How Would Directors Make Business Decisions Under a Stakeholder Model?

Robert T. Miller is Professor of Law and F. Arnold Daum Fellow in Corporate Law at the University of Iowa College of Law. This post is based on his recent paper, forthcoming in The Business Lawyer.

Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here); Stakeholder Capitalism in the Time of COVID, by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Corporate Purpose and Corporate Competition (discussed on the Forum here) by Mark J. Roe.

In a new paper forthcoming in The Business Lawyer, I ask, “How Would Directors Make Business Decisions Under a Stakeholder Model?”

I here understand the stakeholder model in the strong form first articulated by Dodd and more recently endorsed by Blair and Stout in which boards may choose to confer a benefit on a corporate constituency other than the shareholders without regard to whether their decision benefits the shareholders, even in the long run. This strong form of stakeholder theory thus differs from most ESG advocacy, which typically claims that pursuing ESG goals maximizes value for shareholders. It also differs from weak forms of stakeholder theory, which merely seek to remind directors that managing the business in the manner of an unreformed Ebenezer Scrooge is unlikely to maximize value for shareholders in the long run.

The paper makes several points about the strong form of the stakeholder model. First, contrary to what advocates of stakeholder theory often say and even more often imply, stakeholder theory does not put all corporate constituencies on a par, letting directors give equal consideration to the interests of all constituencies. Rather, stakeholder theory uniquely disadvantages shareholders. The reason is that the claims of other corporate constituencies, such as customers, employees, creditors, or suppliers, are founded in contract (or sometimes based on a statute). These legal claims against the corporation thus become floors under what a constituency receives from the corporation. There is no analogous minimum that shareholders must receive. Hence, under the stakeholder model, a non-shareholder constituency always receives at least what it is owed in contract (or under a statute), plus, perhaps, more, and whatever more a non-shareholder constituency may receive comes, not at the expense of some other non-shareholder constituency (each of which also receives at least its contractual or statutory minimum), but at the expense of the shareholders.

For example, suppose the company has unionized workers employed under a collective bargaining agreement. If the company generates profits much greater than anyone expected, many stakeholder advocates would say that the company should pay more to the employees than the agreement requires. But if the company generates profits much lower than anyone expected, no stakeholder advocate would say that the company may pay the employees less than the bargaining agreement requires in order to pay the shareholders a return closer to what they reasonably expected. Because non-shareholder constituencies have contractual (or statutory) claims against the corporation and shareholders do not, the stakeholder model, which purports to treat all constituencies equally, in fact becomes a one-way ratchet uniquely disadvantaging shareholder.

The second major point the paper makes concerns the criticism, which goes back to Berlet, that the stakeholder model provides directors with no clear standard by which to make business decisions—that is, it provides no clear criteria by which directors could determine how much value should be allocated to constituencies in particular cases. I argue in the paper that this criticism of stakeholder theory grossly understates the problem. The reality is that the stakeholder model says nothing at all about which interests of non-shareholder constituencies are legitimate interests, and it says nothing at all about how such interests should be balanced against each other. As a result, the model provides no normative criteria of any kind whatsoever on the basis of which we can intelligibly say that any business decision by the directors is any better—or any worse—than any other. Put another way, under stakeholder theory, every possible decision is as good and as bad as every other possible decision. The stakeholder model is thus not just less determinate than the shareholder-wealth maximization model, not just insufficiently determinate—it is, in truth, radically indeterminate.

This radical indeterminacy makes the stakeholder model the polar opposite of the standard shareholder-wealth maximization model. For, under that latter model, directors should select, from among the legally permissible alternatives, that course of action that promises the highest net present value per dollar of investment. Although there will always be empirical uncertainty about the net present value of projects (indeed, often great uncertainty), nevertheless, modulo empirical uncertainty, the shareholder-wealth maximization model uniquely determines which course of action the directors should pursue. By contrast, even if there were no empirical uncertainty at all about the consequences of the various alternative courses of action, the stakeholder model remains radically indeterminate, providing no basis at all for thinking any possible action is any better or any worse than any other.

The cause of this radical indeterminacy is the absence of any normative criteria in the stakeholder model by which to evaluate and rank alternative courses of action. The question thus becomes whether there are any plausible normative criteria that can be added to the stakeholder model to make it reasonably determinate. The paper considers various alternatives. Probably the most obvious candidate is Kaldor-Hicks efficiency. The paper argues, however, that Kaldor-Hicks efficiency cannot supply the lacuna in the stakeholder model because, since the directors are merely distributing value among various recipients, every distribution is as efficient as every other—i.e., no decision is Kaldor-Hicks superior to any other. Unlike decisions under the shareholder-wealth maximization model, in which directors are attempting to maximize value, decisions under a stakeholder model are not maximization problems but merely distribution problems. Hence, even adding an efficiency norm to the stakeholder model does nothing to relieve its radical indeterminacy.

Another way to attempt to fill the normative lacuna in the stakeholder model would be to rely on hypothetical bargains: the directors should allocate value among the corporate constituencies in accordance with what the constituencies would have agreed to, had they bargained about the matter ex ante. The problem here is that the parties actually did bargain about the matter ex ante: the constituencies other than the shareholders bargained for their contractual rights, and the shareholders bargained for the residuary. Hence, appeals to hypothetical bargains collapse into the actual bargains among the parties, and such appeals would support, if anything, the outcomes entailed by the shareholder-wealth maximization model: each constituency gets what it is legally entitled to get under its contract with the corporation, and the shareholders get the residuary.

We can take the hypothetical bargaining idea a step further and ask what the corporate constituencies would agree to ex post regarding dividing corporate profits if any distribution of such profits required the consent of all constituencies, but this too fails. For one thing, hold-out problems, and other forms of strategic behavior—all the usual difficulties associated with unanimity rules—would paralyze the board, making it the corporate equivalent of the historical Polish Sejm. For another, the outcomes of bargaining in such zero-sum situations depend on the bargaining power and negotiating acumen of parties, and it is hard to see why normative significance should be attributed to such factors. A rule under which the powerful and shrewd gets the largest share of the pie has little to recommend itself from a normative point of view.

A final idea is to supplement the stakeholder model with a robust normative theory, such as that in John Rawls’s Theory of Justice, Mill’s act utilitarianism, or Aquinas’s natural law theory. If we did that, then the normative theory, whichever we chose, would largely solve the problem of radical indeterminacy in the stakeholder model, making it reasonably clear in at least a wide range of cases what the board should do. It is entirely unrealistic to think, however, that public company directors will become experts in moral philosophy, and, moreover, that all the directors at any given company will agree on which moral philosophy to implement in their business decisions. This alternative echoes the improbabilities of Plato: until directors become moral philosophers or moral philosophers’ directors, there shall be no coherent stakeholder governance.

In a final section, I return to the writings of stakeholder advocates and show that, even according to its supporters, under a stakeholder model the decisions of directors will be essentially political—i.e., the result of a tug-of-war of interest groups exerting various forms of pressure on the directors. I conclude that, if even its advocates concede that business decisions made under a stakeholder model would not be reached in accordance with any normative principles, the model is hopelessly and fatally flawed.

The complete paper is available for download here.

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