Private profits, public business: When shareholder primacy doesn’t work

A review of 'Private Profits and Public Business,' by Aneil Kovvali (Indiana University Maurer School of Law) and Joshua Macey (Yale Law School). The prizewinning paper in the junior scholars category at the 2024 Berkeley-ECGI Corporate Governance Forum Prize.

Let’s talk (again) about shareholder primacy - the classic idea that corporations exist to maximize shareholder value. Shareholders, being the residual claimants, are thought to care about efficiency, innovation, and all the other good things that drive societal wealth because they only get paid after everyone else. It’s a neat theory, and markets love neat theories.

But Aneil Kovvali and Joshua Macey, in their forthcoming paper Private Profits and Public Business which won a prize at the Berkeley-ECGI Corporate Governance forum recently, point out that this neatness often unravels when you bring in the government. Specifically, in industries like utilities, defense, finance, and pharmaceuticals, where Uncle Sam is not just a referee but also the stadium owner, the rulemaker, and sometimes the only fan in the stands.

Their argument boils down to this: in government-dominated markets, the incentives that supposedly make shareholder primacy work—like the alignment of shareholder profits with societal value—just don’t hold up. And when they don’t hold up, bad things happen. Utilities overcharge ratepayers. Defense contractors pass along cost overruns. Banks gamble with public money, knowing they’ll get bailed out. It’s not pretty.

The Shareholder Primacy Fairy Tale

The shareholder primacy model relies on two big assumptions. First, shareholders internalize the upsides and downsides of corporate performance. If a company innovates and creates value, shareholders win big. If it screws up, they’re the first to lose. That’s supposed to make them care about long-term success.

Second, non-shareholders—employees, customers, the government—can take care of themselves. Workers negotiate wages, customers shop around for better prices, and regulators keep things in check. This division of responsibility lets corporations focus laser-like on shareholder returns, with the side benefit of (supposedly) making the world a better place.

Kovvali and Macey argue that these assumptions fall apart in government-dominated industries. Shareholders don’t face the same risks, and non-shareholders can’t always protect their interests. When a firm’s profits are underwritten by taxpayers, regulated by public agencies, or tied to essential services, the idea that shareholders bear all the residual risks becomes a myth.

The Holdup Problem

Take utilities. Electricity and water companies operate as regulated monopolies because nobody wants two sets of wires or pipes running through their neighborhood. Regulators cap utility profits to prevent gouging, but utilities still need to make big investments—building power plants, maintaining grids, etc. So, the government guarantees them a return on investment. Sounds fair, right?

Except this creates what the authors call a "holdup problem." Once a utility starts building, the government can’t just walk away if costs spiral. If Georgia Power racks up $17 billion in cost overruns on a nuclear reactor, what’s the regulator going to do? Abandon the project after pouring billions into it? Of course not. Regulators cave, and shareholders walk away richer, while ratepayers foot the bill.

This isn’t just a utilities problem. Defense contractors are notorious for ballooning budgets. Banks operating under the "too big to fail" doctrine can take outsized risks, knowing that taxpayers will clean up the mess. In all these cases, shareholder primacy leads to perverse outcomes: profits get privatized while losses are socialized.

Governance in Government-Dominated Markets

So, what’s the fix? Kovvali and Macey suggest that in these industries, shareholder primacy needs to take a backseat to a more inclusive approach to corporate governance. Instead of relying on external mechanisms like contracts and regulation, the government should participate directly in corporate decision-making.

Imagine a world where the Department of Defense has a seat on Lockheed Martin’s board, or where utility regulators weigh in on executive pay and merger approvals. These aren’t far-fetched ideas; some of this authority already exists. The Federal Reserve, for example, can fire bank executives under certain circumstances. The problem is, regulators rarely use these powers.

The authors propose a range of interventions: expanding fiduciary duties to include non-shareholder interests, requiring government approval for major corporate decisions, or even giving public stakeholders board representation. These measures, they argue, would align corporate behavior with public goals, mitigating the holdup problem and reducing waste.

Trade-Offs and Skepticism

Of course, there are trade-offs. Giving the government more say in corporate governance could scare off investors or lead to bureaucratic inefficiency. And let’s not pretend that regulators always get it right—see: the FAA and Boeing, or Fannie Mae and Freddie Mac. There’s also the risk of regulatory capture, where firms cozy up to their overseers and turn them into cheerleaders instead of watchdogs.

But the authors make a compelling case that the current system isn’t working. The standard playbook of regulation and contract is ill-equipped to handle the complexities of industries where private firms deliver public goods. In these contexts, the authors argue, the trade-offs of more direct government involvement may be worth it.

A New Corporate Purpose?

The broader implication of the paper is that corporate governance doesn’t have to be one-size-fits-all. In traditional markets, where competition keeps firms honest and contracts are enforceable, shareholder primacy might work fine. But in government-dominated industries, where firms rely on public subsidies, guarantees, or demand, a different governance model is needed.

This isn’t about nationalizing industries or turning corporations into arms of the state. It’s about recognizing that in certain contexts, the rules of the game need to change. Firms that depend on the public shouldn’t operate as if they’re accountable only to their shareholders. They should be accountable to the public too.

Kovvali and Macey’s paper raises a provocative question: what do we owe each other in a system where private firms deliver public goods?

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