Claims that a stakeholder-focused system of corporate governance cannot succeed in the US are perverse because they take as given that corporations in the US ought to operate in the antediluvian framework Friedman preferred rather than within the enlightened one associated with the New Deal and high-performing economies in Germany and Scandinavia.
Editor’s note: To mark the 50-year anniversary of Milton Friedman’s influential NYT piece on the social responsibility of business, we are launching a series of articles on the shareholder-stakeholder debate. Read previous installments here.
Fifty years ago, Milton Friedman said that the social responsibility of business is to increase its profits.((Milton Friedman (1970), “A Friedman Doctrine: The Social Responsibility of Business is to Increase its Profits”, New York Times, 13 September.)) He was wrong, and the consequences of the mistaken thesis have been mounting environmental and social problems around the world. Remedying this mistake requires that environmental and social policies be combined with changes to corporate law that place corporate purpose beyond profit at its heart.
According to Friedman’s doctrine, directors of a company have a duty to do what is in the interests of their masters, their shareholders: to make as much profit as possible. Those who supported Friedman’s stockholder focused view of the corporate world now claim that a different approach—one that embraces the notion that corporations that exist only by right of society have a corresponding duty to treat all their stakeholders with respect and be responsible citizens—cannot work.
This claim is perverse because it takes as given that corporations in the US ought to operate in the antediluvian framework Friedman preferred rather than within the enlightened one associated with the New Deal and that still exists in high-performing economies in Germany and Scandinavia. It fails to acknowledge businesses’ own complicity in the erosion of that framework, as the very corporations that embraced their pre-reform vision of the role of businesses led the way in undermining the values of the New Deal that had previously acted to create greater economic security, equality, and fairness.
Unfortunately, some of our academic friends and colleagues are resisting a sensible rebalancing of the American corporate governance system to take into account the profound change in power dynamics that has resulted from the influence of Friedman and his anti-New Deal acolytes. That influence has markedly increased the power of the stock market and institutional investors over corporations and diminished the protections for other stakeholders.
This has left American corporate managers with far less room to balance all interests, to treat workers fairly and accord them with their prior share of productivity and profit gains. It has encouraged businesses to take shortcuts resulting in serious harm to consumers, the environment, and society generally. Not only that, it has left American corporations, even after a decade of recovery and massive tax cuts, running on fumes, with imprudent balance sheets, risky supply chains, and an inability to weather the pandemic with resilience.
In the face of this, respected thinkers like Professor Lucian Bebchuk argue that a more stakeholder-focused system of corporate governance cannot succeed in the US.((“The Illusory Promise of Stakeholder Governance” by Lucian Bebchuk and Roberto Tallarita, SSRN, April 2020, forthcoming Cornell Law Review, December 2020.)) We respectfully disagree. For starters, Bebchuk et al. ignore the fact that the US, together with the United Kingdom, is actually an outlier among the most productive, advanced, democratic market nations in terms of its stockholder-focused corporate governance. The stakeholder-focused system he says cannot function efficiently and effectively is actually in place in Germany, Scandinavia, and throughout much of the OECD.
Professor Bebchuk is, of course, right that it is difficult for corporations in the US now to operate in this effective and more enlightened way.((Lucian Bebchuk, Kobi Kastiel and Roberto Tallarita (2020), “For Whom Corporate Leaders Bargain”, Working Paper, August 19.)) But that is in large measure because for too long we have followed Friedman’s lead in making public corporations playthings of the stock market, and not imposing requirements on institutional investors to represent the real interests of their human investors in sustainable growth, the fair treatment of workers, and the elimination of externalities that cost all investors in not only slower economic growth, but also higher taxes and serious harm to human health and welfare.
We note that, although the singular pursuit of shareholder value may not have become as extreme in the EU as in the US, nonetheless in many EU member states, a marked shift towards the shareholder-dominated-governance model has occurred, even in states that formally would endorse a stakeholder approach. In a recent study for the EU Commission on directors’ duties and sustainable corporate governance, EY concludes that over the period 1992-2018 there was a growing trend for publicly listed companies to focus on short-term benefits of shareholders rather than on the long-term interests of companies, and that this had had a negative effect on long-term sustainable investment and company workers’ pay.((European Commission (2020), Study on Directors’ Duties and Sustainable Corporate Governance, July.))
Shareholder pay-outs have quadrupled from less than one percent of revenues in 1992 to almost four percent in 2018, with a significant number of companies paying out more than 75 percent of net profits. As an example, with its publicly proclaimed stakeholder model, the Netherlands is among the top three dividend pay-out countries in the EU. In line with this, investors rejected a proposal in the Netherlands this year to introduce an explicit duty of the board to ensure the corporation acts as a responsible corporate citizen on the presumption that investors would do the job of ensuring responsible behavior by corporations. Again, societal responsibility of corporations is acceptable only so long as it is in the interests of shareholders.
Commitments to a stakeholder approach in member states have primarily been in the form of workers’ councils and systems of co-determination that were designed in the 1960s and 70s. Their ability to protect workers has not been modified, in particular, to counteract the greater pressures exerted on EU corporations by activist hedge funds and institutional investors focused on short-term profits. Furthermore, co-determination and worker consultation systems in the EU were not designed to address wider concerns about social and natural capital that have risen to the fore recently. The European Commission is currently considering what regulatory measures should be taken to promote a more sustainable corporate governance framework in Europe.
What is required is a commitment to stakeholder governance that is matched with a supporting power structure. That is what is lacking. Outside corporate law, that means restoring the spirit of the New Deal and applying it to a 21st Century world by revitalizing the right to join a union and increasing worker voice at all companies, updating minimum wage and worker safety laws, taking aggressive action to address climate change, reinvigorating antitrust enforcement and consumer protection, and requiring large corporations and institutional investors to disclose information about whether they are treating their stakeholders and society with respect.
Within corporate law itself, the time has come for change to restore needed balance and focus corporations on the socially responsible, sustainable wealth creation. Right now, corporate law leaves it up to directors and managers subject to potent stockholder power to give weight to their other stakeholders. Corporations may have a commitment to purposes beyond profit and may treat stakeholders with respect, but only if their powerful investors allow them to do so. Absent an effective mechanism for encouraging adherence to the BRT statement and the system is stacked against those who attempt to do so. When the chips are down, not many corporations turn to their purposes to support their stakeholders, because as a practical matter of power dynamics, they cannot.
That is exactly the problem—the BRT signatories could propose purposes that support their stakeholders as well as their shareholders, but they do not have to, or do so only in so far as they promote the success of the corporation for the benefit of their shareholders. In other words, the interests of stakeholders are at best derivative of those of shareholders.
What is needed is a uniform federal mandate requiring large corporations, say with revenue over $1 billion, to become PBCs under state law, such as under the leading version in Delaware, harnessing the magic of federal and state cooperation in corporate governance that has made the American markets so successful. External regulation detailing what corporations can and cannot do alone will never be able to fill the responsibility void that has been created by making corporations only responsible for financial success in the interest of their shareholders, especially when supported by incentive structures that encourage executives to dismantle legal guardrails on corporate opportunism. Corporate law needs to ensure that corporations and boards of directors rise to the challenge of developing profitable businesses that contribute to solving society’s pressing challenges.