Putting Milton Friedman’s Shareholder Primacy Ideas in Historical Context

In a new Reason Foundation study, I express skepticism about public pension fund investments in private equity funds and hedge funds. The conclusion may have seemed unusual for a libertarian think tank, because free market advocates often applaud the efforts of “activist investors”—those who buy shares in companies with the objective of changing company management. These activists, often known as corporate raiders, try to elevate low stock valuations by addressing the underperformance of incumbent management, putting assets to better use and benefiting other investors in the process.

This libertarian perspective was likely influenced by Milton Friedman’s 1970 New York Times essay outlining his theory of shareholder primacy. Friedman wrote, in part:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom.

If corporate executives eschew profits in pursuit of social responsibility, they are, in Friedman’s terms, “spending someone else’s money for a general social interest.” Looked at from this vantage point, managers who fail to maximize shareholder value are underperforming employees, and their bosses, i.e., shareholders, are well within their rights to replace them with new managers. If lax shareholders fail to carry out this task, it is reasonable for more aggressive investors to buy them out and make the necessary management changes.

Friedman’s advancement of shareholder primacy came at a difficult time for investors in public equities. As University of Cambridge Corporate Law Professor Brian Cheffins notes, the S&P 500 fell 31% between late-1968 and mid-1970. Indeed, the S&P 500 did not permanently move above its 1968 peak until August 1982. Investors, on average, received minimal nominal returns on their stock investments despite the high inflation rates prevailing at the time. 

Equity performance has been quite different ever since.  In the 38 years following its August 12, 1982, trough, the S&P 500 rose by a factor of 32.5, reflecting a compound annual growth rate of 9.6%. This turnaround in stock market performance coincided with the rise of corporate raiders and likely has some association with their activities.

As Jane Katz noted in a 1997 article in the Federal Reserve Bank of Boston Regional Review, most corporate boards were effectively under the control of company management during the 1970s—a circumstance that could lead to inefficiency and complacency. When senior managers place their own interests above that of shareholders, Katz argued, they may avoid opportunities that provide positive risk-adjusted returns to avoid jeopardizing their job security, and “they may use the firm’s extra cash to fund vanity projects and make acquisitions that enhance their own power and influence.”

Free marketeers were not the only ones concerned about the negative impact of management control of boards on company shareholders. Katz discussed a set of corporate governance principles drafted by the California Public Employees’ Retirement System (CalPERS), the nation’s largest pension fund, that called for term limits on corporate board members. Authors of the draft principles (which were not ultimately adopted) were concerned that long-serving board members would become too cozy with management and ignore their responsibilities to shareholders.

But as equity valuations have soared in recent decades, reservations about shareholder primacy have grown. In 2019, the Business Roundtable, a nonprofit made up of corporate Chief Executive Officers (CEOs), adopted a new “Statement on the Purpose of a Corporation,” which formally incorporated a multiple-stakeholder model. The statement, signed by 181 CEOs, stated that companies should not only generate shareholder value, but also:

• Deliver value for customers;
• Invest in their employees;
• Deal fairly and ethically with suppliers; and
• Support the communities in which they work.

Such a statement could be dismissed as a justification for a return to 1970s-era management complacency and vanity, but it may also be a necessary realignment of interests after a long period of shareholder primacy.

Although many libertarians continue to advocate a shareholder first or shareholder only approach, others disagree. One notable dissenter is John Mackey, co-founder and former CEO of Whole Foods, who advocates a “conscious capitalism” in which companies follow a multi-stakeholder model. Mackey’s conscious capitalist credo includes the following:

Conscious businesses are galvanized by higher purposes that serve, align, and integrate the interests of all their major stakeholders. Their higher state of consciousness makes visible to them the interdependencies that exist across all stakeholders, allowing them to discover and harvest synergies from situations that otherwise seem replete with trade-offs. They have conscious leaders who are driven by service to the company’s purpose, all the people the business touches, and the planet we all share together. Conscious businesses have trusting, authentic, innovative, and caring cultures that make working there a source of both personal growth and professional fulfillment. They endeavor to create financial, intellectual, social, cultural, emotional, spiritual, physical, and ecological wealth for all their stakeholders. 

In 2005, Mackey, Friedman and Cypress Semiconductor’s T.J. Rodgers had a thought-provoking debate on “Rethinking the Social Responsibility of Business” in the pages of Reason magazine.  

To the extent that centrists and free market supporters are open to corporate governance models that balance stakeholder interests, they may also be open to the progressive critique of private equity and other alternative investment techniques that focus on increasing enterprise value and harvesting a portion of that increase.