What is stakeholder theory and what does it mean for capital markets and investments?

Welcome to Finance and Fury. What is stakeholder theory and what does it mean for capital markets and investments? World Economic Forum annual agenda occurred a few weeks ago. One year ago, the World Economic Forum launched a new ‘Davos Manifesto’ in support of stakeholder capitalism – this year – stakeholder capitalism, or stakeholder theory was at the forefront of many of the agenda’s

What is stakeholder theory – like many things, the definition has changed over time –

1. Originally – Stakeholder Theory is a concept from R. Edward Freeman (American Philosopher and Professor) when he introduced it in 1984 – it was a theory of organisational management and business ethics – aimed to address morals and values in managing an organisation – The theory argues that a firm should create value for all stakeholders, not just shareholders
   1. Since the 1980s – there has been a massive rise in the theory – as well as an expansion on what is defined within the term value and who is considered a stakeholder
   2. From R. Edward Freeman – “The 21st Century is one of “Managing for Stakeholders.” The task of executives is to create as much value as possible for stakeholders without resorting to tradeoffs. Great companies endure because they manage to get stakeholder interests aligned in the same direction.”
   3. The issue with this is the concept of providing value without resorting to tradeoffs – is this actually possible? Individuals and companies have to make decisions every day – with every decision there is an opportunity cost – and likely a tradeoff
2. Today – Stakeholder theory is closer to a version of corporate social justice – or in other words, the concept of equity in the world and a merging of company’s responsibility for communities (who are technically non-stake holders)
   1. To explain this further – Equity (in the non-financial sense) is about outcomes – the fairness of an outcome – is not equality of opportunity – but equality of outcomes
   2. unlike equality of opportunity – equity actually requires the different treatment of individuals and different distribution of resources to get to an equitable outcome – if you have $10,000 in shares but your friend doesn’t, that isn’t equitable, you should technically both have $5,000 – if you earn $100,000 but your neighbour only earns $50,000 – that isn’t equitable
   3. This is one of the big changes in stakeholder theory – that is the growing support in calls for equity –
      1. Under this theory business firms should entertain all kinds of noneconomic goals and outcomes. No longer may owners simply concern themselves with profit or loss, but instead must consider the broader societal implications of everything their business does.
      2. Social media has really helped to accelerate this – when looking at the online presence of massive companies – it is all about cultivating an image of social responsibility – PR teams working around the clock to support any cause that is in vogue –

• Whether corporate leaders concern themselves with social justice out of genuine desire or merely to avoid backlash is an open question – to find an answer it helps to look at what a company does versus what picture they have on

3. Under the original conception of stakeholder theory – businesses have four primary elements when it comes to stakeholders – namely owners, managers, employees (or suppliers), and customers
   1. All four have skin in the game – they either have invested money in the company, are employed by the company, require the company to buy their goods/services or in turn, buy this companies goods and services – at every stage each of these elements has their own money or income is involved in the decision-making process –
   2. Each of these individuals are making tradeoffs – making decisions based around what they believe will provide them the greatest value
      1. Owners/Investors – tradeoff in that they could have invested money elsewhere – but do so as they see value in investing in the company
      2. Managers/employees – trading their time/effort for an income – the income needs to provide a value – i.e. enough to compensate for time

• Customers – have to see a value in what they are buying to exchange money

1. Value itself – think about the value that a company can provide – even a small one – provides wealth to the owners – but based on the value it can provide to the other key stake holders

4. Today – stakeholder theory argues that there are other parties involved, including governmental bodies, political groups, trade unions, communities, financiers, suppliers, employees, and customers – extension to include governmental bodies, political groups, trade associations and unions and communities – which means every person on earth
   1. WEF agenda this year: “It is also a system where companies, government, civil society and international organizations are recognized as equal partners, and where they all pursue a common goal: the well-being of people and the planet. It would prevent economic inequality to get out of hand in the way that it did.”
   2. The difference is that those who are not stakeholders – or have no skin the in game now have power over companies’ business practices
   3. This notion of stakeholders actually inverts the original concept – grants a new degree of power over private businesses to those who take no risks and provide no benefit – no trade offs and provide no value
   4. Going back to value – if someone who has no skin in the game starts to determine company decisions – is this good for the value that this company provides? To employees, who require a company turn a profit to remain employed, to shareholders, who require a company to perform well long term, also generating profits to make money?
5. To suggest that the general public or society at large ought to be a de factopartner in any business, based on the interconnected nature of any economy, actually starts to undermine the very concept of private ownership – which is the bedrock of any functional economy
   1. This new wave of stakeholder capitalism starts to imply collectivism as insists everyone in society has the right to an interest in what companies do – and not only with respect to their profits, but even their business practices and mission
   2. remember, this concept is being pushed from the same organisation that produces works that state: “Welcome to the year 2030. I Own Nothing, Have No Privacy And Life Has Never Been Better. Welcome to my city – or should I say, “our city”. I don’t own anything. I don’t own a car. I don’t own a house. I don’t own any appliances or any clothes. It might seem odd to you, but it makes perfect sense for us in this city. Everything you considered a product, has now become a service.”
6. If this is sounding slightly familiar – Societal ownership of business firms have traditionally taken a few prominent forms – socialism and communism
   1. Similar to R. Edward Freeman, another philosopher came up with an economic theory on value and tradeoffs in Das Kapital in 1867 – over the years it morphed and changed and then with its implementation – about 40-50 years later once it had gained traction in society – we know how well that turned out for the economies that implemented it
   2. Socialism is increasingly popular – using the terms of equity and stakeholders seems to be blurring the distinction between private companies, property ownership and state (governments) – this is the merging of economic means and the political means
   3. However – equity and stakeholder movements do not represent outright socialism or communism – there will still be a share market where we can purchase companies that still have profits and losses – but it is an evolution in the system – where the uneconomic decisions can be further made from non-stake holders – like Governmental organisations like the UN – which further distort the nature of a free market
7. Economic decisions require the concepts of trade-offs – however – there are some entities that seem to be unfamiliar with this concept
   1. Calls for stakeholder theory are coming from Government entities – like the UN and EU – Government entities aren’t known for economic trade-offs – lack of consequences when compared to a free market – when it isn’t your money or you have no skin in the game – i.e. your decisions don’t affect your outcome, just that of others – UN is pushing stakeholder theory as part of the great reset
   2. The European Commission (executive branch of the European Union, responsible for proposing legislation, implementing decisions) recently released a sustainable corporate governance report claiming to find a problem with publicly listed companies due to the investor-driven behaviours of these companies – they are proposing that power be shifted in EU-listed firms to other stakeholders – so stakeholder theory isn’t just some fringe thought anymore
      1. Harvard Business review went through this and found that the EUs reports were deeply flawed. And its proposed policies would actually reduce businesses sustainability in the EU
      2. What the EU claims is that there is a rising level in gross shareholder payouts, dividends and repurchases and declining levels of investment – in other words, firms are increasingly showering cash on shareholders, stripping the company of assets that could be used for long-term value creation – investment in green projects

• Without going through all the numbers – this report relied on a cherry-picked sample of public firms. An analysis of all EU-listed firms reveals that both capital expenditures (CAPEX) and research and development (R&D) increased during the period covered by the report

1. However – The EU report implies that investment might be higher had shareholder payouts been lower. But cash balances grew by nearly 40% over the last decade, from €712 to €973 billion
   1. This could actually suggest that investments by EU public firms is limited by the lack of additional opportunity, not by a lack of available cash
   2. With board decisions – profits have two primary purposes – to be retained – for R&D and other CAPEX, or to be paid out to shareholders – the decision on how much should be paid out comes back to the expect rate of return (IRR) of a project versus the benefit to shareholders – i.e. if a company invests $1bn that may boost share price by 3%, versus paying out shareholders where this payout represents a return of 4%, better to go with the 4%
2. Not only does the report fail to show that EU businesses are misgoverned, it also makes proposals that would actually put these businesses at risk
   1. As part of the stakeholder theme – the report recommends an EU-wide reformulation of directors’ duties to include a broad and ill-defined range of considerations – i.e. representing the interests of the “global environment” and “society at large.” These duties would be enforced by non-investor stakeholders bringing suits in court.
   2. The effect of implementing such proposals would be corporate destruction – any board decision could be legally challenged by some entity with no skin in the game claiming a violation of directors’ almost boundary-less duties – board members and directors will freeze any decision making without having consent from entities like the EU or the courts that they would need to defend themselves through – bad PR can destroy profits as well a legal payout – however – I believe the report makes the directors personally
   3. Ask yourself – How will these firms compete with Chinese firms? Conducting business through an EU-listed firm will simply no longer be sustainable. Firms will go private, or seek to avoid these rules by domiciling and listing elsewhere – Decreases the investment opportunities for us, as more and more companies will de-list
   4. The primary reason of being a listed company – i.e. to raise capital – would be gone, why would investors make the decision, or trade off to invest their funds in a company with an EU mandated fiduciary duty – that requires them to only deploy funds to benefit the global environment or society at large
      1. Remember – the definitions of what this benefit or value is would be defined by governments – we tend to have different definitions on what is valuable of us – which is why choice in a free market is important
   5. In addition – returns could decline – could force directors to cut back on dividends and invest more internally – even if this isn’t the best investment decision and the money is mis-spent – just to avoid being called a short-term focused director
3. In Summary – stakeholder theory means that companies would have a duty to make uneconomic decisions as opposed to trying to maximise value to those who are real stakeholders – or those with skin in the game
   1. Under stakeholder theory – broader societal interests, not real value to shareholders, employees or customers must be considered – these societal interests can be real or imagined based around public perception – leading to further uneconomic consequences
   2. So, companies would need to invest in supposedly green but inevitably less efficient technology or others causes that have the most current attention, which may not be the optimal economic decision – These actions may in fact provide long-term benefits from a positive public image to a company, but they do not directly increase share prices or dividends
   3. It also undermines the purpose of capital markets – raising capital as well as price discovery
      1. Markers help investors and businesses to allocate capital to its best and highest uses – however this is imperfect and has hazards – which do get criticised – but if you get in the ring, you might get punched
      2. But if a company does not wish to subject itself to director mandates for stakeholder value or public campaigns – they will start to take themselves private

• Markets and companies as they stand are imperfect because humans are imperfect – there is no perfect system to get the perfect outcomes – But the alternative is nothing less than creeping socialism by another name
  1. The ideal economy of the EU/UN is outlined in their SDGs – Does increase the equitable nature of the mega-corporations – where you have a handful of companies that provides the world their needs – one specialises in each sector of the market – to a point they can force equity and not have to listen to the real stakeholders anymore – but the non-stake holders
  2. This in turn, then reduces the outcomes to the individuals that make up the real economy – companies making non-economic decisions – hurts economic output at optimal levels –

1. All companies are not built alike – I am critical of mega-companies – those that act in anti-competitive behaviours – but I have the feeling that these companies will do just fine under any stakeholder theory – it would be smaller companies and those people working for them, or using their goods that suffer
2. I’m not saying that companies should destroy the environment and shouldn’t care about their contribution to society – most companies indirectly do benefit society and us in our day to day lives – they provide value to us in goods and services, they employ people, they can make people wealthy through investments – you simply need to participate to reap the rewards

9. But to completely revamp the concept of companies could lead to a much worse economic outcome for us – but not the people pushing this

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