Profits, Not Causes
The enduring wisdom of shareholder primacy
A few years ago, at a risk-management conference for big-wave surfers, I witnessed a heated debate over the latest innovation: an inflatable vest that could prevent drowning if a surfer wiped out. The vest was a technological marvel that had taken years to develop. Two vendors made the product: Patagonia, which made a black vest; and Quiksilver, which made a red one.
The crux of the debate was that inexperienced surfers who used the vest might feel emboldened to take undue risks, harming themselves and potentially others. Patagonia’s announcement that it would sell the vest only to experienced surfers brought lots of closed-eye head-nodding among the tanned, fit, and flip-flop-wearing surfers. That crowd fiercely disapproved of Quiksilver, which said that it would restrict the number of stores carrying its vest but would be more liberal about whom it would sell to. One well-known surfer said to me, “You see these guys out there on the waves in the red vests—they don’t belong there. . . . Quiksilver is just about making money.”
I later spoke with a Quiksilver executive who winced when I told him this story. He pointed out that his company is not a charity and had spent years and many resources developing the vest. “Besides,” he said, “are we going to not sell something that can save someone’s life?”
Patagonia is a privately owned company; its owner is entitled to sell to whomever he pleases. Quiksilver is a publicly traded company that, in theory, anyway, should be primarily concerned with maximizing profits for its shareholders. But this principle—shareholder primacy—is undergoing a rethink in the business world.
Early corporations in America, mostly privately owned, carried out public works projects and were seen as serving the community. But as the industrial era progressed, publicly held corporations began to dominate the private sector. When the manager is also the owner, it’s clear whom he is accountable to: himself. But when a firm employs many people in a community, produces products or services everyone uses, and is owned by many people with no management role or liability, it’s not so obvious whose interests the corporation should serve. Fifty-one years ago, Milton Friedman made the case in the New York Times Magazine that it was the owners—namely, the shareholders—who have a residual claim on a publicly traded company’s profits.
Friedman argued that shareholder primacy benefits not just the corporation but all of society. When corporate management pursues social objectives other than profit maximization, it is spending other people’s money. The corporate officer who does not pursue profit in effect imposes a tax on shareholders and customers, even though he was not elected to do so and often has no special skills or knowledge when it comes to discerning the common good. Author and biotech entrepreneur Vivek Ramaswamy has questioned why shareholders should subsidize CEOs’ personal brand-building. Friedman went even further, arguing that the alternatives to profit maximization are a slippery slope to socialism.
Friedman acknowledged that the interests of other stakeholders in society often aligned with profit maximization. The economy is not zero-sum. Paying employees well can make them more productive and loyal. Investing in the community generates goodwill, makes it easier to do business, and attracts better talent. For a corporation like Nike, which aims to attract young, hip customers, throwing its weight behind, say, Black Lives Matter is good marketing.
The law, for its part, is not entirely clear on whose interests a corporation must serve. The late Lynn Stout, a Cornell professor, argued that the law does not require corporate managers to maximize shareholder value; their only fiduciary duty is to the corporation itself. Leo Strine, a former Delaware judge, believes that corporate boards should serve the shareholders who elect them. Some state-governing laws for corporations give explicit guidance. Indiana law, for example, says: “A director may, in considering the best interests of a corporation, consider the effects of any action on shareholders, employees, suppliers, and customers of the corporation, and communities in which offices or other facilities of the corporation are located, and any other factors the director considers pertinent.”
Though the law is ambiguous, for the last few decades many corporate officers have behaved, or claim to have behaved, as if they were accountable to shareholders above all. They did so partly because of Friedman’s arguments but also because increasing a company’s share price made it less vulnerable to hostile takeovers in the 1980s.
Now the winds are changing. In 2019, the Business Roundtable, an association comprising nearly all of America’s high-profile CEOs, published a manifesto pledging allegiance not just to capitalism and the needs of shareholders but also to other stakeholders: “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.”
ProMarket, a publication of the Stigler Center at the University of Chicago’s Booth School of Business, recently published a series of essays in honor of the 50th anniversary of Friedman’s New York Times essay. The concluding one, by Booth School professor and sometime City Journal contributor Luigi Zingales, contended that shareholder maximization benefits society under just three conditions: when corporations don’t have monopoly power—in other words, when they don’t set the rules or prices in the markets that they compete in; when there are no externalities (side effects) to profit maximization, or, if there are, the government can eliminate them through taxation or regulation; and when contracts are complete, meaning that all stakeholders have contracts that specify payoffs in all states of the world.
Zingales notes that for many corporations, none of these conditions holds. Large firms have some pricing control over the market and the ability to influence policy though lobbying. Some damage the environment, and government regulations and voluntary action aren’t always effective at limiting this damage. As for the third condition, complete contracts rarely exist; if they did, there would be ways to insure fully against a company failing, shareholders losing equity, and workers losing wages.
All this suggests that, if a company pursues profit maximization above all, society does not always benefit. Profit maximization can harm the environment, increase risks, and give corporations outsize power in society. And one can cite plenty of examples of corporations pursuing short-term profits to boost their current share price at the expense of long-term growth and job security for their workers.
Still, as Churchill said of democracy, shareholder primacy is the worst system—except for the alternatives. Stakeholder value, or the multiple-stakeholder model, which would require corporate management to consider the needs of everyone with an interest in the firm, would be worse for corporations as well as society.
Stakeholder value leaves corporations without a clear objective. Who, exactly, are the various stakeholders? Workers, bondholders, members of the community where the firm is located, or, as Joe Biden has suggested, the entire society? If a corporation is considering moving a factory from Michigan to Kentucky, whose interests matter? The workers in Michigan (and its local economy), or future workers in Kentucky (and its local economy)? If stakeholder interests conflict, how much consideration should each get? If the primary objective is not profit, the answer is unclear.
Last year, consulting firm McKinsey published a report arguing that the stakeholder model requires measuring “your social and environmental impact,” as well as the impact of everyone in your supply chain. But how much weight should the supply chain get, and what makes a morally impeccable supplier? None of the answers is clear.
In fact, it is so hard to define the identity and interests of various stakeholders that the effect of trying may be to make corporations even less accountable. Corporate officers could argue that profits were down because the company was pursuing some other ill-defined and impossible-to-verify objective in the service of a stakeholder. A paper by Harvard Law professor Lucian Bebchuk and law student Roberto Tallarita estimates that firms that follow the stakeholder model not only skirt accountability to shareholders; they also fail to deliver more to stakeholders (for example, by providing higher wages for employees).
“But here’s the implication for stakeholder capitalism: by making CEOs accountable to literally everyone, those CEOs actually become accountable to no one,” Ramaswamy told me. “It’s the logical extension of the basic consequence of agency problems that arise within classical capitalism, except on steroids.”
Some critics of shareholder primacy argue that it might have made sense in 1970 but no longer works in a world facing threats like climate change and rising inequality. Actually, the opposite is true: Friedman’s argument has never been more relevant.
While we have a better understanding of externalities like pollution, we also live in an arguably more partisan environment. The multiple-stakeholder model would invite that partisanship into the boardroom, since, by definition, it asks businesses to take different, sometimes competing, interests into consideration. Weighing those interests requires making value judgments—an inherently subjective and often political exercise.
Suppose you own a gun because you believe that it makes you safer, and you also own shares in a steel company. Now suppose that the steel company’s management supports gun control—the stakeholder for the firm here is society—and decides not to sell steel to a gun manufacturer, thereby raising gun prices while lowering its own profits. Management’s action would have diminished your welfare as you understood it. Friedman maintained that it would be better for the company to maximize profits and leave management and shareholders to use their own money to support their favored causes. This arrangement may be less efficient if the goal is reducing the number of guns, but it is better at maximizing welfare in a society divided on this particular question.
Injecting such political or moral ends into corporate decision-making is bad for both profits and society. Consider the case of large, public technology firms like Facebook and Twitter. They claim to care about the social harms that their services cause. Currently, people of all political persuasions use the platforms and, in so doing, get some exposure to different viewpoints. Last fall, each corporation temporarily blocked a New York Post article critical of presidential candidate Joe Biden and his son Hunter. Both companies had been pressured to avoid giving a platform to inaccurate or harmful information—especially close to the election. But critics saw the move as targeting conservatives because news stories with similarly sourced information that harmed Trump could be widely shared. As a result of their decision, the story garnered even more attention than it might have otherwise, several politicians threatened the firms with more regulation, and many conservative social media users were motivated to switch to competing social media services like Parler, deemed politically more sympathetic. Thus, not only did their decision potentially harm the social media giants’ bottom line; it also arguably harmed society by reinforcing people’s ideological bubbles. When we all use the same social media platforms, we get some exposure to different viewpoints, but if these trends continue, one day conservatives and liberals may use different social media entirely and see only arguments that confirm their opinions.
It’s certainly true that pure profit maximization is not always morally neutral when externalities are present. Friedman conceded that the pursuit of profits should be constrained by laws and widely held social norms. But companies that explicitly enthrone moral objectives extrinsic to the business inevitably alienate some customers, staff, and shareholders.
The pursuit of moral objectives may also be why many conservatives and libertarians claim to feel uncomfortable working in progressive tech firms. Silicon Valley values may attract progressive talent in the short run but only at the cost of narrowing the overall recruiting pool over time. Economist Lisa Cook claimed that more diversity in Wall Street management would have spared us the financial crisis because including people with different “lived experiences” is a check against the kinds of groupthink that allowed the risks to build unseen. Surely this argument applies to diversity of opinions and values, not just gender and race.
More ideologically homogeneous workforces are a net loss for society, too. The workplace is one of the few venues where people with different views must interact and cooperate. Corporations that pursue moral or ideological goals appealing to only a narrow subset of the population undermine this dynamic.
Adding more stakeholders does not guarantee morally superior outcomes. Public-sector workers get a say in how their municipalities are run and what services are provided. Some teachers’ unions, like the one in Fairfax, Virginia, have said that they would prefer to offer remote-only education until August 2021 and may not agree to open schools fully next fall. If society’s sole purpose were preventing diseases like Covid-19, that might be a wise and ethical choice, but if we also have other goals—like educating children and reducing inequality in the next generation—then this is morally indefensible.
Critics of shareholder primacy also object that it distorts incentives. Corporate officers become fixated on boosting short-term share price, to the detriment of long-term value creation. Investing in new technology and paying and training employees well may not pay off right now, but they eventually benefit society and the company.
Stock prices, however, don’t just reflect short-term expectations. For example, major pharmaceutical companies make large, risky bets on innovation. Drug patents eventually run out, so analysts also look to a company’s pipeline of potential drugs in addition to current profits. Corporations that do not invest in long-term growth accordingly have lower stock prices.
Corporations sometimes try to boost their share price by buying back shares or increasing dividends instead of investing or hiring more. But it’s not shareholder value that makes them do this; such actions often reflect a lack of good investment opportunities. Some evidence suggests that firms have spent less on R&D since shareholder value became popular, but this may also reflect structural changes to the economy that make it more profitable to acquire startups that do the innovating rather than having it done in-house.
Besides, a multiple-stakeholder model would not necessarily make corporations more mindful of the long term. It’s unlikely that labor unions would support R&D investing that would make workers more productive and the firm more profitable but also result in fewer employees. Public-sector unions have a long history of demanding unsustainable health and pension benefits. Multiple stakeholders operating according to different time horizons can make management even more focused on the short term.
Shareholder primacy was no less divisive an idea when Friedman wrote about it in 1970 than it is now. But 51 years later, even as issues like inequality, the environment, and the pandemic have made us realize how interconnected we are, Friedman’s argument stands the test of time. As social norms and values change with lightning speed, maintaining objective, apolitical standards for corporate management has never been more essential.
In these politically charged times, corporations may not always have the luxury of keeping their heads down and worrying only about the bottom line, of course. Young employees increasingly demand political engagement, boycotts threaten profits for some companies, and the rising popularity of ESG (environmental, social, and governance) funds means that taking a moral stance could mean cheaper access to capital.
To return to the big-wave surfers’ debate: Patagonia’s website promises that some of the profits from the vest go to an environmental cause and contains a link (now broken) to submit an application to buy it. Quiksilver doesn’t sell the vest online, instead directing customers to its stores; it also warns that the vest should be used carefully and requires buyers to submit a declaration that they understand the risks involved and will take necessary precautions.
Which of these two approaches is best for society and for shareholders? Buy-in and approval from the big-wave surf community is important for marketing, but this is also a piece of safety equipment that was expensive to develop and now has very limited distribution. The answer is not obvious. It rarely is.
As we become more socially minded and demand that corporations take more aggressive moral stances, goals like profits, innovation, and general welfare may have to take a backseat. If that happens, we will all lose out.
Photo: Quiksilver, a publicly held surf-wear maker, decided to make its safety vests widely available—and was criticized for pursuing profits. (ROOM THE AGENCY/ALAMY STOCK PHOTO)
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