The Emergence of Welfarist Corporate Governance

Marcel Kahan is the George T. Lowy Professor of Law and Edward B. Rock is the Martin Lipton Professor of Law at New York University School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) both by Lucian Bebchuk, Kobi Kastiel, Roberto Tallarita; and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.

Corporate governance is on the verge of entering a new stage. Until the 1970s, managerialism dominated the view of the corporation. Managerialism focuses attention on making individual firms thrive, with managers holding the power to choose both strategy and tactics as well as the discretion to balance the interests of shareholders and other stakeholders.   In the 1980s, shareholderism started to supplant managerialism. For shareholderists, the value of a firm to shareholders takes the center stage. With a simpler metric and concern that managers will pursue their self-interest, shareholderism grants far less deference to managers on questions of strategy and tactics, and even less on balancing the interests of shareholders and stakeholders.  The emerging ideology—an ideology we tentatively dub corporate governance “welfarism”—focuses on corporate governance as a means of promoting activities that generate positive externalities and controlling those that generate negative ones.

Corporate governance welfarism comes in three strands: portfolio welfarism, shareholder welfarism, and direct social welfarism. Portfolio welfarism starts from the observation that shareholders’ economic interest lies in maximizing portfolio value not firm value. For diversified shareholders, the value maximizing strategy is often to push companies to refrain from activities that generate negative intra-portfolio externalities even if those activities would raise firm value. Shareholder welfarism resembles portfolio welfarism in that both, while accepting the primacy of shareholder interests, give weight to shareholder interests other than firm value.  While portfolio welfarism goes beyond firm value by taking into account shareholders’ portfolio financial interests, shareholder welfarism goes beyond firm value by also including shareholders’ non‐financial interests, which are viewed as more reflective of social interests than shareholders’ financial interests. Direct social welfarism departs from shareholderism in prioritizing general social welfare over shareholders’ interests.  Unlike managerialism, however, direct social welfarism accords little deference to management and effectively extends the concept of stakeholders from anyone who has dealings with the corporation to anyone who is either alive or yet to be born.

Like shareholderism, portfolio welfarism and shareholder welfarism are consistent with shareholder primacy—the view that corporations should be managed for the exclusive benefit of shareholders, rather than other stakeholders. Nevertheless, portfolio and shareholder welfarism represent a fundamental departure from shareholderism.  Under shareholderism, corporate law and corporate governance are focused on the individual firm.  Within this “single firm focus,” directors and managers are to promote the value of their particular corporation which, intermediated by the invisible hand of the market, will promote overall welfare.  By rejecting this classical liberal economic approach and instead embracing goals that are much broader than firm value as a means to promote overall welfare, portfolio welfarism and shareholder welfarism place themselves on the same side of the divide as direct social welfarism and on the other side  from shareholderism. Welfarism, in turn, departs from managerialism in looking beyond the single firm, in relying on shareholder and stakeholder pressure rather than on managerial discretion to balance firm value maximization and broader objectives, and in embracing a much wider set of potential stakeholders.

The ideas underlying portfolio welfarism, shareholder welfarism, and direct social welfarism are not new. What has changed is that these ideas have moved from the ivory tower and are increasingly becoming part of the mainstream thinking by shareholders, asset managers, regulators, legislators, and corporate decisionmakers.

Though welfarism is clearly on the rise ideologically, it is less clear how much welfarism has already affected operations at individual firms. Whatever the present impact of welfarism, however, several underlying trends indicate that the move towards welfarism will take hold, grow, and, over time, generate a welfarist turn in corporate governance.

In particular, the ever-increasing concentration of shareholdings in the hands of large, widely-diversified investors increase both the influence of these investors and their incentives to pursue portfolio welfarism.  A large and growing segment of shareholders have material interests in the activities of companies in which they invest that go beyond the effect of these activities on their financial returns. While the efforts of these investors to push companies towards greater social responsibility is still relatively new, it is likely to grow stronger as the percentage of assets under management devoted to values-based investment grows, as values-based investors develop more expertise in dealing with portfolio companies, and as corporate resistance to investor demands declines. At least on a rhetorical level, executives are embracing the notion that companies have a fundamental commitment to an expanded set of stakeholders. This erosion of the shareholder primacy norm may over time affect the attitudes of outside directors and judges, as well as the compensation structure of executives. Finally, regulatory initiatives are increasingly driven by corporate governance welfarist goals.  What makes these initiatives distinct from classic public interest regulations that are fully compatible with shareholderism is that they apply only to public corporations and are designed to achieve goals beyond investor protection.

Welfarism, however, is subject to two inherent limitations. First, welfarism as a corporate objective is mostly addressed to companies with dispersed ownership. This is hardly coincidental.  Because welfarism seeks to induce a company to pursue objectives that are extraneous to the corporation, the benefits to a shareholder from achieving the extraneous goal are not tied to the shareholder’s stake in the corporation, while the costs (in terms of reduced firm value) are.  Other things being equal, shareholders with a small stake are therefore more likely to favor sacrificing firm value to achieve extraneous goals.

Importantly, welfarism’s preference for corporations with dispersed ownership is another dimension along which welfarism differs from shareholderism. For scholars in the shareholderist mold, dispersed ownership is a source of agency costs. For welfarists, by contrast, dispersed ownership is a feature, not a bug.  For any given investor with a certain amount to invest, the more dispersed the ownership, the better. This, notably, is not because dispersed ownership is a by-product of reducing one’s risk through diversification.  Rather, it is because more widely dispersed owners internalize more intra-portfolio externalities, weigh the losses in firm value less in relation to their non-economic gains (which, for a shareholder welfarist, proxy for reduced externalities), or will put up less resistance to companies deviating from shareholder primacy to follow the prescriptions of direct social welfarism.

Second, the informational gaps and lack of consensus that prevent effective political solutions to social problems and create dissatisfaction with traditional shareholderism re-emerges under welfarism at the firm level. Shareholder welfarists must confront the question why shareholders in corporate elections would be more successful in inducing companies to create solutions at the firm level than citizens and voters in political elections. Direct social welfarism presupposes that one can arrive at a consensus on the social objectives beyond profit maximization that a corporation is supposed to serve even though such a consensus it not already reflected in regulations governing and constraining corporate activities. Finally, portfolio welfarism, in order to reconcile conflicting views, assumes that capital markets work well enough to incorporate into stock prices the benefits from reduced externalities even when these benefits arise over a long term, are not easily quantifiable, and will accrue to companies that are not easily identifiable.

If corporate governance welfarism transfers the political polarization that produces deadlock in the political sphere into individual firms, it will improve neither our corporate governance nor our politics.

Download the complete paper here.

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