting this policy to public companies threatens to undermine it. Blackstone, for instance, boasts that its portfolio companies employ over 400,000 people. And why should Koch Industries be exempted? Or what the large and wealthy nonprofits, such as the leading universities, which have no shareholders? Public companies already face significantly more regulatory burdens than private companies; a change of this magnitude would further increase the cost of going public and drive even more large firms into private ownership. At the same time, there is nothing that prevents large private companies from implementing the same structure.
Palladino also does not discuss how any cash received by the employee trust would be used. Would it simply be distributed to employees? If so, would it be allocated equally or by seniority, wage level, or some other criterion? How would these trusts be governed? Could the funds be used to provide an additional collective benefit to employees rather than simply pay cash distributions? Perhaps the trusts could be thought of as somewhat analogous to a voluntary employee benefit association (VEBA), with a different funding model and fewer restrictions on the use of proceeds.
More fundamentally, it is important to note that Palladino’s plan does not actually grant full ownership: the “equity” allocated to employee trusts cannot be sold. Presumably, this limitation would also severely constrain its use as collateral for borrowing or derivative transactions. In other words, the ability to collect dividends would be the only monetary benefit of this restricted stock. Yet many companies pay little or no dividends, and share repurchases have become the preferred means of returning cash to shareholders. Palladino, of course, is a prominent critic of excessive share buybacks, but dealing with this issue would appear to be a prerequisite for implementing her employee-ownership plan. If the corporation paid no dividends, the employee stock held in trust would effectively have no financial value.
Furthermore, what would happen in the case of dilution? Palladino describes the process by which the employee trust would initially acquire 1 percent ownership annually, up to 10 percent in total. But what happens if the company subsequently issues new equity or repurchases a material amount of shares? And is there any particular rationale behind the 10 percent level in the first place?
I highlight these technical questions not only because I think they must be answered before the plan can be fully evaluated, but because the technicalities that differentiate the restricted equity in this plan from ordinary ownership are highly significant. Conceptually, policy-mandated employee ownership sounds quite radical, but in practice the effects of implementing this plan are likely to be less disruptive than might be expected.
From a purely financial perspective, consider that the 2017 Tax Cuts and Jobs Act reduced corporate tax rates by 14 percentage points. Palladino’s plan would only direct a maximum of 10 percent of dividend distributions to employee trusts—and it would probably not even be necessary to grant “shares” to the trust to achieve this result; it might actually be preferable to do so through different means. From the company’s perspective (making some simplifying assumptions around taxable and distributable income), Palladino’s plan would probably be less costly than merely returning to 2017 tax rates. Moreover, it would have the advantage of tying a component of worker compensation to the company’s ability to distribute cash to shareholders, ensuring flexibility as well as aligning incentives, in theory at least. If this was seen as a good idea for executives, why not for other employees?
The advantage of Palladino’s plan is that it links employee interests with shareholder interests. That benefit could also present a risk, however.
Of course, the employee shares would also carry voting power (though this could also be accomplished without granting ordinary shares). A concentrated 10 percent vote could be significant in proxy contests, and it may deter activist investors from pursuing measures that are clearly extractive and short-termist. It would ensure that employee views were at least heard by boards.
Aside from that, Palladino argues that employees should have more than merely “token” board representation. But even after these changes, there are still only two groups represented: capital and labor. (After the explosion of stock-based compensation, management is effectively capital, and Palladino is vague on what other stakeholders might be given representation.) That means that the employee vote is likely only to be meaningful when other shareholders are divided, which is a reasonable arrangement.
The advantage of Palladino’s plan is that it links employee interests with shareholder interests. That benefit could also present a risk, however. Although a permanent employee trust should be a long-term actor, there is some danger that employees might seek to maximize cash distributions in the short term, at the expense of the long-term health of the company. That is what shareholders have chosen to do many cases during the last few decades, after all, and this plan would expose employees to the same incentives.
Indeed, distributional concerns are not the only issue with shareholder primacy. Another—perhaps more fundamental as well as more difficult problem—is that it incentivizes financial engineering over productive investment. Admittedly, it is unfair to demand that Palladino address every problem, but left-wing thinkers too frequently ignore these issues. As Roberto Mangabeira Unger wrote recently, “Progressives have largely abandoned the supply side to conservatives and resigned themselves to the primacy of demand-oriented policies.” Arguably, it was the abandonment of the supply side that led to neoliberals’ political victories in the first place, and moving beyond neoliberalism will require serious supply-side solutions to today’s stagnation.
It is eminently possible that implementing Palladino’s plan could make the economy more productive as well as more equitable. But her proposal remains too inchoate for that vision to be fully realized or carefully evaluated. Commentators are likely to focus on the words “employee ownership,” which grabbed the headlines surrounding the similar Labour plan in the UK. But what is actually being proposed is something far more subtle, and these subtleties are far more exciting. Neoliberal shareholder primacy offered a simplified account of ownership and the role of business. Overcoming its destructive legacy will require a renewed willingness to navigate complexity.
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October 02, 2019
6 Min read time