The Stakeholder Theory Summary

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02/02/18 Business Law Reference this

Last modified: 02/02/18 Author: Law student

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The development and implications of the stakeholder theory

The primary debates of the stakeholder theory

The comparison between the shareholder primacy and stakeholder theories


2.1 The development and implications of the stakeholder theory

In the previous chapter, the shareholder primacy theory has been evaluated integrally, with the result that because the theory has serous moral and ethic issue, it is no longer popular. In this chapter, the stakeholder theory as an antithetical theory will be analysed effectively.

The stakeholder theory is another outcome produced by the battles between Berle and Dodd in 1930s. Dodd believed that directors are the trustees of corporations, with the result that they have to balance the interests of all constituents of companies and behave in a socially responsible behavior. [117] One of the most important developments of the theory is usually referred back to R. Edwards Freeman, who observed: “our current theories are inconsistent with both the quantity and kinds of change that are occurring in the business environment of 1980’s…A new conceptual framework is needed.” [118] The stakeholder theory was a response to this dare. Freeman also defined a stakeholder as “any group or individual who is affected by or can affect the achievement of an organization’s objectives.” [119] Although the definition of stakeholders is quite broad, there are five types of stakeholders that have been accepted widely, namely, shareholders, customers, employees, suppliers and the local community. [120]

Traditionally, the law has not given a voice to non-shareholder stakeholders in corporations. [121] For instance, in comparison with shareholders, these stakeholders do not have rights to trigger derivative actions against directors where they have breached their duties; also they do not have voting rights in companies. As a result of that, the stakeholders have little influence in corporation even they are affected by the downfalls of corporations. [122] Standing on the moral and ethic ground, the traditional attitude of stakeholders is unfair, because like shareholders, the stakeholders contribute to the success of corporations too, and that their interests, therefore, should be considered. Lastly, the traditional unfairness notion has been changed by the stakeholder theory as it addresses the perceived injustices. [123]

The stakeholder theory is a doctrine that ensures companies as organisations are accountable to their stakeholders, and balance divergent interests between stakeholders. [124] There are three aspects of the theory: 1) instrumental power, 2) descriptive accuracy and 3) normative validity. [125] The first aspect of the theory creates a framework for checking the connections between the practice of stakeholder management and the success of a corporation’s performance. The second aspect of the theory is used to describe particular corporations’ behaviors. The normative validity as a fundamental basis of the theory used to interpret the purpose of companies. Because the objective of corporation is key issue of corporate governances, the normative validity is the central core of the theory. [126] This section concentrates on an analysis between the instrumental and normative aspects, because they are the main fields to evaluate the arguments for and against the stakeholder theory, which will be discussed in a moment.

The stakeholder theory has a very tight connection with social responsibilities, which means that the corporations’ social value [127] is concerned and it focuses on promoting the utter potential of all participants. That is to say, the theory tries to keep the ethics and economics together, [128] and achieve a successful goal of corporations. To put it in another way, the companies should be run for the benefit of all stakeholders and directors are accountable to them. [129] This notion produces twofold meanings of the theory: first, corporations cannot use stakeholders to benefit themselves in the long run; instead, making profits for all stakeholders is the final objective of companies. [130] Second, as “mediators”, directors have to be answerable to stakeholders and balance the divergent interests of stakeholders. [131] In other words, directors must be diligent and allegiant to stakeholders and disclose every action that they have done and bring stakeholders into play with companies’ operations.

Moreover, the stakeholder theory has been accepted by the case law by allowing directors to decline shareholders’ interests in consideration of other stakeholders’ benefits. [132] It was recognised implicitly by courts that directors could serve parties other than shareholders. A good example is the case of Shlensky v Wrigley. [133] Because the directors of National League Ball Club, Inc. considered that night games would have serious influence on neighborhood, they rejected to install the lights at Wrigley Field stadium, thereby the stadium failed to hold any night game. The shareholders of the club sued the directors as their interests were harmed by that decision. However, the directors’ decision was upheld by the court, reasoning that directors have the discretion to give up shareholders’ benefits to advance other profits. This means that exclusion the shareholders’ interests, directors need to consider other parties’ benefit too.

2.2 The primary debates of the stakeholder theory

As clarified in the previous section that not only shareholders contribute to companies, but also stakeholders make contributions and affected by the operations of corporations. For these reasons, the stakeholder theory asserts that directors have responsibilities to both shareholders and non-shareholder stakeholders and run the companies for their benefits. [134] Some believes that because the shareholder primacy only concentrates on increasing shareholders’ interests, it harms non-shareholder stakeholders’ interests and against the moral and ethic standards. As a result of that, the corporate law has moved closer to stakeholder theory and the shareholder primacy has started losing lead power of governing corporate behavior. [135] Nonetheless, this does not mean that the stakeholder theory is a perfect theory. There are still plentiful of arguments for and against the theory. The main arguments, such as the fairness and trust as supporting points and uncertainty as adverse view, will be appraised shortly.

2.2.1 The arguments for the theory

The main arguments in favour of the stakeholder theory are that the theory is not only a single model to resolve the problem of identifying the proper objective of corporations, but also considers economics and ethics issues that make companies take social responsibilities, and to presents fairness to everyone involved in business, with the result that directors will run corporations for benefiting all stakeholders. Thus, the theory can be called a good combination between economy and ethic that enables the corporations to growth and promotes social wealth as a whole.

It has to be admitted that a company cannot withstand survival and prosperity if it only has shareholders’ capital contribution and does not have any input from other stakeholders such as employees, creditors, suppliers and customers, etc. Hence, it is necessary for companies to consider stakeholders’ interests as their investment affects the corporations’ performance and wealth directly. Because of that, the theory asserts that if the interests of stakeholders are concerned by directors, not only stakeholders’ value will be increased but also the social wealth will be enhanced ultimately. [136] This is a same conclusion given by the shareholder primacy, but reaching that final point through a different approach. Unlike the stakeholder theory, the shareholder primacy does not take non-shareholder stakeholders interests as a part of directors’ duties to operate the business, so the social wealth increase only replies on maximising shareholders’ interests. Nevertheless this notion is criticised that the shareholder primacy cannot enhance the social wealth, because this theory merely produces short-term earnings performance, [137] and discourages other stakeholders’ work incentives by ignoring their contributions to corporations. Consequently, it is argued that the stakeholder theory is a more reasonable and beneficial theory. [138] In other words, the stakeholder theory acknowledges that in order to assist corporations with succeeding in efficiency, fertility and challenge, stakeholders are recognised as chief instruments to make foregoing aims come true. [139]

Further, the theory states that a great social wealth will be produced as companies win the loyalty from their stakeholders. It is believed that the more attention paid to the interests of stakeholders, the more loyalty companies receive. The loyalty is key factor to companies to be competitive in an “economic jungle”. [140] Let us take the firm-special investment as an example to illustrate why the loyalty is important to corporations. If companies solely give attention to shareholders’ interests, other stakeholders will lose trust to directors and withdraw their loyalty. This means that employees who have specialised skill may stop working for corporations or suppliers who invest in tooling particular products for companies may halt co-operated relationship. As a result of that, corporations will gradually erode till they disappear. Conversely, if directors consider all relevant stakeholders’ benefit, the companies’ reputation will be enhanced and the more trust will be given by others. Besides that, extra reward will be paid by stakeholders. [141] Most likely employees will spend more energy working, creditors will charge less interests, suppliers will require less processing charge, and customers will maintain loyalty when companies are in difficulty times. All of this would not only benefit all stakeholders involved but also increasing the social wealth simultaneously. [142]

Finally, there are others advantages of the stakeholder theory. The theory presents a moral basis for respecting human rights and promoting efficiency. [143] Directors who communicate with stakeholders are encouraged to take care of the interests of stakeholders. In doing this, stakeholders give their trust and respect to directors, because their rights and interests are protected. Meanwhile, stakeholders will do their best to reward companies and work more efficiently. Moreover, the theory is consistent with the reality. In the real trade world, there are several factors (such as environmental issue and welfare policy) that need to be concerned other than maximising shareholders’ interests. The stakeholder theory intends to balance economics and ethics issues connected with corporations’ operations, so it can be said that the theory “takes in the complexity of the world.” [144]

2.2.2 The arguments against the theory

Because the stakeholder theory contains the balance between economics and ethics issues and produces several advantages mentioned above, it has spread rapidly in last two decades. Yet, it does not mean that the theory is faultless. Although the multiple objectives attract more and more people apply the theory, there are still numerous criticisms about the theory. This section concentrates on the estimate of main disadvantages of the theory, such as ambiguous features, the problem of balancing, the contract and/or regulation protection of stakeholders and the enforcement issue. Now, these cons will be analysed in this order. The theory contains ambiguous features

A. The difficulty of defining who stakeholders are

The stakeholder theory does not provide a solid normative foundation of indentifying who can be ascertained as a stakeholder of companies. [145] Because of that, the concept of stakeholders is various, which means that stakeholders may not only include human-beings but also non-persons. [146] Body Shop is a good example of broad concept of stakeholders. The company insists on producing cosmetics without experiment on animals, so the animals can be regarded as stakeholders, because they receive benefits from the company’ decision that is not hurting animals for the purpose of producing cosmetics. However, if this kind of explanations of stakeholders is accepted, the theory becomes useless and meaningless, as there will be unlimited groups can be defined as stakeholders, and no matter they have direct relationship to corporations or not that directors have to concern their interests fully to run business. That is to say, directors take irrelevant risks to manage corporation, and as a result of that, the relevant or “real” stakeholders will not be benefited. Moreover, in the absence of normative concept of stakeholders, some commentators have set up their own criterion of distinguishing stakeholders which even confuse directors more as they do not know which standard should be applied.

An additional problem is that the theory fails to guide directors to determine which group of stakeholders is more important than others. [147] Although “there is no easy way to delineate the stakeholder class.’, [148] it is very important to directors to understand the aforementioned issue, because it has compact causality in benefiting stakeholders as a whole. However, because there is no clear guidance under the theory, it is ambiguous to directors to make right judgment that identify which stakeholders are more important than others. Accordingly, a misunderstanding of foregoing matter may ruin companies’ business.

B. What should stakeholders expect?

It is easy to see that the expectation of shareholders from their companies is to get an abundant return on their investment. In contract, non-shareholders stakeholders’ expectations are not straightforward observed, because they contribute different things to companies. Nevertheless the theory fails to clarify this uncertainty as there is no provision of what stakeholders should expect. [149]

Actually, because of this ambiguity those stakeholders are treated unequally, which means that stakeholders will not receive the same amount of interests. For instance, if shareholders’ dividends increase by 30%, shareholders receive these interests directly. Yet, it does not mean that other stakeholders should expect to get the same percentage benefits. Hence, stakeholders are unequal as the stakeholder theory does not produce a guideline to such a dilemma.

In short, the stakeholder theory seems to be powerless, because it does neither provide a standard concept of stakeholders nor respond what stakeholders should expect that causes the issue of unequally between stakeholders. The problem of balancing the divergent interests of stakeholders

As expounded in the introduction of this chapter, the theory assigns a task to directors that is balancing the interests of all stakeholders when making decisions and operating companies. The reason of doing this is that there are divergent interests held by stakeholders. However, in fact this task is “a neverending task of balancing and integrating multiple relationships and multiple objectives.” [150] Therefore, the most significant exception of the theory is the problem of balancing. It has been demonstrated that the balancing is an impossible task to directors. [151] Moreover, there is another drawback links to this problem, so-called, “too many masters” problem: “a manager who is told to serve two masters (a little for the equity holders, a little for the community) has been freed of both and is answerable to neither.” [152] That is to say, the consideration of many interests is probably lead directors to engage in opportunistic behaviors and shirking, because directors are likely to be accountable to nobody but a vague group. [153]

Stakeholders are built up by a number of groups such as shareholders, creditors, employees, suppliers and others, and each group includes numerous persons. This means that directors have not only balanced the interests between different groups also they have to balance the interests within groups. Considering that “it is logically impossible to maximise in more than one dimension at the same time.” [154] , so balancing is quite hard to do so. It has been discussed in the shareholder primacy part that it is not easy for directors balancing the divergent interests between shareholders as there are different types of shareholders exist. Thus, balancing the benefits of all stakeholders will be harder as more groups and persons involved.

The material difficulties of balancing the conflict interests between stakeholders are: first, directors cannot ascertain who the stakeholders are. This causes that the balancing task fails at the start point, because directors do not know whose interests should be concerned. Second, directors are incapable to know stakeholders’ expectations. In other words, each stakeholder may have different definitions, standards and attitudes of benefits, [155] so it is impossible to directors to make a fair distribution for stakeholders.

Third, there is no guidance in the theory to inform directors that how to balance divergent groups. As a result of that, the balance made by directors, so-called, “standardless discretion” [156] decision may harm some stakeholders’ interests, because it is not possible to favour them all equally. Especially when the consideration of non-shareholder stakeholders’ interests conflicts shareholders’ interests, the decision will not advance the interests of non-shareholder stakeholders. [157] Also, the case law has proved that the theory has not set a principle which can clarify whose interests is more important than other’s and should be prevailed. The court stated that it is directors’ responsibility to judge whose interests is more important within stakeholders, and in making this judgment that directors have to use their professional knowledge. [158] This means that directors are freely making their own decision to balance the divergent interests of stakeholders, but this balance may not benefit any stakeholders as there is no direction made in the theory for monitoring directors’ behaviors. So it is said that “multiple objects is no object”. At length, like the shareholder primacy theory, the stakeholder theory fails to balance the interests held by a person who play double role in corporations either. [159]

As mentioned earlier, because there is no provision to guide directors how to balance the conflict interests of stakeholders, directors liberally do whatever they like. [160] Advocators of shareholder primacy suppose that lack of trust and the freedom are likely to end up with an opportunistic behavior and shrinking as there is no mechanism to monitor directors’ performance. Considering it is difficult to review their decisions, [161] directors can always benefit themselves by saying that after balancing interests of all stakeholders a decision is made to benefit some groups of stakeholders. Accordingly, directors’ self-interest actions harm stakeholders’ interests. In response, the adherents of stakeholder presents that stakeholders should trust directors, because as professional managers they are running business with their fame and honesty, which can prevent themselves from making self-interests.

To conclude, the problem of balancing divergent interests of stakeholders is a major shortcoming of the stakeholder theory, which might produce two serious results. First, because there are too many interests need to be considered at the same time, it confuses directors’ performance. Second, under the theory directors may easily gain self-interests as there is no provision to judge whether or not their activities are really working to increase stakeholders’ interests as a whole. It is unnecessary to consider non-shareholder stakeholders’ interests as they are protected by contract and/or regulation

It has been argued that the interests of non-shareholder stakeholders are protected by contracts and/or other legal regimes which are outside of corporate law, [162] so it is unnecessary to consider these stakeholders’ interests.

For the questions of contract protection, the adherents of the stakeholder theory respond that in fact the interests of non-shareholder stakeholders are not guaranteed to be protected, reasoning that because of the informational asymmetry, stakeholders are in a low position to sign the contract to companies and they do not have power to bargain. [163] Thus, their interests are not protected through the terms of the contracts. However, that is not to say stakeholders’ benefit are not protected by contract completely, in some circumstances such as banks which are powerful creditors of corporation, their interests are fully protected by the contract. Another argument against the protection is that if the contract is incomplete, these stakeholders are hardly protected. [164]

In addition, it has been suggested that there is no need to protect the benefits of non-shareholder stakeholders, because their protection in the wider law of business, [165] such as The Health and Safety at Work Act, which is a protection of employees . However, triggering this kind of protection involves a major cost and time factors as stakeholders have to inform relevant regulatory authorities or take civil activity themselves. [166] The enforcement issue

Although the stakeholder theory presents a good combination of economics, fairness, CSR, social wealth, and ethic, which is attractive, it still has a significant problem of enforcement. As discussed in previous paragraphs, the theory fails to guide the directors how to achieve the balance between stakeholders, so that corporations may be hurt by directors’ activities as there is no normative principle to regulate their behavior. Hence, this ambiguity causes a problem of the enforcement.

Another problem connects to enforcement is that stakeholders have no remedy which can be used when directors breach their duties. That is to say, stakeholders are not able to trigger any legal proceeding if directors are in the breach of duty that harms companies’ interests. According to trite law, only company itself is entitled to sue directors if they have breached their duties and hurt the company. In fact, it rarely happens that the company takes legal action to against its directors, because directors are the persons who have the power to decide whether the company should institute proceedings or not.

However, in some jurisdictions such as the UK, Canada, Australia, Singapore and New Zealand, shareholders are given derivative actions, [167] which can be applied to against anyone who harm corporations’ benefit. In other words, if the directors do not discharge their duties properly that damages the corporation, shareholders can institute derivative proceedings to obtain a judgment which favours the corporation. Nevertheless, that is not to say that all stakeholders will benefit from this kind of legal activities, because shareholders, who are only small proportion of stakeholders, are unwilling to decrease their interests to other groups as they are the people who spend money and time taking part in derivative proceedings. [168] In short, enforcement is one of main drawbacks of the stakeholder theory.

2.3 The comparison between the shareholder primacy and stakeholder theories

Having analysed the two prominent theories of corporate governance, the shareholder primacy and stakeholder theory, the comparison between them will be made in this section.

A. The similarities

The shareholder primacy and stakeholder theories are two outstanding theories of corporate objective, which have far-reaching of corporate governance and management. It is said that these two theories are the normative doctrines of CSR, because they dictate what a company’s role should be. In addition to this, they are also called the normative theories of business ethics as the directors should make decisions which are consistent with the right judgment. [169]

B. The differences

The assumption and presumption of shareholder primacy is that companies are private property, so directors should run business for increasing shareholders’ interests. Conversely, stakeholder theory assumes that companies are organizations or social institutions, thus directors should consider all stakeholders’ interests and “justice for all”. [170] Thus, the former emphasises the sole objective that is to maximise the interests of shareholders, and latter concentrates on balancing divergent interests between stakeholders and enhancing their benefits as a whole. It is believed that single objective not only promoting directors do a better job but also monitoring directors’ behaviors. The problem of the multiple objectives is that directors may take advantage in favour of their own interests as the mandate of directors is amorphous. In contrast, the shareholder primacy is more pragmatic than stakeholder theory, because it mitigates the directors engage in opportunism and shrinking activities. [171] However, from a business point view, it is asserted that one objective function makes the difficulties of corporate governance and man

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