In a 1987 paper, available here, we argued that non-investor stakeholders play an important role in influencing financial policy and corporate valuation. We also distinguished explicit claims between a company and its counterparties from what we called implicit claims. In more recent years, there has been a growing focus on non-investor stakeholders and environmental, social, and governance (ESG) and, in particular, their role in creating corporate value. Left largely unexplained, though, is how this occurs. Here we argue that one of the keys is the distinction between explicit and implicit claims.
Explicit claims are familiar contracts. These include employment contracts, bond indentures, and product warranties. The distinguishing feature of implicit claims, as we define them, is that they are too nebulous to reduce to writing at a reasonable cost. For this reason, implicit claims have little legal standing. Examples include fair treatment of employees, promise of continuing service to customers, and honest dealing with suppliers and distributors. We suggest that implicit claims are a critical link that ties non-investor stakeholders and ESG, often termed corporate social responsibility (CSR), to corporate value creation and financial policy. However, the link cuts both ways as some policies advocated by ESG enthusiasts may actually destroy value by reducing the value of current implicit claims and also impeding the ability of a company to sell new ones. By “sell,” we mean include in the price of products. Implicit claims of quality and service, for example, can allow a product to be sold at a higher price, while the implicit claim of treating employees fairly can make hiring less costly and allow the product to be sold at a lower price.
The link between implicit claims and shareholder value is straightforward: Firms create value by selling implicit claims for more than the cost of honoring them. The need to create value by selling implicit claims implies that value maximizing companies typically will behave in a socially responsible manner. Consequently, to a large extent there is no inherent conflict between maximizing shareholder value and treating non-investor stakeholders properly.
In the context of implicit claims, it is important to distinguish between two separate criticisms made by advocates of corporate social responsibility. The first amounts to advice to corporations to recognize that shareholder wealth maximization must be interpreted in a broad context. Managers need to be aware of the impact that their relationships with other stakeholders has on shareholder value. If this is what CSR amounts to then there is really little debate. Companies are simply being advised to manage their implicit claims properly.
The second criticism put forth by CSR advocates makes a much stronger political statement. According to this broader interpretation of CSR, managers should take actions that benefit other stakeholders even if those actions result in a decline in shareholder value. For instance, firms should purchase electric power from renewable sources even if it is more expensive. As Friedman (1970) emphasized long ago, this position amounts to corporate managers taxing shareholders in order to pursue a goal they see as socially desirable. Leaving aside the fiduciary obligation that directors and managers have to their shareholders, what gives managers the right to levy such a tax or to decide how the proceeds are to be spent? Both levying taxes and funding social projects are generally assigned to duly elected or appointed public officials. Why, and to what extent, should those functions be extended to corporate managers? As Friedman stressed, corporate executives are being asked to make social decisions without being duly elected and with little evidence that they have the proper training or incentives.
Hiding in plain sight in these examples is a critical stakeholder issue, perhaps the most important of all for the current debate over CSR—namely, who is a legitimate stakeholder holding legitimate implicit claims? In writing our 1987 article, we were quite clear that the corporate stakeholders we were discussing were those parties—customers, employees, suppliers, distributors, and so on—who had a business relationship with the company. Examples we cited included car buyers having an implicit claim to continued service, software companies offering routine upgrades, suppliers making key parts available, and employees being treated fairly when seeking promotion. As such, we were able to apply standard economic analysis to examine the nature of the implicit claims they held and how the existence of those claims affected corporate behavior and valuation.
In contrast, many of the stakeholders being talked about today—groups like environmentalists and promoters of social and racial justice—are self-identified, with no business relationship with the company. Unlike traditional stakeholders with economic relationships with the company, these new stakeholders assert their ownership of implicit claims without having paid for them. Given the lack of business relationships with these new, self-appointed stakeholders, economic analysis tells us nothing about whether and how a company will honor these claims or what the financial consequences of attempting to honor these novel claims might be.
The issue is similar, but even more vexing, in the case of climate change. If companies are being asked to properly comply with environmental regulations and to take prices, including components such as carbon taxes, as given, that is a defined implicit claim that they can honor. However, if companies are being asked to determine whether current government policies are appropriate, and if those policies are not appropriate, to decide what implicit claims they need to honor to take account of governmental shortcomings, the problem becomes overwhelming. It is far beyond the capabilities of most companies to determine the appropriate tax on shareholders in order to pursue climate change objectives. To make matters worse, who are the counterparties to the climate-related implicit claims that the company is endeavoring to honor? Because greenhouse gas emissions have a global impact, the counterparties are effectively everyone. Furthermore, because the gases remain in the atmosphere for decades, and in some cases centuries, the counterparties even include future generations. Such broad and ill-defined claims are not something a typical company, or even the most sophisticated companies, could manage. As a result, there is an incentive to make proclamations, such as “our company will be carbon neutral by a given date,” without defining what is meant by carbon neutrality or spelling out what will happen if the objective is not met. These proclamations just add to public confusion regarding climate change.
Finally, in a democratic society, we argue that the questions of which social issues to address, how to address them, and the amount of resources to allocate to these issues can only be fairly dealt with through the political process. The logical implication of this viewpoint is that CSR advocates are trying to access and use corporate resources to achieve objectives that they have failed to attain through the political process. But doing so interferes with the process by which companies create value, namely, selling implicit claims to stakeholders that do business with the company. The exchange of implicit claims between a company and its direct stakeholders is a process that, in most cases, will likely have evolved over a substantial period of time in an effort to deal with contracting problems at the lowest possible cost. Outside interference with the sale of implicit claims—which our analysis, both present and past, suggests is a key element of running a successful organization—is likely to have negative unintended consequences that CSR advocates have not adequately addressed.
Before CSR critics advocate that companies take on more implicit claims involving stakeholders that are not normal counterparties, they need to define clearly what those claims are and how they will impact the general ability of the company to create value by selling future implicit claims.
This post comes to us from Bradford Cornell, emeritus professor of finance at UCLA’s Anderson School of Management, and Alan C. Shapiro, emeritus professor of finance and business economics at USC’s Marshall School of Business. It is based on the recent article, “Corporate Stakeholders, Corporate Valuation, and ESG,” available here.