Although deriving and explaining the ethical norms that support and lubricate a well‐​functioning market economy are worthwhile tasks, the intellectual fashion in business ethics is quite a different matter. For among business ethicists there is a consensus favoring the stakeholder theory of the firm—a theory that seeks to redefine and reorient the purpose and the activities of the firm. Far from providing an ethical foundation for capitalism, these business ethicists seek to change it dramatically.

Shareholders and Stakeholders

Stakeholder talk is rampant. In Great Britain, Tony Blair’s Labour Party came to power promising Britons a “stakeholder society.” Perhaps capitalizing on the trend, Yale law professors Bruce Ackerman and Anne Alstott argue for a far‐​reaching overhaul of the American tax and welfare systems in their recent book, The Stakeholder Society. But stakeholder theory, as it has emerged in business ethics, is different.

Stakeholder theory is most closely associated with R. Edward Freeman, Olsson Professor of Applied Ethics at the University of Virginia’s Darden School. The theory holds that managers ought to serve the interests of all those who have a “stake” in (that is, affect or are affected by) the firm. Stakeholders include shareholders, employees, suppliers, customers, and the communities in which the firm operates—a collection that Freeman terms the “big five.” The very purpose of the firm, according to this view, is to serve and coordinate the interests of its various stakeholders. It is the moral obligation of the firm’s managers to strike an appropriate balance among the big five interests in directing the activities of the firm.

This understanding of the firm’s purpose and its management’s obligations diverges sharply from the understanding advanced in the shareholder theory of the firm. According to shareholder theorists such as Nobel laureate economist Milton Friedman, managers ought to serve the interests of the firm’s owners, the shareholders. Social obligations of the firm are limited to making good on contracts, obeying the law, and adhering to ordinary moral expectations. In short, obligations to nonshareholders stand as sideconstraints on the pursuit of shareholder interests. This is the view that informs American corporate law and that Friedman defends in his 1970 New York Times Magazine essay, “The Social Responsibility of Business Is to Increase Its Profits.”

Corporate Social Responsibility and Stakeholder Theory

Stakeholder theory seeks to overthrow the shareholder orientation of the firm. It is an outgrowth of the corporate social responsibility (CSR) movement to which Friedman’s essay responds. According to CSR, the firm is obligated to “give something back” to those that make its success possible. The image of the firm presented in CSR is that of a free rider, unjustly and uncooperatively enriching itself to the detriment of the community. Socially responsible deeds (such as patronizing the arts or mitigating unemployment) are necessary to redeem firms and transform them into good citizens.

One wonders, however, why firms are obligated to give something back to those to whom they routinely give so much already. Rather than enslave their employees, firms typically pay them wages and benefits in return for their labor. Rather than steal from their customers, firms typically deliver goods and services in return for the revenues that customers provide. Rather than free ride on public provisions, firms typically pay taxes and obey the law. Moreover, these com‐​pensations are ones to which the affected parties or (in the case of communities and unionized employees) their agents freely agree. For what reasons, then, is one to conclude that those compensations are inadequate or unjust, necessitating that firms give something more to those whom they have already compensated?

Stakeholder theory constitutes at least something of an advance over CSR. Whereas CSR is fundamentally antagonistic to capitalist enterprise, viewing both firm and manager as social parasites in need of a strong reformative hand, stakeholder theory takes a different tack. Rather than offer stakeholder theory as a means of overthrowing capitalist enterprise, stakeholder theorists profess to offer theirs as a strategy for improving it. As Robert Phillips of the University of Penn-sylvania’s Wharton School writes, “One of the goals of the stakeholder theory is to maintain the benefits of the free market while minimizing the potential ethical problems created by capitalism.”

On the theory that “you’ll catch more flies with honey than with vinegar,” stakeholder theorists ostensibly praise corporate leaders and maintain that firms are social institutions and their managers are community leaders. Given appropriate latitude, firms and managers are disposed to serve the social good. Corporate law and the market for corporate control, however, preclude firms and managers from following their inclinations and serving their social missions. Stakeholder theory seeks to free both firm and manager from their exclusive attention to the narrow, parochial concerns of shareholders so that they can focus on a broader set of interests.

But although the diagnosis of the problem with capitalist enterprise is (at least, on the face of it) different from that advanced in CSR, the stakeholder theorists’ remedy is largely the same: the elevation of nonshareholding interests to the level of shareholder interests in formulating business strategy and policy. The stakeholder‐​oriented manager is admonished to weigh and balance stakeholder interests, trading off one against another in settling on a course of action. Stakeholder theorists seek a reorientation of the corporate law toward the interests of stakeholders and the insulation of managers from the market for corporate control.

Problems

Whatever the appeal of the stakeholder theory’s inclusiveness of and sensitivity to the myriad interests that affect and are affected by firms, there are several powerful reasons to resist the theory’s adoption and embodiment in a reformed corporate law.

Equity Capital. Because it undermines shareholder property rights, stakeholder‐​oriented management denigrates and discourages equity investment. In the stakeholder‐​oriented firm, equity investors bear the same downside risks that they bear in the traditionally governed, shareholder‐​oriented firm. The upside potential of their investment, however, is diminished significantly; for in distributing the fruits of the firm’s success, equity investor interests are only some among many to be considered and served. In short, when the firm loses, shareholders lose; when the firm wins, shareholders might lose anyway if other interests are deemed to be more weighty and important.

Stakeholder‐​oriented management effectively eliminates issuing shares as a means of financing the firm’s growth and new ventures. By diminishing the orientation of the firm toward shareholder interests, stakeholder‐​oriented management will presumably lead investors to discount sharply the value they attach to shareholdings. So stakeholder‐​oriented management essentially entails a near‐​exclusive reliance on debt as the fuel of expansion.

But the problems do not stop there. Debtholders, whether banks or bondholders, typically use equity holdings, returns to equity, and appreciation in the market price for shares as signals of financial health, and hence as mechanisms for pricing debt capital. Widespread or legally mandatory adoption of stakeholder‐​oriented management threatens to undermine well‐​established, stable, and efficient market norms for pricing capital in favor of a regime under which capital is more costly for firms to acquire because investment (whether in the form of equity or debt) is an inherently riskier proposition. That, in turn, threatens prospects for economic growth, stable employment, and the liquidity of financial markets. In short, stakeholder‐​oriented management promises poorer, static, risk‐​averse firms and hence a poorer, static, risk‐​averse economy. Stakeholder‐​oriented management is contrary to the interests of the very stakeholders it is intended to help.

Managerial Accountability. People recoil in horror at corporate officers’ and directors’ salaries, perks, and other bonuses that at times bear no relation to the performance of the firms they manage. This sorry state of affairs results from the confluence of a number of recent trends in corporate law that make it more difficult for shareholders to discipline self‐​serving managers:

• The decline of the ultra vires doctrine (under which shareholders could sue managers for embarking on projects contrary to the corporate purpose).
• The emergence of so‐​called corporate constituency statutes (which permit managers to consider and appeal to a broader range of interests in determining how and whether to fend off a takeover bid—and thereby hamper the smooth operation of the market for corporate control).
• The expansive reading given to the business judgment rule (which shields some managerial actions from substantive review by courts) by the Supreme Court of Delaware—where many firms are incorporated.

But whatever the impediments to disciplining self‐​serving managers under current law and public policy, they pale in comparison with those promised by stakeholder‐​oriented management (and a stakeholder‐​oriented corporate law). Whereas under the current corporate law much self‐​serving managerial behavior is recognizably self‐​serving but shielded from substantive review, under stakeholder‐​oriented corporate law such behavior would be considerably more difficult even to detect, as well as to deter.

It would be more difficult to detect because all but the most egregious of self‐​serving managerial behavior will coincide with the interests of somestakeholding group, and hence the self‐​serving manager may point to the benefited and burdened stakeholders and argue that, in his estimation, this was the optimal way to balance competing stakeholder interests. Absent a powerful principle of balanced distribution of the benefits of the firm (something stakeholder theorists have been notoriously slow to sketch), stakeholder theorists must acquiesce in self‐​serving managerial action that can plausibly be said to accomplish some sort of balance among competing stakeholder interests. That point is made with admirable clarity by Frank Easterbrook and Daniel Fischel in their 1991 book, The Economic Structure of Corporate Law: “A manager told to serve two masters (a little for the equity holders, a little for the community) has been freed of both and is answerable to neither. Faced with a demand from either group, the manager can appeal to the interests of the other.”

Self‐​serving managerial action would be more difficult to deter under stakeholder‐​oriented corporate law because stakeholder theory anticipates that good‐​faith stakeholder‐​oriented managerial actions will serve some interests and frustrate others in pursuit of an overall balance of interests. Therefore, stakeholder‐​oriented corporate law must provide protections to managers at least as extensive as those afforded under current business judgment rule doctrine—lest managers be the perpetual object of derivative lawsuits brought by shareholders, employees, customers, suppliers, or communities who believe that their interests were unfairly or improperly weighed and balanced. Between the ability of managers to justify their self‐​serving behavior in terms of the balanced pursuit of stakeholder interests, on the one hand, and the protections that a stakeholder‐​oriented corporate law must afford to managers if firms are to be managed at all, on the other hand, the accountability of managers for their actions must necessarily suffer.

Interest‐​Group Politics. Because stake‐​holder‐​oriented management anticipates the weighing and the balancing—and hence often the frustrating—of competing interests, it promises to make the boardroom (populated, per Freeman, by representatives of all stakeholding groups) the site of wasteful, inefficient interest‐​group politicking. That is, the corporate boardroom will be transformed from a forum in which econom‐​ically rational strategies are adopted in pursuit of added value into one in which legislative and bureaucratic political maneuvering will be the order of the day. Surprisingly, stakeholder theorists recognize and, apparently, welcome this. In a 1998 issue of Business Ethics Quarterly, com‐​munitarian thinker Amitai Etzioni is comforted by the thought that there “is no reason to expect that the politics of corporate communities would be any different from other democratic systems.”

One can scarcely imagine how firms, whose resources are far more limited than are those of governments (and unsupported by the taxing power), can remain viable if their decision procedures are characterized by the strategic bargaining, logrolling, and other wasteful tactics that are the hallmark of democratic politics. If a camel is a horse designed by a committee, then what misshapen beast is a firm shaped by the strategic interactions of its stakeholder representatives?

Small Victories

The market economy, the liberty it safeguards, and the prosperity it secures are threatened not, as in the recent past, by firebrands who seek to abolish it, but by more modest tinkerers who seek to “improve” it in the name of myriad social concerns. Defending the market economy from this attack requires more than cataloging the defects of alternative economic systems and the merits of markets. It requires a principled defense of the shareholder‐​oriented firm—the basic productive institution on which the market economy is constructed.

Despite its worrisome implications, stakeholder‐​oriented management and its accompanying rhetoric encounter little systematic opposition in philosophy departments, business schools, or board‐​rooms. The costs of complacency about that state of affairs are potentially high. For although they have so far failed to bring wholesale change to the corporation and the law that governs it, stakeholder‐​oriented activists have won important piecemeal victories. The passage of corporate constituency statutes in several states has weakened the market for corporate control and, hence, the property rights of shareholders. Federal plant‐​closing legislation has legitimized among policymakers the idea that firm managers ought to be responsive to a multiplicity of interests. Corporate mission statements in which stakeholders and their interests feature prominently—whether adopted earnestly or as cover for self‐​serving managers—serve to further legitimize the subordination of shareholder interests to other concerns. If the market economy and its cornerstone, the shareholder‐​oriented firm, are in no danger of being dealt a decisive blow, they at least risk death by a thousand cuts.

Business Ethics Reconsidered

Too often the free‐​market response to the changes sought by stakeholder‐​oriented business ethicists has been to denigrate the role of ethics in business—as if stakeholder‐​oriented reforms are the inevitable consequence of injecting concern for ethics into business. But the partisans of stakeholder theory are not spokespeople for ethics; they are spokespeople only for a particular conception of ethics—and a particularly flawed conception, at that. The manifold failings of stakeholder theory should not be taken to reflect poorly on the project of business ethics; rather, they reflect poorly on stakeholder theory itself.

Defenders of the free market, limited government, and the rule of law must articulate an alternative business ethics, one that recognizes and provides reasoned argument for the moral merit of the shareholder‐​oriented firm. Norms of honesty, integrity, and fair play, rather than an albatross around the neck of the free market, are a central, if neglected, part of the story of the success of the shareholder‐​oriented firm. In short, shareholder‐​oriented firms are not merely wealth‐​enhancing, they are good.

This article originally appeared in the May/​June 2000 edition of Cato Policy Report.