Journal of Law, Finance, and Accounting, 2017, 2: 247–274
Companies Should Maximize
Shareholder Welfare Not Market Value
Oliver Hart
1
and Luigi Zingales
2∗
1
Department of Economics, Harvard University, USA; ohart@harvard.edu
2
Booth School of Business, University of Chicago, USA;
Luigi.Zingales@chicagobooth.edu
ABSTRACT
What is the appropriate objective function for a firm? We analyze
this question for the case where shareholders are prosocial and
externalities are not perfectly separable from production decisions.
We argue that maximization of shareholder welfare is not the
same as maximization of market value. We propose that company
and asset managers should pursue policies consistent with the
preferences of their investors. Voting by shareholders on corporate
policy is one way to achieve this.
1 Introduction
This paper is concerned with a venerable question: what is the appropriate
objective function for a firm, particularly a public company? This question
can in turn be divided into two sub-questions. The first is, what does the law
(in the United States, say) require the board of directors or managers of a
(public) company to do? The second is, what should managers do? We will be
concerned more with the second sub-question than the first, but our analysis
will have implications also for the design of law.
A natural starting point for our analysis is the famous article that Milton
Friedman published in the New York Times Magazine in 1970 (Friedman,
∗
We are grateful for feedback from audiences at the JLFA conference in Cambridge,
MA (November, 2015), the National University of Singapore (November, 2015), the Crisis
in the Theory of the Firm conferences at Harvard Business School (November, 2015) and
Booth School of Business, University of Chicago (March, 2017), the Hans-Werner Sinn
retirement conference in Munich (January, 2016), the 2016 Global Corporate Governance
Colloquia in Stockholm (June, 2016), the Committee for Organizational Economics meeting
in Munich (September, 2016), the ALEA Conference at Yale (May, 2017), the Contract Law
and Economics in the Next One Hundred Years conference at Copenhagen Business School
ISSN 2380-5005; DOI 10.1561/108.00000022
©2017 O. Hart and L. Zingales
248 Oliver Hart and Luigi Zingales
1970).
1
In this article, Friedman starts off by arguing that a corporate
executive is the employee of the owners of a (public) company and has a
direct responsibility to his employers. He goes on to say: “That responsibility
is to conduct the business in accordance with their desires, which will generally
be to make as much money as possible while conforming to the basic rules of
the society, both those embodied in law and those embodied in ethical custom.”
Friedman’s article has been enormously influential and his general position,
that companies should maximize profit or market value, commands wide
acceptance among both economists and lawyers today. It can even be seen as
providing the intellectual foundation for the “shareholder value” revolution.
In this article we take issue with one part of Friedman’s argument. We
follow him in supposing that, for many public companies, shareholder welfare
is an appropriate objective. However, we argue that it is too narrow to
identify shareholder welfare with market value.
2
The ultimate shareholders
of a company (in the case of institutional investors, those who invest in the
institutions) are ordinary people who in their daily lives are concerned about
money, but not just about money. They have ethical and social concerns. In
principle, these could be part of the “ethical custom” Friedman refers to, but
does not elaborate on. Not only do shareholders give to charity, something
Friedman discusses at length, but they also internalize externalities to some
extent. For example, someone might buy an electric car rather than a gas
guzzler because he or she is concerned about pollution or global warming; she
might use less water in her house or garden than is privately optimal because
water is a scarce good; she might buy fair trade coffee even though it is more
expensive and no better than regular coffee; she might buy chicken from a
free range farm rather than from a factory farm; etc. As another example,
many owners of privately-held firms appear to care about the welfare of their
workers beyond what profit maximization would require.
However, if consumers and owners of private companies take social factors
into account and internalize externalities in their own behavior, why would
they not want the public companies they invest in to do the same? To put
it another way, if a consumer is willing to spend $100 to reduce pollution by
$120, why would that consumer not want a company he or she holds shares in
to do this too?
(June, 2017), and the NBER Corporate Finance meeting (July, 2017). We would also like to
thank Henry Hansman, Michael Klausner, Bruce Kogut, John Matsusaka, Holger Spamann,
two referees, and especially Niko Matouschek, for helpful comments. Luigi Zingales gratefully
acknowledges financial support from the Stigler Center at the University of Chicago.
1
Friedman had written about the same topic earlier; see Friedman (1962). But the
question has a much longer history. See, e.g., Berle (1931) and Dodd (1932).
2
We are by no means the first to argue that shareholder welfare and market value are
not the same. Related contributions are Elhauge (2005), Graff Zivin and Small (2005),
Baron (2007), Bénabou and Tirole (2010), Morgan and Tumlinson (2012), and Magill et al.
(2015). We discuss some of these papers further below.
Companies Should Maximize Shareholder Welfare Not Market Value 249
A response that Milton Friedman or his followers might make is: we should
separate money-making activities from ethical activities. Let companies make
money and let individuals and governments deal with externalities. In some
settings (like charity, which is Friedman’s leading example), this is a powerful
argument, but as a general matter we disagree with it because we believe
that money-making and ethical activities are often inseparable. Consider the
case of Walmart selling high-capacity magazines of the sort used in mass
killings.
3
If shareholders are concerned about mass killings, transferring profit
to shareholders to spend on gun control might not be as efficient as banning
the sales of high-capacity magazines in the first place.
More generally, Friedman’s separability assumption requires consumers to
have a (scalable) project that is the reverse of the project implemented by the
corporation. But is there any reason to think that the reverse of an oil digging
project, say, always exists? In many cases this would seem to defy belief.
In this paper we will be particularly interested in non-separable activities,
where profit and damage are inextricably connected for technological reasons.
4
The company has the technology to create both, and individuals do not have
the technology (costlessly) to undo this. In this case we will argue that
Friedman’s conclusions do not hold: shareholder welfare is not equivalent
to market value. In contrast, in the case where the externality is separable
from money-making, such as with charitable giving by companies, Friedman’s
argument is correct.
A second argument that Friedman and his supporters make in favor of
profit maximization is that externalities should be left to government. Like
many people these days (and maybe always), we are not that sanguine about
the efficiency of the political process. Also, even if the political process is
efficient, it might be very difficult to write a regulation that specifies, say, that
companies should treat their workers with dignity. It might be better to leave
the implementation of this goal to shareholders. Finally, in the United States
there are some areas where the Supreme Court has made political intervention
very difficult by, for example, ruling that individuals have a constitutional
right to own a gun and that corporations have a constitutional right to support
political campaigns. If political change is hard to achieve, action at the
corporate level is a reasonable substitute.
5
An example of such an action is
the attempt by some Walmart shareholders, such as Trinity Church, to include
in the Walmart proxy statement a proposal requiring the board to oversee
the sale of “products that especially endanger public safety” (Bainbridge and
Copland, 2016).
3
https://www.forbes.com/sites/clareoconnor/2015/04/15/walmart-beats-out- church-in-
court-over-gun-sales/#5e48811f66c8.
4
Elhauge (2005), Bénabou and Tirole (2010), and Morgan and Tumlinson (2012) also
consider the case of non-separable activities.
5
See Bénabou and Tirole (2010) for a discussion of this issue.
250 Oliver Hart and Luigi Zingales
We are aware of a further counter-argument to our suggestion that com-
panies should pursue shareholder welfare rather than value maximization. If
the board is encouraged to take into account ethical concerns, which are hard
to quantify, might this not open the door to self-interested behavior under
the guise of ethical behavior? This is a legitimate worry and we will discuss
possible remedies.
We model prosocial behavior in a somewhat novel way. In the existing
literature on social investing (Heinkel et al., 2001; Graff Zivin and Small,
2005; Barnea et al., 2016; Baron, 2007; Hong and Kacperczyk, 2009), prosocial
investors are supposed to be sin-averse and to discount shares of dirty companies
relative to those of clean companies. We do not proceed in this way for the
following reason. Under sin-aversion the marginal investor in a company, that
is, the investor whose valuation of shares equals their market price, will be the
most prosocial of the shareholders since by definition inframarginal investors
have a valuation above the price and so must be less sin-averse. Thus a value
maximizing company will maximize the valuation of its most prosocial investor,
and this will naturally lead it to act in a somewhat prosocial way. (“Prosocial
behavior is good for profit.”)
We think that this conclusion is too optimistic. We believe that in reality
many investors are prosocial even though they are willing to hold the shares of
tobacco or gun companies. To capture this, we suppose that each individual
puts some weight on doing the right or socially efficient thing, but only if he
feels responsible for the action in question. The relative weights on private and
social payoffs vary across individuals. This formulation implies that a consumer
may vote for a company to adopt a clean rather than a dirty technology even
if this reduces profit, but will be willing to hold shares in a dirty company if
he is not responsible for the decision (or once the decision has been made).
We discuss the robustness of our results to different specifications of moral
behavior in Section 5.
Our paper should be seen as a contribution to the vast literature on
objectives of firms. This literature can be divided into several parts. One part
emphasizes that a Friedman-type argument holds only in an Arrow-Debreu
complete markets economy where each firm is a perfect competitor. If there is
uncertainty and some contingent commodity markets do not exist, consumers
will care about the types of securities firms issue as well as the value of these
securities, and shareholders will disagree about what a firm should do: net
market value maximization will not be a universally approved goal.
6
The same
is true if there are complete markets but the firm is an imperfect competitor
in the product or labor markets. A shareholder of General Motors who is also
a purchaser of cars may favor a low price policy for GM, even if this sacrifices
6
See the papers in Magill and Quinzii (2008).
Companies Should Maximize Shareholder Welfare Not Market Value 251
some profit (Farrell, 1985). Similarly, a GM shareholder who works at GM
may favor a high wage policy rather than a profit-maximizing one.
A second part of the literature emphasizes the idea that, particularly these
days, shareholders have diversified portfolios and so are interested in total
market value rather than the value of a particular firm. If managers respond
to this and maximize combined value, the good news is that some coordination
failures between firms will be avoided. The bad news is that managers may be
able to exploit their joint monopoly power without needing to reach formal or
informal agreements, rendering anti-trust laws powerless.
7
A third part of the literature has been concerned with the relations between
a firm and its stakeholders, which include workers, consumers, producers and
creditors, as well as shareholders. In a world of incomplete contracts, these
groups are all vulnerable to opportunistic behavior and so to encourage them
to make relationship-specific investments it may be important for managers to
deviate from short-run profit or value maximization.
8
Under some conditions
it may be efficient for the company to be set up as a worker, producer, or
consumer co-operative or as a non-profit.
9
Our paper is closer to a fourth part of the literature that emphasizes
corporate social responsibility.
10
This part of the literature, and it is vast, is
mainly concerned with the empirical implications of a company’s pursuing a
broader objective than just shareholder value. Might putting some weight on
social issues actually increase profit in the long-run? There is also a small
theoretical literature on corporate objectives when shareholders care about
public goods and externalities. We will discuss the relationship between our
paper and this literature in Section 6. One point to note is that most of the
theoretical literature is concerned with corporate gift-giving rather than with
the mitigation of externalities, which is the focus of our paper.
The closest work to ours is Elhauge (2005). Elhauge (2005) makes many
of the same arguments that we do in a more informal way. Specifically, he
recognizes that profit maximization is too narrow a goal for managers when
shareholders have social concerns. He also identifies the role of takeovers in
pushing companies to maximize profits, even against the interest of shareholders
themselves, given that shareholders may be subject to a collective action
problem. Elhauge (2005) does not model prosocial behavior, nor does he
explain the asymmetry, i.e., why in a world of socially conscious shareholders
we do not observe prosocial takeovers; this is one of the concerns of our paper.
He also does not advocate shareholder voting as a way to determine corporate
7
For recent empirical work on the importance of this effect, see Azar et al. (2017). For a
discussion of the theory, see Rotemberg (1984), Gordon (1990), and Azar (2017).
8
See, e.g., Shleifer and Summers (1988), and Blair and Stout (1999). For a recent
discussion, see Mayer (2013). For a related idea, see Magill et al. (2015).
9
See, e.g., Hansmann (1996).
10
For a recent survey, see Kitzmueller and Shimshack (2012).
252 Oliver Hart and Luigi Zingales
policy, as we do. At the same time his paper considers a number of issues that
we do not. Stout (2012) also argues that, given that shareholders are prosocial,
managers should pursue a broader agenda than profit maximization.
The paper is organized as follows. In Section 2 we consider a very simple
model of a founder who wants to take a company public. We ask whether the
founder prefers to create a “clean” company or a “dirty” company assuming
that she has complete control over the company’s future. In Section 3 we
discuss various governance structures that will allow the founder to influence
the direction of the company given that she does not have complete control over
its future. In Section 4 we compare the governance arrangements suggested by
our analysis to what is observed or feasible in practice. Section 5 discusses the
robustness of our results to the particular way we model prosocial behavior.
Section 6 contains a very short literature review. Section 7 concludes.
2 A Very Simple Model
Consider a company initially 100% owned by a founder F. At date 0 F will take
the company public and sell off her entire stake.
11
A new board of directors
will be appointed and this board together with senior executives will take an
action at date 1. For simplicity we suppose that this action
x
takes on two
values: clean or dirty. The action has two effects: it creates some profit
π
that
is distributed to shareholders, and some environmental damage that affects
people in the rest of the economy (possibly in other countries). Note that
this environmental damage is supposed not to affect shareholders directly. We
assume that the damage is measured in money. For simplicity we assume that
the environmental damage of the clean action is zero while the environmental
damage of the dirty action is d. The interest rate is zero.
We can thus write the payoffs as follows, where social surplus equals profit
minus damage:
profit damage social surplus
Clean π
clean
0 π
clean
Dirty π
dirty
d π
dirty
− d
Our economy contains a large number of consumers (one of whom is F).
Most consumers are not wealthy (F is an exception), and some consumers
are prosocial (or socially conscious). We model prosocial behavior as follows.
11
The analysis would not be very different if F initially sells only a fraction of her shares.
As long as she retains control, she will feel responsible for the choice of action or governance
structure. Furthermore, she will be concerned about what happens after she loses control,
an event that is bound to happen eventually.
Companies Should Maximize Shareholder Welfare Not Market Value 253
We suppose that a consumer puts some weight on doing the right or socially
efficient thing, but only if he feels responsible for the action in question. An
implication of this is that a consumer does not object to holding shares in a
dirty company if he had no role in choosing the dirty action—indeed he will
pay full price for such shares. If the consumer is asked to vote on a clean
action rather than a dirty action, however, he may be prepared to vote for the
former. We will take the view, discussed further below, that a consumer will
vote as if he is pivotal since this is the only time his vote matters.
12
Moreover,
if his vote is pivotal, he feels responsible for the outcome.
13
We make a distinction between how a consumer decides between actions
and his final payoff. We will refer therefore to two types of payoffs: decision
payoffs and final payoffs. The decision payoff incorporates the damage that
his decision causes, while the final payoff does not.
Start with decision payoffs. We assume that the decision payoff from an
action that consumer
i
feels responsible for is a weighted average of his private
payoff and a fraction of the social surplus corresponding to the action, where
the weights are (1
− λ
i
) and
λ
i
, respectively, and the fractional weight on the
social surplus term equals consumer
i
’s shareholding.
14
That is, the decision
payoff to consumer
i
who owns a fraction
α
i
of the company’s shares from the
dirty action is
(1 − λ
i
)α
i
π
dirty
+ λ
i
α
i
(π
dirty
− d) = α
i
(π
dirty
− λ
i
d), (1)
while from the clean action it is
(1 − λ
i
)α
i
π
clean
+ λ
i
α
i
π
clean
= α
i
π
clean
, (2)
where 0 ≤ λ
i
≤ 1.
It follows that consumer i will vote for clean over dirty if and only if
α
i
π
clean
> α
i
(π
dirty
− λ
i
d), (3)
which, as long as α
i
> 0, simplifies to
π
clean
> π
dirty
− λ
i
d. (4)
12
We ignore the cost of voting.
13
For a model of responsibility, see Engl (2017). People may try to avoid knowing about
or being responsible for decisions in order to make selfish choices. On this, see Rabin (1995)
and Bénabou and Tirole (2010). But evading responsibility may be more difficult if you are
voting on an issue.
14
We suppose that a consumer feels responsible for the share of social surplus correspond-
ing to his shareholding in order to avoid a situation where the social surplus term overwhelms
the profit term for a small shareholder. A similar assumption is made in Graff Zivin and
Small (2005) and Baron (2007). The evidence in Schumacher et al. (2017) on dispersed
benefits provides another explanation for why the social surplus term may fail to overwhelm
the private payoff.
254 Oliver Hart and Luigi Zingales
Comparing
(4)
and social surplus, we see that the only difference is that
consumer i puts weight λ
i
rather than 1 on damages.
Let us turn now to final payoffs. We assume that once the consumer has
made his decision—taking externalities into account—he is no longer plagued
by this decision. He neither suffers from the externalities resulting from it nor
receives a warm glow from avoiding them.
15
Thus consumer
i
’s final payoff is
α
i
π
clean
if the clean action is implemented and
α
i
π
dirty
if the dirty action is
implemented. Later in the paper we will provide a fuller discussion of why we
distinguish between decision payoffs and actual payoffs.
It follows from
(4)
that a consumer never votes for an action that is less
profitable and also less socially efficient. More formally, we have
Proposition 1. (a)
If
π
clean
> π
dirty
, all consumers vote for clean over
dirty.
(b) If π
clean
< π
dirty
− d, all consumers vote for dirty over clean.
To make the analysis interesting we assume a tension between profitability
and social efficiency, i.e.
π
dirty
> π
clean
> π
dirty
− d, (5)
that is, neither (a) nor (b) applies.
Let us return to the situation of the founder F at date 0. We are interested
in the case where F through a choice of governance structure can affect the
determination of the decision at date 1. Thus F will see herself as responsible
for the choice of action
x
. The simplest case is where F can choose
x
directly.
What x does she want?
The
x
that F chooses will affect the market value of the shares at date 0
and hence the amount that F receives when she cashes out. The market value
is given by
π
clean
if clean is chosen and
π
dirty
if dirty is chosen. As with any
other person in the economy, F’s decision payoff is a weighted average of profit
and social surplus. Thus, if
(4)
holds, F will choose clean and if it does not,
then F will choose dirty. In other words, F will choose clean if and only if
λ
F
>
π
dirty
− π
clean
d
, (6)
i.e., if and only if the weight F puts on social considerations is sufficiently large
relative to the ratio of the difference in profits to damages. F’s final payoff is
just given by the profit associated with the action chosen (absence of warm or
cold glow).
One special case of our model is when clean is a lower profit, lower damage
action, but is no more socially efficient than dirty, i.e.,
π
clean
= π
dirty
− d. (7)
15
For a discussion of warm glow effects, see Andreoni (1990).
Companies Should Maximize Shareholder Welfare Not Market Value 255
One interpretation is that choosing clean stands for giving some of the share-
holders’ money to a (environmental) charity. This is a situation where external-
ities are separable from money-making activities. Proposition 1(b) implies that
all shareholders would vote for dirty over clean, as would the founder. In such
a case, our model says that value maximization is the appropriate objective of
a company. Thus, we can see Friedman’s conclusion that individuals rather
than companies should give to charity as a special case of our model where
externalities are separable from money-making activities.
So far we have assumed that F chooses
x
directly. In the next section we
discuss how F’s choice might be implemented in practice.
3 Implementing the Founder’s Choice
Before we turn to discussing how F could try to implement or at least influence
the choice of
x
, it is important to analyze how the market for corporate control
will affect this choice in the absence of any restrictions. Even though hostile
bids are rare these days, we will analyze how they could impact the choice
of x.
3.1 Amoral Drift
Suppose that a board is expected to choose clean. Then the value of the
company (just before date 1) will be
π
clean
. A bidder with
λ
i
= 0 (or a low
λ
i
), that is, someone who cares only or mainly about money, could make an
unconditional offer for the company at a price
π
dirty
> p > π
clean
. At the
same time he could announce that if successful (more than 50% of the shares
are tendered), he plans to freeze-out non-tendering shareholders at a price
between
p
and
π
clean
. If successful this unconditional offer nets the bidder a
profit of π
dirty
− p.
How will shareholders react to such a bid? We argue that even prosocial
shareholders will tender. The reasoning is as follows. Each shareholder is
small and so the chance that his tendering decision will determine the success
of the bid is negligible. If a shareholder thinks that the bid will fail then it
is better for him to tender since he will receive
p
and can always buy back
his shares at
π
clean
. If the shareholder thinks that the bid will succeed then
since he is extremely unlikely to be pivotal he will barely feel responsible for
the outcome even if he tenders (to put it another way, the second term in
his decision payoff,
(1)
-
(2)
, will be weighted by the probability of his being
pivotal). Thus, the second term in
(1)
-
(2)
drops out. Hence he compares
p
,
the price he receives if he tenders, to the freeze-out price, which is lower. Thus,
it is again better to tender.
256 Oliver Hart and Luigi Zingales
So tendering is a dominant strategy even for a prosocial shareholder and
the bid succeeds.
16
This is true even if the majority of shareholders have
high
λ
i
’s and would have voted against the bid if given the opportunity. The
bidder is taking advantage of the collective action problem to coerce dispersed
shareholders into accepting an outcome that collectively they may not like. A
prosocial shareholder with a high
λ
i
would vote for clean rather than dirty
because he reasons to himself: If my vote is pivotal, and this is the only time
it matters, I will be responsible for the dirty outcome if it occurs. I should put
a lot of weight on the second term in (1)-(2), and the second term outweighs
the first if my
λ
i
is high. However, such a shareholder will tender to a bidder
even if he knows the bidder will choose dirty rather than clean because he
reasons to himself: My decision is almost certain not to be pivotal and so
the probability of my being responsible for the success of the bid is very low.
Hence the second term in
(1)
-
(2)
gets very low weight and according to the
first term I should tender.
Thus, the market for corporate control will push a board who wants
to choose clean into a choice of dirty: we call this an “amoral drift”. An
example of this amoral drift is provided by Shleifer and Summers (1988), who
argue that a hostile bidder who gets control of a company might profit by
reneging on implicit contracts made by previous managers with employees.
Our model explains why prosocial shareholders might favor upholding the
implicit contracts and yet might still tender to the bidder.
It is important to note that the unrestricted takeover market just described
is a thing of the past in the United States. First, as a result of a number of
legal decisions it is now difficult, if not impossible, in Delaware for a bidder to
make a two-tier offer where the freeze-out price is significantly below
p
. The
closer the freeze-out price is to
p
the less inclined will be a shareholder who
favors clean to tender if he thinks the bid will succeed. Second, the widespread
use of poison pills effectively forces a bidder to hold a vote before taking
over a company. This avoids the problem we have identified since prosocial
shareholders can vote against a bid to turn a clean company into a dirty one.
For the same reasons, activist investors do not pose the same dangers for
clean companies as bidders. An activist accumulates a toe-hold in a company
but then relies on other shareholders to support its position, which is akin
to a vote. Thus if the majority of shareholders favor a clean technology an
activist investor should not be able to turn a clean company into a dirty one.
16
This “pressure to tender” problem is well-known. For a discussion, see Bebchuk and
Hart (2001), and, in the context of profit-seeking bidders and prosocial shareholders, Elhauge
(2005). Note that a version of our argument also holds if the bidder makes a conditional
offer at a price
p > π
clean
. Now there are two equilibria. If shareholders expect the bid to
succeed they will tender and it will succeed. However, there is a second equilibrium where
the shareholders expect the bid to fail, do not tender, and it fails.
Companies Should Maximize Shareholder Welfare Not Market Value 257
(However, given that the activist votes his shares, there will still be a force in
the direction of dirty.) We return to this question in Section 4.4.
Given the above the amoral drift may be less serious than it once was. At
the same time we think that that an amoral drift may still exist to the extent
that company boards and asset managers think (mistakenly in our opinion)
that they have a fiduciary duty to maximize shareholder value, something that
we discuss further below.
We see that an unfettered market for corporate control can imperil clean
companies. Is the opposite true? If there are many consumers with high
λ
i
’s,
might there not be at least one wealthy one who is willing to take over a
company that is expected to choose dirty and turn it into one that will choose
clean?
We believe that the answer is no. There is an important asymmetry here.
First, when it comes to removing an externality, there is a collective action
problem. Someone who takes over a profitable dirty company and converts
it into a less profitable clean company will take a loss and so each prosocial
consumer would prefer someone else to do the job. But there is a second issue.
We have assumed that the second term in
(1)
-
(2)
enters a prosocial consumer’s
decision payoff only if he feels responsible for an action, and also that it does
not enter his final payoff. Consider the bidder’s calculation. If he does not
make a bid his payoff is zero. If he does make a bid he will have to offer
shareholders (at least) the current market price
π
dirty
to persuade them to
tender.
17
Once the bidder has a majority of the shares, say he acquires 100%,
he will feel responsible for the choice of x and so will choose according to
(4)
.
If his λ
i
is high and he chooses clean, his final payoff is
− π
dirty
+ π
clean
< 0, (8)
i.e., he makes a loss. Thus it is better for him not to make a bid.
Note again the assumptions we have made. A consumer takes damage into
account if and only if he feels responsible for an action causing the damage.
But after he has chosen his (presumably correct) action the damage does not
enter his final payoff as a negative term: there is no cold glow. Nor does the
removal of damage enter as a positive term: there is no warm glow.
To use a numerical example, a prosocial consumer might vote to make
$100 profit and cause no pollution rather than to make $150 profit and cause
pollution equal to $60. Indeed he will do so if his
λ
exceeds 5/6. His final
payoff from doing so, however, will be $100. Once he makes the right decision
he does not feel good about the damage of $60 that he is preventing.
For this reason the same prosocial consumer would not pay $150 to change
a company that is making $150 profit and causing damage $60 into one that
17
At any price below
π
dirty
it is a dominant strategy for a shareholder not to tender as
long as any future freeze-out price has to exceed the pre-bid market price,
π
dirty
; this is
consistent with U.S. corporate law.
258 Oliver Hart and Luigi Zingales
makes $100 profit and causes no damage. If he did so, his final payoff would
be
−
150 + 100
<
0. There is something like the endowment effect at work here
but the cause is different.
Of course, these assumptions about payoffs and behavior could be ques-
tioned. Some evidence consistent with them can be found in Lazear et al.
(2012) and Della Vigna et al. (2012). In Lazear et al. (2012), half of the
subjects exhibit a preference for avoiding a situation where they must decide
whether to share the proceeds of a game. Similarly, in Della Vigna et al. (2012),
between 10% and 25% of households do not answer the door bell when they
have been warned that the visitor might be a fund raiser. Thus, people prefer
to avoid situations where they have to make a prosocial decision.
This simple asymmetry has a very sharp implication: without any restric-
tions publicly traded companies will naturally drift towards social indifference,
i.e., they will tend to put little weight on the externalities they produce. They
will underweight social surplus much more than privately held companies.
Ironically, in the United States proxy access rules are not designed to solve
this problem—if anything they go in the opposite direction. Under rule 14a-8,
the SEC requirement to include shareholders’ proposals in companies’ proxy
material is limited to “proper subjects for action.” The SEC later opined that
“proposals which deal with general political, social or economic matters are
not, within the meaning of the Rule, ‘proper subjects for action by security
holders.
18
”’ Consistent with this approach, in 1951 a federal court upheld
the exclusion of a proposal seeking desegregation of buses as an improper
subject for shareholders (Peck v. Greyhound, 97 F. Supp. 679, 680, S.D.N.Y.
1951). In 1954, the SEC added the “ordinary business” exclusion, which further
limited the ability of shareholders to introduce social considerations in proxy
ballots.
In the late 1970’s the SEC introduced the idea that the “ordinary business
exclusion” would not apply to matters with significant policy implications,
such as tobacco to minors, nuclear power and the like (Anderson, 2016). The
effective boundaries of this public policy exception are heavily litigated to this
day (see the Walmart case mentioned above). Overall, it is fair to say that
law and regulation have not helped to prevent the amoral drift.
3.2 The Founder’s Choice
The existence of this amoral drift makes it relatively simple for an F who
wants to implement a dirty decision, but is worried that a future board might
put too much weight on ethical concerns and choose clean: F should make
18
The SEC Today Released An Opinion Of Baldwin B. Bane, Exchange Act Release No.
3638, at *1 (Jan. 3, 1945).
Companies Should Maximize Shareholder Welfare Not Market Value 259
hostile takeovers easy.
19
One way she can encourage takeovers is to put in
place a non-staggered board.
20
F’s task is more difficult if she wants to implement clean. One possibility is
to put in place a staggered board. Another possibility is to set up the company
as a dual class one and retain voting control with relatively few income rights.
We are seeing more and more efforts along these lines: Google and Facebook
are prominent recent examples. But dual class companies have their own
corporate governance problems, as one can see from the recent spat involving
Viacom.
21
A third possibility is for F to write a charter that specifies the decision
clean in advance. Of course, in practice this decision is not easy to describe and
will be contingent on future states that are also hard to describe. Hence, the
complete contracting/charter solution is probably infeasible. It is also the case
that the courts might not uphold a charter that is set in stone, particularly if
enough future shareholders want to change it.
Given that any actual corporate charter is likely to be incomplete, fiduciary
duty, the duty of loyalty and care, which the future board will owe shareholders,
becomes important. Everyone agrees that fiduciary duty means that the
board (or executives) cannot enrich themselves at the shareholders’ expense.
Some have also interpreted it to mean that the board must pursue long-run
shareholder value. But this is a narrow notion of fiduciary duty. Suppose that
F puts a mission statement in the corporate charter, laying out the goals of
the company. (A mission statement is just an incomplete version of a complete
corporate charter.) The statement might say that future boards should put
a lot of weight on environmental protection, should not deal with corrupt
regimes, etc., or it might say the opposite: this company is dedicated to making
money, while staying within the law. The courts could then interpret fiduciary
duty to mean behavior that is consistent with the mission.
In other words, founders could choose whether to create a “Friedman”
company or another type of company. A founder who prefers dirty would
choose a “Friedman” charter that specifies profit maximization as the goal. A
board that did not follow this would be open to breach of fiduciary duty suits
by shareholders (presumably those with low
λ
i
’s). A founder who prefers clean
would choose a charter that emphasizes broader goals. In this case, a board
that focused too narrowly on profit maximization would be open to breach of
fiduciary duty suits by shareholders (presumably those with high λ
i
’s).
19
The founder could also encourage managers to pursue profit by placing a large amount
of debt in the company’s capital structure or imposing high-powered profit-based incentive
schemes.
20
For a discussion of how staggered boards (often in combination with poison pills) can
impede takeover bids, see Bebchuk and Cohen (2005). Daines et al. (2016) provide empirical
evidence that staggered boards can increase shareholder welfare for reasons other than those
emphasized here.
21
For details see Cohan (2016).
260 Oliver Hart and Luigi Zingales
We are somewhat skeptical about this third solution. Even with “standard”
corporations, where value maximization is taken to be the right goal, the
business judgment rule effectively shields boards from most fiduciary duty
suits (unless the board enriches itself or uses explicit language to the effect
that it is not maximizing value). We can only imagine how much more difficult
it would be to sue for failure to stick to a mission statement, or to maximize
shareholder welfare, a very slippery concept to define and measure.
For these reasons we wonder about the likely success of a new corporation
that has emerged in the United States, the Benefit Corporation.
22
A benefit
corporation is a type of for-profit corporate entity that includes a positive
impact on society and the environment in addition to profit as its legally defined
goals. Rather than simply allowing management to take other considerations,
e.g., ethical ones, into account, a benefit corporation requires them to take
particular ones into account. Thus a benefit corporation can be seen as
including the kind of mission statement that we have described above. Only
time will tell whether founders can write mission statements that are clear,
not too rigid, and can be enforced.
A fourth possibility is for F to entrench a board of like-minded individuals,
allowing them to co-opt new like-minded board members in the future. This
mechanism works well (and is very much used) in charitable foundations, where
there is little or no external pressure towards efficiency. Of course there are
examples, such as the Ford Foundation, where the wishes of the initial founder
were later betrayed. By and large, however, these are exceptions rather than
the rule.
In spite of tools like staggered boards and poison pills, this entrenchment
strategy is less successful in corporate boards, because it comes with an
important cost: it prevents the removal of incompetent or ineffective managers.
In charitable foundations, most decisions are about allocation, not efficiency.
In these decisions, taste is more important than competence. By contrast, in
for-profit corporations the taste component is less important relative to the
efficiency dimension. The cost of entrenching a particular management team
can be so high that it is unwise for founders to try to do so. Even when they
try, they rarely succeed because of the pressure of activist investors.
An interesting combination is when a large block of shares in a for-profit
corporation is endowed to a charitable foundation, where the founder chooses
the initial board members to reflect her preferences. An example of this dual
structure is the Carlsberg Foundation.
23
We now turn to our final possibility: voting. One way that a prosocial
founder could try to ensure clean is to encourage future shareholder voting.
Suppose that the board of directors is required to bring matters of policy to a
22
For a discussion, see Cummings (2012).
23
http://www.carlsberggroup.com/Company/Foundations/CARLSBERGFOUNDATION/
Pages/Default.aspx.
Companies Should Maximize Shareholder Welfare Not Market Value 261
shareholder vote. Assume that it is known at date 0 that shareholders will
vote between clean and dirty. Then clean will be the outcome as long as the
median value of λ
i
, λ
m
i
say, satisfies
λ
m
i
>
π
dirty
− π
clean
d
. (9)
In this case the date 0 market value of the firm will equal
π
clean
since
investors will anticipate the date 1 choice of clean. The outcome is the same
as if a prosocial F could choose x directly.
Of course, for this to work the founder F has to be confident that enough
of the future shareholders will have similar preferences to her. If
λ
m
i
does
not satisfy
(9)
, the shareholders will vote for dirty. But the important point
is that, in contrast to takeovers, there is no asymmetry in voting. If most
shareholders put a lot of weight on money, they will vote for dirty. If most
shareholders put a lot of weight on externalities, they will vote for clean. This
is in contrast to takeovers where a bidder interested mainly in money has an
incentive to take over a clean company and turn it into a dirty one, but a
bidder with strong social concerns does not have an incentive to take over a
dirty company and turn it into clean one.
24
3.3 The Impact of Competition
So far we have considered a company operating in isolation. What happens if
the company competes with others?
Consider first the case of perfect competition. Dirty choices by other
companies will likely reduce marginal costs and force prices down, reducing
this firm’s profit, whichever technology it uses. To take a simple example,
suppose that the company has a constant marginal cost that is
c
1
if the
company is dirty and
c
2
if it is clean, where
c
1
< c
2
. Assume also that the
company has a capacity constraint
Q
, and that the environmental damage is
independent of company scale: it is a fixed social cost that depends only on
the choice of technology. Then under perfect competition with a market price
of p,
π
dirty
= (p − c
1
)Q, (10)
π
clean
= (p − c
2
)Q, (11)
as long as p > c
2
. Using (9), we see that a shareholder will vote clean if
λ
i
>
(c
2
− c
1
)Q
d
. (12)
24
Bebchuk and Hart (2001) also argue that voting can lead to better outcomes than
takeover bids, although the reasons are different from those discussed here.
262 Oliver Hart and Luigi Zingales
However, if
p
falls below
c
2
, then
π
clean
= 0 (it is more profitable to close down
than to use the clean technology), and so (12) is replaced by
λ
i
>
(p − c
1
)Q
d
. (13)
Clearly the right-hand side of
(13)
is less than the right-hand side of
(12)
if
p < c
2
, and so a shareholder is more likely to vote clean as the environment
becomes more competitive.
Of course, in reality, many other factors may be important. We have
supposed that environmental damage does not depend on the scale of the
company’s operations, we have considered a very simple bang-bang technology
where a company either operates at full capacity or not at all, and we have
conducted a partial not a general equilibrium analysis. Also we have ignored
any non-pecuniary benefits that managers or workers might enjoy. The latter
might make survival of the company a first-order concern and might persuade
shareholders to vote for a dirty technology if that is the only way for the
company to keep going as p falls. Finally, we have ignored the possibility that
as shareholders become poorer they may put less weight on ethical concerns,
that is, morality is a normal good. For a discussion of this idea, see Shleifer
(2004).
Still the above analysis does suggest that an often-made argument that
competition drives out good behavior must be qualified.
A new effect arises once we depart from perfect competition. Suppose
that our company A is in duopolistic competition with a second company B
that has chosen a dirty technology. Assume that the companies produce a
homogeneous good at constant marginal cost (with no capacity constraints) and
that competition proceeds a la Bertrand. Then the shareholders of company
A are faced with the following dilemma. If they choose clean, they will lose
the market to company B if B’s marginal cost is lower and the consequence
may be a large amount of environmental damage by B. On the other hand,
if they choose dirty they may produce (possibly smaller) damage themselves
and make money. Which is better?
A full analysis of this question is beyond the scope of this paper, but it
clearly raises a number of fascinating issues including new moral ones: is it
acceptable to do bad things yourself if others would do them anyway in your
absence?
4 Practical Issues
The question we try to answer in this paper is not just an academic one: it is
very relevant for the debate on the fiduciary duty of both corporate directors
and investment managers.
Companies Should Maximize Shareholder Welfare Not Market Value 263
4.1 Corporate Directors’ Fiduciary Duty
There is considerable confusion about what the fiduciary duty of a corporate
board is. It is not unusual for boards and CEOs to justify a controversial action
on the grounds that fiduciary duty to shareholders requires them to do it. This
was the case, for example, with the (former) CEO of Turing, Martin Shkreli,
who was criticized for raising the price of Daraprim fifty-fold. According to
a news article, “Turing opted to not lower the price of Daraprim in order to
make money for Turing’s shareholders. He [Shkreli] cited a Delaware law that
he said states he must do everything to maximize the financial return for his
shareholders—something he claimed was his fiduciary duty.”
25
As we understand it, this is wrong. Shkreli could easily have refused to
raise the price of Daraprim, without the fear of shareholder suits, on the
grounds that the reputational effects would be disastrous (as they turned out
to be). But the press reported the story as if Shkreli were, or at least might
be, right. This muddled state of affairs does not seem to be desirable.
We think that part of the reason for this confusion is that the academic
literature itself is confused. Under the current regime, where corporate directors
are elected by shareholders to whom they owe a fiduciary duty, corporate
directors have a duty to maximize shareholder welfare, not just shareholder
value. If a company has a single shareholder, nobody would suggest that this
single shareholder cannot instruct directors to maximize her utility, rather
than her financial return. Why should things be different when there are
multiple shareholders?
One reasonable objection is the cost of reaching a consensus among investors
on what objectives (other than money) a company has to pursue.
26
We do not
think that this problem is insurmountable. Directors can poll their members
on some fundamental choices and then decide accordingly. For example, they
can ask their investors if they are willing to sacrifice some of their returns to
avoid the sale of tobacco to children or of high-capacity magazines to ordinary
citizens (as in the Walmart case). In the contemporary wired world, these
polls are extremely cheap and fast to arrange. Thus, we do not see any reason
why directors and asset managers should not use them.
If there is a concern about the cognitive load of all these decisions on indi-
vidual investors, then one solution is the formation of mutual fund companies
specialized in voting on certain issues. Imagine an index fund, identical in
every respect to all other mutual funds, with the exception that it votes against
any sale of assault weapons and ammunition to ordinary citizens. The fund
25
http://www.pharmalive.com/turings-says-he-should-have-increased-the-price-of-dara
prim-higher-than-5000/
26
Hansmann (1996) has argued that one benefit of allocating votes to shareholders is that
shareholder preferences are relatively homogeneous in the monetary domain: all shareholders
have a strong interest in maximizing profit.
264 Oliver Hart and Luigi Zingales
would eliminate the cognitive overload and would not be any more expensive
than a standard index fund, which has to pay a proxy advisor anyway to direct
it how to vote. Prosocial investors should rush to such a product, ensuring its
success in the market. In fact, the idea is so simple that one might wonder
why we do not already see such products in the marketplace. We think that
the answer can be found in the existing proxy access rules, which make it
difficult for moral issues to be put up for a shareholders’ vote. If these rules
were eased, we would expect this kind of ethical fund to arise.
4.2 Invest and Engage
The existing literature on social investing (Hong and Kacperczyk, 2009) as-
sumes that some, but by no means all, investors are prosocial. Under this
assumption, the strategy of divesting from stocks of companies engaging in
unethical/sinful/polluting behavior seems at best ineffective, at worst counter-
productive.
If the divestment of prosocial investors were to depress the stock price of a
targeted company, the non-socially concerned investors would flock to the stock,
attracted by the higher yield, driving the price back to the pre-divestment
level. Thus, unless the amount of wealth held by prosocial investors greatly
exceeds the amount of wealth of selfish investors, divestments cannot have
persistent effect on prices and the cost of capital.
If – in spite of the previous argument – divestment had an impact on
prices, it would move controversial stocks into the hands of the least prosocial
investors, who will maximize the negative externality.
For this reason, we think that a strategy of “invest and engage” is potentially
much more successful. Yet, this strategy is available only if moral issues are
regularly brought up for a shareholders’ vote, something that does not happen
today.
One might wonder whether this strategy is compatible with prosocial
investors who feel responsibility only if faced with a choice. Would not these in-
vestors try to avoid votes and engagement? There are two reasons not to worry
about this. First, responsibility cannot be eliminated, it can only be transferred.
So, if some retail investors try to avoid assuming responsibility by buying stocks
only in companies where divisive future votes will not take place, prosocial
founders will find it optimal to allocate their shares to institutional investors
who take on that responsibility. Second, if a retail investor buys an index fund,
she cannot avoid being confronted with the choices that companies make.
4.3 Asset Managers’ Fiduciary Duty
When Friedman wrote his piece, 80% of publicly traded equity was owned by
households and only 16% by institutional investors (Zingales, 2009). Now the
Companies Should Maximize Shareholder Welfare Not Market Value 265
numbers are reversed: only 27% of public equity is owned by households and
60% by institutional investors. The growing role of institutional investors in
corporate governance has raised a new and important question: what should
asset managers maximize? This question is particularly important when the
funds in question are part of a retirement system, since they guarantee the
support of older people.
In the United States the fiduciary duty of private pension funds is defined
by the Employee Retirement Income Security Act (1974) (ERISA). While
not obliged to do so, state pension funds, mutual funds, and endowments
tend to follow the ERISA rules as well. Another important normative source
that provides guidance on investment decisions for nonprofit and charitable
organizations is the Uniform Prudent Management of Institutional Funds Act
(abbreviated UPMIFA), currently adopted in 49 U.S. states.
The ERISA rules state that “a fiduciary shall discharge his duties with
respect to a plan solely in the interest of the participants and beneficiaries and
for the exclusive purpose of: (i) providing benefits to participants and their
beneficiaries
. . .
” This obligation is generally expressed in financial terms given
that the goal of these plans is to provide retirement benefits. UPMIFA, by
contrast, provides more discretion to the fiduciary allowing him (or her) to
“consider the charitable purposes of the institution and the purposes of the
institutional fund” in managing an institutional fund. It allows him to consider
also “an asset’s special relationship or special value, if any, to the charitable
purposes of the institution.”
This ambiguity has generated an active debate on whether asset man-
agers should (or even could) factor in other considerations (often defined as
environmental, sustainability, and governance or ESG) in their investment
decisions (Sullivan et al., 2015). The intensity of the debate is driven by the
fact that there are two opposite risks. On the one hand, if other considerations
are allowed, there is the risk of transforming asset managers into political
decision makers, without any accountability. On the other hand, preventing
any considerations except financial ones will lead to an amoral drift in the way
companies are run.
The solution depends upon the type of institutional investors. For manda-
tory retirement plans (like the California Public Employees Retirement fund),
voting at the fund level is the only viable solution. Without a vote, asset
managers will either ignore the preferences of investors for anything other
than money or be forced to interpret investors’ preferences, running the risk
of imposing their own preferences on investors.
27
If a fund is not part of a mandatory plan, then investors can vote with their
feet, as long as there are funds offering alternative approaches. Indeed, there
27
For an interesting recent discussion of voting behavior of mutual funds, how this often
seems to differ from the preferences of their investors, and what might be done about it, see
Hirst (2017).
266 Oliver Hart and Luigi Zingales
exist open funds aimed at attracting people with special preferences, such as
reducing
CO
2
emissions (Auther, 2015). The strategy of these existing funds,
however, is to divest from controversial stocks, not to invest and engage. As
we stated earlier, we think that “engaged” funds have not arisen yet because
proxy access rules do not favor votes on the issues in which investors want to
engage.
As Dyck et al. (2016) show, institutional investors are having an impact
on the Environmental & Sustainability performance of corporations, especially
in Europe. In some cases they even survey their investors (as we suggest in
our paper), but in most cases they arbitrarily set their goals themselves.
4.4 Activists and Takeovers
In the last decade hostile takeovers have been rare. A much more important
mechanism to shape the governance of enterprises has been the acquisition of a
toehold by activist investors (often hedge funds), who challenge the incumbent
managers via a vote on directors.
Many commentators (Lipton, 2016) see activist investors as detrimental to
corporations. Others (Brav et al., 2015) attribute to them the same beneficial
effects as produced by takeovers. Yet, both sides perceive them as a close
substitute for hostile takeovers. Our model, however, points to an important
difference: the amoral drift present with takeovers is smaller with activist
investors. The reason is that activists rely on other shareholders to vote with
them and voting allows shareholders to reject welfare-reducing decisions, even
when these are wealth maximizing.
One qualification should be made. The support that activists rely on
often comes from institutional investors who may believe that they have a
fiduciary duty to their shareholders to vote for value-maximizing actions. Thus
institutions may support an activist who wants to turn a clean company into
a dirty one even if most shareholders are against this. This problem would
disappear if the position advanced in this paper is accepted, that institutions
have a broader fiduciary duty to maximize shareholder welfare rather than
shareholder value.
5 Motivating Our Assumptions
28
We have chosen a particular way of modelling ethical concerns and it is worth
saying more about our assumptions. First, a more standard approach would
have treated the damage
d
caused by the company in the model of Section
2 as a public good. That is, we could assume that the pollution from firm
28
We are very grateful to Niko Matouschek for his suggestions about this section.
Companies Should Maximize Shareholder Welfare Not Market Value 267
j
hurts all consumers in the economy including shareholders and write the
payoff function of consumer i as
u
i
(α
i
π
j
, d
j
). (14)
We did not proceed in this way because it seems strong to assume that a
consumer is affected by all the externalities in the economy. Rather we are
interested in a situation where a consumer cares about things that he feels
some responsibility for, even though they may not impact him directly (think
about environmental damage in another country).
One way we have captured this responsibility is by multiplying the damage d
by the shareholding
α
i
. The implication is that a small shareholder internalizes
only a small part of the damage that a firm causes. He feels a responsibility
that is proportional to his stake in the company.
But this is not all. We have also distinguished between decision payoffs
and actual payoffs. The former includes the damage term (weighted by the
shareholding), while the latter does not. The reason for this is that we are
trying to model limitedly ethical behavior. We are interested in analyzing
people who are willing to hold shares in tobacco or gun or oil companies, and
indeed will pay full price for these shares, as long as they are not responsible
for the company’s actions. This is true in our model since consumers put a
value
π
dirty
on these shares, their payoff from holding them. If a consumer’s
payoff included the damage term d, a consumer would be willing to pay only
π
dirty
− d.
The final piece of the picture is that the damage must appear somewhere
in the consumer’s payoff if ethical concerns are to have any bite. This is why
we introduce the decision payoff that does contain the damage term.
A simple example can illustrate our approach. Consider someone who
drops a piece of litter on the sidewalk by mistake. Should this person bend
down to pick it up? The consumer in our model might do so because she feels
responsible for the litter. Her decision payoff is
−λ
i
d
if she does not pick up
the litter, where
d
is the social damage from the litter lying around, and
−c
if she picks it up, where c is the cost of bending down. (There is nothing
corresponding to the shareholding
α
i
in this example.) If
λ
i
d > c
, her decision
payoff is maximized if she picks up the litter and so she will do this. Her
final payoff will be
−c
; she has incurred the cost of bending down, but by
assumption there is no warm glow. On the other hand, if
λ
i
d < c
, her decision
payoff is maximized if she does not pick up the litter, and so she will not. Her
final payoff is zero; the damage term drops out.
Now consider the same consumer who sees a piece of litter on the ground
that she has not dropped. Will she pick it up? If she does, her decision payoff
is
−c
(this would also equal her final payoff), and if she does not, her decision
payoff is 0 (since she does not feel responsible for the litter). Maximizing her
decision payoff implies not picking up the litter, and her final payoff is zero.
268 Oliver Hart and Luigi Zingales
This modelling choice corresponds to a philosophical assumption on the
type of morality shown by prosocial investors. To appreciate this point, it is
useful to rewrite the objective function described in (1) as
U
i
= α
i
π
dirty
− R
i
α
i
λ
i
d,
where
R
i
is a “responsibility” function, which determines how a prosocial
investor internalizes the social damage. In the paper we assume that
R
i
= 1
if
i
causes the externality by taking the action, but
R
i
= 0 if
i
causes the
externality by not taking the action.
At first, this assumption may appear very ad hoc. Yet, there are two
reasons why we consider it plausible. First, the moral distinction between
omission and commission has been discussed at least since the time of Aquinas,
who wrote that “transgression is a graver sin than omission” (Aquinas, 2013).
Second, an investor who feels moral responsibility for omission would feel
responsible also for all the companies she has not invested in, which is hard to
imagine. Thus, even investors with a prosocial attitude have limits to what
they feel responsible for.
Yet, this is not the only possible approach. Below we briefly explore the
robustness of our results to two alternatives with a long intellectual tradition
in moral philosophy.
5.1 Consequentialism
A different approach would have been to embrace consequentialism. The
Oxford Dictionary defines consequentialism as “the doctrine that the morality
of an action is to be judged solely by its consequences.” In terms of our
responsibility function this can be written as
R
i
= 1 if
i
’s action causes the
externality and zero otherwise. No distinction is made between omission and
commission: a consequentialist is as likely to pick up the litter someone else
has dropped as litter she has dropped.
In what ways would a consequentialist shareholder behave differently from
what we described in Section 3.1? If she owns a stake
α
i
in a non-polluting
firm, she would feel responsible for selling to a bidder who buys the firm to
start polluting only if she is pivotal, i.e., as before. On the other hand, if she
was asked to vote on whether the firm should choose clean or dirty she would
make her choice according to (3) and (4), again as before.
The one difference is when a consequentialist shareholder owns a share
α
i
of a polluting company and considers the possibility of launching a bid to
transform the company into a clean one. In Section 3.1 we showed that the
bidder’s payoff from such an action is always negative. This is not the case
anymore with a consequentialist shareholder, since she feels “guilty” about
the pollution produced if she does not act to curb it. Since the utility cost
Companies Should Maximize Shareholder Welfare Not Market Value 269
of that guilt is equal to
α
i
λ
i
d
(we continue to assume that it is proportional
to her shareholding), a consequentialist shareholder will become a bidder if
π
dirty
− π
clean
< α
i
λ
i
d
. Therefore, with a consequentialist prosocial investor
the amoral drift derived in Section 3 will exist only for moderately inefficient
pollution (i.e., pollution such that
π
dirty
−π
clean
d
> α
i
λ
i
).
Notice that if the initial toehold of the potential social bidder is zero, then
the result is as in Section 3.1. Given that the potential bidders are few and the
number of companies to fix is potentially large, then the amoral drift identified
in Section 3.1 is largely robust to consequentialism.
5.2 Categorical Imperative
An alternative assumption about morality is that shareholders follow a Kantian
categorical imperative: “Act only according to that maxim whereby you can, at
the same time, will that it should become a universal law” (Kant, 1993). This
approach will substantially change our conclusions. For example, a Kantian
categorical imperative will deter inefficient takeovers, since social investors
would feel moral responsibility even when they are not pivotal. Hence, they
will tender to a bidder who wants to take over a non-polluting firm and turn
it into a polluting one if and only if
p − π
clean
> λ
i
d
. In the extreme case of
λ
i
= 1, social investors with a Kantian categorical imperative will make all
inefficient takeovers impossible.
Yet, prosocial agents following a Kantian categorical imperative change
not only some of our results, but most of economic analysis. Pushed to its
extreme consequences, the application of a Kantian categorical imperative
will eliminate any problem of free riding, of collective action, even of adverse
selection or moral hazard. Selling an overpriced car cannot become a universal
law, thus agents will be restrained from doing it. The same can be said for
shirking on the job.
6 Comparison to the Literature
In this section we briefly compare our work with the relatively small theoretical
literature on corporate social responsibility.
Many papers in this literature are concerned with charitable giving by
a firm rather than with externalities that are inseparable from the firm’s
production decision. The main interest is whether charitable contributions by
a firm completely crowd out private contributions. Leading examples in this
vein are Graff Zivin and Small (2005) and Baron (2007). Both papers assume
that individuals experience a warm glow from charitable giving. Graff Zivin
and Small consider a public company that already exists while Baron considers
270 Oliver Hart and Luigi Zingales
the situation from the point of view of a founder. Both sets of authors identify
conditions under which complete crowding out does not occur.
Apart from their focus on charitable giving, these papers do not assume
that social concerns are present only if a person feels responsible for the
decision in question. One significant implication of this is that Baron (2007)
finds that prosocial bidders will have an incentive to buy up dirty companies
and turn them into clean ones. In contrast we obtain an asymmetry: bidders
will buy up clean companies and turn them into dirty ones but not the other
way around.
A paper that does consider externalities that are inseparable from a firm’s
production decision is Morgan and Tumlinson (2012).
29
This paper supposes
that, in our language, the damage caused by a firm is a public bad that enters
every consumer’s utility function, whether the consumer is a shareholder or
not (and whether he is responsible for the damage or not). Morgan and
Tumlinson consider a company that already exists and show that the company
can overcome free-rider problems that arise in the provision of public goods.
They obtain conditions under which corporate giving can have a positive role.
Most of these papers do not consider the implementation and practical
issues that are the focus of Sections 3 and 4 (an exception is Baron (2007),
who considers the market for corporate control but obtains different results
from ours).
In spite of the various modeling differences we should stress that we
reach conclusions that are broadly consistent with those of the above papers:
shareholder value maximization is not the appropriate goal for a company in
many circumstances.
7 Conclusions
Milton Friedman, in his celebrated 1970 article, argued that there should be a
clear separation between the goals of companies and the goals of individuals
and government. Public companies should focus on making money and leave
ethical issues to individuals and government. In this paper we have argued that
Friedman is right only if the profit-making and damage-generating activities
of companies are separable or if government perfectly internalizes externalities
through laws and regulations. Neither of these seems very plausible.
In the absence of these conditions we have argued that shareholder welfare
and market value are not the same, and that companies should maximize
the former not the latter. One way to facilitate this is to let shareholders
vote on the broad outlines of corporate policy. Note that if profit-making and
damage-generating activities are separable, or if government has internalized
29
See also Besley and Ghatak (2007).
Companies Should Maximize Shareholder Welfare Not Market Value 271
externalities, or if shareholders are not prosocial, then the vote will yield the
Friedman outcome: the shareholders will favor value maximization. However,
in other cases the outcome will be different and we believe superior.
Of course, there are costs associated with voting. One cost is the risk of
too many frivolous proposals being put forward by shareholders, which will
distract management. But this cost can be minimized (if not eliminated) by
requiring that a certain percentage of shares (say 5%) be behind a proposal
before it is put to a shareholder vote. The second potential cost is that
company money will be spent in promoting management’s point of view. Yet,
the issues that we think should be put to a vote – such as the decision to
sell high-capacity magazines in Walmart stores – are a matter of individual
preference, not of managerial expertise. Thus, company by-laws can reduce
(and potentially eliminate) this cost by restricting management’s ability to
use corporate resources for campaign purposes. Finally, in a wired world we
regard the bureaucratic cost of administering proxy votes as trivial.
A more serious concern, identified in the social choice literature, has to
do with whether voting is an appropriate method of aggregating individual
tastes into social preferences. Given well-known collective choice problems,
it is possible that market value maximization can be justified as a second-
best objective in a world where the social preferences of shareholders are
sufficiently heterogeneous. We cannot rule this out. But in the absence of
evidence establishing this conclusion to be correct, we believe that shareholder
welfare maximization should replace market value maximization as the proper
objective of companies.
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