The Stakeholder Fallacy

Norman Barry is professor of social and political theory at the University of Buckingham in the UK. He is the author of Business Ethics (Macmillan, 1998).

As the saying goes: “There is more than one way to skin a cat.” And former collectivists, embarrassed by the dismal failure of economic planning to provide any kind of life for the people unfortunate enough to live under it, have been quite creative in discovering new ways to undermine capitalism. Some of these efforts come from soi-disant philosophers who, in search of employment, have discovered “business ethics.” However profitable to the practitioners this is, it is in no sense an entrepreneurial discovery. Company directors, stockholders, and assorted “fat cats” (unskinned) are daily bombarded with demands for business to be “socially responsible”; it is a request that many managers are only too happy to satisfy: after all, working for “society” is surely more morally pleasing and less demanding than working for the shareholder.

The business ethicists’ current fad is to demand that the traditional profit-seeking corporation be transformed into a curious (and unspontaneous) business enterprise consisting entirely of stakeholders. The shareholders, the people who put up the capital and bear most of the risks, are apparently only one part of this heterogeneous collection. As prominent American stakeholder theorists William M. Evan and R. Edward Freeman assert: “The reason for paying returns to owners is not that they ‘own’ the firm but that their support is necessary for the survival of the firm.”¹ The ultimate purposes of an enterprise, and the decisions made within it, should be determined jointly by all the groups who play a part in its functioning. These groups—primarily workers, suppliers, residents of the community in which the enterprise is located, and bankers (who in some economic regimes, such as Germany and Japan, are also equity holders)—should have an equal share in all decisions that the firm has to make. Indeed, there is really no limit to the groups that might claim to be stakeholders, since almost anyone can assert at least a nodding acquaintance with the activities of the business. The annual reports of many publicly quoted companies are prefaced by soothing references to what they have done for their organization’s myriad stakeholders. Leading “New Democrats,” such as former Labor Secretary Robert Reich, find the allure of stakeholderism quite irresistible.²

But it is not difficult to show that behind the anodyne language of stakeholderism lies a sinister doctrine indeed. It is an idea and practice, the ideologues claim, that is perfectly compatible with capitalism, but in fact it undermines the defining feature of that economic system: the exclusive rights of ownership. What the doctrine amounts to is the democratization, or even worse, politicization, of what is essentially an individualistic economic institution. It is no coincidence that stakeholder groups are frequently called “constituencies” in the new descriptions of the firm.³

Anglo-American Capitalism and the Stakeholder Model

In the conventional structure of the Anglo-American firm, the rights to action are all ultimately derived from property relationships: there are residual rights, control rights, and decision rights. The shareholders (as residual claimants) are entitled to any surplus that remains after all operating costs have been paid, and therefore they possess the first type of rights. Control rights are the rights to appoint managers, and these are delegated to directors by the owners. Decision rights are exercised in the day-to-day activities of management. Although the shareholders ultimately determine the rights structure, the familiar separation between ownership and control means that they will not directly exercise decision rights. Those are exercised by the managers under the guidance of the directors.

Undoubtedly there is authority in the traditional firm. Decisions have to be made that are not the results of political-style negotiations between groups, but rather are the judgments of personnel driven by the objective of maximizing long-term owner value.⁴ The theoretical explanation of all this is in Ronald Coase’s famous 1937 article in which he demonstrated how the bilateral contract between employees and owners replaced the benign, multilateral, and instantly renegotiable contracts of pure market society; the excessive transactions costs involved in the latter made it an uneconomic way of doing business.⁵

Of course, the firm does not have to be organized like this. In less individualistic capitalist economies, the drive for shareholder value is less insistent and interests other than those of the owners are allowed, either by law or practice, an influence on corporate decision-making. For example, Germany has had worker co-determination since the early 1950s. This system makes trade union membership of the supervisory board of a public company obligatory (although ultimate residual rights are exercised by the owners, for example, in the event of a takeover, which rarely happens). And Japan, despite its superficial resemblance to the Anglo-American model, has in practice developed a system with derisory residual rights for the owners and great power for the managers.⁶

However, the classical-liberal model has been immensely successful, largely because of its admirable flexibility; Japan has been mired in recession for a decade, and Germany is suffering serious capital flight as owners look for more propitious venues for their property than the rigid and unresponsive industrial structures at home. Germany has, however, slowly been adopting Anglo-American business methods in the past few years. As usual, the intellectuals are behind the times.

The stakeholder theorists want to replace a successful production method with one more in keeping with their communitarian inclinations. For them, it is not the property invested that should determine who should exercise decision-making rights but the roles that particular groups play in the organization. Thus in plant relocation, all sorts of affected groups—for example, employees, residents of the area where the firm is currently situated, and inhabitants of the possible new destination—are to be taken into account, in addition to the profit-maximizing goals of the owners. Perhaps remuneration should be a function of group pressures (that is, “social” justice) as well as market value, and severance (if allowed at all) might be negotiated on terms dictated by trade unions.

Most important, takeovers that threatened “communities” (entrenched groups) would most likely be forbidden or strictly regulated in a stakeholder society. In the Anglo-American model this would be catastrophic, since the takeover is the only method by which potential managements can be disciplined. In the “arm’s length” relationships of an essentially anonymous system, there are no intimate social bonds that can prevent opportunism in this type of capitalism.

There is always the agency problem in a business practice that embodies an advanced separation between ownership and control: how do the owners prevent the self-aggrandizing managers’ surreptitiously asserting residual rights? Ironically, left-biased Hollywood movies portrayed accurately this permanent feature of Anglo- American business; we all remember Gordon Gekko’s brilliant speech to the stockholders in Wall Street (the similar one in Other People’s Money is perhaps even better). Maybe the more communitarian capitalist economies prevent managements’ shirking their contractual duties and engaging in self-aggrandizement by enforcing a complex notion of “trust,” although it is hard to see how that method is at all effective in Anglo-American-style individualism. But it is noteworthy that the anti-takeover statutes passed by the American states in the wake of the amazingly successful 1980s corporate restructuring process were promoted by stakeholder groups using communitarian language. In fact, nonshareholding managements stood to lose most from the wealth-creating activities of the “predator.”

Decision-Making in the Stakeholder Model

There is a very simple problem that lies at the heart of all stakeholder theory: how can the potentially conflicting demands of the various stakeholder groups be coordinated? There is no problem here in the Anglo-American model (unencumbered by stakeholders), for although the participants in an enterprise will have different views on how it should be run, what investments to make, what divestitures to effect, and so on, they are ultimately harmonized and put to the test of experience through the price mechanism. That is not the case with a stakeholder corporation, for there is no common scale of values, no surrogate for the price mechanism, but only incessant bargaining between, in essence, political groups that will likely have no immediate financial interest in the company.

Despite openly declaring that “The very purpose of the firm is to serve as a vehicle for stakeholder interests,” Evan and Freeman are at least aware of this problem, though their proposed solution to it is laughable.⁷ To resolve the conflicts between competing stakeholder groups, they recommend the appointment of a “metaphysical director” to adjudicate between rival groups.⁸ This is, of course, self-aggrandizement by philosophers (well, they aren’t paid very much) and no solution to the problem. Any such person will simply divert income to himself up to the point at which the viability of the firm is threatened. Anyway, who would ever invest in a firm whose goal was not to make money for its owners but to satisfy disorganized groups and various social demands?

Maybe this does not bother Evan and Freeman; their article is subtitled, “Kantian Capitalism,” and we know that the rightness or wrongness of actions for Kantians in no way depends on beneficial consequences (even though, like most business moral philosophers, Evan and Freeman insist that corporate ethics are profitable).

A Meaningful Concept of the Stakeholder

None of the above is meant to imply that the idea of the stakeholder is completely useless. It certainly has some function in business. It is quite likely that long-term owner value will not be advanced if labor is treated as an easily disposable factor of production, to be dismissed as soon as a downturn in business activity occurs. This is especially true of “firm specific” human capital, workers whose skills are only appropriate for one particular company. They are the people most vulnerable in the event of a takeover. The firm needs a good reputation, and if it is to prosper it will have to attract labor in the future; its prospects will be harmed if it acquires a reputation for cavalier treatment of its staff.

Again, it will not be to a firm’s long-term advantage if it dispenses with a reliable supplier just because an alternative turns up with a slightly lower price (offering, perhaps, only a temporary advantage). And of course it will pay a company to establish good relationships with the community in which it is situated.

But this has nothing to do with ethics; it is simple prudence. The contemporary theorists of the doctrine, however, are not talking about good business practice. They are objecting to the property-rights structure of the modern corporation and renouncing its economically necessary authority relationships. The alleged equality between the various stakeholder groups is potentially a deadly constraint on profitability. As we know, if everybody owns everything, then nobody owns anything, and no one has an incentive to preserve and expand economic value. Similarly, if everybody is responsible for decision-making, then no one is, and no one is properly accountable. The stakeholder prescription is singularly inappropriate to the Anglo- American capitalism that still functions in a more or less anonymous world where its agents are held together by little more than the impersonal price mechanism and the rules of competition.

Perhaps stakeholder capitalism is more appropriate for closely knit societies, or economies in which transactors do not deal at arm’s length, but participate in a common enterprise. Indeed, such arrangements significantly reduce transaction costs since the individualistic (and often takeover-driven) Anglo-American business world is compelled to spend a lot of resources on lawyers and financial intermediaries. Perhaps there really is a lack of trust in this world. But it is the world of the present and the future, a world characterized by highly mobile labor and quicksilver capital. It is one that certainly requires rapid responses to ever-changing economic circumstances.

The stakeholder theory, despite its meretricious, supposedly modern language, is really rather reactionary. It belongs to the nineteenth-century world of large-scale industry, big unions, more or less unchanging production techniques, and stagnant social relationships. It is the world originally described by Coase. But transactions costs are changing, and it is now becoming efficient to use market methods within the firm. Entrepreneurship does take place there. Future work arrangements will include people working from home and using the Internet. The corporation may become a thing of the past. There will then be no more work for business ethics writers.

It is curious that the antiquated doctrine of stakeholding should have such an appeal at a time of rising stock values, newly emerging companies, a revitalized individualism, and rapid social change.⁹ It is little more than a sanitized version of socialism. Its contemporary irrelevance can be seen from the fact that it has a declining appeal, especially to those economies in which it began, Germany and Japan.

Notes

1. W. Evan and R. Freeman, “A Stakeholder Theory of the Modern Corporation: Kantian Capitalism,” in T. Beauchamp and N. Bowie, Ethical Theory and Business, 4th edition (Englewood Cliffs, N.J.: Prentice Hall, 1993), p. 82. For a critique, see Norman Barry, Business Ethics (London: Macmillan, 1998), chapter 4.
2. Robert Reich, “The New Meaning of Corporate Social Responsibility,” California Management Review, 1998, pp. 8-17.
3. See J. Kuhn and D. Shriver, Beyond Success (London: Oxford University Press, 1991).
4. E. Sternberg, Just Business (London: Little, Brown, 1994), chapter 3.
5. Ronald Coase, “The Nature of the Firm,” Economica, 1937, pp. 386—405.
6. Barry, pp. 80-83.
7. Evan and Freeman, p. 82.
8. Ibid.
9. See W. Beaver, “The End of the Stakeholder Model?,” Business Horizons, 1999, pp. 8-12.