By maximizing efficiency, traditional shareholder capitalism—not ESG—may better promote the interests of society

Does Adopting a Stakeholder Model Undermine Corporate Governance?

The purpose of privately owned businesses has been an increasingly important issue confronting executives and members of corporate boards since Friedman’s iconic 1970 essay that argued that the purpose of private businesses is to maximize profits, which equates to producing and distributing their products as efficiently as possible. Perhaps the most prominent challenge to Friedman’s argument is the claim that a narrow focus on benefiting shareholders is inconsistent with benefiting society more broadly. Critics of Friedman’s shareholder model of corporate governance propose that administrators of companies implement a stakeholder model. The stakeholder model of corporate governance prioritizes the interests of a range of different economic agents including consumers, employees, suppliers, local communities in which companies are located, and the physical environment in addition to shareholders.

The practical relevance of the stakeholder model has been questioned on the grounds that a profit-maximizing business will act in the interests of important stakeholders anyway, particularly consumers and employees, because it is profitable to do so. A business that ignores the interests of its customers will lose sales to companies that promote their consumers’ welfare, while a business that “underpays” or otherwise takes advantage of its employees will find it more difficult to hire competent employees compared to rivals who offer competitive compensation packages and related conditions of employment. In this context, the stakeholder model is a relevant challenge to the shareholder model only if business behaviour differs between the two models. Specifically, the models differ in their relevance only if promoting the interests of non-shareholders comes at the expense of shareholders.

Obviously, if the stakeholder model of governance is inconsistent with economic efficiency, it is possible that other stakeholders besides shareholders will fare worse under the stakeholder model of governance than they would under the shareholder model. Most obviously, a decline in efficiency implies that consumers will be charged higher prices and employees will earn less compensation. Suppliers will be paid less for their inputs, and communities will realize lower business tax revenues. In short, an argument can be made that many stakeholders would be better off if companies maintained the “traditional” shareholder model of corporate governance.

Bebchuk and Tallarita (2020a; 2020b) make a case for why the stakeholder model of corporate governance is inferior to the shareholder model from the perspective of overall social welfare. The reason is that senior executives and corporate board members are more likely to implement strategies and actions that benefit themselves at the expense of shareholders and other stakeholders. This is because it is more difficult for stakeholders to monitor the performance of executives and board members when the latter operate with broad, possibly conflicting, and difficult-to-measure objectives, as well as because the incentives to monitor the performance of executives and board members are weaker when there is a large number of principals whose interests are at stake. The potential for principal-agent conflict (i.e., a situation in which a company’s management prioritizes its own pecuniary and non-pecuniary interests over the interests of shareholders) is relevant even when the shareholder governance principle guides corporate actions. In this context, Bebchuk and Tallarita’s main contribution is their extension of the problem that principals have in ensuring that their agents act in their interest to the stakeholder governance model.

Proponents of the stakeholder model of corporate governance argue that adopting the model will promote corporate actions that address social pathologies such as climate change, discrimination, and income inequality. Conversely, Bebchuk and Tallarita argue that stakeholder governance will displace laws and regulations which are more effective instruments to address broad environmental and social issues. In this regard, Bebchuk and Tallarita’s objection to stakeholder governance is similar to Friedman’s admonition that private sector executives should not be expected to assume the roles of politicians in a democratic society.

While there is no direct evidence bearing upon the issues that Bebchuk and Tallarita discuss, there is some evidence from the performance of mixed enterprises suggesting that expanding the mandate of corporate executives to include environmental and social objectives is likely to produce the worst of all possible worlds. Mixed enterprises are organizations in which there is both public (government) and private ownership. As such, mixed enterprises are meant to focus on achieving social goals such as reducing unemployment, while also making profits for their private owners. In fact, evidence suggests that mixed enterprises are less profitable that their privately owned counterparts, while they are also less likely to achieve targeted social benefits compared to their non-profit counterparts.

This and other indirect evidence suggests that the interests of society are more likely to be promoted by the wealth created by efficient businesses operating under a shareholder governance model than by mandating or otherwise pressuring companies to pursue environmental and social goals within a stakeholder governance framework. Increased wealth provides the financial and technological means to help address environmental and other social objectives.