Formal stakeholder protection
The firm’s choice of a course of action may be constrained by stakeholder protection
rules. We model this by assuming that - once projects are discovered - with probability
xr the manager is obliged to pick the project yielding B to stakeholders, independently of
whether this maximizes profits. This assumption has two interpretations. (a) Legal Stake-
holder Protection - A regulatory agency with the unique objective of maximizing stakeholder
welfare, and deriving no utility from money, has the formal right to make binding recom-
mendations over the choice of projects (for instance, it may rule out projects requiring a
polluting production process or impose a minimal standard of safety for consumers and
workers). However, it effectively exerts this right only if it is informed about the projects’
payoffs,10 which happens with probability xr ∈ (0, 1). We think of xr as being inversely
correlated to the authority’s degree of overload, and directly related to the quality of its
staff and the resources on which it can draw to pursue its investigations and enforce its de-
cisions.11 (b) Contractual Stakeholder Protection - A mutually agreed contract between the
firm’s owners and its stakeholders includes covenants ruling out projects that yield very low
outcomes to stakeholders (i.e., Bk = 0). The extent to which these covenants are enforced
(xr ) depends in turn on the amount of hard information that the firm is obliged to disclose to
stakeholder representatives. Firms’ agreements with NGOs and so-called “ethic indexes” to
comply with a minimal level of environmental performance and labor safety, and to produce
reliable information on these dimensions, are an example of such covenants.
Timing
The timing of events is described in figure 1. At t = 1, with probability π an alternative
manager challenges the incumbent CEO. If so, stakeholders may campaign and threaten a
boycott against the potential new management. The campaign succeeds with probability
a. At t = 2, the manager who is in control learns the payoffs and selects a new project
with probability θi (i = I, R). If stakeholder protection rules or covenants are enforced, the
manager has to comply with them; otherwise, she is free to choose her most favored project.
At t = 3, monetary payoffs accrue to shareholders and the manager (who also enjoys the
10 This descends from the assumptions that some projects yield a negative payoff to stakeholders, and that
projects all look alike ex-ante.
11This is a reasonable description of what determines the extent of regulatory agencies’ interference in firms’
activity. For instance, environmental activists consider the Environmental Protection Agency’s budget as a
crucial variable to be monitored. Friends of the Earth, a well-known US environmentalists organization, has
recently stressed how the Bush administration’s cuts to the EPA budget may damage EPA’s ability to make
and enforce recommendations and environmental laws. Among all budget cuts, the most criticized are those
to the Office of Science and Technology, which provides scientific backbone to EPA’s regulatory decisions
and actions, and those to EPA’s enforcement office (see http://www.foe.org).