. 5
( 8 .)


illustration, the Southern Baptist Convention voted in 1997 to boycott Disney
theme parks and movies in response to the airing of “Ellen” a show on the ABC
network, starring Ellen de Generes as a gay bookstore owner. It is because of this
fear of a backlash that Disney maintains separate movie studios “
Touchstone/Miramax for grown-up movies and Disney Studios for animated
Aracruz is at the center of the controversy about the deforestation of the rain

forests in South America. In the later 1990s, Aracruz was accused by

environmental groups of replacing old growth forests in Brazil with eucalyptus
plantations and displacing native and indigenous peoples from these areas.22
Deutsche Bank has been challenged for its role as banker for the Nazis during the

holocaust. Its acquisition of Bankers Trust in 2000 was almost derailed by
accusations that it had helped fund the construction of the concentration camp at
Auschwitz during the Second World War. Both Deutsche Bank and Dresdner
Bank were sued by survivors of the holocaust for profiting from gold and other
assets stolen from concentration camp victims during World War II.23
For all three companies, these accusations are serious not only because they damage their
reputations but can also create serious economic costs. All three aggressively defended
themselves against the charges and spend a substantial number of pages in their annual
reports detailing what they do to be good corporate citizens.
In Practice: Stakeholder Wealth Maximization and Balanced Scorecards
Some theorists have suggested that the best way to consider the interests of all of
the different stakeholders in a modern corporation is to replace stockholder wealth
maximization with a broader objective of stakeholder wealth maximization, where
stakeholders include employees and society. While it sounds wonderful as a concept, we
believe that it is not a worthwhile alternative for the following reasons:
When you have multiple stakeholders, with very different objectives, you will

inevitably have to choose between them. For instance, laying off employees at a
firm that is overstaffed will make stockholders and bondholders better off while
creating costs and society. Stakeholder wealth maximization provides little
direction on the proper way to balance these competing interests.
Adding to the problem is the fact that not all of the costs and benefits to some

stakeholders can be quantified. This is especially true of social costs and benefits,
leaving the assessment to analysts who have their own biases.

22 In the 1990s, the Tupinikim and Guarani Indians launched an international campaign against Aracruz in
the state of Espirito Santo to recover and expand their traditional territories
23 A 1946 investigation by the US military recommended Deutsche Bank be liquidated and its top officials
be tried as war criminals.

Most importantly, stakeholder wealth maximization makes managers accountable

to no one by making them accountable to every one. Managers can essentially go
before each stakeholder and justify their failures by arguing that other stakeholder
interests were being considered.
It may still useful for firms to go beyond the proverbial bottom line, which is what a
balanced scorecard attempts to do. As devised by Robert Kaplan, a Harvard strategy
professor, balanced scorecards try to go beyond financial measures and look at customer
satisfaction and internal business processes.24

The Real World - A Pictorial Representation
We have spent the last few pages chronicling the problems, in the real world, with
each of the linkages -- managers and stockholders, stockholders and bondholders, firms
and financial markets and firms and society. Figure 2.2 summarizes the problems with
each linkage in a pictorial representation.

24 The Balanced Scorecard: Translating Strategy into Action, 1996, Robert.S. Kaplan and David P. Norton,
Harvard Business School Press.

Figure 2.2: Stock Price Maximization in the Real World


Put managerial
Have little
interests over
control over firm
stockholder interests

Large Social Costs
Lend Money
Hurt by stockholder Cannot trace social
actions costs to firm

Delayed or Markets that are
Misleading volatile, short
Information term and make


Alternatives to Stock Price Maximization
There are obvious problems associated with each of the linkages underlying
wealth maximization. Stockholders often have little power over managers, and managers
consequently put their interests above those of stockholders. Lenders who do not protect
their interests often end up paying a price, when decisions made by firms transfer wealth
to stockholders. Information delivered to financial markets is often erroneous, misleading
or delayed, and there are significant differences between price and market value. Finally,
firms that maximize wealth may do so while creating large costs for society.
Given these problems, there are alternative courses of action that we can follow.
One is to find a different system for keeping errant management in check. The second is
to find an alternative objective for the firm. In this section, we will consider these

A Different System for Disciplining Management (Corporate Governance)
In the system we have described thus far, stockholders bear the burden of replacing
incompetent management; we can call this a market-based corporate governance system,
where investors in financial markets govern how corporations are run. There are some
who believe that this is too much of a responsibility to put on investors who, as they see
it, often operate with poor information and have short time horizons. Michael Porter, a
leading thinker on corporate strategy, has argued that firms in the United States are
hamstrung by the fact that investors are short term and demand quick returns. He
contrasts them with Japanese firms, which he argues can afford to adopt strategies that
make sense in the long term, even though they might not maximize profits in the short
term. He suggests that investors should form long-term relationships25 with firms and
work with them to devise long-term strategies. His view of the world is not unique and is
shared by many corporate executives, even in the United States.

25 There is some movement towards "relationship investing" in the United States, where funds such as
Allied Partners (run by Dillon Read), Corporate Partners (run by Lazard Freres) and Lens (run by activist
Robert Monks) have attempted to create long term relationships with the managers of firms.

These executives argue that there are alternatives to the market-based corporate
governance systems, where stockholders act to discipline and replace errant managers
and stock prices measure their success. In the German and Japanese systems26 of
corporate governance, firms own stakes in other firms and often make decisions in the
best interests of the industrial group they belong to, rather their own. In these systems, the
argument goes, firms will keep an eye on each other, rather than ceding power to the
stockholders. In addition to being undemocratic - the stockholders are after all the owners
of the firm -- these systems suggests a profound suspicion of how stockholders might use
the power if they get it and is heavily skewed towards maintaining the power of
incumbent managers.
While this approach may protect the system against the waste that is a by-product
of stockholder activism and inefficient markets, it has its own disadvantages. Industrial
groups are inherently more conservative than investors in allocating resources and thus
are much less likely to finance high risk and venture capital investments by upstarts who
do not belong to the group. The other problem is that entire groups can be dragged down
by individual firms that have made bad decisions27. In fact, the troubles that Japanese
firms have had dealing with poor investments in the 1990s suggests to us that these
alternative corporate governance systems, while efficient at dealing with individual firms
that are poorly run, have a more difficult time adapting to and dealing with problems that
are wide-spread. These problems, consequently, tend to fester and grow over time. For
instance, while financial markets pushed corporate banks in the United States to confront
their poor real estate loans in the late 1980s, Japanese banks spent much of the 1990s
denying the existence of such loans on their books28.

26 There are subtle differences between the Japanese and the German systems. The Japanese industrial
groups called keiretsus are based primarily on cross-holdings of companies and evolved from family owned
businesses. The German industrial groups revolve around leading commercial banks, like Deutsche Bank or
Dresdner, with the bank holding substantial stakes in a number of industrial concerns.
27 Many Korean industrial groups (called chaebols), that were patterned after the Japanese keiretsu, were
pushed to the verge of bankruptcy in 1990s because one or two errant firms in the group made bad real
estate loans.
28 Kaplan, S.N., 1997, Corporate Governance and Corporate Performance, A Comparison of German,
Japan and the United States, Journal of Applied Corporate Finance, v9(4), 86-93.. He compares the U.S.,

Is there a way in which we can measure the effectiveness of alternative corporate
governance systems? One suggestion is that corporate governance systems be measured
on three dimensions - the capacity to restrict management's ability to obtain private
benefits from control, easy access of firms that want capital to financial markets and the
ease with which inefficient management is replaced. It can be argued that corporate
governance system in the United States does a better job than alternative systems on all
three counts.29

Choosing an alternative objective
Given its limitations, the easy answer would be to cast aside stock price
maximization as an objective. The tough part is replacing it with another objective. It is
not that there are no alternatives, but that the alternatives come with their own sets of
problems and it is not at all obvious that there is a benefit to switching. This is especially
true when the alternative objective is evaluated on the three criteria we used to evaluate
the wealth maximization objective - Is the objective clear and unambiguous? Does it
come with a timely measure that can be used to evaluate success and failure? Does it
create side costs that exceed the overall benefits? Let us consider three commonly offered
alternatives to stock price maximization.

1. Maximize Market Share
In the 1980s, Japanese firms inundated global markets with their products and
focused their attention on increasing market share. Their apparent success at converting
this market share to profits led other firms, including some in the United States, to also
target market share as an objective. In concrete terms, this meant that investments that
increased market share more were viewed more favorably than investments that increased
them less. Proponents of this objective note that market share is observable and

German and Japanese corporate governance systems. He finds that the U.S. system provides better
incentives for firms performing well and that it is easier for companies in the U.S. to return cash to the
29 Macey, J.R., 1998, Measuring the Effectiveness of Different Corporate Governance Systems: Towards a
more Scientific Approach, Journal of Applied Corporate Finance, v10(4), 16-25.

measurable like market price, and does not require any of the assumptions about efficient
financial markets that are needed to justify the stock price maximization objective.
Underlying the market share maximization objective is the belief (often unstated)
that higher market share will mean more pricing power and higher profits in the long
term. If this is, in fact, true, maximizing market share is entirely consistent with our
objective of maximizing firm value. If however, higher market share does not yield
higher pricing power, and the increase in market share is accompanied by lower or even
negative earnings, firms that concentrate on increasing market share can be worse off as a
consequence. In fact, many of the same Japanese firms that were used by corporate
strategists as their examples for why the focus on market share was a good one
discovered the harsh downside of this focus in the 1990s.

II. Profit Maximization Objectives
There are objectives that focus on profitability rather than value. The rationale for
them is that profits can be measured more easily than value, and that higher profits
translate into higher value in the long term. There are at least two problems with these
objectives. First, the emphasis on current profitability may result in short term decisions
that maximize profits now at the expense of long-term profits and value. Second, the
notion that profits can be measured more precisely than value may be incorrect, given the
leeway that accountants have to shift profits across periods.
In its more sophisticated forms, profit maximization is restated in terms of
accounting returns (such as return on equity or capital) rather than dollar profits or even
as excess returns (over a cost of capital). While these variants may remove some of the
problems associated with focusing on dollar profits next period, the problems with
accounting measurements carry over into them as well.

III. Size/Revenue Objectives
There are a whole set of objectives that have little to do with stockholder wealth
but focus instead on the size of the firm. In the 1970s, for instance, firms like Gulf and
Western and ITT, with strong CEOs at their helm, were built up through acquisitions into
giant conglomerates. There seemed to be no strategic imperative to these acquisitions,
other than the desire on the part of the CEOs to increase the sizes of their corporate

empires. Empire building may no longer be in vogue, but there have been cases where
corporations have made decisions that increase their size and perceived power at the
expense of stockholder wealth and profitability.

Maximize Stock Prices: Salvaging a Flawed Objective
The alternatives to stock price maximization “ a corporate governance system
build around self-governance or a different objective “ have their own limitations. In this
section, we consider the case for salvaging stock price maximization as an objective, but
consider ways in which we can reduce some of the problems highlighted in the earlier
section. In particular, we consider ways in which we can reduce the conflicts of interest
between stockholders, bondholders and managers, and the potential for market failures.
We also present an argument for stock price maximization based upon the market™s
capacity to correct systematic mistakes quickly and effectively.

Conflict Resolution: Reducing Agency Problems
If the conflicts between stockholders, managers and bondholders lie at the heart of
the problems with stock price maximization, reducing these conflicts should make it a
more palatable objective. In this section, we examine the linkages between stockholders
and managers, stockholders and bondholders, firms and financial markets and firms and
society and look at how best we can reduce the side costs to maximizing stock prices.


. 5
( 8 .)