Shareholder versus Stakeholder Theory

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Introduction

The unethical business practices of Enron and Worldcom have sparked off debates as to which of the two theories – shareholder or stakeholder theory – should prevail. These are two competing corporate governance theories on what the objective of organisations should be. Shareholder theory asserts that the overriding duty of an organisation is to maximise shareholder returns (Friedman, 1962). Stakeholder theory broadens the first perspective, recognising that managers have a duty to not only its shareholders, but also its customers, employees, suppliers and the community (Freeman, 1994). This blogpost aims to review existing literature and argue on why stakeholder theory is preferred to shareholder theory in promoting business ethics.

Misguided Use of the Shareholder Theory Results in Unethical Behaviour

Business ethicists have argued that the shareholder theory promotes unethical behaviour as it focuses on the myopic pursuit towards earnings. The temptation to maximise short-term returns and distortion of the truth, results in unethical means. As cited in the Financial Times (2009), Jack Welch labelled shareholder theory as the “dumbest idea in the world.” However, I believe that the shareholder theory is in itself a sound theory, but the problem lies with the misguided use of the theory.

Investors do not always act rationally. Their expectations may drive short-term share prices to deviate from a firm’s intrinsic value, serving as a poor measurement for long-term shareholder value. As managers are typically paid according to short-term movements in share prices, they will pursue short-term activities that will push share prices up quickly. The 2008 financial crisis epitomises the problem. Lehman Brothers engaged in risky ventures like mortgage securities, resulting in a high debt-to-equity ratio of 60 to 1, in 2008 (Lehman Brothers Annual Report, 2008). As Milton Friedman (1962) wrote, “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 … engages in open and free competition, without deception or fraud.” Thus, the theory dictates that the pursuit of profits should be conducted legally and ethically. The financial crisis is evidence of the misuse of the shareholder framework, whereby managers abused the model and behaved unethically through the excessive use of leverage to maximise short-term profits.

Stakeholder Theory Promotes Ethical Behaviour and Creates Shared Value

According to stakeholder theory, managers need to ensure that the ethical rights of the stakeholders are not infringed upon, as well as balance stakeholders’ interests during the decision-making process. Given the negative social repercussions of the financial meltdown, policymakers and business leaders need to promote ethical behaviour through the use of stakeholder theory. In shareholder theory, managers were compensated for generating stellar returns, but when the firm performed poorly, managers did not have to compensate for the losses. These compensation schemes rewarded risk taking for high returns, but did not punish for losses. Hence, by taking into consideration the interest of various stakeholders like depositors and bondholders, it will promote ethical behaviour and mitigate excessive risk-taking. Thus, possibly preventing the next financial crisis.

Critics of the stakeholder theory argue that the pursuit of business ethics by managing multiple stakeholders’ interests reduces profitability, which is in turn detrimental to shareholders (Laffer, 2005). This has been true for corporate social responsibility (CSR) programs, which have often remained on the periphery of business strategy and functioned as a cost center for organisations (Ethical Corporation, 2005). However, I believe that Porter and Kramer’s (2011) concept of creating shared value (CSV) will enable companies to balance multiple stakeholders’ interests while achieving profitability. In contrast to CSR, CSV involves creating economic value in a way that also creates social value by addressing social needs.

Unilever’s Project Shakti is a CSV initiative that allows low-income women in rural India to sell Unilever’s products. With more than 50,000 Shakti entrepreneurs covering over 100,000 villages in rural India, Unilever has redesigned its distribution strategy to reach previously inaccessible areas. The model has increased the household incomes of these entrepreneurs and enhanced living standards through Unilever’s hygiene products. Sales from Project Shakti contributes to 5% of the company’s total revenue in India, and it also serves as replicable distribution model to penetrate other emerging markets (Unilever, 2015). In addition, Paul Polman, CEO of Unilever, commented “I don’t drive this business model by shareholder value … I work for the customers” (Financial Times, 2010). Nonetheless, Unilever’s share price has appreciated significantly under Polman’s leadership since 2009, achieving an annualised return of 8.23% (Yahoo Finance, 2015). Evidently, embracing stakeholder theory allows companies to increase shareholder value as well.

Conclusion

Shareholder theory is in itself a sound theory, but the problem lies in its execution. The model has been abused by focusing on the myopic pursuit of earnings, at the expense of business ethics. Hence, I believe that organisations should adopt the stakeholder model to promote business ethics and create shared value.


References

Friedman, M. (1962). Capitalism and Freedom, University of Chicago Press, Chicago, IL.

Freeman. (1994). Strategic Management: A Stakeholder Approach.

Financial Times. (2009) Welch condemns share price focus. Retrieved from http://www.ft.com/intl/cms/s/0/294ff1f2-0f27-11de-ba10-0000779fd2ac.html#axzz3WE1ntYSk

Lehman Brothers Annual Report. (2008).

Laffer, A. (2005). Corporate Social Responsibility Detrimental to Stockholders.

Ethical Corporation. (2005). Noted economist says corporate social responsibility is irresponsible. Retrieved from http://www.ethicalcorp.com/ content.asp?ContentID=3415

Unilever. (2015). Project Shakti. Retrieved from http://www.hul.co.in/sustainable-living-2014/casestudies/Casecategory/Project-Shakti.aspx

Financial Times. (2010). Unilever chief backs criticism of shareholder primacy.

Yahoo Finance. (2015). Retrieved from http://finance.yahoo.com/

 

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