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Ethics of shareholder referendums: corporate democracy or hypocrisy?

Evidence indicates that managers cannot be relied upon to make either economic decisions Lhat are in the best interests of shareholders (Jenson and Meckling (1976), and Jenson (1989)), or moral decisions that are in the best interests of society at large (see Walking et al. (1984), and Klein (1988)). In addition, even if one assumes that managers are able and willing to make moral decisions, thcy are not free to do so. They are constrained by a fiduciary responsibility to other stakeholders in the corporate milieu; in particular the corporate shareholders. A manager, therefore, is not a free moral agent when it comes to ethical decisions that may conflict with the economic objectives of the firm.

In recognition of the above problems, several corporation have turned to shareholder referenda as a means of making ethically charged decisions. In 1987, for example, the Kellogg, Union Carbide, and Variety Corporations all employed referenda in making the ethically charged decision of whether or not to divest themselves of subsidiaries in South Africa (Dobson (1991)). Interestingly, as a result of the respective referendum, each of these companies chose not to divest. This paper argues that shareholder referenda are not the optimal way of making such decisions. In essence, the argument builds from two premises.

First, the majority of contemporary corporate shareholders are like managers in that they are not free moral agents. Over fifty percent of the shares that comprise the Standard and Poors 500 (an index of the five hundred largest corporations in the U.S.) are owned by pension funds, and some seventy percent are owned by one or another type of institutional investor. For example the California Public Employees Retirement System, the largest institutional investor in the U.S., currently holds several billion dollars worth of corporate equity, and this amount grows daily (the fund takes in some $12 million per day in employer and employee contributions).

These institutional investors are themselves economic agents. They have a fiduciary responsibility to their subscribers, policyholders, or depositors. Thus in contemporary financial markets the representative shareholder is not an individual moral agent, but rather an intermediary in a complex web of contractual relations. This type of shareholder is no more at liberty to make ethical decisions than is management.

Second, consider a corporation that has shares outstanding, the majority of which are owned by individual investors rather than institutions. Would this corporation be justified in using referendums to solve ethical dilemmas? Or consider a referendum in which the votes are passed through the institutional investors to the individual subscribers, policyholders, or depositors. Would such a modified referendum solve the aforementioned problems? In neither of these hypothetical situations would a referendum be appropriate. Most individuals are not sufficiently versed in the nuances of moral reasoning. Even if they were, corporations are unlikely to be willing to make public all the information necessary for making such moral decisions. Also the time involved in conducting a referendum renders it infeasible in many situations.

If neither management nor shareholders are in a position provide a corporation with moral guidance, then who is? This paper argues that the responsibility for ethical guidance within a corporation should rest entirely with the board of directors. Corporations should be required, by law, to seat on their boards at least one individual who has no economic allegiance to either management or shareholders, and who in one way or another is a qualified ethicist. Such individuals will act as both monitor and mediator when conflicts arise between profits and ethics.

The Corporation as a Contractual Nexus

Within the last decade financial-economic theory has made a significant contribution to economic philosophy. Unfortunately, the broad implications of this contributions have, to date, gone largely unrecognized. This contribution relates to the theory of the firm. Traditionally the firm has been viewed by financial economists as an atomistic unit, a single unified decision node from which strategies emerge. In addition, theories of this atomistic firm have been conjured in the pristine environment of perfect and frictionless capital markets. Albeit mathematically convenient, models developed in such an environment have exhibited minimal explanatory power in realistic economic environments. As Chung and Smith (1987) note: "The firm, in that literature, is an abstraction stripped of such intangible assets as reputation and with no distinction made between the profit objective of investors and the utility maximization objective of agent managers" (p. 146).

More recently, however, financial economists have relaxed perfect-market assumptions to reveal the firm in a more realistic light. In this light the firm emerges, not as an atomistic unit, but "as a nexus for a set of contracting relations among individuals" (Jenson and Meckling, 1976). This contractual nexus' includes the overlapping interests, claims and objectives of several groups: suppliers and customers, employees and the community, management, shareholders and bondholders. As the growing body of agency theory demonstrates, these claims and objectives frequently conflict (see Fama et al., 1983).

The broader philosophical implication of these developments concerns the notion of a |corporate objective'. If, rather than being an atomistic unit, the firm is in fact an amalgamation of stakeholder groups, then clearly the idea of a corporate objective is something of a misnomer. Management may have one objective, shareholders another, and debtholders yet another; not to mention customers, employees, and suppliers.

One might argue that management represents the pivitol stakeholder group in-that it controls the immediate corporate milieu. Thus the term |corporate objective' is often taken as being synonomous with |management's objective'. The corporate contractual fabric is constructed in such a way that management is vested with the fiduciary responsibility of making economic decisions that affect all stakeholder groups. The challenge that all diversely held organizations face is to structure their contractual relations in such a way that one stakeholder does not feather its own nest at the expense of other stakeholders. Fama and Jensen (1983) note the existence of boards of directors as the stakeholder group that adjudicates these conflicts of interest. Evidence indicates, however, that this adjudication is not perfect. For example, Walker and Long (1984) find that, in defending their companies from hostile takeovers, managers tend to look after their own interests in preference to the interests of shareholders. Indeed Jensen (1989) argues that these conflicts of interest or agency problems have lead to the "Eclipse of the Public Corporation" (p. 1) in favor of privatization through leveraged buyouts.

The Manager as Moral Agent

This corporate contractual web may be seen as being made up of three fundamental and overlapping groups. Group |M' is management. It provides the decision-making function within the corporation; both day-to-day tactical decisions and long-term strategic investment and financing decisions. Group |R' comprises shareholders: the residual risk bearers. Shareholders provide the risk capital, yet they have no direct control over the tactical and strategic decisions of management. Management, therefore, has a fiduciary responsibility to make decisions that are in the best interests of shareholders.

Clearly there exists potential for conflicts of interest between groups |M' and |R'. These conflicts have been investigated at length in the agency theory literature of finance (see Jensen and Meckling, 1976). Within the corporate milieu, these conflicts are endogenously controlled by group |C': the board of directors. There is overlap: some directors are also managers and some are also shareholdcrs, and some are all three. But some directors arc neither managers nor shareholders; these are the |outside' directors. This eclectic board of directors is necessary in order to control conflicts with sufficient expertise. The inside directors provide expertise on the internal organization of the firm, while the outside directors, who ideally are aligned neither with management nor shareholders, ensure fairness and objectivity. As Fama and Jensen (1983) note;

"The outside board members act as arbiters in

disagreements among internal managers and carry

out tasks that involve serious agency problems

between internal managers and residual claimants,

for example, setting executive compensation or

searching for replacements for top managers" (p.


In essence, therefore, the corporation-as an amalgamation of groups |M', |R', and |C' - is a machine designed to derive the benefits of divisions of capital and labor while controlling the conflicts arising from self-interested agents. The corporation is thus an organism well designed for economic decision-making, but what about ethical decision-making? Specifically, what if management is faced with a decision in which economics and ethics appear to conflict?

Consider the following scenario. An oil company plans to build a petrochemical plant. Management is considering two possible locations, one in California, the other in China. Current anti-pollution laws in California will add considerably to the costs of building and running the plant. Conversely, the lack of similar regulations in China means that the plant can be built relatively cheaply and waste can simply be flushed into the nearby river. Thus, the project team's estimates indicate that firm value will be maximized if the plant is built in China. These cost estimates assume that, given location in China, the new plant will be equipped with merely the minimal toxic-waste handling facilities, in compliance with Chinese law.

Although the decision seems clear in economic terms, the project manager is uncomfortable. She feels that there is something |wrong' with locating in China in order to economically exploit lax anti-pollution regulations. She is unable to justify her concern on economic grounds. For example, there is no indication that environmental pressure groups will berate her company if it pollutes outside the U.S. and Europe. So the probability of future economic costs, engendered by consumer boycotts or other environmental-group actions, is negligible. She also is cognizant of her fiduciary responsibility to shareholders and other stakeholders within the corporation; her job is to maximize firm value. Her moral dilemma appears to leave her with three fundamental choices:

1) She can suppress her personal moral apprehensions,

honor her fiduciary responsibilities, and locate the

plant in China.

2) She can choose not to locate the plant in China,

thereby failing to maximize firm value, and breaching

her fiduciary responsibility to shareholders.

3) She can shift the perceived moral dilemma from

herself to shareholders by conducting a referendum.

Let shareholders vote on whether or not to locate the

plant in China in order to exploit (in an economic

sense) the lax environmental regulations.

The Referendum Solution

Of the three alternatives, the third might appear to be optimal from the project manager's point of view. A referendum enables her to maintain her moral integrity while not breaching her fiduciary responsibility to shareholders. A referendum could be justified on philosophical grounds as follows. It recognizes the diversity of moral sentiments among individuals. The corporation becomes a democracy in which the moral majority of residual claimants holds sway.

In reality, this notion of corporate-moral democracy is gaining popularity. Moral issues are becoming more frequent as topics for debate and ballot during during American corporations' annual-general-meetings (AGMs). The Investor Responsibility Research Center (IRRC) in Washington DC, for example, identified 175 large corporations that faced "social responsibility resolutions" at their 1989 AGMs.[1] This resurgence of interest in business ethics has been reflected in the academic community. For example, the Harvard Business School recently received a $30m grant to fund a new program in ethics and leadership, while many other business schools are implementing similar programs.

This increasing interest in ethics, and the accompanying increase in referenda as a means of resolving ethical dilemmas, implies that ethical decisions are becoming more frequent, or more complex, or both. Dobson (1990) supplies three reasons to explain why ethics in business is becoming more complex. All three reasons relate to the disappearance of moral codes. These may have guided managers in the past, however - as Dobson (1990) points out - they no longer seem to be honored.

First, with the advent of computers, business dealings are becoming more impersonal. This makes ethical contracts less easy to enforce. Second, managers are increasingly relying on external forces to guide the corporation ethically. Examples of these external forces include the Securities and Exchange Commission, and the Environmental Protection Agency. Managers have therefore become accustomed to |passing the buck' when it comes to ethical decision making. Finally, the secularization of western society has increased popular confusion as to what is ethical. Managers no longer feel comfortable assuming that their ethical beliefs dove tail with those of other stakeholders.

These three factors have contributed to the increasing use of referenda in an ethical context. However, despite the apparent efficacy of the shareholder referendum as a means of resolving |ethics-versus-profits' dilemmas, it has three serious drawbacks. These three drawbacks, when taken together, tend to render the |referendum solution' impotent. Referendums are incapable of providing corporations with sound moral guidance. The three reasons for this can be categorized as economic, contractual, and philosophical.

Economic; Minor economic reasons include the expense and delay involved in organizing referendums. The major economic problem concerns information disclosure. Corporations cannot be reasonably expected to release the type of sensitive information necessary for shareholders to make adequately informed ethical decisions. If released, such information might dramatically reduce the firm's competitiveness, and might expose the firm the greater potential legal liability.

Information disclosure becomes particularly problematic when international investment is considered. Corporate disclosure laws and shareholder-voting-rights laws are less extensive outside the U.S. This fact is illustrated in Exhibit One. The numbers in the Exhibit are percentages relative to the U.S.; where the U.S. equals 100%. Thus, for example, Canada/disclosure of 80% implies that Canadian corporations disclose to their shareholders 20% less information than do U.S. corporations. Given the steadily increasing amount of overseas investing, these discrepancies between countries will become increasingly relevant in hampering the use of shareholder referendums.

Contractual; As discussed earlier, the majority of the shares of the largest corporations are not held by individuals, but by institutions. For example, on the New York Stock Exchange the largest investor group is the pension funds, which own more than fifty percent of all shares outstanding. The money-managers who run these institutions are not free moral agents in that they have fiduciary responsibilities to their subscribers, or policyholders in the case of insurance companies. Given the referendum logic, therefore, if an institutional investor were to provide ethical guidance for a corporation it would have to conduct its own referendum in order to determine the moral consensus of its claimants.

Philosophical; Even if all the above problems could be overcome, a final one remains. Effective ethical guidance requires some minimal level of philosophical sophistication on the part of the guide. Specifically, the guide should be able to weigh ethical alternatives in light of prevailing moral philosophies. There is no a priori reason to expect individual shareholders to be adept in this regard.

An Ethicist on Every Board

As discussed above, every firm needs outside directors in order to control conflicts between management and shareholders. Outside directors are not aligned with any other stakeholder group, and are not beholden through any type of fiduciary obligation. Consequently, they are able to render unbiased economic guidance when conflicts arise.

A professional ethicist could perform a similar role within the corporate milieu. This individual would sit on the board of directors and would owe no particular allegiance to management, or shareholders, or any other stakeholder group.

This system of moral adjudication is already established in the hospital industry. Many hospitals employ some medical-ethics professionals on a full-time basis to advise doctors and hospital administrators on ethically sensitive issues. The ethicist is always available to render quick and decisive guidance while in full possession of all pertinent information; thus overcoming the aforementioned |contractual' problems. Finally, the ethicist is fully qualified to render moral guidance; thus overcoming the |philosophical' shortcomings of other stakeholders.


|And what is good, Phaedrus,

And what is not good -

Need we ask anyone to tell us these things?' (Plato)

As morally mature individuals, we may possess a strong sense of right and wrong in regard to our own isolated actions. As members of a corporation, however, our responsibilities to other individuals may muddy the once clear ethical waters. Perhaps, as Klein (1988) argues, managers are forced to adopt a dual moral standard;" [acting] amorally as an official of an organization and morally as a private person" (p. 63).

If the litany of corporate moral abuses in recent history is any guide (see Dobson, 1989), firms frequently lack moral guidance. By placing a professional within the corporation whose only function is to provide such guidance, many future ethical abuses can be averted. It is unlikely that federal regulators will have to force corporations to place ethicists on their boards. As is already apparent in the medical industry, such a trend is occurring naturally in response to the demands of a well informed and increasingly interdependent society.


(1.) See The Economist, April 29, 1989, pp. 75-76.


[1.] Chung, K.S., and R.L. Smith II: 1987 "Product Quality, Nonsalvageable Capital Investment and The Cost of Financial Leverage" in Modern Finance and Industrial Economics Edited by Thomas E. Copeland, Basil Blackwell, inc. 1987. [2.] Dobson, John: 1990 "The Role of Ethics in Global Corporate Culture" Journal of Business Ethics 9; 481-488. [3.] _____ : 1991 "Ethics in The Transnational Corporation: The Moral Buck Stops Where?" Journal of Business Ethics, forthcoming. [4.] Fama, E.F., and M.C. Jensen "Seperation of Ownership and Control" Journal of Law and Economics 26 (June 1983), pp. 301-325. [5.] Jensen, M.C., and W.H. Meckling: 1976 "Therory of The Firm: Managerial Behavior, Agency Costs and Ownership Structure" Journal of Financial Economics, Vol. 3, No. 4 (October, 1976) pp. 305-360. [6.] Klein, Sherwin: 1988, "Is A Moral Organization Possible?" Business and Professional Ethics Journal, Vol. 7, No. 1 (Spring 1988). [7.] Walking, Ralph A., and Michael S. Long: 1984, "Agency Theory, Managerial Welfare and Takeover Bid Resistance" Rand Journal of Economics 1 (Spring 1984), pp 54-68.
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Title Annotation:related article included: Counterpoint
Author:Dobson, John; Sabino, Anthony Michael
Publication:Review of Business
Date:Dec 22, 1991
Previous Article:Utilitarianism: an ethical framework for compensation decision making.
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