Exactly 50 years ago, Dr. Milton Friedman, a renowned economist, Nobel Memorial Prize winner wrote an influential and eye-catching piece in New York Times about social responsibility of corporations. He firmly argued in the piece that “Only social responsibility that corporation has is to maximize value of its shareholders as long as it stays within rules of game.”
Before starting this debate, we first need to get ourselves clear with some of the terminologies. When Prof. Friedman said maximizing shareholder value, he was pointing towards present value of all future benefits that shareholders receive from investing in the underlying business. The general notion to measure this value is profit earned by it. So, ultimately, Prof. Friedman was referring to long term profits of firms. It is noteworthy to emphasize the word “long term” here. Shareholders can even earn value by selling all the assets of underlying business today but benefits received from such sell would be lesser than present value of all future benefits that shareholder would receive from its ongoing operations.
Many scholars and people criticized this idea of putting profits of shareholders above all. People argued that companies are also responsible to their other stakeholders which includes its employees, suppliers, bond holders, and the community. For a moment, let’s be clear what do we want from businesses? We want them to cater needs of consumers, we want them to hire employees which in turn can use their salaries to purchase other goods, we want them to invest their profits to innovate new technologies which will ultimately help our society. All summarized, there can be number of ways in which firms can help society but what we would ultimately want from them is to maximize collective social welfare. For instance, if firm focuses too much on its employee salaries, then it may miss out share of its profits which it would have invested in inventing new technology. On the other hand, dividend given to shareholder will decrease which results into lesser people investing in such company restricting potential growth of corresponding firm.
So how do we align interest of all the stakeholders involved and maximize total social welfare? To answer this question, Prof. Friedman came up with shareholder’s value maximization principle. Shareholders are residual risk bearers. If firm defaults then shareholders are last ones to get anything from company’s assets. Prof. Friedman argued that shareholders are owners of firm and a corporate executive (CEO, CFO, COO) are employees of them. It is essential to understand that Prof. Friedman was not in favour of shareholders or any private agents but as per his opinion, if we try to maximize shareholder value then at the end of the day, we would achieve increased social welfare. One of the most powerful supportive argument given by Dr. Friedman was about charity. For example, a CEO decides to charity share of the business profits then it refers to using shareholder’s money to cater her own preferences towards society. Instead, we can distribute these profits in form of dividends to shareholders and they with their individual preferences can donate it to society. After all, one dollar donated by the corporation is not worth more than one dollar donated by shareholders but in later case, shareholders get their individual rights.
In this article, we will try to summarize opinions of different scholars. We will look out for frequently asked questions like - is there any problem with this argument? If yes, what is it? And how should we tackle it then?
Companies should maximize social welfare not value! – By Prof. Luigi Zingales and Prof. Oliver Hart
Recently, Prof. Luigi Zingales and Prof. Oliver Hart (Nobel laureate) pointed out in their recent study that companies should maximize shareholder’s welfare not value. Now what is shareholder welfare? Prof. Oliver Hart argues that sometimes shareholders themselves are not only interested in profits that they receive. To counter Dr. Friedman’s example on charity, he presents an argument on climate change. To tackle climate change, individuals may install solar panels or they may buy electric cars but these examples are like small potatoes. Instead, it is much more effective for company to reduce its carbon footprint by using green/renewable energy systems. So unlike, example on charity, sometimes it becomes easier for companies to act for welfare of shareholders on behalf of them because in such cases companies have comparative advantages over individual shareholders.
Both professors also assert this by saying shareholders of a company such as Walmart are concerned about mass killings in the United States. Walmart’s ability to restrict the sale of high-capacity magazines or assault rifles in its stores would be more effective than if it took the extra profits from those sales, returned them to shareholders, and let shareholders donate to gun control advocacy. Restricting gun sales is shorter route compared to later one for shareholders.
But, to understand this scenario in detail, let’s look at a brief history of this incident. Walmart is one of the largest sellers of guns and ammunition in the world. On August 3, 2019, a mass shooting occurred at a Walmart store in El Paso, Texas, United States. A gunman shot and killed 23 people and injured 23 others. On the eve of this incident, Walmart announced it will discontinue all sales of handgun ammunition and sales of short-barrel rifle ammunition that can be used with military-style weapons. But the question is whether this decision was against profit maximization principle? As per expert opinions, sales of guns and ammos is not a high margin business. Secondly, it is declining since the first decade of 21st century. In addition, Walmart faced a backlash from its own employees, for not pulling weapons out from stores after a deadly shooting happened in July 2019. Hence, it is possible to get illusioned by this decision because one can see decrease in short term profits but by taking this decision, it created a reputation as a brand which may help them to have better relationship not only with their employees but also with customers. After all, safety of their employees and customers is essential for them to run their stores. Therefore, in my opinion, professors made a strong argument when it comes to reducing carbon foot prints but it’s hard to gauge the decision of Walmart as non-profitable (in long term).
Shareholders are not always the residual claimants – By Prof. Raghuram Rajan
Prof. Rajan argues that shareholders do not always bear the residual risks. When firm gets closer to financial distress, the residual claimants are debt/bond holder rather than shareholders. Let’s look at how? Financial distress is a condition in which a company or individual cannot generate sufficient revenues or income, making it unable to meet or pay its financial obligations. In such cases, shareholders have incentives to liquidate assets at prices below their market values and distribute the proceeds as a dividend on the other hand increasing chances of going bankrupt because in the end once company files bankruptcy, assets are generally used to repay a portion of outstanding debt. Hence, as rightly pointed out by Prof. Rajan, it is hard to strictly follow the rule of shareholder maximization all the time.
Secondly, Dr. Rajan claims that there are others who have made long term investments in the firm. In any human capital-intensive firm (ex. Manufacturing firms), workers have made tremendous investments in the firm. And often, they become partners in the firm—sometimes they are explicit shareholders, sometimes they are implicit shareholders since their “sweat equity” is not formally recognized. He adds apart from shareholders, long-term debt holders, long-term suppliers, employees are long-term stakeholders. And company should maximize the value of long-term stakeholders in the firm. He cites an example - if a firm says: I’m going to be more trusting toward my workers and work on their behalf, they respond by choosing their employers over others. That firm attracts more talent, they demand less pay because they trust the firm to not squeeze them in bad times, and they respond by going the extra mile for it. But, if we careful observe given argument, not only employees but shareholder’s long-term value also increases in above analogy. So, sometimes, it is better to leave it to hands of executives. With their business judgement, they can come up with an ideas where they may be seemed as non-profitable at first sight but have potential to increase long terms profits of shareholders. One of the finest example of such judgement is doubling of wages by Ford motors in 1914 to enhance productivity of employees which ultimately helped company to achieve record profits.
Real markets are not perfectly competitive in nature – Prof. Stefano Zamagni
Prof. Zamagni argues that position defended by Dr. Friedman would be acceptable if all markets were perfectly competitive; if income distribution was equitable in the minimal sense, whereby everyone is permitted to play the market game. When Dr. Friedman made his famous argument, he didn’t forget to mention that this argument holds if and only if corporations stay within “rules of game”. In perfect market competition, we expect free entry and free exit in the market. We expect workers a complete freedom to choose his entry and exit from a firm. But lot of these are not valid under current circumstances due to high levels of government intervention and large wealth and income inequalities.
Market forces already address Environmental, Social and Governance (ESG) issues and the issues raised by stakeholder capitalism – Prof. Eugene Fama
Dr. Fama (Nobel laureate) states contract structures are an important ingredient in the survival of firms. In a competitive environment, firms have incentives to negotiate contracts that allow them to deliver the products demanded by customers at the lowest cost. Firms go with contracts to shareholder or debt holders when they raise their capitals from primary markets. Firms write contracts with their supplier and employees when they hire them. If all of these stakeholders have given rights to influence the firm’s decisions, they are unlikely to agree about a decision to maximize combined wealth, and they are unlikely to agree about how combined wealth is split among stakeholders. So, the common solution to this problem is all stakeholders negotiate fixed payoffs (basically, forms of interests, salary), and shareholders bear the residual risk of net cashflows - revenues minus costs (This is why shareholders are called residual risk bearers).
Thus, in exchange for fixed payoff contracts for other stakeholders, shareholders get most of the rights with respect to decisions that affect net cashflows. Hence, shareholders considering the underlying cost of other contracts try to take decisions to maximize net cashflows (revenues – costs) which in turn keep company running in long term. In addition, fixed payoff contracts (like employee salaries) are often subject to periodic (annual) negotiation. The prospect of renegotiation limits opportunistic behavior of shareholder as employees demand more salaries if profits are increased.
Dr. Fama also argues that shareholder’s welfare unlike value has multiple dimensions. For example, an Environmental & Social (E&S) virtuous firm may commit to transfer half of annual profits that would otherwise accrue to shareholders. For some investors, 50 percent may be too much, and for others it is too little. There is also likely to be disagreement on how the 50 percent is split among different Environmental and different Social actions. One way to resolve this problem is to take voting among shareholders. Dr. Fama does not forget to mention that consumers can also react to such E&S actions by paying more to a product produced cleanly, without any pollution at higher costs. But the end results would be partial as some consumers may be indifferent to pollution. Ultimately, Dr. Fama concludes that market forces address the issues raised by the stakeholder capitalism and ESG movements. He says - market solutions are not perfect, especially in the presence of externalities, but no solutions are perfect when contracts are not costlessly written and enforced.
In conclusion, Dr. Friedman was right in many aspects of this principle. But, as the time goes, it has become difficult to rule out emerging issues such climate change and global warming (to name a few). High levels of government intervention and rising inequalities have diverted markets away from perfect competitions. Market solutions were never perfect to solve such issues neither the government regulations currently are. So as rightly said by Prof. Sanjai Bhagat and Prof. Glenn Hubbard, “Friedman’s shareholder primacy— long-run shareholder value maximization—remains the right place to start, even if it is not the end of our road.”
References
[1] R. Rajan, “‘50 Years Later, It’s Time to Reassess’: Raghuram Rajan on Milton Friedman and Maximizing Shareholder Value - Pro Market.” https://promarket.org/2020/09/18/50-years-later-its-time-to-reassess-raghuram-rajan-on-milton-friedman-and-maximizing-shareholder-value/ (accessed Oct. 03, 2020).
[2] Z. Stefano, “It Is Time to Move on From Friedman’s View of the Corporation - Pro Market.” https://promarket.org/2020/09/17/it-is-time-to-move-on-from-friedmans-view-of-the-corporation/ (accessed Oct. 03, 2020).
[3] E. Fama, “Market Forces Already Address ESG Issues and the Issues Raised by Stakeholder Capitalism - Pro Market.” https://promarket.org/2020/09/25/market-forces-esg-issues-stakeholder-capitalism-contracts/ (accessed Oct. 03, 2020).
[4] S. Bhagat and G. Hubbard, “Which Problems Should Companies Try to Solve? - Pro Market.” https://promarket.org/2020/09/21/which-problems-should-companies-try-to-solve/ (accessed Oct. 03, 2020).
[5] O. Hart and L. Zingales, “Serving Shareholders Doesn’t Mean Putting Profit Above All Else - Pro Market.” https://promarket.org/2020/09/05/serving-shareholders-doesnt-mean-putting-profit-else/ (accessed Oct. 03, 2020).
[6] O. Hart, “Shareholders Don’t Always Want to Maximize Shareholder Value - Pro Market.” https://promarket.org/2020/09/14/shareholders-dont-always-want-to-maximize-shareholder-value/ (accessed Oct. 03, 2020).
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