This paper was first published on the website of the Russian International Affairs Council.
What standards should businesses observe in their own countries, or abroad? Businesses now have resources and influence that rival or surpass those of governments and certainly of ordinary people.[i] The choices businesses make can profoundly influence the lives of every person on the planet. Businesses, governments, and people now recognize that businesses must do much more than merely obey the law. Yet discerning and agreeing on globally appropriate rules for business behavior has been a formidable and contentious discussion among business leaders and academics.
While acknowledging all of the contentiousness, we now offer a modest proposal for a unifying global business ethics principle:
A basic duty of every organization is to earn stakeholder trust.
This principle is meant to replace a more familiar but flawed imperative: that the basic duty of each business leader is to “maximize shareholder value.” [ii] Such a duty has never been explicitly written into corporate law, yet is often practiced by CEOs as a way of avoiding dissatisfied shareholders and being replaced by a similarly dissatisfied Board of Directors. But a single-minded (заостренность) focus on profitability – especially very short-term profitability – has serious limitations and risks to the ongoing enterprise; we will explain why earning and maintaining stakeholder trust – including shareholders — can not only serve businesses’ bottom line over time, but also make the market economies where they operate much more sustainable.
Stating that businesses should earn and maintain stakeholder trust clearly implies that business should give moral consideration not only to owners, but also to small and large interest groups related to the business – groups such as customers, employees, creditors, suppliers, and even government. “Stakeholders” is, then, a much broader term than “investors.” The investors in a corporation include its shareholders, in a partnership its partners, in a privately held business its principals. These terms – particularly “shareholders” – are most often used when discussing who is affected by a business. Yet while investors are important, they are not the only groups with whom a business interacts. A business will typically have workers, customers, suppliers, and other people with whom it directly interacts. A business may owe money to a bank, or to bondholders, or other institutions. A business might interact with people and groups less directly. For example, a business might be the center of a community, or conduct research important to sick people, or develop technology to enable people. All of these groups, all of these people, are stakeholders in that business. All of these groups and all of these people are also part of the wider economy and social sphere in which these businesses operate.
So, it is the job of each business to earn stakeholders’ trust. But “trust” is an even more elusive concept than “stakeholders.” For each business, trust is often expressed in the value of its brand and its reputation. For a nation’s economy, largely powered by its businesses, the value of widespread trust among its businesses and institutions is abundantly clear: robust market economies need a high degree of trust to prosper. [iii] Trust contributes immeasurably to the functioning of an economy; a relative lack of trust degrades and disempowers a nation’s economy. No better example can be offered than the global economic crisis of 2008, which we will discuss in a future post.
The logic of establishing trust as a unifying principle is, therefore, straightforward. Businesses operate in an economic context and in a larger social and natural environment. Individual businesses succeed when there is consistent and positive economic performance. Because trust is a critical factor in creating a robust economy, businesses should therefore act in ways that engender trust in all its activities, not only in its interactions with shareholders, but with all relevant stakeholders. To do otherwise would degrade the economic environment and would ultimately condemn businesses to failure. When business succeeds investors, stakeholders and society benefit.
Stakeholder trust is created by organizational behaviors valued by stakeholders. Our hypothesis is that these behaviors are consistent with principles of business ethics, and therefore that trust levels can serve as accurate barometers for assessing a company’s business ethics.
Trust can be defined as expectations of reliable behavior under conditions of risk. A market economy depends on trust because its fundamental activities — trade and investment — require exposure to counterparty risks.
Trust is based on confidence in both character and competence. For example, the standard banking industry criteria for borrower trustworthiness (“5 C’s of Credit”) begins with character. Pirson and Malhotra find that “internal stakeholders, such as employees and investors, look most for evidence of managerial competence…. External stakeholders, such as customers and suppliers, typically care much more about technical competence”.[iv] Trust reflects reactions to personal experience with the organization’s representatives (fellow employees, marketing representatives) and to organizational culture, policies, reputation.[v]
Analyzing what behaviors are most likely to create trust is a challenge to every organization, and priorities will likely vary by industry, by national culture, by institutional strategy, etc. Research on both employee and customer trust, though, suggests that the basic elements are similar[vi]:
- Integrity, honesty
- Reliability, dependability, consistency
- Fairness, accountability
- Competence, capability: required skills, resources, authority are available
- Benevolence, shared values, empathy: a genuine interest in partner’s welfare and finding mutual benefit
- Communication, transparency: timely, comprehensive, comprehensible information; listening as well as speaking
- Responsiveness: timely, constructive reactions to issues
Research also indicates that there is a strong correlation between employee trust and customer trust; and that employee trust and customer trust both influence shareholder value.
Stakeholder Trust and Shareholder Value
Milton Friedman, a Nobel economist, famously wrote in 1970 that “The social responsibility of business is to increase its profits”.[vii] This evolved in the 1980s to the market economy mantra: “The purpose of the corporation is to maximize shareholder value,” where “value” was nearly always assumed to mean “financial value.” Money quickly became an end in itself: the common terms “capital markets,” “market economy,” “shareholder value” – now dominating discussions of business and economics – did not appear in 1970s economic texts. Today, maximizing shareholder value may be particularly inappropriate as a guide for businesses in emerging economies.[viii]
Profits serve as a proxy for value. It is widely assumed that profits reflect the collective judgment of the market, allocating resources to the “best” firms. But this assumption is undermined by a major shift in the behavior of investors: many shareholders no longer take long-term positions in most firms; rather, they acquire a financial interest on a temporary basis by buying securities. This has led to a very short-term focus on profitability, and has unintentionally encouraged firms to make highly-leveraged risks. One factor among many causing the 2008 subprime “meltdown” was short-term thinking by over-leveraged financial firms. Ignoring value to all stakeholders, some firms lost their economic value as well.
One of the world’s most successful shareholders, Warren Buffet, provides a different definition of “shareholder value”: “Lose money and I will forgive you. Lose even a shred of reputation and I will be ruthless.” Buffet goes on: “Wealth can always be recreated, but reputation takes a lifetime to build and often only a moment to destroy.”
Warren Buffet’s experience has taught him that stakeholder trust enhances shareholder value. The cost of losing trust can be demonstrated anecdotally: earnings decline, loss of market share, loss of market cap, etc. There are also other examples of the economic benefit of trust:
- In emerging economies, research indicates that the single most important element in economic development is trust, specifically “bridging trust,” or the willingness to cooperate across groups.
- In developed economies, shareholder trust can be quantified by the difference between a company’s asset value and its market value.
- The S&P 500 Price to Book Value list shows that from 1999 to 2014, the “trust premium” ranges from half the companies’ average value (in 2008, following the financial crisis) to about 84%.
- In accounting terms, the difference between book value and market value is called “goodwill.” Many of the components of goodwill are related to trust. Recent research on purchase price of acquired companies suggests that goodwill may make up on average as much as a third of the value of these companies.[ix]
- In recent years, the “competition” paradigm has shifted to a trust-dependent “cooperation” paradigm, called “coopetition”[x]: it is common now for companies to optimize their economic performance and customer service through sharing resources with competitors, in order to increase market size rather than market share. Examples include airlines sharing routes with other airlines; universities expanding their curriculum by sharing classes with other universities; banks making their cash machines available to customers of other banks. Intel, Nintendo, American Express, NutraSweet are among numerous other companies using this strategy.
The West, we believe, has done a serious injustice to emerging economies – including Russia – to have exported a version of capitalism that measures success by money only. It is time to correct that error.
In future posts we would like to discuss the following topics and others of interest to our readers:
- role of trust in reducing corruption
- role of customer and employee trust in enhancing profitability;
- role of trust in emerging economy economic development;
- unique role of trust in the global financial system and how this failed in 2008;
- role of civility in creating trust
While we will focus on business, we propose that earning stakeholder trust is not only the obligation of businesses but of all organizations. We look forward to your discussion of this proposition
We are grateful to Professor Donald Mayer, whose generosity in sharing his extensive knowledge and experience in the field of business ethics has been a valuable contribution to this paper.
[i] Daniel Yergin and Joseph Stanislaw, The Commanding Heights: The Battle Between Government and the Marketplace (2008)
[ii] Creating Shareholder Value by Alfred Rappaport: “VBM [Value Based Management] is an approach to management whereby the company’s overall aspirations, analytical techniques, and management processes are aligned to help the company maximize its value by focusing management decision making on the key drivers of shareholder value.” http://www.imanet.org/PDFs/Public/Research/SMA/Measuring%20and%20Managing%20Shareholder.pdf
[iii] Francis Fukuyama, Trust: The social virtues and the creation of prosperity (1995)
[iv] Unconventional Insights for Managing Stakeholder Trust by Michael Pirson and Deepak Malhotra, p.11
Unconventional Insights for Managing Stakeholder Trust by Michael Pirson and Deepak Malhotra, p. 17
Altman and Taylor, 1973;
Dwyer and LaGace 1986;
Larzelere and Huston 1980;
Heide and John (1992)
Dwyer, Schurr, and Oh (1987) p 21
An Examination of the nature of Trust in Buyer-Seller Relationships, Patricia M. Doney and Joseph P. Cannon Journal of Marketing April 1997 p.1
How the Best Leaders Build Trust, Stephen M. R. Covey http://www.leadershipnow.com/CoveyOnTrust.html
[viii] Mary Gentile describes other critical weaknesses in the “shareholder primacy” corporate governance concept, among them the fact that it is based on assumptions about underlying legal and cultural systems that don’t apply to emerging economies. See http://www.aspeninstitute.org/sites/default/files/content/docs/bsp/EABIS.GENTILE.2004-1.DOC.
[ix] 2013 Purchase Price Allocation Study by Houlihan Lokey http://www.hl.com/us/press/insightsandideas/4862.aspx
[x] Co-opetition by Adam M. Brandenburger and Barry J. Nalebuff (290 pages, Currency/Doubleday, 1996)