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What Is the Purpose of a Corporation?
In a memorial service honoring Milton Friedman held at the Hoover Institution shortly after his death in 2007, Hoover Senior Fellow Edward Lazear hit the nail on the head when he said, only half in jest, “It is amazing how many people can best Milton in an argument when he is not in the room.”
His remark has added relevance today because last week the Business Roundtable (BR), a non-profit comprised of CEOs of major U.S. organizations, did battle with an empty chair with its short announcement entitled, “Statement on the Purpose of a Corporation.” The statement rejects the received wisdom—boldly pronounced in Friedman’s famous 1970 New York Times Magazine article, “The Social Responsibility Of Business Is to Increase Its Profits”—that corporate directors and officers should maximize shareholder value rather than some nebulous concept of social responsibility.
In tune with our populist times, the BR’s declaration has been interpreted in the press as a conscious rebuke of Friedman for his propagation of what the late Lynn Stout termed “The Shareholder Value Myth.” Friedman treated his statement as a means to an end. The corporation that seeks to maximize its profit within the rules of the game will maximize social welfare as well. But the new wisdom is that Friedman’s model invites dangerous and selfish actions. That’s why the New York Times used the following caption for its story on the BR’s statement: “Shareholder Value Is No Longer Everything, Top C.E.O.s Say.”
But what exactly is the alternative? On this matter, the BR’s statement is a self-conscious effort to play both ends against the middle. Its first paragraph takes the sensible position that “the free-market system is the best means of generating good jobs, a strong and sustainable economy, innovation, a healthy environment and economic opportunity for all.” Its next sentence should have taken a page out of Friedman’s playbook to denounce the many forms of regulation that hamper activities in a free-market economy. Chief on the list would be those regulations that upset competition in labor markets, which include minimum wage and overtime regulations, unionization, family leave, health care mandates, and much more. By limiting the options for both parties to a labor contract, these kinds of regulations constrain the opportunities of employees and employers alike.
Yet the BR’s statement veers off in exactly the wrong direction. “While each of our individual companies serve its own corporate purpose,” the statement reads, “we share a fundamental commitment to all of our stakeholders.” Tremble at their underlined all. The list of stakeholders to whom companies commit themselves, according to the statement, includes customers, employees, suppliers, communities, and, bringing up the rear, shareholders. The problem with that pesky “all” lies in the nature of these commitments. The word “stakeholder” has a built-in ambiguity because it begs the question of whether failure to meet some particular “commitment” is backed by a legal obligation to mend ways or pay damages in the event of any corporate malfeasance.
James Copland of the Manhattan Institute takes comfort in the simple yet powerful fact that the statement does not undermine the specific fiduciary duties that corporate boards and officers only have to their shareholders. In contrast, the Wall Street Journal is much more troubled that “Stakeholder CEOs” will find it all too easy to subordinate the interests of shareholders to other stakeholders, given that they sit last on the list of protected parties. And more progressive groups find this same Delphic pronouncement to be “a monumental step toward setting broader standards for corporate leadership”—though they wonder if this “shocking reversal” in priorities is achievable by the current group of American CEOs.
It is easy to see how a broader rendition of this statement can unload heavy artillery on the free market. The next iteration could read, as Bernie Sanders would have it, as a universal commitment by all corporate CEOs to embrace higher minimum wage laws, the narrowing or eliminating of income inequality, and, of course, a full scale campaign against global warming, even if all of these undertakings would dramatically diminish corporate bottom lines.
Yet so much of this modern rhetoric relies on the premise that thinkers like Milton Friedman made serious errors in reasoning that today’s CEOs have corrected. To make a better assessment of that claim, it is necessary to go back to first principles. First, Friedman never denied that any serious business had to have good relationships with its customers, employees, and suppliers. But it hardly follows that businesses owe special or fiduciary duties to these stakeholders, which is how the BR statement is commonly being read. Within corporate law, fiduciary duties arose, especially within public corporations, to offset the fundamental structural imbalance when ownership was separated from control, as is common whenever a large group of diffuse shareholders become passive investors in a venture controlled by corporate boards and officers. The fiduciary duty is one key tool for making corporate officers and directors protect the investors who have entrusted them with their wealth.
There are two levels of corporate duties to shareholders. First, corporate boards and officers deal at arm’s length with outsiders, and here, their responsibility is governed by the so-called business judgment rule, which protects them against suits by shareholders so long as they follow appropriate procedures in reaching a decision and act in good faith to maximize shareholder value. This rule both constrains corporate insiders but also protects them from liability if their good faith efforts turn out less well financially than expected. Indeed, if officers had to make good on every loss that occurs when deals go sour, no one would take on such roles. And second, whenever corporate officials enter into any kind of self-dealing transaction, the standard of care is much higher, given the conflict of interest. For such transactions, insiders must analyze whether corporate shareholders received “fair value” from the transaction.
One way to cash out the verbal switch from shareholder to stakeholder is to insist that similar fiduciary duties now apply to both groups. But this proposal is a bad idea for two reasons.
First, the stakeholders are not passive investors. They can negotiate on their own behalf in order to protect their own interests, both in the short and in the long-term. Every corporation knows that these counterparties will look after their own interests. These parties, like the corporations they deal with them, require long-term contractual protections, which they get under the Friedman view.
Second, the broader stakeholder model makes it impossible to discharge fiduciary duties to multiple parties simultaneously. One reason why large corporations tend to have only a single class of shares is to minimize unnecessary conflicts among shareholders. However, the expanded stakeholder model suffers from one of two fatal objections. Either the directors and officers of the corporation must be persuaded into looking after the interests of other parties who are not present, or these boards must expand membership to accommodate these interests, at which point they lose compactness and coherence. In the extreme form, stakeholder corporations might have to accede to Sen. Elizabeth Warren’s wacky Accountable Capitalism Act, in which government officials get to appoint 40 percent of each board of a corporation worth $1 billion or more—effectively, a partial nationalization of trillions of dollars of corporate assets.
The counter-argument to the Milton approach is that corporations that continue to work under the existing rules will remain flawed. First, they will be greedy. And second, they will engage in antisocial activities, such as generating pollution.
But there are four responses to these charges. First, Friedman’s position does not prevent the formation of corporations that have express charitable functions, such as churches, hospitals, and universities. Second, corporations can, should, and do make contributions to socially beneficial organizations to the extent that such contributions improve shareholder value. Such gifts could advance goodwill by supporting local charities, or by attracting employees who might prefer to take a lower wage in exchange for working for an enterprise that supports social causes. Third, individual shareholders can donate either their dividends or appreciated shares to charitable causes, thereby avoiding the potential conflicts of interest that arise when firms make controversial contributions to certain organizations or causes that other shareholders oppose, like Planned Parenthood or groups that oppose same-sex marriage.
Finally, all corporations must comply with laws and regulations that, for example, limit the amount of pollution a corporation can generate, or that set terms and conditions for labor contracts. It is well understood that all fiduciary duties exist within this legal framework. Indeed, it has long been understood that a trustee is never under an obligation to perform some illegal action even if the action would be profitable to the trustee’s beneficiaries and the trustee could get away with it.
It is therefore all too fashionable today to argue that certain recent events have exposed a fatal weakness in the traditional model of corporate responsibility—a model that has generated so much wealth and economic success over the years. This overwrought charge should be rejected. The key problems run in the opposite direction: government regulations and taxes imposed on corporations attempting to advance certain social improvements. Socialism, heal thyself!
© 2019 by the Board of Trustees of Leland Stanford Junior University
Published in Economics, Law
It often seems that every time corperations go wrong, there are regulations behind it
Richard,
Milton’s point that maximizing profits while playing by the rules (rules that have already factored in social responsibility) is well taken. However, by only repeating this argument without an update one allows the other side to get away with corrupting the naive which is what they have always been up to anyway.
What isn’t stated clearly is the fact that nebulous attempts at imaginary social responsibility have a huge downside that can end in a Chairmen Mao-like cultural tyranny. This guarantees the destruction of both individual freedom and the destruction of collective prosperity which will only produce more social misery that needs attention. It is Freedom of thought, Freedom of Speech and Freedom of Association (think Brendon Eich) that will be destroyed by the obsession with some vague idea of social responsibility.
You’ve got to add this extra bit onto Milton’s argument or you come off as just some spreadsheet wielding technocrat. You’ve got to get them where they live and make it clear what the stakes are. Do they want to live the rest of their adult working life in a Chinese style “reeducation facility”? Some are so far gone that they would accept anything but most would be revolted by the thought.
Regards,
Jim
When you’re talking about “socially responsible” corporations, you’re describing the economic system of Fascist Italy and Nazi Germany.
Corporate heads will conspire with or without their associates in government. Hyper-regulation and regulatory capture are serious problems. But politics is more than law. I’m not sure regulations are the main threat here.
If a corporate board acts against its fiduciary interest for some other goal, and if government reduces the board’s liability for that negligence, then the corporation seems a bad investment and will enjoy less capital. Is this not a self-correcting situation?
We live in an imperfect world. The USSR survived for many decades despite the self-defeating idiocy of communism. Similarly, a self-defeating company can long endure by credit of its original power.
But if a CEO claims, as Steve Jobs once did, that his public corporation must prioritize something above profit, and a majority of that company’s shareholders choose to remain invested, so be it. An individual company’s priorities are evident for potential investors to embrace or not as they please.
More people should know more about the wisdom of Milton Friedman. Good behavior of corporations depends on the Adam Smith notion of customers rewarding “lovely” corporations. Where the customer is indifferent or there is secrecy (ie, a military contractor, big tech,…) good behavior is less likely. There is also a management issue, when long-term value can easily be sacrificed for short-term gains. It is important to align the incentives of management with long-term investors. I wonder if passive investing will make a long-term perspective more common and if computerized (AI) trading will push towards short-term.
I think a Christian business rule would be that the business does not knowingly, in order to increase profit, market a product or service to consumers that results in harm to people not intended by those consumers. I hope that wording says what I mean. It appears that we have some businesses who clearly fail to follow this rule, among them pharmaceutical distributors, packaged food distributors, and pesticide and fungicide producers.
The New York Times is on the side of corporate greed. In this case, the corporation is the government corporation, which is greedy to take what doesn’t belong to it under the guise of “stakeholder” commitment.
Yes. Each of these are among the most government regulated, which insulates leadership and gives them more room to play to their own interests independently from shareholder interests.
One definition of the term “in compliance with regulations” is “as bad as the law allows”.
I might be mistaken, but I think California now has a law on the books that all corporations with assets greater than a certain amount must have a woman on the board. This looks like the beginning of all kinds of regulatory mischief to me.
Do corporations actually pay any attention at all to statements that come out of the Business Roundtable, or are they just inconsequential mutterings by social justice warriors who want to make themselves look good?
If a stakeholder wants to have a hand in running a corporation, the stakeholder should become a shareholder. Shareholders are owners of the corporation and have the first right to the benefits of ownership in the form of profit, short and long term.
I forgot where I read this, but regulating the meat industry was a reaction to Upton Sinclair’s The Jungle, a work of fiction. Sinclair was a socialist who had big ideas on what rules the meat industry needed to follow, despite never stepping foot in a meat-packing plant. Hmm…revolutionary socialist ideas, never stepped foot in an actual factory…. this sounds familiar.
And all the federal inspections did was cause smaller meat-packers to close shop as they couldn’t afford the safety inspections. Only the big corporations could. Corporate welfare at it’s finest. Thanks, T.R.
Starts with the ‘good intentions’ then morphs into something unrecognizable as good for anyone beyond those deeply inside. Johnson & Johnson is involved in a process now that has potential to identify if, in fact, there have been actions within the pharmaceutical industry designed to increase shareholder value while making major contributions to drug addiction among those not initially having been prescribed the manufactured products by physicians. Also the process may reveal whether or not members of the physician community are doing harm by over-prescribing. Some other corporations involved in this issue are settling which avoids a detailed investigation of what is happening. Just know that physician offices are constantly swarmed by pharmaceutical sales representatives with inducements to prescribe the drugs of the companies they represent.
Many years ago I read The Triumph of Conservatism by New Left historian Gabriel Kolko.
At the beginning of the 20th century, Kolko was astonished to find, big business was lobbying for Federal regulation — because, overriding State regulation, it advantaged big (interstate) business over local enterprises, and permitted economies of scale.
At the beginning of the 21st century, of course, still bigger business sees the same advantages in international regulation.
Silly. How many small businesses are started without intending to make money? Certainly nobody that needs money does so.
Bingo!
As noted on a podcast I listened to this morning (I don’t remember which one), a corporation “accountable” to everyone will actually be accountable to no one.
With the help of your comment, I would add, which almost inevitably leads to rule by government, which means it eventually becomes accountable only to the politically powerful. One of the wonderful benefits of a free market system is that it allows people without political power to have power.
This is the source for the Brexit conflict now going on in Europe. Nations within the European Union are having a disagreement over whether the member nations are sovereign or not. We are having the same disagreement between President Trump with his supporters and the Democrats.
Didn’t notorious libertarian CEO John Mackey write a book on conscious capitalism about how the wise CEO considered his entire stakeholder community in order to drive shareholder value?
The problem is that you cannot get the capital back from the company. You can sell the stock to someone else who shares the company’s priorities, but that’s it. If the stock would have been worth $100 a share with a profit maximizing management, but is worth only $60 with a woke management, kiss $40 a share goodbye.
If the company tries to raise more capital, it will have to dilute the existing shareholders more to raise the same amount of capital, but that won’t keep them from raising the money.
Money talks. First, if managements’ interest doesn’t need to be aligned with shareholders, then they shouldn’t need all those stock options. Certainly no more grants, and shouldn’t they give back at least those granted last year.
Management shouldn’t need as much in performance-based cash/deferred cash compensation. Say a Fortune 500 CEO is capped at $1 million in salary and another $1 in performance-based cash compensation and benefits. Scale the rest of the management group back accordingly. Take the money that would have gone to their comp and split it three ways–one third to lower prices, one-third to raise non-management employee comp and one third to dividends.
You’ll discover that this produces almost no change in prices, minor changes in employee comp and more significant changes to dividend income. Relatively speaking, shareholders are bearing most of this cost. Maybe employees would like to pitch in to make up the difference, since they have a stake too.
Yes, I’ve recently read standard-issue, academic (leftish) historians who have pointed out how the railroads wanted to be regulated by the feds. While these historians have done good work, they sometimes have trouble connecting all the dots.
Quite a few businesses started without intending to make a profit (in IRS terms). In the late 80s I took a night course on small business startup at the local community college; one of the instructors was taken aback when a couple of the attendees responded in the affirmative to his request for a show of hands for those who didn’t intend to make a profit.
Of course, not making a profit in IRS terms is not the same as not making money.
Kolko’s other book was Railroads and Regulation.