Why Shareholders Come First

In one of the great twists of 20th century American capitalism, Henry Ford’s attempt to support employees of The Ford Motor Company and the city of Detroit back in 1916 had the unintended side effect of creating case law that put the shareholder returns of the company ahead of all other interests.

Most of us today are used to the notion of measuring dividend yield according to the prevailing price of the stock. If Philip Morris pays out a $4.08 dividend, and the price of the stock is $87.32 per share, we would say that the current dividend yield on the stock is 4.67%. Unless you really get into this stuff, you’re probably not inclined to think “Philip Morris has 1.5 billion shares paying out $6.12 billion.” The concept expressed relates to the same elements, but we often choose to relate the income generated compared to the current price because we are interested in what can be generated by an investment if we buy it today.

That is not how American investors thought in the 1910s. Back then, investors spoke in terms of “capital stock.” It is a nearly identical term used to refer to the cash or property used as the “financial basis to enact and prosecute a business of corporation.” If you wanted to become an owner of a business, you would either give money, a home, or farmland to the businessman that was bringing the company public and in exchange you would receive partial ownership of the business.

If you wanted to become an early owner of Ford Motor Company Capital Stock in 1911, Henry Ford made the company public to the American people under the following terms: 20,000 shares of stock existed with a total capital stock value of $2,000,000. If you wanted a share, you had to pay $100 in 1911. In today’s dollars, that was around $5,800 per share. Under the Articles of Incorporation for the capital stock, Henry Ford promised to pay 5% dividend on that $2,000,000 in capital stock each year. If you owned a share, you would get $5 per year, and Henry Ford would direct the agents of Ford Motor Company to pay dividends on the capital stock so that you would receive a $0.416 capital stock dividend each month.

At the time, The Ford Motor Company was making 18,664 cars per year and was making $4,521,509 in profits. He was only on the hook for paying capital stockholders $100,000 per year, so it is easy to see why he had a replenishing war chest of cash to grow his enterprise. Even after going public, Henry Ford still owned 11,600 shares of capital stock, for about 58% of the company.

There was one thing Henry Ford loved more than seeing black Model T Fords fill the scenic landscape of the Rust Belt: drenching himself in capital stock dividends. As Ford Motor Company grew, Henry Ford used his authority as the President of the firm to make special dividend payments on the capital stock so that he could begin converting all of those lucrative automobile sales into cash on his family’s balance sheet.

The next five years of Henry Ford’s life were extraordinary, from an income generation point of view. He declared $1,000,000 in special dividends on those 20,000 shares in December of 2011. By May of 1912, he declared another $2,000,000. Two months later, another $2,000,000. The following June? A monster $10,000,000 special dividend. In May, June, and July of 2013, Ford made $2,000,000 special dividend payments in each of those periods. By August of 1914, the special dividend grew to $3,000,000. Then, another exceptionally large dividend of $10,000,000 in May 2015, followed by a $5,000,000 special dividend in October 1915. Between 1911, and 1915, Henry Ford ordered the Ford Motor Company to pay out $41,000,000 in special dividends on $2,000,000 in capital stock of the company.

This growth in special dividends was backed by real growth in Detroit’s automotive-producing capacity. By the end of 2015, Ford was producing 264,351 cars and making $24,641,423 in profit per ten months (back then, counting Christmas sales seemed like cheating because they were so unusually high, so especially ethical businessmen would provide ten-month profit figures to give a feel for the business in ordinary times without the gift-giving season boost.)

Although Henry Ford himself owned 58% of the capital stock, and dominated the firm so thoroughly through the sheer force of his personality, he was not legally the entire company. There were other shareholders, and the most prominent were the Dodge brothers–John and Horace. The Dodge brothers voted the same on all corporate matters, and together controlled 2,000 shares of the capital stock, or 10% of the company. These guys made some of the easiest passive income in the 20th century–they sat by while Ford mailed them $4,100,000 cumulatively between 1911 and 1915. Each brother collected $2,050,000 in special dividend income from the capital stock over a five-year period, and that is the current equivalent of receiving $111 million.

Despite receiving torrents of wealth passively while Henry Ford did all the hard work of growing the car business, the Dodge brothers were never quite happy with their status in the company. Henry Ford did whatever the heck he wanted, and never consulted them for administration advice regarding the firm. What was that line they used to say about the Yankees’ minority owners under George Steinbrenner? Something about never truly knowing the meaning of being a silent partner until running a corporation majority-owned by the late New York baseball owner. The Dodge brothers felt disrespected, and quietly built resentment against Henry Ford even as he mailed them special dividend checks galaxies above their expectations at the time of making the investment.

In 1916, the Dodge brothers saw their opening to exact revenge against Henry Ford. On July 31, 1916, John and Horace Dodge were horrified to open the Detroit Free Press and see Henry Ford’s declaration that the Ford Motor Company would stop all special dividends, only pay the 5% dividend on the capital stock that was required, and reinvest all earnings back into the corporation.

Specifically, Henry Ford said, “My ambition is to employ still more men; to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this, we are putting the greatest share of our profits back into the business.” The spigot had been shut off. That $4.1 million collected by the Dodge Brothers over five years, for an average of $820,000 per year, had been reduced to $10,000 per year at the seeming whim of Henry Ford.

The Dodge brothers sued, arguing that Henry Ford exercised his powers arbitrarily, and had decided to run the Ford Motor Company as a charity rather than as a profitable enterprise. The trial court judge in Wayne County, the Honorable George S. Hosmer, agreed with the Dodge brothers that Henry Ford was not driven by shareholder value, noting: “The record, and especially the testimony of Mr. Ford, convinces that he has to some extent the attitude towards shareholders of one who has dispensed and distributed to them large gains and that they should be content to take what he chooses to give. His testimony creates the impression, also, that he thinks the Ford Motor Company has made too much money, has had too large profits, and that, although large profits might be still earned, a sharing of them with the public, by reducing the price of the output of the company, ought to be undertaken.”

Henry Ford’s braggadocio put him in a position unlike any other previous corporate executive. If an American executive wanted to reward employees or donate to charity, he would often justify it through the lens of shareholders returns. He would state charity would generate goodwill and drive sales, or argue that increased employees would build more and grow profits so that special dividends would be higher at some date in the future. But that is not what Henry Ford said at the trial court in Wayne County back in 1916–he said he needed to hire more people and give back to the Detroit community because he had made too much money easily, and the shareholders were being ungrateful and lecherous in demanding more, more, more from the Ford Motor Company. Ford was emphatic in saying that the shareholders had gotten too much, and it was time to think of somebody else.

By the time Ford’s words were reviewed at the Michigan Supreme Court in 2016, the remaining question was: What should happen when the President of a publicly held American company spends the funds of the corporation with no purpose of developing future shareholder returns?

The Michigan Supreme Court gave the following ruling: “A business corporation is organized primarily for the profit of the stockholders, and the discretion of the directors is to be exercised in the choice of means to attain that end, and does not extend to the reduction of profits or the nondistribution of profits among stockholders in order to benefit the public, making the profits of the stockholders incidental thereto.”

The remedy for the Dodge brothers? The Michigan Supreme Court affirmed Judge Hosmer’s ruling that Ford Motor Company must pay out a $19,000,000 dividend to shareholders because the Ford Motor Company showed that it had $54,000,000 in cash with an expected $60,000,000 in profits and expected manufacturing and employment growth expenses of $24,000,000.

It is interesting that the Michigan Supreme Court did not force Henry Ford to lay off employees or forbid him from hiring extra workers. This sentiment reflects the notion that the American judiciary is uncomfortable with telling executives how to run their business–it would be quite the interference to try and figure out whether Ford needed 25,000 employees, 35,000 employees, or 50,000 employees.

But it did establish the concept of shareholder primacy. People always wonder: How come public company executives never say they are doing a good thing simply because they believe it is the moral thing to do? Why not say “Screw it, we are donating $10,000,000 to fight homelessness in our community because it is right, and we must do it.” The answer is that the lawsuit filed by the Dodge brothers in 1916 is still good law in Michigan, and has been expanded throughout every state except Louisiana since then.

Although I find Henry Ford far more sympathetic than the Dodge brothers, I agree with the Michigan Supreme Court’s ruling. The issue for me comes down to authority. When a corporate executive does something like donate to charity, he is not merely spending his money–he is spending other people’s money. If Henry Ford donated $1,000,000 to charity in 1916, he would be donating $580,000 of his own money and $420,000 of other people’s money. People don’t buy publicly traded stock because they want it to be charitable; they want it to generate profits that can be retraced back to them so they can spend it as they wish–and hopefully, of their own volition, they will donate some of that money to charity if they are able.

But the concern is that people have different preferences based on communities and types of charities to support. Henry Ford may want to support Detroit; you may want to support St. Louis, Missouri. Henry Ford may have wanted to support a homeless shelter; you may have wanted to support a scholarship fund at Washington & Lee University. Or, you may have been investing in the publicly traded common stock to generate a profit that could one day pay off your home, fund your retirement, and permit you to upgrade your wardrobe and afford better food. Henry Ford shouldn’t get to spend the 42% of the company’s funds for recreational purposes–he is a steward on their behalf and should take it seriously to act in the collective interest of all shareholders.

The life of Henry Ford is far more impressive than that of the Dodge brothers. Throughout their lives, the Dodge brothers wanted more, more, more and didn’t enter the game themselves but rather profited off of the others that went into the battlefield on their behalf. Henry Ford had a dream and made it real, and he had a very real style and signature personality that enabled himself to be both authentic and fabulously wealthy–something very few men achieve. But on the issue of spending funds for no corporate purpose, Ford was a bit off. It wasn’t his money to spend, and his honesty is to be commended–but it also provided the opportunity for the courts to mandate that corporate executives must make decisions driven by shareholders rather than employees, charities, or society at large.