What is Shareholder Primacy?
Shareholder Primacy is a kind of corporate governance that keeps the interest of shareholders above any other party. In a corporation there are several parties involved, like creditors, debtors, employees, consumers etc. This kind of governance keeps its main focus to maximize shareholder’s wealth as they consider shareholder to be the owner of the company.
The concentration on only the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. in shareholder primacy has been debated a lot. There are debates regarding the corporation’s duty towards the environment and consumers, but shareholder primacy focuses on the wealth creation of shareholders only. So the governance stipulates rules for accepting projects with the highest NPVNPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not., even if that project is not environment friendly. The governance also focuses on charging the maximum competitive price to customers that increase shareholders’ wealth.
Background of Shareholders Primacy
Adolf Berle and Gardiner Means published “The Modern Corporation and Private Property” in 1932. The book was regarding the foundation of United States Corporate Law. In the book, for the first time, the idea of “shareholders are the corporation’s true owner” was introduced.”
Later economist Milton Friedman added to the theory that the main purpose of corporations is to maximize shareholders’ wealth.
Criticism of Shareholders Primacy
- The main focus of the management will be short term earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. (EPS) if shareholders primacy is followed. So management will involve in decisions that will benefit in the short-term and ignore the long-term effect. This will be devastating for the corporation. A corporation doesn’t have the maturity; it goes on forever. So always, long term effect must be seen.
- This governance will force management to have a high payout ratio. So most of the earnings will be distributed in the form of dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., and no earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. will be retained for further growth of the corporation.
- Management will be shaky to take the optimal risk to earn the optimal return because increasing risk may lead to negative earning also. So shareholders will not be benefited in that year.
Is Shareholders Primacy Legally Mandated?
The modern economic era considers shareholders’ wealth to be the primary factor for the corporation. There is still no law for shareholders’ primacy. Shareholder primacy in most places described as “norm” rather than “law.” Shareholders’ primacy is taken as a belief in most parts of the world.
Shareholder Primacy vs. Stakeholder Theory
All shareholders are stakeholders, but all stakeholders are not shareholders. So shareholder primacy only focuses on the well-being of shareholders, whereas stakeholder theoryStakeholder TheoryStakeholder theory refers to the ethical concept that addresses business decisions, trends, profits and their collective impact on all stakeholders, including the shareholders, employees, financers, government, customers and suppliers. focuses on the well-being of all related parties to a project. It is the management’s duty to identify the most important stakeholders and protect their interests. Important stakeholders could be consumers, environment, creditors, etc.
- Shareholders are considered the owner of a corporation, and shareholder primacy protects their interests. Governance allows the maximum wealth creation of shareholders. Shareholders take the maximum risk, so they should get the maximum wealth creation
- As the earning of the company increases, so the share price also increases, which helps shareholders to sell shares at a higher price. Capital gains are taxed at low rates. So it is beneficial for the shareholders.
- Shareholder primacy forces management to focus on profit maximization, which should be the ultimate goal of the management. The corporation needs profit to survive.
- Companies opt for projects with the highest NPVs, so the chances of the project failing are less.
- As most of the profits are distributed due to a high payout ratio, so due to less retained earnings. The growth of the corporation is hampered
- Management gets so much involved in maximizing EPS that it accepts projects with huge short term benefits and low long term benefits. This affects long term profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance..
Shareholders’ primacy is an outlook that portrays that shareholders are the owners of the corporation and other stakeholders are not so important. So the attention of the management should be to protect the wealth of shareholders. Other stakeholders are not considered. This conduct is debatable and has been criticized on many platforms. Many believe that shareholders should be the ultimate owner as they are taking the maximum risk.
This has been a guide to what is Shareholder Primacy and its definition. Here we discuss criticism, background, and is shareholder primacy legally mandated along with advantages and disadvantages. You may learn more about financing from the following articles –