From Shareholder Primacy to Stakeholder Capitalism

Capital Market Policies for the 21st Century

The U.S. capital markets have failed to create an inclusive and equitable economy or durable prosperity because they are built atop policies formulated over the last 150 years. These policies fail to account for (1) the injustice that naturally accrues in an unregulated free market (e.g., the lottery of birth), and (2) the planetary boundaries we are now approaching. This post proposes new legislative and regulatory reforms that promote capital stewardship to preserve market mechanisms in a more equitable economic system designed to create justice and ecological balance.

The policies we propose will create a foundation for U.S. markets that channel resources toward durable productivity and equity for workers. With these policies in place, investors will have the tools to create sustainability guardrails for company behavior that will distinguish between efficient, innovative profits that benefit us all and profits derived from negative-sum behaviors that put critical systems at risk and continue to exploit communities.

Reflexive Shareholder Primacy Is at the Root of the Failure of Capital Markets

The laws, regulations, and culture that currently govern U.S. capital markets are designed as if the purpose of business were unrestrained profit, regardless of the damage caused by earning that profit. This design is not accidental and arises from two linked ideas: First, that focusing on individual company financial return will protect shareholders (“agency theory”); and second, that such focus will optimize the allocation of resources in the economy (the “invisible hand”). The blunt application of these concepts without concern for market failures has created a broad culture of shareholder primacy.

But protecting shareholders and relying on unfettered market forces to create value is not sufficient to create a just, equitable, and inclusive society. In the increasingly financialized economy, markets are decoupled from productivity; as a result, financial success often derives from business practices that extract value rather than produce it. This severance of profit from social benefit leads to investing practices that threaten the workforce, the economy, and the environment; and often exacerbate already existing inequalities. We saw this in a pre-COVID-19 economy that produced rising profits but also rising inequality and ecological breakdown; it also left us unprepared for the foreseeable tragedy of a pandemic.

Replacing Shareholder Primacy

But we cannot simply eliminate shareholder primacy and allow corporate executives unlimited discretion to satisfy the interests of all stakeholders. Investors cannot be expected to provide risk capital without some measure of control through their fiduciaries. Moreover, it would be unwise to rely on management wisdom and good faith to replace the pricing and resource allocation functions of markets and profits. That is why we cannot solve the problem of shareholder primacy by simply eliminating it; we must replace it with modified principles that still address agency concerns and preserve market functions. Such new principles must serve the broad interests of human shareholders and other stakeholders, and corporate control must be wielded to do more than maximize financial returns at individual companies.

The complete publication proposes policies based on such principles: They are designed to maintain the market mechanism inherent in profit-seeking but correct market failures that allow for profits derived by extracting value from common resources and communities, including workers. Eliminating this inefficiency and unfairness will benefit human shareholders themselves, who rely on a healthy economy, society, and environment in order to support the return on their diversified portfolios and their other interests, including jobs, health, and social stability. These broad interests give human shareholders and the institutional investors who represent them the incentive and broad perspective to follow the lead of the new policies we propose.

Our Proposals Are Built around a Change in the Fiduciary Obligations to the Human Shareholders

The key element of our proposal is a change in the perceived obligation of those who manage the nation’s collective investment capital: fund trustees, money managers, and corporate directors and executives. It is essential that they change their focus in order to prioritize protection of the broad interests of their beneficiaries, rather than the returns of individual portfolio companies. This starting point is based upon a realistic understanding of the full set of common interests of the ultimate beneficiaries of the financial system — the ‘human shareholders’ and workers who rely on pension funds, foundations, endowments, and other institutional investors that own the bulk of shares in publicly traded companies and alternative investments like private equity and venture capital. Public policy must require business and institutional investors to look beyond individual company financial returns to be responsible for the impact they have on the shared social and natural systems needed for a just, equitable, inclusive, and prosperous economic system. Under our proposal, all companies and institutional investors must adopt benefit governance to enable these broader fiduciary considerations.

Because the institutional investors affected by our proposals control the voting stock of a large proportion of corporations, they will have the power to collaborate on sustainability guardrails across the economy, including the behavior of the corporations in which they invest. In turn, because the companies subject to such guardrails will have broad duties to all stakeholders, their directors and officers will have the legal incentive to follow, rather than evade, these restrictions. The proposal thus aligns the legal incentives for corporate and financial intermediaries with the interests of the human shareholders they are supposed to represent.

The remainder of our proposed policy changes involve a series of supportive legislative and regulatory changes necessary to ensure that fiduciaries have the tools to impose sustainability guardrails and protect these broad interests, and that their beneficiaries are able to hold them accountable for doing so. With these interests protected, investors, financial intermediaries, and companies would continue to have the incentive to seek profits and financial return, but on a level and sustainable playing field that produces regenerative profits.

This policy agenda includes the following categories of interventions required for a broad transition to Stakeholder Capitalism.

We have drafted proposed Federal legislative language, “The Stakeholder Capitalism Act,” attached in Exhibit A of the full paper linked to below, which incorporates each of the following ideas:

Responsible Institutions: We propose that the trustees of institutional investors be required to consider certain economic, social, and environmental effects of their decisions on the interests of their beneficiaries with respect to stewardship of companies within their portfolios. This clarified understanding of fiduciary duty will ensure that institutional investors use their authority to further the real interests of those beneficiaries who have stakes in all aspects of the economy, environment, and society. These changes can be achieved through an amendment to the Investment Company Act of 1940 (15 U.S.C. 80a) by inserting language after paragraph (54) of Section 2 and after subsection (c) of Section 36.

Responsible Companies: Just as trustees of invested funds must expand their notion of the interests of their beneficiaries, the companies in which they invest must also expand the understanding of the interests of the economic owners of their shares, who are more often than not those same beneficiaries. We propose a federal requirement that any corporation or other business entity involved in interstate commerce be formed under a state statute that requires directors and officers to account for the impact of corporate actions not only on financial returns, but also on the viability of the social, natural, and political systems that affect all stakeholders. This change can be achieved through the addition of a new Chapter 2F of Title 15 of the U.S. Code.

Tools for Institutional Accountability: In order to allow beneficiaries to hold institutional investors accountable for the impact of their stewardship on all the interests of beneficiaries, we propose laws that mandate disclosure as to how they are meeting their responsibility to consider these broad interests, including disclosure of proxy voting and engagement with companies. We propose that the Securities and Exchange Commission should promulgate rules requiring each investment company and each employee benefit plan required to file an annual report under section 103 of the Employee Retirement Income Security Act of 1974.

Tools for Company Accountability: Corporate and securities laws that govern businesses must also be changed in order to give institutional investors the tools to meet their enhanced responsibilities. This will include requiring large companies to meet new standards for disclosure regarding stakeholder impact as an important element of their accountability. This proposal can be achieved through an amendment added to The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) after section 13A.

Reactions to the White Paper

We have received many responses, critiques and notes of support since ‘From Shareholder Primacy to Stakeholder Capitalism: A Policy Agenda For Systems Change” was released on September 28, 2020. One of the immediate responses was a thoughtful critique from Wachtell, Lipton, Rosen and Katz, a law firm known as a fierce defender of the prerogatives of corporate management. Another important challenge to the utility of the benefit corporation form is included in an article written by Professor Lucian Bebchuk and Professor Roberto Tallarita of Harvard Law School, who worry about expanded management discretion harming shareholder interests.

Response from “Management Side”

In recent years, Lipton has proposed a vision for the conduct of business that is very close to what we imagine in the White Paper. His New Paradigm, along with the World Economic Forum’s Davos Manifesto and the Business Roundtable’s Statement, strongly endorse measures by business to account for all stakeholders in their decision-making. The difference in our approaches is that they rely on the voluntary actions of individual companies to reimagine the ethos of business. In contrast, we do not believe that company-level decisions will be sufficient to address systemic issues like climate change, pervasive racial injustice, and growing inequality.

It is not that we doubt the good intentions of corporate executives: the question is one of economics, not individual goodwill. A market economy depends on competition among companies striving to maximize their profits; we rely on that competition to price and allocate goods and services. Capitalism’s upside is that competition encourages profits that result from efficiency and innovation; its downside is that it can also encourage profits that come from exploiting the planet and its inhabitants. The real difficulty is that profits from those two sources cannot be easily distinguished: on a P&L, a dollar earned from efficient energy use looks just like a dollar earned by skimping on emission controls.

It would be great if companies could simply decide to focus on the good profits and leave the bad behind. But in a market economy, companies that do the right thing and only the right thing will be put at a competitive disadvantage. They need a level playing field to compete on; otherwise, in the struggle for margin, talent and reduced capital costs, there will be unrelenting pressure to conclude that every dollar of profit available is a good dollar.

Business leaders often argue that no conflict really exists because the interests of shareholders and other stakeholders always converge, at least over the long run. Often this is true—many companies have done extremely well by doing good. But it will not always be the case—consider the billions of dollars tobacco companies have made since it was discovered that it was deadly and addictive, the amount that the oil and gas industry invested in climate denial over decades, or the millions in contributions to dark money pools that have supported racial gerrymandering across the country. These are not short-term decisions that companies made in order to make their next quarter: these are investments with returns measured over decades in which companies have clearly increased the financial value they delivered to their own shareholders while burdening our economy with disease, climate change and racial injustice.

This tension cannot be wished away. The White Paper proposes a solution: rules that facilitate and encourage investor-sanctioned guardrails. Such guardrails would allow shareholders to insist that all companies that they own forgo profits earned through the exploitation of people and planet. Unlike executives, the institutional shareholders who control the markets are diversified, so that their success rises and falls with the success of the economy, rather than any single company. This means that these institutions suffer when individual companies pursue profits with practices that harm the economy. We believe that by leveling the competitive playing field, these changes will pave the way for the type of corporate behavior imagined by the New Paradigm, the Davos Manifesto and the Business Roundtable Statement.

Indeed, far from being “state corporatism,” as the memo claims, what we propose is “human capitalism,” where the workers, citizens, and other humans whose savings fund corporations are given a say in the kind of world they live in. Will it be one in which all compete in a manner that rejects unjust profits? Or, in contrast, will it be one in which corporations continue to lobby against regulation that protects workers while the corporate executives make 300 times the median salary of workers?

The Shareholder Response

“The Illusory Promise of Stakeholder Governance” by Professors Bebchuck and Tallarita (discussed on the Forum here) looks at the idea of “stakeholderism,” and describes how it is likely to fail stakeholders, shareholders and society. Its general argument is that giving management discretion to decide how to balance the interests of shareholders with those of stakeholders will result in management simply using that broad discretion to favor itself.

We agree with the paper to the extent it is criticizing the type of stakeholderism that is described in the New Paradigm. But as we have noted, that form of stakeholder governance simply imagines that management has great discretion to account for workers, communities, the environment and other stakeholders. Our policy proposals give shareholders the responsibility and tools to protect environmental and social systems from company activity that generates financial value by exploiting common resources. Mandatory benefit governance at the corporate level is one of those tools.

The problem with the models of stakeholder governance Bebchuck and Tallarita attack isn’t a problem of purpose, but of power. We believe that their concerns are addressed by requiring fiduciaries throughout the investment chain (including corporate directors) to account for systemic concerns, and by equipping institutional shareholders with tools (including mandatory benefit governance, relevant disclosure and better incentive models) to enforce those responsibilities, as contemplated by the White Paper proposals.

The complete publication is available here.