What should be the purpose of the public corporation?  Over the last few years, that has become an increasingly open and contested question, as evidenced by the recent statements of the corporate sector itself, the practice of B corporations like Kickstarter or Patagonia, which pledge a concern for broader goals, and the attentions of Columbia Law Professor Jeffrey Gordon.

I wanted to use the renewed debate to take a look back at a classic defense of the shareholder value maximization model,  “The End of History for Corporate Law,” published in 2000 by professors Reinier Kraakman and Henry Hansmann, then both of Harvard Law School.   In a time of shifting debate, consider it an opportunity to look back and assess what was once claimed to be the conventional wisdom.

Their title was a play on political scientist Francis Fukuyama’s 1992 book “The End of History and the Last Man,” which had proclaimed the triumph of liberal free-market democracy over all other forms of government.  As Fukuyama wrote, humanity had reached “the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.”  Kraakman and Hansmann thought the same thing had happened in the field of corporate governance.  As they said, “[t]here is no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value.”

Despite being an outsider to corporate law, I’ve long been fascinated by this paper, given that its claims are so bold as to be almost comical.  Unfortunately, as with Fukuyama’s  book, history has not been kind to the Kraakman-Hansmann thesis.  Its main factual assertion has proven wrong, given the rise of a corporatist model in China and its persistence in other countries, like Brazil.  And the idea that there is no normative competition to the model is also obviously wrong, unless one is disposed just to ignore the growing body of dissent.  This isn’t to say that the normative position taken by Kraakman-Hansmann has been eclipsed or defeated. It has many defenders, including the Council of Institutional Investors, the Wall Street Journal’s editorial page, and Jeffrey Gordon’s recent post on this blog. But, at the risk of stating the obvious, the idea that history ended in 2000 was an embarrassing overstatement.

It might be a little unkind to criticize a paper written many years ago, and I’m hardly the first to do so.  But both the title and the authors’ continued defense of their position merit the reevaluation.  With the benefit of hindsight, it is clear that the authors committed the typical error of mistaking their times (the 1990s) for eternity (a little like the baby boomers who cannot let go of the 1960s).  But I think they made at least one other, more subtle error as well: taking an exceedingly optimistic, almost Panglossian view of the ability of law and government to take care of the problems created by the shareholder primacy model and its deliberate neglect of so many of the naturally arising problems created by its operation.  While relying on government to fix things, the authors also didn’t seem to consider the fact that the primacy model logically incentivizes corporations to prevent government from acting in ways that might be social welfare-maximizing.  In retrospect, what was actually predictable in the year 2000 was that urging corporations to focus only on shareholder value would yield the backlash we see today.

Let’s begin with the prediction of normative convergence, where the error is more obvious but also more forgivable.  The authors believed that the shareholder value model was the consensus global winner, based on what they viewed as the failure of every other model over the 20th century (labor-centered, management-centered, etc.).  They believed irresistible forces of convergence made the emergence of other models untenable.

But they forgot about China.

This was an easy mistake to make (Fukuyama made the same mistake, albeit eight years earlier).  Plenty of people were wrong about China.  But the emergence and self-proclaimed success of China’s corporatist model, in which corporations take direction from the state and jointly pursue “national greatness,” pretty much destroys the global convergence thesis.

I am no fan of the Chinese corporatist model, which I fear melds private and public power in terrifying ways.  But it is hard to deny that it is seen by some, especially in China, as a better model, based on the argument that the model has given China an advantage in matters of economic growth or responding to the global financial crisis of the late 00s.

What is more surprising, but telling, is that Hannsman and Kraakman decline to admit error.  Instead, in a follow-up written in 2012, they claim, implausibly, that China actually does or will soon follow the model of corporate governance that they advocate.  This claim is premised not on any study of Chinese corporate behavior, but instead an anecdotal and non-falsifiable assertion that “the Chinese economic elites that matter … probably already embrace the [shareholder value maximization model].”  There are doubtless shareholders who wish this were true, but to suggest that this makes it the prevailing normative model of the Chinese corporation is a laughable proposition.

The reality is that the corporatist model of economic development is alive and well, that it comes with a very different view of the goals of a public corporation.  I think it is a dangerous model with a dangerous history, but those of us who believe in a non-corporatist approach to the economy need to do better than just assuming countries like China desperately want to be more like us.

But let us move instead to the normative claims and see why Hansmann and Kraakman were wrong to assert that the shareholder value model would come to transcend debate.

In their 2000 piece, the authors agreed that social welfare matters more than shareholder welfare, but they thought that asking corporations to maximize shareholder welfare was the best means to achieve the former.  As they wrote: “All thoughtful people believe that corporate enterprise should be organized and operated to serve the interests of society as a whole, and that the interests of shareholders deserve no greater weight in this social calculus than do the interests of any other members of society.”

The question is, and was, when one set of actors — shareholders — are given primacy in social welfare terms, what about the welfare of other stakeholders like employees, customers, or members of a community?   Most Americans are actually shareholders and employees.  And one’s treatment as an employee, for most of us, has much more of an effect on quality of life than our lives as shareholders.  If you really care about maximizing social welfare, isn’t ignoring all of these other interests at least a bit risky?

The authors’ main answer — and Jeffrey Gordon’s, too — is a version of pass the buck.  Let the legal system, not public companies, ensure that workers have good jobs, that communities are not destroyed, that the environment is protected, and that middlemen don’t squeeze out suppliers.  Implicit or explicit in this view is another fear:  that if corporations begin thinking about the interests of those other than shareholders, they will use that as an excuse for pet projects, the hiring of cronies, and other forms of management misfeasance. (More on this in the next post).

I’m personally in favor of laws that protect the environment or the unemployed, and I also agree with Gordon that the state would make everyone happier (maximize social utility) with some protection against economic insecurity.  But the pass the buck approach has a deep and serious flaw.  Most of all, it is extraordinarily optimistic about both the ability and likelihood of government doing that which the corporation is being asked to ignore.

We can break this down.  First, passing the buck ignores public choice theory and the obvious incentives of corporations who are told to maximize shareholder welfare to prevent the legal system from actually providing protections that might decrease corporate profit.  That is evidenced by the United States, where one reason there is so much mounting pressure for corporations to take action today is that government has failed to act in many areas that people care about, often by overwhelming margins.  And the shareholder value model is not independent of governmental failure but one of its causes.

Take environmental protection.  Say we recognize absolutely no duty in corporations to take into account harms caused to the environment and ask them only to maximize profit.  If new environmental laws will reduce long-term shareholder value by some billions of dollars, it is in the interest of the corporation to spend millions, if not billions, of dollars to prevent the passage of such laws and try to weaken those already in existence.  That’s elementary public choice theory.  And it shows the problem with any pass the buck theory.

Second, and more deeply, it grandly overestimates the legal system and what it can realistically do for people.  Yes, government is powerful, and laws are commands backed by a threat of force.  But to expect law to fill in all the gaps is to expect far too much.

Take just one matter: the conditions of employment.  In the first instance, how pleasant or humane a work environment is will depend on the norms of the corporation in question.  The law, of course, can curb abuses and outliers by barring sexual harassment or policing misconduct, like failures to pay overtime.  But to say the corporation has no ethical duties, and we’ll leave it to the law to create the working conditions we’d like to see, is a recipe for terrible work conditions once you accept the limits of the law.

There is a large literature on the comparative efficacy of internal motivation versus external sanctions as a method of inducing good behavior (the famous study of day care with penalties for late parents is an oft-cited example).  The risk is that replacing the internal, ethical motivations of a company and its leadership with shareholder primacy plus the external sanctions of the legal system will crowd out whatever beneficent instincts may exist, sometimes at great social cost.

The pharmaceutical industry provides an example of what happens when old norms disappear.  This was an industry which for many decades didn’t extract the prices it might have for live-saving or scarce drugs, nor attempt to profit from addictive drugs, based on the commonplace understanding that to do so would be cruel and exploitative. Over the last 20 years, the replacement of those ethics (often in firms owned by hedge funds) in the name of profit maximization has caused not just the overcharging of customers (as in the EpiPen), but much unnecessary suffering, addiction, and death.  It has transformed the industry from an inspiring healer of the sick into a disgraced industry currently being prosecuted around the country.

It is easier to criticize the shareholder primacy model than to set forth what exactly might work as a means of ensuring both a reasonably efficient corporate sector and broader social duties (more on this in my next post).  But when it comes to the duty of the corporation to maximize social welfare, what we should be doing is asking the question of comparative efficiency.  What should be the duties of the corporate sector alone, what should just be left to government, and when should we insist on corporate duties, as overseen by government?  Jeffrey Gordon inadvertently engages in just such an analysis, focusing on the problem of economic insecurity, which may indeed be better handled by a government guarantee (as in Scandinavia) than a corporate guarantee (as in Japan).  Similarly, making the employer the centerpiece of American healthcare seems to have been a dubious idea in a world where people change jobs and where the sheer costs of healthcare administration have come to account for an astonishing percentage of national GNP. The division of labor in the solving of the nation’s and world’s most difficult problems — this feels like the debate that is worth having.

This post comes to us from Tim Wu, the Julius Silver Professor of Law, Science, and Technology at Columbia University Law School.