Constraining the Corporation

A well-functioning market in which businesses fulfill their obligations to workers, families, communities, and the nation depends upon legal, economic, and social constraints that have fallen away in recent decades.

I once committed the faux pas, at a gathering for business executives to discuss workforce investment, of proposing legislation that would require them to invest more in their workforces. “This group should not be in the business of changing the behavior of our businesses,” retorted an indignant participant unironically. The many comments preceding mine had suggested new public programs, partnerships, and tax credits that might reward employers for changing their behavior. Those were welcome. The prospect of a constraint was heresy.

Constraints are precisely what businesses need. They can come in many forms. Some are legal—requirements for what a firm must do and prohibitions on what it must not. Some are economic—the result of competitive pressures and the demands made by counterparties with whom the firm transacts. Some are social—shaping the business leader’s understanding of his obligations and promising censure for falling short. A well-functioning market system depends on all of these mechanisms to ensure that the private sector delivers on capitalism’s incredible capacity to support a flourishing nation. Corporate responsibility entails accepting—indeed, supporting—such constraints and acting within them.

This contrasts starkly with the new-age dogma of “Corporate Social Responsibility” (CSR), which is built on the premise that constraints are unnecessary because firms will voluntarily advance the common good. CSR reached its apogee one year ago in the Business Roundtable’s lauded and nonsensical announcement that it was “redefin[ing] the purpose of a corporation” with a commitment from nearly 200 CEOs “to lead their companies for the benefit of all stakeholders.” Trust us, we can behave ourselves, say the slickly produced marketing brochures and web videos touting enthusiasm for “sustainability,” “diversity,” and now “equity and justice.”

Read between the lines and the glossy façade whispers precisely the opposite—that modern multinational corporations have become unmoored from their social purpose and incapable of delivering on it. Their leaders have lost contact with the communities and institutions that might hold them accountable, escaped from the oversight and regulation that would channel their activities, and proven themselves shameless in the face of whatever weak standards of decency the culture still attempts to muster. Their “responsibility” campaigns are the indulgences they pay to maintain this status quo, calibrated to deliver the maximum political return on the minimum investment.

Business leaders have lost contact with the communities and institutions that might hold them accountable, escaped from the oversight and regulation that would channel their activities, and proven themselves shameless in the face of whatever weak standards of decency the culture still attempts to muster.

A return of corporate actual responsibility is a prerequisite for restoring America’s economic engine to a condition that generates broadly shared growth and prosperity. It will require a concerted effort to re-establish rules, norms, institutions, and transparency that once bound business leaders and their firms in relationships of mutual obligation to workers, their families and communities, and the nation they all call home.

The Virtues of Virtue

The preliminary question, of course, is whether considerations beyond profit should matter. Two different arguments against corporate obligation and in favor of so-called “shareholder primacy” require analysis. One, the principled argument, holds that corporate managers must act only in pursuit of profit, as that is the task handed to them by the owners for whom they work. The other, the practical argument, holds that we should want corporate managers to behave this way because it will deliver the best economic outcomes. Neither is correct.

The principled argument appears most famously in Milton Friedman’s seminal New York Times essay, “The Social Responsibility of Business Is To Increase Its Profits,” which celebrates its fiftieth anniversary this summer as the Business Roundtable’s collection of platitudes reaches its first. Friedman argued that a corporate executive has responsibility to “conduct the business in accordance with [ownership’s] desires, which generally will be to make as much money as possible while conforming to the basic rules of the society.” Talk of other responsibilities, he wrote, is “preaching pure and unadulterated socialism.” Washington Post columnist Megan McArdle provides a contemporary illustration of this mindset, suggesting that consideration of anything beyond the bottom line means “asking CEOs to appropriate the necessary resources from anyone unlucky enough to own their company’s stock.”

Friedman and McArdle are wrong to assume that the desire of shareholders is “to make as much money as possible” and to characterize any other action as “appropriat[ion].” A CEO who chooses to pay entry-level employees $15 per hour when he could get away with $10 has appropriated no one’s resources. He has made an executive decision as he has been delegated to make, and shareholders will receive the resulting profit, as they are entitled to receive. Shareholders dissatisfied with the resulting profit can sell their shares, or attempt to elect directors who will replace management.

Will shareholders do that? Perhaps. But the default assumption that owners wish their firms to be operated in whatever cutthroat manner will yield the highest return is a questionable one. Sole proprietors and closely-held firms often operate in ways considerate of their workers, communities, and customers that are far from profit-maximizing. The difficulty in discerning the preferences of the anonymous and dispersed owners of a public company is not an argument for making profit maximization the default. And if their anonymity and dispersion make them unlikely to care about anything else, then perhaps the wisdom of that control structure requires revisiting.

The competitive “market for corporate control” can also seem to make an exclusive focus on profit inevitable. Private equity shops and activist hedge funds specialize in grabbing hold of a firm whose management is not maximizing profit and then squeezing, the mere threat of which forces managers who wish to retain their own positions to squeeze preemptively. But if that is the case, perhaps those investment models need more scrutiny and constraint themselves. Let such “capitalists” squeeze their own customers and workers in businesses that they start in their own communities with their own names emblazoned on the doors.

Recognizing Friedman’s principled argument as merely one choice of default, and one that could be altered with reforms to corporate governance or constraints on the modern buyout frenzy, shifts attention to the practical argument. Received wisdom in the business community and among self-declared guardians of the “free market” holds that maximizing profit maximizes growth and prosperity, and so the fewer constraints on that pursuit the better. “Our economy works because corporations focus on generating profits,” says Andy Puzder, a former fast-food CEO and President Trump’s initial nominee for Secretary of Labor. “If you impose non-economic obligations on corporations and thereby reduce their focus on profit, you reduce the incentive to invest and the capital available for dynamic growth. What that means for the broader community is fewer jobs, poorer paying jobs, reduced innovation, fewer products for consumers and reduced prosperity.” Harvard Law School professor Jesse Fried warns that with priorities beyond profit in focus, “excess capital would be trapped. … Resources would be misinvested. … The economy would suffer.”

But one man’s trapped excess capital is another’s long-term investment, and whether it redounds to the benefit of a nation’s economy and workers is a very different question from whether it maximizes shareholder return. In the century before Friedman’s polemic against “social responsibility” as “unadulterated socialism,” the unprecedented innovation and dynamism of the American economy operated quite effectively within legal, economic, and social constraints far stronger than today’s. Indeed, a focus on building strong, resilient, and far-sighted organizations rather than generating immediate returns was vital to the nation’s economic success.

In his report on the decline of domestic business investment, Senator Marco Rubio quotes the business historian Alfred Chandler Jr. describing the mindset in the great American corporations of the early 20th century:

…organizational capabilities, of course, had to be created, and once established, they had to be maintained. Their maintenance was as great a challenge as their creation, for facilities depreciate and skills atrophy. … Because of these capabilities the basic goal of the modern industrial enterprise became long-term profits based on long-term growth—growth that increased the productivity, and so the competitive power, that drove the expansion of industrial capitalism.

Firms reinvested the majority of profits and paid workers a wage that ensured they could support their families.

It was in the context of shareholders asserting their primacy and heightening the focus on their own returns, not the context of limited global markets and strong organized labor and heavy sectoral regulation, that investment plunged, growth slowed, wages and productivity stagnated, and inequality surged. “On the face of it, shareholder value is the dumbest idea in the world,” says former GE CEO Jack Welch, once the very embodiment of that idea. “Shareholder value is a result, not a strategy. . . . Your main constituencies are your employees, your customers and your products.”

The dysfunction of our modern economy is likely what Adam Smith would have predicted. Free-market fundamentalists quote fondly his argument in The Wealth of Nations that, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.” But Smith had more than that to say about self-interest and economic motives. As he observed earlier, in The Theory of Moral Sentiments, nature had endowed mankind:

not only with a desire of being approved of, but with a desire of being what ought to be approved of; or of being what he himself approves of in other men. The first desire could only have made him wish to appear to be fit for society. The second was necessary in order to render him anxious to be really fit.

While Smith’s vision of the well-functioning market entailed butchers, brewers, and bakers acting out of self-interest rather than benevolence, implicit was an assumption that self-interest included both the profit motive and the desire not only to appear, but also to be virtuous. Anything less, and they would not be really fit for society. Friedman’s version of the free market turns this thinking on its head, defining responsibility solely in terms of shareholder returns and thus denouncing virtue as selfish—McArdle suggests the virtue of paying a living wage might border on theft. Smith never endorsed, nor would he even recognize, such an economic model. Perhaps Smith misjudged the human character. Or perhaps the legal, economic, and social pressures that once supported business leaders in their virtue have given way to ones that discourage or outright prohibit it. Either way, faced with an unvirtuous marketplace, Smith would surely be among those demanding constraints.

The Corporation Unbound

 What changed? Businessmen did not suddenly become more greedy or unscrupulous; to the contrary, many of the worst labor abuses, most dangerous working conditions, and tawdriest scams can be found in an earlier time. Friedman’s influence was unquestionably immense, but New York Times essays do not themselves reshape the economy’s contours. It took until 1997 for the Business Roundtable to revise its own view from “the shareholder must receive a good return but the legitimate concerns of other constituencies also must have the appropriate attention” to “the paramount duty of management and of boards of directors is to the corporation’s stockholders.”

The real change was not the rising of some conceptual tide but the tsunami of broader political, economic, and social trends that swept away the constraints within which businessmen operated. Friedman opined blithely on the elegant simplicity of managers delivering profits to their shareholders in a 1970s context that took for granted the presence of so many other institutions and rules that channeled the profit motive productively. One might fairly wonder whether he would write the same essay with the same confidence today—would he so eagerly cheer on the National Basketball Association kowtowing to the Chinese Communist Party or Disney forcing employees to train their own replacements brought into the country on H1-B visas?

One such trend, as those examples suggest, has been globalization. In 1970, imports and exports totaled 11 percent of GDP and the nation ran a slight trade surplus; in 2019, they totaled 26 percent and yielded an enormous deficit. In 1970, foreign-born workers were less than 5 percent of the labor force; in 2019, they were more than 17 percent overall and more than 25 percent of those who had not attended college. Whereas firms once had no choice but to think and act locally—buying from, producing for, and hiring in the domestic (and typically regional) market—the greatest profit is now often associated with doing just the opposite.

Owners, for their part, have become not only diffuse and anonymous but also in many cases hidden behind layers of legal fiction. They are not accountable, or even known, to the communities in which their companies operate. They likely do not know, or care to know, how those companies operate.

A corollary is that workers find themselves far less able to exercise countervailing power. Americans compete in a labor market that now includes hundreds of millions of foreign workers in laxer regulatory environments and with lower reservation wages and costs of living. Meanwhile, unionization has declined precipitously and the rise of the “fissured” workplace means jobs are more likely to be temporary, on-call, and freelance. From 2005 to 2015, such jobs accounted for nearly the entire net increase in employment nationwide.

Another corollary of globalization is that managers and owners have less connection and accountability to their communities or their nation. The American model of meritocracy extracts talented young people from around the country, concentrates them in elite universities, and then launches them into professional careers in select economic hubs. For each of the past five years, the majority of Harvard Business School graduates have proceeded to careers in the same three cities: Boston, New York, and San Francisco. Perched thusly, professionals tend to identify and affiliate most closely with their fellow placeless knowledge workers and with peers in similar hub cities around the world, rather than with either their newfound homes or their erstwhile hometowns. Places that are not talent destinations, meanwhile, find themselves without the leaders and locally owned businesses that traditionally played a cornerstone role.

Owners, for their part, have become not only diffuse and anonymous but also in many cases hidden behind layers of legal fiction. As discussed above, the owners of a widely-held, publicly-traded firm are difficult to identify and their preferences impossible to discern. They are not accountable, or even known, to the communities in which their companies operate. They likely do not know, or care to know, how those companies operate. In recent decades that relationship has become further attenuated, as financialization has rendered ownership not only diffuse but also opaque and abstract. The operating company may now be part of a holding company whose shares sit with mutual funds and in exchange-traded index funds on behalf of pension plans and endowments, at least until a private-equity fund itself acting on behalf of institutional investors forms a shell corporation through which to take control with debt issued by a different private-equity fund.

All of these actors now operate in a radically less constrained competitive landscape, reshaped as policymakers gave priority to market “efficiency,” deregulating the economy sector by sector and imposing constraints only for purposes of correcting “externalities.” On one hand, this led to new regulation—the Environmental Protection Agency did not exist when Friedman wrote. But on the other, in 1970, bank holding companies could not acquire banks across state lines and most states limited branching even within their own borders. The Civil Aeronautics Board awarded flight routes to airlines and set ticket prices. Federal antitrust doctrine still considered the concerns of small business and “a mix of economic, social, and political goals,” rather than merely “consumer welfare.” Each of these changes may well have been salutary, but taken together (and with countless others) they transformed the economy from a zoo of caged habitats to a veritable savannah.

With fewer constraints did come massively increased profits. Wages stagnated, but U.S. corporate profits rose by 145% from 1978 to 2015 after adjusting for both population growth and inflation. CEO pay at the 350 largest American firms went from 30 times the median worker’s salary to 286 times.

For the capital class, things were going almost too well. A democratic society will tolerate such trends only so long before a backlash occurs; how to keep the gravy train running? Enter Corporate Social Responsibility. The term originated in the 1950s but surged into prominence in the late 1990s, just as the Business Roundtable was renouncing its obligations to anyone besides shareholders. “The perceived importance of corporate environmental, social, and governance programs has soared in recent years,” reported McKinsey & Company in 2009, “as executives, investors, and regulators have grown increasingly aware that such programs can mitigate corporate crises and build reputations.”

The central fact of CSR is that it is a sham. It constitutes “responsibility” only in the way that a child who never cleans up his room exhibits “responsibility” by tidying in exchange for an ice cream cone. Both corporate leaders and outside consultants understand and are surprisingly candid that CSR is intended not to constrain or cost firms at all, but rather to pursue profit more effectively, in part by earning the public-relations benefits of appearing socially responsible. McKinsey, for instance, notes that the “best” programs “create financial value in ways the market already assesses—growth, return on capital, risk management, and quality of management. Programs that don’t create value in one of these ways should be reexamined.”

The Business Roundtable’s 2019 statement provides a case in point. Declaring “a fundamental commitment to all of our stakeholders,” the statement carefully avoids making any firm commitments to anyone. The quote leading the press release from JPMorgan Chase & Co. CEO Jamie Dimon, then the Roundtable’s chairman, declared: “Major employers are investing in their workers and communities because they know it is the only way to be successful over the long term. These modernized principles reflect the business community’s unwavering commitment to continue to push for an economy that serves all Americans.” In other words, businesses do things in their own interest, and will “push” no one in particular for nothing in particular. Unsurprisingly, the main result appears to have been a more concerted effort to brand and promote existing projects, combined with frequent announcements about “diversity” and “sustainability”—areas already governed by extensive regulation and tailormade for marketing campaigns that contribute directly to the bottom line.

More recently, these themes have given way to what is called “woke capital,” the direct engagement of the corporate sector in progressive political causes, seemingly to placate and distract progressive critics who might otherwise demand economic reform. In the New York Times, Ross Douthat observed:

Corporate activism on social issues isn’t in tension with corporate self-interest on tax policy and corporate stinginess in paychecks. Rather, the activism increasingly exists to protect the self-interest and the stinginess — to justify the ways of C.E.O.s to cultural power brokers, so that those same power brokers will leave them alone (and forgive their support for Trump’s economic agenda) in realms that matter more to the corporate bottom line.

Just as CSR is notable for the naked admission of its practitioners that the goal remains unconstrained profit maximization, woke capital is admirably upfront about its cynicism. Apple and the NBA, for instance, remains silent on human-rights abuses in Hong Kong and Xinjiang, but found intolerable North Carolina’s requirement that people use public bathrooms corresponding to their biological sex. “I think we deal with whatever set of circumstances are dealt to us,” said Commissioner Adam Silver when pressed on his principles. “I don’t have a cut-and-dried response to that. … It’s net incredibly positive for us to be [playing games in China]. It wasn’t a net positive to continue the track we were on and playing our All-Star Game this season in Charlotte.”

Corporate decisions on when to take a stand or demur are incomprehensible when viewed through the lens of principle. They make perfect sense if understood as profit maximization and, specifically, an effort to curry favor with the highest-value consumers and employees, who are presumed to be cultural elites with socially progressive priorities. Sometimes firms even say the quiet part out loud. Trendy companies like Zoom, Slack, Square, and BirchBox published a full-page ad in the New York Times warning that abortion restrictions are “bad for business.” Nearly 400 companies including McKinsey, Goldman Sachs, and Google submitted an amicus brief to the Supreme Court in Obergefell vs. Hodges asserting that “allowing same-sex­couples to marry improves employee morale and productivity.” They added, lest there be any confusion, “our corporate principles of diversity and inclusion are the right thing to do. Beyond that, however, such policies contribute to … significant returns for our shareholders and owners.”

Corporate Actual Responsibility

 The publicly-held multinational corporation, so alien to Adam Smith’s conception of the well-functioning market, has no moral intuition. Its owners do, but they are rendered powerless, anonymous, and unaccountable behind layers of abstraction and aggregation. The managers who make its decisions do, but the express premise of shareholder primacy is to disavow and override any broader sense of obligation. Happy statements of stakeholder obligation, subject to the stipulation that such obligation shall be fulfilled only insofar as doing so improves shareholder return, are not departures from shareholder primacy but convenient addenda; not real constraints but an effort to avoid any.

The constraints will have to be imposed from the outside, by policymakers in government and institutions of civil society. In some cases, old ones can be reimposed. In others, new ones will be needed. The first step is to establish the right focus.

Declaring everyone a stakeholder and everything a priority is a surefire recipe for avoiding meaningful action or accountability. The needed social functions for which firms are the indispensable contributors are creating good jobs for workers, maintaining a workplace compatible with family life, providing the economic foundation for strong communities, and advancing the long-term prosperity of the nation. These are where corporate actual responsibility should focus.

The softest form of constraint to reimpose is the social one—creating greater non-economic benefits for owners and managers who fulfill their obligations and raising the non-economic costs of failure. A good place to start would be within the nation’s educational and cultural institutions, which play a unique gatekeeping function in the conferral of social status. Wealthy businessmen have historically “laundered” their reputations by making large financial contributions in return for all manner of prestigious honors. Yet the institutions granting them these honors are typically non-profit organizations to whom shareholder primacy does not apply. Harvard University does not have to name its buildings after the highest bidders, nor do think tanks have to honor investment managers at their annual banquets. The leaders of these tax-exempt organizations do have explicit obligations to the society and could help to fulfill them by more thoughtfully distributing our cultural currency.

Voluntary disclosure and media scrutiny can also heighten reputational constraints through both social considerations of pride and shame and the economic effect on customers and employees. Straightforward metrics could provide all these “stakeholders,” and the wider community, with a clear understanding of who is living up to their obligations.

  • For workers, firms should offer good jobs—which at a minimum should provide for what the Good Jobs Institute defines as “basic needs”: pay and benefits that are fair for the work and meet a family’s basic needs; stable and predictable schedules that offer adequate hours; a career path offering clear and fair advancement to higher pay; and security in the job and safety on the job. Disclosures should report how well firms pay their employees, and how much upward mobility they afford. What share of employees have annual earnings below 200% of the federal poverty line for a family of four? What share of workers are still with the firm five years after being hired, and how much did their earnings grow from the first year to the fifth? [Case Study: QuikTrip]
  • For families, those key characteristics of a good job are also vital. Further, employers should offer jobs that provide for a manageable work-life balance, which requires both a predictable day-to-day schedule and the ability to have periods of time both in and out of the workforce. What share of employee hours are logged within a fixed schedule versus what share are subject to variable or on-call scheduling? For workers who leave the firm to fulfill care-giving responsibilities, what share are subsequently rehired? [Case Study: Mars, Inc.]
  • For communities, large firms with a nationwide presence and management often distant from places of operation should emphasize geographic diversity and strong attachments to their locations. How quickly is total payroll growing outside of the highest-income metro areas? And what share of just-graduated new hires come from local institutions, whether high schools, colleges, or training programs? To play constructive roles in their communities, firms should leverage their own assets and operations to address local needs, not just write checks. [Case Study: Gallery Furniture]
  • For the nation, multinational firms should re-invest profits in the research and facilities that will strengthen their long-term standing and they should do so here. What is the ratio of annual capital expenditures to shareholder distributions in the form of dividends and share buybacks? What is the ratio of total operating expenditures recorded domestically versus abroad? [Case Study: Intel]

If consumers want to buy only from firms certified “carbon-neutral” and job-seekers want to work only at firms that employ a particular percentage of women or minorities, they can do so. They should also know whether those firms actually treat their workers and communities well.

Workers are particularly well positioned to hold corporations accountable—their working conditions, their families, their communities, even their nation are what is at issue. But to impose economic pressure they must have countervailing power. This could mean formal unionization, but it need not. European-style “works councils,” for instance, create collaborative relationships between management and worker committees at the local facility level, which is what workers say they want. At broader scale, “sectoral bargaining” would allow representatives of labor and capital to establish broad ground-rules industry- or economy-wide. “Co-determination” places representatives of labor directly on corporate boards, short-circuiting the default assumptions of shareholder primacy by including workers among those to whom management is accountable.

Concerns that constraining the pursuit of profit will prevent an 'efficient' allocation of resources lose much of their force upon realization that they are entirely question-begging, starting from a definition of 'efficient' as the allocation that would occur absent constraint.

While social pressure could make progress in many of these cases, most would benefit from, if not depend upon, legal reform. Disclosures, for instance, can be mandated for public companies. New relationships with, and forms of, organized labor can be recognized. In other cases, legal reform is the only pathway. For instance, trade and immigration policies that constrain access to foreign labor or outright require domestic production have a way of focusing corporate attention. An education system that emphasizes on-the-job training could dragoon the corporate sector into a constructive role if participation were vital for gaining access to new talent. One easy adjustment would be prohibiting the requirement of a college degree in a job description. Another would be banning “non-compete” and “no-poach” agreements.

Finally, like Odysseus at the mast, corporate leaders could facilitate the process of constraint. Suppose they do acknowledge and wish to fulfill their obligations, but feel powerless in the face of economic and legal imperatives to maximize profit. A remedy is available: act together; not with empty “stakeholder” commitments, but with concrete pledges. Nothing stops the Business Roundtable’s members from agreeing to eliminate non-compete and no-poach agreements, or to partner in creating an apprenticeship system that pairs community-college coursework with on-the-job training. They could agree tomorrow to stop seeking handouts from states as a precondition of their investments, an unsavory practice that reached its nauseating nadir in Amazon’s “HQ2 competition.” Upon making pledges like these, keeping their word would immediately become rational. And with all likewise constrained, none would be at a competitive disadvantage.

An analogy suggested by David Rolf, longtime leader of SEIU 775 in Seattle, is instructive. While companies like Uber and Lyft resist bargaining with drivers at all costs, he notes, “one thing I’ve never seen Uber trying to do is get out of paying the tolls on the New Jersey Turnpike, because they have confidence that Lyft will pay the tolls, taxis will pay the tolls, limos will pay the tolls.” Pledges by America’s business leaders could achieve much the same—on disclosure, on labor, on CEO pay, and more.

How will the economy manage to thrive in the face of so many inconvenient obligations? Concerns that constraining the pursuit of profit will prevent an “efficient” allocation of resources lose much of their force upon realization that they are entirely question-begging, starting from a definition of “efficient” as the allocation that would occur absent constraint. That outcome is not necessarily a desirable one. The mystery is not how prosperity emerges when the interests of workers, families, communities, and the nation factor into business decisions alongside shareholder returns. It is how we ever thought the contrary.

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Oren Cass

Oren Cass is the executive director at American Compass.