The “Greater Good” or Greater Profits? How ESG Fits Into the Shareholder Primacy Debate

Mar 22, 2022 | Blog

In 1970, Nobel laureate and economist Milton Friedman published his highly influential essay, “A Friedman doctrine—The Social Responsibility Of Business Is to Increase Its Profits.” Published by the New York Times on September 13, 1970, Friedman’s economic theory (also referred to as “the Friedman doctrine,” “shareholder primacy,” or “shareholder theory”) posited that public corporations do not have a social responsibility to pursue objectives outside of maximizing profits for shareholders:

“There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”

Friedman further argued that as agents of shareholders’ money, company executives should be prioritizing short-term shareholder interests (i.e., maximizing profits) over “general social interests” such as providing employment, fighting discrimination, avoiding pollution, or battling poverty. He believed that social responsibility should be left up to the government and to individuals, not corporations.

Friedman’s doctrine was widely embraced by corporate America from the 1980s through the mid-2000s, becoming a founding principle by which many companies operated (think Michael Douglas’ “Greed is Good” speech in the 1987 film Wall Street). But during the 2000s, a succession of financial and social crises put the Friedman doctrine under the microscope. The 2008 stock market crash and ensuing Great Recession coupled with several large-scale fraudulent schemes coming to light around the same time (Enron, WorldCom, Bernie Madoff, etc.), made the business world start to rethink the consequences of embracing a system that catered to shareholders at the expense of other constituents. Instead, many in the corporate world began to lean towards “stakeholder theory.” Stakeholder theory sees companies as having responsibility not just to shareholders, but to all stakeholders—including employees, customers, vendors, suppliers, and local communities.

In 2020, on the 50th anniversary of Friedman’s essay, the New York Times published 22 responses to Friedman’s doctrine penned by leading economists, CEOs, and Nobel laureates. Overwhelmingly, the takes were anti-Friedman, with most authors advocating for some form of stakeholder theory, citing the general destructiveness of shareholder theory.

There is, however, a question of law and fiduciary duty that may be involved in this debate. In his written response to Friedman’s essay, Daniel S. Loeb (CEO of Third Point) said:

“Friedman’s timeless essay resonates today as corporate America embraces ‘stakeholder capitalism,’ a popular concept that is inconsistent with the law. Stakeholder capitalism distorts the incentive that prompts investors to risk their capital: the promise of a profit on their investment. So, I share Friedman’s concern that a movement toward prioritizing ill-defined ‘stakeholders’ might allow some executives to pursue personal agendas… Fortunately, in the United States we operate in a codified system of law and governance that enshrines our rights as owners to challenge or replace boards whose members stray from their fiduciary duty to prevent the sort of mission creep that Friedman describes.”

Loeb makes the argument that Friedman was warning against a scenario in which company executives flout shareholder best interests in order to follow personal agendas, regardless of how charitable or worthy those agendas might seem. And it’s a fair point to bring up. If a company has responsibilities to stakeholders beyond its shareholders, can this misalign incentives and ultimately lead to a breach of fiduciary duty? Will there inevitably be a conflict of interests? Must companies choose between either satisfying shareholders or implementing responsible ESG practices?

There are two main points to consider when answering these questions:

1) ESG initiatives have been empirically shown to be economically beneficial and to drive higher returns over time.

A recent meta-analysis conducted by the NYU Stern Center for Sustainable Business and Rockefeller Asset Management looked at over 1,000 studies conducted between 2015 and 2020 that examined the relationship between ESG and corporate financial performance. The meta-analysis found that 58% of the studies found a positive relationship between the two, where firms implementing ESG strategies saw better financial returns through mediating factors such as innovation, operational efficiency, risk management, stakeholder relations, and firm reputation.

There also needs to be a distinction between short-termism and long-termism in regard to ESG and profitability. The study points out that “improved financial performance due to ESG becomes more marked over longer time horizons.” So it’s quite possible that an ESG-driven decision that a company makes today could be less profitable for a shareholder in the short-term, but may pay off in the long run. For example, perhaps a change to using more sustainable materials and processes will slightly reduce company profits in the short-term but will save the company substantial amounts in operating costs over the next several decades. Perhaps enhanced employee benefits may cost a company more money at the outset but will lead to greater employee retention and the ability to attract top-tier talent.

ESG policies can be working in shareholders’ best interests and be implemented with the goal of maximizing profit—it just may be over a longer time horizon and in a way that’s not immediately quantifiable. Someday, ESG considerations may even become essential to company profitability.

2) One cannot assume that shareholders simply want the most money possible and don’t care about other factors.

The events of the past two years have caused many people to take a step back and reevaluate their priorities. A global health crisis, various social justice movements, and a litany of natural disasters have changed the things people care about and have put a spotlight on the need for ESG-related policies. People are valuing different things now than they did even a few years ago, not to mention 50 years ago when Friedman wrote his paper. In 1970, climate change wasn’t nearly as accelerated as it is now, corporations didn’t yet wield the political influence they do today, and many marginalized groups were still fighting for basic safety and civil rights.

Simply too much has changed socially, politically, and marketwise to blanketly assume that shareholders want the highest returns possible and care nothing about whether the company operates responsibly. In fact, 2021 saw several instances in which shareholders took on an activist role and used their voting power to steer companies towards certain ESG goals, such as a reduced carbon footprint and greater diversity.

In another written response to Friedman’s essay, Oliver Hart (Nobel Prize winner and professor of economics at Harvard University) perhaps said it best:

“Instead of assuming that shareholders always want more money, companies should ask them if they are willing to sacrifice some profit in exchange for the pursuit of environmental and social goals.”

While companies should certainly not eschew shareholder interests for the “greater good,” they should put effort towards figuring out how they can align the goals and incentives of shareholders with those of other stakeholders.