To whom should corporate boards be responsible?

John Quiggin argues against the notion, popular at my alma mater, that a company's only duty is to maximize shareholder value.

So, presumably, the obligation to maximize profits is a matter of enlightened self-interest. Posner argues, plausibly enough, that a company that doesn't maximize profits is weakening itself in competition with other firms. To be more precise, the probability of bankruptcy or hostile takeover is presumably increased by deviations from profit maximization. But this doesn't mean that the probability of firm survival is maximized by maximizing profits. And there's no obvious reason why socially concerned managers couldn't conclude that the strategy that yielded them the best expected personal value, adjusted for the risk of corporate failure, was one in which the company pursued broad social goals.

Well, for starters, the managers aren't supposed to be maximizing their best expected personal value, which might well involve embezzling if they could get away with it.  They are supposed to maximize value for the people who hired them, i.e. the shareholders.  Now, one can hold arguments about whether the corporate board system has become dysfunctional, with CEOs manipulating the composition to give themselves excessively high pay.  But that would still be a violation of the board's responsibility to the owners--the other "stakeholders" have no just cause for complaint.  It is not enough to say that they have an interest in the outcome.  We make distinctions between positive and negative rights for good reason.  You have a very strong interest in the outcome of cancer research.  That does not give you any right to force cancer researchers to work on any terms you care to name.

But from a strictly economic perspective, this also misses the point.  Diminishing the fiduciary rights of shareholders raises the cost of capital to the firm, because it lowers their expected return.  America has extraordinary deep capital markets precisely because we reward shareholders for investing here.  Giving the "stakeholders" control over the process is a one-trick pony--you temporarily seize accumulated value for them, at the price of slowing capital accumulation, and hence productive investment, and hence growth, in the future.

Comments

"John Quiggin argues against the notion, popular at my alma mater, that a company's only duty is to maximize shareholder value."

No he doesn't. Quiggin argues against Posner's claim that "The managers of corporations have a fiduciary duty to maximize corporate profits." Quiggin repeated this, and you quoted his restatement.

You completely missed the point of Quiggin's and Posner's exchange.

Posted by rick | July 25, 2008 2:22 PM

Wow, this gets better and better. McArdle is a true supply sider!

Posted by Crusader | July 25, 2008 2:26 PM

Ah, the Principal-Agent Problem. Solving it would yield even more fruit than proving Fermat's Last Theorem ...

Posted by caveat bettor | July 25, 2008 3:18 PM

And there's no obvious reason why socially concerned managers couldn't conclude that the strategy that yielded them the best expected personal value...

Management by narcissim. Good one, John!!

Posted by matt | July 25, 2008 3:19 PM

matt-

Do you disagree with your quote of Quiggin? Quiggin's describing something that a manager may conclude--it is perfectly reasonable that a manager may belief that his personal interests are in the interests of maximizing profits. Quiggin isn't advocating this, just describing it as a possibility.

Posted by rick | July 25, 2008 3:27 PM

"Enlightened" executives are free to "do good" with their own paychecks, but they should leave company money out of it, with the possible exception of paying for "good will" in the hopes of better sales and more profits in the future than would otherwise be the case.

Corporate profits should either be reinvested to make even more profits or else be distributed to shareholders. It is immoral to use shareholder money in ways that can not profit the shareholders. If the stock holders wished to use their investment money to do good deeds instead of making profits, they would have given it to a charitable organization instead of buying shares in a for-profit company. Taking their money, even for supposedly good reasons, is simple theft.

Posted by Nelson | July 25, 2008 3:35 PM

"It is immoral to use shareholder money in ways that can not profit the shareholders. "

Like, its totally immoral to NOT enslave people if it'll make my 401(k) bump!

Posted by rick | July 25, 2008 3:42 PM

Am I the only one who thinks that maximizing corporate profits and maximizing shareholder value are not necessarily the same thing? Is it not possible to destroy a company by maximizing short term profit at the expense of everything else?

At some point people will realize that a company with a reasonable price/earnings ratio and good long term prospects is a good investment.

A long term strategy includes obeying the law, giving good value to customers, not squeezing the suppliers too much, and otherwise not fouling its own nest.

I don't know how you set up the incentives for the executives and board to encourage that way of thinking.

Posted by BobW | July 25, 2008 4:36 PM

rick,

Must every statement be qualified with "legally" at the end in order to avoid your silly accusatory hypotheticals?

"It is immoral to use shareholder money in ways that can not profit the shareholders [legally]."

I fail to see how any serious person that respects property rights can disagree with this. I do understand the money grubbing, covetous thieves would argue for requiring corporations to spend money on things that don't make them money in return.

Generally speaking, corporations that don't offer some form of contribution to society don't last long. You may wish those corporations were completely illegal from the get go, but I'd prefer that we don't have a corporation cazar that dictates what a company can do and what they must do to help society.

Leave the corporations to making money and leave the helping of society to... geee, society. You and me. Stop complaining that Exxon isn't doing enough and get off your butt and go help someone.

Posted by sam | July 25, 2008 4:53 PM

"...for starters, the managers aren't supposed to be maximizing their best expected personal value ..."

I genuinely thought this was the set up for a joke, but the punchline didn't come.

Posted by Njorl | July 25, 2008 4:58 PM

"Is it not possible to destroy a company by maximizing short term profit at the expense of everything else?"

Of course it's possible, but this does not maximize overall corporate profits or the stock price. What happened to Enron's stock price, and how profitable has it been lately? No one is arguing that managers should focus on only short term gains. Granted, making sure that managers find the right balance between short and long term goals is tricky and the subject of much research. The main argument in favor of focusing on the current stock price is that the stock price takes into account not just current but also expected future earnings, adjusting for risk.

Managers should maximize the returns to the stockholders because the stockholders are last in line. As the residual claimants, they get paid only after everyone else, including employees, suppliers, the government (i.e. taxes), etc. To get money to the back of the line, the company must first fulfill its obligations to everyone else, so everyone gets paid.

As for pursuing personal agendas, how would any of you feel if you deposited money in a bank or a retirement fund, but the manager decided that you probably wouldn't make good use of the money and that it was more socially desirable to donate that money to the manager's favorite charity? Let the manager donate her own money!

Posted by Ann | July 25, 2008 5:14 PM

Megan,

My comment here got held for approval. In the event that's not the same thing as the circular file, take a look at it. It includes a quote from Berkshire Hathaway's 2006 annual report (and a link to that report, which is probably why the post got held for approval) that's relevant to this discussion.

Posted by DaveinHackensack | July 25, 2008 5:49 PM

Some corporations have bad investors who only want short-term profits at the expense of bad strategic decisions(see GM, Ford). Those investors did well, and if they're smart sold their shares a while ago.

Posted by Crusader | July 25, 2008 6:26 PM

I seems some people are confused with what employees/mangers/executives *should* do as individuals and employees of the company.

It's really not difficult. Do everything within the rules to maximize your personal value, while at the same time do everything within the rules to benefit the company and its shareholders according to (and above and beyond at times) your job description.

So yes, I will leverage my position and abilities to get as much personal gain as I can from the job. If I get paid more and decide to donate that to fight global warming.com or something thats fine. But I don't, as an employee or a manager decide that my company needs to donate to cause X simply because its important -- unless it's a part of a broader strategy of maintaining a positive corporate image to retain customers/sales. That doesn't make the donation any less sincere -- ie just because they hope to get something in the long run out of their donation doesn't mean its bad. If you feel otherwise, please proceed to donate everything you own to charity and then we'll talk -- except we won't because you won't have a computer.

Is this really hard to understand? Companies should not do what they can't make money doing. You should not dictate what a company should do to make money. I don't want the prices of things going up because every guilt-conscience consumer blackmails companies into donating to charity for their business.

Companies should provide value goods and services, while employing people to accomplish that end. Individual members of society should help each other out.

Seems fair to me. I don't need Microsoft to donate to Charity, but it's nice the Bill Gates does.

Posted by sam | July 25, 2008 6:29 PM

A better question might be: to whom should corporate managers be responsible?

In theory they report to the board. But since in many or most cases they have captured the board...

Kind of amazing that corporate charters allow managers to sit on their own boards, be their own bosses.

Something of a digression, I agree.

Posted by Steve Roth | July 25, 2008 7:10 PM

The only valid argument for "socially" responsible corporations, is that corporations are the most efficient vehicle to deliver social services. This may be true, but I doubt it.

We got in trouble when we started to think of corporations as vehicles for social services, without creating a legal structure to accompany it. Giving board's a duty to stakeholders is a reasonable idea, but I've never seen a legal structure that provides for doing so, while providing for accountability.

Maybe giving standing to stakehodlers to sue in court, like shareholders, but this would be a huge strain on our court system. I just don't see how it could work.

My conclusion: rely on corporaitons to make money, rely on governments to provide social services.

Posted by Travis | July 25, 2008 8:10 PM

As far as I can tell, Quiggen is making a non-point and a feeling good about making it. Generally speaking, all for-profit business entities owe their existence to investor(s) whose principal motivation for investing was the expectation that a positive return was more likely then not. If they wanted to turn their money into something else, there are plenty of non-profits and charities for them to choose from, or adequate mechanisms to start yet another.

It is possible that any given company can improve the investors' ROI by making certain social investments in the workers' health and well-being (to improve their job satisfaction and/or productivity), or by engaging in acts of community service (to bolster good will in the community). Perhaps these are the kinds of things Quiggen has in mind; however, at some point these acts must ultimately contribute to the company's bottom line or be very small relative to the scope of the company's operations. Value-maximizing or within the noise margin, in other words.

The company that begins targeting "broad social goals" will correctly communicate to the for-profit investors that their ROI is better elsewhere, and many will reinvest accordingly. Like, for example, the fund managers that handle the stock-invested portion of my 401(k), which is expressly not intended for achieving anyone else's broad social goals. Long term it either grows at/above the market average, or it leaves for greener pastures.

Posted by aMouseforallSeasons | July 25, 2008 8:14 PM

Laissez-faire economics and profit-maximization: the current economic and regulatory structure must be like ice cream on a stick for you.

Posted by masaccio | July 25, 2008 11:55 PM

You need to read Daniel Davies' post on this and respond to it, Megan, or you're not really participating in the conversation.

Posted by Christopher M | July 26, 2008 12:09 AM

actually - from the strictly economic perspective - the cost of capital does not change, that is dependent only on the covariance of returns with the market portfolio.

it increases the probability of lower cash flows and therefore reduces the expected value of the firm's future cashflows.

Posted by gsbalum | July 26, 2008 12:12 AM

At my children's school, 5th grade teachers argued that, as consumers and investors, we should only buy from or invest in companies that practice "social justice."

I asked my kids, how will they rate companies for social justice? Will they conduct extensive research into the business practices of each and every company — not just the Starbucks of the world, but every company that makes a product? If a company is found less than perfect, will they boycott? What if their favorite store fails to live up to high standards? Will they have to shop with a scorecard?

It didn't take much convincing. My kids found the lesson too difficult to follow. They want to buy things they like, shop in stores with good products and good prices, invest in companies that seem poised for success. They don't want to keep a scorecard.

Posted by DebbieSim | July 26, 2008 2:43 PM

Apparently, when comments get "held for review" they disappear. Here's the relevant quote from Berkshire Hathaway's 2006 annual report (p.18) that I referred to earlier:

In selecting a new director, we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say “truly” because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on directors’ fees to maintain their standard of living. These payments, which come in many forms, often range between $150,000 and $250,000 annually, compensation that may approach or even exceed all other income of the “independent” director. And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is not.)

Charlie and I believe our four criteria are essential if directors are to do their job – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?”

Posted by DaveinHackensack | July 26, 2008 4:39 PM

"This doesn't mean that the probability of firm survival is maximized by maximizing profits."

Yes it does. In the context of business, "maximizing profits" is a matter of intent, not result. The more your intent is to maximize, the more likely you are to survive in a world where the vast majority of businesses don't. Quiggens needs to familiarize himself with the "grain in the balance" principle of competition.

Posted by M. Hodak | July 26, 2008 6:04 PM

OOO, Interesting story))

Posted by Hiposaasa | July 26, 2008 7:15 PM

Properly understood, the fiduciary duties of directors do not require them to "maximize profits." My take on the definitional question is premised on the notion that boards of directors sometimes face decisions in which it is possible to make at least one corporate constituent better off without leaving any constituency worse off. In economic terms, such a decision is Pareto efficient—it moves the firm from a Pareto inferior position to the Pareto frontier. Other times, however, they face a decision that makes at least one constituency better off but leaves at least one worse off. The familiar concept of zero sum games is just the worst-case variation on this theme. Imagine a decision with a pay-off for one constituency of $150 that leaves another constituency worse off by $100. As a whole, the organization is better off by $50. In economic terms, this decision is Kaldor-Hicks efficient. With this background in mind, what we call the shareholder wealth maximization norm in fact is best described as a bargained-for term of the board-shareholder contract by which the directors agree not to make Kaldor-Hicks efficient decisions that leave shareholders worse-off. See Crooked Timberites on the Corporate Directors’ Duties to Shareholders

Posted by Steve Bainbridge | July 27, 2008 1:44 AM

Apparently, when comments get "held for review" they disappear.

I can't prove anything, but in my experience risk of being "held for review" corresponds highly with the number of links in a comment. When I reduce the number of links to one what was previously "held" seems to get prompty posted.

I do know that many comment-system spam filters flag comments with multiple links as likely spam.

FWIW.

Posted by Jim Glass | July 27, 2008 2:46 AM

A guy named Michael Milkin made a "brief" living buying firms and getting rid of the manipulative CEO's. In fact scared them so bad the CEO's went screaming (with dollars in hand) to the government and bingo, Michaels in jail and leveraged buy-outs are severely curtailed.

Posted by Jim | July 27, 2008 3:13 PM

Jim Glass,

Yes, too many links we'll usually get your comment snagged. That particular comment had just one link though (to the Berkshire annual report). I wonder if it made a difference that it was a link to a PDF.

Might as well mention a post I wrote last week on agency conflicts, where I referred to Justin Fox's work. Anyone who's interested can click on my name for it. One point I made there:

One advantage of investing in small companies where the senior managers own significant stakes in their companies is that there are fewer agency conflicts. When the agents are also the biggest owners, the agents' interests are more closely aligned with those of their outside shareholders.

Posted by DaveinHackensack | July 27, 2008 5:16 PM

There was an interesting exchange about this in Reason in 2005 (Rethinking the Social Responsibility of Business) among Milton Friedman, John Mackey (Whole Foods), and T.J. Rodgers (Cypress Semiconductor).

Posted by Gil | July 27, 2008 5:41 PM

You need to read Daniel Davies' post on this and respond to it, Megan, or you're not really participating in the conversation.

Megan already knows everything she needs to know from reading "Free to Choose", she doesn't have to understand anything else. Check out Bainbridge's link if you want a conversation.

Generally speaking, all for-profit business entities owe their existence to investor(s) whose principal motivation for investing was the expectation that a positive return was more likely then not.

All corporate business entities owe their existence to the grant of a corporate charter from the government, whose principal motivation was the belief that this grant of privileges and immunities would, on net, make society as a whole better off.

The discussion above is painfully freshman econ. Nobody reasonable is talking about turning corporations into social service agencies. The charitable contribution thing is somewhat of a red herring as well, although that does have some relevance to real corporate behavior.

The question is really how singleminded corporations should be about short-term profit maximization. There are very frequent instances where business can aggressively maximize profits through violating the spirit if not the letter of the law, and/or through sacrificing the interests of customers or suppliers or workers. You can appeal to long-term profit maximization in such cases, but the long term is by nature fuzzy and difficult to predict. An overemphasis on stock price in such cases can easily make for bad management (great corporations are much more likely to be motivated by serving their customers than serving their stockholders; there's a reason for that). Besides that, corporations do have a social purpose -- not providing social services but being responsible actors in a well-functioning market.

Posted by MQ | July 28, 2008 1:47 AM

Corporations don't exist for long if they produce products society doesn't want. I'm glad that so many corporations produce toilet paper, for example. Useful stuff, as you discover the minute you don't have any.

I suspect that people who get bogged down in these arguments have a very limited definition of "social purpose" in mind.

Posted by M.C. | July 28, 2008 3:26 PM

"The question is really how singleminded corporations should be about short-term profit maximization."

No, that wasn't the question. Maximizing short-term profit isn't the same thing as maximizing shareholder value. If you are going to deride every other commenter as participating in a "painfully freshman econ" discussion, you should at least get the question right.

Regarding the societal benefit of corporations, any corporation that operates profitably and legally benefits society, by providing income to its owners, work for its employees, products or services for its clients, and taxes to the government.

Posted by Sam | July 28, 2008 3:28 PM

Who is to decide what is 'Just'? The trouble with maximizing 'Social Justice' is that no one will agree on what it is. One person's ' Social Justice' is another's racism, corruption, or exploitation. Is the plan to let our government dictate the definition of 'Justice' so that they are in control of all corporations, suborning the management of every firm in the US?

If you change corporate law, requiring companies to pursue perceived justice at the expense of shareholder value, then shareholders will require their stock purchase agreement to abridge this requirement. If shareholders aren't allowed to contract this way, they will invest instead in corporations which are legally resident in countries which do not recognize a 'Social Justice' requirement. There are plenty of Chinese, Russian, or Korean ETFs available.

Posted by wGraves | July 28, 2008 5:07 PM