Corporate governance is often described as cooperative. On this account, shareholders, directors, officers, employees, suppliers, customers, communities, and other constituencies are members of a team, each contributing to a common enterprise, and each entitled to some consideration in the distribution of corporate benefits. Modern ESG and stakeholder-capitalism theories rest heavily on this description. They assume, sometimes explicitly, that corporate managers can and should balance the interests of many constituencies in pursuit of a broader social good.
In a new article, we argue that this account is incomplete and idealistic. Corporate actors are neither angels nor demons, but ordinary people and groups responding to incentives. They evaluate choices, pursue their own preferences, seek to maximize their own welfare, and adapt when rules change. That is the case with managers, shareholders, employees, suppliers, customers, advocacy groups, institutional investors, regulators, and politicians. Once that point is taken seriously, corporate governance, in the absence of limiting institutions, looks like a free-for-all over the corporate residuum.
Shareholders’ claim to it is familiar in bankruptcy, where shareholders stand last in line after creditors and other claimants have been paid. But shareholders do not acquire that residual interest only at the moment of insolvency. They hold it from the corporation’s formation, contributing capital in exchange for it.
But because shareholders do not directly control corporate assets, their residual claim is vulnerable. Managers control the assets. Other constituencies may want access to them. Some, like employees, suppliers, and creditors, have contractual claims. Others have no contractual or property-based claim but may assert moral, political, reputational, or regulatory pressure. If corporate law allows managers to divert the assets to whichever group successfully demands them, the assets become a type of commons. With each claimant having reason to extract what it can, and no claimant having sufficient reason to preserve the whole, the predictable result is depletion.
Public choice economics helps explain this danger. Public choice is the economic study of collective decision-making. It rejects the assumption that political actors set aside self-interest when they enter public life. We apply the same approach to corporate governance. Just as legislators, regulators, and voters respond to incentives, so do directors, officers, shareholders, activists, index-fund managers, and interest groups. The corporation is a voluntary association. It requires collective decisions about valuable resources. Those decisions create rent-seeking opportunities.
Interest-group theory is especially useful. In politics, groups seek favorable laws, subsidies, regulatory exemptions, and other rents. In corporate governance, interest groups have several routes to similar ends. They can buy control of the corporation. They can buy enough shares to submit shareholder proposals or gain access to shareholder lists. They can campaign externally against the corporation. They can pressure management directly. Or they can seek government mandates that force corporations to adopt the group’s preferred policies. The last two paths are particularly important. It often costs less to persuade a small number of managers or regulators than dispersed shareholders whose wealth will fund the policy.
Social choice theory also matters. Calls for corporations to pursue “society’s interests” assume that there is a coherent social welfare function for managers to maximize. But corporate constituencies have different and often conflicting preferences. Some investors may value ESG objectives at the expense of financial return. Others may prefer dividends or capital appreciation and then decide for themselves whether certain causes deserve their charitable donations. Employees prefer higher wages while consumers prefer lower prices. Advocacy groups may prefer policy commitments. Managers may prefer wealth, prestige, or other personal advancement. To say that managers should balance all of these interests is to give them discretion rather than a workable standard. Corporate law historically developed three institutions to limit that discretion: shareholder wealth maximization, fiduciary duties, and the business judgment rule.
Shareholder wealth maximization protects the shareholders’ residual claim. It does not require courts to second-guess every business decision or to demand short-term profit at the expense of long-term value. Rather, it supplies the end toward which managerial discretion is directed. Fiduciary duties provide the enforcement mechanism. Directors and officers, as agents, must act with care and loyalty, treating shareholder assets reasonably and not diverting the assets to themselves or favored groups. The business judgment rule, properly understood, protects managers when they make informed, good-faith business judgments. Courts are not well positioned to decide whether a pricing strategy, product launch, acquisition, compensation plan, or reputational investment will maximize long-term value.
But a problem arises when the business judgment rule becomes detached from the business purpose it is meant to serve. The rule should protect managers’ discretion in choosing means to advance shareholder wealth. It should not protect transfers of shareholder wealth to non-shareholder constituencies for reasons unrelated to corporate value. Yet 20th-century developments have expanded management latitude in ways that weakened the connection between discretion and shareholder interests. What began as a doctrine of judicial humility became, in some settings, a shield for rent transfers.
ESG and stakeholder capitalism exploit that opening. Our claim is not that every corporate decision touching environmental, social, or governance matters is suspect. A firm may rationally invest in risk management, employee retention, regulatory preparedness, reputation, or governance reforms because those investments serve long-term value. Nor is there any objection when shareholders, through private ordering at the outset, form an enterprise with nonpecuniary goals. These can be legitimate vehicles for investors who knowingly choose them.
But when managers of ordinary business corporations use ESG or stakeholder rhetoric to justify transferring residual value to constituencies with no contractual or property claim, they reallocate shareholder assets rather than implement shareholder choice. When institutional investors use other people’s savings to pressure corporations toward political or social commitments that individual investors and pensioners never chose, that pressure should not be mistaken for market demand. When regulators or legislators mandate ESG commitments, the problem is compounded: Shareholders cannot discipline corporations for rent-seeking if every corporation must participate.
Some might respond that markets will nonetheless correct the problem. Companies that dissipate shareholder wealth should see lower share prices and become targets in the market for corporate control. That mechanism still matters, but its efficacy has weakened. Passive investing, the concentration of voting power in large institutional investors, takeover defenses, and legal mandates cushion market discipline. This creates incentives for investors to flee public markets for private ones, worsening the decline in public-company investment opportunities and disadvantaging the retail-investing market. Entrepreneurs may avoid public markets if going public means exposing their corporate assets to mandated redistribution.
There are broader social costs. If profitable firms are pushed into unprofitable activity by legal mandates or sanctioned (or mandated) rent-seeking, resources are diverted from higher-valued uses to lower-valued ones. Some businesses may fail, not because consumers no longer value what they produce, but because the legal and governance environment has made value creation harder. Managers asked to serve many masters easily become accountable to none save their whims. The corporation’s extraordinary capacity to aggregate capital for productive enterprise depends on credible assurances that investors’ residual claims will be respected.
Corporate governance need not be bloodsport. Institutions can channel self-interest toward productive cooperation. That is the lesson of both corporate law and the work of political economist Elinor Ostrom and other scholars on commons governance. But institutions must be maintained. If shareholder wealth maximization, fiduciary duties, and a properly bounded business judgment rule are treated as obsolete obstacles to stakeholder governance, corporate assets become vulnerable.
Corporate actions plainly affect employees, communities, consumers, and the environment. The path forward is to recognize that corporate law works by assigning rights, claims, and duties in ways that make large-scale cooperation possible. Shareholders bear the residual risk and hold the residual claim. Managers are entrusted with control because they are expected to use that control for the corporation and its shareholders, not as allocators of social wealth among competing constituencies.
Scholars, judges, regulators, and policymakers should recognize that rent-seeking does not disappear when it is dressed in the language of ESG, stakeholderism, or corporate social responsibility. Recognizing it for what it is would allow corporate law to reaffirm the institutions that made the modern corporation possible: fiduciary duties, shareholder wealth maximization, and a business judgment rule that protects genuine business judgment without authorizing the dissipation of shareholder wealth.
Jeremy Kidd is a professor at Drake University Law School, and George A. Mocsary is a professor at the University of Wyoming College of Law. This post is based on their recent article, “Corporate Governance as Bloodsport,” available here.