A novel conference at Harvard Business School brought together top scholars in order to answer the question: Is Milton Friedman’s dictum that firms that maximize shareholder value maximize social value as well still relevant in a post-Citizens United world?
In recent years, it has become increasingly difficult to reconcile the growing political influence of American corporations with Milton Friedman’s theory of the firm. Friedman’s dictum that firms can and should only benefit society by focusing on maximizing returns has become sacrosanct in the last few decades, but is it still relevant at a time when firms are seen not only as economic actors but as political actors as well? Even Friedman, after all, assumed that firms operate within pre-set rules of the game.
However, in the six years since the Citizens United ruling, in which the Supreme Court effectively relaxed restrictions on corporate political spending, has it become increasingly easier for firms to tweak the rules of the game in their favor?
In November, a select group of top economists, legal scholars, political scientists, sociologists, and historians gathered at Harvard Business School for an innovative conference that aimed to answer this very question. For two days, the participants debated whether the underlying assumptions of Friedman’s theory of the firm are still valid in a post-Citizens United world.
According to Harvard Business School associate professor Karthik Ramanna, who co-organized the event, the idea for the conference grew out of conversations amongst several scholars on the logical inconsistency between Friedman’s belief in the general immutability of the rules of the game and George Stigler’s theory of regulatory capture. These conversations eventually led to a brief paper coauthored by HBS faculty Paul Healy, Rebecca Henderson, David Moss, and Ramanna. The paper, which served as an intellectual backdrop to the conference, explores whether and how it might be possible to resolve the apparent contradiction between the current theory of the firm and current evidence on corporate political engagement in shaping the rules of the game. If firms are always trying to capture regulation and design the rules of the game for their benefit, how can the rules of the game be immutable?
The conference, says Ramanna, “raised three important questions: First, what is the evidence that we can bring to bear on the role of firms in shaping the rules of the game? Second, what is the evidence that we can bring to bear on the harm, if any, that is created from firms shaping the rules of the game? Third, what is the evidence that these harms are such that they would provoke a reexamination of the theory of the firm as it applies to the role of businesses in setting the rules of the game?”
While the conference was characterized by a lively debate and did not end in universal consensus on any of these points, participants did manage to reach some common agreement. Despite a broad cross-section of disciplines, views, and research methods, a majority of speakers and participants generally agreed that, among other things, firms maximize profits by also tweaking the rules of the game to their advantage.
“More than a crisis [in the theory of the firm], I think there’s an unresolved tension between Friedman’s view of the world and Stigler’s view of the world,” says Luigi Zingales, the Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance at Booth and the Director of the Stigler Center, who participated in the conference. “We don’t know, either from a theoretical or from an empirical point of view, what are the welfare consequences of a world where part of the profit maximization of firms involves lobbying and changing the rules of the game.”
Do firms have a role in shaping the rules of the game?
In regards to the first question raised by the conference’s organizers—”Do firms actually pursue profits by trying to tilt the rules of the game in their favor?”—virtually all the speakers seemed to answer in the affirmative.
One of the concepts raised and debated was that of financial entropy. According to this theorem, financial regulations and their effectiveness tend to get weakened over time, due to industry workarounds, regulatory changes, and legislative changes. Periods of tranquility often lead to regulatory complacency and pressure from special interests for deregulation. The only periods during which this process can be challenged are in the aftermath of financial crises or major scandals, where public backlash is so intense that it enables and sometimes even forces vigorous regulations. Therefore, conference attendees debated whether there are advantages to overreacting and over-regulating an industry as a “cushion” against a recurrence of watering down existing regulations.
In the cat-and-mouse game between industry and regulators, according to this theory, the “mouse” (that is, the firms) has several built-in advantages: brain and speed, money, cognitive capture, and politicians, who often side with corporations.
Does that mean that firms have a legal obligation to maximize profits by any means, even tweaking the rules of the game in their favor? Economists have debated this question for a long time. Some believe that the fiduciary duty of boards necessitates that they maximize shareholder value, while others believe that they have enough flexibility that they can make decisions not based solely on profit-maximizing considerations.
Which of the two approaches is right? How should boards and corporations interpret their fiduciary duty to the shareholders? Can they take ethical considerations into account or are they obliged to maximize long-term shareholder value above all else? Here, participants disagreed.
One economist, for instance, brought up the example of the (disputed) claims that IBM’s German subsidiary cooperated with the Nazi regime in the 1930s. Suppose the Nazi regime approached IBM with the offer, and the deal was profitable, would board members at the time be obliged to sell to the Nazis? Another example (a much less hypothetical one, given recent developments in the pharmaceutical industry) was that of a drug company that recently purchased the right to manufacture a drug that can cure a serious illness. If the company can make a lot more money by raising the price 50-fold, must it do this, so long as the profits are greater than the damage from regulatory scrutiny and reputational costs?
According to the economist, the answer to both these questions, under current Delaware rules, is an emphatic yes. If they don’t deal with the Nazis or hike prices on ethical grounds, then board members could presumably be sued for breach of fiduciary duty, he claimed.
One participant, a noted legal scholar, however, countered that by saying that the law does give boards recourse, and that they can refuse to do certain things, like make a deal with the Nazi regime or hike the price of a drug 60-fold, without essentially being disingenuous and justifying it as an attempt to maximize returns. He quoted from Section 2.01 of the American Law Institute’s Principles of Corporate Governance: “Even if corporate profit and shareholder gains are not thereby enhanced…the corporation may take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business.”
Are companies legally required to aggressively pursue shareholder wealth maximization? The short answer, said the legal scholar, is no. And yet, more and more companies do aggressively pursue shareholder value maximization, sometimes in ways that are considered by society to be “egregiously anti-social.” A topical example would be a pharmaceutical firm like Valeant, which made headlines in 2015 after engaging in dramatic price hikes.
If it’s not a legal requirement to maximize shareholder wealth, what could be leading this type of behavior? One scholar made the connection between this question and the debate over short-termism, and explained it as a wearing-thin of corporate “break pads” that used to restrain reckless behavior. Firms today, he claimed, are pressured to maximize shareholder value at all costs due to a number of factors. First, boards are composed of independent directors with little attachment to the firm or its culture. Second, the rise of hedge fund activism has led to the creation of “wolf packs” (a loose association of hedge funds that don’t formally work together but share a common goal). Third, the structure of stock option compensation creates incentives to maximize share value.
From a historical perspective, one historian claimed that the evidence is overwhelming: firms have always endeavored to change the rules of the game, and Friedman’s theory of the firm is not particularly useful for ignoring it. Firms have always been political actors who depend on the state, and the state depends on them. The codependence between entrepreneurs and the state allowed firms to shape political outcomes and thus the political environment. A separation of firms and politics, he suggested, is “conceptually impossible.” A plausible theory of the firm needs to acknowledge the political character of firms.
One of the dissenting voices against the notion that there is indeed a crisis in the modern theory of the firm was that of Chicago Booth professor Steven N. Kaplan. There are two contrasting criticisms lobbed against American firms today, he said: one, that they are not profitable enough (because they are poorly managed), and another, that they are too profitable (because they ruthlessly maximize profits). “The data are consistent with the second. Firms are extremely well-managed. People have been saying that U.S. firms are too short-term for 40 years—today, therefore, is the long term they warned about. If CEOs had been maximizing short term profits over the last 40 years, profits and performance should be lower now; instead, profits have been running at historically high levels,” he says.
“The argument that U.S. companies are too successful is more persuasive than the argument that they are poorly managed,” he said. Their success, he suggested, has been hugely beneficial to the world at large over the past 30 years, in which corporate success has coincided with a tremendous rise in well-being globally, as well as with positive political changes. Much of this social value, he said, has been aided by, if not driven by, corporations maximizing shareholder value. “Is the theory of the firm broken? No.”
Kaplan did not deny that firms do in fact try to influence the rules of the game. But the notion that there is a crisis in the theory of the firm, he claimed, relies on the assumption that there are no countervailing pressures against firms changing the rules of the game. “It’s completely ridiculous, in my opinion, to assume there’s no countervailing pressure. There’s nothing new here, after all. Stigler wrote about this: companies try to capture regulation, and from time to time they do; but there are countervailing forces. In the 1800s, at the time of the so-called ‘robber barons,’ it was much worse. The muckrakers, and political actors like Teddy Roosevelt and Woodrow Wilson, were countervailing forces. Look at Bernie Sanders, Occupy Wall Street, even Donald Trump today: these are countervailing pressures.”
“I agree with Steven [Kaplan] that there are countervailing forces,” says Zingales. “But the question is if on the one hand we have a billion dollar check, and on the other hand we have a guy with a $100, would the two forces play the same role? I’m glad he sees the value of Bernie Sanders, but if we have to rely on Bernie Sanders to make capitalism better we are in deep trouble.”
Is it in fact harmful that firms have a role in shaping the rules of the game?
If participants were generally in agreement on the issue of firms trying to affect the rules of the game, when it came to the second question raised by the conference organizers—“Are these attempts to influence the rules of the game harmful? And if so, how serious is that harm?”—opinions varied widely.
Some participants raised concerns that when firms tweak the rules it leads to policies that serve narrow interests at the expense of the public interest. This has wide-ranging implications not only for public policy or the health of the democratic system but also for the operations of the firms themselves. “Egregiously anti-social” behavior can expose companies to political, regulatory, and financial risks.
While many agreed that firm-influenced regulations do not always align with social welfare, some pointed out that not all forms of corporate influence are equally problematic. Firms, for instance, often have information that can defeat bad policy.
In his book Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy, Ramanna developed the concept of “thin political markets.” In thin political markets, he said, small groups of informed representatives of special interest groups with deep experiential expertise are able to shape the rules of the game in self-serving ways. But there are also upsides to the dissemination of corporate knowledge regarding highly technical (and also highly consequential) issues, about which specialists from regulated firms know much more than regulators.
According to one suggestion, there is room for reducing corporate influence in the form of lobbying, while still finding a way to encourage an advocacy model that creates and disseminates useful information on complex technical issues. Of course, there are a number of major caveats necessary for this to work: decision makers have to be unbiased and act in the interests of society; resources devoted to both sides of the issue have to be well-balanced; and the information generated by advocates has to be “hard,” of the kind that cannot be distorted or concealed.
Kaplan, again, was a voice of dissent. If companies were changing the rules of the game, it should have helped incumbents, but there has been a huge turnover among top corporations in the U.S. in the last 50 years, he said. “You could make the case that companies are too successful, and maybe that’s true, and that’s why there’s pressure on the middle class and lower middle class. Technology and globalization have hurt people in manufacturing, clerical, and some other lower skill professions in the U.S. and developed countries. That is a real concern. At the same time, however, technology and globalization have led to lower costs and lower prices that benefit a lot of people in the U.S. Perhaps more importantly, they have had huge benefits in emerging economies—billions of people in China, India, and elsewhere are not starving any longer. On net, there has been a huge benefit to the world. Where’s the crisis of the firm?”
What is to be done?
What can be done about firms tilting the rules of the game in their favor? One proposition raised during the conference was that of over-regulating the industry. Keeping in mind the theorem of financial entropy, which dictates that financial regulations tend to weaken over time but are often emboldened in the aftermath of financial crises, the proposed solution was regulatory overreaction following such crises, essentially making the new laws and regulations “too tough.”
While support for potential regulatory solutions like reinstating Glass-Steagall or reinvigorating antitrust was mixed, many of the participants agreed on the importance of ethical norms. Managers and board directors are not under any legal obligation to maximize shareholder value at all costs. Yet profit maximizing is the norm, and the market weeds out “ethical managers” because incentives for gaming the system are just too strong. Social norms have a powerful influence on both managers and regulators.
In terms of market solutions, scholars noted a variety of existing mechanisms to promote social value, among them the use of “benefit corporations” (for-profit entities that include a positive impact on society as part of their stated goals) and the option for founders to add a statement about the goals of their company (beyond maximizing profits) into their articles of incorporation, as a way of giving boards more flexibility.
Other ideas were to directly constrain the resources that firms can devote to lobbying and advocacy; to attempt to reorient managers away from focusing solely on shareholder value and towards a broader notion of duty to society; and to find the right incentives that will allow private sector specialists to disseminate knowledge of technical issues to regulators, without trying to subvert the rules of the game.
One of the more interesting notions discussed was the need to change the way business schools educate MBA students. In light of attempts made by corporations to affect the rules of the game through political activities, some participants expressed concern that teaching MBA students that their only duty as future managers is to maximize shareholder value effectively contributes to the unraveling of the theory of firm, and with it the type of market society it hoped to create. As a solution, some suggested that when we teach business ethics to MBA students, we should emphasize the importance of avoiding profit-maximizing activities that might harm society at large, similar to medical schools that teach students to “do no harm.” Business school professors have a responsibility to instill norms that are beneficial to society; teaching the executives of the future to maximize profits in ways that don’t tilt the rules of the game in their favor is one way of achieving that. However, this approach does contradict Friedman’s assertion that ascribing businesses social responsibilities beyond profit-maximization is not only harmful but potentially dangerous.
One organizer concluded by offering this summary of the debates: one way in which companies pursue profits is by bending the rules of the game to their advantage. When the rules of the game are bent to favor private interests, the general interest (including the health of the commons) may suffer. The political process is itself part of the rules of the game, and may be bent or depleted to favor private interests. As a result, countries that allow their commons to be depleted may face difficulties in achieving and sustaining robust growth and a good society over the long term, particularly in a competitive global environment. The question, then, is how to balance, on the one hand, the need of firms in a competitive marketplace to pursue every legal profit opportunity with, on the other, the need of the public to ensure the health of the commons, particularly when the commons itself (including the political system) may be depleted as a result of profit-seeking political activity.
In the end, the conference did not end with an agreement beyond the basic issue that, indeed, one way in which firms pursue profits is by bending the rules of the game to their advantage. Participants were not able to reach a consensus on whether this harms the general interest or how to balance the need for firms to pursue every legal opportunity to increase profits with the public need to ensure the integrity of the political process.
One thing that was widely agreed, though, was the need for more empirical research to prove that when companies change the rules of the game to their advantage, this behavior can potentially harm social welfare.
“I think that as academics we have three responsibilities,” says Zingales. “The first one is to analyze theoretically the implications of this. The second is to improve our empirical assessments of the outcomes. Thirdly, to be much more careful in our teaching and in particular dedicate some time to teach this tension to our students.” As a result of the conference, the Stigler Center has begun to develop cases in order to help facilitate the teaching of some of the tensions and questions it has raised
“I went into the conference with the understanding that one could question the premise of the Neoclassical paradigm in economics through logical arguments—e.g., the inconsistencies between Friedman’s assumptions and Stigler’s theory. I left with a sense that logical arguments on their own are unlikely to carry the day, because the Neoclassical paradigm is so powerfully ingrained into the discipline, into the fabric of modern economics,” says Ramanna.
“Many economists, for better or worse, have come to see themselves as doing ‘positive research,’ in a philosophical sense. What isn’t always explicit is that the so-called positive research is nestled in a set of normative axiomatic assumptions about how the world works. One such assumption is that the basic rules of capitalism and democracy are immutable. I’ve learned that those who seek debate over the validity of these assumptions carry the burden of establishing conclusively that the assumptions are violated in practice. If we’re going to make progress on the economic theory of the firm as it applies to corporate political activity, we need more economics-based empirical research on the harms, if any, of corporate lobbying.”