Stakeholder Theory

The term stakeholders dates back to 1963 where it was defined by an internal memorandum at the Stanford Research Institute as “those groups without whose support the organization would cease to exist”, and include shareholders, suppliers,

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customers, employees, lenders and society (Freeman and Reed 1983, p.89). In 1968 a study by Igor Ansoff discussed what he called “stakeholder theory” stating that “this theory maintains that the objectives of the firms should be derived by balancing the conflicting claims of the various “stakeholders” in the firms: managers, workers, stockholders, suppliers, vendors”. (Freeman and Reed 1983, p.89).

Despite this history of the stakeholder concept, stakeholder theory was first publicized and brought to the forefront of the management field in 1984 by Edward Freeman (Stoney and Winstanley 2001), who was later called the father of the stakeholder theory (Laplume et al. 2008). Freeman and Reed (1983), in their seminal work, argue that the Stanford Research Institute definition of stakeholders is too general and proposed a definition which includes both friendly and hostile groups:

Any identifiable group or individual who can affect the achievement of an organization’s objectives or who is affected by the achievement of an organization’s objectives (p.91).

According to Freeman and Reed (1983), these groups or individuals could include government agencies, unions, competitors, shareholders, customers, protest groups, trade associations etc. Despite this specification of the stakeholder constituencies, the stakeholder theory does not provide guidance on who are the appropriate groups or individuals who should be included in the term stockholders (Sternberg 1999). If stakeholders include all those who are affected or can affect the organization, this would result in an infinite number of groups whose benefits are to be considered (Sternberg 1999).

Freeman and Reed (1983) differentiate between the broadly used stockholder model and their proposed stakeholder model and discuss the implications of the shift from the first view to the second. Particularly, they argue that in contrast to the stockholder model which put intense emphasis on managers to achieve the ultimate

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goal of maximizing shareholders’ wealth or value, the stakeholder model develops a wider view of corporate life and operations which focuses on addressing the responsibility of the firm not only towards owners, but also towards a broader group of constituencies “who have a stake in the actions of the corporation”: the stakeholders (Freeman and Reed 1983, p.89). Further, they contend that in a stakeholder model, public policy questions should be taken into consideration to provide an understanding of how the organization-stakeholders relationships would change in the light of implementing certain policies.

In a more recent study, Donaldson and Preston (1995) criticize the stakeholder literature arguing that it has failed to differentiate among the various aspects of the model, namely, descriptive, instrumental, normative and managerial. They define the first aspect as descriptive by which the theory “describes the corporation as a constellation of cooperative and competitive interests possessing intrinsic value” (p.66). This aspect was used by researchers to describe specific behaviours and characteristics of corporations such as their nature, how they are managed and how their boards perceive stakeholders’ interests.

The instrumental aspect views the theory as a base for examining the links between how stakeholders are managed and how different corporate objectives, whether they are financial, economic or societal, are achieved. In other words, proponents of this aspect suggest that adhering to stakeholder practices and principles would help corporations achieve their corporate objectives.

From a normative perspective, the theory was used “to interpret the function of the corporation, including the identification of moral or philosophical guidelines for the operation and management of corporations” (Donaldson and Preston 1995, p.71). Stakeholders are viewed as ends in themselves and not means to other ends,

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“and therefore must participate in determining the future direction of the firm in which it has a stake” (Donaldson and Preston 1995, p.73). Donaldson and Preston (1995) conclude that “the three aspects of stakeholder theory are mutually supportive and that the normative base of the theory – which includes the modern theory of property rights – is fundamental” (p.65).

Finally, using the managerial aspect the theory helps managers solve practical problems through offering prescriptive solutions and through recommending “attitudes, structures, and practices that, taken together, constitute stakeholder management” (Donaldson and Preston 1995, p.70). Managers are expected to respond to the various stakeholder interests “within a mutually supportive framework”, in an attempt to adhere to “the legitimacy of the management function” (Donaldson and Preston 1995, p.87).

Interestingly, Freeman and Reed (1983) demonstrate how the roles and tasks of the board of directors can be understood from a stakeholder perspective. They articulate that as stakeholders are encouraged to be involved in the governance and decision-making process, the board of directors is expected to “set the tone for how the company deals with stakeholders” and consider how their decision would impact key stakeholder groups (p.96). Yet, the board will not just monitor how managers are managing the firm, but also whether the latter is assessing each stakeholder group in terms of stake and power.

In the same vein, Wang and Dewhirst (1992) contend that the board’s role to “manage stakeholders and enhance corporate social performance” is more important than the other roles that the board is expected to discharge such as spanning boundaries (resource dependence perspective) and monitoring agents (agency perspective). “A firm’s objectives to identify various key stakeholders concerned,

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balance conflicting interests of and manage all key stakeholder groups, and enhance corporate social performance [are achieved] through the board of directors who represent various constituency groups” (p. 116).

Wang and Dewhirst (1992) argue that similar to the agency and resource dependence perspectives, the stakeholder approach considers non-executive directors on the board as crucial instruments to a firm’s performance. Such directors serve as delegates and guardians of a wide range of stakeholder groups and their role is to enhance corporate social performance rather than just to promote the financial performance of the firm.

Examining the association between the board of directors and stakeholder orientations, Wang and Dewhirst (1992) find that boards of directors perceive stakeholders distinctly and that stakeholders’ orientations differ between CEO directors and non-CEO directors as well as between inside directors and outsiders. Moreover, their results were consistent with the call of stakeholder proponents and reveal that boards of directors have perceived that their responsibilities include a wider group of constituencies than shareholders and that they have moved their belief from “the traditional management for stockholders to the management for stakeholders” (p.120). Finally, Wang and Dewhirst (1992) find that CEO’s are more concerned about issues related to customers and government regulations and less concerned about those related to shareholders than non-CEO’s.

Unlike agency theory, the stakeholder theory undermines private property and agency (Sternberg 1999). It undermines the former through denying owners the right to choose how they want to use their property; whether their choice is consistent with maximizing their own value or that of stakeholders (Sternberg 1999). On the other hand, it undermines agency through denying “the duty that agents owe

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to principals”, and being that the agent is accountable to all stakeholders means that he is effectively accountable to no one (Sternberg 1999, p.32).

Despite all the theoretical contributions of the stakeholder theory, it is still “incompatible with corporate governance” (Sternberg 1999, p.20). That is because it rather destroys than support firm’s conventional accountability which is the fundamental concept in corporate governance8 (Sternberg 1999). Moreover, the theory provides no guidance on how to choose among multiple inconsistent and competing interests of different stakeholders (Jensen 2002). Which stakeholder group to prioritize? Do firms focus on customers who want high quality and low prices or employees who want fringe benefits and high salaries? These are some of the questions which the stakeholder theory is not able to answer.