An Argument for Stockholder Wealth Maximization

Let us start off by conceding that all of the alternatives - choosing a different corporate governance system, picking an alternative objective and maximizing stockholder wealth with constraints - have their limitations and lead to problems. The questions then become how each alternative deals with mistakes and how quickly errors get corrected. This is where stock price maximization does better than the alternatives. It is the only one of the three that is self-correcting, in the sense that excesses by any stakeholder attract responses in three waves.

1. Market reaction: The first and most immediate reaction comes from financial markets. Consider again the turmoil created when we have well publicized failures like Enron. Not only did the market punish Enron (by knocking its stock and bond price down) but it punished other companies that it perceived as being exposed to the same problems as Enron - weak corporate governance and opaque financial statements - by discounting their values as well.

2. Group Activism: Following on the heels of the market reaction to any excess is outrage on the part of those who feel that they have been victimized by it. In response to management excesses in the 1980s, we saw an increase in the number of activist investors and hostile acquisitions, reminding managers that there are limits to their power. In the aftermath of well-publicized scandals in the late

1980s where loopholes in lending agreements were exploited by firms, banks and bondholders began playing more active roles in management. 3. Market Innovations: Markets often come up with innovative solutions to problems. In response to the corporate governance scandals in 2002 and 2003, Institutional Shareholder Services began scoring corporate boards on independence and effectiveness and selling these scores to investors. After the accounting scandals of the same period, the demand for forensic accounting, where accountants go over financial statements looking for clues of accounting malfeasance, increased dramatically. The bond market debacles of the 1980s gave birth to dozens of innovative bonds designed to protect bondholders. Even in the area of social costs, there are markets that have developed to quantify the cost. Note that we have not mentioned another common reaction to scandal, which is legislation. While the motives for passing new laws to prevent future excesses may be pure, laws are blunt instruments that are often ineffective for three reasons. First, they are almost never timely. It takes far more time for legislation to be put together than for markets to react, and the outrage has often subsided before the laws becomes effective. Second, laws written to prevent past mistakes often prove ineffective at preventing future mistakes, as circumstances change. Third, laws often have unintended consequences, where in the process of correcting one distortion, they create new ones.

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