Monday, September 3, 2007

STAKEHOLDERSHIP, CORPORATE RESPONSIBILITY AND THE ETHICS OF MANAGERIAL CONDUCT

By Niceto S. Poblador, Ph.D.

Easily one of the hottest and most contentious topics of discussion now-a-days among business and academic circles is corporate responsibility and the related issue of corporate governance.

While there is widespread agreement as to what constitutes “good” corporate behavior, the basis for the acceptability of business practices are long established and universal norms of conduct about which there can be no quarrel. Who is to argue against fairness, or honesty or concern for others? There is much less consensus, however, as to what these ethical norms imply for corporate strategy and operational decisions made by corporate managers. When it comes to the nuts and bolts of managerial decision making, corporate statements of “core values” are of little help.

In addressing the issue of corporate responsibility, many progressive companies have been taking a more serious look at their system of management oversight. They are reworking the administrative control mechanisms that are intended to insure that the interests of the various groups that have stake in the organization – investors, customers, creditors, workers and the community at large – are taken into account in the running of corporate affairs.

The reform of corporate governance is actively being supported by the Securities and Exchange Commission (SEC). for the purpose of providing a set of guidelines for redesigning corporate governance mechanisms, the SEC has recently come up with a “Code of Corporate Governance” (SEC Memorandum Circular No. 2, Series of 2002). It prescribes, among other things, the size, composition and qualifications of the board of directors, and provides for mechanisms for disclosure and transparency.

It is worthwhile noting, however, that the Code, by and large, is concerned primarily with the interests of corporate shareholders. While the Code provides for the inclusion of independent directors in the boards of publicly held corporation, these are still to be elected by shareholders. Nowhere does the Code specify what constituencies these independent directors are supposed to represent. There is no explicit provision ion the Code for board representation of other stakeholders in the company such as its employees and customers. The Code’s silence on the environment and other concerns of the community is also disconcerting.

The growing awareness among corporate managers of the need for reforming corporate governance, and the active involvement of the SEC in the endeavor, should be applauded. However, current debates on the matter are mostly about policies, procedures and formal implementing mechanisms. Little has been done to address the substantive issues that underlie these mechanisms.

To be sure, these mechanisms provide a set of potentially effective constraints on managerial abuse. But given the area of latitude within which managers can operate, these same mechanisms do not provide any meaningful guidelines for action. From a given set of feasible options, which one should the manager choose? And, more importantly, why?

To answer these questions in any meaningful way, we have to know just exactly what the purpose of the organization is. And herein lies the rub.

Contending Viewpoints

A generally accepted goal of firm, one which is consistent with neoclassical economic theory, is the maximization of shareholder value. However, this theory has been shunned by many “progressive” managers and academics because of its exclusive concern for the interest of the owners of the firm.

By contract, “Stakeholder Theory” (stakeholder, for short) prescribed that managers should be concerned with the interests of all groups that have a legitimate stake in corporation. This alternative framework has been gaining more and more adherents in recent years. Indeed, it serves as the main rationale for current thinking on corporate governance.

On closer examination, however, stakeholderhip may turn out to be more of a catchy phraseology than a theory. To begin with, it has no concept of what economists call "equilibrium," the imaginary point towards which a system tends to gravitate. But more seriously for the practicing manager, it provides no rational basis for action.

The Crux of the Matter

In more precise terms, our main concerns are twofold: (1) How do we specify the firm’s ultimate objective or goal? (2) How can we pursue this goal in such a way as to satisfy the needs of all groups that have a stake in the enterprise? If we can come up with a precise statement of the firm’s ultimate goal (that is, specify clearly what economists call its “objective function”), then we have a basis for defining rationality. If we can come up with a set of criteria for meeting the needs of all corporate stakeholder’s, then we have defined in operational terms what is and what is not ethical behavior.

In other words, what we are looking for is a set of guidelines that will make managerial decisions both rational and ethical at the same time. Is this a quixotic quest, or is it something worth exploring?

A Closer Look at Stakeholdership

The concept of stakeholdership, as currently articulated, is flawed for a number of reasons:

(1) By failing to specify corporate goals in terms of a single, well-defined variable, stakeholdership fails to provide a rational basis for choice. While its concern for the interests of all stakeholders in an enterprise is well taken, stakeholdership fails to provide a rational basis for establishing tradeoffs among these oftentimes conflicting interests. This puts decision makers at a loss in deciding whether one course of action is to be preferred over another.

(2) As a consequence of (1), managers have to be “empowered” to exercise their discretion, subject only to incompletely specified constraints. Managers are able to maneuver within their specified areas of accountability and can divert corporate resources in pursuit of their own interests. This enhances what economists call “agency costs.”

(3) Stakeholdership unnecessarily politicizes the corporation by sharply drawing the boundaries between the interests of one group and those of the others. As a consequence, the enterprise emerges as a zero-sum game, and the stakeholders are put in a confrontational relationship vis-à-vis one another. Lost is the idea that their concerns are mutually interrelated.

Enlightened Value Maximization

As a possible way out of this dilemma, a noted economist has proposed what he calls “Enlightened Value Maximization” (EVM) as a theoretical basis for a managerial action and corporate governance. It is essentially identical to the wealth maximization framework except that here, the decision maker endogenizes the economic interests of others and factors these into her utility function. In this way, the tradeoffs (marginal rates of substitution) among the different arguments in the firm’s objective function are established, and it is theoretically possible to find a unique solution to the optimization problem.

However, because we are all “boundedly rational,” optimality is a will-o’-the-wisp, and we can only hope to move heuristically from the current position to a preferred one. In this version of the traditional theory, the goal of the firm is NOT to maximize its market value as such but to enhance it. Any course of action is rational if it results in an increase in the total value of the enterprise, taken here to mean the long-term value accruing to ALL stakeholders and not just that of the shareholders. Within the EVM framework, the corporate manager is seen as a “value seeker” rather than as a “value maximizer.”

As a rule, the various stakeholders of an enterprise have conflicting interests. They do have one goal in common, however, and that is to realize a net economic gain (or surplus) from each transaction that they enter into.

All economic exchanges are intended to create value for both parties to the transaction. For example, when a customer purchases a product, she does so knowing that the perceived value of the product is higher than the price she is asked to pay for it. The difference is the net economic value gained by the consumer, or what economists call “consumer surplus.” In this same transaction, the seller also realizes a surplus which is equal to the difference between the price and the cost of producing the product.

It is also true that corporate decisions typically serve the conflicting interests of many, if not all the stakeholders involved. Notable examples include:

Competitive strategies that are focused on creating consumer value

Measures intended to enhance worker productivity through various types of profit-sharing arrangements

Environment-friendly policies that are designed to enhance corporate image (and hence, the firm’s long-term profitability)

By and large, however, the interests of one stakeholder can only be pursued at the expense of those of others. The following are typical examples:

Efforts to seek protection from imports knowing that consumers will suffer as a result

Investments that result in severe damage to the environment

The employment of child labor

In handling issues of this nature, the enlightened manager must weigh the benefits enjoyed by one stakeholders against the costs incurred by another. For example, the short-term profits gained from employing child labor should be weighed against the life-long economic suffering that will be endured by such young workers. In the case of activities that degrade the environment, the immediate gains to the firm and its workers – indeed, to the economy as a whole, must be weighed against the potential damage to the environment and the resulting decline in future economic output.

The same principle applies in dealing with the conflicting interests of individuals within a particular stakeholder group. For example, decisions made in publicly-held corporations typically favor certain investor groups more than the small shareholders. This is especially true in countries with relatively undeveloped capital markets, and where prominent families and the government are the dominant investors groups.

Decisions in which the overall economic gains exceed the overall economic costs are, by our definitions, rational. For example, the decision to upgrade worker retirement benefits that results in a decline in long-run corporate profits is rational if the resulting enhancement of worker value more than offsets the fall in shareholder value. Obviously, such an act is also ethical. Paradoxically, however, a decision to reduce worker compensation or to retrench some workers in order to insure the continued survival and profitability of the enterprise may also be both rational and ethical. Ethical, we must stress because if we allow for time for economic forces to work themselves out, economic society as a whole may benefit.

Our definition of ethical is very difficult to accept. It is not easy for most of us to think of an act as being ethical knowing that particular individuals (especially those personally known to us) may suffer as a result of a corporate decision. We tend to have a closer affinity to a few warm-bodied individuals whom we know of or are part of our extended selves, compared to the countless but faceless and nameless individuals who nonetheless are affected one way or another by our choices, in the realm of social policy, this is reflected in our desire to protect inefficient industries in order to save the jobs of a relatively few. Seldom do we realize that such protective measures are disadvantageous to consumer who will be forced to pay higher prices for their purchases. Moreover, they prevent the movement of productive resources to activities that are more value generating. The inevitable result is that society as whole suffer. This many of us fail – or refuse – to see.

Enlightenment requires that we extend our realm of interests to the countless others who will be affected by our choices. We must look at the ultimate impact of our decisions on society as a whole.

Clearly, we speak here not only of moral enlightenment but of perceptual and cognitive edification as well. In addition to being genuinely concerned about the interest of others, the corporate manager must be perceptive to their needs. He or she must also be cognizant of the complex economic and socio-psychological dynamics that underlie individual and social behaviour.

To conclude, what is needed in corporate governance is an institutionalized system of controls that will not just insure that things are done by the books. We must look for governance mechanisms that will insure that what is done by the books takes into consideration not only the interests of one group, but also those of others that have a rightful stake in the enterprise.


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