TCS Daily

The Siren Song of Corporate Social Responsibility

By Stephen Bainbridge - November 14, 2005 12:00 AM

Back in 2001 Henry Hansmann and Reinier Kraakman, of the Yale and Harvard Law Schools respectively, published a well-known essay The End of History for Corporate Law, in which they argued that global corporate governance rules are converging towards "the 'standard shareholder-oriented model' of the corporate form." The title of their article, of course, was a riff on Francis Fukuyama's book The End of History.

As we've all learned, Fukuyama was wrong. History definitely has not ended.  

Hansmann and Kraakman also erred.  

Corporate governance questions are resolved in a two dimensional space. Along one axis are the means of corporate governance; i.e., who is in charge? The short answer is captured by the phrase director primacy, which conceptualizes the corporation as a vehicle by which directors hire factors of production and which limits shareholders to the very modest set of control rights for which they have bargained. At the other end of the spectrum on this axis lie scholars like Lucian Bebchuk, who equally forcefully argue for reuniting ownership and at least ultimate control in the hands of shareholders.  

The other axis along which corporate governance debates play out relates to the ends of corporate governance. What is the decision-making norm that guides corporate governance? At one end of that axis lie scholars (like myself) who believe that the end of corporate governance is shareholder wealth and that the discretion of directors must be exercised towards that end. At the other end of this axis lie scholars who have staked out various versions of stakeholderism. In various ways, these scholars seek to temper the Friedmanesque notion that the corporation's social responsibility is to maximize its profits.  

Large segments of the global business community, especially in the EU, have surrendered to the stakeholderists. As The Economist observed:   

        "Companies at every opportunity now pay elaborate obeisance to
        the principles of corporate social responsibility. They have CSR 
        officers, CSR consultants, CSR departments, and CSR initiatives 
        coming out of their ears."  

Here in the US, CSR has been somewhat less successful in taking over corporate boardrooms. A 1995 National Association of Corporate Directors (NACD) report stated: "The primary objective of the corporation is to conduct business activities with a view to enhancing corporate profit and shareholder gain," albeit with some mushy qualifying language. A 1996 NACD report on director professionalism set out the same objective, without any qualifying language on nonshareholder constituencies. The 2000 edition of Korn/Ferry International's well-known director survey found that when making corporate decisions directors consider shareholder interests most frequently, although it also found that a substantial number of directors feel a responsibility towards stakeholders. A 1999 Conference Board survey found that directors of U.S. corporations generally define their role as running the company for the benefit of its shareholders.  

I offer two reasons for believing that director allegiance to the principle of shareholder wealth maximization is preferable to the siren song of CSR. First, absent the shareholder wealth maximization norm, the board would lack a determinate metric for assessing options. Because stakeholder decisionmaking models necessarily create a two masters problem, such models inevitably lead to indeterminate results.  

Suppose that the board of directors is considering closing an obsolete plant. The closing will harm the plant's workers and the local community, but will benefit shareholders, creditors, employees at a more modern plant to which the work previously performed at the old plant is transferred, and communities around the modern plant. Assume that the latter groups cannot gain except at the former groups' expense.  

By what standard should the board make the decision? Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards.  

Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.  

The conflict of interest rules governing the legal profession provide a useful analogy. Despite many years of refinement, these rules are still widely viewed as inadequate, vague, and inconsistent -- hardly the stuff of which certainty and predictability are made.  

Second, absent clear standards, directors will be tempted to pursue their own self-interest. One may celebrate the virtues of granting directors largely unfettered discretion to manage the business enterprise without having to ignore the agency costs associated with such discretion. Discretion should not be allowed to camouflage self-interest.  

Directors who are responsible to everyone are accountable to no one. In the foregoing hypothetical, for example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.  

They say that when a politician starts talking about "our kids" that taxpayers need to hang onto their wallets. Likewise, when a businessman starts talking about how socially responsible his business has become, investors need to hang on to their wallets.

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