Frances Haugen chose to join Facebook after a family member became radicalized online. She wanted to help make the social media platform less toxic. As she would later testify before Congress, however, she found that she had joined a company that persistently put profit before the broader social good.
“I saw Facebook repeatedly encounter conflicts between its own profits and our safety. Facebook consistently resolved those conflicts in favor of its own profits,” Haugen told Congress in 2021. “The company’s leadership knows ways to make Facebook and Instagram safer and won’t make the necessary changes because they have put their immense profits before people.”
Haugen brought receipts. She provided Congress and the press with a trove of internal documents showing how Facebook and its senior leadership, including CEO and co-founder Mark Zuckerberg and chief operating officer Sheryl Sandberg, knew of the damage their product was doing. In the ensuing firestorm, the Menlo Park, California-based social media company changed its name to Meta Platforms and Sandberg announced she was stepping down from the company.
In coming forward, the whistleblower believed what she was doing “was right and necessary for the common good.”
While Haugen’s testimony highlighted the conflict between Facebook’s financial success and the public interest, a similar, but largely hidden, conflict exists between the company’s executives and most of its shareholders: While Meta’s antisocial actions might buoy its stock price and create wealth for senior leaders, the socially destructive nature of these activities is a threat to the diversified portfolios of its own shareholders.
Most individual and institutional investors, including pension plans and endowments, are not concentrated in a single stock. They hold diversified portfolios. But when Meta threatens the public interest to drive up its own value, it can compromise the long-term value of the economy that supports these portfolios.
In our complex economy, decisions by a single company can have profound effects on almost every other company an investor owns. Meta’s decisions can degrade public discourse, instill social unrest, and undermine efforts to create an informed public, reducing the intrinsic value of the economy, which is directly correlated with the long-term performance of diversified portfolios.
This is why we at The Shareholder Commons (TSC) have supported shareholder proposals at companies including Meta, Alphabet, BlackRock, UPS, McDonald’s Corp., and Tractor Supply Co., urging them to report on the negative costs of their business practices to diversified investors. Addressing this conflict is why I founded TSC three years ago, following a 30-year career as a corporate governance lawyer: I believe that directors fail to meet their fiduciary duties when they ignore negative impacts on their own diversified shareholders.
And yet, most institutional investors, including those that analyze a company’s impact on the environment, social responsibilities, and corporate governance (so-called ESG factors), fail to address this conflict.
The ESG Explosion
Investors’ concern for social and environmental issues has increased exponentially, with close to one-third of global managed assets now falling under some form of ESG mandate.
But this interest focuses almost exclusively on the relationship between a company’s choices and its own financial performance.
To fulfill the potential of ESG, investors must understand that company executives also have a conflict of interest with their diversified shareholders. Naming this conflict is not an ethical judgment; it simply describes a market economy that channels savings to thousands of individual businesses competing for capital, talent, and margin. But we need to identify the inherent conflict so we can design mechanisms to address it.
Recognizing the conflict is also critical in responding to the accelerating political pushback against ESG investing. With the support of corporate lobbyists, lawmakers in a number of states have passed legislation that will hamper the ability of institutional investors to use ESG risk assessments in their investing practices, or even invest with managers that use ESG criteria. Highlighting the divergent interests of corporate managers and their diversified shareholders will help explain why such legislation is so dangerous to investors.
Refocusing investors on portfolio impacts may require that they demand individual companies in their portfolios make decisions that reduce enterprise value — even over the long term. This runs counter to the “doing well by doing good” narrative that ESG activists cling to, as well as the ethos of an ecosystem that equates success with financial outperformance. But to maintain a market economy that does not violate critical social and environmental boundaries, shareholders must insist that each company account for all of the costs of its activities — including those costs that it can externalize.
Elon Musk’s attempt to purchase Twitter is an excellent example of this conundrum. Even though the offered price might have provided shareholders with the best value, the sale of a critical social media platform to one individual with very particular economic and other interests may have threatened the integrity of the public square. And because the economy depends on healthy public discourse, ensuring that Twitter is a positive social force long into the future is likely more financially material to the diversified shareholders of Twitter than is receiving a premium for their shares today. Yet no ESG investors made this case or sought to condition support of the transaction on public-square protections. Because this critical “S” interest runs contrary to maximizing financial returns at Twitter, the ESG community has remained largely silent, even as the company tries to force Musk to follow through on his agreement in Delaware Chancery Court. As long as investors focus on enterprise value alone, they will repeat this mistake and will miss the opportunity to secure long-term portfolio value.
Corporate Law and the Davos Denizen
I spent the first 25 years of my career as a lawyer in Delaware, the most important corporate law jurisdiction in the world, and the crucible where fiduciary duty law is developed. I worked with directors, executives, and bankers as they tried to raise money, auction companies, or stave off hostile bidders. I also worked with large shareholders and bidders pushing companies to sell or change course.
All through this work, the North Star guiding my advice (and arguments to judges) was unquestioned: The job of directors and the executives they oversaw was to optimize the company’s financial return to shareholders. Sometimes directors overseeing the sale of a company would ask me about protecting workers after the sale. As legal adviser, I thought it was my job to say that if the company was being sold for cash, all that mattered was the price to shareholders.
There is an economic logic to this answer. We rely on competitive markets to price things, including inputs like petroleum and labor — but also companies. We rely on those prices to allocate scarce resources. So, the theory goes, we should encourage business decisions that maximize profits, because higher profits mean more value is being created, which means resources are being allocated optimally: We are growing the pie. Under this view, it is the role of government — not executives — to protect workers, the environment, and other common goods. Indeed, if executives tried to balance all these different interests, the economy would go awry.
Of course, not everyone believes this. Academic and policy arguments as to why corporate fiduciaries should look beyond shareholder financial return are common. But since the late 20th century, lawyers, directors, and executives have all bought into an artificially narrow version of shareholder primacy. This remains true even for most proponents of “stakeholder capitalism,” such as the Business Roundtable and the World Economic Forum. While these organizations make broad declarations about the need for corporations to act with purpose, stakeholder relationships are still viewed as a tool by which to improve financial return to shareholders. But they — the leaders of business and finance calling for stakeholder capitalism at meetings in Davos, Switzerland, and elsewhere — have not yet called for companies to surrender long-term shareholder value when necessary to improve the environment or the lives of workers.
Around 2010, Delaware was asked to adopt a truly alternative corporate governance model that would protect social and environmental interests along with shareholder returns. While the idea was initially treated with extreme skepticism, Delaware ultimately authorized public benefit corporations (PBCs). Personally, I thought the PBC’s time had come. I left my law practice to advocate for corporate governance that would allow companies to prioritize social and environmental systems.
But while debates over stakeholder capitalism and corporate purpose continued, there was no change in the financial markets’ measurement of success for individual companies: cash flows and enterprise values, with no regard for whether that success depended on externalized costs that would weigh down the global economy and capital market returns. In 2019, I formed TSC as a nonprofit advocate for the interests of diversified shareholders that works to help the financial system move its focus from trees to forest.
TSC seeks to catalyze the establishment of guardrails — minimum standards of conduct that ensure that the companies investors own do not externalize costs that end up being paid by other portfolio companies. Such parameters help to establish a playing field that is both level and sustainable.
The ESG Loophole: Doing Well by Doing Good, but Doing Even Better by Doing Bad
ESG shareholder activism uses different tactics and covers many areas. However, there is one commonality: Most ESG activism champions changes in corporate behavior that will improve impact and financial performance at the same time.
This tactic often has merit. A company may be able to improve financial performance by being more energy efficient or by treating employees well. In such instances, the company can improve its social or environmental impact and its financial returns at the same time.
But it is naïve to believe that this always holds; very often, the most profitable route for a company (even over the long term) is one that externalizes social and environmental costs. In a study of the global public markets, asset manager Schroders found that in one year, listed companies around the world earned $4.1 trillion in profits, but they also created net social and environmental costs of $2.2 trillion. More than half of public company profits are subsidized by sapping critical systems that undergird the value of the economy.
This shouldn’t be surprising; our system equates company success with superior financial performance. Thus, from the vantage point of a company, successfully externalizing costs is a free lunch. But the lunch is not free for shareholders. They pick up the tab because they are, for the most part, very diversified, owning shares in hundreds or even thousands of companies through index funds, mutual funds, and other pooled investments.
Over long time spans, there is a direct correlation between GDP and portfolio value. Thus, when a company externalizes a systemic cost that is borne by the economy, diversified portfolios are harmed.
In the U.S., for example, companies like Walmart and McDonald’s may increase their financial returns through poor pay, but the prevalence of low-wage work contributes to poor health, reduced educational opportunity, reduced civic participation, and inequality. An unhealthy, undereducated, and disengaged population means the nation’s economic potential will remain unfulfilled, leading to portfolios as a whole performing below their potential over time.
Diversified shareholders essentially own a slice of that economy, so when companies in their portfolios increase their own financial returns with conduct that damages systems, they are making a bad trade on behalf of these investors. There are many more examples:
- Climate. Swiss Re recently reported that failing to stick to the Paris Agreement would lower GDP by 7% to 14% by 2050. Just 100 companies are responsible for 71% of industrial global greenhouse gas emissions.
- Obesity. The World Health Organization assesses the unpriced social burdens of obesity as equaling almost 3% of global GDP annually. The food and beverage business bears significant responsibility for this issue.
- Inequality. The Economic Policy Institute estimated in 2017 that rising inequality had slowed growth in demand by 2 to 4 percentage points of GDP annually in recent years. In the U.S., corporate depression of wages for low-income workers and exploding executive pay are expanding inequality.
- Racial and gender disparities. Gender and racial gaps created $2.9 trillion in losses to U.S. GDP in 2019, according to the Federal Reserve Bank of San Francisco, and corporations’ failure to address racial disparities will cost the U.S. economy $5 trillion over five years, Citi Global Perspectives & Solutions predicts.
- Financial risk. In the lead-up to the 2008 crash, financial industry players pursued profits for their own shareholders while creating risks that threatened the entire economy.
- Public health. The COVID-19 pandemic revealed that for-profit medical facilities had reduced their inventories of protective gear to reduce costs, creating the risk that the economy would be unable to sustain itself in the event of an infectious disease crisis; pharmaceutical companies are using intellectual property rights in ways that maximize their cash flows but appear to limit global vaccine-manufacturing capacity, creating greater opportunities for the evolution of dangerous variants that threaten long-term economic health.
Protecting our economy (and diversified investors) from such threats will require some companies to change their business plans and accept lower returns. Such changes will not be feasible unless the playing field is leveled, as business will flow to companies that continue to externalize costs unless a critical mass is forced to end the practice.
Stock Compensation: Feeding the Conflict’s Fire
Ballooning equity compensation of recent decades has only intensified the conflict.
In 2022, the median salary of an S&P 500 CEO rose to a record $14.5 million. With salaries paid almost entirely in stock and options, CEOs and other senior leaders are fixated on the financial performance of their companies.
Boards, who approve these grants, use vesting periods and holding requirements to ensure that management’s financial interest is aligned with long-term shareholders’ and not just short-term traders’.
But large share grants do not align executive interests with those of diversified shareholders. Instead, by giving executives an outsize incentive to increase a company’s financial return, equity compensation becomes gasoline on the ESG conflict fire.
A CEO with $50 million in company stock will benefit greatly from the profits that come to her company by externalizing costs. Presumably, she does not have comparable wealth in other companies, so the proportional personal benefit she receives from such practices will far outweigh her exposure to the systemic risks that threaten diversified shareholders.
The Uncomfortable Reality
This leads to two conclusions that might seem counterintuitive:
First, the financial interests of shareholders sometimes will be best served if the companies they own reduce their own long-term financial returns. Second, executive pay should encourage such reductions if they result in net benefits to the economy.
Frances Haugen captured the tension when she highlighted Facebook’s repeated decisions to favor profit over the public good. Instead of “public good,” she could easily have said, “What was good for the long-term value of diversified portfolios.”
Facebook’s complicity in the Myanmar genocide, where the military was allowed to systematically use Facebook to foment hate and violence against the country’s minority Rohingya population, provides a horrifying example of profit maximization causing human suffering, but it also shows the economic devastation created by Facebook’s prioritization of profit over broad economic interest.
What Protecting Diversified Shareholders Means in Practice
It is 34 years since James Hansen, then the director of NASA’s Goddard Institute for Space Studies, told the Senate that “the greenhouse effect has been detected, and it is changing our climate now.” Despite the provisions of the Inflation Reduction Act designed to mitigate climate change, carbon emissions in the U.S., and much of the rest of the world, remain far off the track of scientific consensus. There are many reasons that governments around the world are unable to adequately address the externalization of the cost of carbon by businesses that find such activity profitable.
While we might prefer government-led solutions, myriad existential economic threats — including growing inequality, declining social cohesion, tax evasion, and soil loss — are not waiting on more effective regulation.
By acting at the investor level, shareholders can avoid the value-maximization trap that precludes executives from making system-preserving changes. Investors can level the playing field with standards that preserve the resource-allocation function of competition while making sure the competition occurs within sustainable boundaries, so profits represent true value creation rather than exploitation of scarce common goods.
Investors can take the following steps:
Establish universal guardrails. Unlike current ESG standards, guardrails must be developed outside of companies so they are set with a view toward maximizing the overall value of the systems that uphold markets, not the value of individual companies or industries involved in the negotiation.
Apply the guardrails through collective action at all relevant companies. To ensure that companies stay within guardrails, investors can vote against directors, take-private transactions, and companies that want to go public but don’t commit to follow the measures. Investors can do the same in private equity, venture capital, and hedge funds. Other companies outside of these channels can be influenced through their supply chains.
Avoid the trap of individual company engagement. As described at the beginning of this article, individual companies are not structured to address the broad systemic concerns that matter most to diversified investors. Moreover, without universal guidelines to create a level playing field, progress toward sustainability will be undone by nonconforming peers.
Design stock compensation that dovetails with guardrails. Equity plans should claw back shares when companies fail to adhere to guardrails.
Engage asset managers. Investors are not well served by managers that focus on matching or beating a benchmark if they are not engaging in the systemic stewardship described in this article. Mandates for managing portfolios, voting shares, or otherwise impacting governance must address this critical aspect of value for diversified shareholders.
It is time for a new paradigm that shifts the emphasis of investing from the performance of individual elements of diversified portfolios to the performance of the portfolio as a whole, with a focus on the interdependence of all companies, which are connected in the complex, global web that is the modern economy.
This shift is necessary to avoid potentially catastrophic violation of numerous planetary and social boundaries. A realistic assessment of corporate decision-making today must conclude that many current business models depend upon exploiting critical social and environmental systems.
Without a change in the investment paradigm, businesses will continue to drain critical social and natural resources, putting not just their investors at risk, but our entire global economy. Diversified shareholders have the power to push back; it is their responsibility to use it.
Frederick Alexander, a corporate governance lawyer for 30 years, is founding partner and CEO of The Shareholder Commons.
