“Businesses have a responsibility, too,” said Obama in his weekly address on Saturday. “If we make America the best place to do business, businesses should make their mark in America. They should set up shop here, and hire our workers, and pay decent wages, and invest in the future of this nation. That’s their obligation.”
Wrong. The social obligation of business is to sustainably maximize long-term profits for shareholders. Nothing more. Nothing less.
The case against corporate social responsibility is too complex and nuanced to be readily boiled down into a blog post. But let's take a shot. Because even a post of this length cannot do the subject justice, I direct your attention to the following post, which links my extensive scholarship on CSR.
One of the chief tenets of corporate law theory is that the law ought to facilitate private ordering; hence, the preference for default rules the parties are free to modify. So long as the default rule is properly chosen, most parties will be spared the need to reach a private agreement on the issue in question. Default rules in this sense provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule. Yet, the law should not always facilitate private ordering. Where there is a market failure, regulatory intervention may be appropriate. Welfare economics classically recognizes four basic sources of market failures: producer monopoly; the good to be produced is a public good; informational asymmetry between producer and consumer; and externalities. Of these, the latter is most pertinent for our purposes.
Corporate conduct doubtless generates negative externalities.[1] In appropriate cases, such externalities should be constrained through general welfare legislation, tort litigation, and other forms of regulation. The question here is whether the law should also seek to constrain them through the fiduciary duties of corporate directors.
Properly understood, fiduciary duties are gap-fillers by which courts resolve disputes falling through the cracks of incomplete contracts. More specifically, however, fiduciary duties prevent corporate directors and officers from appropriating quasi-rents through opportunistic conduct unanticipated when the firm was formed. Quasi-rents arise where investments in transaction specific assets create a surplus subject to expropriation by the contracting party with control over the assets.[2] A transaction specific asset is one whose value is appreciably lower in any other use than the transaction in question. Once a transaction specific investment has been made, it generates quasi-rents—i.e., returns in excess of that necessary to maintain the asset in its current use.[3] If such quasi-rents are appropriable by the party with control of the transaction specific asset, a hold up problem ensues. Investments in transaction specific assets therefore commonly are protected through specialized governance structures created by detailed contracts. Under conditions of uncertainty and complexity, however, bounded rationality precludes complete contracting. Under such conditions, accordingly, fiduciary duties provide an alternative source of protection against opportunism.
The shareholder’s investment in the firm is a transaction specific asset, because the whole of the investment is both at risk and turned over to someone else’s control. In contrast, many corporate constituencies do not make firm specific investments in human capital (or otherwise). Many corporate employees, for example, lack significant firm specific human capital. For such employees, mobility is a sufficient defense against opportunistic conduct, because they can quit and be replaced without productive loss to either employee or employer. If the employee’s general human capital suffices for him to do his job at Firm A, it presumably would suffice for him to do a similar job at Firm B. Such an employee resembles an independent contractor who can shift from firm to firm at low cost to either employee or employer.[4] Because the relationship between such employees and the corporation does not create appropriable quasi-rents, opportunism by the board is not a concern.
Consequently, shareholders are more vulnerable to director misconduct than are most nonshareholder constituencies. Consider a classic case of self-dealing. Assume a solvent corporation able to pay its debts and other obligations (especially employee salaries) as they come due in the ordinary course of business. Further assume that the corporation has substantial free cash flow—i.e., cash flows in excess of the positive net present value investments available to the corporation. If the directors siphon some portion of the corporation’s free cash flow into their own pockets, shareholders are clearly hurt, because the value of the residual claim has been impaired. Yet, in this case, there is no readily apparent injury to the value of the fixed claim of all other corporate constituents.
For the sake of argument, however, assume that appropriation of quasi-rents is an equally severe problem for both shareholders and nonshareholder constituencies. Many employees do invest in firm specific human capital. Creditors may also develop firm specific expertise, particularly in long-term relationships with a significant number of repeat transactions.
Relative to many nonshareholder constituencies, shareholders are poorly positioned to extract contractual protections.[5] Unlike bondholders, for example, whose term-limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations. The dispersed nature of stockownership, moreover, makes bilateral negotiation of specialized safeguards especially difficult:
Arrangements among a corporation, the underwriters of its debt, trustees under its indentures and sometimes ultimate investors are typically thoroughly negotiated and massively documented. The rights and obligations of the various parties are or should be spelled out in that documentation. The terms of the contractual relationship agreed to and not broad concepts such as fairness [therefore] define the corporation’s obligation to its bondholders.[6]
Put another way, bond indentures necessarily are incomplete.[7] Even so, they still provide bondholders with far greater contractual protections than shareholders receive from the corporate contract as represented by the firm’s organic documents. Accordingly, we can confidently predict the majoritarian default that would emerge from the hypothetical bargain. Shareholders will want the protections provided by fiduciary duties, while bondholders will be satisfied with the ability to enforce their contractual rights, which is precisely what the law provides.[8]
Like bondholders, employees regularly bargain with employers both individually and collectively. So do other stakeholders, such as local communities that bargain with existing or prospective employers, offering firms tax abatements and other inducements in return for which they could and should extract promises about the firm’s conduct. In general, the interests of such constituents lend themselves to more concrete specification than do the open-ended claims of shareholders. Those nonshareholder constituencies that enter voluntary relationships with the corporation thus can protect themselves by adjusting the contract price to account for negative externalities imposed upon them by the firm.
Granted, the extent of negotiations between the corporation and nonshareholders is likely to vary widely. In many cases, such as hiring shop floor employees, the only negotiation will be a take it-or-leave it offer. But so what? Is a standard form contract any less of a contract just because it is offered on a take it-or-leave it basis? If the market is competitive, a party making a take it-or-leave it offer must set price and other terms that will lead to sales despite the absence of particularized negotiations. As long as the firm must attract inputs from nonshareholder constituencies in competitive markets, the firm similarly will have to offer those constituencies terms that compensate them for the risks they bear.
This point persistently eludes proponents of the stakeholder model, who ask: “Can it really be said that employees (or local communities or dependent suppliers) are really better able to ‘negotiate’ the terms of their relationship to the corporation than are shareholders?”[9] While they presumably intend this to be a purely rhetorical question, in fact it has an answer and the answer is an affirmative one.
Shareholders have no meaningful voice in corporate decisionmaking. In effect, shareholders have but a single mechanism by which they can “negotiate” with the board: withholding capital. If shareholder interests are inadequately protected, they can refuse to invest. The nexus of contracts model, however, demonstrates that equity capital is but one of the inputs that a firm needs to succeed. Nonshareholder corporate constituencies can thus “negotiate” with the board in precisely the same fashion as do shareholders: by withholding their inputs. If the firm disregards employee interests, it will have greater difficulty finding workers. Similarly, if the firm disregards creditor interests, it will have greater difficulty attracting debt financing, and so on.
In fact, withholding one’s inputs may often be a more effective tool for nonshareholder constituencies than it is for shareholders. Some firms go for years without seeking equity investments. If these firms’ boards disregard shareholder interests, shareholders have little recourse other than to sell out at prices that will reflect the board’s lack of concern for shareholder wealth. In contrast, few firms can survive for long without regular infusions of new employees and new debt financing. As a result, few boards can prosper for long while ignoring nonshareholder interests.
Let us assume, however, that nonshareholder constituencies are unable to protect themselves through contract. The right rule would still be director fiduciary duties incorporating the shareholder wealth maximization norm. Many nonshareholder constituencies have substantial power to protect themselves through the political process.[10] Public choice theory teaches that well-defined interest groups are able to benefit themselves at the expense of larger, loosely defined groups by extracting legal rules from lawmakers that appear to be general welfare laws but in fact redound mainly to the interest group’s advantage. Absent a few self-appointed spokesmen, most of whom are either gadflies or promoting some service they sell, shareholders—especially individuals—have no meaningful political voice. In contrast, many nonshareholder constituencies are represented by cohesive, politically powerful interest groups. Consider the enormous political power wielded by unions, who played a major role in passing state anti-takeover laws. Because those laws temporarily helped kill off hostile takeovers, the unions helped slay the goose that laid golden eggs for shareholders. From the unions’ perspective, however, hostile takeovers were inflicting considerable harm on workers. The unions were probably wrong on that score, but the point is that the unions used their political power to transfer wealth from shareholders to nonshareholder constituencies.
Collective bargaining obviously does not protect nonunionized workers, but they receive comparable protections from both legal and market forces. Various market mechanisms have evolved to protect employee investments in firm specific human capital, such as ports of entry, seniority systems, and promotion ladders. As private sector unions have declined, moreover, the federal government has intervened to provide through general welfare legislation many of the same protections for which unions might have bargained. The Family & Medical Leave Act grants unpaid leave for medical and other family problems.[11] The Occupational Safety & Health Administration (OSHA) mandates safe working conditions.[12] Plant closing laws require notice of layoffs.[13] Civil rights laws protect against discrimination of various sorts.[14] And so on.
Such targeted legislative approaches are a preferable solution to the externalities created by corporate conduct. General welfare laws designed to deter corporate conduct through criminal and civil sanctions imposed on the corporation, its directors, and its senior officers are more efficient than stakeholderist tweaking of director fiduciary duties. By virtue of their inherent ambiguity, fiduciary duties are a blunt instrument. There can be no assurance that specific social ills will be addressed by the boards of the specific corporations that are creating the problematic externalities.[15]
[1] It is for this reason that one cannot justify the shareholder wealth maximization norm by claiming that a rising tide lifts all boats. In many cases, this will be true. Nonshareholder constituencies have a claim on the corporation that is both fixed and prior to that of the shareholders. So long as general welfare laws prohibit the corporation from imposing negative externalities on those constituencies, the shareholder wealth maximization norm redounds to their benefit. In some cases, however, the rising tide argument is inapplicable because it fails to take into account the question of risk. Pursuing shareholder wealth maximization often requires one to make risky decisions, which disadvantages nonshareholder constituencies. The increased return associated with an increase in risk does not benefit nonshareholders, because their claim is fixed, whereas the simultaneous increase in the corporation’s riskiness makes it less likely that nonshareholder claims will be satisfied. Hence, the rising tide argument cannot be a complete explanation for the shareholder wealth maximization norm.
[2] See Benjamin Klein et al., Vertical Integration, Appropriable Rents and the Competitive Contracting Process, 21 J. L. & Econ. 297 (1978).
[3] The asset may also generate true rents—i.e., returns exceeding that necessary to induce the investment in the first place—but the presence or absence of true rents is irrelevant to the opportunism problem.
[4] This is not to say that exit is costless for either employees or firms. All employees are partially locked into their firm. Indeed, it must be so, or monitoring could not prevent shirking because disciplinary efforts would have no teeth. The question is one of relative costs.
[5] The analysis herein applies mainly to voluntary constituencies of the firm, although the political process point is not wholly inapt with respect to involuntary constituencies. In any case, corporate law is an exceptionally blunt instrument with which to protect involuntary constituencies (and voluntary constituencies, as well, for that matter). Tort, contract, and property law, as well as a host of general welfare laws, provide them with a panoply of protections. See generally Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23 (1991).
[6] Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986).
[7] See Thomas A. Smith, The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98 Mich. L. Rev. 214, 234 (1999) (stating that “[a]ll contracts have gaps”). The claim here is simply that the shareholder-corporation contract is especially “gappy.” The ownership-like rights conferred by the shareholder’s contract follow from this phenomenon.
[8] See, e.g., Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. Ch. 1986) (holding that “the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature”); see also Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1524-25 (S.D.N.Y. 1989); Simons v. Cogan, 549 A.2d 300, 304 (Del. 1988); Revlon, Inc. v. MacAndrews & Forbes, Inc., 506 A.2d 173, 182 (Del. 1986).
[9] Ronald M. Green, Shareholders as Stakeholders: Changing Metaphors of Corporate Governance, 50 Wash. & Lee L. Rev. 1409, 1418 (1993).
[10] Where the board has been captured by senior management, nonshareholders also are indirectly protected because management’s interests are more likely to be aligned with those of nonshareholder constituencies than with those of the shareholders. Salaried managers hold what amounts to a fixed claim on the corporation’s assets and earnings, which is not too dissimilar from the claims of other nonshareholder constituencies. Moreover, much of corporate managers’ wealth is tied up in nondiversified firm specific human capital. These factors tend to make them more concerned with ensuring the firm’s survival than with taking risks that would maximize shareholder wealth.
[11] 29 U.S.C. § 2612.
[12] 29 U.S.C. § 651.
[13] 29 U.S.C. §§ 2101(b)(1), 2102.
[14] See, e.g., 42 U.S.C. § 2000e-2 (prohibiting employment discrimination on the basis of race, color, sex, or national origin); id. § 2000e-3 (prohibiting employment discrimination for the bringing of charges, testifying or other participation in law enforcement proceedings or for employer publication or advertisement of a preference for employees of a specific race, color, religion, sex, or national origin).
[15] Targeted legislation becomes an even more attractive alternative to fiduciary-based norms of corporate social responsibility when one realizes that consideration of nonshareholder interests is a task for which corporate directors are poorly suited. The shareholder wealth maximization principle dominates both legal and managerial thinking about fiduciary duties. Given the socialization and training of modern U.S. corporate managers, shareholder wealth maximization is the norm most likely to prevail in any consensus-building process.
