by the Editor
What is the proper role of the corporation? This question is currently a hot topic in the world of investing and corporate governance. Should a corporation prioritize the growth of shareholder value or, as suggested by advocates of “Stakeholder Capitalism,” should it work to improve outcomes for other stakeholders such as employees, customers, suppliers, the community, and the environment?
While many of the tenets of Stakeholder Capitalism sound appealing, the application of these proposals can create a host of problems by imposing social or political goals on corporations at the expense of shareholders. This is inefficient, unfair, and anti-democratic.
There is a better way to achieve the outcomes advocated by the proponents of Stakeholder Capitalism. It is more equitable and efficient for a society to achieve socio-political goals through a democratic process that weighs costs and benefits to prioritize objectives and creates a transparent framework that is applied fairly to all members of society, including corporations.
The Corporation: A Value Creation Machine
As a starting point, it is important to understand the corporation and its purpose. The corporation is an impressively beneficial organizational structure that allows large numbers of individual investors to pool their resources and pursue business opportunities. Shareholders are not just wealthy individuals. They include pension funds and individuals saving for things like housing and retirement. For many small investors, buying shares in corporations is the best way to access diversified investment opportunities.
A corporate board of directors hires a management team and tasks them to run the business with the goal of increasing value for shareholders. For this arrangement to work properly, management needs to have a clear mandate to focus on the single objective of maximizing shareholder value. Otherwise, they will have a hard time balancing different priorities. This division of labor is so important that the board of directors is charged with a fiduciary duty to act in the best interests of the shareholders.
Not only does the corporation create value for shareholders, it creates value for society by providing goods and services at fair market prices. By operating this way, corporations have been a huge contributor to economic growth and improvement in the standard of living around the globe.
The mandate to maximize shareholder value is often misunderstood. It does not mean corporations should operate with a short-term view or take advantage of employees or other stakeholders. Maximizing shareholder value requires management to operate with a long-term perspective and run their business in a sustainable manner. Corporations should always operate in compliance with the law and behave ethically with honesty and integrity.
Some voices argue that corporations should not seek to optimize shareholder value. Rather, corporations should pursue “Stakeholder Capitalism” and direct more resources to improving outcomes for customers, employees, and the community. These proposals create significant problems, so they should not be imposed lightly. Implementation of stakeholder-focused mandates can be unfair and can introduce inefficiencies into the operation of corporations, resulting in value destruction for both shareholders and the broader economy.
What is Stakeholder Capitalism?
Stakeholder Capitalism has multiple manifestations with different points of emphasis, but generally proponents say that a corporation should not focus solely on increasing shareholder value but should also consider the interests of certain “stakeholders,” namely employees, customers, suppliers, the environment, and society in general. There is a growing trend in the investment world that emphasizes Environmental, Social, and Governance (ESG) factors. The scope of ESG-driven investing is wide-ranging. For example, environmental issues can include greenhouse gas emissions or water management while social factors may focus on topics such as diversity and employee compensation. The governance category analyzes how the business is run by the board of directors and management and how they interact with shareholders.
Most of the advocates of Stakeholder Capitalism maintain that a focus on stakeholder interests is important for a business to be “sustainable.” Consequently, they say this approach will ultimately benefit shareholders in the long run. Sometimes this is true, sometimes not. Other supporters of Stakeholder Capitalism explicitly acknowledge their objectives will impose a cost on shareholders, but they believe this is justified as a way to achieve social or political goals. Some proponents say certain mandates on companies are warranted as a way to address negative externalities imposed by businesses onto society at large. To better understand Stakeholder Capitalism, it is helpful to break the discussion into these four categories:
- Objectives aligned with shareholder value
- Objectives incorrectly claimed to be aligned with shareholder value
- Objectives that would explicitly use shareholder value to achieve socio-political goals
- Negative externalities
1. Objectives Aligned with Shareholder Value
Most advocates of Stakeholder Capitalism maintain that a focus on stakeholders such as employees, customers, suppliers, and society at large will ultimately be more “sustainable” and therefore beneficial for long-term shareholder value. Much of this is common sense and is already established practice for corporations. Businesses will struggle if they do not treat their employees fairly and pay them market wages. Delivering value for customers is critical for companies to succeed and good relations with suppliers and the surrounding community are also helpful. Likewise, robust corporate governance practices are healthy for corporations and their shareholders.
To the extent shareholder value is actually enhanced by directing corporate resources to improve stakeholder outcomes, well-run companies should already be doing this. These types of stakeholder considerations can be categorized into the first type of Stakeholder Capitalism: “Objectives aligned with shareholder interests.” All parties, including management and shareholders, should be in violent agreement that pursuing these sorts of goals is a good idea.
2. Objectives Incorrectly Claimed to be Aligned with Shareholder Value
Problems quickly arise when various parties reach different conclusions regarding which stakeholder considerations are in the long-term interests of shareholders. For example, some may argue that corporations should reserve a certain number of board seats for employee representatives and that this practice would be improve shareholder value over the long-term. Company management may disagree. Implicit in these types of arguments is the assumption that Stakeholder Capitalism advocates are somehow in a better position than management to determine what is in the best interests of shareholders. Since management teams are hired for their expertise and are evaluated by the board of directors on a regular basis, this seems highly unlikely. And if it is the case that a management team is missing opportunities to increase shareholder value by directing shareholder resources to improve stakeholder outcomes, the best solution would be to replace management.
Despite assertions to the contrary, the stakeholder objectives in this group are fundamentally similar to the next category of Stakeholder Capitalism where proponents openly seek to accomplish their socio-political goals at the expense of shareholders.
3. Objectives that Would Explicitly Use Shareholder Value to Achieve Socio-Political Goals
Some supporters of Stakeholder Capitalism are very explicit that the stakeholder-related obligations they want to impose on corporations are not aligned with the interests of shareholders. Rather, these proponents openly seek to achieve some social or political goal at the expense of shareholders. Often, these advocates of stakeholder capitalism seek to justify their attempts to commandeer shareholder resources as a sort of quid pro quo for the privilege of a corporation to do business. While profoundly lacking in understanding regarding the value of free-market capitalism, at least the people in this category get credit for honesty.
It is quite possible some social or political objectives, such as improving compensation for the workforce, are worthy goals. However, this misses an important point. The threshold question is which objectives should be prioritized and who should bear the cost.
4. Negative Externalities
Negative externalities occur when the operation of a company generates costs that are not fully absorbed by that business itself but instead fall on the community to some extent. One frequently cited example of a negative externality is the emission of pollution by businesses.
It is entirely appropriate for a society to establish mechanisms to address negative externalities. Challenges arise because there can be differences of opinion within a community regarding how best to deal with them. For example, is the best way to reduce greenhouse gases through a carbon tax, increased nuclear power, or subsidies for renewable energy? Well-meaning members of society can have sincere disagreements on these questions.
Stakeholder Capitalism Comes with Serious Drawbacks
While many of the objectives of Stakeholder Capitalism may be worthwhile, problems can arise when the proposed goals are not aligned with optimizing shareholder value. To better understand these issues, the following discussion will exclude stakeholder objectives that are aligned with shareholder interests and will focus on the categories of Stakeholder Capitalism that seek to provide benefits to stakeholders at the expense of shareholders.
One of the most troubling problems implicit in Stakeholder Capitalism is its unfairness. It maintains that certain targeted shareholders should bear the burdens for initiatives intended to benefit other stakeholders or society in general. It is also inefficient to outsource socio-political objectives to corporations – they are specialists in running their business, not achieving policy goals. The situation is further confused because there are disagreements regarding which stakeholder objectives are more important. Furthermore, Stakeholder Capitalism does not generally use a democratic process to prioritize various stakeholder objectives or to evaluate their costs and benefits. Instead, the current operation of Stakeholder Capitalism is opaque and its costs are obscured.
It is important to understand the drawbacks of Stakeholder Capitalism and to consider alternative ways to achieve the desired results. Otherwise, Stakeholder Capitalism will become a recipe for the misallocation of resources, disadvantaging all members of society.
Stakeholder Capitalism is Inherently Unfair
Stakeholder Capitalism unfairly puts burdens on some businesses and not others. Private companies are excluded from the requirements imposed on publicly listed corporations and businesses operating in different jurisdictions, such as sovereign-owned entities, are often not impacted. Individuals who are shareholders in companies subject to these requirements are disadvantaged by effectively being required to fund socio-political goals while other citizens get a free ride. Not only is this type of discriminatory value extraction unfair to shareholders, it puts the corporations subject to these requirements at a competitive disadvantage.
Stakeholder Capitalism Hurts the Economy Through Hidden Value Destruction
It may seem like the shareholder is paying for the stakeholder benefits sought by Stakeholder Capitalism, but that is only part of the story. There is no free lunch – it becomes a question of who picks up the tab. If a company is required to pay above market wages, it will hire fewer workers. Some higher costs will be passed along to consumers. If shareholder returns are artificially reduced to fund socio-political goals, the cost of capital will increase resulting in less investment in the economy.
Asking management to sacrifice shareholder value to achieve other objectives introduces confusion that is virtually unlimited. Instead of focusing on running their business with a clear mandate to optimize shareholder interests, corporate management teams would be put in a position of negotiating competing demands with no clear guidance on how to balance priorities. Since it is impossible to maximize two variables at once, it is important for management to maintain focus on one objective, namely optimizing shareholder value. Losing this clarity of purpose will inevitably create inefficiencies that flow into the overall business environment. These challenges are exacerbated because non-shareholders do not have “skin in the game” – they are seeking to appropriate benefits while bearing none of the costs, inevitably leading to suboptimal decisions regarding the allocation of resources.
Spread over an entire economy, these costs can be a significant drag on productivity, growth, and job creation. When this happens, all members of society suffer. What makes the situation worse is that the costs are often hidden, meaning it is difficult to evaluate trade-offs.
Stakeholder Capitalism is Fundamentally Anti-Democratic
Adding insult to injury, Stakeholder Capitalism often operates outside the traditional democratic process. This is a significant problem because there are different points of view regarding how to prioritize various objectives and how to allocate the related costs. For example, who gets to decide which social or political goals are the most important? Is it the group with the loudest voice or the most effective lobbyist? How should competing interests be weighed? Is it more important for a corporation to pay above market wages or to buy energy at higher prices to expand its use of renewable energy? What is the best way to address negative externalities? How much of the shareholders’ resources should be taken to achieve these goals? Ten percent? Maybe half?
These are difficult questions where legitimate differences of opinions exist. As long as we live in a world with limited resources, there will need to be some trade-offs. The process of a society reaching agreement on priorities is difficult and takes time. This is one reason proponents of Stakeholder Capitalism seek to impose their desires on corporations and burden shareholders with the costs – they want to short circuit the hard work of making the case with the public for their preferred outcomes versus other objectives. However, by operating outside the traditional political process, these efforts become fundamentally anti-democratic.
Stakeholder Capitalism Undermines the Principle of Fiduciary Duty to Shareholders
Directors serving on a board of a corporation have a fiduciary duty of care and loyalty to their shareholders that requires corporate directors to act in good faith in the best interests of shareholders. This principle is critical to the healthy operation of a corporation because it gives shareholders the confidence to delegate responsibility to others to manage the business. Actions taken by corporations that sacrifice shareholder value to achieve other objectives are a breach of this fiduciary duty, a deviation that erodes the trust necessary for the corporate model to function effectively. Ultimately, weakening the principle of a corporate fiduciary duty to shareholders in this way would adversely affect the growth potential of our economy.
Stakeholder Capitalism Suggests Business Needs to Justify its Existence
Businesses should strive to create value for customers, maintain healthy operations, pay their taxes, follow the law, and behave ethically. In doing so, corporations deliver essential products and services and create tremendous value for their community and the economy. Despite all these benefits, there is often a notion underlying Stakeholder Capitalism that companies owe something more to society in exchange for the right to exist.
The Sustainability Accounting Standards Board (SASB), one of the most prominent standard-setting bodies for Stakeholder Capitalism, is emblematic of this sentiment. The SASB, in describing the scope of its Sustainability Framework, says it “relates to the expectation that a business will contribute to society in return for a social license to operate.”
This type of thinking is deeply pessimistic about humanity in its assumption that individuals would prefer to extract unearned benefits from companies rather than have opportunities to realize their potential in a vibrant economy. This mindset also misunderstands the inherent value of free-market capitalism. By providing goods and services desired by people at market prices, business performs an important public function for society where both sides benefit.
It is misguided to characterize profits as something that has been “taken” from the community. Rather, business profits are the sum of the value generated for the public as determined by the people themselves in their everyday purchasing decisions. Some proponents of Stakeholder Capitalism overlook the mutually beneficial relationship between business and society and suggest corporations need to further justify their existence. This misguided notion undermines the legitimacy of free-market capitalism and harms an important pillar of the economy.
Stakeholder Capitalism Suffers from Significant Implementation Problems
Stakeholder Capitalism suffers from a variety of implementation problems that are in many ways related to the flaws in its unfair, anti-democratic approach. Difficulties arise because different people have varying opinions about what Stakeholder Capitalism means, including what to prioritize and at what price. Not surprisingly, these disagreements lead to confusion, inefficiency, and inconsistent treatment of different businesses.
Much of Stakeholder Capitalism is built upon an approach that emphasizes corporate disclosure of certain selected items, for example greenhouse gas emissions or workforce diversity. Supporters often justify such disclosure requirements by invoking the argot of good corporate governance, citing the importance of “transparency” and disclosure of “material risks.” The strategy of building on the well-established concept that “material” risks should be disclosed by corporations may be designed to capture the high ground and make it difficult to object to additional stakeholder-related disclosure requirements. What could possibly be wrong with requiring more disclosure? Upon examination, quite a lot.
Public companies are already required to disclose material risks, an important principle to ensure that investors have the information necessary to fully understand investment opportunities. Proper assessment of materiality includes the analysis of potential risk and return. To do this correctly, risks should be probability weighted and future events should be discounted back to today’s dollars. A risk that is highly unlikely to occur or that would happen far in the future may not be material at all. Or the cost of addressing a potential risk may far outweigh the benefits. Without a complete analysis of all the aspects of risk and return, materiality cannot be assessed accurately. This process is helpful to enable businesses to focus on the most impactful issues. On the other hand, the disclosure of immaterial risks can be distracting and misleading for investors.
Supporters of Stakeholder Capitalism can have different opinions about which objectives to prioritize and how to measure progress, resulting in quite a bit of confusion. In response, many organizations have emerged that specialize in providing ratings that purport to assess corporate compliance with the objectives of Stakeholder Capitalism, particularly in the world of ESG-driven investing. According to Bloomberg, by 2019 there were over a dozen major ESG rating companies providing ratings on businesses and their compliance with ESG objectives. All of these ESG rating companies have different standards and approaches. To perform this function, the ESG raters often ask corporations to provide a range of information above and beyond their normal public disclosures.
Compliance with these supplemental reporting requests puts a significant burden on corporations. Hester Peirce, Commissioner of the Securities and Exchange Commission, recounted that, “a senior counsel from a major insurance company reported her experience… Her company had received approximately 55 survey and data verification requests from ESG rating organizations in the prior year. By her company’s estimate, it took 30 employees and 44.8 work days to respond to just one of these surveys.” Multiply this drain on resources across all the different rating companies and the companies they survey, and the result can be a meaningful drag on economic productivity.
Given the large number of ESG rating companies and their different standards and approaches, it is not surprising that their rating results can be inconsistent. A recent paper from MIT found that ESG rating organizations can reach quite different ratings for the same corporation, reflecting differences in which factors are rated, the weightings of the different factors, and how they are measured.
In addition to the ESG rating companies, there are a number of organizations that seek to establish guidelines for sustainability reporting. These include the SASB, the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD), among others. Unfortunately, the profusion of different reporting standards has created confusion and inefficiency. In 2019, the International Organization of Securities Commissions (IOSCO) conducted a survey of securities regulators and market participants regarding sustainability reporting requirements. The IOSCO concluded the results found “a need to improve the comparability of sustainability-related disclosures. The lack of consistency and comparability across third party frameworks could create an obstacle to cross border financial activities and raise investor protection concerns.”
Burdensome reporting requirements can make it less attractive for a business to choose to operate as a public corporation as opposed to remaining a private company. Public markets have already seen an example of this dynamic. Since the peak in the 1990s, the number of publicly listed companies in the U.S. has fallen by almost half. Many observers attribute this decline in part to new governance requirements and expanded reporting obligations applicable to public companies included in the Dodd-Frank Act of 2010. These changes added to the increased corporate regulations contained in the Sarbanes-Oxley Act of 2002. Additional reporting requirements make it more onerous for companies to participate in the public markets, thereby damaging the efficiency of the capital markets, reducing economic potential, and limiting the investment opportunities for ordinary Americans.
There’s a Better Way:
Use the Democratic Process and Apply Requirements Fairly
Stakeholder Capitalism promotes a range of worthy objectives such as improving the outcomes for employees, customers, and the community. Many of these goals are naturally consistent with increasing shareholder value and good management teams should already be pursuing them. Problems start to arise when the mandates of Stakeholder Capitalism are not aligned with shareholder interests. In these cases, Stakeholder Capitalism amounts to the appropriation of shareholder resources to achieve socio-political goals. It is unfair to target certain shareholders while others get a free ride. And shareholders are not the only ones who suffer when this happens. Stakeholder Capitalism’s approach of outsourcing socio-political goals onto corporations is inefficient, reducing the productivity and health of the overall economy. The resulting economic friction adversely affects all members of society and is all the more insidious because it is often obscured.
This damaging outcome is made worse because it is often implemented outside the traditional democratic process. Special interests should not be permitted to impose their socio-political preferences on corporations and the economy while other members of society are excluded from the debate.
Instead, society should use an open democratic process to agree on socio-political priorities and develop a framework to implement them with a set of operating rules that apply fairly and transparently to all members of society. This framework should include an equitable plan to allocate the related costs, such as taxes or behavioral mandates. If the objectives of Stakeholder Capitalism are valuable and compelling, proponents should make their case in the political arena.
The good news is that this democratic approach has significant advantages over the current incarnation of Stakeholder Capitalism. Involving all members of society in the process of deciding priorities and weighing the related costs will more accurately reflect the true desires of the citizenry and give the outcome more legitimacy. Additionally, a renewed focus on shareholder value will allow businesses to concentrate on what they do best – providing goods and services at attractive prices. Applied across the business landscape, this focus will improve productivity and benefit everyone by producing a healthier, more dynamic economy.