August 22, 2005
Conglomerate Junior Scholars Workshop: Matt Bodie on the False God of Shareholder Primacy
Posted by Christine Hurt

Welcome to the first installment of Conglomerate Junior Scholars Workshop.  Our featured paper today is AOL Time Warner and the False God of Shareholder Primacy by Matthew Bodie.  Matt is an assistant professor at Hofstra University School of Law teaching both business courses and employment law.  He has published several articles including an article at the intersection of business law and employment law:  Aligning Incentives with Equity: Employee Stock Options and Rule 10b-5, 88 Iowa L. Rev. 539 (2003).

Matt has brought his paper to the right place, as resident shareholder primacy expert Gordon Smith will undoubtedly be able to offer helpful comments.  Gordon has written on this topic before:  see D. Gordon Smith, The Shareholder Primacy Norm, 23 J. Corp. L. 277 (1998); Robert B. Thompson & D. Gordon Smith,  Toward a New Theory of the Shareholder Role:  "Sacred Space" in Corporate Takeovers, 80 Tex. L. Rev. 261 (2001).

Conglomerate also asked Professor Doug Moll of the University of Houston Law Center to begin discussion of this paper.  Doug teaches in the areas of business organizations, securities regulation, and secured credit, and writes in the area of shareholder oppression and closely held corporations.  Doug's comments on the paper:

In AOL Time Warner and the False God of Shareholder Primacy, Professor Matthew Bodie uses the "almost universally regarded as a disaster" merger of AOL and Time Warner to explore the norm of shareholder primacy in a practical, real-world context. Professor Bodie characterizes AOL as a company that believed in the notion of shareholder primacy -- a company whose efforts "focused . . . almost entirely on the stock price." Time Warner, on the other hand, is characterized by Professor Bodie as a company with "a culture which placed the institution above the shareholder, and journalistic ethics above any requirement to make short-term profits." By tracing the relative decline of AOL and the relative success and continuity of Time Warner (at least in terms of influence), Professor Bodie challenges us to think about what shareholder primacy means in operation and to consider the "potential perils of shareholder zealotry." As I read Professor Bodie's provocative piece, I had some discomfort with the association of AOL and shareholder primacy. Professor Bodie describes AOL's focus on short-term performance and its obsession with meeting Wall Street's quarterly and annual numbers -- at almost any cost. As one example, seeking long-term relationships with advertisers was essentially seen as pointless. The goal was simply to get whatever could be gotten -- at that moment in time -- regardless of whether the relationship suffered. And, as Professor Bodie points out, this short-term focus did a fabulous job of maximizing shareholder wealth -- at least for the shareholders who sold out in time. I wonder, however, about the relationship between shareholder primacy and short-term value. To the extent that maximizing short-term value harms long-term prospects, a company that focuses on short-term value is presumably operating inconsistently with the core of the shareholder primacy norm. Indeed, AOL seemed to focus on stock price as the product rather than as the result of a product. Professor Bodie acknowledges this point -- he suggests that primacists would object to illegal actions that boost stock price in the short term because "it will generally be a losing strategy in the long term." But then what does AOL teach us? Does it convey that shareholder primacy is, indeed, a "false god?" Or does it simply suggest that shareholder primacy has a temporal element -- it's about the marathon, not the race?

Readers, feel free to comment in the "Comments" section to this post. No anonymous posts, please.

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Comments (9)

1. Posted by Vic Fleischer on August 22, 2005 @ 14:03 | Permalink

Corporate law strikes me as an area that is overtheorized. Matt's paper is a welcome contribution -- now we can start talking about how these concepts work in action, instead of just jousting about shareholder vs. stakeholder.

I enjoyed the paper, and I think Matt's observations about the culture clash are important. Like Doug, though, I'm not entirely convinced that AOL's culture had much to do with shareholder primacy. I think, using the same evidence Matt uses, one could argue that AOL reflected rampant managerial rent-seeking as managers sought to maximize the short-term value of their options.

The sort of BS accounting that AOL used was similar, as a conceptual matter, to Enron's accounting gimmicks. (I've just finished Eichenwald's Conspiracy of Fools, so Enron is on the mind.) And I don't think Enron's culture could be fairly described as shareholder primacy.

Both AOL and Time Warner, I would argue, reflected the triumph of managerialism over shareholder values. Time Warner's managerialism was just a different flavor, more benign and less destructive.

I also think it would be a mistake to make TW out to be a bunch of saints. For example, I'm suspicious of Time Warner's massive write off of good will that Matt describes. As I understand it -- I saw an accounting presentation about this some time ago -- TW is calling AOL virtually worthless. The proper accounting, I would suspect, should write this off over time. Writing it off all at once, as TW did, allowed them to take a huge loss just once and show higher earnings in the future. The merger was a massive mistake, but the accounting manipulation allows TW to prey on the market's ability to forget. Maybe an accounting expert will help us out.

In sum, Matt's paper tells a good story, but we disagree about the takeaway points. Is shareholder primacy a false god? Even if it is, I'll stick with it until someone offers me a better one.

Matt's paper has convinced me that those of us who advocate shareholder primacy need to justify our theory with examples from the real world. Private equity -- where shareholder primacy trule exists -- may be the place for us "qualitiative empiricists" to start looking.

More on this later if I get a chance.


2. Posted by David Zaring on August 22, 2005 @ 14:30 | Permalink

As Matt may know, I've always wondered at the purported horribleness of the AOL-TW merger from the AOL shareholders' perspective, given that said shareholders bought real assets - bricks - with incredibly overvalued clicks. Matt says something about this on pp.31-32, but I wonder if the merger was win-lose, rather than lose-lose.

To me, the key to telling Matt's story, though, is to establish that shareholder primacy encourages cheating. I could see an alternative story told about how bubble cultures or young company cultures result in similarly unhappy corporate outcomes.

On a side, ripped from the headlines, note, the value of journalistic integrity to TW's management is asking for reinterpretation in light of the different ways the corporate masters of Cooper and Miller supported their employees. Although that might be taken as a sign that AOL left its mark on the company, the current head of Time magazines is a Time veteran (and a former journalist), and he somewhat explicitly chose to turn over Cooper's notes because he was worried about the company, rather than its journalistic mission.

I agree with Vic - the Enron similarities at the end of Matt's paper are very interesting.


3. Posted by Frank Snyder on August 22, 2005 @ 17:56 | Permalink

I enjoyed the paper. The analysis of how Time’s managers and its “culture” have triumphed over larger companies is interesting and insightful. But I draw a different lesson from the story, perhaps because I go back to the Time-Warner merger. Yes, Time’s managers remained in control and Time’s “culture” -- accurately pictured here as stressing status over profits -- continues to influence the business. But these achievements are less impressive when it’s realized that they were accomplished by systematically sacrificing Time’s own shareholders (including employees who had large amounts of company stock in their retirement plans or in options) to the shareholders first of Warner and then of AOL.

Time prevented its shareholders from getting $200 a share for the company in 1987; it’s now been 18 years and the stock owned by Time shareholders has never been that high since; the last time I checked a share of Time stock was, adjusted for the various transactions, worth about half of what it was in 1987. Time management deliberately gave Warner shareholders a bigger slice of the deal than Warner’s market cap justified, in exchange for the structure that would keep the “Time culture” in place.

During the 1990s, Time Warner’s share price languished because, as the article makes clear, employees were much more interested in fighting for their turf and increasing their status than in making money. There were divisions that were well run and profitable (HBO), but the company as a whole was not working to maximize profits. It’s easier to keep your “culture” in place if no one is pushing you to make money.

Finally, with 13 years of dismal stock performance behind them, Time’s management decided to trade its valuable assets for AOL stock. As the article suggests might be the case, AOL’s focus on its share price actually provided a tremendous service for its shareholders – they enjoyed a highly favorable exchange rate on the transaction. I seem to recall also that this deal also was structured to give AOL shareholders a somewhat larger share than the market cap alone would justify (though I don't have the records here) which means that Time management again simply used shareholder money to protect its culture. Once the merger was done, the Time culture continued to operate, ensuring that the combined firm would languish. I suspect that one of the drivers of the deal was Time management's desire to swap AOL's price history for TWX's -- if you look at a chart of the stock today, you get AOL's history, not Time's.

All this means is that I respectfully dissent from the conclusion. Other than “cultural survival,” how has Time been successful? The company as it now exists is nothing more than the sum of its various parts, none of which appear to work together. As someone recently pointed out, TWX ran a whole stable of ad-driven media companies but couldn’t figure out how to get AOL to cash in on the Internet advertising boom. It managed to own both Warner Music and AOL and yet couldn’t come up with the iPod. It couldn't even figure out how to get the two together, spinning off Warner Music and talking about spinning off AOL. It's hard to think of a company that's done less with some marvelous assets than post-1987 Time.

I think the paper would be stronger if a better case were made that TWX is a successful company in some way other than survival of its “culture.” I myself don’t see any such measure, if compared to anything other than its lousy AOL division.
Compared with The Washington Post Co., for example, Time has been an abject failure. WPO has managed to keep its journalistic integrity while still rising about fivefold from its price in 1987 while successfully diversifying into new areas.

In any event, thanks for a useful and interesting read!


4. Posted by Christine on August 22, 2005 @ 18:16 | Permalink

Like the others, I enjoyed the case study approach of the paper. I think this scenario reflects the need for better terminology than "shareholder primacy" and "shareholder wealth maximization." These terms are easy enough to define for the relationship between a target board and its shareholders in a final period situation, but they get fuzzy the morning after for a board making daily decisions of a going concern. As Vic points out, the focus of the AOL guys on hitting analyst targets to ensure share price increases, presumably to inflate the value of their stock prices, is hardly "shareholder primacy." What slice of shareholder? The day trader that bought at 9 am? The long-term investor who buys and holds? The mutual fund who generally holds until something happens? The employee who has company stock in a retirement fund that she cannot sell? In a merger situation, all shareholders have the same time horizon, more or less. So, do we mean long-term shareholder primacy? Short-term shareholder primacy?


5. Posted by Gordon Smith on August 22, 2005 @ 22:11 | Permalink

Matt, you are getting some good comments here, and I hope that I can add something useful to the mix.

Like the others who have commented, I enjoy reading case studies. You obviously understand the limits of case studies as an analytical tool, but even with these limited purposes in mind, I think you struggle with this case study because it depends on caricaturing TW as a "culture" company and AOL as a "shareholder primacy" company. As others have noted, this is, at best, too simple, and, at worst, a distortion. (In my view, this isn't necessarily a fatal objection to this case study because if we have learned one lesson from the sociologists, it is that all law stories are fables to some degree.)

You suggest that the "ultimate lesson" of the TW-AOL merger is "the importance of having a corporate 'culture' beyond simply maximizing shareholder value." Moreover, you emphasize in your conclusion "the danger of shareholder primacy as an organizing principle." There is some tension between this conclusion and your case study, in which one of the companies (indeed, the prevailing company) did not follow the shareholder primacy principle. In any event, for me the missing link in your argument is the connection between shareholder primacy as a legal "rule" and shareholder primacy in the boardroom.

At the beginning of the article, you describe shareholder primacy in the structure of corporate law, but also emphasize shareholder primacy as ideology. In this part of your analysis, you seem to include directors' duties. In my view (as I wrote in The Shareholder Primacy Norm, which Christine kindly mentions in her introduction), the duty of directors to pursue a goal of shareholder primacy has almost no effect on board decisions. I wrote:

the shareholder primacy norm is nearly irrelevant with respect to conflicts of interest between shareholders and nonshareholders and is outmoded with respect to conflicts of interest between shareholders. In short, the shareholder primacy norm may be one of the most overrated doctrines in corporate law.

I suspect that the structural mechanisms that you describe, combined with market forces, account for much of the strength of shareholder primacy in modern US corporations. When you decry the emphasis on shareholder primacy, therefore, I would be interested to know more about what aspect of the system you would propose changing.

Finally, it occurs to me that your target for this paper may not be law reform, but a call for change in scholarly emphasis. You refer to the "ideology" of shareholder primacy and the "shareholder primacy movement," and you seem concerned about the primacy of shareholder primacy among your fellow legal scholars. Will your argument about the ineffectiveness of shareholder primacy as a business strategy be persuasive to those who embrace shareholder primacy as a legal rule? Here's the problem: under the current system, managers have the flexibility to embrace shareholder primacy (late-stage AOL) or they can embrace another management philosophy (early Time), so why do we need to change the system?


6. Posted by Matt Bodie on August 23, 2005 @ 7:11 | Permalink

I’d first like to thank Christine, Gordon, and Vic for creating this terrific workshop series. I’m grateful for the opportunity to present, and I’m looking forward to the papers that follow.

And thanks to all the commenters who have given me a lot to think about. There’s plenty of food for thought here, and I’m happy to get a chance to respond and get your further thoughts as I develop the paper.

First, Doug and Christine discuss the distinction between the short term and the long term in thinking about shareholder primacy. I agree that I don’t take this on enough clearly enough in the paper. But I do think there’s a response. And it is this – true believers in shareholder primacy have to have a de facto focus on short-term shareholder value. Why? Because when you stretch out the shareholder primacy horizon to the long term, almost anything is justified under the norm. You can pay your employees more, reward your managers handsomely, institute classified boards, and even rejigger a merger to turn down $200 a share in the name of “long-term” shareholder wealth maximization. Jerry Levin is still insisting that, long-term, the merger with AOL will be a successful strategy. So to borrow a phrase from Gordon about the nexus of contracts, the shareholder primacy norm is either trivial or wrong. A focus on long-term shareholder wealth maximization is trivial; a focus on short-term shareholder wealth maximization is wrong.

Second, Vic and David question whether the accounting irregularities at AOL can be put at the feet of shareholder primacy. I am certainly not saying that firms focusing on shareholder primacy are inevitably drawn to corruption. But if you look at the AOL culture, I think there’s a lot of evidence that it was a shareholder primacy culture. Managers focused on meeting Wall Street expectations in order to keep the stock price rising. Executives and other employees had generous stock option grants, and as a result employees almost always knew how the stock was doing. The company took a very aggressive approach to advertising revenues in order to maximize profits. The pressure to keep the stock price high is what led, in my view, to the accounting irregularities. Enron execs were probably subject to similar pressures. What muddies the Enron waters, however, are the efforts by Fastow and his crew to siphon off money for themselves while they were engaging in the accounting hijinks. Although AOL execs did make money from their improprieties, to my knowledge they only made that money from the rising stock price – something that benefited all the shareholders at that time.

Third, as Frank points out, Time Warner is not the paragon of the corporate form. I am not trying to set it up as the angel to AOL’s devil. Time Warner simply serves as a foil here: it is an old-school, entity-driven corporation, but at the end of the day its managers and its culture are in the driver’s seat. I admit to being somewhat of an agnostic about the proper corporate law norm. I am more sympathetic to employee ownership and participation than most, but there are serious difficulties with both: lack of diversification (on the employee side) as well as concern about greater agency costs (from the capital side).

Gordon is right when he offers that my focus is the primacy of shareholder primacy in the legal academy. And I agree that on most boards and in most Delaware cases, the shareholder primacy norm does not play a preeminent role. But I do think that some of the scholarship has taken an almost utopian view of the shareholder primacy norm: if *only* boards and managers would align their interests with shareholders, then wealth would be maximized and everyone would sing kumbaya standing together on a mountain. My point is that at AOL, they did align their interests with shareholders, and look what happened. It’s only one narrative – and perhaps a stylized one. But I do think that it points up some of the potential perils of actually putting the shareholder primacy norm into practice.


7. Posted by Michael Guttentag on August 24, 2005 @ 11:47 | Permalink

I think the questions that Professor Bodie raises are interesting ones. What leads some organizations to fail while others succeed? Does corporate culture play a role, as compared with or in interaction with the attitudes and values of the firm’s leaders? Are these outcomes in some way related to commonly held beliefs about the appropriate role of the firm? Are these attitudes related to the level of fraudulent behavior in the firm? By the way, Professor Bodie is also clearly quite a fine writer.

But I think the paper suffers, as others have noted, from quite damaging over- simplification. I don’t have much to add to what others have said, but I would quibble most with Professor Bodie’s methods. He relies on just a few sources, and this leads him to paint what seems to me to be an incorrect picture of the complexity of organizational life. I worked as an executive at Time Warner during some of the period he discusses, and I had numerous personal and professional relationships with some of the key players at AOL. There were many points on which my interpretation of the events was completely different than Bodie’s analysis. Finding a quote supporting a position is not equivalent to offering a robust delineation of the phenomenon under consideration.

Similarly, the reliance on the Lowenstein explanations of what causes fraud is unjustified.
There is, for example, a fairly extensive literature on what the construct of corporate culture means, and how that may interact with firm outcomes. I would have like to see at least some discussion of that body of scholarship.

In sum, I think Professor Bodie is asking some really interesting questions, but I think his methodology needs to be much more rigorous, even if it is grounded in a case-study approach, to be compelling.


8. Posted by Paul Gowder on August 24, 2005 @ 19:04 | Permalink

A few thoughts from the peanut gallery...


Allow me to suggest one refinement that can go either way: consider in some more significant sense the impact of the .com bubble bursting (and 9/11 later). (And what's the evidence for the "so much cheating" in the .com industry beyond AOL noted on p. 31? As I recall from the time, hardly any .commers were actually reporting profits at the height of the frenzy, so how could they have been inflating them?)

It seems that close consideration of that event, depending on the facts uncovered, could lead to one of several conclusions:

1. AOL's stupidity partially caused it.
2. It caused AOL to tank notwithstanding the foolish behavior
3. It drove AOL to the foolish behavior (particularly all the fraud stuff) because of their exec's shareholder orientation.

Any one of those conclusions would be very interesting. 3 in particular might suggest that shareholder focus, or short-term shareholder focus, might be more or less a false god depending on whether the company or industry is doing poorly or well. At any rate, it would make the piece more nuanced.

Second Moll's concerns about whether AOL's behavior was no more shareholder-oriented than TW's, just shorter-term (which is noted and partially addressed around p. 30). On page 3 (2?), particularly, the interesting phrase leapt out at me: "This worship of the shareholder and the share price led AOL to mislead investors..." does one lie to God?

Also, the paper notes that AOL's first piece of accounting fraud came in 1996, when "visionary" Case with his non-shareholder ideals was running things. (And then Case turned around and went shareholder-nut after 9/11?) That's not necessarily inconsistent with the idea that Pittman's behavior, motivated by shareholder value, was the cause of AOL's misbehavior, but it calls into question the notion that it was the sole cause. Also, many of the edgy but non-fraudulent practices attributed to Pittman don't seem to have any obvious causal connection with the collapse -- the "BA" hardballing, for example: I'm not aware of any evidence that angering its advertisers led to AOL's fall. (If there is such evidence, it perhaps ought to be cited.) Honestly, it seems like a leap is being made from the change from "mission" to "used car salesman" to the eventual collapse that isn't theoretically justified. (Some more info about the relationship, especially in terms of control before and after the merger, between Pittman and Case might be helpful.)

Also, doesn't Levin's error in failing to sevure a "collar," apparently because he valued managerial perogatives and a display of confidence more than protecting shareholder value, show a danger of non-primacy? (Especially since it caused his shareholders to eat it big time.) (This is briefly noted on p. 35 but needs to be given the respect it deserves, I think, as a counter-point.)

And why did supposedly non-shareholder-oriented Levin hand over power to Pittman and resist Case's claims to power, if Pittman was the shareholder fanatic and Case was Levin's fellow visionary? It doesn't make sense, from an armchair psychology/common sense viewpoint. Levin's supposedly non-shareholder-primacy errors need to be explained if the collapse is to be attributed to the corporate culture of AOL. It's in tension with the idea that Levin agreed to the deal after finding Case "more humanistic" etc.

The point of all this character commentary is that it's hard to see anything like yin-yang consistent shareholderism in AOL and consistent non-shareholderism in Time Warner (especially under Levin) in the facts you recite. The picture seems a whole lot muddier, and that muddy picture may not support the normative conclusions drawn.


9. Posted by Frank Snyder on August 24, 2005 @ 19:54 | Permalink

Two points, one follow-up suggested by the comments. Why should long-term shareholders be privileged over short term shareholders? Both play an important role in the markets, and given that about1/2 of 1 percent of TWX's shares turn over every day, that means an awful lot of shareholders aren't holding for 20 years. Not everybody can afford to be Warren Buffett; some people have to buy houses with their stock portfolios. Why is Buffett the one we want to look out for?

Second, I'm not sure whether some are suggesting that the "short term" valuation and the "long term" valuation differ. Under the efficient market hypothesis, as I understand it, the stock's current price reflects the judgment of its long-term value -- the discounted value of all its future outflows. Absent fraud, any actions that increase that share price (like beating earnings estimates) do so because they increase the perceived long-term value. (Whether the market is wrong in assuming that beating earnings estimates is a sign of future profitability is a separate issue.) Any action that a company takes to increase its long-term valuation will, if credible, be priced into the current stock price.

Of course, the reason why the market discounts most of these alleged "long term" benefits is the fact that "long term" improvements are extremely hard to predict and have a marked tendency not to show up -- whereas cash that actually comes into the bank today is real.

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