Companies (and countries) which make maximization of shareholder value, that is shareholder wealth, the central aim of corporate governance perform better, it is claimed, than those which additionally acknowledge the rights of other interests—such as employees and the environment. The superior performance, it is said, not only increases shareholder wealth but also creates more corporate growth, improved returns for employees, and welfare and economic benefits for society at large. The ‘rising tide lifts all boats’. The pursuit of maximum shareholder wealth is, Bughin & Copeland (1997) state, “a virtuous cycle”. Maximizing shareholder wealth is therefore justified not only as consequence of ownership but on grounds of economic efficiency and wider social gains. Not surprisingly these claims are contested.

How is the “virtuous cycle” supposed to be achieved? Usually it is said through three processes: efficient allocation of scarce economic resources; providing an effective mechanism for monitoring and rewarding top management; and internalizing maximum shareholder value as the basis for decision-making within companies. Each of these claims is considered.

1. Allocation of scarce resources

At best, it is argued, that management has knowledge only of its own company and industry. At worst it pursues its own interests and awards itself excessive compensation or perks or misuses free cash flow (Greenwood, 2007). Shareholder-value maximizing advocates however, regard the ‘market’ as an epistemic device, a discovery procedure for processing, concentrating, and concisely transmitting (via price signals) dispersed information. By punishing underperforming companies through refusing further investment and rewarding better performing companies by investing in them, better use of resources results.

But there are two crucial problems with the representation of the stock market as an efficient allocator of resources. Contrary to the widely held view, stock markets are almost insignificant as a source of investment funds. And stock market valuations of companies are often influenced by irrationalities and always by incomplete information.

Stock markets are primarily mechanisms for the transfer of ownership of stocks/shares rather than to provide investment funds. Only when a share is issued for the first time does the amount paid possibly (not always) become available for investment (or other uses) by the issuing company. Whenever shares are sold again the payment is to the owner of the shares not the company which first issued them. The stock market is a second hand, third-hand, fourth-hand, …, nth market. Very rarely is it a first-hand market. In most countries the stock market is not, and never has been an important source of investment funds for major corporations. Instead, as O’Sullivan points out, throughout the 20th century: corporate retentions (that is profits not distributed to shareholders and capital allowances) and debt (borrowings) have been the main sources for business investment (2000: p. 78).

From the late 1920s (the period for which O’Sullivan’s data starts) corporate retentions overall in non-financial corporations in the US have never been less than 66% of all sources of funding over any 5 or 6-year period. In contrast with that, shares have provided less than 18% of corporate funding and only reached close to that level (17.8%) in 1927–1930 when companies sold large amounts of shares to speculators. During the period 1982–1987 shares provided only 3.1% of net sources of funds for the 100 largest US manufacturing companies. But even the relatively small funding from new share issues overstates the amount of investment funds via the stock market as funds from shares have “generally been used not to finance investment in new productive assets, but to transfer financial claims over existing assets” (quite often through an initial public offering (IPO) when the founders of a company sell their shares—they, not the company, get most or all of the money) or “to restructure balance sheets” (O’Sullivan, 2000: p. 79) (for instance, to pay off loans).

Eulogising the ‘efficient market hypothesis’, Michael Jenen states: “[There is] no other proposition in economics which has more solid empirical evidence supporting it” (1978). But does the evidence support this view? The Wall Street Journal describes it as “The most remarkable error in the history of economic theory” (23 October, 1987) and Soros calls it “absurd” (2003: p. 3). There is an immense body of empirical studies demonstrating market irrationalities and imperfections. These include: dominance of short-term horizon; herd mentality; bubbles ‘irrational exuberance’; panics and over-reaction to prospects of losses; the Monday effect; the Friday effect, and so on ([Montier, 2002] and [Shleifer, 2000]). Cooper, Orlin, and Raghavendra (2001) found in a study of the period June 1998 to July 1999 – a time of exuberance for shares in Internet companies – that the inclusion of a ‘.com’ suffix in a firm’s name resulted in a 53% increase in price. Even firms with very little links to the Internet who added a ‘.com’ suffix got a 23% increase in price. As Lee states: “empirically we find that news about fundamentals explains only a fraction of volatility in returns… stock prices move for reasons that have little to do with fundamentals (2001).

2. Stock market-based incentive schemes

To ensure that top management, the ‘leaders’, of companies focus on maximizing shareholder wealth their incentive schemes should, it is argued be linked to the stock market performance of the company’s shares. The remuneration of such managers, especially in Anglo-American countries has certainly increased dramatically since the rise of the ideology shareholder-value maximization. And the notion of disproportionality high pay for top managers has also been adopted in the public sectors of some countries. ‘Leadership’, indeed ‘visionary leadership’ is represented as probably the most crucial element for success and those who fortunately posses that quality (fortunate for us all) must be handsomely rewarded.

Arguments for shareholder maximization incentive schemes have two key defects: a causal link between such schemes and shareholder value demonstrably does not exist and the pursuit of maximum shareholder value is not the most effective way of achieving that aim.

The remuneration of top executives of major companies has increased enormously. The median pay of a FTSE director is more than £1.5 million; that of a CEO almost £3 million. In 2006/2007 alone the pay of full-time directors of the UK’s top companies soared by 37% following a rise of 28% in 2005/2006 (The Guardian, 2007). During 2006/2007 average earnings in the UK rose by 3.4% in the private sector and by 3.1% in the public sector (National Statistics, 2007). Similar rises in other Anglo-American countries such as Australia and New Zealand can also be observed. Somehow the ‘leaders’ of leading German, Korean, and Japanese companies have not required such hugely disproportional incomes.