We examine how shareholders and other stakeholders were affected by a quasi-exogenous shock to corporate governance that began to emerge state-by-state across the United States in the 1980s. The shock came from so-called “constituency statutes,” which allow, but do not require, directors to take into consideration stakeholders rather than just shareholders when making decisions (Orts 1992-1993). These statutes prompted an important shift in governance. Under the shareholder primacy principle, directors and managers had a fiduciary duty to make the interests of just one type of stakeholder – shareholders – a priority. Under constituency statutes, they now held the “right” to give priority to some stakeholder interests over others, a principle also known as stakeholder theory, stakeholder governance, or conscious capitalism. We are not the first to investigate the impact of constituency statutes on shareholders or non-shareholder stakeholders. However, to our knowledge, ours is the first empirical study to investigate how constituency statutes facilitate trade-offs among multiple stakeholders, with some stakeholders benefiting at the expense of others.
Our study contributes to the debate over the objective of the firm, which has been reinvigorated recently by the Business Roundtable statement that “corporate leaders should take into account ‘all stakeholders’ in business decision making” and the Council of Institutional Investors’ retort that “accountability to everyone means accountability to no one.” Over decades, scholars across disciplines have proposed myriad firm objectives, including shareholder value maximization (Berle 1932; Friedman 1970; Jensen and Meckling 1976), stakeholder accommodation (Dodd Jr. 1932; Freeman 1984), long-term firm value maximization (Jensen 2002), shareholder welfare maximization (Hart and Zingales 2017), and alignment of shareholder wealth maximization with stakeholder interests (Bhagat and Hubbard 2020). By and large, all these objectives stand between two extremes: shareholder primacy and stakeholder governance.
Despite claims that accountability to multiple stakeholders would harm both shareholders and the firm (Macey 1991; Bebchuk and Tallarita 2020), the consequences of the adoption of these statutes (and the shift from “duty” to “right”) have been surprising. With few exceptions (e.g., Alexander et al. 1997), constituency statutes have been shown to enhance shareholder value through, for example, narrower loan spreads (Gao et al. 2020), increased Tobin’s Q (Cremers et al. 2019), and increased innovation (Flammer and Kacperczyk 2015), while at the same time benefiting other stakeholders through, for example, greater board representation (Luoma and Goodstein 1999) and increased corporate social responsibility (CSR) activity (Flammer 2015). Given that constituency statutes open the door to trade-offs between different constituencies, we feel that there is value in examining possible trade-offs happening at the same time, rather than focusing on the impact of the statutes on any constituency in isolation. By examining such contemporaneous trade-offs across constituencies in sort of zero-sum game, we can assess which constituencies suffered and which benefited from the change in governance effected by the introduction of a constituency statute. Our approach also determines whether there is a possibility of a Pareto optimal solution, wherein shareholders were unaffected but other stakeholders benefitted.
Using a sample of U.S. publicly traded firms from 1981-2010 and employing a difference-in-difference methodology, we find that the discretionary adoption of stakeholder governance leads to managerial entrenchment and a reduction in institutional ownership and shareholder wealth with little to no trade-off benefits to other stakeholders. As states adopted constituency statutes, signs of managerial entrenchment increased (represented by significant declines in earnings transparency and increases in CEO and director compensation). At the same time, we do not observe potential trade-off benefits to the non-shareholder stakeholders these statutes were intended to help. Careful examination of potential benefits to labor (measured as labor expense, unionization percentage, labor productivity, and Selling, General, and Administrative (SG&A) expenses-to-sales ratio), to creditors (measured as interest coverage ratio), to customers (measured as advertising expenditure), and to shareholders (measured as price-to-earnings growth and institutional-investor holdings) suggest that stakeholders broadly did not benefit from the introduction of constituency statutes (as the drafters may have intended). We also find that shareholders reacted negatively to the adoption of constituency statutes and that major institutional investors divested from such firms.
Overall, we find evidence that constituency statutes exacerbated managerial entrenchment, whose negative impact was not offset meaningfully through benefits to labor, customers, debtors, and shareholders. We attribute these findings to three factors – stretched resources, overextended board members and managers, and an entrenchment mindset among managers aware that board members were overextended. Our results are robust to a battery of checks, including orthogonality to other anti-takeover laws, bias in traditional methodology, differences between firms affected by these statutes and firms not so, subsample analyses, and temporal dynamics analyses.
Alexander, J. C., Spivey, M. F., & Marr, M. W. (1997). Nonshareholder constituency statutes and shareholder wealth: A note. Journal of Banking & Finance, 21(3), 417-432.
Bebchuk, L. A., & Tallarita, R. (2020). The illusionary promise of stakeholder governance. Cornell Law Review, forthcoming.
Berle, A. A. (1932). Corporate powers as powers in trust. Harvard Law Review, 44(7), 1049-1074.
Bhagat, S., & Hubbard, R. G. (2020). Should the modern corporation maximize shareholder value? Available at SSRN: https://ssrn.com/abstract=3548293.
Cremers, M., Guernsey, S. B., & Sepe, S. M. (2019). Stakeholder orientation and firm value. Available at SSRN: https://ssrn.com/abstract=3363686.
Dodd Jr., E. M. (1932). For whom are corporate managers trustees? Harvard Law Review, 45(7), 1145-1163.
Flammer, C. (2015). Does corporate social responsibility lead to superior financial performance? A regression discontinuity approach. Management Science, 61(11), 2549-2568.
Flammer, C., & Kacperczyk, A. (2015). The impact of stakeholder orientation on innovation: Evidence from a natural experiment. Management Science, 62(7), 1982-2001.
Freeman, R. E. (1984). Strategic management: A stakeholder approach. Boston: Pitman.
Friedman, M. (1970). The social responsibility of business is to increase its profits. New York Times Magazine, Sept. 13.
Gao, H., Li, K., & Ma, Y. (2020). Stakeholder orientation and the cost of debt: Evidence from state-level adoption of constituency statutes. Journal of Financial and Quantitative Analysis, Advanced Online.
Hart, O., & Zingales, L. (2017). Companies should maximize shareholder welfare not market value. Journal of Law, Finance, and Accounting, 2, 247-274.
Jensen, M. (2002). Value maximization, stakeholder theory, and the corporate objective function. Business Ethics Quarterly, 12(2), 235-256.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.
Luoma, P., & Goodstein, J. (1999). Stakeholders and corporate boards: Institutional influences on board composition and structure. Academy of Management Journal, 42(5), 553-563.
Macey, J. R. (1991). An economic analysis of the various rationales for making shareholders the exclusive beneficiaries of corporate fiduciary duties. Stetson Law Review, XXI, 23-44.
Orts, E. W. (1992-1993). Beyond shareholders: Interpreting corporate constituency statutes. George Washington Law Review, 61(1), 14-135.
This post comes to us from Jitendra Aswani, Alona Bilokha, Mingying Cheng, and Benjamin Cole at Fordham University’s Gabelli School of Business. It is based on their recent article, “The Cost (and Unbenefit) of Conscious Capitalism,” available here.