Joseph Mariathasan: Shareholders or stakeholders?
The battle lines are being drawn up in the debate over whether shareholder value maximisation or satisfying all stakeholders should be the primary objective of corporate management.
It is a critical issue for investors focused on environmental, social and governance (ESG) issues – but the arguments can often be off the point.
The Economist magazine sees itself as a standard bearer for “the classical liberalism of the 19th century”. This means it is a great supporter of the traditional idea of free markets with the view that “government should only remove power and wealth from individuals when it has an excellent reason to do so”.
Its leader on 22 August – in response to the revised statement of corporate purpose issued by the US Business Roundtable – was excoriating: “However well-meaning, this new form of collective capitalism will end up doing more harm than good. It risks entrenching a class of unaccountable CEOs who lack legitimacy. And it is a threat to long-term prosperity, which is the basic condition for capitalism to succeed.”
These arguments are worth considering by all ESG-focused investors. The Economist argues that the sort of “collective capitalism” espoused by the US Business Roundtable suffers from two pitfalls: a lack of accountability and a lack of dynamism.
In the case of accountability, The Economist makes the fair point that it is not clear how CEOs should know what “society” wants from their companies. The domination of the economy by large firms means that a small number of unrepresentative business leaders “will end up with immense power to set goals for society that range far beyond the immediate interests of their company”. The power of social media companies like Facebook is a clear illustration that this is already occurring, even in the absence of collective capitalism.
Collective capitalism leans away from change, The Economist argues: “In a dynamic system firms have to forsake at least some stakeholders: a number need to shrink in order to reallocate capital and workers from obsolete industries to new ones. If, say, climate change is to be tackled, oil firms will face huge job cuts.”
However, influential economist Milton Friedman argued that companies should not “make expenditures on reducing pollution beyond the amount that is in the best interests of the corporation or that is required by law in order to contribute to the social objective of improving the environment”.
What that has meant is that companies are free to cause a negative impact to other stakeholders in the pursuit of maximising shareholder value as long as they stay within the law as it stands. Corporations are able to operate without the impact of their activities fully priced into their profit and loss statements because they are not legally forced to do so. It justifies private gains at the expense of public losses.
The conflict between shareholder value maximisation and stakeholder satisfaction could be resolved if all external impacts of a corporation were able to be fully priced and accounted for.
In the US, an initiative was set up in 2011 called the Sustainability Accounting Standards Board Foundation with the objective of establishing industry-specific disclosure standards across ESG topics.
Though it is still essentially an independent entity with no legal powers, it is modelled on the Financial Accounting Standards Board and the International Accounting Standards Board. A key element of its activities is dialogue with the US regulator regarding accounting disclosures.
Accounting for all externalities would be only a first, albeit essential, step.
Knowing that burning a rainforest to create cattle grazing land may produce far more in terms of public losses than the private gains to the cattle rancher (and taxes accrued to the government) is one thing. It may prevent ESG-focused investors from investing, which may only benefit other investors with less scruples.
What would resolve the issues raised by The Economist – and promote sustainable investment with a shareholder maximisation philosophy – would be if corporations were charged for all external negative impacts created by their activities.
However, it may never happen – not be because it is such a revolutionary concept, but because many of today’s corporations would be producing large overall losses rather than net profits.