14 Apr 2022
From board composition mandates to newly proposed climate-related disclosures, corporations are being challenged to consider non-financial factors alongside traditional business metrics when making decisions about how their operations affect broader society. This is prompting some to question whether companies should shift their focus from maximising shareholder returns to stakeholder capitalism.
In episode 44 of The Flip Side, Global Head of Research Jeff Meli is joined by guest host James C. Spindler, Hart Chair in Corporate and Securities Law at the University of Texas Law School and Professor at McCombs School of Business, to discuss a range of government, social and corporate forces that are converging to redefine the primary objectives that corporations set out to achieve.
Jeff Meli: Welcome to the Flipside, I'm Jeff Meli, the Head of Research at Barclays, and I'm speaking today with James C. Spindler, the Mark L. Hart Endowed Chair in Corporate and Securities Law at the University of Texas Law School. He's also a professor at the McCombs School of Business. Thanks for joining me today, James.
James Spindler: Thanks for having me.
Jeff Meli: All right. Today, we're going to talk about corporate purpose. That's the objective that corporations set out to achieve. Now many people believe that corporations are currently too focused on their shareholders and motivated in part by some recent corporate scandals, like the role Big Pharma companies played in the opioid crisis. The proponents of this view think that we would get better outcomes if corporations took into consideration a broader set of stakeholders.
James Spindler: Yes, that's right. There are some concrete policy proposals currently out there right now that are intended to make this a reality. And they would do that by changing who governs corporations, primarily by changing the membership of the Board of Directors. So, as an example, as a candidate for President, Senator Elizabeth Warren proposed a law mandating that labor be represented on the boards of large corporations. And this is not a far-fetched or unprecedented proposal. Germany has a similar system to what was proposed in the Accountable Capitalism Act. And so, others have proposed rules mandating for board diversity.
So, NASDAQ currently has such a proposal that's currently undergoing SEC comment. California enacted such a law requiring diversity on its boards. However, these things can be contentious. One example of that is that the California law was recently struck down on equal protection grounds.
Jeff Meli: James, even more recently, the SEC proposed new requirements for climate related disclosures for public companies in the U.S. And one of the motivations for that proposal is to facilitate ESG investing, which is really all about convincing or forcing corporations to consider non-financial factors alongside all the traditional business metrics they usually consider when they're making decisions.
James Spindler: Yes, and the SEC proposal is controversial too. Some of this criticism is technical, like whether the SEC actually has the authority to do this. Some of the opposition is more substantive. And so, what we're seeing is that there's substantial factions on both sides of these issues.
Jeff Meli: Well, let's start with the traditional view of corporate purpose. And then we can talk about how this might change. So, the traditional view for corporate purpose is shareholder maximization. This was a view that was first articulated by Milton Friedman, in 1970, he wrote, "The social responsibility of a business is to increase its profits." I think that's like a pretty easy concept. And I think it's also aligned with how most people out there with just sort of naturally think about the role of a corporation, it exists to make as much money as possible.
James Spindler: Yes. And there's economic support for this view, as well. And that's essentially based on the fact that shareholders are what we would call the residual claimants. And what that means is that to the extent that the value of a corporation goes up or down in value, we would expect the shareholders are the ones that enjoy those gains or bear those losses. At least that's true for solvent corporation, once you have an insolvent corporation, those gains and losses are probably going to be borne by somebody else.
Jeff Meli: Just to be clear, when we talk about maximizing shareholder value, that doesn't mean you know, companies should dump mercury in a reservoir, if that helps them make more money, it really means maximizing shareholder value in the context of the applicable laws and regulations that govern how corporations behave. So, the idea is, society sets guardrails, and those define sort of the acceptable realm of behavior. And then corporations maximize shareholder value conditional on staying within those boundaries.
James Spindler: And those rules are really everywhere around us. Some are very widely applicable, we might look at things like minimum wage laws, workplace safety laws that are designed to force companies to behave in a certain way with regard to their workers. You can look at things like the tort system, which generally say that if you negligently injure folks, you have to pay for it that applies to corporations too.
And then we have industry specific rules as well, especially where we think we have particularly dangerous or sensitive industries, such as in the realm of environmental regulation, or banking regulation.
Jeff Meli: So, James, I think this is the traditional view for a reason. I mean, there's a lot of benefits of this approach. I think one of them is that the directive for corporations is pretty easy to follow. You obey the rules, but otherwise go out there and make money.
The guardrails so to speak, they are determined by regulators and policymakers, that means that they apply widely, and they're not subjective. So, when I say they apply widely, it means every corporation is subject to exactly the same rules, they don't decide which rules are going to follow or tweak them in some way. They're all sort of operating under the same system, and then left to compete with each other.
And I guess then, of course, there's also the notion that the corporations themselves aren't the ones who devise the rules, society, devise the rules, decides what's OK and what's not. OK. We don't leave it up to the entity who's going to either make more or less money as a result of the rules. And that sounds actually like kind of a clean system. So, what's the problem here?
James Spindler: Well, maybe there's not a problem. You know, after all, the U.S. does have a large and successful corporate sector, the residual claimant theory is a pretty good theory, again, so long as you have solvent corporations. And as long as you have good rules, shareholders ought to be internalizing the costs and benefits of corporate activity, and that ought to lead to maximizing overall social welfare.
But a key component of this is that corporations really will be internalizing all these costs and benefits. And that does rely in part on government setting the right guardrails. So that's what stops corporations from making money in ways that cause harm to society.
And one thing we've seen recently is that it's not clear that our system is particularly good at keeping up with corporations. We think when we look at firms in the financial sector, or the energy sector that these firms maybe know their business better than the government does, in short, they might have more resources, they might even be smarter than the folks that government that are setting the regulations.
If you're relying on the legislature to pass laws, that takes time, if you're relying on regulatory agencies to pass regulations, they have limited budgets and limited personnel. So, the first company that figures out it can find a loophole, and it can, for instance, make money dumping mercury in a reservoir, well, then the prediction is at that company that's figured out that loophole is going to exploit it. And then only later, perhaps government or regulators figure out that something bad has happened. And that's when the rules adjust.
So, if you look, for instance, at the financial sector, or banking, more particularly, which is an area that I work in, you see that a lot of these rules, and laws come about after something really bad has happened. So, after the Great Depression, we get a lot of our modern banking law and a lot of our modern securities law. Same thing, when you look at the financial recession in 2007-2008, we get all sorts of law that's designed to prevent problems like that occurring, but we don't get those rules until those big meltdowns have actually occurred.
Jeff Meli: That's interesting, because I can think of some other examples as well in other industries. So, one is, we've had a rise in gig economy workers, right, with all the companies that use workers as sort of contractors on a job-by-job basis, rather than making them full time employees and California recently proposed a law that would have effectively required a lot of those workers to be treated like full-time employees, I guess, under the notion that maybe these companies were effectively relying on the government to provide the sorts of things like unemployment insurance, or support during downturns that a company would normally be expected to apply to their full-time employees. But that law didn't get passed, it was up for referendum and was rejected.
You've seen modern problems around data privacy, as another example where big tech companies have obviously a lot of incentives to make money off of all the data that they capture as people use their products. But there's a lot of concern about whether that use maybe violates people's privacy in some way that we're uncomfortable with as a society, but we're struggling to craft the laws that address that. And I guess my favorite example, going back to a Flip Side episode a few months ago, is the carbon tax.
The carbon tax was first proposed in the United States in 1973. That's almost 50 years ago, subsequent to its first proposal, we've now emitted 50 years' worth of carbon without taxing it, despite I think a large consensus that releasing carbon into the atmosphere has costs for society. I guess another sort of challenge is this notion of whether or not corporations actually have a say in the rules.
There's a big concern about regulatory capture, whether it's through lobbying or sort of a revolving door of regulators moving into the corporate sector after their stint in the government, that there's sort of channels through which corporations can in fact influence the rules.
James Spindler: Yes, that's absolutely true. As these industries become more and more technical, the only folks that can write meaningful rules and regulations to govern them are industry insiders.
So, we really do have this problem and even many of our government regulatory agencies do rely on the revolving door just to have personnel that are capable of dealing with these industries. So, if the basic problem is that you think corporations are smarter than the government, then perhaps one solution is to try and give corporations better incentives, so that they'll do the right thing on their own and govern themselves in a way that's maybe more pro-social.
And that I think, is part of the motivation behind stakeholder capitalism. The idea is that if you can affect the composition of the decision-making body of these entities that they will consider the interests of other stakeholders, maybe society at large, and not just the shareholder. And so, then you can kind of cut out the government middleman of designing the guardrails, so to speak, when they're deciding what they do. And so, there's particular examples of this that people point to.
So, AOC (Congresswoman Alexandria Ocasio-Cortez), for instance, has made a recent statement about the importance of having worker representation in the governance of companies. So, if you have worker representation on the boards of these companies, or they're taking into account worker interests through a conscious process, maybe then we don't need to worry as much about writing regulations that are designed to protect workers.
Jeff Meli: So that's interesting. And I think you mentioned, even a constituency as broad as society, right? So, employees are obviously a constituency of a company, customers, probably is another constituent, you think about my data privacy example that's really more focused about the customers of a company. But you mentioned society and I think that's interesting. It's quite broad, obviously.
But you could look at even the 2016 election and see the criticism that for example, Facebook received for not, say protecting American democracy, because it was allowing inaccurate political advertising through its system. And you could see that that the kinds of concerns we're talking about can be very narrow, like the people who show up in your building every day. And they can even be as broad as like our entire political system.
James Spindler: So, I think that is a – that is a serious and profound criticism. If you believe that a company like Facebook is able to sway the election. That's a serious concern. And it does implicate the ability of government to effectively govern if you think that democracy itself is up for grabs in this sense. So, this does kind of lead to the point of whether corporate interests are actually opposed to societal interests. And this is something that a lot of these proposals are somewhat squishy on.
Many of these proponents of whether it'd be ESG, or diversity on boards, or labor representation as with the Accountable Capitalism Act, they tend to conflate the concept of society's interests in long-term profits.
So, much of what you will hear with regard to these stakeholder capitalism proposals is that what this really does is that this forces the company to focus on the long-term, and then in the long-term, this type of focus will in fact, be better for the corporation and shareholders and society. But that's kind of a rosy view of things. And there are probably many cases where what's good for the corporation, if the guardrails aren't there, just aren't good for society.
So, dumping mercury in the river would be a prototypical example of such a case. And so, if you really take stakeholder capitalism seriously, then what that means is a tradeoff between shareholder welfare, the productivity of the corporation and the welfare of other stakeholders out there in society.
Jeff Meli: Yes, I agree that this is a point of confusion and I think a point of contention. So, for example, some big asset managers out there have started to push companies towards a more pro social direction.
And I think when they speak about it, they do sometimes confuse whether this is really what's truly in the interest of shareholders in the long run, or is it a sacrifice or a tradeoff between the welfare of shareholders and other stakeholders? And I think that actually, in some cases, they've received a backlash, in part from shareholders maybe and also from sort of commentators who believe that the current corporate purpose is a good one, and is very productive.
And so, I do think that you really have to figure out, are you talking about activity that truly sacrifices shareholder welfare, for some broader objective? That's really stakeholder capitalism. The other bit like, it's really better for you, you just don't realize it to take a longer term view. That's just like a different take on the traditional view, right? It's like saying, you're executing your traditional mandate, but you're not doing it in the right way. And I think what we're really talking about here is, when the interests of shareholders and stakeholders are not aligned.
James Spindler: Yes, if it's a win-win for everyone, then it's an easy decision. And this makes everyone better off and there's really no reason to debate it, but that's probably not true. And it's certainly not true in every, every case. Right. But that said, there has been a backlash to some extent against these stakeholder capitalism initiatives, as we've come to realize that there are probably significant costs associated with it and significant tradeoffs.
Now that said, just in the course of the past five or ten years, I think stakeholder capitalism has gone from something of a fringe view in Corporate America to being something that's being taken very, very seriously. You see that with ESG, You see that, just with the dialogue that's occurring today.
Jeff Meli: James, that sounds sort of aspirational to me that we can just convince corporations that this is important. And then they're going to embark on this shift in their purpose. Certainly, in a prior Flip Side, I was a bit of a skeptic on the long-term implications of ESG investing on corporate behavior.
I mean, in the end, corporations are operated by representatives of shareholders. So ultimately, shareholder welfare is the main objective. So, how can you practically embed stakeholder concerns into corporate decision making?
James Spindler: Well, that's a great question. And it's true, as long as you leave the same shareholders in-charge, we wouldn't expect very much to change. And that's where some of the stakeholder proposals have, I think, an innovative concept that has some promise to actually do something. And that's by actually changing the composition of the Board of Directors. And there's various ways of doing that the diversity proposals would seek to simply make Boards of Directors more diverse, probably disrupts the way the Boards of Directors are chosen.
The inclusion mandates such as the Accountable Capitalism Act would actually have directors that are elected by labor and therefore are accountable to labor to some extent. And so, once you've done this, you've essentially changed the composition of the people that sit around the Board of Directors table.
And a seat at the Board of Directors table is obviously an important thing. It's probably worth something in particular, right? So, it's – you could conceive of it as being a property right of sorts, you have the power to hold up board actions, you have the ability to participate in deliberations and decision making, there's a potential for log rolling, it probably facilitates efficient contracting.
So, for instance, if you have employee representatives on the board, they can strike a deal with management in some way or another that they wouldn't have been able to do without that board seat.
Jeff Meli: First glance to me, this seems like swapping one owner for another, like I take your point that it is like a property right, right. It's like a property right over a corporation.
And so, I can see why, for example, putting labor on the board, you might take some of what is currently shareholder value, and you effectively award it to that other stakeholder in that case, labor, maybe you would get higher wages, or you would get increased pensions coming at a shareholder expense. But what I don't see is how that actually changes corporate behavior.
OK, we're splitting the pie a little bit differently. But it would strike me that at least at first pass, everybody who's sitting around the table still wants the pie to be as big as possible.
James Spindler: That's certainly one of the economic predictions of what might happen. So, it's quite possible that corporate behavior itself really isn't going to change. And what you're going to have is a distributional change, that the corporate engine is going to keep creating value the same way it was creating it before. But that pie is going to be sliced up differently. If you put workers on the board, then workers are going to get more of that corporate surplus, even if the corporate activity itself doesn't change.
Now, as an aside, there is some evidence that in Germany, where labor is on the board through their process of so-called Corporate Co-Determination that you actually do get improved bargaining between labor and management. And you might imagine that this just improves the informational flows between labor and management, because instead of meeting in the form of, say, labor negotiations, which can be contentious, that they're all sitting around the board, the board table, and that's just a better way of negotiating and bargaining.
So, this might reduce strikes, it might help address workplace issues more effectively. And overall, it might actually improve performance. So, you might actually get a bigger pie just from improving, improving the bargaining dynamic that takes place between these constituencies.
But that said, in many cases, Jeff, I think you're right, that if all you're doing is swapping out corporate owners without anything more, that shouldn't really affect corporate purpose or corporate activity overall.
Jeff Meli: Yes. But before we were talking about an example where you dumped mercury into a reservoir, which is obviously hypothetical, but you can imagine now maybe a different scenario, where if you're putting someone on the board who uses that water, right, so who's harmed by the activity of the corporation, maybe now that's a place where you could actually start to affect behavior.
And what we're really talking about there is the concept of a negative externality. So, some activity of the corporation imposes a cost on someone out there someplace that the corporation by itself would largely ignore or not take into account when it makes this decision. And if we found that person and put them on the board, now, maybe we could actually change the way the board operates.
James Spindler: Yes, that's right. And that's where I think these proposals get really interesting and potentially may fulfill their purpose of causing corporations to serve society better. Many of the examples that we think of where the government has failed to put up the right guardrails, where they failed to put up the right regulations will create externalities.
So, the pollution dumping would be an example, if the corporation's been dumping mercury on the town of Springfield, putting Springfield representatives on the board will bring that cost into the boardroom, it'll be something that they'll be able to bargain over. And so, we might get an efficient outcome where we had an inefficient outcome before.
You can think of current or recent real world examples, such as the bailouts that occur seemingly, whenever we have a significant financial crisis, taxpayers end up being on the hook for these bailouts to a large extent, that is an externality, right. So, if we have some way of representing those interests, on the boards of these financial institutions, maybe we should expect less risky behavior.
Similarly, if you have some way of putting a representative for the environment on the board of a company that is putting carbon into the atmosphere then that corporation itself may start to internalize the cost of the carbon that it's actually pumping out. Now, there's a tough question of who exactly would do that.
And you find the Lorax, who speaks for the trees and put him on your Board of Directors, that that raises a whole host of tricky questions about who the right representative for these issues would be. But that said, these things seem to have some promise to them in that, in that regard.
Jeff Meli: What I think we're saying here is that we're talking about swapping, the need to craft effective regulations sort of in advance of bad behavior, right? So that we, we have sort of modern and current guardrails at all times, we're going to drop that and somehow we're going to do instead is, we're going to identify the issues or the sources of externalities that we need to be worried about.
And we're going to make sure we get the representatives of those issues onto boards. I mean, that by itself also seems like a challenge, right? Like, we know, we talked a lot about what the challenges are with crafting the right regulations, but you have to still have to be pretty forward thinking, it would seem to me to identify all of the issues that corporations might drive and make sure that they're represented on boards.
And I guess you'd need some sort of a system to make sure that corporations we're sticking to that those issues and find – and sort of discovering them as they arose.
James Spindler: I think that's exactly right. That is the tricky thing here is that we can identify the social need, whether it be something like global warming, or pollution, or systemic risk, finding the right representative for that is tricky. There's also an additional problem of making sure that those representatives have adequate skin in the game. And there's a few ways of conceptualizing this. One is that let's say I'm an environmentalist. And so, in order to cause our subject corporation here to internalize environmental welfare a little more, we put me on the board.
Well, I may have some preferences or better environmental outcomes. But at the same time, the corporation has some ability to buy me off, given that I have this now valuable property right of being able to direct corporate activity, I may have some preferences for the environment, but I myself don't internalize everything that could possibly happen to the environment all around the world. So, you need to make sure when you're putting people on the Board of Directors that they are accountable in some way.
So, the labor representation has some accountability built in, in that the labor representatives that would be appointed under Senator Warren's Accountable Capitalism Act would be elected by labor itself. And so, if those labor representatives fail to represent labor's interests, they'll get voted off. And so presumably, then they will represent those interests fairly.
Again, it's more tricky to figure out how to do that with something like environmental concerns. If I get bought off by the – say the oil producer whose board I'm serving on, the whales and the trees aren't going to be able to get me fired from my Board of Directors position. So that is a tricky issue. And it's this issue of making sure or that there's adequate skin in the game with the representatives that we've now included on the board via our stakeholder capitalism mandates.
Jeff Meli: And you know, having skin in the game can be even trickier, even for stakeholders like labor where there's an obvious like that people have jobs at the company, for example. But, there's an interesting example with Volkswagen and the diesel scandal where there's certain commentators who believe that labor had sort of a cozy relationship with management, or at least labor leaders did.
And they – one way or another looked the other way, whilst this sort of emissions avoiding system was being built and implemented, and, you know, maybe because labor was going to get some of the upside from better sales and have more employees or better wages, but then when it got discovered, the shareholders ended up being on the hook.
So, all the fines, for example, were paid by the shareholders, which is traditionally who is on the hook for that. And so, you ended up with these, I think, maybe twisted incentives where labor had an incentive to – maybe not facilitate, but at least look the other way, as this was being done. And that didn't actually bear any of the downside.
James Spindler: That's right. That's right. And the basic point is that you can put labor on the board, and you may be able to make the Board Representatives accountable to labor. But at the end of the day, labor's interests are not the same as society's interests. And so that creates a host of potential problems.
One would be this issue of, they might have the upside from emissions tampering, and not a lot of the downside. And that does seem to be true. If you look at say the way the Accountable Capitalism Act is written, if there were a corporate scandal, and the company was restructured as a result of that, and emerges, say from chapter 11, labor would still have its seats on the board.
So, their interest in the corporation hasn't been extinguished by the fact that the corporation failed, right? That it violated the rules, got punished and was driven into bankruptcy, labor emerges with its interests intact.
So, in that sense, they're not the residual claimant in the way that the shareholders might be. So, they might actually have worse incentives than shareholders and having labor running the firm in that case might lead to more anti-social outcomes than would shareholder governance running the firms.
Jeff Meli: Another potential pitfall of awarding labor a substantial fraction of a corporation is that it could result in excessive risk aversion. One of the sort of benefits of a shareholder model is that shareholders are generally considered to have very diverse exposures. So, they have a big diversified portfolio, because of the law of large numbers, they will be supportive of profitable investment opportunities that come with risk, right.
So, your corporation, faced with a great new project, there's some tiny chance that it results in a bankruptcy. But as a shareholder, you would like them to participate in that project, because it has expected outcomes that are positive and the shareholders can sort of diversify away the downside risk by having lots of these sort of bets going across the corporate universe.
But workers obviously work at one company. And so, if the workers have a large stake in that company, it's necessarily not diversified. And they might actually choose to reject that project. And so, if you took this too far, you might end up actually creating disincentives to invest.
James Spindler: Yes. And you'd have to ask, could you have a company like Tesla, making cars in a place like Germany, where labor is sitting on the board with its somewhat risk averse incentives, we don't really have the ability to run experiments and the data are always going to be imperfect when making these sorts of comparisons.
But there's a pretty good argument to be made, that it really is only something like shareholder governance that could lead a company like Tesla to be successful in an environment like the United States, then you just wouldn't be able to roll the dice and take those risks, which in this case, seem to have been relatively good risks that are starting to pay off.
And it's possible that if we move away from shareholder governance and endowing say labor, with these control rights over firms, that we're going to end up with less of those sorts of good risks as well as less of those bad risks.
Jeff Meli: Well, James, what I take away from this conversation is that there are some issues with the current system, and maybe a stakeholder-based system would address some of them, but implementing that in reality presents many of its own hurdles, a lot of which are not acknowledged by the supporters of change. Anyone interested in learning more about this topic can read James and my recent research on it entitled The Promise of Diversity, Inclusion and Punishment in Corporate Governance.
See the related paper authored by Jeff and James, “The Promise of Diversity, Inclusion, and Punishment in Corporate Governance”.
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