This was the question we gathered Kellogg faculty to debate three years ago, shortly after CEOs at the Business Roundtable proclaimed their intent to redefine the purpose of a corporation. In their statement, the CEOs explicitly clarified their obligations toward other stakeholders, including employees, suppliers, customers, and communities, in addition to maximizing long-term shareholder value.
At the time, the Kellogg faculty we spoke with were skeptical about the CEOs motives, or that anything would come of it—or even that this was the right way to drive social change. But several were also curious to see how the situation would play out.
Since then, of course, we’ve seen a global pandemic, racial-justice protests, political upheaval culminating in the January 6 uprising, and a seemingly endless parade of climate disasters.
Kellogg Insight recently brought together the same faculty to ask whether their views had changed in the intervening years, and how we should continue to understand the purpose of a corporation. The upshot: they are still as skeptical as ever. Carola Frydman, Ravi Jagannathan, Bob Korajczyk, and José Liberti are professors of finance, and Aaron Yoon is an assistant professor of accounting and information management.
This discussion has been edited for length and clarity.
Kellogg INSIGHT: I wanted to start our conversation with brief history lesson about the primacy of shareholder value. What problem was Milton Friedman reacting to in 1970 when he proclaimed that “the social responsibility of a corporation is to increase its profits?” And why are we still talking about it today?
Carola FRYDMAN: Firms have gone through a transformative change in the past 200 years. In the beginning-to-middle part of the 19th century, most firms were very small, and they were primarily owner-managed. So that meant that one person owned the firm, made all the decisions, and got whatever profits the firm generated.
In the late 19th century, some firms get much larger in ways that require a lot more capital. Take railroad infrastructure: that’s very capital intensive. One person doesn’t have all the funds to finance that. So firms start having a lot of shareholders to provide equity capital. That creates many advantages. Because shareholders of publicly held firms can diversify a lot of their risk exposure by holding different stocks, that lowers the firms’ cost of equity financing. Having public equity then allows firms to take on bigger and riskier projects. So it’s good for the economy.
But now the people who own the firms, and who are going to get the cash flows from the investments, are not the ones making the day-to-day decisions. That separation of ownership (who gets the cash flows) from control (who makes decisions) gives rise to what we call the “agency problem,” where the person running the firm can make decisions that maximize their own welfare, even if they are not good for shareholders. This is costly.
That problem came to a head in the 1970s, when managers were not always running firms very well. There was an intellectual push by economists like Friedman to put the shareholders at the forefront. And that’s what we have lived with since the 1970s, with firms needing to think about their profitability in order to maximize value for shareholders, at least in the U.S. (The emphasis on shareholder-value maximization as guiding principle has varied across countries.)
But in recent years there has been more of a discussion about whether we should be thinking about only shareholders. When a firm does well, some of its cash flows could go to shareholders, but firms could also pass it onto consumers by lowering prices of goods, or give it back to the workers as higher wages or benefits. Firms could decide they want to spend it to fight climate change, and so on. Should there be a push for firms to maximize all of these complex constituencies? Or should firms maximize shareholder value, and institutions other than corporations can address (or are better suited to address) the interests of these other constituencies?
INSIGHT: Which brings us to the last time we all chatted, when the Business Roundtable had just come out with their statement about expanding the purpose of a corporation to include other kinds of stakeholders. Have the last few years, and particularly the pandemic and its reverberations, offered an important test of this new commitment? And if so, have corporations succeeded or failed?
Jose LIBERTI: Well, my personal opinion was that the Business Roundtable proclamation never made any sense. Delaware, where the companies of most of the CEOs who signed the statement are incorporated, doesn’t have a constituency statute, so you can do whatever you want. Legally, they never had to maximize shareholder value!
And we’re talking about public companies, right? If they partner with an institutional investor or a hedge fund, and that investor or hedge fund wants returns, what are they going to do? What’s the average tenure of a stock owned by a portfolio manager? Three months? Six months? Two earning calls? The CEO may want long-term investment, but the only thing these investors want is returns.
Robert KORAJCZYK: But maximizing shareholder value is not the same as maximizing today’s stock price. Maximizing today’s stock price is beneficial for those shareholders who are selling out, as well as the managers whose pay package is tied to share price, but it is not necessarily beneficial for the long-term shareholders. Managers who create the most long-run value are often the ones who ignore the current stock price.
Ravi JAGANNATHAN: Right. A company’s business is not really to produce returns. Whatever their business is, if they do it right, they are rewarded with returns. A car company’s business is to make cars that people want to buy more than other companies’ cars. So they have to compete in the product market. And then if they want to hire the best talent, they have to compete on that dimension, too. So if they don’t treat their staff well and they don’t like the culture inside the company, they will leave or not work hard. There are also strict laws, which if you violate, you pay a penalty. And there are softer laws, moral laws, from which if you deviate, you also pay a penalty, because people won’t come work for you. Making a profit doesn’t mean you can ignore everything else! Profit is not the goal; it is a measure of how well a firm is meeting its goals. So I’m also very skeptical about CEOs issuing these kinds of public statements. It just tells me they’re doing it because they’re facing pressure.
KORAJCZYK: Exactly, a well-run firm that is focused on creating value can make everyone better off. Consider Costco. Their customers are ecstatic. Their employees seem to be happy. And they have created huge value for the shareholders. Their stock price has gone up by nearly 80 percent in the last three years, and 215 percent in the last 5 years. But they first have to create value: make the pie bigger. That is their job. That value flows to the stakeholders.
Aaron YOON: In the summer of 2019, when the proclamation came out, there were serious concerns about a potential recession. Who would have known, at that time, that we’d have COVID in less than a year? For CEOs, their compensation is tied to stock price. So in order to hold that stock price up during a potential recession, there are incentives to engage in communication that is costless, nonbinding, and unverifiable. I think my colleagues are right to take a critical viewpoint here.
Since 2008, firm managers, investment managers and asset owners had considerable bandwidth to make claims about their stakeholder orientation: the market was going up every year because of quantitative easing. But now the market is very volatile. So right now and into the future will be the time when a lot of a firms’ intentions on ESG will be revealed.
JAGANNATHAN: The pandemic has caused a lot of problems and highlighted the importance of managing good and bad externalities. I don’t have a solution. I don’t even have an enumeration of all the problems. But if you think that businesses are going to solve all these problems, good luck to you.
To address externalities, like environmental and social issues, we have to set up a mechanism, an institution, that can collect everyone’s concerns and bright ideas, and then decide how to move forward. People must collectively act and come up with institutions that meet the demands of the time.
INSIGHT: So you are still envisioning a political solution to these social problems? Even in a country as deeply divided as the U.S.?
JAGANNATHAN: There’s nothing that is likely to solve the social and environmental problems except a political solution. The CEOs of large companies are not the right people to make these kind of decisions. They do not have the mandate; they were selected to manage businesses, not solve society’s problems. If they want to have a leadership role in formulating policies that affect people in general, they should go through the electoral process and get elected.
LIBERTI: The CEOs aren’t the only people we don’t want making these decisions. We don’t want institutional investors making that call either.
JAGANNATHAN: We are on the same page. It’s fine when individual investors say, “I don’t want to hold a fossil-fuel stock.” It’s their money. But when we, regular people, are all investing through ETFs, and some institutional fund is set up to manage the ETF, they should manage the ETF! You don’t want somebody who’s managing trillions of dollars to make those kinds of judgment calls on behalf of everyone. Which is why I’m calling for a legislative solution. These solutions can be effective. Solar electricity is an example. Actions by governments through subsidies to consumers, etc., played an important role in the meteoric rise of photovoltaic solar electricity during the past decade. It can now compete with coal-based electricity in many places even without subsidies.
Good policies induced public and private companies to innovate for the benefit of their shareholders, resulting in innovations that immensely benefited society in general, too. Over time we have created institutions and processes that make these companies work for the benefit of society, and there has to be serious public debate before we institute changes that interfere with the way they function.
KORAJCZYK: Given changing consumer and investor awareness of climate issues, a negative screening approach—one that insists on divestment from “brown” fossil-fuel companies—is not likely to be the way to create value anyway. The way to create value is to invest in brown companies whose stock prices are depressed due to their brown profile and find an efficient way to convert them to green (or at last greener) companies. This approach was discussed in a recent Kellogg Insight interview I did with Jeff Ubben.
LIBERTI: Here’s my question about ESG investment: When companies say they will do something, who is verifying this information on behalf of investors? How do we know it’s happening?
YOON: We don’t. In my opinion, we haven’t reached that maturity stage with ESG yet. These funds that committed to incorporate ESG into their investment decision attract a lot of flow, but most of them on average provide little ESG follow-through, or evidence of their own positive social impact.
The reason, in my opinion, is because disclosure of most ESG information is not regulated. So there is no accountability. It’s actually a very serious problem.
INSIGHT: It seems we should acknowledge where this urge for corporations to consider other stakeholders, or for investors to consider ESG information, is coming from. There’s a broad sense that the status quo isn’t working. It’s going to be very bad for the entire economy, not to mention people’s lives, if the average global temperature goes up by five degrees Celsius! So do corporations have no role in spearheading big social changes?
FRYDMAN: They do have a big say: in innovation. A lot of the innovation these days happens in firms. Think about the pandemic. Amazing firms that had been investing, in small and big ways, for a long time were able to create a vaccine within days. It took a while to manufacture and to get approval, but the technology was there. So corporations make an incredible difference because they have the resources to make those investments. We don’t want all the innovation to happen in government.
INSIGHT: In terms of market-based strategies for encouraging corporate social responsibility, there’s another topic that comes to mind and that’s reputational risk. So if consumers aren’t happy with your brand, they may boycott you, or choose a competitor.
FRYDMAN: And that’s great, because that’s people deciding where they’re going to spend their hard-earned dollars.
But we still need laws. Let’s say we agree that a drug is killing people and we shouldn’t have it. Are you going to tell the firm, “Stop producing it out of goodness of your heart just because people are still buying it?” At some point you need regulation. And lawsuits. Look at baby products: there may be very, very few negative incidents, but all the products may be voluntarily recalled. And that’s because the liability is going to be massive.
We have an imperfect but reasonable process for dealing with corporate misbehavior.
LIBERTI: To bring this back to the Business Roundtable discussion: the CEO of Johnson & Johnson was at the Business Roundtable. Well, the company’s talc baby power is a massive liability against Johnson & Johnson. So what does the company do? They use a bankruptcy maneuver to spin off a new subsidiary, and then they put the potential tort liability onto the new firm, to protect the valuable assets of the old Johnson & Johnson. At the same time, the new subsidiary files for Chapter 11 bankruptcy protection.
What happened with the stock price of Johnson & Johnson? It went up. Of course! Because the tort liability is not going against the operating assets of Johnson & Johnson.
JAGANNATHAN: There’s no alternative to good laws, and those have to go through the legislative process. You have to abide by the laws of the land. And that includes not violating the moral and ethical principles of the society, too: if you don’t, and it becomes an issue, people will incorporate them into laws, imposing a potentially huge cost to you.
FRYDMAN: Right, though it’s also true that big firms try to influence the political process. So it’s not a perfect system. But take it away, and what’s the alternative? The alternative, at least to me, is even scarier. We’d be in a completely totalitarian system, for example. But that doesn’t mean that one shouldn’t go vote, and work to make things better.
And businesses are responding to changes in consumer preferences. To be honest, that’s why the CEOs are saying what they are saying: because they think that’s what people want to hear and that’s going to help their firms.
And then, if it really is going to help their firms, they’ll do it.