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Missing in Friedman’s Shareholder Value Maximization Credo: The Shareholders

Fifty years after the publication of Milton Friedman’s essay ‘The Social Responsibility of Business Is to Increase Its Profits’, the debate on whether directors and managers should only aim to maximize profits (or value) for shareholders rages on.

In a corporate world where institutional shareholders have taken center stage, this old question must similarly be asked with regard to asset managers. Where passive portfolio value maximizers dominate the scene, socially responsible corporate behavior may become more common based on premises that are, on their face, fully consistent with Friedman’s framework.

Like other participants to this debate, before moving on I will summarize Friedman’s New York Times essay.

What Friedman’s Essay Says

As Alex Edmans has noted here,

Friedman’s article is widely misquoted and misunderstood. Indeed, thousands of people may have cited it without reading past the title. They think they don’t need to, because the title already makes his stance clear: companies should maximize profits by price-gouging customers, underpaying workers, and polluting the environment’.

That is not, of course, what Friedman wrote. According to Friedman:

  1. Talking about the ‘social responsibility of business’ makes no sense because the responsibility lies with people. Public corporations are legal persons and may have their responsibilities, but they act through their directors and managers. Therefore, attention must be focused on the responsibilities of such players.
  2. Managers are employees of corporations, which in turn are owned by their shareholders. Therefore, managers must act in accordance with the wishes of the shareholders. Unless the shareholders themselves explicitly determine an altruistic purpose, this means ‘conduct[ing] the business in accordance with [shareholders’] desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom’.
  3. If managers also had a social responsibility, they would find themselves in the position of having to act against the interests of shareholders, for example by hiring the ‘hardcore’ unemployed to combat poverty instead of hiring the most capable workers. By doing so, they would spend shareholders’ money to pursue a general interest. In other words, they would impose a tax on shareholders and also decide how to use its proceeds. Yet, it is countered, if there are serious and urgent economic and environmental problems, then it is necessary that managers face them without waiting for politicians’ action, which is always late and imperfect. According to Friedman, it is undemocratic for private individuals using other people’s money (and, importantly, exploiting the monopolistic rents of the large corporations they lead) to impose on the community their political preferences on how to solve urgent economic and environmental problems, which should instead be addressed through the democratic process.
  4. The market is based on the unanimity rule; in ‘an ideal free market’, there is no exchange without the consent of those who participate in it. Politics, on the other hand, operate according to the conformity principle, whereby a majority binds the dissenting minority. The intervention of politics is necessary because the market is imperfect. But the social responsibility doctrine would extend the mechanisms of politics to the market sphere, since a private subject (enjoying some monopoly power) would impose its political will on others.
  5. Often, the idea of corporate social responsibility (CSR) is just a public relations exercise to justify managerial choices already consistent with the interests of shareholders. Looking after the well-being of employees, devoting resources to the firm’s local communities, and so on may well be (and, as a rule, will be) in the long-term interest of corporations. Indeed, cloaking these actions under the label of CSR, as it was fashionable to do in 1970 (and is again today), can in itself contribute to increasing profits.

Missing from Friedman’s Picture: The Shareholders

Friedman’s essay assigned a totally passive role to what he calls the corporation’s ‘owners’ or ‘the employers’—that is, the shareholders. They are merely the beneficiaries of directors’ duty to increase profits, but they have no role to play in pursuing that very goal other than (as he notes in passing) when they elect the board.

That’s understandable. When Friedman wrote his piece, the shareholders of US companies were mostly individuals and rarely voted at annual meetings other than to rubber-stamp managers’ proposals. Today, a large majority of listed firms’ shares are held by institutional investors—that is, managers of other people’s funds. Institutions have become key players at US (as well as non-US) listed corporations (eg, this OECD study with data from across the world), because they regularly vote portfolio shares at shareholder meetings. And their pro-management vote is nowadays anything but certain.

This creates one additional layer of employee/employer relationships, to use Friedman’s terminology (today, we would say principal/agent relationships): the one between the institutions holding shares or (as Friedman saw it) their own managers, and the individuals (usually workers and pensioners) whose funds the managers invest. (To be sure, it is often more complicated than that because some institutions, such as pension funds, often delegate their asset management to other institutions; but this is not relevant for the purposes of my analysis).

Friedman’s essay raises the question: is there any room for asset managers to assume social responsibility duties in deciding how to invest and how to vote? In Friedman’s logic, the answer should be ‘no’, and it’s easy to imagine that he would chastise those fund managers who portray themselves (not always veritably) as socially responsible investors. Like corporate managers, fund managers manage other people’s money and should not grant themselves the license to make political choices, which will inevitably please some of their beneficiaries and not others. Their only goal should be giving their clients the highest returns on the funds invested.

Of course, much like a corporation can be set up with an altruistic (or mixed) purpose, so can asset management products expressly be marketed as socially responsible or ethically-investing. Intuitively, investors in such funds expect them to invest and vote in accordance with the socially responsible commitments undertaken. But absent a CSR connotation—namely, if the mutual fund has been marketed as a tool for generating financial returns—fund managers have to assume that the fund’s investors have a financial objective in mind and do not expect their own political preferences to be promoted by their fund manager, especially if that comes to the detriment of their return. Whether implicitly or explicitly, that’s the bargain with each of the fund shares buyers.

However, things are not always so straightforward. Passive institutional investors replicating indexes and, therefore, holding the entire market rather than picking stocks now hold more than 40 percent of the US stock market. As Madison Condon and Jack Coffee have noticed—here and here, respectively—for investors of that kind, portfolio value maximization may well mean pushing for ESG (Environment, Social and Governance) policies at the individual company level that, while not necessarily profitable for that company, will increase portfolio returns by making other companies more profitable. Think, for instance, of systemically important financial institutions adopting more conservative risk management policies that significantly reduce the chances of a potentially devastating financial crisis.

Hence, the overlap between socially responsible and profit-maximizing behavior, which Friedman himself acknowledged to be present at the individual company level and criticized only as being politically dangerous, is now even more pervasive at the institutional shareholder level.

In theory, all portfolio value maximizers’ decisions on ESG matters should be based on an assessment of the effects that the adoption of a given policy by an individual portfolio company would have, both on its value and on the value of the totality of other portfolio companies. Because ESG policies require widespread adoption to be effective, different scenarios will have to be elaborated and factored in to estimate those effects. Multiple other variables will have to be considered and a number of questionable assumptions made.

Passive investors, like any organization, are unlikely to have the human and financial resources to fully engage with this kind of assessment, let alone reach solid conclusions. And it would be naïve to assume that political preferences do not affect the simplified analysis they inevitably resort to in determining their ESG preferences.

Owing to shareholder pressure and/or managers’ desire to retain their jobs, the ESG preferences of portfolio value-maximizing institutions may well trickle down to the individual portfolio company level. Under what conditions that is the case will depend on a number of factors, including whether the company is protected from competition, undiversified shareholders’ stakes in the company, how politically divisive the socially responsible action is, and so on. Yet in some cases, and in respect of some of the socially and politically sensitive issues, managers will yield to those preferences. Given Friedman’s premise that ‘increasing profits’ must be the only corporate goal because the shareholders are the owners/employers, there is some irony to that.

Irony aside, today’s corporate world is very different from the one Milton Friedman wrote in. Yet, his essay still provides a useful framework for understanding the implications of managing companies for one purpose or another. And perhaps also for answering the reframed question of whether corporate managers should cater to the preferences of their portfolio-value-maximizing indexing investors when making decisions on behalf of their corporations.


The author wishes to thank Alessandro Romano and Thom Wetzer for the helpful comments to a previous draft.

This post was originally published on ProMarket—the blog of Stigler Center at the University of Chicago Booth School of Business—and is available here.

Luca Enriques is Professor of Corporate Law at the University of Oxford.



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