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READINGS in FINANCIAL ETHICS

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John Dobson California Polytechnic State U. San Luis Obispo, CA

Jean L. Heck Saint Josephs University Philadelphia, PA

Readings in Financial Ethics

John Dobson
California Polytechnic State U. San Luis Obispo

Jean L. Heck
Saint Josephs University Philadelphia, PA

Copyright 2011 JLH Press


632 West Wayne Ave. Wayne, PA 19087

The editors gratefully acknowledge the financial support of the Pedro Arrupe Center for Business Ethics at Saint Josephs University, Philadelphia, PA 19131.

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Table of Contents

Preface ............................................................................................................................................. A Crisis of Ethic Proportions .......................................................................................................... Of Greed and Creed ........................................................................................................................ It is Time to Treat Wall Street Like Main Street ............................................................................ Is Shareholder Wealth Maximization Immoral? ............................................................................ Shareholder Theory - How Opponents and Proponents Both Get It Wrong ..............................

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Readings in Financial Ethics


PREFACE

The life of money-making is one undertaken under compulsion, and wealth is evidently not the good we are seeking; for it is merely useful and for the sake of something else. Aristotle, Nicomachean Ethics
Although most business subject areas such as marketing, accounting, and management have in recent years been expanded to formally accommodate ethics, no such expansion has yet occurred in finance. Marketing ethics, accounting ethics, and management (i.e., business) ethics are now established disciplines, but Financial Ethics has yet to officially appear. Some might argue that this is inevitable since finance is essentially a technical subject. But even the most cursory review of the actual concepts covered by contemporary finance shows this presumption to be false. The majority of finance concerns behavior. The models of finance, and the predictions of these models, depend crucially on the behavioral assumptions made, and these assumptions inevitably have moral content. Even the most superficially technical models of finance contain, at least in their application, a human element; to this extent at least they are all behavioral theories. These theories rest on assumptions about how people choose one action over another, assumptions about what constitutes reasonable behavior. These assumptions are just that, 'assumptions'. They are not statements of fact. If we assume, as financial economists frequently do, that agents endeavor to maximize their personal wealth in whatever way they can, ad infinitum, then we are making certain value-judgments about these individuals. To date, finance has been reluctant to recognize these value judgments. Specifically, finance has tended to ignore the fact that these are value judgments: wealth-maximization-type behavior is tacitly assumed to be an inevitable law of nature. Finance has tended to ignore the ample evidence from psychology, philosophy, and indeed from the other business disciplines, that human behavior is both complex and highly suggestible. Albeit unrecognized to-date, finance theory does possess an implicit moral agenda. The purpose of this readings book is to address this lacuna: to place ethics at the center of finance. As such, the readings collected here can be placed within the growing discipline of behavioral finance. As a subdiscipline within finance, behavioral finance has developed both theoretically and empirically. From an empirical perspective, behavioral finance observes the actual behavior of individuals in financial markets and studies the extent to which such behavior diverges from economic rationality. On the theoretical side -recognizing the complexity of human behavior -- behavioral finance models human activity within the theories of financial economics. Questions such as, 'On what basis do managers or investors make decisions?' are now being recognized as central to the subject area of finance. Recognition of the suggestibility of human behavior leads inevitably to a consideration of the best justification for behavior; not just How do market participants make decisions? but also How should market participants make decisions? Financial Ethics is born. The readings that follow are taken from a variety of sources. Thus -- by invoking such concepts as cooperation, trust, justice, and fairness -- this collection of readings broadens the conceptual horizons of finance theory and practice.

John Dobson
California Polytechnic State U., San Luis Obispo

Jean L. Heck
Saint Josephs University

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Reprinted with permission of John C. Bogle The Wall Street Journal, April 21, 2009.

A Crisis of Ethic Proportions


John C. Bogle
Founder and former Chief Executive of the Vanguard Group of Mutual Funds

I recently received a letter from a Vanguard shareholder who described the global financial crisis as "a crisis of ethic proportions." Substituting "ethic" for "epic" is a fine turn of phrase, and it accurately places a heavy responsibility for the meltdown on a broad deterioration in traditional ethical standards. Commerce, business and finance have hardly been exempt from this trend. Relying on Adam Smith's "invisible hand," through which our self-interest advances the interests of society, we have depended on the marketplace and competition to create prosperity and well-being. But self-interest got out of hand. It created a bottom-line society in which success is measured in monetary terms. Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. The result is a shift from moral absolutism to moral relativism. We've moved from a society in which "there are some things that one simply does not do" to one in which "if everyone else is doing it, I can too." Business ethics and professional standards were lost in the shuffle. The driving force of any profession includes not only the special knowledge, skills and standards that it demands, but the duty to serve responsibly, selflessly and wisely, and to establish an inherently ethical relationship between professionals and society. The old notion of trusting and being trusted -- which once was not only the accepted standard of business conduct but the key to success -- came to be seen as a quaint relic of an era long gone. The proximate causes of the crisis are usually said to be easy credit, bankers' cavalier attitudes toward risk, "securitization" (which severed the traditional link between borrower and lender), the extraordinary leverage built into the financial system by complex derivatives, and the failure of our regulators to do their job. But the larger cause was our failure to recognize the sea change in the nature of capitalism that was occurring right before our eyes. That change was the growth of giant business corporations and giant financial institutions controlled not by their owners in the "ownership society" of yore, but by agents of the owners, which created an "agency society." The managers of our public corporations came to place their interests ahead of the interests of their company's owners. Our money manager agents -- who in the U.S. now hold 75% of all shares of public companies -- blithely accepted the change. They fostered the crisis with superficial security analysis and research and by ignoring corporate governance issues. They also traded stocks at an unprecedented rate,

Readings in Financial Ethics

engaging in a dangerous spree of speculation. Adam Smith presciently described the characteristics of today's corporate and institutional managers (many of whom are themselves controlled by giant financial conglomerates) with these words: "[M]anagers of other people's money [rarely] watch over it with the same anxious vigilance with which . . . [they] watch over their own . . . they . . . very easily give themselves a dispensation. Negligence and profusion must always prevail." The malfeasance and misjudgments by our corporate, financial and government leaders, declining ethical standards, and the failure of our new agency society reflect a failure of capitalism. Free-market champion and former Federal Reserve chairman Alan Greenspan shares my view. That failure, he said in testimony to Congress last October, "was a flaw in the model that I perceived as the critical functioning structure that defines how the world works." As one journalist observed, "that's a hell of a big thing to find a flaw in." What's to be done? We must work to establish a "fiduciary society," where manager/agents entrusted with managing other people's money are required -- by federal statute -- to place front and center the interests of the owners they are duty-bound to serve. The focus needs to be on long-term investment (rather than shortterm speculation), appropriate due diligence in security selection, and ensuring that corporations are run in the interest of their owners. Manager/agents need to act in a way that reflects their ethical responsibilities to society. Making that happen will be no easy task.

Reprinted with permission Financial Times, London, December 24, 2008, p. 8.

Of Greed and Creed


Patrick Jenkins

To the majestic clang of its bells, hundreds of sober-suited people scurried through the portals of St Paul's Cathedral last week to take part in a carol service, hear the familiar story of Jesus's birth and generally get into the Christmas spirit. Yet this was no ordinary festive occasion. Instead, assembled beneath the dome of Christopher Wren's City of London masterpiece was a private congregation made up of staff from Lloyds Banking Group. They were there to sing their hearts out after a year in which their employer veered from rescuer (of the rival HBOS) to rescued (by the state, after the take-over beset it with troubles). Nor was it an isolated event. Vicars in the capital's financial district have been reporting steadily swelling numbers of worshippers for months now - anecdotal proof, seemingly, that some of the bankers who contributed to the crisis of the past two years are seeking salvation or at least an understanding of their place in the world. "Most people want to do a good job," says the Rev Oliver Ross, dean of the City of London and vicar at St Olave's, one of the capital's few remaining mediaeval churches. "The church is growing. There is an increased desire among a lot of City workers to look at the ethics of what they do. People want to talk about it, to question it." Some of those questions are purely personal - with hundreds of thousands already made redundant over the past two years, how secure is anyone's job and will praying help to keep it? Other questions are more profound - why did financial capitalism become synonymous with crazy risk-taking, with the passing off of toxic investments to unwitting counterparties and the earning of multi-million pound bonuses, regardless of merit? Amid all the doubt, one thing is clear: the fragility of financial capitalism, and the moral bankruptcy of some of it, have been exposed. It is striking that even big-name bankers have been looking back at the crisis through a religious prism. Stephen Green, chairman of HSBC and an ordained Church of England minister, has said there was no consideration of the "rightness of what was done". He has charted the history of global finance and offered up a new moral code for bankers everywhere in an ambitious book, Good Value. Ken Costa, chairman of Lazard International and of Alpha International, an interdenominational programme aimed at introducing non-churchgoers to Christianity, has said that "capitalism slipped its moral moorings". Even Lloyd Blankfein, chairman of Goldman Sachs, famed for its Wall Street aggression, felt compelled to describe himself as a banker "doing God's work". So what was really wrong with the morals of the financial sector? Ask the public and the most common answer is likely to be: bankers' bonuses. Though Mr Green heads one of the world's biggest banks - and one of

Readings in Financial Ethics

the big-league bonus payers - he has criticised the "greedy focus on the short term". Over the past decade, many bonuses became one-way bets. If a banker negotiated a guaranteed bonus, it made no difference whether his business made a loss; if there were any long-term negative fallout, no comeback was possible because he had already been paid in cash. A nonchalance about risk, underpinned by greed, fostered a culture of spiralling inflation in bonuses, out of kilter with the long-term risk bankers were taking. Worst, say analysts, many bonuses were built on sand funded by accounting revenues that did not exist in real cash-flow terms, such as unrealised trading book profits and the net present value of future derivatives flows. "Paying out 50 per cent of revenues to staff had become the rule," Martin Taylor, former chief executive of Barclays, pointed out in a recent Financial Times article, "even when the 'revenues' did not actually consist of money." Others echo the view that a sense of responsibility was lacking in the boom times, allowing personal and institutional self-interest to overshadow customer service and risk management. "If you talk about ethics," says Josef Ackermann, chief executive of Deutsche Bank, "I consider the right risk ethic as central to the moral obligations of a banker." Even bankers now acknowledge that it was in the absence of a "risk ethic" that complex credit derivatives, such as residential mortgage-backed securities, were parcelled and sold on to investors. "Loving your neighbour is something that got forgotten in the market boom," says Andy Brookes, a former Bank of England economist and City financier who three weeks ago jumped off the money machine to become chief executive of the Anglican Diocese of London. "In the business context, that means serving your customers, not just yourself." Mr Costa bemoans the mixing of high-risk and low-risk activities in banking - particularly "the immorality of retail bank deposits being leveraged for trading". Such blas, unchristian attitudes have lain behind banks' arrogant treatment of customers through high fees, poor call centres and missold investments, he says. The arrogance went unpunished in the boom times, but in the wake of the crisis and the bank bail-outs which have benefited all institutions either directly or indirectly - penance must be paid, he says: "Some in the City have been slow to realise the moral obligations that the bail-outs have placed on them." The root problem, Lord Turner, free-thinking chairman of the Financial Services Authority, the UK industry regulator, famously said this summer, is that too much business over the past decade has been "socially useless" - a buzz-phrase that has since informed the thinking of regulators and politicians. Many of the derivative products dreamt up by bankers, not to mention the "casino banking" practised by proprietary traders betting the banks' own capital, would fall into Lord Turner's "useless" category. While bankers, regulators and politicians find it hard to agree about where the borderline between usefulness and uselessness lies, there is a general recognition that finance for finance's sake is at least out of fashion. "Finance must show it is a servant and not a master," says Mr Costa. Instead, goes the moral argument, finance must do a better job of serving the "real economy", real industries that need banks to lend to them, to hedge risk for them, to place shares and bonds with investors for them. Banking has always attracted moral controversy, particularly among the religious. The foundation stone of banking - lending with interest (if you agree with it); usury (if you do not) - has underpinned global trade since middle-ages Italy, when Florentine merchants began prospering from the wool trade using money, rather than other commodities, as a currency. Usury - seen by purists, including modern-day Islam, merely as a way to make money out of money - was outlawed by the Roman Catholic Church in 1311. Fast-forward 700 years and today's Pope Benedict XVI has been lashing out in similar tones, albeit with a focus shifted away from "heretical" usury towards a broader definition of irresponsible banking. In July, the Pope's third encyclical, Charity in Truth, condemned the "grave deviations and failures" of capitalism.

Of Greed and Creed

"Financiers must rediscover the genuinely ethical foundation of their activity so as to not abuse the sophisticated instruments which can serve to betray the interests of savers," he wrote. Big business should "prioritise ethics and social responsibility over dividend returns." The crisis has indeed been a profound "learning experience", at least for the UK, says one big bank boss. "I'm not sure the US has gone through the same learning experience. And I'm certain Asia has not. The general response in Asia is a slight smugness, more smugness than is warranted." In the US, for all its religiosity, soul-searching has been less evident than the quips such as Mr Blankfein's "God's work" remark. Even in continental Europe, aside from the odd comment from Mr Ackermann, the moral debate has been muted. The severity of the crisis in the UK and the intensity of the ensuing ethical debate has seen the FSA, spurred on by Lord Turner, emerge as the keenest reformer of any global regulator. And it is through regulation that the moral compass for the future of banking will be set. The FSA has acted both on bonuses and on capital and liquidity reforms. It is also leading moves to develop so-called living wills for multinational, systemically important banks to ensure they have plans in place for a break-up. It is that kind of concrete action that gives hope to the reforming spirits - both within banking and the church - that a moral lesson has been learnt. "I find it difficult to believe that any time soon people will go back to the go-go mentality of the early part of the decade, because I think this was such a searing experience," says Mr Green. "I don't think regulators or the market will permit the degree of gearing, structured products and so on." Sitting in a slick bar behind St Paul's, Canon Giles Fraser, the man who organised the Lloyds carol service and oversees the cathedral's relations with the City, is hopeful, too. "Have things really changed? It doesn't look that different," he says, casting an arm around the throng of suited young drinkers around him. "There's still a silly bravado about morality, that there's something wet about it. But some people now feel conflicted about that: people are thinking about ethics, they feel they ought to have these conversations." Additional reporting by Andrew Hill

Readings in Financial Ethics

Reprinted with permission Financial Times, London, February 25, 2010.

It is Time to Treat Wall Street Like Main Street


George Akerlof and Rachel Kranton
Nobel Laureate, University of California, Berkeley and Duke University.

Thirty years ago, when we were still using typewriters and fewer than 25 per cent of households invested in the stock market, economists conjectured that employees would work harder and make better decisions under a "pay-for-performance" system. This theory became popular in boardrooms - especially since it was an influential argument for increasing the pay of the chief executive and top officers. Bonuses tied to performance became standard practice in US companies and on Wall Street in particular. But economics has not stood still, and we now know there are at least four reasons why bonuses and payfor-performance are a risky business. First, it can be hard to see whether employees make the right decisions; superiors do not hold the same information, and the results of decisions play out years later. Second, performance pay will attract exactly those who are willing to take on more risk. People interested in high but steady income will choose other careers. Third, to get their pay, employees may manipulate the system, against the interests of those who set up the incentives: like teachers who are threatened with losing their jobs and teach to the test. Finally, and most perniciously, performance pay can crowd out intrinsic rewards, as when children, having received gold stars for drawing pictures, later draw less than before in their own time. Why draw without getting paid? But if monetary incentives do not work, what does? Identity economics - a new way of thinking about motivation - gives an answer. In organisations that work well, employees identify with their work and their organisations. People want to do a good job because they think they should and because it is the right thing to do. In organisations that function effectively, the goals of the workers and of the organisation are aligned. There is little conflict of interest and little need for performance pay. Identity economics also tells us why the public, in America and elsewhere, are so angry about the bonuses on Wall Street. Most of us just get up in the morning and do our jobs - jobs that for the most part are neither glamorous nor well paid. We take pride in jobs well done, and we celebrate people such as Sully Sullenberger who, after ditching his plane in the Hudson River, checked the cabin twice for remaining passengers before being the last to evacuate. As he explained: "I was just doing my job." (A month later, his pay was cut by 40 per cent and his pension was terminated.) The New York City firefighters on September 11 and the troops who stormed Omaha Beach just did their jobs. Most people's work is not as dramatic and involves less risk, but these are role models we admire. Why then, we ask, do traders and bankers need outsize bonuses and performance pay to get them to do their jobs? High salaries attract and keep talented, hard-working people, with specialised skills. But fair compensation should not be confused with outsize bonuses. In identity economics, performance pay demonstrates bad faith.

Readings in Financial Ethics

It tells employees they are not trusted to do the right thing. Rather, incentives have to be right. (In any case, there is no magic formula for bonuses and stock options. Without a crystal ball, incentives will never be right.) Identity economics gives us a new way to think about work and rewards. The incentive should not be to manipulate the system, but to live up to responsibilities: to pilot the plane; to storm the beach; to run to the fire. In the financial world, it is called fiduciary duty. It is an obligation to serve the client and the larger good of an organisation. Current US law misses a fundamental point. Misconduct and decisions that benefit a company but not the clients are not seen as violations of this simple principle, but rather as failure to meet a dizzying maze of procedures and codes. For example, under the Sarbanes-Oxley Act, chief executives must attest that their organisations have followed extremely detailed accounting procedures. Such laws guarantee a robust market for accountants and for lawyers. But procedures, like bonus schemes, can be manipulated. And procedures, like bonus schemes, are impossible to get exactly right. Acting in your own interest and not in the interest of clients is a failure to carry out the duties of office, to fulfil one's fiduciary duty. While principles and responsibility sound lofty and idealistic, they can be taught, followed, institutionalised and enshrined in law. We see it every day in fire stations, on factory floors, in surgery rooms and schools. It is time to treat Wall Street like Main Street. Otherwise, it is just more risky business.

Reprinted from Financial Analysts Journal, Vol. 55, No. 5 (Sep-Oct., 1999), pp. 69-75, with permission of the CFA Institute. All rights reserved..

Is Shareholder Wealth Maximization Immoral?


John Dobson
California Polytechnic State U. San Luis Obispo

For those educated in modern business schools, the justification for decisions made by financial professionals in business organizations has been supplied by financial economic theory. Broadly, this theory posits that the ultimate objective of a business organization is to maximize its market value (often referred to as maximizing shareholder wealth). This objective is, in turn, justified (in a theory often termed the invisible hand) by the premise that such activity undertaken competitively, within the law, by individual firms will lead to maximal social welfare. This view of the ultimate aims of corporate activity has come under increased scrutinyand, indeed, challengeby a growing body of thought that can be loosely labeled business ethics theory. As business ethics theory filters in to the financial professional's milieuthrough, for example, corporate creedssome confusion is inevitable. This article clears the confusion by evaluating the objective of shareholder wealth maximization as a moral justification for behavior in business. In this article, I consider whether, in light of some 25 years of bona fide business ethics theory, backed by 2,500 years of moral philosophy, a business professional who justifies decisions ultimately with a view to the bottom line is acting amorally, immorally, or morally. At first blush, this question might appear to be quite different from the questions addressed in my previous articles, which were concerned primarily with the 1 individual and the development of certain character traits or virtues as a foundation for professional ethics. What I show here, however, is that the current debate about the ultimate objective of business organizationswhether the objective is share-holder wealth maximization or some other enddistills down to an examination of the character of those individuals who are the primary decision makers in the business organizations. The moral worth of the organization, therefore, is inseparable from the moral worth of the decision makers in it. Financial professionals may question the worth of any reflection on organizational objectives. After all, in their M.B.A. coursesand, in particular, their finance coursesthey will have had drummed into them that the ultimate objective of all activity within the firm is the maximization of shareholder wealth. Nevertheless, they should be increasingly aware of growing dissent from, or at least equivocation on, that standard finance definition of corporate objectives. At the educational level, one certainly does not have to look far to see a conflict in philosophies. Whereas texts in corporate finance invariably open with a statement to the effect that managers' primary goal is stockholder wealth maximization, authors in the field of business ethics espouse views such as there is no justification for shareholders holding such an important position ... and having first priority

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as regards corporate activity... [The idea that shareholders are the group that takes the greatest risk and thus deserves special treatment is a fiction. (Buchholz and Rosenthal 1997, p. 169).

Who is correct? As the 20th century ends and we enter what is being called the postindustrial or postmodern era, what is the moral status of shareholder wealth maximization as the ultimate justification for corporate activity? My answer comes in three parts. The first two parts entail dispelling two myths. The first myth is that making decisions on the basis of stock price maximization is amoralthat is, morally value neutral. The second myth is one commonly held by business ethicists, namely, that decisions premised on shareholder wealth maximization are strictly immoral. Dispelling these two myths will reveal the decision-making premise of shareholder wealth maximization as a particular moral stance open to moral evaluation. This evaluation is the third part of my answer. The Amoral Financial Manager The myth that making decisions on the basis of stock price maximization is morally value neutral is commonly held by financial economists. Consider the following: Shareholder wealth maximization serves as a conduit of ethics, rather than a net determinant of ethical behavior.... Market values can price ethics just as they can price anything else. (Chambers and Lacey 1996, p. 93) This myth is understandably popular among financial economists because belief in it exempts them from any moral self-examination. As with any discipline, however, financial economics has evolved over time. One evolutionary development has been the growing incursion into the discipline of some discussion of ethics. To date, this discussion has been somewhat limited and superficial; indeed, a cynic would view it as no more than paying lip service to a passing fad. It has been superficial in the sense that the moral scrutiny has been limited to issues that a business professional might face in day-to-day activity, such as creative accounting or expense account padding. Although important, such a limited moral examination does not challenge the foundations of corporate activity. What is rarely held up to the light of moral scrutiny is the very ontology or reason for being of financial economicsshareholder wealth maximization. Within the discipline of financial economics, and within business culture generally, shareholder wealth maximization is traditionally exempt from moral scrutiny. When a defense of this objective is offered, it is invariably grounded in the concept of the invisible hand: Each individual firm competitively pursuing shareholder wealth maximization leads ultimately to maximum aggregate economic benefit: In this text we designate the goal of the firm to be maximization of shareholder wealth....Not only will this goal directly benefit the shareholders of the company, but it will also provide benefits to society. This will come about as scarce resources are directed to their most productive use by businesses competing to create wealth. (Keyed, Scott, Martin, and Petty 1998, p. 2) The implication of such a defense is that share-holder wealth maximization is morally neutral. Although this idea is superficially appealing to corporate finance theorists and practitioners because it enables them to

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avoid moral self-examination, consider what it means to label shareholder wealth maximization morally neutral. It means that a manager acting in accordance with shareholder wealth maximization is not exercising any particular moral judgment. The manager is part of the market mechanism. He or she, taking a morally neutral, passive stance, merely tries to make decisions on the basis of signals received from others through the market mechanism. For example, suppose the president of World-wide Seafood Company realizes that the publication of evidence linking tuna fishing to the death of dolphins is reducing canned tuna sales. The president is receiving a market signal that is based on an ethical value judgment of some consumers. If the signal from these consumers is sufficiently strong, the decision for the president that will be consistent with shareholder wealth maximization may be to redesign the nets so that they will not interfere with dolphins. The president has not exercised any personal moral judgment; she has merely reacted to the moral judgments of a large number of consumers. Furthermore, because the consumers were able to convert their judgment into an economic signal, the president did not have to react directly to their ethical judgments but could make an economic decision (to modify the nets) on the basis of an economic observation (lower canned tuna sales). The president did not have to act as a moral adjudicator between dolphin-loving consumers and possibly dolphin-indifferent shareholders; because of the economic impact of dolphin-loving consumers on sales, modifying the nets was in the financial interests of Worldwide Seafood's shareholders. In short, the president has acted as a conduit for the ethical beliefs of stakeholders. She did not need to become an expert on animal rights, nor did she need to conduct some stockholder referendum to determine their moral beliefs. This example apparently illustrates the amorality of pursuing the maximization of shareholder wealth: Shareholder wealth maximization puts money in the hands of shareholders who can efficiently pursue their own ethical agendas. (Chambers and Lacey, pp. 95-96) But consider more closely the actions of this manager. In pursuing shareholder wealth maximization, was she truly being morally neutral? Prior to taking any action, the president made a decision. She decided that the best way of tackling decisions in business is to pursue shareholder wealth maximization. Is this not an ethical decision? Because such a basic decision determines the moral tenor of the firm, in making this decision, the manager was acting as a net determinant of ethical behavior. That is, by adopting shareholder wealth maximization as Worldwide Seafood's objective, the president adopted a certain moral context. Maclntyre commented that all nontrivial activity presupposes some philosophical point of view (i.e., a context) and that not to recognize this is to make oneself the ready victim of bad or at the very least inadequate philosophy (1977, p. 217). So, what is the moral context of shareholder wealth maximization? The acceptance and implementation of share-holder wealth maximization as the ultimate goal entails the acceptance and implementation of several layers of philosophical context. First, it entails the acceptance of a narrow interpretation of utilitarianism (in which value is defined as the greatest good for the greatest number), one in which moral decisions within the firm can be based solely on the consequences of those decisions for the firm's stock price. Thus, to choose shareholder wealth maximization is to choose a specific moral context within the broader context of utilitarian moral philosophy. Utilitarianism, in turn, is simply one context or ethical determinant within the broader context of modernist philosophy. Modernist philosophy is simply one ethical determinant within yet broader contexts. Indeed, only when one steps outside this modernist context does one realize that such concepts as cost-benefit analysis, means-end reasoning, and individualism are all ethical

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determinants among other possible ethical determinants. They entail a certain nonunique and nonstable view of what reality is and of what reality should be. For example, the president in the Worldwide Seafood case, in adopting shareholder wealth maximization, adopted a narrow interpretation of utilitarianism. Not only has she taken a moral position, but the position is simply a subset of a subset of a subset of all possible moral positions. This manager determinedor adopteda moral context that the right thing to do is to act in the interests of whoever has the greatest economic influence on the company's stock price. If that group is the dolphin lovers, then money will be spent to save dolphin lives. If that group is the dolphin indifferents, then shareholder wealth maximization determines that no resources will go to save dolphins. In essence, shareholder wealth maximization in this case is a variant of might makes right, where might is defined purely in economic terms. For now, I do not wish to pass moral judgment on shareholder wealth maximization; I merely wish to dispel the myth that it is morally neutral. Nothing exists outside a metaphysical context, and shareholder wealth maximization is no exception. Perhaps the reason finance professionals tend not to see this truth is because shareholder wealth maximization exists within a contextthe modernist worldviewthat we rarely, if ever, step out of. The Immoral Financial Manager The viewpoint that decisions premised on share-holder wealth maximization are immoral has a long vintage in moral philosophy. It dates back at least as far as Aristotle, who viewed commerce as an activity inferior to politics or philosophy, which had nonmaterial objectives and were thus inherently superior: The life of money-making is one undertaken under compulsion, and wealth is evidently not the good we are seeking: for it is merely useful and for the sake of something else. (Aristotle 1991 edition, p. 32) The business ethics literature provides recent examples: The primary obligation ... [of business] is to provide meaningful work for ... employees (Bowie 1991); If in some instance it turns out that what is ethical leads to a company's demise ... so be it (DeGeorge 1990); Provision to meet need is the highest purpose of business; provision to satisfy unreasonable and socially harmful desire ... perverts the purpose of business (Byron 1988); .... it is usually profitable to be honorable, and virtue is more than its own reward (Barach and Elstrott 1988). These quotations clearly reject shareholder wealth maximization as an ultimate justification for decisions in business, and they apparently proffer some more ethereal, less material ultimate justification as an alternative. This notion of a clear distinction between moral and material corporate objectives is also, however, a myth. As a justification for behavior, shareholder wealth maximization is rarely sanctioned by business ethicist. Their criticism generally rests on the premise that, as the term implies, shareholder wealth maximization places preeminent emphasis on the interests of shareholders. For example, Hasnas (1998) criticized shareholder wealth maximizationor what the business ethicist call the stockholder modelfor exactly this reason: It is woefully incomplete...and...entirely fails to address the managerial obligations that arise out of the actual agreements made with the nonstockholder participants in the business enterprise. (p. 35) Is this criticism accurate; is it fair?

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The very term shareholder wealth maximization seems to imply a narrow materialistic concentration on shareholders, but what it really represents is a focus on equity market value, which is revealed in the company's stock price. A manager pursuing shareholder wealth maximization is concerned with anything that can affect the company's stock price or value, and other stakeholders can certainly influence company value. In fact, stock price is increasingly being determined by a host of intangible factors: employee relations, credit quality, environmental sensitivity, product reliability, cultural sensitivitywhatever society values. For example, consider the Worldwide Seafood example: If a company wishes to maximize shareholder wealth and if society values dolphins, the company will act in a way that values dolphinsthat is, in line with society's values. Note well that whether or not stockholders actually care about dolphin is not crucial; as long as some critical mass of stakeholders cares about dolphins, management will react to the stakeholders' moral concern. Thus, a true understanding of the stockholder model includes recognition that this model in no way implies a concern solely, or even primarily, for stockholders over and above other stakeholders. Indeed, a concern among managers for stakeholders, such as animals or the environment, is indelibly intertwined with a concern for the financial health of the firm. A management group that is insensitive to the needs and concerns of stakeholders will not flourish financially and, of course, a company that does not flourish financially will not be able to help stakeholders. Will man (1998) observed in reference to one paragon of social responsibility: As Ben and Jerry's has discovered in recent years, the financial bottom line has to take priority, since without adequate profits little can be achieved on the social mission. (p. 8) Consider, for example, the Royal Dutch/Shell Group's much publicized decision to reverse its original plans to dispose of the Brent Spar oil plat-form in the mid-Atlantic Ocean. The moral outrage of certain stakeholdersegged on by Greenpeace and manifested in a boycott of Shell gas stationssent an economic signal, as in Worldwide Seafood's case, to Shell managers. The result, as will be discussed later, was that in the economic interests of stockholders, Shell acted in the moral interests of certain stakeholders. As one of the largest corporations in the world, Shell is the epitome of a multinational corporation (MNC). The moral acid test for these MNCs is their activities in developing countries. In these countries, regulation is often minimal and largely unenforceable, and the sheer size of MNCs means that they exert considerable power. (Of the 100 largest economies in the world today, more than half are MNCs, not nation states.) But, in this case, a focus on share-holder wealth maximization is acting as a moral discipline, as it did in Worldwide Seafood's case. Shell features in other examples. For instance, criticism of Shells tacit support of the Nigerian government led the company not only to modify its activities in that developing country but also to establish an internal social responsibility division to monitor such activities in the future. Cozine (1998) noted that, in addition, Shell plans to shake up its tradition-bound corporate culture by increasing the number of women and range of nationalities in its top management tier (p. 17). Cozine stated that the main reason for this shake up was that the narrowness of Shells senior management base has been cited by critics as one reason why it has struggled with rapid change in its business. Critics point to the controversy over the scrapping of the Brent Spar oil rig and Shells problems with human rights in Nigeria. They say a broader management base might have helped Shell to respond more effectively to those issues. (p. 17)

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So, pressure from various stakeholders has, through the market mechanism, led this massive oil company to reflect prevailing social values. As moral censure hurt Shells stock price, Shell, in the interests of its stock price, reacted to the moral censure. The market acted as a conduit by which social values of economic significance to the company were transformed into corporate values. The stockholder model recognizes this central role of the market as a type of translation mechanism. The language of business is, by definition, financial, and the market enables whatever moral values prevail in the broader culture to be translated into a language that business can understand. A major reason why the market mechanism is leading managers to react to a wider array of issues today than in the past is the greater availability and dissemination of information about corporate activities. The availability of information combined with historically unprecedented wealth (generated in large part by MNCs) has led to the growth of numerous watchdog groupsnongovernmental organizations (NGOs) such as Greenpeace International, Worldwatch Institute, Friends of the Earth, and Amnesty International. The interplay between MNCs and NGOs is rapidly evolving from one of conflict to one of cooperation. A good example of MNCs and NGOs learning to work together for mutual benefit comes from Yanacocha, the location of a hugely profitable U.S.-Peruvian gold mining joint venture in northern Peru. Largely as a result of pressure from NGOs, Yanacochah as the best-developed community assistance program in Peru, spending some $3 million a year on projects in 35 communities around the mine.... The alliance [between NGOs and MNCs] works both ways. As well as being a source of project funding, mining and oil companies can allow NGOs access to remote areas they would not normally reach. (Bowen 1998, p. 6) A joint venture between Shell and Mobil Corporation to develop Peru's vast hydrocarbon reserves in the region of Camisea's virgin jungle has invited the cooperation of more than 30 NGOs and local groups. These groups will monitor the performance of the two MNCs in relation to environmental and social issues. Such cooperation took further tangible form recently with a conference in London sponsored by the oil industry to which delegates of Greenpeace and other NGOs were invited. Rather than standing outside with placards, members of Greenpeace found themselves sitting around the conference table with senior executives of the largest oil MNCs. Indeed, MNCs are increasingly taking proactive moves on social issues to prevent the costly negative publicity that results from moral faux pas. An overt Ben-and-Jerry's-type approach to socially responsible business is increasing. In the future, the distinction between NGOs and MNCs may become opaque as MNCs subsume the moral watchdog role within the corporate sphere. For the MNC, the role of moral watchdog is becoming entirely consistent with (indeed, essential for) the maximization of shareholder wealth. Therefore, labeling the objective of shareholder wealth maximization strictly immoral reflects an ignorance of the extent to which concern for stock price necessarily includes concern for the interests of a broad spectrum of stakeholders. A New Model Dispelling these two myths reveals two truths about shareholder wealth maximization. First, it is not morally neutral; in and of itself, shareholder wealth maximization is an ethic. Second, shareholder wealth maximization is not simply immoral; it neither favors strictly material objectives, nor does it unfairly favor

Is Shareholder Wealth Maximization Immoral?

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stockholders over other stakeholders. At a recent meeting of the Society for Business Ethics, the outgoing president, Thomas Dunfee, suggested a new model that accepts that the market itself has an ethic. In this model, shareholder wealth maximization as a particular moral stance is open to moral evaluation. Dunfee called this model the marketplace of morality (1998, p. 127). Dunfee suggested that the marketplace of morality could provide a unifying framework integrating moral preferences, reasoning, behaviors and organizational contexts with broader political and economic concepts (p. 142). He quoted Judge Richard Posner's observation in 1990 that moral philosophy is a weak field, a field in disarray, a field in which consensus is impossible to achieve in our society (in Dunfee, p. 138). In that case, Dunfee asked, why not let the market mechanism price the ebbs and flows of postmodern pluralism? Whether the issue is environmentalism, multiculturalism, animal rights, feminism, or child labor, a marketplace of morality would translate these social concerns into economic concerns. This suggestion horrified many hard-line ethicist, who saw it as an admission of defeat, a throwing in of the towel in the classic ethics-versus-profits debate. What Dunfee was suggesting, however, was not a defeat for ethics but a recognition that the market is not antithetical to ethics. The market itself has an ethic. Furthermore, it may be the most justifiable ethic available today. In a marketplace of morality, the players in the old stockholder model would function as follows: The NGOs would ensure that shareholder-wealth-maximizing MNCs heeded the moral ebbs and flows and, because of the synergies mentioned earlier, the MNCs would willingly assist the NGOs in this pursuit. In short, a marketplace of morality would ensure that, in order to survive and thrive economically, MNCs would heed and perhaps even subsume NGOs. Despite his invocation of a marketplace of morality (MOM), Dunfee did not advocate that markets be given entirely free rein when it comes to ethics. He developed the following procedural principle: The stronger the consensus identified within a MOM, the greater the justification required to override the output of a MOM (p. 140). So, this rule or principle reestablishes the familiar modernist mix of ethical obligations and utilitarianism: If the outcome is clear, go with utilitarianism (i.e., the marketplace of morality), but if it is a close call, look to ethics (i.e., some ethical creed or code of conduct). How strikingly similar this viewpoint is to that propounded by the ultimate defender of the stock-holder model, Milton Friedman: The social responsibility of business is to increase its profits . . . [constrained by] . . . ethical custom (1970, p. 153). Perhaps, as with the apparent conflict between NGOs and MNCs, the apparent conflict between business ethics and financial economics will soon disappear. Another triumph for capitalism? Or would such a disappearanceand the resulting emergence of a marketplace of moralityhave less to do with the moral worth of markets than with the lack of any alternative ethic or ideology (what Francis Fukayama has famously called the end of history)? Finally, what are the implications of a market-place of morality for practicing finance professionals? As an illustration, consider Shell's decision to increase the number of women in senior management positions. The women who join the senior ranks of Shell's management will owe their positions directly to Shells focus on stock price, which, in turn, has been influenced by social pressure. Consequently, providing they do so in an open and noncoercive manner, these women can pursue shareholder wealth maximization in the secure knowledge that this pursuit will also be a pursuit of the moral values cherished by an economic majority of Shells stakeholders.

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One of Sir Winston Churchill's most famous remarks was his defense of democracy: [I]t has been said that democracy is the worst form of government except all those other forms that have been tried from time to time. As we leave the 20th century, a similar defense could be applied to share-holder wealth maximization. Given its moral premise of might makes right, shareholder wealth maximization is the worst justification for corporate behaviorwith the exception of all other known justifications. Under shareholder wealth maximization, a finance professional, rather than having to reconcile diverse moral perspectives, can rely on the market mechanism to translate moral concerns into economic signals. Furthermore, and this point is crucial to the normative justification of shareholder wealth maximization, the translation of these social values into economic values enables managers to act on them without contradicting their fiduciary responsibility to stockholdersa responsibility that, given the unique status of stock-holders as residual claimants, can also be viewed as a moral responsibility. In accepting shareholder wealth maximization as the objective, however, business professionals should not abrogate all moral common sense. As a version of might makes right, shareholder wealth maximization clearly needs tempering, which is where the character and judgment of the manager comes in. As noted, the dissemination of information about corporate activities is crucial to a moral defense of shareholder wealth maximization. Managers must use clear moral judgment, therefore, in making information available to the public. Obviously, in a competitive economic environment, to expose every activity within the firm to public scrutiny would be unrealistic. But if they choose secrecy, managers should examine closely the effect of the secrecy. Who could be hurt directly and who could be hurt indirectly by the decision to withhold information? In exercising the judgment necessary to answer such questions, ethical character traits, virtues, are essential-virtues such as prudence, courage, wisdom, and compassion.2 Only through sound moral judgment on the part of individual managers can the organizational premise of share-holder wealth maximization be morally justified. Notes 1. The current article represents the third in an occasional series on ethics in finance that I have written for the Financial Analysts Journal (1993, 1997). The first two articles focused on the objectives of individuals within financial markets; this article broadens the focus to the objectives of business organizations. 2. See my 1993 and 1997 articles. References Aristotle. 1991 edition. The Nicomachean Ethics. Translated by David Ross; revised by J.L. Ackrick and J.O. Urmson. Oxford, U.K.: Oxford University Press. Barach, J., and John B. Elstrott. 1988. The Transactional Ethic: The Ethical Foundations of Free Enterprise Reconsidered. Journal of Business Ethics, vol. 7, no. 7:545-552. Bartlett, Christopher A., and Sumantra Ghoshal. 1989. Managing across Borders. Cambridge, MA: Harvard Business School Press. Bowen, Sally. 1998. People Power Keeps Peru's Investors in Check. Financial Times (February 6):6. Bowie, Norman E. 1991. Challenging Egoistic Paradigm. Business Ethics Quarterly, vol. 1:1-21. Buchholz,

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Rogene A., and Sandra B. Rosenthal. 1997. Business Ethics: The Pragmatic Path beyond Principles to Process. New York: Prentice-Hall. Byron, W.J. 1988. Twin Towers: A Philosophy and Theology of Business. Journal of Business Ethics, vol. 7, no. 3:525-530. Chambers, Donald R., and Nelson J. Lacey. 1996. Corporate Ethics and Shareholder Wealth Maximization. Financial Practice and Education, vol. 6, no. 1 (Spring/Summer):93-96. Cozine, Robert. 1998. More Top Shell Jobs for Women. Financial Times (January 13):17. DeGeorge, Richard T. 1990. Business Ethics. 3rd ed. New York: Macmillan. Dobson, John. 1993. The Role of Ethics in Finance. Financial Analysts Journal, vol. 49, no. 6 (November/December):57-61, 1997. Ethics in Finance II. Financial Analysts Journal, vol. 53, no. 1 (January/February):15-25. Donaldson, Thomas. 1989. The Ethics of International Business. New York: Oxford University Press. Dunfee, W. Thomas. 1998. The Marketplace of Morality: Small Steps toward a Theory of Moral Choice. Business Ethics Quarterly, vol. 8, no. 1 (January):127-146. Friedman, Milton. 1970. The Social Responsibility of Business Is to Increase Its Profits. New York Times Magazine. Reprinted in W.M. Hoffman and J.M. Moore, eds. Business Ethlics. New York: McGraw-Hill, 1990:153-156. Hasnas, John. 1998. The Normative Theories of Business Ethics: A Guide for the Perplexed. Business Ethics Quarterly, vol. 8, no. 1, (January):19-42. Keyed, Arthur J., David F. Scott, Jr., John Martin, and William J. Petty. 1998. Foundations of Finance: The Logic and Practice of Financial Management. New York: Prentice-Hall. Maclntyre, Alasdair. 1977. Utilitarianism and Cost-Benefit Analysis: An Essay on the Relevance of Moral Philosophy to Bureaucratic Theory. In Values in the Electric Power Industry. Kenneth Sayre, ed. Notre Dame, IN: University of Notre Dame Press:217-237. . 1988. Whose Justice? Which Rationality? Notre Dame, IN: University of Notre Dame Press. Willman, John. 1998. Large Scoops of Social Values. Financial Times (February 9):8.

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Reprinted with permission Journal of Applied Finance, Vol.18 , No. 2 (Fall/Winter, 2008), pp. 62-66

Shareholder Theory How Opponents and Proponents Both Get It Wrong


Morris G. Danielson, Jean L. Heck and David R. Shaffer
Saint Josephs University, Saint Josephs University and Villanova University

Shareholder wealth maximization has long been accepted by financial economists as the appropriate objective for financial decision-making. Recently, wealth maximization has been criticized by a growing array of opponents for condoning the exploitation of employees, customers, and other stakeholders, and encouraging short-term managerial thinking. Although these critics are misguided, proponents of shareholder theory have helped to create this confusion by exhorting managers to maximize the firms current stock price. In a world with symmetrical information, efficient capital markets, and no agency conflicts, the maximization of a firms current stock price and the maximization of its intrinsic value (i.e., the present value of its long-term cash flows) are congruent goals. If these conditions are not met, however, the incentive to increase a firms current stock price can distort operating and investment decisions. When wealth maximization is properly defined as a long-term goal, it is not as narrowly focused as critics believe. The main prescription of shareholder theoryinvest in all positive net present value projectsbenefits not only shareholders, but also key stakeholders including employees and customers.

Shareholder theory defines the primary duty of a firms managers as the maximization of shareholder wealth (Berle and Means, 1932; Friedman, 1962). The theory enjoys widespread support in the academic finance community and is the fundamental building block of corporate financial theory. For example, the net present value (NPV) rule in capital budgeting is a direct application of shareholder theory. If a firm invests in all positive net present value (NPV) projects, the firm will maximize the value of the firms long-term cash flows and will therefore maximize shareholder wealth. Much of the agency cost literature, following Jensen and Meckling (1976), is also an extension of shareholder theory. However, shareholder theory is not universally accepted outside the field of financial economics. As early as 1932, critics of shareholder theory argued that the maximization of shareholder wealth is not an appropriate goal and that firms should consider the interests of other stakeholders when making business decisions (Dodd, 1932). This idea was formalized into stakeholder theory by Freeman (1984). More recently, the shareholder model has been criticized for encouraging short-term managerial thinking and condoning unethical behavior.

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Smith (2003, p. 86) notes that critics believe shareholder theory is . . . geared toward short-term profit 1 maximization at the expense of the long run. Freeman, Wicks, and Parmar (2004, p. 365) assert that shareholder theory . . . involves using the prima facie rights claims of one groupshareholdersto excuse violating the rights of others. This paper explains why such critiques of shareholder theory are both misguided and understandable. They are misguided because wealth maximization is inherently a long term goalthe firm must maximize the value of all future cash flowsand does not condone the exploitation of other stakeholders (Jensen, 2002; Sundaram and Inkpen, 2004a). The criticisms are understandable because many proponents of shareholder theory, in a stylized version of the model, exhort managers to maximize the firms current stock price (Keown, Martin, and Petty, 2008; Lasher 2008; Ross, Westerfield, and Jordan, 2008; Brealey, Myers, and Marcus, 2007; Melicher and Norton, 2007). Although the maximization of the current stock price and the maximization of the present value of long-term cash flows are often congruent goals, some actions that might increase the current stock price can harm the firm in the long-term. For example, unscrupulous managers could manipulate the current stock price, or the firm could attempt to increase short-term profits by reducing costs and sacrificing product quality. If a manager attempts to maximize a firms current stock price without taking into account ethical considerations, or without evaluating the potential affect of the adopted policies on long-term cash flows, the very problems 2 critics attribute to shareholder theory could arise. When a firm attempts to maximize the value of its long-term cash flow stream, the firms shareholders obviously will benefit. However, this policy will also benefit key stakeholder groups, such as employees and customers. Indeed, this paper makes the case that the long-term form of the shareholder model provides a better framework than stakeholder theory in which to protect the interests of future employees and customers. Thus, we reject the notion that stakeholder theory is superior to shareholder theory from an ethical perspective. I. The General Form of the Shareholder Model In the general form of the shareholder model, the goal of the firm is to maximize the present value of expected future dividends. If the dividend a firm is expected to pay in year n is Dn, and the required return on equity is r, the intrinsic (per share) value of the firms equity today (V0) is defined by Equation (1).

Vo

Dn n n = 1 (1 + r )

(1)

The goal of a firms managers is to pursue those policies that will maximize the value of Equation (1). Managers should invest in all positive net present value (NPV) projects, which in turn will maximize the value of the firms future dividends (Brealey and Myers, 2003). The right-hand side of Equation (1) highlights the long-term nature of this goal. Shareholder wealth depends on the firms performance (and dividends) in all future years. A large portion of shareholder wealth is often tied to cash flows to be received in the distant future. For example, if the firm is expected to pay a $1 dividend forever, and the required return on equity is 8 percent, the current stock price is $12.50 (= $1/0.08). The expected dividends during the next 10 years have a present value of $6.71 (= $1 x [1-(1+.08)-10]/.08), meaning 46.3 percent of the equity value will be realized during years 11 through infinity. If the firms dividend is expected to grow at a 4 percent rate per year (forever), the stock price

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today is $25 (= $1/(0.08 0.04)). In this example, dividends during the next 10 years only account for 31.4 percent of the equity value (= $7.86/25), leaving 68.6 percent of the value to be realized in years 11 through infinity. Clearly, shareholder wealth maximization is not a short-term goal. II. The Stylized Shareholder Model The general form of the shareholder model is difficult to implement because the estimated dividend stream on the right-hand side of Equation (1) cannot be observed. In contrast, the firms current stock price is visible. Thus, proponents of shareholder theory often assert that a firms current stock price (P0) equals its intrinsic value (V0) and instruct managers to maximize the firms current stock price. This is the stylized form of the shareholder model. However, maximizing a firms current stock price and maximizing its intrinsic value are equivalent goals only if three conditions are met. First, managers and investors must have access to identical information about the firms past performance and future investment opportunities. Second, capital markets must be efficient. Third, managers must not have an incentive to manipulate the current stock price. If these conditions are not metand they are unlikely to be met for all firmsefforts to maximize a firms current stock price can distort the firms investment and operating decisions. Thus, the maximization of the current stock price is not an appropriate goal for many firms. Asset Substitution Effects It is unlikely that managers and investors will have identical information about a firm. Even if a firm issues complete and accurate financial reports, managers will know more than external investors about the firms past performance and about whether this performance can be sustained in the future. In addition, managers will have access to better information about the potential profitability of future projects. If so, managers and investors might assign different valuations to certain corporate strategies. Consider two mutually exclusive investments requiring an investment of $1 million. If Project A has a NPV of $100,000, while Project B has a NPV of negative $100,000, shareholders will be better off in the long run if the firm invests in Project A. However, with asymmetrical information, external investors might (incorrectly) estimate the NPV of Project A as negative $100,000, and the NPV of Project B as positive $100,000. In this case, the investment decision will depend on what the goal of the firm is. If managers want to maximize the current stock price, they will choose Project B, but if they want to maximize the firms intrinsic value they will choose Project A. This example shows that if a firm is focused solely on increasing the current stock price, it may invest in a project that will generate a positive reaction from investors today, even though the project may not be the best use of the firms resources in the long run. B. Agency Costs of Overvalued Equity If the stock market is efficient, investors will quickly identify mispriced securities, and buying or selling activity will restore the stocks to their fair prices. However, numerous empirical studies provide evidence 3 challenging the notion that the stock market is (perfectly) efficient. If the stock market is not efficient, then a firms stock price may differ from the intrinsic value of the firms future dividend stream. If so, the right-hand side of Equation (1) will not always equal the firms current market value.

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If a firms stock price is too high (meaning the stock price is higher than the intrinsic value of the future dividend stream), and if the firms goal is to increase its stock price, efforts to further inflate the firms stock price may destroy long-term value. These actions could include investments in risky negative NPV projects (i.e., projects with high potential payoffs, but low expected payoffs), accounting manipulation, or the adoption of fraudulent business practices. Jensen (2005) refers to the costs of these actions as the agency costs of overvalued equity. Jensen (2005, pp. 1011) uses Enron to illustrate these agency costs. At Enrons peak market value of $70 billion, Jensen estimates the company was only worth $30 billion. He notes that Enrons managers tried to justify the excess valuation of $40 billion by . . . trying to fool the markets through accounting manipulations, hiding debt through off-balance sheet partnerships, and over hyped new ventures such as their broadband futures effort. Clearly these efforts were not designed with the long-term interests of the firm in mind, and they did not pay off for Enrons shareholders. Thus, the case of Enron does not provide evidence against the general form of the shareholder model. But this experience does show that efforts to increase a firms current stock price can be harmful if these policies are detached from strategies designed to maximize the firms long term revenues, profits, and cash flows. C. Managerial Incentives and the Stylized Shareholder Model The use of incentive stock options has increased dramatically during the past twenty years. Because stock options provide managers with an incentive to consider the interests of shareholders when making investment 5 and operating decisions, options are typically viewed as an effective way to reduce agency costs. However, incentive stock options often align managerial incentives with the stylized version of shareholder theory, not the general form of the model. For example, incentive stock options can encourage managers to adopt a short-term focus as the expiration date approaches. In this case, managers have an incentive to accept projects that might boost a firms stock price in the short-term even if the project will not help the firms stock price in the long-run. Thus, incentive stock options can create asset substitution problems. Incentive stock options can also create agency problems similar to the agency costs of overvalued equity. To illustrate this point, assume that a firm issues incentive stock options when the firms stock price is $100. If the stock price drops to $80, the options no longer provide a direct incentive for managers to invest in all positive NPV projects. For example, the options will not reward managers for selecting positive NPV investments that might stem the price decline, or help the stock price to gradually recover. Instead, the stock price must exceed $100 before the option expiration date, or the options will expire worthless. In this case, Danielson and Press (2006) argue that the presence of the options could encourage managers to pursue policies designed to pump up the stock price in the short term rather than policies aimed at maximizing the firms cash flows in the long run. In essence, the exercise price of the underwater options provides managers with an incentive to justify a stock price that is too high, creating agency costs of overvalued equity. III. The Shareholder Model and Stakeholder Interests When shareholder theory is defined from a long-term perspective (i.e., the goal of the firm is to maximize the value of a firms long term cash flows), it is hard to make a convincing case that the theory sanctions unethical business practices. As Jensen (2002) points out, wealth maximization is only possiblein the long runif the firm creates value for employees and customers, both now and in future years. Thus, the
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maximization of a firms long-term cash flow stream should not harm the firms stakeholders. The dividends a firm can pay in each future year will be constrained by the revenues and profits the firm can earn in its product markets. In order to generate future revenues, the firm must develop products that create value for customers (i.e., the marginal value of the products to customers must exceed the price the firm will charge). And because technology and consumer preferences both change over time, the firms product development efforts must be an ongoing process that focuses on the evolving preferences of customers. The maximization of long-term profits also requires a firm to control costs. When doing this, the firm must realize that policies designed to minimize short-term costs will not necessarily minimize long-term costs. For instance, the firm might be able to reduce short-term costs by paying employees below-market wages. But, over time, this policy might cause the firm to lose its most productive employees. Similarly, the firm might reduce short-term costs by using inferior raw materials, equipment, or other inputs. However, these policies could cause the firm to lose customers, increase warranty costs, or subject the firm to litigation expenses. Thus, the firm must minimize costs subject to the constraints created by labor markets and without reducing the firms ability to create value for customers. When viewed from a long-term perspective, shareholder theory does not endorse policies that will transfer wealth from other stakeholders to shareholders. Instead, shareholder theory recognizes that the maximization of shareholder wealth in the long-term requires the firm to create value for both employees and customers. In contrast, if a managers goal is simply to increase a firms current stock price, there are easier ways to accomplish this goal than going through the difficult process of identifying and developing positive NPV projects. For example, the firm might cut costsperhaps reducing employee morale or product qualityin hopes of improving short-term profit margins. Although these policies can increase shareholder wealth in the short-term, they can also jeopardize the firms long-term financial health as the firms best employees find work elsewhere and customers switch to competing products. Proponents of shareholder theory, of course, do not advocate these actions. But proponents of shareholder theory create confusion about what the theory meansand what it does not meanwhen restrictive assumptions about financial markets are invoked and the goal of the firm is defined as the maximization of the current stock price. IV. Does Stakeholder Theory Promote a Long-Term Focus? Because of the perceived deficiencies of shareholder theory, stakeholder theory has gained popularity in recent years and is now used to guide the business decisions of a wide range of firms (Donaldson and Preston, 1995; Jorg, Loderer, and Roth, 2004; and Kaler, 2006). The stakeholder model recognizes the existence of multiple groups with a stake in a firms success, and recommends that managers balance the interests of these parties when making decisions. However, stakeholder theory, like the stylized shareholder model, can be criticized for encouraging managers to adopt a short-term focus. For example, employees in the steel industry, the auto industry, and the airline industry benefited in the short-term from lucrative union contracts negotiated in the 1970s and 1980s. But these same contracts ultimately contributed to financial difficulties at the firms, reducing job security and compensation for todays employees. Similarly, the current customers of large pharmaceutical companies would benefit greatly if patent laws were revoked, and all drugs were then sold at a price equal to production costs plus, say, 10 percent. However, this policy would reduce both the funds available to invest in research and development and the incentive for firms to do so. Thus, future customers would not benefit from potential life-saving products that might

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otherwise have been developed. Stakeholder theory, of course, does not advocate that firms be managed in the interests of current stakeholders at the expense of future ones. Instead, Freeman (1994, p. 417) recommends that a corporation . . . be managed as if it can continue to serve the interests of stakeholders through time. Similarly, DesJardins and McCall (2005) argue that a corporation should be managed as a social institution, providing benefits to stakeholders both now and in the future. However, the question of how a manager might balance the interests of current and future stakeholders has received very little attention in the stakeholder literature. One notable exception is Mitchell, Agle, and Wood (1997), who argue that managers should consider the urgency of various stakeholder claims when making decisions. But this approach would encourage managers to adopt a short-term focus when implementing stakeholder theory: the needs and requirements of current stakeholders will always be more urgent than those of future stakeholders. Proponents of both shareholder theory and stakeholder theory no doubt agree that employees should be paid a wage that is at least equal to the wage they could earn elsewhere, as long as this wage is less than the marginal product of their labors. Similarly, prices charged to customers cannot exceed the marginal benefits created by the products or services. However, these constraints do not precisely define the appropriate wage to pay, or price to charge. Thus, conflicts can arise between shareholders and stakeholders as to how the cash flows created by a firm should be allocated. The following subsections explain why the general form of the shareholder model provides the best framework in which to resolve these conflicts. A. Who Should Benefit from a Firms Economic Surplus? Because one of the goals of stakeholder theory is to promote an enhancement of distributive justice within the confines of a basically capitalist structure . . . . (Kaler, 1996 p. 250), some advocates of stakeholder theory argue that the economic value created by a firm should be split between stakeholders. The 1988 Sloan Colloquy in its Consensus Statement on Stakeholder Model of the Corporation recommends that firms attempt to distribute the benefits of their activities as equitably as possible among stakeholders, in light of their respective 6 contributions, costs, and risks. Phillips (2000, p. 100) claims that this process will provide shareholders with a fair return. Although advocates of stakeholder theory do not specifically define a fair return, the implication appears to be that a fair return is one that equals or exceeds the risk adjusted cost of capital. Along these lines, Blair and Stout (1999) argue that the board of directors should split a firms economic surplus (i.e., investment returns in excess of the risk-adjusted cost of capital) between shareholders, employees, customers, and other stakeholders. If a firm is forced to allocate a portion of its economic surplus to customers (by charging below-market prices) or employees (by paying wages in excess of the employees marginal productivity), these stakeholders will certainly benefit in the short-term. However, this policy could stifle future innovation, hurting shareholders, stakeholders, and society in the long run. The following example illustrates this potential problem. Assume that a firm operates in a simple one-period world. The entrepreneur invested $100 in the firm at t = 0, and the firm produces a cash flow of $160 at t = 1. If the required return is 10 percent, the economic surplus of the firm is $50 (= $160 $100(1.10)). How should this surplus be allocated between shareholders and other stakeholders? Because the firm has a realized investment return of 60 percent, stakeholder advocates might argue that the

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shareholders profits are excessive. From this perspective, an equitable distribution of the economic surplus might be to increase wages or decrease prices, reducing the economic surplus toward zero and the realized investment return toward the required return of 10 percent. But, this policy would not be fair to the entrepreneur of the firm unless the policy was known before the investment decision was made. Most investments offer risky outcomes; it is likely that the entrepreneur did not know with certainty that the projects t = 1 payoff would be $160 when the initial $100 investment was made at t =0. Assume that at time t = 0, the investment had an equal 50 percent probability of paying either $160 or $60 at t = 1. If so, the expected payoff at t = 1 was $110, and the project had a net present value of 0 (= 110/1.10 100). On an ex-ante basis the project was acceptable, but it did not create an economic surplus. Once the future outcome is revealed, it would not be ethical to change the rules of the game and split the excess return ($160 $100) between shareholders and other stakeholders. If the entrepreneur had known at t = 0 that the project would only yield, say, $150 in the good outcome, the entrepreneur would not have made the $100 investment. Thus, proposals to split the realized economic surplus among various stakeholder constituencies have the potential for reducing future investment, harming society (and potential future stakeholders) in the long run. B. The Conflict between Current and Future Stakeholders Although a firm should not be compelled to split its economic surplus between shareholders and other stakeholders, it is sometimes in the best interests of shareholders for the firm to do so. For example, the firm may choose to pay premium wages to retain employees with valuable firm-specific knowledge, or to attract talented new employees. Or the firm could offer products at discount prices to build brand loyalty. When considering these options, the firms managers must estimate the impact of current decisions on future cash flows. If the firm reduces the amount currently invested in new projects in order to pay dividends or to allocate additional benefits to stakeholder groups, the firms future cash flows may be reduced. Capital budgeting theory clearly states that shareholder wealth will be lower if the firm does not invest in all (independent) positive net present value projects. But are a firms stakeholders, as a whole, harmed if a firm bypasses positive net present value projects? Consider a firm operating in a two-period world. The firms employees and customers have the ability to negotiate additional benefits (i.e., discount prices or premium wages) totaling S1 and S2 in periods 1 and 2, respectively. Assume that the stakeholders wish to maximize the present value of their additional benefits over time. Because S1 and S2 are subsets of the firms cash flows, the discount rate applied to these future cash flows should equal the firms cost of capital k. The stakeholders well-being will be maximized (in period 1) when the following equation is maximized, with respect to S1.

W = S1 +

S2 (1 + k )

(2)

In Equation (2), the stakeholder benefits in period 2 are a decreasing function of the stakeholder benefits in period 1. Any benefits paid in period 1 reduce the amount the firm can invest in new projects, reducing the firms total cash flow stream in period 2. Equation (2) will be maximized with respect to S1 when the following conditions are met:

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S 2
0 = 1+
or,

Readings in Financial Ethics


S1

(1 + k )

(3)

(1 + k ) =

S 2 S1

(4)

Equation (4) implies that stakeholders will forego benefits today as long as future benefits are sufficiently high. That is, the stakeholders will forego $1 in benefits today in order to receive $1(1+k) of benefits in the future. In other words, stakeholders will forego benefits today as long as the firm invests the money in positive net present value projects. The problem stakeholders have in viewing the world through Equation (4) is that the identity of the stakeholders is constantly changing. So the stakeholders who forego $1 of benefits today may not be the ones who receive the additional benefits in the future. But this makes the loss of future benefits (e.g., diseases that remain uncured or jobs that have been shifted overseas) no less real to society as a whole. Because many stakeholders have only short-term interests in a firm, it is the responsibility of managers to view the firm as a going concern and to focus on maximizing the long-term value of the firms cash flows. By doing so, the managers will be protecting the interests of shareholders, future stakeholders, and the firm as a social institution. V. Summary In the aftermath of financial scandals at Enron, Worldcom, and Global Crossings, shareholder theory faces increased scrutiny and criticism. As stated by Freeman, Wicks, and Parmar (2004, p. 366), It is hard to imagine how anyone can look at the recent wave of business scandals, all of which are oriented toward ever increasing shareholder value at the expense of other stakeholders, and argue that this philosophy is a good idea. Many financial economists view critics of shareholder theory, such as Freeman, et al, as being misguided. Proponents of shareholder theory point out that policies adopted by Enron, Worldcom, and Global Crossing clearly did not benefit the firms shareholders in the long-run, and thus are not evidence against shareholder theory (Sundaram and Inkpen, 2004b). Before dismissing critics of shareholder theory outright, however, it is important to recognize that supporters of shareholder theory often emphasize the models short-term implications when defining the theory. Indeed, many leading finance texts equate shareholder theory with the maximization of a firms current stock price. Thus, it should not be surprising that some critics of the shareholder theory might (incorrectly) view it as being a short-term goal. This paper distinguishes between two versions of shareholder theory. In the general case, the goal of the firm is to maximize the value of the firms long-term cash flow stream. In the stylized version of the model, the goal is to maximize the current stock price. In a world with symmetrical information, efficient capital markets, and no agency conflicts, the maximization of the current stock price and the maximization of long-term cash flows are congruent goals. If these conditions are not met, however, efforts to increase the current stock price could distort a firms operating and investment decisions, jeopardizing its long-term financial health. Thus, simply exhorting managers to increase the current stock price may not be the best way to implement shareholder theory. We disagree, however, with those who would use the deficiencies of the stylized model as a reason to abandon shareholder theory in favor of stakeholder theory. Despite its current popularity, stakeholder theory

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provides little guidance about how to balance the often competing interests of various stakeholder groups (Marcoux, 2000; Jensen, 2002). In addition, stakeholder theory can encourage managers to adopt a short-term focus (much like the stylized version of the shareholder model) to the detriment of a firms long-term health. The shareholder modelwhen viewed from a long term perspectivestill provides the best framework in which to balance the competing interests of various stakeholders (including both current and future stakeholders) when making business decisions. However, proponents of shareholder theory must recognize that it matters how the theory is defined and implemented. In particular, the goal of financial managers should be to invest in all positive net present value projects, regardless of whether these decisions will cause an immediate increase in the firms stock price. To focus managerial attention on this goal, corporate incentive structures should reward managers for maximizing a firms value in the long run rather than increasing its stock price in the short term. Notes 1 For example, Freeman, Wicks, and Parmar (2004) criticize managers for pursuing policies designed to continually increase a firms stock price. Fuller and Jensen (2002) criticize mangers for focusing undue attention on whether a firm meets analyst earnings forecasts each quarter, to avoid stock price declines. 2 Some textbook authors acknowledge that managers should attempt to maximize the current stock price subject to constraints. For example, Lasher (2008, p. 15) notes that managers should not attempt to keep the stock price artificially high by misleading investors about the firms historical performance and its future prospects. Others (e.g., Brealey, Myers, and Marcus, 2007) explain that the maximization of a firms current stock price requires a firm to create value for stakeholders and to treat them in an ethical manner. Nevertheless, the stated goal of the firm in these texts is that the firm should attempt to maximize its current stock price (or market value). 3 For a brief review of evidence identifying market efficiencies, see Thaler (1999). 4 Hall and Murphy (2003) document a ten-fold increase in the value of option grants from 1992 to 2000. 5 For example, Ross, Westerfield and Jordan (2008, p. 12) state, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is the option. In fact, options are often used to motivate employees of all types . . . better aligning employee and shareholder interests. 6 This statement is reprinted in the appendix to Marcoux, 2000. References Blair, M. M. and L. A. Stout. 1999. A Team Production Theory of Corporate Law. Virginia Law Review 85 (4), 247-328. Brealey R.A. and S.C. Myers. Principles of Corporate Finance (New York, 2003), McGraw-Hill/Irwin. Brealey R.A., S.C. Myers, and A.J. Marcus. Fundamentals of Corporate Finance (New York, 2007), McGrawHill/Irwin. DesJardins, J.R. and J.J. McCall. 2005. The Corporation as a Social Institution, In Contemporary Issues in Business Ethics, 5th edition. Edited by J.R. DesJardins and J.J. McCall. Belmont, CA: Wadworth. Danielson, M., and E. Press. 2006. Do Stock Options Always Align Manager and Shareholders Interests? An Alternative Perspective, Advances in Financial Education 4, 1-16. Dodd, M.E. 1932. For Whom are Corporate Managers Trustees? Harvard Law Review 45, 1145-1163.

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Donaldson, T. and L.E. Preston. 1995. The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications, Academy of Management Review 20 (1), 6591. Freeman, R.E. Strategic Management: A Stakeholder Approach (Boston, 1984), Pitman. Freeman, R.E. 1994. The Politics of Stakeholder Theory: Some Future Directions, Business Ethics Quarterly 4 (4), 409421. Freeman, R. E., A. C. Wicks, B. Parmar. 2004. Stakeholder Theory and The Corporate Objective Revisited, Organizational Science 15 (3), 364369. Fuller, J. and M. Jensen. 2002. Just Say No to Wall Street: Putting A Stop to the Earnings Game, Journal of Applied Corporate Finance, 14 (4, Winter), 41-46. Hall, B. and K. Murphy. The Trouble with Stock Options, Journal of Economic Perspectives 17 (Summer, 2003), 49-70. Jensen, Michael C. Value Maximization, Stakeholder Theory, and the Corporate Objective Function, Business Ethics Quarterly 12 (2, 2002), 235-256. Jensen, Michael C. Agency Costs of Overvalued Equity, Financial Management 34 (Spring 2005), 5-19. Jorg, P., Loderer, C., Roth, L. 2004. Shareholder Value Maximization: What Managers Say and What They Do, DBW Die Betriebswirtschaft 64 (No. 3), 357378. Kaler, J. 2006. Evaluating Stakeholder Theory, Journal of Business Ethics 69, 249268. Keown A.J., J.D. Martin, and J.W. Petty. Foundations of Finance (Upper Saddle River, 2008), Pearson Prentice Hall. Lasher, W.R. Practical Financial Management (Mason, 2008), Thomson South-Western. Marcoux, A.M. 2000. Balancing Act, In Contemporary Issues in Business Ethics, 4th edition. Edited by J.R. DesJardins and J.J. McCall. Belmont, CA: Wadworth. Melicher, R.W. and E.A. Norton. Introduction to Finance (Hoboken, 2007), John Wiley and Sons. Phillips, R.A. 2000. Remarks on Marcoux: Defending Stakeholder Theory, In Contemporary Issues in Business Ethics, 4th edition. Edited by J.R. DesJardins and J.J. McCall. Belmont, CA: Wadworth. Ross, S.A., R.W. Westerfield and B.D. Jordan. Fundamentals of Corporate Finance (New York, 2008), McGrawHill/Irwin. Smith, H.J. 2003. The Shareholders vs. Stakeholders Debate, MIT Sloan Management Review, 8590. Sundaram, A., A. Inkpen. 2004a. The corporate objective revisited, Organizational Science 15 (3), 350363. Sundaram, A., A. Inkpen. 2004b. Stakeholder Theory and The Corporate Objective Revisited: A Reply, Organizational Science 15 (3), 370371. Thaler, R. 1999. The End of Behavioral Finance, Financial Analysts Journal 55 (6 November/December), 1217.