Purpose of the Firm: The Shareholder-Stakeholder Debate

One of the most common descriptions of corporate governance has been the way in which corporations are directed, administered and controlled and the actual activities of the directors and senior executives have been referred to as steering, guiding and piloting the corporation through the challenges that arise as it pursues its goals and objectives. Jamali et al. explained that the “control” aspect of corporate governance encompassed the notions of compliance, accountability, and transparency, and how managers exert their functions through compliance with the existing laws and regulations and codes of conduct.[1]  At the board level, the focus is on leadership and strategy and directors are expected to deliberate, establish, monitor and adjust the corporation’s strategy, determine and communicate the rules by which the strategy is to be implemented, and select, monitor and evaluate the members of the senior executive team who will be responsible for the day-to-day activities associated with the strategy.  In addition, directors are expected to define roles and responsibilities, orient management toward a long-term vision of corporate performance, set proper resource allocation plans, contribute know-how, expertise, and external information, perform various watchdog functions, and lead the firm’s executives, managers and employees in the desired direction.[2]

Setting the strategy for the corporation obviously requires consensus on the purpose of the firm, the goals and objectives of the firm’s activities and the parties who are to be the primary beneficiaries of the firm’s performance.  Traditionally, directors were seen as the agents of the persons and parties that provided the capital necessary for the corporation to operate—the shareholders—and corporate governance was depicted as the framework for allocating power between the directors and the shareholders and holding the directors accountable for the stewardship of the capital provided by investors.  While economists and corporate governance scholars from other disciplines recognized that the governance framework involved a variety of tools and mechanisms such as contracts, organizational designs and legislation, the primary question was how to use these tools and mechanisms in the best way to motivate and guarantee that the managers of the corporation would deliver a competitive rate of return.[3]  All of this is consistent with what has been described as the “narrow view” of corporate governance, one that conceptualizes corporate governance as an enforced system of laws and of financial accounting, where socio/environmental considerations are accorded a low priority.[4]

While primacy of shareholder interests was the dominant theme of corporate governance, at least in the US, for decades, there is no doubt that one of the most dynamic and important debates in the corporate governance arena, as well as in other areas of society, is the purpose of the firm.  Williams described this debate as follows[5]:

“Is it “simply” to produce products and services that create economic rents to be distributed to rights’ holders according to pre-existing contractual, statutory and (possibly) normative obligations? (Given that close to 70% of new companies ultimately fail, that task cannot be taken as too simple.)  Or does the firm also have a social obligation to minimize harm to people and the natural environment in its pursuits of profits, or even a positive duty to promote social welfare beyond its creation of economic rents?  In corporate governance and law, this debate tracks the competition between a shareholder versus stakeholder view of directors’ and officers’ fiduciary obligations.”

For a long time, the most influential voice among academics with respect to the role and primary objective of corporations was Milton Friedman, the Nobel Prize winning economist who famously declared that the exclusive goal of corporate activities was to maximize value for the owners of the corporation (i.e., the shareholders).  As history shows, this view was seized upon by investors and CEOs who often used aggressive tactics to drive up share prices and create large, yet often dysfunctional, conglomerates.  Friedman and others who shared his view maintained that companies did make a positive social contribution by running a profitable business, employing people, paying taxes and distributing some part of their net profits to shareholders.[6]  Another argument often made for the shareholder primacy approach to corporate governance was that requiring management to invest time and effort in devising ways to create additional social benefits beyond the honest pursuit of profits within the boundaries of the law would dilute management’s focus, undermine economic performance, and thereby ultimately undermine social welfare.[7]  Other supporters of the shareholder-oriented perspective cautioned that corporate responsibility was too much responsibility to impose on directors and pursuing social policy goals was a task best left to the state and not to businesses, which should not get themselves involved with political matters.  Another stated concern about expanding the directors’ power beyond shareholder interests is that it would undermine director accountability by allowing them to act in their own self-interest while claiming to act in other constituents’ interests.[8]

Eventually, other members of the academic community, as well as regulators, politicians, activists and even some of the investors that had grown wealthy during the stock market turbulence over the three decades starting with the 1980s, began to question the primacy of shareholder value and called for rethinking the role of the corporation in society and its duties to their owners and other parties impacted by their operational activities and strategic decisions.  Among other things, this meant challenging the long-accepted assumption that the principal participants in the corporate governance framework were the shareholders, management and board of directors.  For example, Sir Adrian Cadbury, Chair of the UK Commission on Corporate Governance, famously offered the following description of corporate governance and the governance framework in the Commission’s 1992 Report on the Financial Aspects of Corporate Governance: “Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society.”

Cadbury’s formulation of corporate governance brought an array of other participants, referred to as “stakeholders”, into the conversation: employees, suppliers, partners, customers, creditors, auditors, government agencies, the press and the general community.  As described by Goergen and Renneboog: “[a] corporate governance system is the combination of mechanisms which ensure that the management (the agent) runs the firm for the benefit of one or several stakeholders (principals). Such stakeholders may cover shareholders, creditors, suppliers, clients, employees and other parties with whom the firm conducts its business.”[9]  The principles of corporate governance of the Organisation for Economic Cooperation and Development clearly state that the corporate governance framework should recognize the rights of stakeholders (i.e., employees, customers, partners and the local community) as established by law and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

Colin Mayer of the University of Oxford has written and lectured about the need to reject shareholder value primacy and reconceive corporations as being committed to all of its stakeholders including the general economy and the community.[10]  Hart and Zingales have argued that the appropriate objective of the corporation is shareholder welfare rather than shareholder wealth.  While retaining Friedman’s shareholder-centered model, Hart and Zingales elected to focus on the ability of corporations to accomplish objectives that shareholders could not reasonably pursue on their own and called on corporations to consider activities other than wealth creation that enhance the welfare of shareholders as a whole.[11]  This opened the door to considering issues and initiatives relating to sustainability, employee welfare, social concerns and environmental stewardship and, as Hart and Zingales advocated in their proposed “constituency theory” of governance, expanding the beneficiaries of the directors’ fiduciary duties beyond shareholders to other constituencies, or stakeholders, such as employees, customers, members of the local communities in which the corporation operates and society as a whole.[12]

Approval of the constituency theory can often be seen in the statements of institutional shareholder groups such as the Investor Stewardship Group (www.isgframework.org), which has included the following in Endorsement Statement for its Corporate Governance Principles for U.S. Listed Companies: “[I]t is the fiduciary responsibility of all asset managers to conduct themselves in accordance with the preconditions for responsible engagement in a manner that accrues to the best interests of stakeholders and society in general, and that in so doing they’ll help to build a framework for promoting long-term value creation on behalf of U.S. companies and the broader U.S. economy.”[13]  Calvert Asset Management also pointed out that while the fiduciary duties of directors set out by statute do explicitly run to shareholders, the statutes also include similar duties to the corporation itself and thus allows, if not requires, directors to take into account more than just shareholder value when making decisions and be attentive to promoting the welfare of the corporation and the interests of all of its stakeholders.[14]

The focus on interested parties beyond shareholders is the hallmark of a broader view of corporate governance that emphasizes the responsibilities of business organizations to all of the different stakeholders that provide it with the necessary resources for its survival, competitiveness, and success.[15] In this conception, managers remain primarily accountable to the stockholders who have placed their wealth in the hands of those managers; however, managers, particularly the members of the board of directors, are also responsible to groups of stakeholders that have made equally significant contributions to the corporation and these stakeholder responsibilities impose additional constraints on managerial action and the primacy of shareholder rights.[16]  Rahim, noting that the roles and responsibilities of directors have been described as the “board as manager”, pointed out that the duties of board members have been vastly extended as corporate social responsibility has moved from the margins to the center of corporate governance attention, a trend which is discussed in more detail below.[17]

Commentators such as Bower and Paine have written about the fallacies underlying the economic theories used to support the maximization of shareholder value rule and argued that short-termism and hedge fund activism have not actually created value but rather has simply shifted value among a small group of wealthy parties, encouraged corporations to park idle funds offshore and reduce long-term investments in innovation that would benefit future generations, and triggered crises that have drained public funds and harmed workers, consumers and communities.[18]  Bower and Paine advocated an alternative model for corporations based on the health of the enterprise rather than short-term returns to shareholders and encouraged directors and managers to pay more attention to innovation, strategic renewal and investment in projects that ensure future sustainability.

The stakeholder approach to corporate governance arose out of a growing sense that more consideration had to be given to “the whole set of legal, cultural, and institutional arrangements that determine what public corporations can do, who controls them, how that control is exercised, and how the risks and return from the activities they undertake are allocated.”[19]  The impact and importance of corporate governance was emphasized by Gourvevitch and Shinn in the following quotes from their book on the “new global politics of corporate governance”[20]:

“Corporate governance–the authority structure of a firm–lies at the heart of the most important issues of society”… such as “who has claim to the cash flow of the firm, who has a say in its strategy and its allocation of resources.” The corporate governance framework shapes corporate efficiency, employment stability, retirement security, and the endowments of orphanages, hospitals, and universities. “It creates the temptations for cheating and the rewards for honesty, inside the firm and more generally in the body politic.” It “influences social mobility, stability and fluidity… It is no wonder then, that corporate governance provokes conflict. Anything so important will be fought over… like other decisions about authority, corporate governance structures are fundamentally the result of political decisions.  Shareholder value is partly about efficiency. But there are serious issues of distribution at stake – job security, income inequality, social welfare.”

Jamali et al. noted that corporate governance “is also intimately concerned with honesty and transparency, which are increasingly expected of the public both in corporate dealings and disclosure”.[21]  They pointed out that investor confidence and market efficiency has always depended on the disclosure of accurate information about corporate performance and regulators and corporate activists have insisted that companies prepare and disseminate reports that are clear, consistent and comparable.  The growing interest in CSR and the broader view of corporate governance has slowly transformed the concept of disclosure and transparency to include non-shareholder stakeholders of the corporation.  For example, Jamali et al. pointed out that transparency and disclosure of information between managers and employees is essential to earning employee trust and commitment.  As for external stakeholders, such as the members of the communities in which the company operates and society as a whole, transparency has become a fundamental principle underlying the notion that firms need to be “good citizens”.[22]  An additional byproduct of the aspiration for transparency is the creation of reporting systems that provide directors with the information necessary for them to discharge their leadership and strategic duties and ensure that the corporate governance framework works efficiently.

Williams clearly described the rationale for the stakeholder perspective to corporate governance as follows[23]:

“From a stakeholder perspective, successful companies incorporate and rely upon multiple social and natural inputs, such as an educated work-force, the physical infrastructure for the production, transportation and distribution of goods, an effective legal system, and natural capital inputs of water, air, commodities, and so forth. Since some significant portion of the inputs of corporate success, including financial inputs, have been contributed by parties other than shareholders, those parties also have interests to be considered in determining the responsibilities of managers and directors and in distributing the outputs of corporate action.  Some, perhaps many, of those interests will be protected by contractual or regulatory arrangements, but others cannot be specified ex ante, and so must depend on corporate participants to fairly balance multiple parties’ legitimate claims ex post”.

The Australian Parliamentary Joint Committee on Corporations and Financial Services, in its 2006 report on “corporate responsibility”, announced that it endorsed the “enlightened self-interest interpretation” of directors’ duties, which acknowledges that investments in corporate responsibility and corporate philanthropy can contribute to the long term viability of a company even where they do not generate immediate profit.  The Committee felt that it was necessary and appropriate for directors to consider and act upon the legitimate interests of stakeholders to the extent that these interests are relevant to the corporation and noted that addressing some of the driving factors of corporate responsibility (e.g., community license to operate, reputational factors, avoidance of regulation, attraction and retention of staff and attraction of investment from ethical funds) by undertaking activities that contribute to social wellbeing and environmental protection are clearly in the best interests of the company from a commercial perspective (and thus well within the bounds of directors’ duties).[24]

This article is part of the Sustainable Entrepreneurship Project’s extensive materials on Sustainability and Corporate Governance. and an excerpt from Sustainability and Corporate Governance by Alan S. Gutterman, which is available for purchase at various online booksellers.  Readers may also enjoy the author’s book on Board Oversight of Sustainability: A Practical Guide for Directors and Their Advisors.

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[1] D. Jamali, A. Safieddine and M. Rabbath, “Corporate Governance and Corporate Social Responsibility Synergies and Interrelationship”, Corporate Governance, 16(5) (2008), 443, 444 (citing K. MacMillan, K. Money, S. Downing and C. Hillenbrad, “Giving your organization SPIRIT: An overview and call to action for directors on issues of corporate governance, corporate reputation and corporate responsibility”, Journal of General Management, 30 (2004), 15; and A. Cadbury, “The corporate governance agenda”, Journal of Corporate Governance, Practice-Based Papers, 8 (2000), 7).

[2] K. MacMillan, K. Money, S. Downing and C. Hillenbrad, “Giving your organization SPIRIT: An overview and call to action for directors on issues of corporate governance, corporate reputation and corporate responsibility”, Journal of General Management, 30 (2004), 15; A. Cadbury, “The corporate governance agenda”, Journal of Corporate Governance, Practice-Based Papers, 8 (2000), 7) and J. Page, Corporate Governance and Value Creation (University of Sherbrooke, Research Foundation of CFA Institute, 2005).

[3] H. Mathiesen, Managerial Ownership and Finance Performance (Dissertation presented at Copenhagen Business School, 2002).

[4] K. Saravanamuthu, “What is measured counts: Harmonized corporate reporting and sustainable economic development”, Critical Perspectives on Accounting, 15 (2004), 295.

[5] C. Williams, “Corporate Social Responsibility and Corporate Governance” in J. Gordon and G. Ringe (Eds.), Oxford Handbook of Corporate Law and Governance (Oxford: Oxford University Press, 2016), 34, available at http://digitalcommons.osgoode.yorku.ca/scholarly_works/1784.

[6] Id. at 35.

[7] Id. at 35 (citing H. Hansmann and R. Kraakman, “The End of History for Corporate Law”, Georgetown Law Journal, 89 (2001), 439, 442-443).

[8] Id. at 36-37 (citing D. Engel, “An Approach to Corporate Social Responsibility”, Stanford Law Review, 32 (1979), 1; D. Fischel, “The Corporate Governance Movement”, Vanderbilt Law Review, 35 (1982), 1259; and S. Bainbridge, “Corporate Social Responsibility in the Night-Watchman State”, Colorado Law Review Sidebar, 115 (2015), 39, 49).

[9] M. Goergen and L. Renneboog, “Contractual Corporate Governance”, Journal of Corporate Finance, 14(3) (June 2008), 166.

[10] See C. Mayer, Firm Commitment: Why the Corporation is Failing Us and How to Restore Trust in It (Oxford: Oxford University Press, 2013); and C. Mayer, Prosperity: Better Business Makes the Greater Good (Oxford: Oxford University Press, 2018).

[11] O. Hart and L. Zingales, “Should a Company Pursue Shareholder Value?” (October 2016), available at https://www8.gsb.columbia.edu/leadership/sites/leadership/files/Zingales-Hart–Share_value.pdf

[12] Id.

[13] https://www.isgframework.org/become-an-endorser-internationalorganizations-only/.  The Principles Affirm that boards are accountable to shareholders; however, they also require that boards be responsive to shareholders and be proactive in order to understand their perspectives and that boards develop management incentive structures that are aligned with the long-term strategy of the company.

[14] Board Oversight of Environmental and Social Issues: An Analysis of Current North American Practice (Calvert Asset Capital Management Inc. and The Corporate Library, 2010), 8.

[15] K. MacMillan, K. Money, S. Downing and C. Hillenbrad, “Giving your organization SPIRIT: An overview and call to action for directors on issues of corporate governance, corporate reputation and corporate responsibility”, Journal of General Management, 30 (2004), 15

[16] J. Page, Corporate Governance and Value Creation (University of Sherbrooke, Research Foundation of CFA Institute, 2005); and N. Kendall, “Good corporate governance”, Accountants’ Digest, 40 (1999).

[17] M. Rahim, Legal Regulation of Corporate Social Responsibility: A Meta-Regulation Approach of Law for Raising CSR in a Weak Economy (Berlin: Springer, 2013), 13, 22 (citing M. Eisenberg, “The Modernization of Corporate Law: An Essay for Bill Cary”, University of Miami Law Review, 37 (1982), 187, 209-210).

[18] J. Bower and L. Paine, “The Error at the Heart of Corporate Leadership”, Harvard Business Review, 95(3) (May-June 2017), 50.

[19] M. Blair, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century (Washington DC: The Brookings Institute, 1995).

[20] P. Gourvevitch and J. Shinn, Political Power and Corporate Control: The New Global Politics of Corporate Governance (Princeton NJ: Princeton University Press, 2007) (as compiled by J. McRichie at https://www.corpgov.net/library/corporate-governance-defined/)

[21] D. Jamali, A. Safieddine and M. Rabbath, “Corporate Governance and Corporate Social Responsibility Synergies and Interrelationship”, Corporate Governance, 16(5) (2008), 443, 444 (citing J. Page, Corporate Governance and Value Creation (University of Sherbrooke, Research Foundation of CFA Institute, 2005)).

[22] Id. at 444.

[23] C. Williams, “Corporate Social Responsibility and Corporate Governance” in J. Gordon and G. Ringe (Eds.), Oxford Handbook of Corporate Law and Governance (Oxford: Oxford University Press, 2016), 38-39, available at http://digitalcommons.osgoode.yorku.ca/scholarly_works/1784 (citing M. Blair and L. Stout, “A Team Production Theory of Corporate Law”, Virginia Law Review, 85 (2003), 248).

[24] Parliamentary Joint Committee on Corporations and Financial Services, Corporate responsibility: Managing risk and creating value (2006), 52-53.  The Committee also found that the then-current version of the Australian Corporations Act, first adopted in 2001, actually permitted directors to have regard for the interests of stakeholders other than shareholders and recommended that no further amendment to clarify directors’ duties in that regard was required. Id. at 63.