Introduction

The report examines the appropriate objective function for firms, particularly public companies. While law in the United States is often interpreted as requiring boards to maximise shareholder value, the authors argue managers should instead maximise shareholder welfare. Shareholders, as ordinary individuals, care about more than financial returns; they also value ethical and social outcomes. Externalities are often inseparable from production decisions, making profit maximisation too narrow.

A very simple model

A model is presented in which a founder takes a firm public and faces a choice between a ‘clean’ option with lower profit and no damage, and a ‘dirty’ option with higher profit but environmental harm. Prosocial investors may vote for clean outcomes if they feel responsible. The model shows that when externalities are separable, value maximisation aligns with welfare. However, when they are inseparable, shareholder welfare differs from market value, supporting the need for broader objectives.

Implementing the founder’s choice

Without restrictions, hostile takeovers can create an “amoral drift”, turning clean firms into dirty ones due to shareholder collective action problems. Legal measures such as poison pills and staggered boards limit this risk, but the perception of fiduciary duty as maximising value sustains drift. Founders seeking clean outcomes may use dual-class structures, charters with mission statements, or shareholder voting. Voting ensures outcomes align with majority preferences, unlike takeovers which bias towards profit. Competition may complicate decisions, as clean choices reduce margins compared to dirty competitors, though increased competition can sometimes make clean votes more likely.

Practical issues

Corporate directors’ fiduciary duty

There is confusion around fiduciary duty, often interpreted narrowly as value maximisation. The authors argue it should mean maximising shareholder welfare. Directors could poll investors on preferences, such as willingness to forgo returns to avoid harmful products. Digital tools make polling cheap and efficient. Specialised mutual funds that vote consistently on ethical issues could reduce cognitive burdens for investors, though proxy access rules currently limit such initiatives.

Invest and engage

Divestment from “sin stocks” is unlikely to affect long-term prices, as non-prosocial investors absorb them. Instead, “invest and engage” strategies, where investors hold shares and influence policy through voting, are seen as more effective. This requires easier access to shareholder votes on ethical issues.

Asset managers’ fiduciary duty

With institutional investors now holding 60% of public equity, their fiduciary duty is critical. US rules under ERISA focus on financial returns, while UPMIFA allows broader discretion for charitable funds. The report highlights risks of either politicising asset managers or ignoring social concerns. For mandatory pension funds, shareholder voting is recommended to reflect investor preferences. Voluntary funds can differentiate by offering strategies aligned with social objectives. Evidence from Europe shows institutional investors already influencing corporate environmental and sustainability performance.

Activists and takeovers

Hostile takeovers are now rare, with activists playing a larger role. Unlike takeovers, activist campaigns rely on shareholder voting, reducing amoral drift. However, institutional investors may still interpret fiduciary duty as value maximisation, supporting activists pushing for harmful but profitable actions. Redefining fiduciary duty as welfare maximisation would mitigate this issue.

Motivating our assumptions

The analysis assumes prosocial investors feel responsible only when directly involved in decisions, distinguishing between decision payoffs and final payoffs. This captures limited moral behaviour, such as willingness to vote for clean actions but reluctance to pay personally to change dirty companies. Alternative moral frameworks, such as consequentialism and Kantian imperatives, are considered. Consequentialism reduces but does not eliminate amoral drift, while a categorical imperative could significantly alter outcomes by preventing inefficient takeovers.

Comparison to the literature

Previous work often focused on charitable giving rather than inseparable externalities. Some models suggest prosocial bidders would buy dirty companies to clean them, whereas this report finds an asymmetry: clean companies can drift dirty, but the reverse is rare. Literature on corporate social responsibility shows similar concerns, but few explore practical governance mechanisms as this paper does.

Conclusions

Profit maximisation aligns with welfare only if externalities are separable or government perfectly internalises them, conditions rarely met. Shareholder welfare should replace market value as the objective of companies. Mechanisms such as shareholder voting can align firms with investor preferences, though concerns remain about costs and collective choice. Despite these, welfare maximisation is argued to be a more appropriate goal than market value.