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we're speaking today with Eric ortz a
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professor of legal studies and business
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ethics at Wharton about his new book
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released in September here uh titled
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business persons a legal theory of the
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firm thanks for joining us today Eric oh
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you're welcome I'm happy to be here all
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right uh we move on to executive
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compensation uh you take issue with the
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idea that shareholders and executives
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are too often viewed as if they're the
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only entities in the corporation that
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matter no one else is really important
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to the process and that that's uh may be
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reinforced by this concept of
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shareholder value and then the
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executives are the ones who create the
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shareholder value and it's just this you
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know the these two things that that are
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the only things that matter would you
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discuss why you think that's a limited
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view yeah I think if you uh start from
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the view of how businesses are
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constructed from a legal vantage point
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and that's the main argument of the book
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uh there's a bottom up process by which
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people come together into uh teams uh
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that represent Capital that's coming
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into a company Labor uh there's
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organization governing expertise that
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are that are management uh and it's a
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very complex process if you look at this
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historically and legally over time and
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it is and business firms themselves and
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this is why we have uh business schools
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that study this and and and try to teach
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managers the complexities that are
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involved in this are actually very
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intricate uh or organizations you can
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you can have very small startups that
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are only one person but very quickly in
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most businesses you get economies of
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scale and economies of scope that mean
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you have very large Enterprises that are
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putting together lots of moving parts
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and those moving parts are reduced in
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economic theories that say shareholders
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are the only group that matter there's
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advantages to looking at share price and
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I'm not look I'm not saying that
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shareholders don't matter shareholders
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and corporations vote and they
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ultimately have authority over who uh is
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voted onto the corporate board and that
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means uh authority to determine who the
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CEO is but in most circumstances
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shareholders aren't exercising that role
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and I think that the shareholder uh
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value arguments that managers only
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should be looking to shareholder value
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have gotten us into trouble I'll give
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you one example uh that I think is in
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the news right now and that's all the
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the the the series of corporate frauds
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that we continue to have of accounting
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frauds and other kinds of frauds insider
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trading scandals Etc
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but the corporate fraud issue especially
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with respect to some accounting issues I
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think partly has to do with incentives
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that are created by asking managers to
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only manage to short-term shareholder
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value uh the theory is and it works well
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if you're just doing equations in a uh
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article and saying this should work the
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theory is that managers should manage to
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shareholder value if shareholder value
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increases then everybody will be better
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off and if shareholder value increases
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then manager should be be uh compensated
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more in practice though what happens
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sometimes is that when you are using
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short-term options or other mechanisms
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to pay managers only in terms of their
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share price performance you create
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perverse incentives for them to commit
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fraud and I think this is something that
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people did not think about when they
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adopted economic theories and this uh
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basically in the economic jargon is
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called principal agent Theory principal
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agent theory was uh was invented and
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advocated beginning about 2013 30 years
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ago that's now seized the day with
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respect to executive compensation
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debates where you basically see managers
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as the agents uh of of shareholders and
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that that's the only relationship that
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matters and what I argue in the book is
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that there are a number of other uh uh
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there are number of other considerations
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that matter employees matter and how
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they're motivated and that really is not
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taken into account in a simple principle
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agent Theory the other group that
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matters is uh other uh creditors uh Bond
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holders and and other Capital providers
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of the Enterprise the role of retained
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earnings in a firm is is really
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underappreciated in the uh principle
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agent models and so my main argument is
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that these economic models that have
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driven this idea that sh that managers
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should only manage to share price
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particularly in the short term are wrong
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they're the they're the product of
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economic theories that I think at this
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point have been have have sh been shown
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to be wrong and one of the arguments in
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my book is to is to say look here is
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another theory namely traditional legal
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understandings of how uh firms how firms
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are created and how they're formed and
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run over time that are different than
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the these standard economic theories so
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you have um with this uh the the idea of
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shareholder value being Central and
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prominent and and almost overriding uh
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you then have Executives whose
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compensation is based on shareholder
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value I.E the stock price and so
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naturally
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incentive to make sure that stock price
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is as high as possible which generally
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is a good thing but in practice as you
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say um there's this critique that
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they're managing for the short term
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because most of their compensation is
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based on stock options directly related
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to the share price so they want that
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next quarter or certainly the next year
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Financial results to maximize the stock
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price which could undermine the
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long-term soundness of the firm if they
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dump all the assets and resources into
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trying to make that go up short term
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they miss opportunities such and and and
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there's companies that that do it the
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other way like Amazon that invest for
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the long term they'll take losses in
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certain areas in the short term in order
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to invest and guarantee that they
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succeed in the long term so this is
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another part of it this economic
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argument isn't it in addition to the
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fact that you're saying it can it can
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lead to fraud or yeah I think that's
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that's exactly right and in some ways
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that's even more important so so one
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problem you have is that you might
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increase fraud you increase the
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dysfunctionality of the system and I
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think that most ideas of business is
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that you want to have long-term
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sustainable growth that is going to
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raise everyone's boats create more
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wealth uh help to uh make everybody
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better off and so if you have systems in
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place and part of these part of this uh
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is about economic theories that we're
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adopting and part of it is about law
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listening to the economic theories and
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following those economic theories we're
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going to be in some uh trouble and I
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think you identif ify a very big issue
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and that is how do you what is the
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purpose of an Enterprise and how do you
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provide the right incentives both
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legally and economically for long-term
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economic growth one example you
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mentioned Amazon one example I use in my
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book is Google and so Google
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specifically when it went public opted
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out of this traditional pattern of being
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governed only by shareholders and you've
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had some law in Delaware and I think
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it's starting to change where Delaware
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had a famous case that was decided uh in
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the 1980s called re on where they said
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in some circumstances we're going to
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demand that you get the highest price
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for the company if you're selling the
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company if you're a if you're in a sales
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situation there's some complexities
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about that but the argument here is well
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why would we expect that to be the only
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goal for shareholders why would we only
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want to take one uh share price right
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now and say that is the intrinsic value
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of the company there could be all kinds
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of reasons that share prices either up
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or down and to put so many uh to to put
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so much weight on the the artifact of
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share price I think has been a mistake
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over time I think you see Google U
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Google has been a successful company in
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bucking that Trend where they basically
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said no we're going to basically uh hold
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control in a relatively smaller group
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another example historically that seems
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to be pretty successful this way as Ford
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motor company has done the same thing uh
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so that that indicates that maybe this
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idea that only shareholder value and a
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broadly held Market is not the only
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model for a company and that for
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long-term sustainable growth we have to
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have a more complex understanding of uh
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incentives in Enterprises and providing
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for lots of different experiments uh for
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how businesses should work rather than
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rather than I think what uh some
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economists have tried to argue is to put
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a template of of an economic theory on
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the world and say everybody has to has
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to manage to this shareholder maximizing
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model or something of that kind and you
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have a lot of these other examples out
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there where companies are not behaving
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that way and they're actually doing
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better than companies that are uh that
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are being trained to just look at
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shortterm returns so when people talk
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about maximizing shareholder value
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you'll often hear justifying that idea
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uh which tends to mean in the short term
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as you point out you'll you'll sometimes
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hear that they have a you know legal
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term fiduciary responsibility to do so
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but you seem to be arguing that there's
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other responsibilities and in fact you
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could be irresponsible uh in a way by
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not investing longterm by giving out too
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many dividends in the short term you
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then don't have money and retained
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earnings to invest for that next new
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product that's going to give you know
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investing for the long term kind of a
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thing yeah I think in fact there's been
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a lot of misinformation sent out
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sometimes I think I'm afraid in Business
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Schools but it also sometimes happens in
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law schools of what the fiduciary duty
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of directors actually is in the United
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States in fact the business judgment
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rule has uh allowed a lot of discretion
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that directors have in the United States
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and for many businesses there is a lot
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of disc discretion that they have now we
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have had some changes that have moved us
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toward a shareholder maximization uh
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model and the Revlon case I mentioned is
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one of those cases and there have been
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some Delaware law cases that go in that
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direction there also have been Delaware
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cases and other uh other uh legal
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developments that have said wait uh
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companies don't have to manage in that
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way uh one of the interesting
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experiments that I also talk about in
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the book is something called hybrid what
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I call hybrid social Enterprises uh
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aware uh the Justice summer enacted a
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benefit Corporation statute which
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explicitly says you can have two
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different objectives one is making money
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but another is uh an environmental
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objective let's say or some specified
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social objective of trying to alleviate
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uh sanitation in a particular uh country
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or sanitation problems in a particular
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country and what what those experiments
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show is that and and one of the main
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arguments that I give in the book is
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that purposes of businesses are actually
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quite diverse uh you can have a business
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and it can be just maximizing
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shareholder value and I'm not saying we
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shouldn't have businesses that are in
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that uh organized in that way but it
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might be that there are lots of other
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kinds of models and I think there are
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lots of other kind of models not only in
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the United States but in the world of
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different kind of companies that are
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looking at different kinds of objectives
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that they're trying to uh follow and I
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think we're in a better uh circumstance
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if we allow a diversity of different
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companies like that and one of the
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arguments in the book is this is that
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the one of the virtues of of modern
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Western societies is that we have this
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framework of law that allows individuals
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from the bottom up to be entrepreneurs
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to come together to come up with new
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ideas to come up with new ways of
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structuring Enterprises that are either
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going to work or they don't work and we
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allow General markets of Supply demand
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to determine that but we don't mandate
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some particular way in which every
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business has to be managed and I think
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that that's a a good thing and one that
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I hope to uh uh hope to uh encourage in
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writing this book just the final thing
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just to get back to shareholder value
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for a moment uh it was interesting to me
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the point you make which is that uh it
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may be surprising to some which is that
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shareholders although they have an
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equity stake are not the main providers
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of financing for companies and that that
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might be one reason that people would
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think they should have such prominence
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there might be a conception that they
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are the the primary financiers of the
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corporation but in fact you're saying
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that that's not the case uh on average
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in general yeah I think that in many I
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think the finance literature has now
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become pretty clear that the main area
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in which companies get money and which
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they uh property uh to the firm from
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which they decide to allocate New
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Capital to new projects is retained
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earnings uh colum mayor at Oxford was
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one of the main uh uh proponents and and
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authors of Empirical research that shows
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that this is true not only in United
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States but in many uh other countries
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and so what that b basically shows is
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that the shareholder value idea of that
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Capital comes from the shareholders
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therefore you owe uh an exclusive Duty
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only to the shareholders is wrong uh
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it's also true that you get a lot of
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capital provided to companies through
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credit and debt uh financing and so
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usually those are uh interpreted as
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contractual relationships and they are
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contractual relationships but it's also
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true that at the edges uh there are
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duties that can sometimes be owed to
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those Capital providers as well so
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that's an example how the property
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relationships within firms and I go into
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this in a lot more detail in the book
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are actually a lot more complicated and
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ownership is much more fragmented than
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this simplistic idea of managers and
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shareholders uh gives you and there's a
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there's this idea whenever you have a
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simple way of describing something
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sometimes people grab on to that and
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they think that's a hammer that you
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should then uh hammer into any problem
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that comes up you use that principal
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agent model of shareholder managers and
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you that's the answer and and I think
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that's fundamentally wrong uh it's not
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that I'm saying shareholders are not
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important they're primary as I said they
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elect D directors there's a important
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corporate role that shareholders play
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but the idea that that's all there is
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and that we should that managers should
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only think about that to the exclusion
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of strategic uh considerations of
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research and development how you're
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motivating your employees uh how you're
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relating to different governments that
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you're dealing with all those other
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kinds of issues uh I think really uh
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really underplays the the the important
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role that managers have uh and it and it
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subverts it makes the idea of the task a
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little bit too easy so um uh so I think
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that's my answer there that that we do
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care uh shareholder value matters it's
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one measure of how firms are doing uh
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how they're doing well or not doing well
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but it's not the only measure and we
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really have to think about these broader
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uh concerns well thanks very much for
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being with us today than it
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[Music]
