The Shareholders vs. Stakeholders Debate

1 SUMMER 2003H. Jeff SmithThe Shareholdersvs. StakeholdersDebateShould companies seek only to maximize shareholder valueor strive to serve the often conflicting interests of allstakeholders? Guidance can be found in exploring exactlywhat each theory does, and doesn t, 44, No. 4 Reprint #44411 stakeholder theorists smell blood. Scandals at Enron, Global Crossing,ImClone, Tyco International and WorldCom, concerns about the inde-pendence of accountants who are charged with auditing financial statements,and questions about the incentive schema and investor recommendations atCredit Suisse First Boston and Merrill Lynch have all provided rich fodder forthose who question the premise of shareholder supremacy. Many observershave claimed that these scandals serve as evidence of the failure of the share-holder theory that managers primarily have a duty to maximize shareholderreturns and the victory ofstakeholder theory,which says that a manager sduty is to balance the Shareholders financial interests against the interests ofother Stakeholders such as employees, customers and the local community,even if it reduces shareholder returns.

2 Before attempting to declare a victor,however, it is helpful to consider what the two theories actually say and whatthey do not the shareholder1and stakeholder theories are normative theories ofcorporate social responsibility, dictating what a corporation s role ought to extension, they can also be seen as normative theories of business ethics,since executives and managers of a corporation should make decisionsaccording to the right theory. Unfortunately, the two theories are very muchat odds regarding what is right. Shareholder theory asserts that Shareholders advance capital to a com-pany s managers, who are supposed to spend corporate funds only in waysthat have been authorized by the Shareholders . As Milton Friedman wrote, There is one and only one social responsibility of business to use itsresources and engage in activities designed to increase its profits so long as engages in open and free competition, without deception or fraud .

3 2On the other hand, stakeholder theory3asserts that managers have a dutyto both the corporation s Shareholders and individuals and constituenciesthat contribute, either voluntarily or involuntarily, to [a company s] wealth-creating capacity and activities, and who are therefore its potential benefici-aries and/or risk bearers. 4 Although there is some Debate regarding whichstakeholders deserve consideration, a widely accepted interpretation refersSUMMER 2003 MIT SLOAN MANAGEMENT REVIEW85 TheShareholders vs. StakeholdersDebateH. Jeff Smith is a professor of management at the Babcock Graduate School of Man-agement at Wake Forest University in Winston-Salem, North Carolina. Contact him companies seek only to maximizeshareholder value orstrive to serve the often conflictinginterests of all stake-holders? Guidance can be found inexploring exactly what each theory does,and doesn t, Jeff Smith86 MIT SLOAN MANAGEMENT REVIEW SUMMER 2003to Shareholders , customers, employees, suppliers and the to the stakeholder theory, managers areagents ofallstakeholders and have two responsibilities: toensure that the ethical rights of no stakeholder are violated6andto balance the legitimate interests of the Stakeholders whenmaking decisions.

4 The objective is to balance profit maximiza-tion with the long-term ability of the corporation to remain agoing fundamental distinction is that the stakeholder theorydemands that interests ofallstakeholders be considered even if itreduces company other words, under the share-holder theory, nonshareholders can be viewed as means to the ends of profitability; under the stakeholder theory, the interestsof many nonshareholders are also viewed as ends. 7 Unfortunately, shareholder theory is often misrepresented inseveral ways. First, it is sometimes misstated as urging managers to do anything you can to make a profit, even though the share-holder theory obligates managers to increase profits only throughlegal, nondeceptive , some criticize the shareholdertheory as geared toward short-term profit maximization at theexpense of the long run. However, more thoughtful shareholdertheorists often refer to a need for enlightened self-interest, which if embraced would lead acorporation s managers to take along-term orientation.

5 Third, it issometimes claimed that the share-holder theory prohibits givingcorporate funds to things such ascharitable projects or investing inimproved employee morale. Infact, however, the shareholder the-ory supports those efforts inso-far as those initiatives are, in theend, the best investments of capi-tal that are , the stakeholder the-ory is sometimes is sometimes claimed that the stakeholder theory does notdemand that a company focus on profitability. Even though the stakeholder theory s ultimateobjective is the concern s contin-ued existence, it must be achievedby balancing the interests of allstakeholders,including the share-holders, whose interests are usu-ally addressed through , because many stake-holder theory descriptions pro-vide no formula for adjudicating among the Stakeholders dis-parate interests, some have claimed that the theory cannot beimplemented.

6 While it is true that some versions of the theoryprovide no guidance in this regard, many stakeholder theoristshave provided algorithms for trade-offs among Stakeholders interests. For example, one might assess the level of risk that eachstakeholder has embraced and rank their interests accordingly, orone might simply assert that one stakeholder group s interestsshould always prevail, as Richard Ellsworth has recently There Always Been a Dispute?As many observers have pointed out, the stakeholder view doeshave a historical tradition in the economic system. Histori-cally, argued John Cassidy in the New Yorker, Many chief execu-tives saw their main task as overseeing the welfare of theiremployees and customers. As long as the firm made a decentprofit every year and raised the dividend it paid its stockholders,this was considered good enough. 11 But it is also clear that, in thepast two decades, expectations have shifted, driven by two force was the pointed arguments of free-market econo-mists.

7 In a widely cited 1970 article, Milton Friedman arguedthat the fundamental obligation of managers is to return profits to Shareholders not to invest corporate funds inendeavors that they find socially beneficial but that reduceshareholders 1976, Michael Jensen and WilliamMeckling explored the notion of principal-agent conflicts,arguing that executives often fail to maximize profits unless theshareholders invested their time and money in creating appro-priate incentives to do so and monitored the resulting suggestion, and others that followed, heightenedinvestor awareness that many managers might not be maximiz-ing , and probably related to the growth of the principal-agent arguments, many corporate raiders during the 1980sbought stock of companies they considered undervalued, jetti-soned the existing management and often dismantled the com-panies. There is scant evidence that such takeovers (sometimessubsumed under the rubric of market discipline ) lead to long-term gains for those who finance them.

8 However, the prospect ofsuch takeovers seemed to have made it, for a time, more danger-ous for executives to acknowledge publicly anything other thanthe shareholder theory14or to behave in any fashion that couldsuggest a nonoptimal return to be sure, many would prefer that the shareholder-stake-holder dispute simply go away. In particular, many shareholdertheory advocates are quick to claim that the theories actually con-verge, that our society s norms clearly favor the shareholder the-ory or that market forces and the law leave one no choice but toembrace that theory. However, none of these assertions can with-stand logical criticizeshareholdertheory as gearedtoward short-termprofit. However,more thoughtfulshareholdertheorists refer to a need for enlightened self-interest. SUMMER 2003 MIT SLOAN MANAGEMENT REVIEW87 First, consider the assertion that the theories converge thatif managers take care of the Stakeholders , they will wind up max-imizing profits and shareholder returns in the long run.

9 In thatvein, one thoughtful treatise recently argued that stakeholderrelationships are not a zero-sum game (that is, anything gainedby employees comes out of the pockets of investors or customers)but a mutually reinforcing, interactive , thatis clearly not the case in all a business with many long-term employees that hasmanufactured its products for more than 30 years in a small Mid-western town. Those products have been sold in many foreignmarkets but for the past 10 years, not in the United States. Itsexecutives have recently concluded that they can no longer affordto manufacture the products domestically, and the most cost-effective solution is to outsource the manufacturing to anothercountry. The shareholder theory would support closing the plantand would direct the executives to provide only what the lawrequires to the community and the employees, since there is littlepossibility of a backlash against the company due to a plant clos-ing (because the products are solely for export).

10 To expend anycorporate funds on retraining affected employees or on contri-butions to the community would be a waste of Shareholders money, since the investments would never be returned. However,the stakeholder theory would infer a normative obligation to boththe community and the employees; while it might not demandthat the company continue to operate the plant, it would expectsome attempt to retrain the employees, help the communityattract new industry and so on. Obviously, these efforts wouldreduce the concern s profitability, but the stakeholder theorywould not support a cut and run approach to the example and many others like it show that reasonableapplications of the theories will sometimes yield different nor-mative obligations on managers parts. To claim that the theoriesconverge requires that one assume that actions in favor of stake-holders ultimately resonate positively to the bottom line and/oractions against Stakeholders are eventually punished on the bot-tom line.