28  Shareholder versus Stakeholder Models of the Firm

ImportantLearning Objectives

You will be able to:

  1. State the shareholder model of the firm and the strongest arguments for it.
  2. State the stakeholder model and the strongest arguments for it.
  3. Identify the questions on which the two models genuinely differ, as distinct from those where they converge.
  4. Explain where Indian company law and the listing framework place the firm’s obligations.
  5. Compare the two models on a live governance decision and evaluate the implications for accountability.

28.1 Introduction

This chapter closes Module IV with the question the whole module has been circling. Governance holds management accountable, and this chapter asks: accountable to whom, and for what.

Two answers have organised the debate for fifty years. The shareholder model holds that a company should be run to maximise returns to those who own it, and that managers who pursue other objectives are spending other people’s money on purposes those people did not choose. The stakeholder model holds that a company affects many groups whose contributions and vulnerabilities give them a claim, and that management’s task is to balance those claims (A. C. Fernando, 2019).

The debate is often conducted badly, with each side attacking a version of the other that nobody defends. This chapter tries to state both strongly, then to identify where they actually differ, because the areas of genuine disagreement are narrower and more interesting than the rhetoric suggests (Anne T. Lawrence & James Weber, 2020).

flowchart LR
    subgraph SH["<b>Shareholder model</b>"]
        A["Owners bear<br>residual risk"] --> B["Managers are agents<br>of the owners"]
        B --> C["Single objective,<br>testable performance,<br>clear accountability"]
    end
    subgraph ST["<b>Stakeholder model</b>"]
        D["Many groups make<br>firm-specific investments"] --> E["Each has a claim<br>on how the firm is run"]
        E --> F["Balanced objectives,<br>broader legitimacy,<br>contested trade-offs"]
    end
    C -.->|"objection: harms<br>borne by others"| F
    F -.->|"objection: accountable<br>to everyone is<br>accountable to no one"| C
    style C fill:#e3f2fd,stroke:#1976D2
    style F fill:#e8f5e9,stroke:#388E3C

28.2 The Shareholder Model

The position is most associated with the argument that a corporate executive is an employee of the owners of the business, with a direct responsibility to conduct it in accordance with their desires, which will generally be to make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom (Milton Friedman, 1970).

Stated at its strongest, the argument has four parts, and only the first is about property.

Ownership and agency. Shareholders supply capital and bear the residual claim: they are paid last, and their return is whatever remains. Managers are their agents. An agent who diverts the principal’s resources to purposes the principal did not authorise is exceeding the mandate, however admirable the purpose.

Taxation without representation. When a manager spends company money on social objectives, they are in effect levying a tax and deciding how to spend it. That is a governmental function, exercised without the accountability that attends government, by a person selected for commercial competence and answerable to no electorate.

Accountability requires a single objective. This is the strongest part of the argument and the one most often overlooked. Performance against one objective can be measured, and a manager can be held to it. A manager instructed to balance the interests of six constituencies can justify almost any decision by reference to whichever constituency the outcome happened to serve, and can never be shown to have failed. A multiple-objective mandate is therefore not merely vague; it weakens accountability.

Other claims are protected by other instruments. Employees have contracts and labour law, customers have consumer law and competition, communities have environmental regulation, and creditors have security and insolvency law. These are better instruments for protecting those interests than managerial discretion, because they are specific, enforceable and democratically set.

WarningCommon Misconception: The Shareholder Model Says Profit at Any Cost

The formulation includes conformity with the rules of society, both those embodied in law and those embodied in ethical custom. That qualification is not decorative, and dropping it produces a position its author did not hold.

The real content of the disagreement therefore is not whether firms may break the law or deceive customers, which the shareholder model prohibits. It is what happens in the space the rules do not reach: whether a firm should decline a lawful practice that harms a community, bear a cost no competitor bears, or protect employees beyond what contract requires. That is a narrower question than the debate usually implies, and it is a real one.

28.3 The Stakeholder Model

The stakeholder position, developed as a theory of strategic management, holds that a firm should be understood as a set of relationships among groups with a stake in its activities, and that managing those relationships is the substance of management rather than a constraint upon it (R. Edward Freeman, 1984).

Its strongest arguments are also four.

Firm-specific investment. Shareholders are not the only group bearing residual risk. An employee who has spent twenty years acquiring skills valuable mainly to this firm, a supplier who built dedicated capacity for it, and a town whose economy depends on it have all made investments they cannot readily redeploy. Shareholders, by contrast, are often diversified and can sell in seconds. If residual risk is the ground of the claim, several groups have one.

Incomplete contracts. The shareholder model’s answer, that other interests are protected by contract and law, assumes contracts anticipate everything and law reaches everywhere. Neither holds. Contracts are incomplete, bargaining power is unequal, and law lags, which is Chapter 15’s point restated. Something must govern the gap, and management discretion is what occupies it whether or not it is acknowledged.

Value creation is joint. Returns come from the combined contribution of capital, labour, suppliers, customers and the permission of the community. Treating one contributor’s claim as the objective and the rest as costs to be minimised misdescribes how value is actually produced.

Long-term value converges. A firm that mistreats employees, suppliers, customers or communities eventually pays through turnover, quality, reputation and licence. On a long enough horizon the two models recommend similar behaviour, and the disagreement is substantially about horizon.

WarningCommon Misconception: The Stakeholder Model Means Everyone Gets a Vote

The serious version of stakeholder theory does not propose that a firm be run by a committee of constituencies, and does not claim all claims are equal. It claims that stakeholder interests must be identified, weighed and taken into account in a decision whose responsibility still rests with the board.

The genuine difficulty is the accountability objection from the shareholder side, and it is not answered by asserting good intentions. If management is answerable for balance, someone must be able to say when the balance was wrong. The credible answers are procedural: name the stakeholders whose interests are being weighed, state the trade-off made and why, disclose it, and let those affected respond. That is why the stakeholder model in practice generates reporting obligations, which is where Module V begins.

28.4 Where the Models Actually Differ

NoteConvergence and Divergence
Question Do the models differ?
May a firm break the law to increase profit? No. Both prohibit it
May a firm deceive customers or conceal a defect? No. Both prohibit it
Should a firm treat employees and suppliers well where doing so improves performance? No. Both recommend it, for different reasons
Should a firm accept a cost that will not be recovered, to avoid harm to a community? Yes. This is a real divergence
Should a firm forgo a lawful practice its competitors use, at a competitive disadvantage? Yes
Over what horizon should performance be judged? Yes. Much of the apparent disagreement reduces to this
To whom is the board finally accountable when interests conflict? Yes. This is the constitutional question
Who decides the trade-off, and how is that decision reviewed? Yes, and this is where the practical action is

The last two rows are where the argument matters for governance. The shareholder model gives a clean answer to accountability and a weak answer to the harms that fall outside contract and law. The stakeholder model gives a strong answer to those harms and a weak answer to accountability. Neither weakness is fatal, and both are addressed the same way: by requiring the trade-off to be made explicitly, recorded, and disclosed.

28.5 Where Indian Law Sits

India did not adopt either model wholesale, and its position is more interesting than a compromise.

The duty of a director under the Companies Act is to act in good faith to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of the environment (Government of India, 2013). That is an unusual formulation. It names constituencies beyond shareholders in the duty itself, which the shareholder model would not, while keeping the duty owed to the company rather than to those constituencies, so that employees and communities do not acquire a right to sue.

Three further features point the same way. Corporate social responsibility is a statutory obligation for companies above prescribed thresholds, requiring a policy, a committee and expenditure, which is a legislative judgement that the question is not left to managerial discretion (Government of India, 2013, 2014). Business responsibility and sustainability reporting requires listed entities to report on environmental, social and governance performance, which Chapter 30 examines in detail (Securities and Exchange Board of India, 2021). And the National Guidelines on Responsible Business Conduct set out principles addressed to businesses generally (Ministry of Corporate Affairs, 2019).

TipPractitioner Insight: The Practical Question Is Not Which Model, It Is Who Decides and What Is Recorded

A board rarely faces the abstract question. It faces a specific trade-off: whether to close a plant, accept a supplier’s cost increase, fund a remediation nobody is demanding, or decline a lawful contract. The model a director professes predicts very little about how they vote.

What does predict outcomes is process. Was the affected group identified and were its interests set out in the paper, or did the paper contain only financial cases? Was the trade-off named as a trade-off, or presented as though there were none? Is there a record of what was decided and why, in terms someone could challenge later? And is the decision disclosed to those affected in a form they can use?

A board that does these four things is behaving in the way the stakeholder model requires, whatever its directors believe about the theory, and it is also meeting the shareholder model’s demand for accountability, because a recorded trade-off can be assessed. A board that does none of them has adopted no model at all; it has simply decided in favour of whoever was in the room.

28.6 Case Studies

28.6.1 Case Study 1: The Remediation Nobody Required

The following situation is constructed rather than reported.

A chemicals company discovers legacy contamination at a site it has operated for thirty years. The contamination predates current standards, no regulator has raised it, no claim has been made, and the company’s legal position is strong. Remediation would cost a material sum with no recoverable return. Testing shows groundwater in an adjacent settlement is affected at levels below current action thresholds but above what the company’s own scientists are comfortable with. The board must decide.

Discussion questions

  1. State what a strict shareholder analysis recommends, including the reputational and future-liability considerations it can accommodate.
  2. State what a stakeholder analysis recommends and identify the specific claim the settlement has.
  3. Apply the four process questions. What would a board that took none of the theoretical positions still need to do?

28.6.2 Case Study 2: The Practice the Competitors Use

The following situation is constructed rather than reported.

A consumer lending company observes that competitors generate substantial revenue from a fee structure that is lawful, disclosed in the schedule, and understood by very few borrowers. Adopting it would materially improve returns. Declining it means underperforming peers on margin, which the company’s analysts will notice. The chief executive believes most borrowers who pay the fee do not understand it.

Discussion questions

  1. This case sits in the space the shareholder model’s ethical custom qualification is meant to cover. Does that qualification resolve it? Argue both ways.
  2. Apply the disclosure test from Chapter 17 and the stakeholder analysis from Chapter 19. Do they agree?
  3. If the board declines the practice and the share underperforms, to whom is it accountable for that decision, and how should it explain it?

28.6.3 Case Study 3: The Closure and the Town

The following situation is constructed rather than reported.

A board must close a plant that has been loss-making for four years, in a town where it is the largest employer. Continuing costs shareholders money with no prospect of recovery. Closing costs roughly nine hundred jobs in a place with little alternative employment, and the company has operated there for four decades. Options include immediate closure, a phased closure over two years at additional cost, and closure with a funded retraining and relocation programme.

Discussion questions

  1. Set out what each model says about each of the three options, being precise about where they agree.
  2. Chapter 16 analysed a similar closure through utilitarian reasoning and Chapter 17 through Rawls’s device. Bring those analyses to bear and say what they add to the shareholder and stakeholder framing.
  3. Draft the four elements of the record this board should leave: who was identified, what trade-off was made, on what reasoning, and what was disclosed to whom.

28.7 Applying the Chapter

ImportantExercise: The Constitutional Question in a Real Decision

A listed Indian textile company faces a decision. Its largest export customer has demanded a fifteen per cent price reduction, failing which it will move the business. The order is a third of the company’s revenue. Management has identified three routes to the reduction: moving a large part of production to contract units with lower labour costs and no long-service workforce; pressing its own suppliers, most of them small spinning units dependent on the company, for equivalent reductions; or accepting a materially lower margin and funding it by deferring a planned effluent treatment upgrade that is not yet legally required but that the company’s own environment head has recommended. A fourth option, refusing the demand and losing the order, would trigger substantial job losses and a probable fall in the share price.

Working in a group, produce a board paper. CO-4 requires evaluation of accountability and identification of governance gaps, so the paper must reach a recommendation and specify how the decision will be reviewed.

  1. Identify the stakeholders for each of the four routes, using Chapter 19’s method, and state what each stands to gain or lose. Disaggregate any group whose members differ.
  2. Analyse under the shareholder model. For each route, state what the model recommends, including everything the model can properly take into account such as reputation, future liability and long-term value. Be honest about where the model’s answer depends on the horizon assumed.
  3. Analyse under the stakeholder model. For each route, state what the model recommends and which claims it treats as weightiest, and say how the board would defend that weighting.
  4. Locate the genuine divergence. Identify precisely which of the four routes the two models rank differently, and explain what feature of that route causes the divergence.
  5. Apply the ethical frameworks. Bring Chapters 16, 17 and 18 to bear on the route that divides the models most sharply, and state what each adds.
  6. Test against Indian law. Explain what the directors’ duty under the Companies Act requires here, including the named constituencies, and what it does not require. State whether any route would breach it.
  7. Recommend, and design the record. Recommend one route. Name the trade-off explicitly, state who bears it, say what will be disclosed to whom and when, and specify the review point at which the board will assess whether the decision was right.
  8. Identify the governance gap. State what in this company’s decision process would have to change for a decision of this kind to be taken well as a matter of routine rather than by chance.

Present a board paper of no more than four pages, structured as options, analysis, recommendation, trade-off statement, disclosure plan and review point.

28.8 Summary

NoteChapter Summary

Governance holds management accountable, and this chapter asks to whom. The shareholder model holds that a company should be run for those who own it and that managers pursuing other objectives spend other people’s money on unchosen purposes (Milton Friedman, 1970). Its four strongest arguments are ownership and agency, the objection that a manager spending on social objectives levies a tax without accountability, the point that accountability requires a single measurable objective while a multiple-objective mandate lets any outcome be justified, and the claim that other interests are better protected by contract, labour law, consumer law and regulation than by managerial discretion. The formulation includes conformity with law and with ethical custom, and dropping that qualification produces a position its author did not hold.

The stakeholder model holds that a firm is a set of relationships among groups with a stake in its activities, and that managing them is the substance of management (R. Edward Freeman, 1984; Anne T. Lawrence & James Weber, 2020). Its four strongest arguments are that firm-specific investment means several groups bear residual risk and shareholders are often the most diversified and most easily exited, that contracts are incomplete and law lags so management discretion occupies the gap whether acknowledged or not, that value creation is joint, and that on a long horizon the models converge so much of the disagreement is about horizon. The serious version does not give everyone a vote or treat all claims as equal; its real difficulty is the accountability objection, answered procedurally by naming the stakeholders weighed, stating the trade-off, disclosing it, and allowing response.

The models agree that a firm may not break the law, deceive customers or conceal defects, and that treating employees and suppliers well where it improves performance is right. They genuinely differ on accepting an unrecoverable cost to avoid harm, forgoing a lawful practice competitors use, the horizon for judging performance, final accountability when interests conflict, and who decides a trade-off and how it is reviewed.

Indian law adopts neither wholesale. The directors’ duty names employees, the community and the environment alongside members while keeping the duty owed to the company (Government of India, 2013), and statutory corporate social responsibility (Government of India, 2014), sustainability reporting (Securities and Exchange Board of India, 2021) and the national guidelines on responsible business conduct (Ministry of Corporate Affairs, 2019) all reflect a judgement that these questions are not left wholly to managerial discretion. The practical question for a board is not which model but who decides and what is recorded: whether affected groups appear in the paper, whether the trade-off is named, whether the reasoning is recorded in challengeable terms, and whether the decision is disclosed to those it affects.

TipKey Terms

Shareholder model · Residual claim · Agency mandate · Taxation without representation · Single objective and accountability · Ethical custom qualification · Protection by other instruments · Stakeholder model · Firm-specific investment · Incomplete contracts · Joint value creation · Convergence on a long horizon · The accountability objection · Procedural answer · Genuine divergence · Horizon · The constitutional question · Duty to the company · Named constituencies · Statutory CSR · Sustainability reporting · Naming the trade-off · The recorded reasoning · Review point

Summary

Concept Description
The Shareholder Model
Shareholder model The view that a company should be run to maximise returns to those who own it
Residual claim The shareholders' position as last paid, which grounds the claim that they bear the residual risk
Agency mandate The argument that managers are agents who may not divert resources to unauthorised purposes
Taxation without representation The objection that spending company money on social objectives is a governmental act without accountability
Single objective and accountability The strongest argument for the model: one measurable objective can be enforced, several cannot
Ethical custom qualification The proviso requiring conformity with law and ethical custom, without which the position is misstated
Protection by other instruments The claim that contract, labour, consumer, environmental and insolvency law protect other interests better
The Stakeholder Model
Stakeholder model The view that a firm is a set of relationships among groups with a stake in its activities
Firm-specific investment The investment an employee, supplier or town makes that cannot readily be redeployed elsewhere
Diversification asymmetry The point that shareholders are often the most diversified and the quickest to exit
Incomplete contracts The condition under which contract and law cannot cover everything, leaving discretion to occupy the gap
Joint value creation The observation that returns come from the combined contribution of capital, labour, suppliers and permission
Convergence on a long horizon The convergence of the two models over sufficient time, which makes horizon central to the dispute
The accountability objection The serious objection that accountable to everyone means accountable to no one
Not everyone gets a vote The clarification that the model does not distribute votes or treat all claims as equal
Procedural answer The answer to the objection: name the stakeholders weighed, state the trade-off, disclose it, allow response
Where They Agree
Agreement on law and deception The shared prohibition on unlawful conduct, deception and concealment
Agreement on treating people well The shared recommendation where good treatment improves performance, reached by different routes
Where They Differ
Unrecoverable cost to avoid harm The first genuine divergence, where a cost will not be recovered
Forgoing a lawful competitive practice The second, where competitors use a practice the firm could lawfully adopt
Horizon The third, and the one to which much apparent disagreement reduces
The constitutional question The fourth: to whom the board is finally accountable when interests conflict
Who decides the trade-off The fifth and most practical: who makes the trade-off and how the decision is reviewed
The Indian Position
Indian directors' duty The Indian formulation requiring good faith to promote the objects for the members as a whole
Named constituencies Employees, shareholders, the community and the environment, named within the duty itself
Duty owed to the company The feature keeping the duty owed to the company, so named constituencies acquire no right to sue
Statutory CSR The statutory obligation of policy, committee and expenditure above prescribed thresholds
Sustainability reporting The listed entity obligation to report environmental, social and governance performance
National guidelines The principles addressed to businesses generally on responsible conduct
What a Board Must Do
Naming the trade-off The discipline of presenting a trade-off as a trade-off rather than as a decision without cost
The recorded reasoning The record in challengeable terms, which is what allows accountability for a balanced judgement
Review point The date at which the board returns to assess whether the decision was right