The Character of the Corporation: ESG Faces Tests of Staying Power, Especially With the Ghost of Milton Friedman in the Wings

Will a potential economic downturn, or the ghost of Milton Friedman, dampen the social-purpose movement?  

For more than 30 years, the accepted religion of corporate boards, investors, economists and the courts have held that the foremost obligation of directors is to take actions that make money for the owners of company stock. Directors who took steps to benefit other “stakeholders” — including workers, community, customers and suppliers — at the expense of the shareholder risked being in breach of their fiduciary duties.

In recent years, however, there’s been a significant backlash against that orthodoxy with the rise of corporate sustainable investing.

Powerful investors, such as activist hedge funds and pension funds, have pushed back against shareholder primacy by evaluating a company’s impact on the environment, society and corporate governance (ESG). High-profile examples include the social-good campaign targeted at Apple Inc. by activist investor Jana Partners LLC and the California State Teachers’ Retirement System that calls on Apple to help reduce the harmful effects of smartphone overuse on children. Larry Fink, the CEO of BlackRock, the world’s largest asset manager, has used his megaphone to tell CEOs that companies must show how they make a positive contribution to society.

But the ESG investing and decision model could be facing a major test of its staying power. If the economy softens or dips into a recession, the focus on social-good initiatives could be shoved aside by hard-nosed concerns about financial performance and share price. Nearly half of CFOs at American companies believe the economy will fall into recession this year, according to Duke University’s CFO Global Business Outlook.

“We shouldn’t kid ourselves and think it’s ‘Kumbaya’ time,” says Rick Wartzman, a director at the Drucker Institute and author of “The End of Loyalty.” “I do think in this tug of war between shareholder capitalism and stakeholder capitalism, shareholder primacy is undoubtedly winning. I think if there’s an economic downturn those pressures will undoubtedly grow.”


• The Character of the Corporation. (Intro) Delaware Supreme Court Chief Justice Leo Strine tells Directors & Boards that it is not “sustainable to have societies where large corporations do not have to align their business practices with the interests of living, breathing human beings who deserve a safe environment, economic security and consumer protection.” 

• Profit and PurposeIndra Nooyi, former PepsiCo chairman, talks about balancing bottom line and societal success.

• ESG Is On Costco's Board AgendaChairman Hamilton E. "Tony" James discusses the company's focus on environmental, social, governance issues.


• The Story of "S"What does "social" in ESG encompass? We talk to governance experts about their take.

• Best Buy's Road to Gender Parity in the Boardroom: It's not about tokenism, it's about business strategy and doing the right thing.

Courageous Boards Can Drive the Profit-People-Planet Agenda: CEO of The B Team talks about the role boards need to play.

• How Can Boards Wrestle the ESG Agenda?Questions to ask the CEO.

• ESG Faces Tests of Staying Power: Will a potential economic downturn, or the ghost of Milton Friedman, dampen the social-purpose movement?

• Stop Fighting ESG: Tips for becoming environmental, social and governance board leaders despite the lack of ESG clarity and standards.

• To Figure out the "S" in ESG, Look Within:Directors need to assess how their core business connects to society.

 ESG Point/Counterpoint: Should environmental, social and governance reporting be standardized and mandated?

There are several reasons for this. For starters, not all investors agree on what practice or initiatives constitutes a social good and can be in sharp disagreement. No less an investor than the legendary Warren Buffet has said that personal political views have no place in investing. “I’m not their nanny,” Buffet said last year of shareholders and employees on CNBC.

And while millennials are said to embrace ESG investing and decision making, research shows actual investment in mutual funds and exchange-traded funds integrating ESG factors are modest. Nearly a quarter of financial advisors report that they believe such strategies have a negative impact on investment performance, according to Cerulli Associates.

Some advisers might have trouble understanding ESG factors, speculates Cerulli senior analyst Brendan Powers. For many, the ESG umbrella is a catch-all for everything from the #MeToo movement to community relations. Skeptics cynically say ESG stands for “Everything is So Good.”

What’s more, shareholder primacy, while a relatively modern view of the purpose of a corporation, has strong underpinnings. In 1970, famed economist Milton Friedman famously ridiculed businessmen who promoted social ends for their “analytical looseness and lack of rigor,” in an article in The New York Times Magazine.

For Friedman, the responsibility of corporate leaders is to make as much money as legally and ethically possible for the stockholders they serve.

“There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game…” Friedman wrote.

Other scholars bolstered that view. Delaware court decisions soon spelled out the legal rules of the game for directors, according to attorney David J. Berger. Under Delaware corporate law, as it’s been interpreted in recent years, boards can’t place the interest of non-stockholders above the shareholder. Instead, boards must manage in ways to maximize the economic value of a company for the shareholders’ benefit.

Directors of a for-profit company who favored non-stockholder interests over shareholders have been found in breach of their fiduciary duties, explains Berger, who wrote “In Search of Lost Time: What If Delaware Had Not Adopted Shareholder Primacy?” for the Harvard Law School Forum on Corporate Governance and Financial Regulation.

Many countervailing forces that historically opposed that doctrine, including labor unions, have weakened over the decades. Whether the fledgling ESG movement will weaken the focus on shareholder primacy is still an open question.

“We’re in the third inning of a nine-inning ballgame,” Berger says.

There’s no doubt about the outcome to David A. Silverman. He’s a managing director of private investment firm Blue Harbour Group, considered among the first activist investors to use ESG criteria.

Clients of Blue Harbour have “multi-decade outlooks and a keen appreciation that ESG considerations are not mere complements to balance-sheet and shareholder-value considerations,” but are integral to the process, he says. The sustainability of business models come under the microscope more when the markets are volatile or weak, Silverman adds.

“For investment firms like Blue Harbour that integrate ESG into their decision process, it would be hard to untangle ESG at any given point in an economic cycle. For those firms that simply assign a separate rating or weighting to a company, then it could be undone, but even for such firms, if ESG is part of the total view on a company, it is difficult to stop using it. It’s difficult in several senses of the word — complicated, impractical and undesirable,” Silverman says.

For example, investors who understand the importance of having the CEO’s compensation align with their interests are not going to jettison that knowledge because the economy slumps, he says. The same applies to knowing the evidence in favor of added returns coming from areas like a diverse array of viewpoints on a board of directors.

“You just don’t easily unlearn that when the economy turns,” he says.

Brace Young, who heads Arabesque Asset Management USA, a global asset management firm, agrees an economic slump won’t put the ESG genie back in the bottle. “My view is ESG is not a product. It is a component of an investment process.”

Neither is Sister Nora Nash, director of corporate social responsibility with the Sisters of St. Francis of Philadelphia, about to give up the fight for ESG investing.

“You can never give up,” she says. “We always need to remind the corporations of the very serious responsibilities they have to the citizens they serve.” 


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