Freeman

ARTICLE

Do Corporations Have Social Responsibilities?

Free Enterprise Creates Unique Problem-Solving Opportunities

NOVEMBER 01, 1998 by JOHN HOOD

John Hood is president of the John Locke Foundation, a public-policy think tank in North Carolina, and the author of The Heroic Enterprise: Business and the Common Good (Free Press, 1996).

Businesses are accustomed to being criticized for neglecting their responsibilities to society. Complaints that private enterprise puts profit before people have long provided reliable applause lines for politicians and assorted activists, and material for the briefs of crusading public-interest attorneys. But in the past few years, the concept of corporate social responsibility—increasingly part of the curriculum in America’s schools of business and management—has established itself as a political and social force to be reckoned with. This can be seen in recent proposals in Congress and elsewhere to offer tax breaks or regulate differently firms that shoulder their “social responsibilities.”

Another sign of the increasing prominence of the idea was the formation of Business for Social Responsibility (BSR) in Washington, D.C., in 1992. The 54 founding members of BSR—including Ben & Jerry’s Homemade, Inc., The Body Shop, Stride Rite Corp., and Working Assets—were well known as advocates of environmentalism and economic “fairness.” The organization said it intended, through lobbying and public relations, to make “social equity,” “environmental responsibility,” and “developing a sustainable economy” integral to corporate decision-making. BSR now has more than 800 members and affiliates, including AT&T, Federal Express, Hallmark, and Time Warner.

Social responsibility isn’t expected only of large corporations. If commercial activities are perceived to be unethical or destructive, it doesn’t matter what type of business enterprise engages in them. However, publicly traded corporations are the target of most discussion about social responsibility because of how they are created and managed.

Corporate social-responsibility advocates note that since corporations are “fictitious persons,” created by law and sustained by government grants of limited liability for individual shareholders, they have obligations to society that surpass those of sole proprietorships or partnerships. One such scholar, business professor Thomas M. Jones of the University of Washington in Seattle, explained that “the corporation which acts in a responsible manner may simply be paying society back for the social costs of doing business, costs for which the firms rarely receive an invoice.”

This view is hardly new. In fact, it was accepted doctrine in the United States and other Western societies until the nineteenth century that the right to conduct business in the corporate form was a matter of royal or state prerogative, not of private economic interest. Monarchs issued charters to public-stock corporations that promised public benefits, such as exploration and colonization of the New World. Individuals could own shares of the corporation, and sell them (with some limitations), but the purpose was not merely to serve the interests of stockholders. In the American colonies, the earliest business corporations established during the eighteenth century were founded to perform such services as building transportation infrastructure, supplying water, fighting fires, and providing insurance. These early corporations were rare and closely regulated in size, scope, and property holdings.

Self-Incorporation Permitted

After the break from England, however, American states began to pass charters that allowed self-incorporation rather than incorporation by special legislative act. At first, these corporations could be created only for religious, charitable, or municipal functions. The first private incorporation statute, passed by the North Carolina state legislature in 1795, applied only to canal builders, and the canals had to pass to state ownership. Later, however, states broadened the scope of self-incorporation to the point where firms began to arise throughout the economy for the clear purpose of conducting private business.

At the turn of the century, the implicit assumption underlying state corporate law was that the corporation existed to make money for its shareholders. This consensus was rarely challenged. The first important legal test of the responsibilities of corporate directors came in the influential 1919 case of Dodge v. Ford. Despite its name, the case had nothing to do with competition between automakers. Instead, it had to do with the intended largess of Henry Ford, president and controlling shareholder of the Ford Motor Company. In August 1916 Ford owned 58 percent of company stock. John and Horace Dodge owned 10 percent. Rather than pay regular and special dividends, as the company had done in previous years, Ford announced that only regular dividends would be paid. The remaining profits would be used to expand production capacity, increase wages, and offset losses expected from his cutting the price of cars.

Many analysts have interpreted Henry Ford’s strategy as an astute business decision calculated to increase profits in the longer run. But that wasn’t his stated purpose. Ford proclaimed broader social goals: “to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes.” The Dodge brothers sued, claiming that Ford was using shareholder equity to pursue his own personal philanthropic goals. The Michigan Supreme Court, while professing to respect Ford’s business judgment, agreed with the Dodges. It stated that a corporation exists to benefit its stockholders and that corporate directors have discretion only in the means to achieve that goal. It may not use profits for “other purposes.”

The court went on to say that corporate behavior such as charitable giving could pass legal scrutiny as long as it had a legitimate relationship to corporate profits. Other state courts codified this standard by upholding corporate expenditures such as gifts to local training schools, community chests, recreational facilities, hospitals, and even churches. Expenditures designed to attract customers and advance corporate interests by obtaining “good will and prestige” also passed muster.

As a practical matter, then, Dodge v. Ford and similar cases throughout the early twentieth century gave corporate managers great discretion. Nevertheless, the case did establish in the minds of corporate managers and others the notion that corporations had direct responsibilities only to shareholders.

Principle Under Fire

After the Great Depression hit and throughout the war years, this notion came under fire from several fronts. First, a number of scholars and observers of business came to advance the proposition that corporations, far from being owned and thus controlled by their shareholders, were really accountable to no one but their managers. Adolf Berle and Gardiner Means, in their influential work, The Modern Corporation and Private Property, argued that shareholders were passive owners at best; they effectively exercised only the power to sell their shares if dissatisfied with corporate policies or performance. “By surrendering control and responsibility,” Berle and Means wrote, shareholders had “surrendered the right that the corporation should be operated in their sole interest.” Their book, published the same month Franklin Roosevelt was elected, helped justify the economic regulations imposed in the early New Deal.

Another argument advanced was that corporations had grown so large and amassed so much power over society that previous formulations of their social responsibilities had simply become outdated. This view was stated by the New Jersey Supreme Court in A.P. Smith Manufacturing Co. v. Barlow, the 1953 case that helped redefine the purpose of corporations in the minds of many executives, judges, and scholars. In 1951, the board of directors of A.P. Smith, a manufacturer of valves and fire hydrants, adopted a resolution to contribute $1,500 to Princeton University. Corporate shareholders challenged the donation as being outside the proper scope of corporate expenditure. The court disagreed and upheld the contribution. Harking back to the royal charters, the court said that the shareholders, “whose private interests rest entirely upon the well-being of the corporation, ought not to be permitted to close their eyes to present-day realities and thwart the long-visioned corporate action in recognizing and voluntarily discharging its high obligations as a constituent of our modern social structure.”

Around the same time, other court decisions and new state statutes recognized the power of corporations to make donations to the public welfare or for charitable, scientific, or educational purposes. Advocates of corporate social responsibility began to argue that if philanthropy was a legitimate corporate activity, then perhaps other activities that placed social goals over shareholder returns were also legitimate, such as abandoning profitable but (in their view) socially or environmentally destructive product lines. The actual legal status of corporate social responsibility probably did not change a great deal between Dodge v. Ford and Smith v. Barlow, since managers had always enjoyed a substantial amount of discretion in how to serve what they perceived to be the economic interest of the corporation. But in Smith, the court, along with other legal and academic commentators, suggested that the corporate interest itself had changed. Because they controlled institutions of economic power and social influence, responsible corporate managers (as well as government regulators), according to this outlook, should consider a host of goals other than profit maximization.

Reaction and Counteraction

Many business leaders and academics viewed the corporate social responsibility movement with alarm. To them, it went hand in hand with increased government control over private economic decisions. The most famous critic is Nobel laureate Milton Friedman, author of Capitalism and Freedom. Friedman, while teaching at the University of Chicago, wrote perhaps the most widely cited—and criticized—essay on corporate social responsibility in the past 30 years: “The Social Responsibility of Business Is to Increase Its Profits.” In that modest five-page article in the September 13, 1970, issue of the New York Times Magazine, Friedman sought to clarify the legal and ethical issues involved in the debate by noting that businesses are simply groups of people and that only people have responsibilities. If a corporation makes a donation to charity without the shareholders’ authorization, wrote Friedman, the managers are deciding how to spend other people’s money. It would be better to return the money to shareholders as dividends or capital gains and let them decide which charities to support.

In Friedman’s view, the purpose of the corporation is clear: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”

It is no exaggeration to say that, with very few exceptions, every major article on or analysis of corporate social responsibility since the publication of Friedman’s article has cited, mentioned, or challenged it. Some critics maintain that Friedman’s understanding of corporate ownership is badly dated. Since shareholders are passive or even unknowing investors in particular companies (through pension or mutual funds), they don’t exercise the type of control that real owners of property do. “With the dissolution of ownership in the traditional sense,” wrote Michigan State University legal scholar Jeffrey Nesteruk in the Cincinnati Law Review, “the dichotomy between shareholder and societal member must be reconsidered.” Another argument lodged against Friedman’s view is that dividing profit-seeking business activity from the larger world of political, legal, and social decision-making is impossible. “Role specialization, which perhaps is desirable, does not and cannot exist in our modern industrial economy,” Thomas Jones stated. “Corporations play a political role; governments play an economic role. Profit alone no longer implies preferred behavior. . . . Corporations are social institutions and as such must live up to society’s standards; society has changed the standards for corporations, as it has every right to do.”

Friedman has responded that social changes have not invalidated the distinction between corporations and other institutions. Nor is the relationship between shareholder and corporate manager anything but an owner-employee, or principal-agent, relationship. To suggest otherwise is merely to substitute one’s own judgment for the judgment of shareholders, who, after all, voluntarily decide whether or not to invest their funds. They (or their agents among money managers) will sell the stock of companies from which they no longer expect competitive returns. Indeed, the proliferation of stock ownership through institutional investors has merely reinforced the responsibility of corporate managers to focus like a laser beam on profit as an objective. Advocates of corporate social responsibility may not like the implications of this trend, but that does not justify their attempts to second-guess shareholders in their wish for an economic return.

Shifting the Debate

The debate over corporate social responsibility has focused on such issues as the nature of corporate ownership in America today and the legal or fiduciary responsibilities of corporate managers in business transactions such as takeovers and mergers. But there remain a couple of points from Friedman’s discussion that are unappreciated.

One is the important notion that corporations do not exist in physical reality. This has implications beyond Friedman’s contention that corporations, as artificial persons, cannot really have social responsibilities. Consider that corporations consist of more than simply their land, plants, machinery, inventory, and products. The value of a corporation—at least in the minds of those who buy, hold, or sell its stock—is based on both tangible and intangible assets. A company with few assets today but a great idea for a new product may dominate the marketplace tomorrow, while a company with millions of dollars in assets and a large market share in a soon-to-be obsolete industry may be destined for failure. Hard-to-quantify characteristics, such as worker morale, management style, systems for promoting internal innovation, and an ability to foresee future trends, determine the expected value of corporate stock.

Can individual shareholders really be viewed as “owners” of such corporate assets as the brainpower and work ethic of employees, or the goodwill and confidence of consumers? A more meaningful way to think about corporations may be that they are bundles of ever-changing and variably valuable private agreements between individual persons. Coca-Cola, for example, might be reasonably thought of as a set of bilateral and multilateral agreements between such groups as farmers, factory workers, plastic designers, bauxite miners, graphic artists, bankers, bond buyers, managers, retailers, soda drinkers, and celebrity spokesmen. All these individuals (and many others) enter into contracts with Coca-Cola in which they agree to provide something of value in exchange for something else of value.

Stockholders are no different; they agree to risk their wealth as equity owners of the corporation in exchange for a shot at a profitable return on their investment. There is nothing socially undesirable about this emphasis on profit. Many American families rely on investments in stocks or mutual funds to make the down payment on their first home, to send their kids to college, or to live decently in retirement. Shareholders of U.S. corporations seek profit in the same way that other groups of Americans seek higher wages as workers, higher interest rates as lenders, lower interest rates as borrowers, and lower prices as consumers. Corporations serve as the venue where these sometimes compatible, sometimes competing interests are accommodated in ever-changing, but always mutually satisfactory ways.

Stephen Bainbridge of the University of Illinois College of Law has suggested that this “nexus of contracts” view of corporations establishes a firmer defense of profit as the goal of corporations than the traditional understanding of shareholder “ownership” that Friedman employs. After all, shareholders of publicly traded companies differ from, say, homeowners in some easily recognizable ways. Someone who buys a few shares in Coca-Cola and is subsequently caught breaking into a bottling plant cannot defend himself by proclaiming that since he is an “owner” of Coca-Cola, he has a perfect right to enter.

Thinking of the responsibility of managers to stockholders as stemming from a contract with a specified goal—the maximization of the return on investment—might be more helpful than thinking about property ownership per se. By embracing the contractual definition of a corporation, Bainbridge is able to argue that state laws allowing incorporation are not special public favors to shareholders, justifying imposition of social obligations. Instead, they are merely “default rules” for establishing contracts between buyers and sellers of equity that would come about in the marketplace anyway, but at a high transaction cost. Rather than having every corporation and potential shareholder negotiate and sign contracts, the law recognizes a baseline corporate contract that everyone is presumed to agree to unless otherwise specified. “Refusing to hold shareholders personally liable for firm debts thus is the precise equivalent of enforcing a standard form sales contract, nothing more and nothing less,” Bainbridge contends.

Profit and the Common Good

Another of Friedman’s points that deserve greater attention is his suggestion that “the people who preach the doctrine of social responsibility are concealing something: the great virtue of the private enterprise system is precisely that by maximizing corporate profits, corporate executives contribute far more to the social welfare than they do by spending stockholders’ money on what they as individuals regard as worthwhile activity.” Here is the crux of the matter. The assumption that profit is inconsistent with the common good is predicated on a perceived tension between making money and serving one’s fellow man. But as Adam Smith said centuries ago, if the pursuit of profit really does act as “an invisible hand” guiding human action toward socially beneficial endeavors, then surely to abandon that pursuit is to lose the social benefits that would otherwise exist.

In other words, perhaps commercial activity—as distinguished from other forms of behavior, such as personal philanthropy or government action—confers unique benefits on society. Realistically, all sorts of problems in society can be viewed as within the purview of corporate activity. But in Friedman’s view, the response of corporations to these problems will and must be different because of the nature of profit-seeking business. “The crucial question for a corporation is not whether some action is in the interest of the corporation, but whether it is enough in its interest to justify the money spent,” he wrote. Companies, then, bring a search for efficiency and economy to the task of solving problems. This search represents a fundamentally different way of addressing social problems from the means employed by governments, charities, churches, or families. To erase the distinctions between corporations and other institutions is potentially to lose the unique problem-solving opportunities that free enterprise creates. In effect, private business is fulfilling its “social responsibility” if, and only if, it tries to make a profit.

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November 1998

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