Last week, Massachusetts Senator Elizabeth Warren announced that she’s about to propose the most significant change in U.S. corporate governance in 100 years. We don’t yet have the full details, but one reading of her piece is that she’s going to propose requiring every company with more than $1 billion in revenue to become a “benefit corporation” — a corporation whose fiduciary duty is not only to its shareholders but to all its major “stakeholders.”

The senator argues that such a charter would redefine the purpose of the firm — away from a single-minded focus on maximizing shareholder value and toward a perspective that balances the need to give returns to investors with the welfare of the firm’s employees, customers, and communities. She suggests that this has the potential to increase both investment and real wages, reversing almost 30 years of accelerating inequality.

Senator Warren has put her finger on something immensely important. In the vast majority of our boardrooms and our MBA classrooms, the idea that the first mission of the firm is to maximize shareholder value is regarded as self-evidently true.

But in its current incarnation, a focus on shareholder value maximization at the expense of everything else is an exceedingly dangerous idea, not just to our society but also to the health of business itself. Taken literally, a single-minded focus on profit maximization would seem to require that firms not only drive down wages but also attempt to fix political processes in their own favor. This can’t be right. Markets only lead to prosperity and freedom when they are genuinely free and fair. Intuitively, if firms can dump toxic waste into the river, lie to their consumers, and get together to fix prices, maximizing profits doesn’t increase either aggregate wealth or individual freedom. (In his essay on shareholder value, Milton Friedman emphasized that firms must play by the rules, meaning that they should not break the law. But he didn’t speak to how firms should think about their power to get the rules changed.)

The first dean of Harvard Business School, Edwin Francis Gay, said that the purpose of business was to “make a decent profit, decently” — not to maximize profits at any costs — and that, in my view, is where U.S. business needs to go.

But why do businesses focus so much on shareholder value? And would Senator Warren’s proposal change that? My experience has been that managers don’t seek to maximize shareholder value because they believe they are legally required to do so. In fact, except in a couple of exceptional situations (such as when a firm has put itself up for sale), directors are not legally required to maximize shareholder value. They have duties of care, candor, and loyalty to their shareholders and to the firm, but the business judgment rule gives them very wide latitude as to what that means in practice. Most public companies maximize shareholder value most of the time because they’re afraid they will be fired if they don’t and they believe they will get rich if they do. As long as firms are running scared of activist investors and CEO pay is tightly linked to the value of the firm, managers are going to seek to maximize the firm’s stock price.

Requiring firms to adopt a new charter with obligations to a broader set of stakeholders would have the great benefit of reminding business leaders (and their lawyers!) that they have more discretion than they often think they have, but it’s not clear that it would change behavior unless there were corresponding shifts in how managers and investors think about their roles and the incentives that they face.

If I were Senator Warren, this is what I would go after.

Requiring stock-based incentives for senior managers to vest over a relatively long period of time, as the senator suggests, is a great first step, but I would also focus on increasing the information available to investors as they make their decisions. Why not make it mandatory for firms to report against an appropriate set of nonfinancial metrics? There’s increasing evidence that, for many firms, focusing on the long term and on a broader range of stakeholders improves performance. Let’s give investors the information they need to take this kind of information into account.

I would also do everything I could to support those firms that are already trying to balance profit with purpose. Firms like Aetna, where the CEO significantly increased the pay and benefits for more than 5,000 of his lowest-paid employees because it was the right thing to do. Firms like Costco and Trader Joe’s, which, as Zeynep Ton has shown, not only invest heavily in store employees but also have the lowest prices in their industries, solid financial performance, and better customer service than their competitors. There are thousands of businesspeople running firms committed to social as well as private good. But they are being forced to compete with those who are only too happy to take shortcuts.

That’s what needs to change. To make world-class corporate citizenship and profitability work in tandem, we need to change the rules so that racing to the bottom is no longer the most effective way to compete, and to ensure that treating people well is the profitable thing to do. This means continuing the push to raise the minimum wage and to make the provision of decent health and educational benefits mandatory — or at the very least, heavily tax-advantaged. It means grappling with the explosion of contract work, ensuring that employers can’t evade their responsibilities by simply relabeling employees as contractors.

It means giving employees a strong voice in their workplace that they are not afraid to exercise. The senator proposes mandatory employee representation on company boards, but my sense is that this is only likely to make a difference if it is backed up by a rediscovery of the power of employee engagement. “Unions” is a dirty word in many business circles, and I’m not a fan of old-style unionization, but there’s overwhelming evidence to suggest that wages rise when employees can organize collectively in productive ways. Let’s find a 21st-century way to make that happen.

Most important, it means investing in infrastructure and education. People stay in dead-end jobs they hate because they fear losing their health care. They underinvest in education because they fear struggling under student debt. Let’s build a workforce that is equipped to compete in today’s world — and then require firms to treat them as we would like to be treated.

Requiring firms to adopt a new charter might be an important first step, but it cannot be the last.

from HBR.org https://ift.tt/2BwqMvP