Environmental, Social, and Governance (ESG) activity at real-world firms is largely about disagreements among shareholders over optimal corporate decisions and not about conflicts between shareholders (as a group) and stakeholders (e.g., customers, suppliers, and employees) who have transactional or contractual connections with a firm.
The important normative question raised by ESG activity is therefore: How should governance architecture (corporate laws and charter provisions) be structured and enforced to deal with disagreements among shareholders about corporate policies?
In a new paper, I address this issue by applying basic principles of property-rights economics traceable to Coase (1960) and Alchian and Demsetz (1972).
The ESG movement has gained serious traction with support from money managers who have exercised their power as agents of shareholders to pressure directors to pursue a variety of social objectives, including a reduced carbon footprint and the use of DEI criteria in personnel decisions. For example, Climate Action 100+ is a group of money managers that lobbies directors to reduce greenhouse-gas emissions and that, in early 2024, reported having a collective $68 trillion in assets under management.
When I speak of ESG, I am concerned with cases in which shareholders disagree about pursuing social (including environmental) objectives. For example, my concern is with shareholder activists seeking to have oil firms sacrifice profitability by scaling back fossil-fuel production, and not with cases in which a green-energy agenda would make shareholders better off financially. In the latter “win-win” cases, firms should obviously pursue ESG objectives. The cases that pose a challenge for the design of governance architecture are those in which shareholders disagree and so they are the sole focus of my paper.
The ESG activity of concern here is surreptitious attempts to convert firms incorporated with a conventional mission – advance the pecuniary interests of shareholders – into firms that sacrifice pecuniary benefits to advance a social or political agenda favored by a subset of shareholders or their agents.
The financial damage inflicted on other shareholders from such ESG activism is no different than if a swashbuckling Wall Street “raider” – say Boone Pickens or Saul Steinberg in the 1980s – obtained a greenmail payment (de facto bribe authorized by directors) in exchange for a promise to stop accumulating shares and threatening to take control.
This ESG lobbying is a subtle form of corporate “piracy” or “raiding.” I use these terms to connote attempts to expropriate property rights that were intended to be secure, but that are not perfectly secure because of the realities of contractual incompleteness. With ESG, I have in mind property rights encroachments that opportunistically exploit confusion and ambiguity about the substance and enforcement of laws and contracts related to corporate mission.
The concern with ESG-based piracy is not just the opportunistic transfer of resources from one group of shareholders to another. Importantly for efficient contracting analysis, such piracy causes a private loss in the form of an avoidable shortfall in attaining the chartered objective – a loss that I will call dissipation. This dissipation includes reduced financial returns from warping of corporate decisions (when the board deviates from a chartered conventional mission) and from time spent in conflict as well as from more costly access to capital because investors anticipate the future consequences of the warped policies.
In the U.S. today, de facto mission changes can be made by coalitions of shareholders lobbying a firm’s board of directors for policies they prefer, provided they can portray those policies as advancing an objective that plausibly sounds socially worthwhile. Financially oriented investors accordingly have incentives to expend resources to monitor the social predispositions of other (current and prospective) investors. That will help them avoid expropriation by coalitions of shareholders that seek to sacrifice pecuniary returns to promote the activists’ preferred social objectives. That, in turn, undermines investors’ willingness to purchase and retain shares in the firm. Consequently, the prospect of corporate piracy through surreptitious mission changes could materially raise the corporate cost of capital and thus diminish a firm’s incentive to undertake investments that would otherwise be both privately and socially beneficial.
Coasian Contracting Efficiency and Corporate Mission
My Coasian analysis of corporate mission does not assume that shareholders care only about maximizing wealth or pecuniary returns. It is fully compatible with many, or even all, shareholders caring about multidimensional elements of personal utility, including externalities and other social issues. Such preferences, of course, imply a pervasive personal willingness to sacrifice some degree of pecuniary return for perceived social benefits.
It might therefore seem that firms should always have a social component to their mission.
Not so. Not in the real world of significant information costs and imperfect knowledge where contracts are necessarily incomplete and thus vulnerable to opportunistic encroachment of property rights.
In the Coasian view, stipulation of a corporate mission is an efficiency enhancing contractual tool. Because of significant information costs, investors form collective enterprises with stated missions that they believe will aid directors in making wise decisions on their behalf. Missions also help mitigate opportunism by directors and by fellow shareholders (such as ESG activists) who are not directors.
Investors who incorporate a firm will virtually always differ in their personal preferences about the specific details of corporate policies, including those policies believed to have important social consequences.
Why would people who care about social issues form a corporation with the conventional mission of exclusively advancing the general pecuniary interests of shareholders?
The answer is that the parties who form a firm expect it to be run more efficiently (for whatever their personal objectives are) when directors are guided by the specific chosen mission. If they are rational, they recognize that the firm cannot – and will not – be run perfectly in accord with individual tastes of people who own shares. Nirvana is not feasible. Rational investors will therefore agree to a mission that is feasible and that they expect to be more productive than the other (also imperfect) feasible alternatives.
Well-formulated mission-related laws and charters effectively work as contractual commitment devices that mitigate dissipation due to disagreement among shareholders. With sensibly formulated laws and charters, a firm’s specific mission can be altered by shareholders, but not too easily, as that would foster dissipative attempts to alter corporate policies to suit the narrow self-interest of subgroups of shareholders.
This answer advances a general principle that is rooted in Coasian contracting efficiency logic and that applies to all firms, not just those with a conventional pecuniary mission.
Shareholder Disagreement, Value Maximization, and Optimal Governance Architecture
My analysis shares one basic component with – but otherwise differs significantly from – the argument of Hart and Zingales (2022, HZ) that emergence of the ESG movement calls for a new corporate-governance paradigm. HZ and I both recognize the importance of the failure of the Fisher Separation Theorem (FST) and its central implication – unanimous shareholder support for corporate decisions that maximize value – when analyzing corporate-governance issues.
However, we focus on different causes for FST failure and therefore reach markedly different conclusions about how corporate-governance architecture should reflect ESG concerns. HZ focus on how externalities and social concerns cause shareholder disagreements over corporate policy, thereby destroying the FST’s choice-theoretic foundation for the shareholder-value-maximization rule.
I focus on information costs and imperfect knowledge, which cause shareholder disagreements even absent externalities and social concerns. ESG has thus revealed new reasons for shareholder disagreement, not a new governance problem. I infer that ESG does not warrant changing basic governance architecture, which has a remarkably long and strong record of fostering productive output despite shareholders who disagree about corporate policy.
HZ’s shareholder-welfare approach would modify governance architecture to require binding shareholder votes on corporate policies that have social overtones. HZ note that their approach could “open the floodgates to thousands of shareholder resolutions” that could distract management from creating value. They accordingly indicate that firms should be able to limit by charter the social issues subject to binding shareholder vote and suggest that a transitory period of advisory votes might make sense.
My approach to ESG would reduce dissipation by clarifying and enforcing the mission that directors are charged with pursuing, while retaining other dissipation-reducing features of governance architecture.
Key Elements of the Paper
- Why shareholder disagreement should be central to any credible analysis of corporate-governance architecture.
- Why there nonetheless is ex ante unanimous shareholder agreement about the firm-specific mission and governance rules.
- What the law says – and what Coasian logic indicates it should say – about the pursuit of social objectives at firms with conventional missions.
- The rampant misunderstanding about the meaning of shareholder democracy and related confusions that have enabled the ESG movement to gain significant traction.
- The role of corporate boards of directors and money managers in fostering ESG-related piracy at conventionally missioned firms.
REFERENCES
Alchian, Armen, Demsetz, Harold. 1972. Production, information costs, and economic organization. American Economic Review, 777-795.
Coase, Ronald. 1960. The problem of social cost. Journal of Law and Economics, 1-44.
Hart, Oliver, Zingales, Luigi. 2022. The new corporate governance. The University of Chicago Business Law Review, 195-216.
This post comes to us from Harry DeAngelo, Kenneth King Stonier Chair Emeritus at the University of Southern California’s Marshall School of Business. It is based on his recent paper, “ESG, Corporate Piracy, and Coasian Contracting Efficiency,” available here.