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Critical Perspectives on Accounting 19 (2008) 603619

Maximizing the firms value to society


through ethical business decisions:
Incorporating moral debt claims
Marco G.D. Guidi , Joe Hillier, Heather Tarbert
Division of Accounting and Finance, Glasgow Caledonian University,
Cowcaddens Road, Glasgow G4 0BA, UK
Received 20 December 2005; received in revised form 22 December 2006; accepted 28 January 2007

Abstract
We argue that all three forms of justice (economic, legal, distributive) require to be incorporated
into the firms business decisions in order to protect stakeholders alienable and inalienable rights.
In addition, the firm has moral debt obligations which require to be distributed fairly amongst all
stakeholders. We develop a model that demonstrates that just distribution of stakeholders moral
debt and residual claims leads to the maximization of the firms value to society in the long-run.
2007 Elsevier Ltd. All rights reserved.
Keywords: Moral debt; Ethical business decisions; Distributive justice; Maximizing the firm value to society;
Alienable and inalienable rights; Pareto optimal; Market and legal systems; Nexus of contracts; Stakeholders and
shareholders

1. Introduction
Authors of corporate finance literature argue that the main objective of the firm is
shareholder wealth maximization (see for instance, Brealey and Myers, 2000; Copeland
and Weston, 1992). Shareholder wealth maximization is usually defined as the maximization of the discounted cash flows, whether in the form of dividends or capital gains, over
time. Clarkson (1991) argues that the concept of shareholder wealth maximization is being

Corresponding author. Tel.: +44 141 331 8076; fax: +44 141 331 3360.
E-mail address: marco.guidi@gcal.ac.uk (M.G.D. Guidi).

1045-2354/$ see front matter 2007 Elsevier Ltd. All rights reserved.
doi:10.1016/j.cpa.2007.01.003

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replaced with the concept of stakeholders wealth maximization through moral corporate
behaviour and decision making (see also Stiglitz, 2006; Donaldson and Dunfee, 2002).
Clarkson (1991, p. 190) defines stakeholder groups as those that are actively or passively
involved in the corporations activities, those groups, in effect, without whom the corporation could not operate or make a profit, and those groups who may be affected by the
corporations actions. In contrast to shareholder wealth maximization, stakeholder wealth
maximization is based on the premise that not one group of individuals are made better off
while some other group of individuals are made worse off. As Jensen (2001, p. 304) states
the real issue to be considered here is what firm behavior will result in the least social
waste or equivalently, what behavior will get the most out of societys limited resources
not whether one group is or should be more privileged than another (see also Pieper,
1966; Steiner, 1999). In order to reconcile the idea of shareholder or stakeholder wealth
maximization with minimum social waste, business decisions of the firm would need to be
ethical. As Pieper (1966, p. 6) points out quite distinctively virtue is a perfected ability
of man as a spiritual person; and justice, fortitude, and temperance, as abilities of the
whole man, achieve their perfection only when they are founded upon prudence, that is to
say the perfected ability to make right decisions. Ethical business decisions are defined as
decisions which would maximize the value of the firm to society. Thus, the nexus contracts
that constitute the firm (Boatright, 2002, p. 1849) would require to incorporate all three
forms of Justice (Pieper, 1966; Wilson, 1991): economic, legal, and distributive. If the firm
does not make Pareto optimal business decisions then all three forms of justice are not incorporated which implies that stakeholder rights will be violated due to unfair redistribution of
residual1 and non-residual claims. Stiglitz (1981) argues that Pareto optimal efficient market exists when there is no feasible allocation of resources which can make some individual
better off without making someone else worse off. Thus, the marginal social cost of a firms
activity increases with no corresponding marginal increase in social benefit.
In order to achieve business decisions that are Pareto optimal, three forms of justice
would require to be integrated into business decisions (Pieper, 1966; Wilson, 1991):
Economic justice can be defined as the right to receive the equivalent for a service rendered
or reparation for a loss sustained. Jensen and Meckling (1998) observe that the market
system is based on the ownership of private alienable2 (property) rights and the ability
to capture proceeds from decisions to sell these rights thus capturing the benefits from
exchange of goods or services.
Legal justice3 can be defined as the individuals or the organizations obligation which
relates to the fairness of participation by individuals in the economic system (Wilson,
1 The right to net cash flows differences between stochastic inflows of resources and promised payments to
agents (Fama and Jensen, 1998).
2 Alienable property rights include intangible assets and intellectual property (Claessens and Laeven, 2003).
3 Jensen and Meckling (1998) state that the assignments of rights in the USA was derived through the legal
system via: court decisions (common law), legislative enactments (statutory law) and administrative decrees
(administrative law). The USAs legal system is based on the English common law tradition characterized by
the independent judges and juries, relatively lower importance of statutory laws, and the preference for private
litigation as a means of addressing social problems whereas other legal systems are more socialist based on civil
law tradition that regulate activity more heavily (Shleifer, 2005, p. 448). See also Stultz and Williamson (2003)
on the relationship between religion, law, and rights.

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605

1991, p. 206). Furthermore, Rose-Ackerman (2002) observes that the firms legal personality gives the same obligation as that of the individual towards society (see also Bowie,
1991).
Distributive justice can be defined as the allocation of the benefits of an economic system
among all the members of that system (Wilson, 1991, p. 206). The firm redistributes4
claims owed to stakeholders in respect to their alienable or inalienable5 rights ensure
these business decisions are not Pareto optimal for society. Nothing belongs to the individual as exclusively theirs; all that belongs to them is a share in something common
to everyone. The purpose of distributive justice is to ensure that rights and claims are
equitably distributed (Feldman, 1971; Pieper, 1966).
Pieper (1966, p. 72) observes that all three forms of justice incur some kind of indebtedness. This indebtedness can be thought of as the firms obligation to protect the alienable
and inalienable rights of its stakeholders, which can only be achieved by integrating economic, legal and distributive justice into its business decisions. The integration of the three
forms of justice are necessary but not sufficient to discharge the firms total indebtedness.
In addition, the moral debt obligation would also require to be met by the agents of the
firm. The concept of moral debt has been discussed by Thomas Aquinas who distinguishes
between a demand of justice that is legally binding and a demand of justice that is (only)
morally binding. I can be compelled to fulfill the first obligation; carrying out the second
depends only on my own sense of decency (Pieper, 1966, p. 57). Therefore, moral debt
arises when the firm takes rights from other stakeholders has their own. In other words,
moral debt originates when the firm takes a benefit from others through not fulfilling just
business decisions (where just means protecting both alienable and inalienable rights).6
Therefore, the business decisions of the firm would need to incorporate the moral debt
claims of stakeholders and so the total value of the firm to society would require to include
all associated moral debt claims. The incorporation of moral debt expands Jensen (2001)
definition of total market value where the traditional definition of total value to society is
the market values of all the financial claims (including equity, debt, preferred stock, and
warrants, current liabilities including wages, taxes, and accounts payable). Theoretically,
according to Boatright (2002, p. 1842), stakeholders are free to bargain with the firm
over the most effective means for protecting its rights. Reiter (1997, p. 616) states the
nexus-of-contracts theory indicates a view of the firm that has perfect contracting relationships and where owners and managers are assumed to have bounded rationality and
self-interested motives. However, the stakeholder theory argument seems incomplete and
inadequate in defining and assigning the set of rights based on implicit and explicit moral
4 An example of redistribution is the unethical withholding of residual claims to any or all stakeholders whose
social contracts constitute the firm.
5 Inalienable rights pertain to a natural common claim associated with human rights such as the right to life,
shelter, work, education, access to clean drinking water, as well as decent wage, holiday pay, share in firms residual
incomeperformance related pay, etc. Therefore, inalienable rights cannot be transferred or repudiated. See also
the UN Universal Declaration on Human Rights (1948).
6 Moral debt differs from externalities in that externalities are a consequence of business decisions where a
monetary cost can be assigned via an appreciation of mainly alienable property rights even if there is no legal
obligation to repay.

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debt and the need for protection of rights (Donaldson and Dunfee, 2002). In fact, Sutton
and Arnold (1998, p. 255) point out that in the U.S. slavery survived because of unjust,
but accepted and enforceable, economic contracts. Current financial economic thinking
is based on the belief that market forces represent natural forces with beneficial powers
in allocating resources that ensures ethical business decisions (Reiter, 1997). In contrast,
there is strong economic argument that society requires to engage in the process of writing
laws and regulations, and ultimately to encourage the enforcement of these laws for better
stakeholder rights protection (La Porta et al., 2001; Stultz and Williamson, 2003; Shleifer,
2005; Stiglitz, 2006). The market system alone ultimately does not provide Pareto optimal
outcomes because not all rights can be defined, assigned and protected properly in the nexus
of contracts that make up the firm7 (Feldman, 1971; Hart and Moore, 1999; Newbery and
Stiglitz, 1982, 1984; Stiglitz, 1981). Newbery and Stiglitz (1982, p. 243) have shown that
even when individuals have rational expectations they have fully absorbed all the information which is available on the market and they use it efficiently in making production
decisions the market equilibrium is, in general, not even a constrained Pareto optimum.
In addition, the fact that the firm does not take ethical business decisions, which are Pareto
optimal, produces moral debt claims in the contracts that define the firm.
The main aims of this paper are to argue for the consideration of moral debt obligations and to formalize a model which demonstrates that just distribution of stakeholders
residual and moral debt claims leads to the maximization of the firms value to society in the long-run. The remainder of this paper is structured as follows. In Section 2,
we discuss the role of market and legal systems on social contracts and the asymmetric
nature of business decisions. In Section 3, we discuss going beyond the legal and market systems in protecting rights and supporting the firm in ethical business decisions. In
Section 4, we discuss the moral debt distribution model, the underlying assumptions
and implications moral debt claims in relation to stakeholders rights, fair distribution of
wealth8 and value-resetting/over-valuation9 of the firms equity. In Section 5, we discuss the
relationship between externalities and redistribution of wealth due to moral debt claims
and the need for informed consent for Pareto optimal business decisions. In Section 6,
concludes.

2. The role of the legal and market systems: a change in perspectives


The traditional financial economic perspective is that the main objective of the firm is
to maximize shareholders wealth. The natural consequences of having this perspective
are agency costs, conflicts of interest, and asymmetry of information between shareholders and stakeholders. Agency costs are due to managers not having identical interests as
shareholders (Jensen, 1986; Jensen and Meckling, 1976). There are also agency costs due
7 See also Chami et al. (2002) for review of why the market is limited to promote societys ethical claims on the
firm.
8 Including pecuniary effects, i.e. the wealth transfers due to price revaluations (Hirshleifer, 1971).
9 Agency costs of overvalued equity sets up organizational forces and incentives that are highly likely to harm
the firm and thus society (Jensen, 2003, 2004).

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to the conflict of interest between employees and managers. Conflicts of interests produce
asymmetrical consequences. This leads to shareholders or managers gaining upside benefits from non-Pareto optimal business decisions whilst the down side costs are borne by
stakeholders and thus society. For example, the dishonest and dangerous business decision
of managing earnings allow managers to achieve their short-term targets and to receive
bonuses, whilst keeping shareholders happy, may have very negative consequences to the
firm and society when the company goes into bankruptcy (Jensen, 2003, 2004). Jensen
(2004, p. 551) argues that the firm and the individual must, of course, be held accountable
for their actions, but if we are to get to the bottom of the problems we must understand
the forces in the system that led to this. A possible solution to non-Pareto optimal business decisions would require laws and regulations to help goal congruence by ensuring that
the firm and director share in the downside costs (Arnold and De Lange, 2004; Stiglitz,
2006; Stultz, 1999). The need for a more direct link between business decisions and consequences would allow more symmetrical distribution of the upside benefits and downside
costs. This will encourage the agents of the organizations to integrate the moral debt
claims in their business decisions by more symmetrical acknowledgement of the rights of
stakeholders.
This approach of sharing both upside and downside risk could also be applied to situations
caused by firm specific risk-taking such as catastrophes from oil spillage, e.g. Exxon Valdez
spill, or loss of life, e.g. in the U.K. with the Piper Alpha oil platform (see Stiglitz (2006) for
an excellent discussion on this matter). Such disasters could be reduced if business decisions
integrated all forms of justice. To encourage more ethical business decisions, the agents and
the owners of the organization should also share in the downside risk (Stiglitz, 2006; Stultz,
1999). For example, this is not the case at present in the US where outside directors
downside risk in the form of liability to personally pay damages or legal fees is covered by
insurance (Black et al., 2005). Nevertheless, US Congress passed The Sentencing Reform
Act in 1984 with specific focus on white-collar crime and the addition of Chapter 8 in 1991
made institutions, as well as agents of the firm, responsible for violations of any federal
law (Bear and Maldonado-Bear, 2002). Stiglitz (1981, 1982) observes that completeness
of (risk) markets is unrealistic and so maximizing current or long-term market value may
require different policies. Thus, laws and regulations that will support new ways to share
risk (Dixit and Pindyck, 1994) are a potential mechanism for alleviating redistribution of
claims and increasing the value of the firm to society (Stiglitz, 2006). In fact, many US firms
have adopted a corporate code of ethics since the introduction of The Sentencing Reform
Act, which may help to reduce fines imposed by the courts if the firm faces charges of
illegality (Brickley et al., 2002). Furthermore, in 2002 the United States Congress passed
the SarbanesOxley Act which makes the CEO responsible for the company accounts and
the misallocation of resources whose side effects are a loss of confidence in the market
system and large social costs that are greater in magnitude than regulatory costs (Stiglitz,
2006).
One school of thought is that the market system does not require more regulations since
the courts should enforce all contracts (Coase, 1960; Eastrebrooke and Fischel, 1991;
Stigler, 1964). Contracts enforced by the legal system are a vital underpinning of the market
system. However, it is assumed that these contracts are negotiated between sophisticated
(informed) issuers and sophisticated borrowers. This is based on the belief that one party of

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the contract cannot or will not exploit the other party by charging economic rents10 or quasi
rents11 and that economic and legal justice (excluding distributive justice) always prevail.
The implication is that these are the only forms of justice necessary to ensure that conflicts
of interests are minimized and thus that markets are efficient in the Pareto optimal sense.
Contrary to the traditional perspective (Arnold and De Lange, 2004; Feldman, 1971;
Hirshleifer, 1971; Jensen and Meckling, 1976; La Porta et al., 2001; Newbery and Stiglitz,
1982, 1984; Shleifer, 2005; Stiglitz, 1981, 1982) reject the argument that the competitive
market system and legally binding social contracts are sufficient to keep markets efficient in
the Pareto optimal sense and sufficient to protect all shareholders and stakeholders rights.
The market system allows informed traders to gain an economic rent at the expense of the
uninformed (Rajan, 1992). This economic rent is not a real social return (Hirshleifer, 1971).
La Porta et al. (1998) find that legal systems throughout the world vary in the way they
formulate legal rules and enforce such rules to protect shareholders rights. Shleifer (2005)
observes that countries with market systems associated with contracting theory (where
market discipline and litigation via the courts is used to obtain socially desirable outcomes)
are not always effective due to market limitations and frequent subversions of the courts (see
also Djankov et al., 2003; Johnson et al., 2002). Shleifer (2005, p. 445) strongly argues, The
Coasian ideal of cheap and efficient justice through private litigation is a far cry from reality.
In general, good protection and enforcement for stakeholders rights will limit the conflict
of interest, agency costs and moral debt claims between inside and outside stakeholders.
How stakeholders secure their set of rights and safeguard their interests depend on how
the nexus of contracts that constitute the firm are negotiated. Stiglitz (2006); Sutton and
Arnold (1998) argue that economic and non-economic stakeholders need to be considered as
constituents of the firm. Shleifer and Vishny (1997) observe that large investors have better
legal protection and can enforce their rights better than small investors. Recent developments
in academic research have shown that stakeholders derive benefits from having their residual
claims and rights protected (Gompers et al., 2003; La Porta et al., 2001). La Porta et al.
(2001) suggest that all outside investors of the firm need their rights protected and that if
rights enforcement is absent then insiders would not have much reason to distribute profits.
Thus, the cost and the limitations of the litigation process in the protection of stakeholders
rights do not conform to the Coasian ideal and additional solutions are required to address
the market system shortcomings (Stiglitz, 2006).
3. Going beyond the legal and market systems for Pareto optimal business
decisions
Fundamental to maximization of societys wealth, it has been argued that there is a
moral need to go beyond the market and legal systems to enforce contracts (Donaldson and
10 Economic rents (Pass et al., 1993)a money payment made for a factor of production which is over and above
the minimum payment to keep it in its present use in other words, a return in excess of the opportunity cost of the
resources to the activity.
11 Quasi rents (Pass et al., 1993)temporary economic rent accruing to such factors of production that are in
relatively price-inelastic supply in the short run but more elastic supply in the long run. In other words, a return in
excess of the short-run opportunity cost of the resources to the activity.

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Dunfee, 2002). As Andolfatto (2002) demonstrates, the well functioning market system will
potentially work against fair distribution of claims (social policy) that requires the legal
system through government intervention to protect inalienable rights (see also Feldman,
1971). Initially, we have to understand that individuals have the right to goods to satisfy
their basic survival needs and that society as a whole is obligated to satisfy moral debt
(Chandler, 1998; Pieper, 1966; Schumacher, 1993; Steiner, 1999). To maximize the value
of the firm to society, the firm would need to protect the alienable and inherent inalienable
rights and claims of all stakeholders.
Without legal justice, i.e. regulation and enforcement to ensure more ethical business
decisions, insiders would not have much of a reason to repay the creditors or to distribute
profits to shareholders (La Porta et al., 2001, p. 7). What La Porta et al. (2001) emphasize
is that alienable rights of stakeholders require legal protection and enforcement otherwise
a redistribution of residual claims will occur. Hence, Pareto optimality cannot be achieved.
Moreover, Gompers et al. (2003) find that firms with the strongest rights protection for
shareholders have significantly higher returns, are valued higher, and have better operating
performance than those firms that have provisions that reduce shareholder rights. Therefore,
there seems to be empirical evidence to indicate that better performing firms usually have
stronger rights protection encouraging a sharing of power between stakeholders rather than
concentrating power to a select few. Furthermore, market growth and efficiency suffers
in countries due to their poor investor protection (La Porta et al., 1997). More efficient
generation and distribution of residual claims arising from intangible assets are found in
countries that provide better rights protection (Claessens and Laeven, 2003). In fact, Shleifer
(2005), La Porta et al. (1997, 1998, 2001, 2004), Shleifer and Wolfenzon (2002), Glaeser
et al. (2001) and Beck et al. (2000) observe that countries that have strong regulations and
enforcement for the protection of stakeholders rights find improvements in development
and public participation in their respective capital markets.
Jensen (1986, 1988) suggests that the markets can be innovative in finding solutions to the
redistribution problem, for example, market driven takeover activities. Shleifer and Vishny
(1997) counter argue that the takeover mechanism is not the best solution for solving the
redistribution problem. Furthermore, Reiter (1997, p. 624) observes that hostile takeovers
do not conform to Pareto optimality stating, even if a total gain is produced by takeover
activity, the distribution in society could be inequitable. This is the concern of distributive
justice.
Legal and economic justice is necessary but not sufficient for Pareto optimal business
decisions. Stakeholders inalienable rights to common goods produce a moral debt claim
that requires to be justly distributed in relation to the firms nexus of contracts in order for
justice to prevail and for the maximization of the firms value to society. Alienable and
inalienable rights violations occur when claims associated with the moral debt obligations are not distributed. Shleifer (2005, p. 441) observes that private orderings indeed
work extremely well in some situations, but they also degenerate into anarchy of private
enforcement, where the strong and not the just win the day. Furthermore, Johnson et al.
(2002) and Djankov et al. (2003) find evidence on the limits of courts to enforce rights.
Ultimately, the problem with the moral debt claim is that it cannot be totally monitored,
regulated and enforced by legislation aloneit requires the individual, the firm, and the
government in power to be willing to be just in their decisions and actions. As in the case

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of the bankruptcy of Enron, the failure of stakeholder protection is non-trivial to a countrys


economic welfare (Stiglitz, 2006). As Morrison (2004, p. 336) observes, The series of
frauds and the governments response to those frauds have serious and wide-ranging consequences to the stability of our financial system. It is then necessary to ensure distributive
justice, which will help to satisfy stakeholders moral debt claims through their alienable
and inalienable rights. Ethical business decisions incorporating moral debt claims ensure
that those in power distribute claims to relevant stakeholders, including shareholders.

4. The moral debt distribution model and value-resetting


Following Black and Scholes (1973) and Merton (1973) path breaking work on financial option pricing modeling, Dixit and Pindyck (1994) observe that business decisions
(investments) are equivalent to call options on a common stock. In this context, the firms
business decisions, which include the moral debt claims, are analogous to a call option on
the common stock of the firm. This option will have an exercise price equal to DT , the total
value of the financial and moral debt, exercisable at the maturity date of the moral debt.
The underlying assumptions of the moral debt distribution model are:
When the probability of the moral debt holder enforcing a claim on the firm is negligible,
then the call option is always in the money for shareholders, all else being equal.
Firms with extremely large moral debt obligations may still have value to shareholders
but not necessarily society due to redistribution of claims.
Date of maturity of the moral debt is potentially instantaneous and ongoing because
alienable and inalienable rights are always present.
Total face value of the moral debt is never zero when the firm is in existence.
The moral debt claim may not be legally enforceable.
Value of the firm to society will be at its most efficient (Pareto optimal) when fair
distribution of the firms wealth and residual claims is achieved through the firms ethical
business decisions.
As can be seen from Fig. 1, the value of the firm to society is always less than to
shareholders if the moral debt is not justly distributed. Therefore, the moral debt claim
requires consideration before the true value of the firm to society is fully realized. It can be
seen from Fig. 1, the value of the firm to society (VSOC ) is always less than the value of the
firm to shareholders (VSH ) when the difference between total debt (DT ) and the financial
debt (DF ) of the firm is not zero. The difference in value between total debt and financial
debt is equal to the value of the moral debt claim (DMD ).
From Fig. 1, the following holds:
1. Value of moral debt is given by DT DF , when DT DF > 0, then VSH > VSOC .
2. Theoretically, the firm could reduce its moral debt claims to zero, then DT DF and
thus VSH VSOC .
3. Value of the firm to shareholders (VSH ) is given by max(MV DF , 0), where the maximum cost of the firm to shareholders is zero due to the limited liability status of firm
and because the moral debt cannot be fully legally enforced.

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Fig. 1. The moral debt distribution payoff graph. This graph represents the value of the firm to various stakeholders. Here we consider the case were business decisions made by the firm does not justly distribute claims to
all stakeholders (non-Pareto efficient) but such decisions are within market and legal (but not moral) acceptability
so will not incur external costs. Then, MV = market value of the firm = equity + debt, VSH = value of the firm to
shareholders, VSOC = value of the firm to society (i.e. all stakeholders), DF = financial debt claim, DT = total debt
claim and DMD = DT DF = moral debt claim on the firm.

4. Value of the firm to society (VSOC ) is given by max(MV DT , DT ), where the maximum cost of the firm to society as a whole is DT, which is when there is total
redistribution of claims.
The ideal situation would be to reduce the gap between total debt (which includes moral
debt) and financial debt to zero. A more realistic goal would be to reduce the gap between
total debt and the financial debt of the firm. The most ethical way to do this is for the
firm to behave justly in distributing all claims. This will ensure that the firms business
decisions incorporate moral debt claims and so will incorporate all three forms of justice
(exchange, legal, distributive). From Fig. 2 by reducing the moral debt claims on the
firm the value of the firm to society will increase by moving societys payoff line to the left
towards shareholders payoff line, all else being equal. That is, the value of the firm to society
increases from VSOC to VSOC2 due to the firm incorporating its moral debt obligations and
thus making more Pareto optimal business decisions, all else being equal.
The reality of justly distributing the moral debt obligations of the firm will impact
on residual claims available to shareholders and produce a value-resetting or fall in the
equity (share price) and thus the market value of the firm (Jensen, 2004). Fig. 3 shows what
happens when the moral debt claim is reduced and at the same time the market value
and thus equity (share price) decreases due to firm distributing residual claims to meet
its moral debt obligations, all else being equal. Jensen (2003, 2004; Fuller and Jensen,
2002) argue that the decrease in the value of the firm to shareholders is not a loss as such
but a value-resetting. From Fig. 3, the value of the firm to society increases from VSOC

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Fig. 2. The moral debt distribution payoff graph (reducing moral debt claims with no change in share price).
This graph represents the value of the firm to various stakeholders due to the distribution of claims by the firm.
Here we consider the case were business decisions made by the firm does justly distribute claims to stakeholders
(Pareto efficient) and such decisions are within market, legal, and moral acceptability will not incur external
costs for the firm. Then all else being equal, MV = market value of the firm = equity + debt. The value of the
firm before fair distribution of claims: VSH = value of the firm to shareholders, and VSOC = value of the firm to
society (i.e. all stakeholders), claims on the firm before fair distribution: DF = financial debt, DT = total debt, and
DMD = DT DF = moral debt. When a fairer distribution of claims is achieved then DT = total debt reduces to
DT2 , moral debt is reduced to DMD2 = DT2 DF and thus the value of the firm to society increases from VSOC to
VSOC2.

to VSOC3 while the value of the firm to shareholders decreases from VSH to VSH3 . This
value-resetting is in line with Jensen (2004) argument that the firm is over valued due to
the dishonest (non-Pareto) business decisions induced by the market system. Fig. 3 shows
that the firms market value is initially overvalued due to non-fulfillment of its moral debt
obligations and when the firm meets its moral debt obligations the firm naturally finds
a more sustainable (lower) market value and equity value and subsequently increases the
firms value to society (in the long-term). Stiglitz (1981, 1982) shows that the market system
serves to clear prices, and serves to convey and aggregate information; however, with costly
information, markets cannot be fully arbitraged. Therefore, information has social value if
it can effect business decisions and prices (Hirshleifer, 1971). Thus, value-resetting seems
to be a natural market system correction when the firm takes ethical business decisions by
integrating stakeholders moral debt claims.
Stakeholders implicitly keep the firms equity overvalued by:
Non-enforcement of all moral debt claims.
The nature of the firm having limited liability. Whereas, for example, partnerships that
have unlimited liability obligations have stronger incentives for contract compliance and
stronger incentives for monitoring than limited liability companies (Brickley et al., 2002;

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613

Fig. 3. The moral debt distribution payoff graph (reducing moral debt claims which leads to a decrease in
share price). This graph represents the value of the firm to various stakeholders due to the distribution of claims
by that firm. Here we consider the case were business decisions made by the firm does justly distribute claims to
stakeholders (Pareto efficient) and such decisions are within market, legal, and moral acceptability. For example,
the firm justly distributes residual claims amongst stakeholders then the share price must be affected if competitive
markets are efficient at discounting future cash flows. Note again, there will not be any external costs. Then the
equity of the firm will value-reset to revalue the firm at MV3 . The revaluation of the market value of the firm
due to revaluation of the equity (share price) and the more just distribution of claims will result in the societys
payoff line moving to the left so that the firms value to society increases from VSOC to VSOC3 . Because of the
firms business decisions, the Moral debt claim on the firm will decrease from DT DF to DT3 DF . Finally,
the value of the firm to shareholders will reset from VSH to VSH3 .

Stiglitz, 2006). Stiglitz (2006, p. 194) argues, limited liability can have large costs for
society, for example, the death, lifelong health and destruction of the community by the
Union Carbide explosion in Bhopal and the disparity between the terrible damage and
what the company was forced to pay an estimated $500 per person is also huge, by
any reckoning.
Shleifer and Vishny (1997, p. 760) suggest that the problem of expropriation by large
investors becomes potentially more significant when other investors are of a different type,
i.e., have a different pattern of cash flow claims in the company. This indicates that large
investors prefer to maximize private benefits of the firms business decisions rather than
distribute maximum residual claims. Then such non-Pareto optimal business decisions by
large investors can only be profitable for them and not for society or other stakeholders
due to the social costs borne through the violation of rights and claims. Thus, the firm can
redistribute wealth to the detriment of other stakeholders by ensuring that all or most of the
moral debt claims associated with alienable and inalienable rights cannot be enforced or
exercised at any time in the near future.
Jensen and Meckling (1976) observe that agency costs enable a firm close to bankruptcy
to become better off by taking higher risk investments, thereby redistributing wealth from

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stakeholders (e.g. bondholders) to shareholders. The value of the option rises when the
variance of the outcomes increases (this assumes of course that stakeholders cannot prevent
the change of the investment programme). When there are inadequate rights protection
for stakeholders the firm and its agents will have a strong incentive to engage in business
decisions that promise very high payoffs (upside benefits) with low probability of success
(downside costs borne by society). If the firm makes such non-Pareto optimal business
decisions, it will ultimately capture most of the wealth whereas other stakeholders will bear
most of the costs. Firms that redistribute moral debt claims have violated stakeholders
rights by taking (high variance) non-Pareto optimal investment decision. In contrast, ethical
investments12 distribute the benefits and costs in a just Pareto optimal manner. Thus, the
firm that undertakes the high variance non-Pareto optimal investment project redistributes
income and wealth from naive stakeholders to the sophisticated shareholders and ultimately
does not maximize societys wealth, i.e. the firms action is non-Pareto optimal. As Jensen
and Meckling (1976, p. 43) observe, If no redistribution of wealth between stakeholders
exist with respect to rational expectations then there will be no welfare loss.
In principle, it is possible in principle for stakeholders, to limit managerial business decision with support of the legal system (La Porta et al., 1998, 2001; Shleifer, 2005; Steiner,
1999). Laws and regulations that protect and effectively enforce every constituent stakeholder (inalienable, alienable) rights would impose constraints on management decisions
to violate these rights. The extent to which the legal system enforces rights protection
will have a major bearing on the effectiveness of capital markets (Shleifer, 2005). The
costs of regulating and enforcing such laws would invariably be non-trivial. Nevertheless it would be beneficial to society as a whole (see Shleifer, 2005 for in depth analysis
of the trade-off between different legal systems that impact on securities markets and
private or public enforcement of laws including the two extremes of capitalism and
communism).

5. Business decisions, externalities and share price over-valuation


Externalities are defined as an incomplete definition and assignment of alienable rights
to someone in the private economy (Coase, 1960). In other words, we might view an
externality-laden good as being composed of two goods: ones own consumption (a regular
good) and the benefit or harm to others of that consumptiona public good (Wheaton,
1972, p. 1039).
There are several views on how business decisions concerning rights and externalities
encourage Pareto optimal business decisions; these are (Boatright, 2002; Coase, 1960;
Eastrebrooke and Fischel, 1991; Wheaton, 1972):
12 The ethical investment program assumptions are: investment projects are beneficial to society if it provides
necessary goods (Fox, 1999; Schumacher, 1993). Investment projects provide wealth to society through job
creation, better housing, etc. That is, all investments require producing goods and services that society need whilst
protecting rights, alienable and inalienable. That is, investments do not produce externalities. Thus, there is no
exploitation by a more sophisticated and powerful stakeholder purchasing the rights of a nave stakeholder unfairly
without latters informed consent.

M.G.D. Guidi et al. / Critical Perspectives on Accounting 19 (2008) 603619

615

Directors must consider the impact of the social costs of business decision making.
Capital markets fail to correct business decisions that lead to externalities.
The political system needs to establish effective regulations, a tort liability system, and
contract law.
Externalities are not a matter for corporate governance.
Business decisions incorporating moral debt obligation ensuring distributive justice (as
well as exchange and legal justice) in protecting rights and thus minimizes externalities.
As Wheaton (1972) observes there may not be a solution within the traditional economic
framework in reducing conflicts of interests derived from externalities. Government intervention is only required when externalities or when relevant business and financial risks
cannot be traded in competitive capital markets (Dixit and Pindyck, 1994). The externalities
problem gives rise to situations in which the full social cost of business decisions are not
borne by the firm or individual taking the decisions (Jensen and Meckling, 1998).
Pieper (1966) observes that philosophers through the ages have concluded that for justice
to prevail individuals must give informed consent in selling their rights and moral debt
claims. Feldman (1971) observes that for the market system to operate efficiently traders
need to be informed so that they can make rational decisions and exercise their property
rights or the marginal benefit would be less than the marginal cost to society. For justice to
prevail stakeholders must give full informed consent with the understanding of the future
upside benefits and downside costs from their decision to sell each particular right. As
Gigerenzer (2003) observes informed consent is rare and many do not dare take an active
part in the decision process. In fact, the informed live in a world of risk (uncertainty)
with the associated costs and benefits of each decision knowing that their goals are different
from other stakeholders (Gigerenzer, 2003). Jensen and Meckling (1998), Eastrebrooke and
Fischel (1991), and Coase (1960) believe the market system, market prices, and litigation
process will ensure informed consent by stakeholders before their rights and moral debt
claims are purchased and at the same time protected. Others believe that the market system
functions better through specific regulations that need enforcing to improve stakeholders
rights protection and to reduce stakeholders claims being redistributed (Feldman, 1971;
Newbery and Stiglitz, 1984; Schumacher, 1993; Shleifer, 2005; Shleifer and Wolfenzon,
2002; Steiner, 1999).
Although certain firms incorporate externalities into their nexus of contracts, this still
does not hide the fact that this will inherently destroy stakeholders rights and redistributes
wealth belonging to the uninformed stakeholder (see Rajan (1992) on how Banks do this
to their customers). Therefore, in the presence of externalities maximization of the firms
value to society cannot be achieved even though firms are value-maximizing (Jensen, 2001).
As can be seen from Fig. 4, when externalities are present the firm will benefit from redistributing claims and this will lead to an over-valuation in the share price (Fuller and Jensen,
2002; Jensen, 2004). Fig. 4 also shows that shareholders will become better off because their
wealth will move from VSH to VSH4 due to the firm becoming over-valued from MV to MV4 .
Furthermore, society will become worse off because its wealth will decrease from VSOC to
VSOC4 due to an increase in the moral debt obligation from (DT DF ) to (DT4 DF ) for
the firm and therefore this will lead to an over-valuation of the market value (equity/share
price) of the firm.

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Fig. 4. The moral debt distribution payoff graph (increasing moral debt claims and market value/equity (share
price) of the firm because of redistribution of residual claims from stakeholders to shareholders). This graph
represents the value of the firm to various stakeholders due to the distribution of claims by the firm. Here we
consider the case were business decisions made by the firm does not justly distribute claims to stakeholders (nonPareto efficient) and such decisions are within market and legal but not moral acceptability. For example, the
firm unjustly distributes residual claims amongst stakeholders then the share price will be affected if competitive
markets are efficient at discounting future cash flows. This time there will be external costs to society that will
benefit the firm or management. Thus, the redistribution will make the market value of the firm MV to become
over valued to MV4 . The over valuation of the market value of the firm due to over valuation of equity (share
price) due to unjust distribution of claims will also result in the societys payoff line moving to the right so that
the firms value to society decrease from VSOC to VSOC4 . The value of the firm to society is because of the firms
non-Pareto business decisions will incur more Moral debt claims on the firm that will increase from DT DF to
DT4 DF . Finally, the over valued firm for shareholders will increase from VSH to VSH4 .

In summary, Fig. 4 shows that there is a direct relationship between moral debt claims,
over-valuation of share prices, and value of the firm to society. Shareholders can increase
the value of the firm by redistributing wealth from other stakeholders to themselves. This
is done by the firm not meeting its moral debt obligations thereby increasing the gap
between the firms total debt and financial debt. The lack of appropriate regulations and
enforcement on the market system in supporting the firm to take (Pareto efficient) ethical
business decisions by distributing residual and moral debt claims fairly to all stakeholders
will lead to over-valued and unsustainable share prices. That is, the firm can increase its
share price in two ways: by being Pareto or non-Pareto optimal in its business decisions.
The first way is to use ethical business decisions to increase shareholders and stakeholders
wealth. This will lead to just distribution of claims and value-resetting of the firms equity
and subsequently the firm value to society will be maximized. On the other hand, the firm in
making non-Pareto optimal business decisions by redistributing stakeholders claims will
also increase the conflicts of interests (agency costs) and thus facilitate an over-valuation of
the firms equity. This over-valuation will also be due to the increase in agency costs, which

M.G.D. Guidi et al. / Critical Perspectives on Accounting 19 (2008) 603619

617

may not necessarily favour shareholders, but may benefit a select group like management
or large block shareholders (Jensen, 2003, 2004; La Porta et al., 2001; Shleifer and Vishny,
1997) and will ultimately decrease the value of the firm to society.

6. Conclusion
To achieve the maximization of the firms value to society would require the integration of
stakeholders moral debt claims into business decisions. Logically, the firm that maximizes
its value only for shareholders incurs moral debt claims from other stakeholders, which
will make the firm less valuable to society. Due to the unique wealth generating power
of the firm, we argue that there is a moral obligation to incorporate the three form of
justice and, in particular, the moral debt claims of those stakeholders who do not have
the legal or financial power to enforce their inherent alienable and inalienable rights. As
can be seen from the moral debt model, the redistribution of claims from stakeholders to
shareholders pushes societys payoff line to the right and reduces the value of the firm to
society by over-valuing the firms shares. The value of the firm to society can only increase
if those in power (shareholders, directors, governments) go far beyond the current corporate
governance mandates and recognize that their business decisions will incur moral debt. The
explicit acknowledgment and incorporation of moral debt claims will ultimately increase
the value of the firm to society.

Acknowledgements
We would like to give special thanks to Robert Watson. We would also like to thank
Michael M. Grayson (referee), two anonymous referees, Reza Kouhy, Alex Russell and the
participants at the Glasgow Caledonian University research seminar for all comments and
suggestions. All errors and omissions are authors responsibility.

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