Stakeholder Theory
We saw earlier the stockholder theory advocated by Milton Friedman in the article titled “The Social Responsibility of Business is to Increase Its Profits.” Now, we’ll examine the alternative which has come to be called the stakeholder theory. As we’ll see this model does address some of the issues raised by the stockholder model, but it also contains some problems which are addressed in the article by Kenneth Goodpaster.
The basic idea is to offer a contrast to the model which says that a corporation is solely responsible to its shareholders and no one else. As you can see in the PowerPoint graphic the stakeholder model illustrates that there are many other groups in which the corporation should have responsibilities. These include the local community, the employees, regulators, customers, and suppliers. Each of these groups has different claims on the corporation and has a “stake” in the actions of the corporation. Therefore, it follows that the corporation has some responsibility to each of these groups.
To illustrate the nature of this relationship, R. Edward Freeman outlines six principles that should govern the relationship between the stakeholders and the corporation. These principles are:
l Principle of entry and exit
l Principle of governance
l Principle of externalities
l Principle of contract costs
l Agency principle
l Principle of limited immortality
Let’s address each of these in turn.
Principle of entry and exit: This principle simply states that there must be clear rules governing how one enters into an arrangement with a corporation and how one may exit if they so choose. For example, with employees, there are clear conditions regarding hiring and firing. These conditions should be known, transparent, and available before one enters into an arrangement with the corporation. This holds for other stakeholders as well.
Principle of governance: This principle addresses how the rules governing the relationship between stakeholders and the corporation can be changed. This rule regarding rules must be transparent as well and according to Freeman, any changes must be agreed upon by unanimous consent.
Principle of externalities: The concept of externalities is very common in economics. The idea is that there are certain costs imposed on a group that does not directly benefit from the actions of the corporation. The simplest example of this is pollution. If you live in a community with a factory you will bear the cost of the pollution whether you work there or not or whether you purchase products from the company or not. So, this is an externality. The company doesn’t compensate you in any way for you bearing this cost. Given this, the principle of externalities says “if a contract between stakeholder groups A and B impose costs upon members of group C, group C has the option to become a party to the contract.” So, if you bear the costs of other stakeholders you have the right to become a stakeholder as well. This is directly implied by the concept of the stakeholder which is anyone who affects or is affected by a corporation.
Principle of contracting costs: The nature of contracts involves costs and this principle simply says that each party to a contract should bear the costs equally or in proportion to their advantage in the corporation. To the extent that some of these costs are non-monetary, this will become difficult to measure and quantify. This principle is based on the notion of fairness which we will have occasion to investigate later.
Agency principle: This principle is the most direct challenge to the corporation. A CEO or manager of the corporation acts as an agent of the corporation and as such has responsibilities not only to the shareholders (as in the Milton Friedman model) but also to every other stakeholder as well.
Principle of limited immortality: The success of the corporation and the welfare of its stakeholders depend on the corporation existing through time. In other words, the intent of the corporation cannot be to simply be a “fly by night” company. This serves the interests of some of the stakeholders at the expense of the others which violates the entire concept of the stakeholder. Therefore, the principle of limited immortality maintains that the corporation should be managed in such a way as to continue its existence. Of course, a corporation cannot be immortal any more than an individual (hence the seemingly strange term “limited immortality”). A company can certainly outlive its founder though and many successions of stakeholders. This principle intends to ensure that the corporation is managed such that this is the intent.
These are the basic principles of the stakeholder theory and the model certainly offers us an alternative to the stockholder model. The main benefit is that it forces the corporation to act in the interests of all the stakeholders. But, does this create a problem? Kenneth Goodpaster seems to think so and his article tries to address this problem. Unfortunately, he does so with a sea of jargon which I will try to help you navigate through!
The problem can be stated simply enough as follows: How can the ethical principles of stakeholder theory be implemented without betraying the fiduciary relationship between stockholders and the corporation? In short, the relationship between the corporation and the stockholder is a particular relationship that is different from other stakeholders and has always been treated as such. But, elevating the other stakeholders to this position seems to betray the nature of this relationship and in doing so potentially damage the central feature of corporate structure, namely private ownership.
To illustrate the problem, Goodpaster outlines several possible ways that stakeholder theory could be implemented and how each of these leads to problems. The two basic approaches he terms stakeholder analysis and stakeholder synthesis. Synthesis is further divided into two categories: strategic and multi-fiduciary. These terms come from a decision model Goodpaster calls PASCAL.
Stakeholder analysis: This occurs when the stakeholders which are affected by a decision are identified and their influence is “taken into account.” But, Goodpaster claims that this is only done in a formal sense with no real interest taken in the stakeholders themselves or what effect the corporation has on them. The analysis may be done for simply informational purposes but is rarely acted on. The problem here should be obvious. If the point of stakeholder theory is to take seriously the responsibilities the corporation has towards the various stakeholder groups this has to entail more than simply enumerating them. But this is all stakeholder analysis seems to do. Therefore, it is insufficient to the task of stakeholder accountability.
Stakeholder synthesis: In general this is where the stakeholders who are affected by a corporate action are taken into account more seriously. Their opinions are taken into account and even acted upon when the corporation makes a decision. There are two ways this can be done:
Strategic stakeholder synthesis: This occurs when the stakeholders who most affect the corporation are identified and integrated into the decision-making of the corporation. However, they are taken into account only in a strategic sense. What Goodpaster means by this is that they are taken into account to the extent that they affect the shareholders but their welfare in and of itself is not seen as important as the welfare of the shareholders. So, there is a hierarchy of stakeholders with the shareholders being regarded as the most important and the ones for whom corporate decisions are made. However, this differs from the standard stockholder model insofar as the stakeholders who will affect the shareholders are integrated into the decision process. The problem here, of course, is that the stakeholders are seen as having only strategic value and not even all of the stakeholders need to be taken into account. So, it is a highly selective and biased process.
Multi-Fiduciary stakeholder synthesis: This mouthful of jargon simply means the arrangement which most closely approaches the ideal of stakeholder theory. All stakeholders are treated as fiduciaries in the corporation. A fiduciary is defined as a person to whom property or power is entrusted for the benefit of another. For stockholders this means they invest money in a corporation and for this money, they earn certain rights including the right to dividends. What does this mean to the other stakeholders? This is unclear since they differ in an important respect from stockholders; they do not invest money. Of course, some stakeholders invest capital of some other kind but this is not necessary. So, as Goodpaster points out, this raises a problem which he terms the stakeholder paradox: “It seems essential, yet in some ways illegitimate to orient corporate decisions by ethical values that go beyond strategic stakeholder considerations to multi-fiduciary ones.” The reason it seems essential is that this is the only way to truly implement stakeholder theory. But, it seems illegitimate since it violates the basic relationship between the corporation and its stockholders.
So, where does this leave us?. That too is unclear. What Goodpaster seems to advocate is an arrangement that recognizes the moral obligation that a corporation has towards all stakeholders even as it recognizes the special relationship (fiduciary) between the corporation and its stockholders. This might leave you wondering how this differs from Milton Friedman’s stockholder model. The answer lies in the recognition of moral obligation. What seems to underlie this obligation is the philosophical concept of justice which we’ll examine in the next lecture.
The basic idea is to offer a contrast to the model which says that a corporation is solely responsible to its shareholders and no one else. As you can see in the PowerPoint graphic the stakeholder model illustrates that there are many other groups in which the corporation should have responsibilities. These include the local community, the employees, regulators, customers, and suppliers. Each of these groups has different claims on the corporation and has a “stake” in the actions of the corporation. Therefore, it follows that the corporation has some responsibility to each of these groups.
To illustrate the nature of this relationship, R. Edward Freeman outlines six principles that should govern the relationship between the stakeholders and the corporation. These principles are:
l Principle of entry and exit
l Principle of governance
l Principle of externalities
l Principle of contract costs
l Agency principle
l Principle of limited immortality
Let’s address each of these in turn.
Principle of entry and exit: This principle simply states that there must be clear rules governing how one enters into an arrangement with a corporation and how one may exit if they so choose. For example, with employees, there are clear conditions regarding hiring and firing. These conditions should be known, transparent, and available before one enters into an arrangement with the corporation. This holds for other stakeholders as well.
Principle of governance: This principle addresses how the rules governing the relationship between stakeholders and the corporation can be changed. This rule regarding rules must be transparent as well and according to Freeman, any changes must be agreed upon by unanimous consent.
Principle of externalities: The concept of externalities is very common in economics. The idea is that there are certain costs imposed on a group that does not directly benefit from the actions of the corporation. The simplest example of this is pollution. If you live in a community with a factory you will bear the cost of the pollution whether you work there or not or whether you purchase products from the company or not. So, this is an externality. The company doesn’t compensate you in any way for you bearing this cost. Given this, the principle of externalities says “if a contract between stakeholder groups A and B impose costs upon members of group C, group C has the option to become a party to the contract.” So, if you bear the costs of other stakeholders you have the right to become a stakeholder as well. This is directly implied by the concept of the stakeholder which is anyone who affects or is affected by a corporation.
Principle of contracting costs: The nature of contracts involves costs and this principle simply says that each party to a contract should bear the costs equally or in proportion to their advantage in the corporation. To the extent that some of these costs are non-monetary, this will become difficult to measure and quantify. This principle is based on the notion of fairness which we will have occasion to investigate later.
Agency principle: This principle is the most direct challenge to the corporation. A CEO or manager of the corporation acts as an agent of the corporation and as such has responsibilities not only to the shareholders (as in the Milton Friedman model) but also to every other stakeholder as well.
Principle of limited immortality: The success of the corporation and the welfare of its stakeholders depend on the corporation existing through time. In other words, the intent of the corporation cannot be to simply be a “fly by night” company. This serves the interests of some of the stakeholders at the expense of the others which violates the entire concept of the stakeholder. Therefore, the principle of limited immortality maintains that the corporation should be managed in such a way as to continue its existence. Of course, a corporation cannot be immortal any more than an individual (hence the seemingly strange term “limited immortality”). A company can certainly outlive its founder though and many successions of stakeholders. This principle intends to ensure that the corporation is managed such that this is the intent.
These are the basic principles of the stakeholder theory and the model certainly offers us an alternative to the stockholder model. The main benefit is that it forces the corporation to act in the interests of all the stakeholders. But, does this create a problem? Kenneth Goodpaster seems to think so and his article tries to address this problem. Unfortunately, he does so with a sea of jargon which I will try to help you navigate through!
The problem can be stated simply enough as follows: How can the ethical principles of stakeholder theory be implemented without betraying the fiduciary relationship between stockholders and the corporation? In short, the relationship between the corporation and the stockholder is a particular relationship that is different from other stakeholders and has always been treated as such. But, elevating the other stakeholders to this position seems to betray the nature of this relationship and in doing so potentially damage the central feature of corporate structure, namely private ownership.
To illustrate the problem, Goodpaster outlines several possible ways that stakeholder theory could be implemented and how each of these leads to problems. The two basic approaches he terms stakeholder analysis and stakeholder synthesis. Synthesis is further divided into two categories: strategic and multi-fiduciary. These terms come from a decision model Goodpaster calls PASCAL.
Stakeholder analysis: This occurs when the stakeholders which are affected by a decision are identified and their influence is “taken into account.” But, Goodpaster claims that this is only done in a formal sense with no real interest taken in the stakeholders themselves or what effect the corporation has on them. The analysis may be done for simply informational purposes but is rarely acted on. The problem here should be obvious. If the point of stakeholder theory is to take seriously the responsibilities the corporation has towards the various stakeholder groups this has to entail more than simply enumerating them. But this is all stakeholder analysis seems to do. Therefore, it is insufficient to the task of stakeholder accountability.
Stakeholder synthesis: In general this is where the stakeholders who are affected by a corporate action are taken into account more seriously. Their opinions are taken into account and even acted upon when the corporation makes a decision. There are two ways this can be done:
Strategic stakeholder synthesis: This occurs when the stakeholders who most affect the corporation are identified and integrated into the decision-making of the corporation. However, they are taken into account only in a strategic sense. What Goodpaster means by this is that they are taken into account to the extent that they affect the shareholders but their welfare in and of itself is not seen as important as the welfare of the shareholders. So, there is a hierarchy of stakeholders with the shareholders being regarded as the most important and the ones for whom corporate decisions are made. However, this differs from the standard stockholder model insofar as the stakeholders who will affect the shareholders are integrated into the decision process. The problem here, of course, is that the stakeholders are seen as having only strategic value and not even all of the stakeholders need to be taken into account. So, it is a highly selective and biased process.
Multi-Fiduciary stakeholder synthesis: This mouthful of jargon simply means the arrangement which most closely approaches the ideal of stakeholder theory. All stakeholders are treated as fiduciaries in the corporation. A fiduciary is defined as a person to whom property or power is entrusted for the benefit of another. For stockholders this means they invest money in a corporation and for this money, they earn certain rights including the right to dividends. What does this mean to the other stakeholders? This is unclear since they differ in an important respect from stockholders; they do not invest money. Of course, some stakeholders invest capital of some other kind but this is not necessary. So, as Goodpaster points out, this raises a problem which he terms the stakeholder paradox: “It seems essential, yet in some ways illegitimate to orient corporate decisions by ethical values that go beyond strategic stakeholder considerations to multi-fiduciary ones.” The reason it seems essential is that this is the only way to truly implement stakeholder theory. But, it seems illegitimate since it violates the basic relationship between the corporation and its stockholders.
So, where does this leave us?. That too is unclear. What Goodpaster seems to advocate is an arrangement that recognizes the moral obligation that a corporation has towards all stakeholders even as it recognizes the special relationship (fiduciary) between the corporation and its stockholders. This might leave you wondering how this differs from Milton Friedman’s stockholder model. The answer lies in the recognition of moral obligation. What seems to underlie this obligation is the philosophical concept of justice which we’ll examine in the next lecture.