To what extend does a company exist only for the benefit of its shareholders? Discuss the place of agency theory and its alternatives, including the problems of putting these theories into practices.
It is widely known that stock market is the place where corporations able to raise large amount of fund from the many investors available in the society. As a return or reward for the investors, they are given a certain amount of share according to the amount of the money contributed. In other words, investors are the owner of the public listed corporations or company. They are the shareholders. Thus, it is reasonable to expect that a company existed to reward the shareholders, because without the pool of funds provided by the many investors, a corporation or company will never existed before (Dobos et. al., 2011). However, such a view is gradually changing in the modern corporate world. There are arguments that company existed not only to serve shareholders, but also the other stakeholders as well (Cragg, 2004). This article will discuss the several issues related to shareholder theories, and the new stakeholder theories, if they are relevant to the corporate world today.
As discussed above, shareholders are essentially the legal owner of corporations, as they provided the fund to start up the company in the very first place. Thus, their rights should be protected. The company is effectively an asset of the shareholders, and thus, the company is logically to be managed to serve the interests of the shareholders (Danielson et. al., 2008). For this, conventional shareholder theory often argued that the management of a corporation is to maximize the shareholder wealth, as the shareholders are essentially the owner of the corporations. Such a view assumes those corporations exist only for the benefits of the shareholders. However, that is more easily said than done, because managers may not necessary work hard to fulfill the shareholders needs or rights. This led us to introduction of Agency Theory as to be discussed in the following section.
Agency theory arises due to the nature of the limited liability of the corporate ownership of public listed company. Particularly in those public listed companies, the ownership as well as the control of the corporations is separated. The ownerships belong to the shareholders, while the control is handed to the management. Effectively, the job to run the daily operations are handed or delegated to the manager. In such a case, managers become the agents, while the owners become the principles.
Very often, managers have personal goals that compete with the mission of shareholder wealth maximization. This leaded to agency problem. Technically speaking, a potential agency problem will arise whenever the manager of a firm is not the owner, or own less than 100% of the shares of the firm. There are several cases or situation that agency problem can arises. These will be discussed as follow.
Manager may not work as hard as possible for shareholder wealth maximization purposes – they may pursue a relaxing working style. As the manager never own the entire company, he may not work as hard as if the company is belong to him entirely. A manager may just want to receive a certain amount of salary, leading a relaxing lifestyle, while not putting good efforts to ensure the success of the company (Brigham et. al., 2004). In the case where manager never own any single share on the company, his risk is minimal, and thus, not face higher risk if the company fail and collapse, as the shareholders are the one to suffer most.
Managers may decide to reward him with excessive perquisites. Instead of maximizing shareholder wealth, manager may engage in works or efforts to maximize his compensation, ranging from salary, stock options, bonuses, travelling claims or allowances and any others (Brigham et. al., 2004). He may also prefer to support his pet projects, or to buy his preferred toys using corporate money. After all, that money is funded fully by the shareholders, and he got nothing to lose. Such acts are truly unethical and are harming shareholders wealth, and indeed a great challenge to good practices of corporate governance.
Managers may decide to maximize the size of the company, not for wealth maximization purposes, but to entrench his position in the firm/ industry. There are also managers that engage heavily on empire building actions, instead of focusing to deliver true value to the shareholders (Fontrodona et. al., 2006). These managers may engage heavily in acquiring smaller competitors or other businesses to enlarge his power in the corporation. Besides, they may use the size of corporations to justify the need to increase his compensation. Furthermore, as the size of the company becomes bigger, their position is more secure, as it become harder for the company to be acquired by the other bigger corporations. However, such an act is detrimental to the financial health of the shareholders.
Managers may engage in actions that can enhance their reputation, at the costs of shareholders wealth. As managers are effectively using the shareholders’ money to manage the corporations, they tend to use the money for personal benefits. For example, they may donate a large sum of money to charity, in order to enhance their personal reputation. Although donation to charity is ethical conduct, but to do that using others’ money for personal benefits is highly unethical. Besides, managers may also engage in excessive risk taking attitudes, by continuously pursuing the high risk high reward projects, as they share the upside, but not the downside of the projects. All these are not really beneficial to shareholders.
As the principal-agents issues outlined above can be detrimental to shareholders (i.e., the rightful owner), good corporate governance practices are suggested to mitigate the issues arise from agency problems. However, that is not something easy to deal with, as agency costs do exist. The several agency costs include: the time and efforts spent to monitor the managers conducts, the resources spent on shareholder engagement, audit as well as risk management programs to be implemented in corporations to control the principle-agents risks. Besides, the measures implemented to control the issues can be costly to the agent side as well. For example, instead of focusing to conduct the business, agents now have to spent time to prove that they are accountable. They, they need to spent time explaining and meeting shareholders (Fontrodona et. al., 2006). The additional paper work for audit, risk management and reporting purposes will also cost a lot to financial, human resources, not to mention the opportunities cost lost in fulfilling the many requirements.
However, there is another viewpoints emerging in the recent years. People started to realize that the existence of corporations should not only serve the shareholders, but also the stakeholders, because the impacts of corporate actions to the society can be huge (Cragg, 2004). Today, corporations are expected to carry out relevant Corporate Social Responsibilities (CSR), mainly for ethical reasons, and partly for financial reasons. This means that the corporations will be held accountable for a wider range of stakeholders. Now, the focus is not merely the relationships between the managers to the shareholders, but also between the corporations to the suppliers, customers, competitors, local community, governments, future generations and the environment (Smith et. al., 2003). All these led to the rise and increasingly popular Stakeholder Theory, which serve as a viable and relevant theory to Shareholder Theory in the past.
According to the Stakeholder Theory, shareholder wealth maximization is no longer the single priority in managing a company, but a more holistic approach to managing the corporations is required (Danielson et. al., 2008). Managers are now burdened with the needs to act morally, responsibly and ethically towards the other stakeholders as well as the society. It is no longer good to act in accordance to the legal framework, but a proactive approach to manage the corporations should be followed. Today, the concepts of green and lean operations are to be emphasized (Cronin et. al., 2011). It is also important for the managers to consider the issues of sustainability (Crittenden et. al., 2011). All of these are important today, as global warming, corporate scandals as well as the need to act in a sustainable manner is becoming more critical to modern society today. All these are becoming more important, as people witnessed how the many irresponsible corporate actions had led the world into very serious financial crises in the year of 2008/ 2009. The reputation of business entities are hurt badly and people seem to trust the business entities less.
Although the Stakeholder Theory sounds compelling, the implementation of such theory in the corporate framework is never an easy task. In the following paragraphs, the various problems of putting Stakeholder Theory into practices will be discussed.
It is hard to balance the needs and aspirations of the various stakeholders. As there are many stakeholders involve, it is very hard for a manager to take care of all of the stakeholders, including customers, employees, suppliers, competitors, governments, society and other at a fair manner. For example, in many instances, to meet the aspiration of a category of stakeholders, for example, the shareholders may not be beneficial for the other stakeholders. Shareholders largely want higher return from their investment, but employees may want higher salary, to the extent that shareholders may be left with little return from their risky investment. There are no fix guidelines on how the balance the efforts to meet each of the categories of stakeholders, and thus, management must exercise their judgment subjectively (Ditlev-Simonsen et. al., 2008). Besides, it is also unsure and debatable that which stakeholders should be placed greater priorities or importance in the Stakeholder Theory. The debate about which stakeholders should be catered for is largely philosophical, and the appropriate judgment may differ from cases to cases. If the management is again burdened with such tasks, they may not have the time to properly run a business, which is their main duty and responsibilities being hired in the firm (Mainardes et. al., 2011).
It is a voluntarily measures, not compulsory. The argument of Stakeholder Theory is about a corporation going the extra mile to meet the several Corporate Social Responsibilities. Thus, some of the corporations may not want to pursue CSR activities. In some instances, such a situation can be detrimental to those corporation actively pursuing CSR activities. For example, in competitive industry, firms that pursue CSR activities may no longer have the privilege to drop the price to compete for greater market shares. These firms are then susceptible to those firms that concentrate fully on price war, regardless of what is argued by Stakeholder Theory. Obviously, there are not benefits to be reaped by those that proactively acted responsibly and ethically. Furthermore, there are no clear evidences that CSR can bring any real benefits to the corporation (as to be argued in section below).
The money invested or spent on Corporate Social Responsibilities may not bring any benefits to the shareholders/ managers. Stakeholder Theory is still largely philosophical in practices, as the question if proactively taking care of all of the stakeholders through a responsible manner will benefit the firm is unclear (Mainardes et. al., 2011). The evidences that ethical firms practicing the Stakeholder Theory can reap better return are mixed. The efforts spent on such activities might not be justified, given that time will be wasted, while company may even gain greater benefits by investing the time and financial resources in other events/ places.
There are trade-offs or sacrifices to be made. Very often, to take care of the many stakeholders’ means the managers have to sacrifice something else. For example, a very kind company may be spending a lot of resources to take care of the employees’ welfare, but at the expense of the customers and shareholders. To make everyone happy is largely impossible (Van Buren et. al., 2003), and this definitely causes the practicing of Stakeholder Theory harder to be implemented. The managers have to decide which items to be sacrifice, and to judge if the trade-off is relevant. Managers will definitely face with several ethical dilemmas in attending to the expectations of so many stakeholders of a firm.
Not all stakeholders’ needs can be met financially. Furthermore, it is not necessary that to spend money can solve all the issues faced by the various stakeholders. As different stakeholders have different expectations, not all of these expectations can be solved by financial terms. After all, not a single company will have the sufficient financial resources to make all stakeholders’ happy.
Overall, this article has shown the rationale for pursuing the Shareholder Theory in the past. Such a theory is relevant as the shareholders are the legitimate owner of the company. It is also discussed how the Agency Theory come into place, as the owner as well as the managers of the companies are largely separated. The concepts of Agency Theory are relevant to understand the rationale for implementing a strong and proper corporate governance practices in the corporations. It is shown that due to the agency problems, a lot of costs may be incurred. Apart from that, this article also proceeds further to discuss the alternative to Shareholder Theory – namely the Stakeholder Theory. In today business landscape, it is argued that to purely manage a firm to maximize shareholders wealth is not sufficient, but corporations should take proactive and extra efforts to exercise Corporate Social Responsibilities. However, it is also discussed that the implementation of Stakeholder Theory is never easy. There are yet many problems to be solved before the Stakeholder Theory can be readily implemented in the corporate world in the future.
References & Bibliography
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Cragg, W. (2002). Business ethics and stakeholder theory. Business Ethics Quarterly, 12(2), 113.
Crittenden, V., Crittenden, W., Ferrell, L., Ferrell, O., & Pinney, C. (2011). Market-oriented sustainability: a conceptual framework and propositions. Academy of Marketing Science. Journal, 39(1), 71.
Cronin, J., Smith, J., Gleim, M., Ramirez, E., & Martinez, J. (2011). Green marketing strategies: an examination of stakeholders and the opportunities they present. Academy of Marketing Science. Journal, 39(1), 158.
Danielson, M., Heck, J., & Shaffer, D. (2008). Shareholder Theory – How Opponents and Proponents Both Get It Wrong. Journal of Applied Finance, 18(2), 62-66.
Dickinson-Delaporte, S., Beverland, M., & Lindgreen, A. (2010). Building corporate reputation with stakeholders: Exploring the role of message ambiguity for social marketers. European Journal of Marketing, 44(11/12), 1856-1874.
Ditlev-Simonsen, C., & Midttun, A. (2011). What motivates managers to pursue corporate responsibility? a survey among key stakeholders. Corporate Social – Responsibility and Environmental Management, 18(1), 25.
Dobos, N. (2011). Non-Libertarianism and Shareholder Theory: A Reply to Schaefer. Journal of Business Ethics, 98(2), 273-279.
Fontrodona, J., & Sison, A. J. G. (2006). The Nature of the Firm, Agency Theory and Shareholder Theory: A Critique from Philosophical Anthropology. Journal of Business Ethics, 66(1), 33-42.
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“[W]hile it remains incomplete in its current form, stakeholder theory is undeniably instrumental in steering the path for businesses in their goal for value creation, be it for shareholder or societal good.”
A reflection paper by Tan Chun Hsien Shawn, as partial fulfillment of a BBA (Honours) module, “Measuring Success in Philanthropy and Impact Investing”.
For decades, the maximisation of shareholder wealth has been the dominant objective of capitalists and corporations (Lazonick & O’Sullivan, 2000). This objective has been an inextricable component of our laws in modern society, the management practices that govern businesses, and even forms the basis of rational economic theory (Saint & Tripathi, 2006). More recently, this view has been challenged with the growing popularity of stakeholder theory. This paper thus seeks to introduce and identify the conflict between the two concepts, to explain how stakeholder theory has been crucial in causing the gradual transition away from shareholder value theory toward a new equilibrium.
Shareholder Value Theory
Shareholder value theory proposes that the primary duty of management is to maximise shareholder returns (Smith, 2003). The roots of this view can be traced back to Adam Smith and the central tenets within his book The Wealth of Nations (Pfarrer, 2010). The theory was framed in its current form by Milton Friedman, who argued that the only social responsibility of businesses was to increase its profits (Stout, 2012). This thought was further reinforced by a paper by Michael Jensen and William Meckling, who described the firm as a legal fiction in which shareholders were principals and managers were their agents (Jensen & Meckling, 1976), and managers who pursued goals other than maximising the wealth of shareholders were reducing social good by imposing agency costs. Such academic backing led shareholder primacy to achieve dominance by the end of the millennium.
However, in the wake of global scandals and crises, the premises of the shareholder-oriented perspective have been increasingly questioned (Smith, 2003). In particular, Enron, exemplary in its corporate governance for maximising shareholder value by fixating on its stock price, inadvertently collapsed due to bad business decisions and accounting fraud (Stout, 2012). A recent article by Forbes also documents the denouncement of shareholder value maximisation by a number of prominent CEOs and top management (Denning, 2015), citing problems such as a focus on short-term returns, a diversion of resources away from innovation, and causing economic stagnation and inequality. It is against the backdrop of the gradually receding prominence of shareholder value theory that stakeholder theory can be discussed.
In comparison with shareholder value theory, stakeholder theory has a far shorter history. The term stakeholder was first used within an internal memorandum at Stanford Research Institute in 1963. While it received initial flak by Igor Ansoff, who viewed stakeholders as a secondary constraint on the main objective of the firm, the stakeholder concept surfaced in the 1970s in several instances of strategic planning literature (Freeman, Harrison, Wicks, Parmar, & Colle, 2010), with the popularisation of the concept ascribed to Richard Edward Freeman in 1984. Since then, the theory has risen in prominence since 1995 (Laplume, Sonpar, & Litz, 2008), and currently represents a shift in perspective within the on-going debate on corporate purpose.
The stakeholder of an organisation can be defined as a group or individual who can affect or is affected by the achievement of organisational objectives (Freeman, 1984). As such, stakeholder theory suggests that the purpose of the corporation should take into consideration all who have an interest in an organisation’s activity (Greenwood, 2008), including shareholders, customers, employees, and the general public (Fontaine, Haarman, & Schmid, 2006). Thus, the objective of management should be to balance the competing interests of these stakeholders (Sternberg, 1996). As such, the theory is seen as a holistic approach to corporate purpose and provides strategic depth to the management of interests through three different approaches: descriptive (explaining corporate behaviour), instrumental (finding links between stakeholder strategies and performance), and normative (interpreting organisational function from a moral standpoint) (Donaldson & Preston, 1995). These theoretical approaches frame the issue on stakeholder interests for further analysis.
While once dominant, shareholder value theory is now contested by the premises of the stakeholder approach. It is in this light that both can now be compared, assessing the factors for change.
Many arguments have been put forth by proponents of stakeholder theory, countering implications of shareholder value theory. One competitive analysis revealed that companies focusing on stakeholders outperformed others even during times when the focus was on shareholder wealth (Pfeffer, 2009), suggesting practical effectiveness of the theory. Furthermore, as the range of performance measurement tools increases, there is reduced need to rely solely on financial measures as well.
In assessing the arguments for shareholder theory, Lynn Stout pointed out in her book that despite the pervasive extent of shareholder value ideology, it remains a managerial choice, rather than a legal obligation or practical necessity (Stout, 2012). Thus, with the exception of self-enrichment, there is much discretion provided by the law with respect to other corporate goals, such as employee protection and serving the community. These goals can and should be pursued by management.
Indeed, stakeholder theory offers a more holistic approach that includes more parties than shareholder theory. Yet it has its detractors as well. According to economist Michael C. Jensen, stakeholder theory should not be considered a valid competing theory since it does not provide a complete specification of the corporate objective function (Jensen, 2001). Unlike the clarity provided by the single objective of shareholder value theory, stakeholder theory directs managers towards many objectives, creating confusion, conflict, inefficiency, and competitive failure for the organisation (Jensen, 2001). Other authors have concurred with this view, stating that accountability to all stakeholders is not only unworkable, but also so diffuse that the accountability created is non-existent (Sternberg, 1996).
A final argument against stakeholder theory is that it undermines fundamental features of society (Sternberg, 1996). For one, it denies owners the right to dictate the use of their assets, stipulating that assets should be used for the benefit of all stakeholders. Due also to this feature and the added entrustment of assets by owners to managers, agent-principal relationships are compromised as well.
Despite the fervent propositions from both sides, the issue of whether the debate has real implications is a question in itself. A survey conducted in 2005 by the University of Melbourne revealed that ideological acceptance may not transit into practical managerial behaviour. Findings from the study showed that even though shareholder primacy had clout among managers, the proposition that directors will pursue shareholder’s interests at the expense of other stakeholders is illegitimate (Anderson, Jones, Marshall, Mitchell, & Ramsay, 2005). While shareholders continue to be seen as the most important of stakeholders, findings revealed that directors prioritise other stakeholders, such as employees, and their interests as well.
Notwithstanding this phenomenon, it is clear that the global business community is in transition to a new ideological consensus. Both the shareholder value theory and the stakeholder theory are theories of value creation, but with different prescriptions to that end. In evaluation, one of the strongest arguments for stakeholder theory is that taking additional stakeholders into account to some extent can be more financially beneficial for the firm in today’s economic landscape (Pfarrer, 2010), perhaps even more so than in shareholder theory. Although contentions remain that stakeholder theory prioritises non-financial market stakeholders at the expense of the firm, empirical observations through competitive analyses of profitable companies in recent years prove this view to be misconstrued (Pfeffer, 2009). Thus, there seems to be a shift not only in ideology, but also in successful managerial business practices, away from the notion of shareholder value maximisation.
That being said, stakeholder theory as it is forms an incomplete approach on both the firm’s corporate purpose and the measurement of its objectives. Thus, more recent theories on both sides of the argument have attempted to synthesize these two goals. For one, enlightened shareholder value theory proposes that companies should pursue the goal of shareholder wealth maximisation with a long-run orientation, seeking sustainable profits by paying attention to relevant stakeholder interests (Millon, 2010). Enlightened stakeholder theory, on the other hand, uses the premises of stakeholder theory, but uses the maximisation of the long-term value of the firm as a criterion for stakeholder prioritisation (Pichet, 2008). We can observe here that there is an apparent convergence from the initially opposing theories, which points to a potential equilibrium at some point between the two theories.
In conclusion, despite the long historical roots of shareholder value theory, we see that stakeholder theory has gradually yet fundamentally changed the perspective of owners, managers, and society. Thus, while it remains incomplete in its current form, stakeholder theory is undeniably instrumental in steering the path for businesses in their goal for value creation, be it for shareholder or societal good.
 E.g. Southwest Airlines, which never had layoffs despite an industry shutdown after the September 11 attacks.
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