The longstanding debate over a company’s role in society has shaped corporate law and governance practices in every major economy. In the wake of the corporate scandals of the 2000s, the outsourcing of domestic jobs and suppliers, and the furore over the profits being raked in by oil companies, it is once again at centre stage.
The key question it raises is this: should a company be managed on behalf of shareholders, non-shareowning stakeholders or both? I will argue that the company must be unambiguously managed on behalf of its shareholders. Moreover, I believe that managing on behalf of non-shareowning stakeholders could, in fact, be detrimental.
The debate over company goals
Finance scholars assert that managers must maximise shareholder value. The reasons they provide are: “exit” – shareholders will sell if they are not satisfied, thereby driving down the share price; “voice” – shareholders will enforce changes to their benefits via the process of shareholder democracy; and “the market for corporate control” – the company will be taken over and run by outsiders if incumbents do not perform.
The shareholder view sees the company as an efficiency-seeking, shareholder value-maximising, economic entity. It emphasises contractual exchanges, and the role of law and government is to promote contractual freedom. Discipline is enforced by the invisible hand, consisting of a competitive market for products, technologies, capital, managerial talent and corporate control.
The stakeholder view sees the company as a collective of constituencies that comes together to achieve a common purpose, and as a political entity where power matters as much as contracts and cash flows. It emphasises the duty of managers to all stakeholders and relationships based on trust, and that the role of law and government is primarily to ensure fairness.
Which view is right?
In its early stages, public policy towards US corporations was applied in a manner that stakeholder proponents might espouse. In the 1800s, US corporations could not be set up for private business purposes. Each incorporation required an act of the state legislature to allow its existence. Thus, the corporation was simply another institution enabled by the state to achieve its public policy goals.
General acceptance of the shareholder view did not become commonplace until the 1970s. During this period, dozens of far-reaching laws were passed by the US government to protect non-shareholder constituencies such as labour, consumers, creditors and the environment from undue corporate influence. Even after the 1970s, most US states responded to the increasing influence of the shareholder view by adopting “stakeholder statutes” that tried to insulate incumbent managers from unwanted acquisition bids.
In Germany, the stakeholder view has always been dominant. German corporate law, as originally set up in the 1930s, states that the goal of the corporation is towards three constituencies: the state (reich), the people (volk), and the employees (gefolgschaft). The shareholder was not even mentioned until a 1960s revision and, even today, has only a subsidiary role.
In the 1980s, US business academics articulated “stakeholder theories” of management, whereby the interests of key stakeholders must be integrated into the goals of the company. The theory critiqued the shareholder view as being narrow and simplistic, and asserted that the goal of managers must be to address the interests of any groups and individuals who can affect – or be affected by – corporate activities.
On the contrary, I will argue that the shareholder view is by no means simplistic. Rather, it offers managers clarity of purpose. The stakeholder view may seem less simplistic and more high-minded, but it is impractically wide in scope. All it does is create a recipe for confusion in decision-making, and reduce opportunities for creating value.
Why maximising shareholder value benefits everyone
There are five reasons why shareholder value maximisation should be the sole guide for managers. Voice, exit and the market for corporate control are a part of it, but those are less important than most economists assume.
■ Maximising shareholder value is the only rule that can increase the size of the pie for all. Shareholders are residual claimants – that is, they are paid only after all the fixed and contractual claimants are paid. It is only when we manage for residual claimants that we have the incentive to increase the size of the pie as much as possible.
By contrast, fixed claimants, such as creditors, suppliers and employees, have no incentive to increase value beyond the point at which their claims are assured. Therefore, managing solely on their behalf will mean that value is left on the table. In other words, shareholder-value maximisation is pro-stakeholder, too.
■ Managing for stakeholders leads managers to assume lower levels of entrepreneurial risk. Fixed claimants worry about “total” risk, that is all of the risks associated with a company’s cash flows, and will, therefore, be too risk-averse in the choices they want managers to make.
Shareholders, however, care only about “systematic” risk; that is, a portion of the overall risk. Since their investment portfolios are diversified, the risk is spread across many stocks, and a portion of risk is mitigated. They tend to be less risk-averse and, as a result, are more likely to induce managers to invest in new growth opportunities, markets and products, and in innovative, cutting edge technologies. Such risk taking is essential if a business is to maintain and enhance its competitiveness in today’s globalised economy.
■ Having multiple goals is a recipe for confusion and paralysis in decision making if those goals conflict with each other. While it is easy to broadly claim to “manage for stakeholders,” which stakeholder is never made clear.
For instance, managing on behalf of employees could make non-employee stakeholders worse off. Similarly, managing on behalf of particular types of employees, say, unionised or managerial, could make other employees worse off. Consider the costs imposed on employees and taxpayers by some bankrupt US airlines via their abrogation of private pension plans in order to address the interests of creditors.
It is wishful thinking to assume that stakeholders are a homogeneous group when, in fact, their goals are often in conflict. For example, consider the following:
■ Non-shareowning stakeholders can easily become shareholders, but the reverse is not possible. Just because I own shares in a company does not mean I can demand to become its employee or supplier. Given that, stakeholder-based governance will necessarily leave out a key constituency while shareholder-based governance will not.
Nothing prevents employees, customers, suppliers and creditors from buying shares in the marketplace and demanding a seat at the table. Indeed, many employee unions, pension funds and NGOs (and creditors in countries such as Germany and Japan) do precisely that. Many of these constituencies have begun to assert, often successfully, their voice in annual shareholder meetings and via proxy voting.
■ The legal system fills judicial voids for non-shareowning stakeholders, but often does not do so for shareholders. The relationship of employees, suppliers, creditors, consumers and society at large with the company is mostly covered by contract law, tort law or regulation. For example, employees have contractual provisions covering discrimination, workplace safety, pensions, health and so on. As a result, courts routinely step in when contracts are violated.
But the shareholder’s relation with the company takes the form of an “implicit contract”. Under the prevailing corporate governance norms in countries such as the US, courts will rarely second-guess shareholder consequences of managerial decisions if certain “business judgment” criteria are met. We can, therefore, think of the assignment of control rights to shareholders as being a socially sensible design to fill a judicial void.
Critiques of shareholder-value maximisation
There are a number of critiques to the arguments above – the most often mentioned are contract failure, imposition of third party externalities, lack of corporate citizenship and proneness to corporate malfeasance.
All of these critiques, however, are either incorrect, overblown or both. Simply put, they could just as easily apply to stakeholder-managed companies, too; the issues they raise do not arise just because the system focuses on shareholder-value maximisation. All contracts are prone to failure because of factors such as inadvertence, unforeseen contingencies, disputes concerning interpretation, pre-contract intentions and verifiability of outcomes. Similarly, any contract (or change in the terms of contract) between private parties can impose third party externalities that are not fully internalised by parties to the contract.
While corporate malfeasants in the US have received much attention, every major economy in the world has had its shameful share. In Germany, for example, many companies – including venerable giants such as Daimler-Chrysler, Mannesmann and Volkswagen – have faced allegations of, or prosecution for, crimes such as fraud, bribery and corruption. Japan has grappled with sokaiya (corporate racketeer) scandals in governance (Nomura Securities, Dai-Ichi Kangyo Bank), allegations of a company passing BSE-tainted food as domestically produced (Nippon Food and Snow Brand), bid-rigging (Mitsui), falsifying nuclear power plant inspection data (Tokyo Electric Power Company), allegations of knowingly hiding thousands of potentially life-threatening customer complaints (Mitsubishhi Motors) and mislabelling of food products (Maruha). And, recall Vivendi in France, Parmalat in Italy and Ahold in the Netherlands. One can name dozens more.
Conclusion
Does this imply that all is well with shareholder-value maximisation? Of course not. At least three major issue have to be addressed:
The short run versus the long run. While we should concern ourselves with long run shareholder-value maximisation, the ability of managers to shift value to themselves (and their cronies) in the short run raises troubling questions. This is especially true because they are able to do this based on information that investors do not have or, in some cases, were misled on.
When do incentives for entrepreneurial risk taking mutate into those for excessive risk taking? This question is closely linked to the use of managerial stock options. Many option grants are tied to short-term performance metrics and have become one-sided bets for recipients. Since option values increase with risk, they can tip the balance towards excessive risk taking. It would be a worthwhile trade-off if options helped to improve performance, but a great deal of evidence points to an almost complete absence of a relationship between managerial stock options and company performance.
The seemingly unstoppable and performance-unrelated growth in CEO compensation leads one to wonder whether society’s “outrage constraint” has been breached. Moreover, it might be leading to a degradation of incentives and employee motivation in organisations whose effects we may not see for years to come.
In any case, such issues are easier to fix than to jettison a simple, value-creating corporate ideology that has, on balance, served economies and societies very well. That ideology is: “Manage for long-run shareholder value creation; you can’t do better.”
Anant K Sundaram is the faculty director of executive education at the Tuck School of Business at Dartmouth College, and a member of the school’s finance faculty. His areas of expertise are corporate governance, corporate valuation and mergers and acquisitions.
