The History Lesson: How We Got Here#

If you’re scratching your head about why your job (or maybe just corporate life in general) seems a bit off, here’s a history lesson that might help it make sense.

Back in 1916, the Ford Motor Company was a game-changer thanks to the Ford Model T. Henry Ford, who founded the company and owned most of it, had a plan for the extra cash they had piled up. He wanted to:

• Build more factories.
• Hire even more workers.
• Make even more cars.

Ford had also famously (and maybe controversially back then) significantly raised the wages for his factory workers. He also offered benefits like the 40-hour work week.

In interviews, Ford talked about his goals: “My ambition is to employ still more men, to spread the benefit of the industrial system to the greatest possible number, to help them build up their lives in their homes.” He added, “To do this we are putting the greatest share of our profits back into the business.”

This approach didn’t sit well with the minority shareholders. All they wanted was for him to:

• Lower wages again.
• Raise the price of the Model T.
• Keep paying them a regular dividend.

Since Ford was the majority owner, they couldn’t just tell him what to do. So, they took him to court.

The Dodge vs. Ford Case: Setting a Precedent#

The court ended up siding with the minority shareholders. This ruling forced Ford to consider the shareholders’ interests above his other business plans.

This case is considered the one that set the precedent for shareholder primacy in America. In simple terms, it meant that a company’s board of directors and executives are generally supposed to try and maximize shareholder value as best they can.

Now, some folks have taken this ruling the wrong way, thinking CEOs and boards have a strict legal mandate to maximize shareholder value at all costs. But that’s not quite true. The court did favor the minority shareholders, but it also upheld the business judgment rule. This rule essentially says that executives can do what they honestly believe is best for the company, even if it doesn’t immediately make the stock price go up.

It’s important to remember that Henry Ford wasn’t paying his workers more or creating jobs just to be a nice guy. He was actually a pretty ruthless businessman. He wanted to control a bigger piece of the growing car market.

• By paying workers better wages, he made it harder for his competitors to find people to hire.
• By pricing the Model T just a little bit above what it cost to make, he made it almost impossible for other car makers to build and sell a cheap car and still make money.

Here’s the biggest twist, the real irony: the minority shareholders who sued Ford were John and Horace Dodge. They owned about 10% of Ford Motor Company. What did they do with the special dividends they won from the lawsuit? They used that money to fund the growth of their own company, Dodge – which eventually became one of Ford’s main competitors!

So, this court ruling? It was bad for the company’s leaders, bad for the workers, bad for the country, and even bad for the Ford shareholders who got a quick payout but missed out on the company becoming even more dominant in the market.

Why Shareholder Primacy Persists (And Why It Fails)#

Even though the historical precedent from Dodge vs. Ford had so many negative outcomes, there are still reasons why people believe in maximizing shareholder value. And, maybe more importantly, there are three big reasons why companies run this way are almost certainly heading for trouble down the road.

It’s time to look at how money works to figure out how this idea, which some call the worst in business history, became the normal way of doing things in Corporate America.

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Corporate America wasn’t always so obsessed with shareholder value like it is today. Even after the big Dodge vs. Ford case in 1919, companies didn’t immediately change everything.

Between the mid-1960s and 1970s, the American stock markets didn’t really go up or down much. CEOs still felt a duty to do what was best for the whole company. They got a regular salary and a small bonus, pretty much like any other employee. According to groups like the Economic Policy Institute and the National Bureau of Labor Statistics, CEOs back then made about 20 times more than the average worker at their company. So, they were well-off, but not so rich they could retire after just one good year. Their main drive was to keep the company stable and running safely so they could keep their well-paying jobs for a long time.

Things changed by the 1990s. A small group of financiers came up with an idea: to get better returns from their investments, they should make sure the CEO wanted the same thing they did – a higher stock price. How’d they do it? By giving CEOs a smaller cash salary but adding stock options. This directly linked the CEO’s bonus money to how well the company’s stock performed.

The results were dramatic. In the 1990s, CEO pay jumped from about 60 times what the average worker made to 380 times! My friend Patrick Boyle made a great video explaining how this seemingly small change in how companies paid their leaders eventually led to situations like Elon Musk asking for a jaw-dropping $50 billion in pay for just one year.

With so much money on the table, CEOs and other top executives were happy to go along with the idea (even if it wasn’t strictly true) that it was their legal duty to maximize shareholder value, even if it meant hurting their companies down the road.

Reason 1: Picking Up Pennies in Front of a Steamroller#

This is the first strategy they used, and it’s as risky as it sounds. You probably won’t be surprised that some of the biggest companies in the world have taken incredibly dumb risks. We’ve seen some of the biggest corporate failures ever just in the last couple of years, and it seems to be happening more often.

If you’re a CEO with a potential bonus of millions of dollars tied to the stock price, you’re going to do everything you can to hit the targets the board set for that bonus. A top goal for you will be to make the stock price go up, pay a big dividend, or both. Most bonuses are paid out year-by-year. And according to Fortune Magazine, the average boss of a big Fortune 500 company only stays in the job for about 7 years now.

For a CEO with that short timeframe, huge projects that might pay off over decades are basically useless. Announcing one might temporarily boost the stock, but even that’s not guaranteed as investors often don’t care much about long-term plans that might never happen anyway.

So, the best plan for a CEO is often to:

• Control any bad news.
• Focus heavily on the numbers for the very next quarter (every three months).

An easy way to make the numbers look good quickly is to cut costs. Where do they cut? In areas like:

• Security
• Auditing
• Risk Management
• Safety Controls
• Long-term Development
• Training

If you cut these enough, you might even see revenue go up at the same time because the sales teams and other groups that bring in money can work more freely without annoying compliance people making sure everything is legal and safe.

Look at the examples:

• Silicon Valley Bank, one of the biggest bank failures in US history, had regulators call its risk management department “terrible” – and that’s about the harshest thing financial regulators ever say.
• Lehman Brothers went broke because it couldn’t stop chasing the money it made from risky subprime mortgage bonds.
• Boeing’s series of airplane troubles has been linked to pushing new planes out faster by cutting back on safety checks and testing.
• HSBC, one of the world’s largest banks, made billions by providing financial services to international criminals.

People lost their jobs, their savings, and even their lives in these scandals. But even worse, the shareholders lost billions of dollars from these messes and many others like them. Yet, the CEOs who were in charge while these terrible risks were taken often still got their huge bonuses. Some even got a large payment, known as a “golden parachute,” when they left.

Business departments like Risk Management and Cyber Security have tough jobs. If everything is running smoothly, people wonder what they’re even doing for the company. If things go wrong, people ask what good they were in the first place.

You can make a little bit of money quickly by picking up small coins right in front of a moving train. But if something goes wrong, you get completely flattened. All for a few bucks.

Reason 2: Guaranteeing Businesses Get Worse#

The short-sighted thinking driven by forcing CEOs to maximize shareholder value is also the second major reason it’s such a bad idea. It almost guarantees that the business itself will get worse over time.

Let’s look at Jack Welch. He was the chairman and CEO of General Electric (GE) from 1981 to 2001. He started at GE in an entry-level job and worked his way to the top. But once he got there, he completely changed the company, all in the name of the shareholders.

Welch:

• Fired 72,000 of GE’s 400,000 employees (made them redundant).
• Sold off entire parts of the company.
• Poured money into the financial and media sides of the business. GE Capital became the main focus for a company that used to be known for making appliances, machinery, and airplane parts.
• He also championed outsourcing (moving jobs overseas) and famously bragged about it on CNBC, a news network he actually helped create after GE bought NBC.

His tough approach seemed to work in the short term. During his 20 years as CEO, GE’s stock price soared from $6 a share to a peak of almost$370 a share just a year before he was asked to leave. And he didn’t leave empty-handed – his exit package was estimated at $417 million!

Other CEOs, who were starting to get paid mainly with stock options just like Welch, saw this famous boss talking about his strategies on his own TV channel. They figured they couldn’t argue with his results and started copying him.

It’s interesting to note, according to data from the Economic Policy Institute, the year Jack Welch became GE’s CEO was the last time that increases in how much workers produced kept pace with how much their wages went up. Make of that what you will.

Welch’s focus on shareholders above everyone else – customers, employees, the community – worked well for quite a while. But since he left, GE’s stock price has fallen by roughly 70% from its highest point. This happened even during a period when the stock market overall has gone way up (like 400%!).

• GE used to make top-quality products that customers loved and were loyal to. Welch’s outsourcing led to worse products, and customers started buying from other brands.
• GE used to be seen as a great place to work because it was stable, paid well, and you could work your way up, just like Welch did. Welch proudly talking about mass layoffs and firing the worst-performing 10% of staff every year made it one of the least desirable places to be employed. So, the best people started going elsewhere.

By ignoring customers and employees to please shareholders in the short term, they actually made things worse for the shareholders in the long run too.

Even Welch himself admitted in an interview that maximizing shareholder value was “stupid.” He said a high stock price is just the result of doing everything else correctly. Why didn’t he follow his own advice? Probably because he made so much money by keeping the people who paid him (the board, representing the major shareholders) happy.

During Welch’s time, GE was almost suspiciously good at hitting its financial targets. Roger Martin, the head of the Rotman School of Business at the University of Toronto, pointed out in an interview that GE met or beat what financial analysts expected in 46 out of 48 quarters between 1989 and 2001 – that’s a 96% success rate! Even more impressive, in 41 of those 46 quarters, GE hit the analyst forecast down to the exact penny – 89% perfect!

Of course, this wasn’t just amazing management skill. It was largely due to good old-fashioned Creative Accounting. This practice got GE into trouble with the SEC (the US financial watchdog) and was part of why Welch was eventually “asked nicely” to leave the company.

Despite the problems and his own admission, Welch’s business methods are still commonly used in many corporate boardrooms around the world today.

Reason 3: The Short Term is All That Matters#

Okay, so you might be asking, if pushing CEOs to chase quick profits has been shown to be bad for pretty much everyone (even the shareholders!), why are companies still doing it?

Well, that brings us to the third reason why maximizing shareholder value is a terrible idea: the short term is all that matters to the people who own the stock these days.

Data from the biggest stock markets in America shows that how long investors hold onto stocks has been shrinking constantly for decades.

• In 1975, people held stocks for an average of 5 years.
• In 2021, they held them for less than 1 year.

Why the change?

• Electronic brokerages have made it much easier to buy and sell shares quickly.
• People are often in less secure financial situations now. Selling shares, even at a loss, might become necessary to cover an unexpected bill. The biggest drops in how long people held stocks happened around 2001 and 2008, during economic downturns and job losses, when people likely had to sell their investments just to make ends meet.
• Even tax rules around long-term capital gains (profits from selling investments held for over a year) encourage people to try and make money by buying and selling stocks more frequently, rather than waiting for dividends, which can sometimes be taxed less favorably.

The result of people holding onto shares for less time is that they only care about quick wins. So, a CEO who can deliver a really profitable three months (a “fourth quarter”) will be more popular with these investors than a CEO who decides to put company earnings back into things like training employees, research and development (R&D), or improving safety – things that might not pay off for years down the road.

This kind of thinking, focusing only on the immediate future, just isn’t sustainable for a company. But, from the perspective of a shareholder holding the stock for less than a year or a CEO whose bonus is tied to this year’s stock price, that’s someone else’s problem down the line.

Want to Learn More?#

This isn’t the only way things have to be! I’m actually going to write an opinion piece (an op-ed) about some business and leadership teams I’ve worked with in the real world who are doing things differently, and having great success.

To get free articles like that and to get access to these videos a day early, sign up for my totally free email newsletter, Compounded Daily. You can find the link to sign up in the description below.

If you want to see just how bad things can get when companies prioritize shareholder value above everything else, go and watch my video about the deadly monetization of nursing homes. That video shows how this exact business strategy has sadly led to the deaths of tens of thousands of vulnerable Americans.

And don’t forget to like and subscribe to keep on learning how money works!