For Review Only - The FINANCIAL...For Review Only 1 Corporate Governance and the Goal of the Firm:...

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Corporate Governance and the Goal of the Firm:

In Defense of Shareholder Wealth Maximization

Journal: The Financial Review

Manuscript ID FIRE-2016-07-068

Manuscript Type: Paper Submitted for Review

Keywords: Corporate governance, Shareholder wealth maximization, Objective of the firm

The Financial Review

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Corporate Governance and the Goal of the Firm:

In Defense of Shareholder Wealth Maximization*

Diane Denis

University of Pittsburgh

Forthcoming in the Financial Review

Abstract

This essay is based on my keynote address at the 2016 annual meeting of the Eastern Finance

Association. I propose that misunderstandings about the traditional model of corporate

governance, with its emphasis on shareholder wealth maximization, contribute to negative

societal attitudes about corporations. I discuss the implications of shareholder wealth

maximization for other corporate stakeholders, the dangers of deviating from shareholder

wealth maximization, and the roles that the media and the government play in the governance

of corporations.

*I thank David Denis, Ken Lehn, Mark Walker, seminar participants at the Eastern Finance

Association annual meeting, and the editors, Srini Krishnamurthy and Richard Warr, for very

helpful comments and suggestions.

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1. Introduction

The modern corporation as we know it took shape during the 19th

century. Though

much of its early evolution took place in Britain and the United States, the basic corporate form

now exists over much of the world. Its defining characteristics – limited liability, tradable

shares, and status as a separate legal entity – allow for separation of the ownership and control

of business enterprises. In such a system those who have managerial talent can accumulate the

financial capital needed to build firms of efficient size, regardless of their own wealth

constraints and risk aversion. At the same time, individual holders of financial capital can invest

their capital across many different enterprises, thereby simultaneously reaping the financial

benefits of productive investment and diversification. These benefits play an important role in

the growth and longevity of the corporate form.

Despite their importance to the world economy – or perhaps because of it –

corporations, especially large corporations, are widely vilified. Criticism of corporations as a

group abounds in scholarly works, the popular press, the political arena, and the entertainment

industry. Ribstein (2012) details numerous examples of popular films that present negative

views of business and of the profit-making capitalists who control them. Such portrayals extend

to the world of children’s entertainment, where the evil corporation run by a despotic leader is

a stock presence. Witness as one of many examples the 2014 blockbuster hit The Lego Movie, in

which the antagonist is Lord Business, an evil tyrant bent on world domination, who takes form

as conglomerate CEO President Business. Nor are such attitudes only a recent phenomenon. In

their engaging history of the corporation, Micklethwait and Woolridge (2003) make it clear that

distrust and resentment of corporations are as old as the corporate form itself.

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The fundamental objections to the corporate form are likely rooted in the very benefits

that have led to its growth and longevity. In the minds of many, firms’ ability to grow into large

institutions results in undue accumulations of power, while their executives are able to avoid

accountability for their own actions by hiding behind the legal entity that is the corporation.

More specific objections include the belief that the high returns to capital and executive labor

provided by corporations lead to unacceptable increases in income inequality, that

corporations are responsible for unacceptable levels of environmental decay, and that fraud

and corruption run rampant among corporate executives.

In this essay I propose that misunderstandings about the traditional agency-based law

and finance definition of corporate governance contribute to negative societal attitudes about

corporations. Under this traditional definition, corporate governance comprises the set of

mechanisms that induce the managers who control corporations to make decisions that

maximize the value of the shareholders who own those corporations.1 There are a multitude of

other stakeholders in a corporation: employees, customers, suppliers, communities, and society

as a whole. One could argue that many of these parties have more meaningful stakes in the

welfare of a corporation than does a typical shareholder, given that the latter has no

involvement in the day-to-day activities of the firm, derives only a very small portion of

personal wealth from any given firm, and can quickly and easily transfer financial capital to

alternative investments. On the surface, then, to suggest that managers should maximize

shareholder wealth smacks of suggesting that no one matters other than people with the

1 Cheffins (2015) suggests that this definition of corporate governance gained acceptance during the 1980s.


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money. This may well be one reason that ‘soulless’ and ‘greedy’ are adjectives frequently

applied to corporations.

While shareholder governance remains the primary governance model among

academics in financial economics, alternative models of corporate governance have evolved in

other academic disciplines. Aguilera Desender, Bednar, and Lee (2015) propose that effective

governance should provide for: protection of the rights of all stakeholders, mediation between

the interests and demands of all types of stakeholder, transparent information disclosure, and

strategic and ethical guidance for firms. Proponents of ‘stakeholder governance’ models argue

that the goal of a corporation – and therefore of its managers – should be to act in the interests

of all of its stakeholders, rather than in the interests of its shareholders only. Moreover, many

such models emphasize that corporations have an overarching responsibility to societal

welfare.

Debate over these seemingly competing models of corporate governance is extensive

and ongoing and is carried out in a wide variety of arenas, both academic and non-academic. A

Google search of the phrase ‘shareholder vs. stakeholder governance’ results in almost 26

million hits. The phrase ‘corporate social responsibility’ returns over 62 million hits. The debate

is broad in scope and the issues involved are many. My goal in this essay is to explore

shareholder wealth maximization as it relates to the other stakeholders of the firm, seeking to

make the case that these systems need not be in competition. I focus on two primary issues.

First, critics of the shareholder wealth maximization model of governance often fail to

understand, or at least fail to acknowledge, that shareholders are at the end of the line in terms

of their claims on corporate cash flows. This has important implications for understanding the


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relationship between shareholder and stakeholder welfare. And second, the corporation does

not exist in a vacuum. The actions of corporate managers are also effectively governed by

external mechanisms that do not seek to maximize shareholder welfare. I discuss two of the

most prominent such mechanisms: media and government.

It is important to note several things about the discussion that follows. First, it is largely

U.S.-centric, though the ideas expressed would apply to any relatively free-market economy.

Second, this essay is in no way intended to be a survey of the extensive literature related to the

topics covered. And finally, a comprehensive discussion of these topics is well beyond the scope

of this essay. My goal is to introduce ideas in order to stimulate further thought and discussion

about the implications of the shareholder governance model for the many parties in society

that have stakes in the operations of firms and about the ways in which society influences the

governance of firms.

2. Shareholder wealth maximization and corporate stakeholders

In this section I discuss the fundamental relationship between shareholder and

stakeholder models of governance, focusing in particular on the extent to which these models

are in conflict with each other.

2.1 Alignment of shareholder and stakeholder interests

To say that shareholder wealth maximization is the goal of the firm does not imply that

only shareholders matter. Shareholders are the residual claimants of the cash flows of the firm

and, as such, bear the residual cash flow risk. All other stakeholders who have a direct claim on


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firm cash flows receive their share of these flows on an ongoing basis. Shareholders’ only claim

is to the cash flows that remain after all other claimants have been paid. Thus, to say that

managers should maximize shareholder value is to say that they should maximize the amount

of cash flow that remains after everyone else who has a claim to those flows has been paid.

Critics may well point to the fact that any funds not paid to stakeholders whose claim

has priority over those of the shareholders increase the wealth of the shareholders. It would

seem, therefore, that managers who are acting in the interests of their shareholders should

seek to under-compensate the other stakeholders of their firms. However, direct stakeholders

of U.S. firms contract with those firms in a relatively free market in which the rule of law

ensures that contracts are enforced. Consider, for example, the employees of the firm. If firms

wish to entice persons to become and remain employees of the firm, they must offer net

compensation and non-pecuniary benefits that exceed those of such persons’ next best

alternative(s) – including the alternative not to be employed at all.2

The other side of the equation is that firms will only be willing to hire and retain

employees whose expected value to the firm is equal to or greater than the cost of employing

them, i.e., whose marginal products are greater than or equal to their marginal costs. A model

in which firms continue to employ persons whose marginal cost is greater than their marginal

value to the firm is not sustainable. Ultimately such a firm would cease to exist. However, to the

extent that employees’ value to the firm is at least as high as what they are being paid – and

2 I define compensation as anything employees receive because of their job for which value can easily be measured

in monetary terms: wages, benefits, etc. Non-pecuniary benefits are things that have value to employees for

which value cannot be directly expressed in monetary terms: satisfactory working conditions, the ability to do

fulfilling work, personal respect, etc.


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assuming that there are no other employees who will do an equivalent job for less

compensation - shareholder value is maximized by retaining those employees.

This is not to say that firms have no incentive to offer employees anything more than

the absolute minimum amount necessary to keep them at the firm. An employee’s marginal

product is not necessarily fixed. People respond to incentives. Thus, higher wages, better

working conditions, more fulfilling work, etc., may lead to increased marginal product, whether

because the firm is able to attract higher-ability employees or because their employees have

more incentive to work hard. To the extent that the benefits of increases in productivity exceed

the costs of achieving them, managers who are acting in the interests of their shareholders

should provide their employees with such incentives.

The discussion above highlights the fact that the corporation is best viewed as a legal

mechanism for coordinating the contracts of its various stakeholders. Or, as Jensen and

Meckling (1976) put it, corporations are “ . . . simply legal fictions which serve as a nexus for a

set of contracting relationships among individuals.” When viewed in this light, it becomes

difficult to characterize corporations as ‘persons’, i.e., as entities to which behaviors – including

negative behaviors – can be attributed.

2.2 Shareholder vs. stakeholder conflicts

A model of governance with shareholder wealth maximization as its overriding goal

protects the interests of other direct stakeholders of the firm up to the level of their value to

the firm and in the broader marketplace for their services. Therefore, if a stakeholder-based

model of governance is to be distinct from a shareholder-based model of governance, it must


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present the possibility of compensating non-shareholder stakeholders at levels that exceed

their value to the firm or the levels required by competing alternative providers. There are two

fundamental problems with such a model of governance. First, it does not provide a clear

prescription for managerial action. For example, all other things equal, it will be in employees’

interests to receive as much compensation as possible. However, any compensation to

employees beyond what is required to retain them at the desired level of productivity reduces

the cash flows available to shareholders – and therefore runs contrary to shareholder interests.

If management is to ignore market values in determining employee compensation, by what

alternative means should they determine how much value to take away from one set of

stakeholders (the shareholders) and give to another set of stakeholders (the employees)? The

advantage of market prices is that they represent the intersection of supply and demand by all

interested parties. Once we leave market prices behind, what alternative decision rules should

be used to determine which interested parties receive above-market rewards, and at which

other parties’ expense? There will be at least as many different opinions about this as there are

types of interested parties. Whose opinion will prevail?

The second fundamental problem is that a system of corporate governance in which

firms are not driven primarily by market forces is not sustainable in an economy in which firms

compete with each other in markets for customers, factors of production, and financial capital.

Customers will choose to purchase goods and services from the firms that offer the most

advantageous combinations of price, quality, convenience, and whatever else is important to

potential customers. The firms able to offer the most advantageous combinations will be those

that employ the set of factors of production – including employees - that offer the most


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advantageous combinations of price, quality, skill, and whatever else is needed in order to

produce goods and services that potential customers demand. Thus, a firm that overpays its

employees relative to its competitors will not be able to compete on price, while a firm that

offers lower wages than its competitors will attract lower-quality employees and be unable to

compete on quality. Ultimately, neither firm will be able to survive.

2.3 The market for factors of production

The bottom line is that factors of production in a free market will move to where they

are most valued. Stakeholders’ relative bargaining power is positively related to the extent to

which they have other opportunities and the ease with which their resources can be redirected

to such alternative uses. While not traditionally thought of as a factor of production per se, the

financial capital provided by shareholders is essential to the production of goods and services.

Just as the prices of goods, services, and the factors required to produce them are set in the

market, so too are the prices of shares of stock. Furthermore, there exist many firms in which

the holders of financial capital can invest. Shareholders of publicly-traded firms can quickly and

economically remove their resources from one firm and invest them elsewhere. Thus,

shareholders arguably have greater relative bargaining power than other stakeholders. Firms

that are not expected to provide such an appropriate risk-adjusted rate of return on their

equity will not be able to raise the financial capital needed to run their business. It is important

to note, however, that shareholders’ greater bargaining power does not suggest that they can

expect to earn economic rents. To the extent that a firm’s share price implies an expected


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return that is higher than the appropriate risk-adjusted rate of return, excess demand by

investors will drive the share price up until it equates to an appropriate expected return.

The relative ease with which shareholders can remove their resources from publicly-

traded firms also contributes to negative attitudes towards shareholder wealth maximization.

While such arguments likely take a number of forms, a basic objection stems from the idea that

shareholders are short-term participants in the firm, able to remove themselves at a few

moments’ notice, while the interests of many other stakeholders are longer-term in nature.

Why, then, should shareholders’ interests be of paramount importance? It is worth noting

three points related to this issue. First, shareholders’ interests in the firms whose equity they

hold are long-term in nature, regardless of how long they expect to hold the stocks. At any

given moment, the value of those holdings is determined by all of the expected future cash

flows of the firm, not only those cash flows that are expected over individual shareholders’

holding periods. Second, stock prices react quickly to news about firms’ changed circumstances.

Thus, shareholders can quickly and easily depart when the firm gets in trouble, but such trouble

will already be reflected in the reduced price for which they can sell their shares. And finally,

though we tend to talk of shareholders and other stakeholders as if they are mutually exclusive

groups, there is in fact considerable overlap between them. The ease with which shareholders

can invest in and disinvest themselves of stocks makes the benefits of stock market investment

available to anyone who has even a small amount of money they wish to invest and the

willingness to bear the risks inherent in equity investments.

In summary, to say that shareholder wealth maximization is the goal of the firm does

not in any way equate to saying that only shareholders’ interests matter. In a reasonably free-


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market economy such as the U.S., all economic agents are free to offer their resources – their

time, skills, abilities, financial resources, etc., - to whichever firms offer them the best

combination of returns on those resources. Direct firm stakeholders other than the

shareholders receive their returns first; thus, to maximize shareholder wealth is to maximize

the cash flow that remains after the other stakeholders have been appropriately compensated.

Furthermore, it is in shareholders’ interests that the claimants ahead of them actually receive

their appropriate compensation. Stakeholders who expect that they may not receive what is

owed to them will price-protect themselves up front by demanding higher compensation. It is

the shareholders, as the residual claimants of the firm’s cash flows, who will bear these higher

costs. In the end, then, a model of governance in which stakeholders receive either below-

market or above-market returns on an ongoing basis is not sustainable in a competitive global

economy.

3. Externalities, frictions, and alternative forces

3.1 Externalities and frictions

The forgoing discussion pre-supposes an economy in which market forces can be

completely relied upon to appropriately protect the interests of everyone who has any stake in

how corporations are run. Critics would be quick to point out that such is not actually the case.

Externalities associated with corporate operations and frictions in the markets in which they

operate can potentially create situations for which effective market solutions do not exist.


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In my discussion to this point I focus on direct stakeholders of the firm, by which I mean

those who willingly enter into relationships with individual firms by purchasing their products,

working for them, selling raw materials to them, etc. However, there are also indirect firm

stakeholders: parties who do not directly enter into relationships with individual firms but can

nonetheless be affected by certain firm actions. To the extent that the effects of such

externalities on stakeholders are negative, they represent a situation in which stakeholders may

be unable to fully protect their own interests against those of corporations. For example,

consider a firm whose operations lead to air pollution, which could be at least partially

controlled by the installation of pollution abatement equipment. Strict shareholder governance

– with its charge to management to maximize shareholder wealth – might not support the

installation of such equipment. Its cost would be fully borne by the shareholders as residual

claimants to the firm’s cash flows, while the majority of the benefits would accrue to the

residents who live near the offending plants.

The existence of frictions in the market can disadvantage even stakeholders who do

enter willingly into relationships with individual firms. Consider, for example, the issue of

monopoly power. If a corporation prices a product such that it earns economic rents, there is

incentive for other firms to enter the market, thereby increasing the supply and lowering the

price of that product. However, to the extent that there are sufficient frictions in the form of

barriers to entering that market – for example, due to high start-up costs – the corporation can

persist in earning rents at the expense of its customers. Because such rents accrue to the

corporations’ shareholders as its residual claimants, the pursuit of monopoly power may well

be consistent with shareholder wealth maximization. However, the surplus generated for the


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shareholders is outweighed by the surplus lost by the consumers, resulting in a deadweight loss

to the economy.

The existence of externalities and market frictions does not imply, however, that

managerial decision-making should be driven by something other than shareholder wealth

maximization. Corporations do not operate in a vacuum. Instead, their collective prominence in

our lives ensures that they attract considerable attention from forces outside the direct

corporate sphere. Below I discuss two of the most prominent such forces – the media and the

government. My primary motivation is to make the point that market forces and shareholder

governance in the U.S. are not absolutes: there are broader additional influences on managerial

actions which often favor stakeholders other than shareholders. However, I will also discuss the

implications of such deviations from strict shareholder wealth maximization for the economy.

3.2 Alternative forces

Critics of corporations point to their considerable power. However, government and the

media are powerful forces in the U.S. economy as well. Both anecdotal and academic evidence

indicates that they collectively exert considerable influence on the actions of corporations. In

terms of their incentive and ability to influence corporate actions, the government and the

media share features in common. First, both are motivated in large part by the desire to please

broad and diverse constituencies. Corporations constitute one such constituency for both

groups – e.g., as potential donors to government candidates’ campaigns and as potential

advertisers in media outlets. I would argue, however, that their non-corporate constituencies –

voters and potential consumers – exert considerable influence as well. For evidence we need


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only look to the spectacle of potential 2016 presidential candidates competing to see who can

express the greatest hostility to big business. Second, in addition to being influenced by the

desires of their constituencies, both the media and the government can shape the desires of

the general public.

3.2.1 The media

The media exerts influence on corporations through its ability to disseminate

information and its ability to shape opinions. We live in an information age; thus ‘the media’ is

an increasingly broad and significant force. It includes traditional media outlets, such as

newspapers, magazines, and television, but also a growing online and social media presence.

The latter allows anyone with information or opinions to share them with a potentially broad

audience without even leaving their own sofa. In this way the media serves to generate and

transfer information across parties in the economy. This increases market efficiency by reducing

information asymmetry in the market. In addition, it provides stakeholders, both direct and

indirect, with means by which to seek to influence corporate actions. The extent to which such

efforts are successful will depend on how widely they resonate in the marketplace. In this way

the many idiosyncratic – and often conflicting - ideas about how corporations should behave

are weeded out, while corporations are forced to consider those ideas that are popular enough

to have potential implications for corporations’ abilities to attract employees, customers,

investors, etc., who contribute to the maximization of firm value.

3.2.2 The government


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The media’s influence on corporate actions, though powerful, is largely indirect. It

cannot force corporations to take or avoid particular actions. The government, on the other

hand, has considerable direct influence on corporate actions via its ability to regulate. Consider,

for example, air and water pollution by corporations, identified earlier as an example of a

market externality. The U.S. federal government, under the auspices of the Environmental

Protection Agency, exercises considerable control over corporate emissions. It takes 465 pages

to enumerate all of the requirements of the Clean Air Act, and another 234 pages for the Clean

Water Act. Thus, while strict shareholder wealth maximization may not lead manufacturing

corporations to protect the interests of those indirect stakeholders who live in the vicinity of

their plants, the government is an overriding force in ostensibly providing such protection.

Similarly, the U.S. government exercises considerable control over corporations’ ability to

amass market power by imposing antitrust laws. It is worth noting that the media can also play

a role in mitigating the negative effects of market frictions and externalities generated by

corporations. The potential effects of widespread information about negative corporate actions

on corporations’ reputations can interfere with their ability to attract customers, high-quality

employees, and other direct stakeholders.

In addition to governments’ ability to impose regulations, its ability to tax its

constituents – both corporations and individuals – provides the government with further tools

with which to influence corporate actions. Consider, for example, the wide variety of tax

deductions and credits available to businesses that engage in green energy initiatives, whether

in terms of their own energy usage or of the production of green products for sale to

consumers. Add to such business incentives the tax credits available to consumers who


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purchase such green products (electric cars, solar energy systems, and many others) and we

have a system in which the government has a considerable impact on both the demand for and

supply of green products.

Critics may well argue that the ability of the government to protect the interests of

those stakeholders whose interests are not sufficiently protected under shareholder wealth

maximization, is hampered by the fact that corporations – in particular large corporations –

have an undue amount of influence over the government. There is merit in this argument, to

the extent that such influence results in outcomes that deviate what would be observed in a

competitive market. Many corporations are significant donors to political campaigns and/or

employ lobbyists to exert influence on the government. In addition, the government may be

reluctant to risk corporate outcomes for which significant numbers of corporate stakeholders

would be adversely affected. In such situations the government may go so far as to bail

corporations out rather than let them fail. This should not, however, be viewed as an

indictment of the corporate form. I argue that it reflects the varied and often conflicting

motives of government agents: their individual opinions about what is best, the election-based

need for money and votes from a wide variety of constituencies, and their desires for personal

power and financial gain.

The notion that there are situations in which societal good warrants deviations from

strict shareholder wealth maximization is quite reasonable. It is more difficult, however, to

define the precise circumstances under which this is true. Government influence over corporate

actions replaces the consensus decisions of a broad marketplace of stakeholders employing

their own resources to act in their own interests with decisions made by a much smaller group


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of government officials who have complicated incentives and are using resources generated by

others. Such replacement should be made only when effective market solutions do not exist;

i.e., there must be clear and compelling reasons to think that the government is able to make

better decisions than the market about any particular issue. If the government is, in fact, overly

responsive to those with great wealth and power, it can hardly inspire confidence in their

decision-making.

What are appropriate roles for government with respect to corporations? This is a

loaded question, and I will not attempt to enumerate an exhaustive list even of my own

thoughts on the matter. I will, however, propose two categories of such roles, while urging that

care be exercised even within these categories. First, I believe there is an important role for

government to play in the protection of stakeholders from the negative effects of corporate

externalities and market frictions. Unchecked pollution potentially has adverse consequences

for many in society who are not in a position to contract on the matter with the offending

corporations. However, the societal benefits of regulating against any externality or friction

must be carefully weighed against the societal costs. Zero pollution is not a realistic goal. At

some point further reductions will require that some products that are valued by many

consumers either cannot be produced at all or cannot be produced at a price that consumers

can afford to pay. The great challenge is in identifying the point at which the societal costs of

regulation outweigh the benefits. Meeting this challenge requires that the government truly

has at heart the interests of society as a whole, as opposed to those of favored interest groups.

Second, I believe there is an important role for the government to play in identifying and

remediating corporate wrong-doing. If market forces are to protect the interests of


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corporations’ direct stakeholders, they must be able to contract with corporations in the good

faith that both sides will act as expected and agreed upon. Similarly, if governments are to

protect stakeholders from externalities and frictions for which market solutions are insufficient,

appropriate rules must be set and followed. This requires that all corporations, and their

relevant individual decision-makers, are held to the terms of their contracts and the rules that

are set, irrespective of the degree of their political influence. Corporate fraud and corruption do

not only harm individual stakeholders; they also contribute to negative societal impressions

about corporations. The challenge, of course, lies in defining what constitutes corporate wrong-

doing. Rule-makers must balance the intended benefits of potential rules against their costs

and unintended consequences.

It would be difficult to overstate the importance of restricting government involvement

in the affairs of corporations to the arguably limited situations in which the benefits of such

involvement outweigh the drawbacks. And there are many drawbacks. First, as noted above,

government involvement replaces the will of the many in the market with the will of the few in

government. Second, government regulations are by nature one-size-fits-all solutions to

complex problems. Government regulations that are ill-suited to individual corporations can

hamper such corporations’ ability to follow the most beneficial course of action. Furthermore,

regulatory prescriptions can reduce a corporation’s incentive to execute the analysis needed to

determine its own appropriate course of action. Berg (2012) relates that the Titanic carried on

board the government-regulated number of lifeboats. Unfortunately, because the Titanic was

considerably larger than any ship before it, this was only half the number of lifeboats needed to

ferry everyone to safety. Finally, government involvement invariably has consequences beyond


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the government’s presumed intentions. Such unintended consequences potentially cause harm

to individual economic agents. Perhaps worse, they may lead to further ill-advised regulation

designed to blunt their impact.

As an example, consider the issue of corporate risk-taking. Risk is inherent in business

operations. Corporate investment in appropriately risky projects benefits the economy as a

whole by providing employment, goods and services, etc. A publicly-traded corporation

operating in a free market maximizes firm value by taking on appropriate risks and avoiding the

risks for which the expected return is not high enough to justify them. However, suppose the

corporation comes to expect that, by virtue of its considerable size and importance to the

economy, the government will bail the corporation out rather than allow it to fail. This creates a

classic moral hazard problem. Firm value is now maximized by taking on additional risk that the

market was unwilling to finance at the given expected return, because the added risk is

effectively financed by the taxpayers. The taxpayers from whom these funds originate include

the same investors who were unwilling to finance these additional risks when they had a choice

about of what to do with their money.

The intended consequence of government bailouts of large institutions is to avoid the

temporary chaos in the market that would result from such a failure. The increase in corporate

risk beyond what is financially justified in the market is a serious unintended consequence. To

the extent that the government is concerned about this increase in risk, they may interfere

further in the workings of corporations, e.g. dictate how much cash firms must maintain, how

much or in what form they must pay their employees, etc. The government, however, lacks the

specific knowledge needed to determine appropriate policies and risk levels for individual


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corporations. Invariably the one-size-fits-all mandates they impose will lead some firms to avoid

taking on taking on appropriate risks, thereby depriving the economy of valuable growth and

development. Government involvement in corporations is a very slippery slope.

Where then does all of this leave us? Is the modern corporate form of organization in

jeopardy? Are corporations as a class doomed to be societal pariahs, under-loved and over-

regulated? Or can we find an appropriate balance, in which corporations are allowed and can

be trusted to maximize the economic well-being of society? Finally, what role can we, as

financial economists, play in addressing these issues? While it is beyond the scope of this essay

to do justice to answering these questions, I provide brief introductory thoughts in the final

section of this essay.

4. Finding the balance in the governance of corporations

The modern corporate form of organization has survived, prospered, and expanded

around the world over its 150+ year history because it provides for the efficient utilization of

society’s economic resources. Thanks to limited liability and the tradability of shares,

managerial/entrepreneurial talent and financial capital can be brought together even when

they do not coincide in individual economic agents. When such combinations are allowed to

operate in relatively free markets, the result is business enterprises that provide members of

society with the goods and services they need or desire, the ability to earn their livelihoods, and

the opportunity to earn financial returns that provide them with better futures. These are

considerable benefits; thus, it is difficult to imagine that the basic corporate form is in danger of

disappearing, particularly given the lack of a preferable alternative form of organization.


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Traditional ideas about the appropriate goal of the corporation, however, are

increasingly in danger. In 1970 Milton Friedman proposed in The New York Times Magazine that

the social responsibility of business is to increase its profits. This view is effectively reflected in

the traditional definition of corporate governance, under which the goal of the corporation is

shareholder wealth maximization. The publication of Friedman’s views set off a firestorm of

debate that continues to the present, and criticism of shareholder wealth maximization comes

from many corners of society. The problem is that to those who take these statements at face

value – without fully understanding the reasoning that lies behind them – the implication

seems to be that only the shareholders matter. This gives the impression that the good of the

corporation and the good of the rest of society are in conflict. In truth, however, shareholder

wealth is maximized when other direct stakeholders receive market-determined returns on

their contributions to firm value. When the returns to all stakeholders – including the

shareholders - are set in a free market, economic outcomes reflect the collective decisions of

economic agents acting in their own interests using their own resources. Thus, the vast majority

of what is good for a corporation is also good for society. Until this is well-understood,

corporations are most likely doomed to be under-loved and over-regulated.

Public discontent with large corporations is an important impetus for excess

government involvement in corporations. For this reason, widespread misconceptions

regarding corporate goals are dangerous for society’s economic well-being. Individual corporate

stakeholders, be they consumers, employees, shareholders, etc., most often have both the

ability and the incentive to make decisions that are in their own interests. Corporations who

seek to maximize shareholder wealth follow a clear decision rule that most often results in


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market-based returns to all of their stakeholders. Governments, on the other hand, typically do

not have detailed knowledge of the interests of individuals or corporations, clear decision rules

with which to determine whose interests should be maximized, or their own resources at risk.

How, then, can the government be expected to make superior decisions? The government’s

role in the workings of the corporation should be to step in when market solutions truly do not

exist and to enforce the terms of the nexus of contracts that constitute the modern

corporation.

What can we, as financial economists, do to improve the reputation of the corporation

in society? First, we can work to actively educate the population about the implications of

shareholder wealth maximization and about the important role that corporations play in

societal well-being. Second, through our research and writings we can be part of the dialogue

on how to identify and address those situations in which the good of the firm and the good of

society are actually in conflict. And finally, on a more personal level, as our children and

grandchildren are exposed to movies and other stories about evil corporations we can make

sure they get the other side of the story.


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Bibliography

Aguilera, R.V., K. Desender, M.K. Bednar, and J.H. Lee (2015). Connecting the Dots: Bringing

External Corporate Governance into the Corporate Governance Puzzle. The Academy of

Management Annals 9: 483-573.

Berg, C. (2012). The Real Reason for the Tragedy of the Titanic. The Wall Street Journal, April 13.

Cheffins, B.R. (2015). Corporate Governance Since the Managerial Capitalism Era. Working

paper.

Friedman, M. (1970). The Social Responsibility of Business is to Increase its Profits. The New

York Times Magazine, September 13.

Jensen, M.C. and W.H. Meckling (1976). Theory of the Firm: Managerial Behavior, Agency Costs

and Ownership Structure. Journal of Financial Economics 3: 305-360.

Micklethwait, J. and A. Wooldridge (2003). The Company: A Short History of a Revolutionary

Idea. New York: Random House. Print.

Ribstein, L.E. (2012), Wall Street and Vine: Hollywood’s View of Business. Managerial and

Decision Economics 33: 211-248.


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