In a memorial service honoring Milton Friedman held at the Hoover Institution shortly after his death in 2007, Hoover Senior Fellow Edward Lazear hit the nail on the head when he said, only half in jest, “It is amazing how many people can best Milton in an argument when he is not in the room.”
His remark has added relevance today because last week the Business Roundtable (BR), a non-profit comprised of CEOs of major U.S. organizations, did battle with an empty chair with its short announcement entitled, “Statement on the Purpose of a Corporation.” The statement rejects the received wisdom—boldly pronounced in Friedman’s famous 1970 New York Times Magazine article, “The Social Responsibility Of Business Is to Increase Its Profits”—that corporate directors and officers should maximize shareholder value rather than some nebulous concept of social responsibility.
In tune with our populist times, the BR’s declaration has been interpreted in the press as a conscious rebuke of Friedman for his propagation of what the late Lynn Stout termed “The Shareholder Value Myth.” Friedman treated his statement as a means to an end. The corporation that seeks to maximize its profit within the rules of the game will maximize social welfare as well. But the new wisdom is that Friedman’s model invites dangerous and selfish actions. That’s why the New York Times used the following caption for its story on the BR’s statement: “Shareholder Value Is No Longer Everything, Top C.E.O.s Say.”
But what exactly is the alternative? On this matter, the BR’s statement is a self-conscious effort to play both ends against the middle. Its first paragraph takes the sensible position that “the free-market system is the best means of generating good jobs, a strong and sustainable economy, innovation, a healthy environment and economic opportunity for all.” Its next sentence should have taken a page out of Friedman’s playbook to denounce the many forms of regulation that hamper activities in a free-market economy. Chief on the list would be those regulations that upset competition in labor markets, which include minimum wage and overtime regulations, unionization, family leave, health care mandates, and much more. By limiting the options for both parties to a labor contract, these kinds of regulations constrain the opportunities of employees and employers alike.
Yet the BR’s statement veers off in exactly the wrong direction. “While each of our individual companies serve its own corporate purpose,” the statement reads, “we share a fundamental commitment to all of our stakeholders.” Tremble at their underlined all. The list of stakeholders to whom companies commit themselves, according to the statement, includes customers, employees, suppliers, communities, and, bringing up the rear, shareholders. The problem with that pesky “all” lies in the nature of these commitments. The word “stakeholder” has a built-in ambiguity because it begs the question of whether failure to meet some particular “commitment” is backed by a legal obligation to mend ways or pay damages in the event of any corporate malfeasance.
James Copland of the Manhattan Institute takes comfort in the simple yet powerful fact that the statement does not undermine the specific fiduciary duties that corporate boards and officers only have to their shareholders. In contrast, the Wall Street Journal is much more troubled that “Stakeholder CEOs” will find it all too easy to subordinate the interests of shareholders to other stakeholders, given that they sit last on the list of protected parties. And more progressive groups find this same Delphic pronouncement to be “a monumental step toward setting broader standards for corporate leadership”—though they wonder if this “shocking reversal” in priorities is achievable by the current group of American CEOs.
It is easy to see how a broader rendition of this statement can unload heavy artillery on the free market. The next iteration could read, as Bernie Sanders would have it, as a universal commitment by all corporate CEOs to embrace higher minimum wage laws, the narrowing or eliminating of income inequality, and, of course, a full scale campaign against global warming, even if all of these undertakings would dramatically diminish corporate bottom lines.
Yet so much of this modern rhetoric relies on the premise that thinkers like Milton Friedman made serious errors in reasoning that today’s CEOs have corrected. To make a better assessment of that claim, it is necessary to go back to first principles. First, Friedman never denied that any serious business had to have good relationships with its customers, employees, and suppliers. But it hardly follows that businesses owe special or fiduciary duties to these stakeholders, which is how the BR statement is commonly being read. Within corporate law, fiduciary duties arose, especially within public corporations, to offset the fundamental structural imbalance when ownership was separated from control, as is common whenever a large group of diffuse shareholders become passive investors in a venture controlled by corporate boards and officers. The fiduciary duty is one key tool for making corporate officers and directors protect the investors who have entrusted them with their wealth.
There are two levels of corporate duties to shareholders. First, corporate boards and officers deal at arm’s length with outsiders, and here, their responsibility is governed by the so-called business judgment rule, which protects them against suits by shareholders so long as they follow appropriate procedures in reaching a decision and act in good faith to maximize shareholder value. This rule both constrains corporate insiders but also protects them from liability if their good faith efforts turn out less well financially than expected. Indeed, if officers had to make good on every loss that occurs when deals go sour, no one would take on such roles. And second, whenever corporate officials enter into any kind of self-dealing transaction, the standard of care is much higher, given the conflict of interest. For such transactions, insiders must analyze whether corporate shareholders received “fair value” from the transaction.
One way to cash out the verbal switch from shareholder to stakeholder is to insist that similar fiduciary duties now apply to both groups. But this proposal is a bad idea for two reasons.
First, the stakeholders are not passive investors. They can negotiate on their own behalf in order to protect their own interests, both in the short and in the long-term. Every corporation knows that these counterparties will look after their own interests. These parties, like the corporations they deal with them, require long-term contractual protections, which they get under the Friedman view.
Second, the broader stakeholder model makes it impossible to discharge fiduciary duties to multiple parties simultaneously. One reason why large corporations tend to have only a single class of shares is to minimize unnecessary conflicts among shareholders. However, the expanded stakeholder model suffers from one of two fatal objections. Either the directors and officers of the corporation must be persuaded into looking after the interests of other parties who are not present, or these boards must expand membership to accommodate these interests, at which point they lose compactness and coherence. In the extreme form, stakeholder corporations might have to accede to Sen. Elizabeth Warren’s wacky Accountable Capitalism Act, in which government officials get to appoint 40 percent of each board of a corporation worth $1 billion or more—effectively, a partial nationalization of trillions of dollars of corporate assets.
The counter-argument to the Milton approach is that corporations that continue to work under the existing rules will remained flawed. First, they will be greedy. And second, they will engage in antisocial activities, such as generating pollution.
But there are four responses to these charges. First, Friedman’s position does not prevent the formation of corporations that have express charitable functions, such as churches, hospitals, and universities. Second, corporations can, should, and do make contributions to socially beneficial organizations to the extent that such contributions improve shareholder value. Such gifts could advance goodwill by supporting local charities, or by attracting employees who might prefer to take a lower wage in exchange for working for an enterprise that supports social causes. Third, individual shareholders can donate either their dividends or appreciated shares to charitable causes, thereby avoiding the potential conflicts of interest that arise when firms make controversial contributions to certain organizations or causes that other shareholders oppose, like Planned Parenthood or groups that oppose same-sex marriage.
Finally, all corporations must comply with laws and regulations that, for example, limit the amount of pollution a corporation can generate, or that set terms and conditions for labor contracts. It is well understood that all fiduciary duties exist within this legal framework. Indeed, it has long been understood that a trustee is never under an obligation to perform some illegal action even if the action would be profitable to the trustee’s beneficiaries and the trustee could get away with it.
It is therefore all too fashionable today to argue that certain recent events have exposed a fatal weakness in the traditional model of corporate responsibility—a model that has generated so much wealth and economic success over the years. This overwrought charge should be rejected. The key problems run in the opposite direction: government regulations and taxes imposed on corporations attempting to advance certain social improvements. Socialism, heal thyself!
