Background of shareholder primacy theory

The main arguments for and against of shareholder primacy theory


1.1 Background of shareholder primacy theory

Shareholder primacy theory is a dominant principle in corporate law that leads the corporation decision-makers focus on the shareholders’ interests. [14] Even though some scholars have questioned the validity of description and norm of the model, it is generally accepted that the objective of companies is to maximise shareholders’ benefits. [15] 

As mentioned earlier, the original shareholder primacy theory can be found in Berle and Dodd’s debate in 1930s. In fact, the argument between them was mainly discussed two issues: how to characterise corporate law and how to develop it in future. [16] Berle’s argument was based on the premise of that shareholders were owners of the company and directors were agents or trustees of these owners. Thus he believed that corporations should be run for shareholders’ interests. [17] Dodd responded that as economic institutions corporations have “a social services as well as a profit-making function", [18] and directors “should concern themselves with the interests of employees, customers, and general public,…". [19] Shortly thereafter, Berle replied to this argument with the view that the managerial accountability could be reduced by increasing managerial discretion. Moreover, he believed that it was impossible to directors to be accountable to all constituencies. [20] Although there were some fluctuations between shareholder primacy and stakeholder theories from the time of Berle-Dodd debate until 1970s, shareholder primacy has become thriftily since the late 1970s, [21] and today in Anglo-American systems, it is the regnant theory in corporation law. [22] 

In 1919, the Michigan Supreme Court’s decision in the case of Dodge v Ford Motor Corp [23] manifested the legal mandate of the shareholder primacy theory. The court stated: “A business corporation is organised and carried on primarily for the profit of the stockholders." [24] Therefore, the key point of the theory is to ensure that directors manage corporations on purpose of maximising shareholders’ wealth to the full extent. [25] Besides, from a business practice point view, shareholder primacy is an accurate description model as it clarifies that directors only have economic goals and responsibilities to shareholders. That is to say, directors are empowered to do anything which can increase shareholders’ benefit that is recoginsed as lawful activities. [26] Meanwhile, this theory avoids yielding to the corporate social responsibility (“CSR") which requires directors consider other groups’ interests when making decisions. [27] 

It can be easily defined from the name of shareholder primacy theory that shareholders are its only subject, which means shareholders’ interests always take priority and other constituencies’ benefits are very much secondary or derivative. [28] However, this is not to say that directors do not take non-shareholder parities’ benefit into account unless considering their interests will influence enhancing shareholders’ wealth. In addition, there is another reason for not focusing on non-shareholder constituencies is that the theory assumes that unlike shareholders, other constituencies’ rights and interests are gained and protected through contracts. [29] 

1.2 The main arguments for and against of shareholder primacy theory

It has been mentioned in the introduction that when a company is solvent, the interests of the company is recognised as the interests of the present and future shareholders as a whole. [30] This is to say, although the company is known as a distinct entity and the consequential displacement of shareholders as legal owners of assets of company, shareholders ownership has remained the core doctrinal elucidation of the shareholders’ position. [31] In recent years, based on the presumption of the legal and practical field, numerous arguments of whether the company should run shareholders’ interests have risen significantly in the UK and elsewhere. The central arguments in this debate will be set out and evaluated in this section.

In order to explain shareholder primacy theory unambiguously, this section will be divided into support and against two parts. There are about four issues worth analysing in arguments for the theory, namely, the shareholder ownership, the residual claimants, the agency theory and efficiency. Equally, short-term perspective management, divergent shareholders’ interests, moral and ethical issues will be the contents of criticisms of the theory. Now, each of the arguments is going to be considered in turn.

1.2.1 The arguments for the shareholder primacy theory The shareholder ownership

Even though company lawyers avoid exploring whether shareholders are owners of companies generally and sometimes they deny that shareholders are owners of the company, they assume that shareholders have proprietorial interests in the company akin to ownership, [32] thus the notion of “the separation ownership and control" is widespread. Conversely, non-lawyers such as the commentators in the popular media and business press are more likely to recognise shareholders as owners of companies and believe this point of view was the underpinning of the doctrinal of western capitalism. [33] Furthermore, it was suggested that the principle of the company law had been forgotten that “… shareholders own the firm and directors merely run it…". [34] This view was also accepted by the Cadbury Committee of UK in its report. [35] Shareholder ownership principle is frequently supported by an economics standpoint. Generally speaking, there is a basic criterion to satisfy the condition of identifying owners of the company, namely, the control rights. [36] If shareholders are proved that they have this rights, it is no doubt that they are owners of the company and the company should run shareholders’ interests.

It can be found from the framework of the corporation that shareholders are regarded as beneficial owners of companies and give control power to directors, who are in charge of companies’ business every day and run for the shareholders’ interests. [37] Actually, except the right to dividends and to transfer shares, shareholders have more of rights linked with ownership. Shareholders have power to elect and remove the directors, to vote on certain essential matters on operation of corporations such as the scope of business and welfare policy, etc. This is to say, shareholders have significant control power over other participators. Furthermore, the most important feature of presenting the shareholders’ control power is that shareholders have capability to influence the management of corporations. [38] For example, shareholders have an effect on the election of directors. Although plurality voting is quit hard for shareholders to remove existing directors, but it is possible to exercise the withhold votes activities to make directors feel that it will be difficulty for them to stay in the board. [39] This means, in practice shareholder actually have more power than the law and legal scholars have proposed what kind of rights they should enjoy. Additionally, shareholders’ voice has become much more powerful in corporate governance recently as they are able to reform the voting standard from plurality to majority. [40] Thus because of this change, removing directors will become easier to shareholders in the future. Undeniably, directors are able to be removed if shareholders work together. This is not to say that shareholders have to be banded together all the time to exercise their control, the market for corporate control will bond them naturally. [41] For instance how the market control works to shareholders let us take a case of takeover. When companies are in a successful takeover condition, shareholders are in control: decide whether to sell companies or not. Equally, because directors are elected by shareholders, directors are regarded as “the elected representatives" of shareholders and have a fiduciary duty owed to them. [42] As a result of these, “…shareholders are entitled to have the company run in their interests: it is their company". [43] 

Originally, the notion of shareholder ownership starts from the joint stock companies’ period. During that time, no matter corporations were incorporated or not, they were recognised as partnership by the law. As a result of that, shareholders were entitled to own the companies’ assets [44] and directors were their agents and were controlled by them. [45] However, this was revised with the changed economy system, and shareholder ownership was no longer survival. Consequently, shares seemed to be legal property in their own right [46] and relying on this view, shareholders had right to receive dividends and to transfer their shares. It was also changed that directors were not the agents of the shareholders any more. [47] 

In a reality, the doctrine of shareholders as owner of companies ceases when it moves from small owner-operated enterprises to medium and large public companies with many shareholders. [48] Considering that shareholders in widely-held companies is different to the small-held company’s shareholders as they do not take a part in running the day-to-day business, so they do not like owners in practice act. [49] Further, the shareholders’ proprietorship has been attenuated by developing the idea that shareholders had no direct interests in companies’ assets since the early nineteen century. A classic example can be found in the case of Bligh v Brent. [50] The court concluded that shareholders had a right to dividends and a right to shares but they had no direct interests in companies’ property. The shareholder ownership was denied by the appeal court in the case of Short v Treasury Commissioners. [51] Later, the shareholder ownership was completely rejected by a representative English case of Saloman v Salomon and Co Ltd [52] which distinguished the separate corporate personality, which means companies are separate from their shareholders. Another criticism of shareholder ownership is control. It is logic to say: “An owner has the power to control the property she owns." [53] , but companies are run by directors not shareholders, so shareholders do not control the operation of corporations and they are not owners.

In short, the shareholders’ control rights described earlier are indirect or derivate. [54] Actually, the influence of shareholders over the board is fairly weak and negligible. This means that exercising the control rights to remove existing directors is quite hard and costly both for time and money. [55] Normally, shareholders do not choose enforcing this kind of rights; instead they sell their shares and escape from the company immediately. Also, because of the development of the corporate separate personality in corporation law, the shareholder ownership is seen as an out-date argument and becoming unpopular in Anglo-American systems. In other words, the shareholder ownership may be recognised as the least powerful argument for shareholder primacy. [56] The residual claimants

The second standard argument for shareholder primacy is the residual claimants. This argument asserts that shareholders are probably not owners of companies but at least they are sole residual claimants of corporations. [57] It is regarded that as residual claimants, shareholders’ interests are affected directly by corporations’ profit and losses. That is to say, shareholders endure heaviest burdens in the result of corporations, [58] as they will receive abundant returns from dividends and shares if companies perform well, in contrast they will loose all their investments if companies’ business fall down and go into liquidation finally. Considering each decision made by companies is vital to shareholders’ wealth, shareholders should have control power of corporation management above other stakeholders. [59] Also compared to any other constituencies, shareholders have the utmost incentive to enhance benefits so that they are the best monitors to inspect directors’ performance. Thus, when companies are solvent, they should be run for residual claimants’ interests, namely shareholders’ interests.

Yet, this justification is found unpersuasive by some advocators of the nexus of contracts principle. The nexus of contracts theory suggests that the company is not an entity but simply an association of individuals. [60] In other words, the company is not a thing, but rather a nexus of simple contracts establishing rights and obligations among the different parties: shareholders, creditors, employees and suppliers to set up the company. In this notion, the foregoing parties who take part in the nexus that can be regarded as residual claimants. That is to say, shareholders as one of several residual claimants groups are not the sole residual claimants of companies, so they do not have priority. [61] 

It is true that the constituencies of corporations bear different sort of risk all the time with various expects. For example, if companies’ business is falling and in financial difficulties, employees face the problem of losing their job which means their families will be in the trouble as they lost their income; creditors may not able to be paid on time when debts are due; supplier will endure a burden of not receiving the payment of goods. However, this truth is not a relevant consideration to residual claimants. [62] Though each person’s claim is risk, not every person is a residual claimant. The definition of residual claimants is someone who is “entitled …to whatever remains after the firm has met its explicit obligations and paid its fixed claim.". [63] Just shareholders are consistent with this explanation. Shareholders are intrinsically more exposed to risk than other stakeholders. [64] But in fairness, there is no prevision in corporate statutes present that shareholders are sole residual claimants. It has been suggested that the law only treats shareholders as residual claimants when corporations are in insolvency. [65] 

Another disagreement with shareholders are sole residual claimants is that stakeholders are entitled being residual claimants because they make firm-specific investments. [66] Nowadays, shareholders are no longer seen as having more influence than other stakeholders on corporations’ decision, because firm-special investments have serious effect upon companies’ fate. Hence, shareholders are not lone residual claimants in corporations.

Consequently, in the absent of corporate legal provision of sole residual claimants and reconsideration of stakeholders’ position, the residual claimant argument has become less persuasive for shareholders primacy. The agency theory

The agency theory [67] enters into alliance with the concept of the separation ownership and control [68] and is supported by many academics and practitioners of corporate law who are in favour of shareholder primacy. The purpose of the theory is to observe the role of directors in corporations. [69] Under the theory, it is regarded that shareholders employ directors as their agents to manage day-to-day business of companies. As principals, shareholders legally lead and educate directors how to perform their powers and duties. [70] It is said that without the norm of shareholder primacy, directors are most likely to further perform for their own interests (“opportunism’) or not to do the things which they could do for shareholders to enhance their wealth (“shirking"). As a result of that, shareholders’ interests are harmed and the trust between shareholders and directors is reduced. Essentially, the agency theory presents a system to ensure that directors are totally accountable to shareholders and mitigate directors’ misconduct such as ignoring shareholders’ profit and looking for self-interests. Also, the “agency costs" which is used to monitor directors’ performance will be minimised by the shareholder primacy model [71] as directors owe duties fully to shareholders and are inspected by their superiors and shareholders. [72] Besides, shareholders are able to exercise derivative actions if directors breach of duties do not maximise shareholders’ interests.

Even though the agency theory deters directors from making self-wealth; produces greater monitors-shareholders to control the work of directors; reduces the “agency costs’; and guarantees that directors are fully accountable for running companies’ business, the case law does not support this theory. For example, Lonrho Ltd v Shell Petroleum Co Ltd case [73] and the case of Pascoe Ltd (in liq) v Lucas [74] both stated that the duties of directors are owed to corporations. Also, the UK company law provides plainly that directors owe their duties to corporations. [75] In addition to that fact, in the English-law based on common law jurisdictions, it is commonly accepted that directors’ fiduciary duties are owed to corporations, not to shareholders directly. [76] A good example is the case of Dawson International plc v Coats Paton plc (No 1), [77] the courts said that “directors owed no general fiduciary duty to shareholders". [78] Also, in a appeal case, Brunninghausen v Glavanics, the courts said that: “the general principle that a director’s fiduciary duties are owed to the company and not to shareholders is undoubtedly correct…". [79] Even if directors had owed fiduciary duties to shareholders, it would not have necessarily included taking care of shareholder’s interests in all matter. [80] Thus, directors only owe indirect responsibilities to shareholders when they run the business for companies. [81] 

Again, considering the standard legal definition of agency given by the second Restatement of Agency, agency relationship between shareholders and directors does not exist. [82] According to the definition, there are several reasons of why directors are not agents of shareholders. First, directors are employed by companies not shareholders. [83] It is factual that directors are elected by shareholders; however the parties of the employment contract are companies and directors. This means that shareholders are not directors’ bosses but companies are. Second, directors are incapable to exercise shareholders’ behalf. [84] Let us take a case of shares’ transfer. Directors are not agents of shareholders, because they are not able to sign a contract with third parties to transfer shareholders’ shares unless they are special empowered. Third, shareholders have no direct control right to directors. [85] The management of companies is the responsibility of the board, which means directors engager exclusively and independently in running companies’ business and they are not ordered by shareholders through the general meeting.

It is concluded that the agency theory has failed to support the theory of shareholder primacy. Efficiency

From the viewpoint of economic efficiency, the shareholder primacy has not only enhanced the interests of shareholders but also increased social wealth. [86] It is set out by the orthodox contention for shareholder primacy relies on the proposition that if the directors’ mandate is amorphous, it will be very difficult to examine whether directors are accountable for what they do in operating companies. As a result of that, “agency costs", which are used to investigate managerial conducts will occur for ensuring whether directors’ performance is diligent and loyal. That is to say, if directors are given a clear mission, such as running the companies’ business for maximising shareholders’ interests, companies’ costs will remain in a small proportion as there is no agency costs needed. [87] Besides that fact, it is believed that under the shareholder primacy policy, non-shareholders are likely to receive better matters than they would under unclear missions. [88] 

It is also said that the economic efficiency will be fostered by shareholders as they have incentives to increase profits. [89] In order to enhance profits furthest and successfully, there are several aspects need to be considered. For instance, if companies do not produce good quality products and service to customers, the companies will close down shortly. This means that shareholders won’t receive any benefit. Hence, directors do have to think about how companies can survive and how to attract customers for the purpose of making profits. In considering these factors, the higher standards of economic structure will be built, the whole society will benefit under a better economic circumstance. Consequently, shareholder primacy promotes social economy.

What is more, directors are able to work more effectively if there only has a single goal like profit-maximisation needs to be considered. Also, it is easier to monitor whether directors are diligent and loyal. [90] There are numerous group people with divergent interests involved in corporations, if the duties of directors are owed to a multitude of constituencies, then balancing all of conflicting interests would be impossible to directors, hence poor decisions will be made. [91] Undoubtedly, it is unattainable for directors to manage the corporations’ business for the interests of various parties as there are competing interests among them. Further, directors as business professionals are not referees or judgers; they do not have to make a judgment that for whose interests companies should be run. Apart from that fact, multiple interests would aggravate the amount of opportunism in which directors engaged, [92] because there is no certain goal which needs to be achieved. In this condition, directors can easily find excuses of advantaging themselves’ interests and ignore making benefit to any constituencies. In contrast, the foregoing difficulties can be resolved by shareholder primacy. Under this theory, fostering shareholders’ interests is sole main aim, with the result that directors required to concentrate on one goal. [93] Because shareholder primacy combines with a onefold aim, it not only administers certainly and uncomplicatedly [94] , also courts are enabled to assess managerial conduct with some rationality. [95] For these reasons, the theory is said workable. [96] 

Again, it is argued that social wealth is increased effectively by shareholder primacy. It was concluded that: “shareholders are the only stakeholders of a corporation who, in seeking to maximise their own claim, simultaneously maximise everyone’s claim." [97] In addition, the notion that shareholder primacy increases social wealth was supported by of CLRSC in 1999. It was said that: “the ultimate objective of companies as currently enshrined in law- ie to generate maximum value for shareholders-is in principle the best means also of securing overall prosperity and welfare." [98] It is not difficult to understand that how shareholder primacy works for increasing social wealth. For example, if shareholders’ interests raise, the better payment and safer workplace will be provided to employees; [99] a good environment protection will be concerned when making business decision; and the customers will be given a lower costs and better quality products. Taking all the matters as a whole, the social wealth will be enhanced eventually.

There are several perspectives question the efficiency of shareholder primacy. It is argued that efficiency is variable; it cannot hold the same effect under different corporate governance system. [100] And shareholders’ interests are not guaranteed to be increased effectively if all contracts are incomplete. [101] Lastly, some people debated that efficiency is not sole benchmark of running business, there are more features need to be considered such as fairness. [102] 

In conclusion, despite that there are some points against the efficiency of shareholder primacy, it cannot be denied that the theory does offer a great guideline to directors that is to focus on one goal-maxising shareholders’ profits. In doing this, not only the interests of shareholders increase, but also it deters directors benefiting self-interests, fosters other parties’ profits and enhances social wealth. In short, the efficiency is the strongest argument for shareholder primacy.

1.2.2 The arguments against the shareholder primacy Short-term perspective management

The shareholder primacy is criticised as “it produces myopic management". [103] Although it is uncertainty of raising shareholders’ interests in the short or long term under the theory, in practice, most directors perceive that they are constrained by the theory to run companies for increasing shareholders’ profits in short-term. [104] Facing business competition, directors are under pressure almost every day that probably makes them looking for short-term benefits as it is the safest way either increasing shareholders’ wealth or avoiding a takeover. Of course, the development and the long-term value of corporations may be harmed by only considering the short-term benefits. [105] However, if directors do not focus on short-term benefits, they will take a risk of being removed by shareholders. [106] Excluding the pressure from outside, there is a personal benefits consideration is taken part into promoting short-term benefits. For instance, if directors hold shares in companies, they would like finding a chance to improve the position of corporations in a short term that abundant bonuses will be paid.

There is a response that suggests that this argument is not strong enough. It is said that the approach of short-term benefits was favoured in the past; today professionals begin to support that shareholder primacy emphasises long-term approach. [107] But even it is true, the precise concept of long term is missing, with the result that it will be harder to assess it as it is difficult to evaluate short term. [108] Moreover, it is implied that even if the long-term benefits can be appraised, but because of information asymmetry, the price of the long-term shares may not equal the true value. [109] Divergent shareholders’ interests

The theory of shareholder primacy ignores the fact that each shareholder has different respects of his/her interests. [110] The divergent interests among shareholders are shown by various share holding. For instance, an ordinary shareholder and a preference shareholder hardly find that they have interests in common. Unlike ordinary shareholders, normally preference shareholders will benefit differently in any given conditions. Similarly, the difference of shareholders’ interests exists between individuals and institutional shareholders, because the former favours short-term benefits and long-term benefits are emphasized by the latter. But from case law study, the case of Mills v Mills [111] and Re BSB Holdings Ltd, [112] it is believed that the divergent shareholders’ interests is not a problem of shareholder primacy, because it has only goal to be achieved in favour of one group interests that is shareholders interests, and directors are able to balance the interests of different types of shareholder. Consequently, directors can act fairly on increasing shareholders’ interests though different classes of shareholders who have conflict interests in shareholder primacy.

Beyond the ignorance, it has also been argued that the theory does not work properly when investors are both the role of shareholders and bondholders in companies. [113] There will be a dramatic divergence of interests between those investors who are pure shareholders and those who are both shareholders and bondholders, because the former only concentrate on capital raise but the latter more care about the balance of the investment made by them. That is not to say that all pure shareholders have the same interests. If some shareholders have the competing companies’ shares, their aim will be different to those who only have shares in one company. [114] 

In short, shareholder primacy does resolve the problem of how to balance divergent interests though a group of shareholders but it has not gone further to balance the interests to investors who are both the shareholders and bondholders. Moral and ethical issues

It is proposed that shareholder primacy is a kind of theory which lacks of moral and ethical basis. The reason why it has been said is the absent of moral basis. The theory makes directors only to concentrate on increasing shareholders’ interests; denies non-shareholder constituencies’ contributions to companies; and enables directors to escape their responsibilities owed to other parties. This means that under the theory, directors do not have to take any CSR to other groups as they merely focus on maximising profits of shareholders. However, except shareholders, there are other groups such as employees, creditors, suppliers and customers, etc. whose interests are influenced by companies’ decision too. So it is unreasonable that directors only choose to run corporations with shareholders’ interests as their objective. Besides, there is no provision in the theory to guide directors how to make decision when they are facing moral challenges. [115] As a result of that, the theory seems to be a great excuse to directors for eschewing social responsibilities and benefiting shareholders’ interests exclusively.

Though shareholder primacy does not say that it is forbidden to be considering the interests of other constituencies, it does not affirm the position of these interests either. So the theory has some ethical issues as directors may sell lower quality products to customers and disclaim responsibility to community that in order to benefit shareholders’ wealth solely. [116] 

1.3 Conclusion

Having analysed the pros and cons of shareholder primacy, it is surprisingly difficult to find support within corporate law for the theory of shareholder primacy. The arguments for shareholder primacy, namely, the shareholder ownership, the residual claimants and the agency theory have failed to sustain this theory. It is clear from the corporate law that shareholders do not own companies and directors are not the agents of shareholders but corporations. Besides that fact, the notion that shareholders are sole residual claimants of corporations has not been clarified by corporate statutes. Hence, the argument of residual claimants also is a weak advocate. Compared to these three arguments, the efficiency is the most persuasive contention favours shareholder primacy and it shows that the theory is practicable. On the other hand, after weighing up the arguments against the shareholder primacy, it can be said that the major shortcoming of the theory is that the social responsibilities of corporations are restricted sharply as it only concentrates on increasing shareholders’ interests.

All in all, despite the fact that shareholder primacy carries several pros, such as deterring directors’ opportunism, ensuring directors’ diligence and promoting economics efficiency, it is becoming unpopular. Reasoning that the theory has several major shortcomings, they are: it ignores other parties’ contributions to companies, lowers other constituencies’ interests, encourages shareholder opportunism and eschews CSR.