Robert E. Wright
Dec 2013 | 328 pages | Cloth $69.95
Business | American History
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Table of Contents
Chapter 1. The Corporation Nation Emerges
Chapter 2. Before the Constitution
Chapter 3. Corporate Iniquity
Chapter 4. Corporate Ubiquity
Chapter 5. The Benefits of Big
Chapter 6. Governance Principles
Chapter 7. Governance Failures
Chapter 8. Regulation Rising
Chapter 9. Corporate Governance and Regulation since the Civil War
Chapter 10. Reforming Corporate Governance
Excerpt [uncorrected, not for citation]
The Corporation Nation Emerges
If they were honestly and safely conducted, [corporations] would afford a safe and satisfactory investment for small sums and thus tend to equalize the wealth of the people.
—V. H. Lockwood, 1897
The development of the for-profit business corporation over time has never been well understood, even in the nation most responsible for its economic ascendance, the United States. "American-style corporate capitalism," two business scholars recently proclaimed, "is an international juggernaut" (an overwhelmingly destructive force) and perhaps the single most important institutional feature of modern, developed economies the globe over. Yet even leading scholars of the U.S. economy have underestimated the number, ubiquity, and economic importance of early corporations, creating the misapprehension that they were insignificant until after, or perhaps during, the Civil War.
Two reporters for the generally astute economics weekly The Economist recently wrote a book that called the corporation "yet another quirky . . . invention" of "Victorian Britain." Many contemporaries, however, believed that America, not the Mother Country, was responsible for raising corporations from vehicles of monopoly privilege to a widely used form of business. "In no other age or country," wrote Andrew Allison in 1884, "have private corporations entered so extensively into the business of the country, never so thoroughly into the details of everyday life, as with us." Moreover, while Britain embraced the corporate form before most other nations did, the economies of both America and Britain were significantly corporatized well before Victoria's long reign began in 1837.
"By the time that [Supreme Court Chief Justice John] Marshall left the Court in 1836," legal historian Arthur Selwyn Miller noted in 1968, "the corporation . . . had become a key institution in American life." As the new data presented in Chapter 4 show, Miller's intuition was right. In addition to setting the historical record straight, this book seeks to improve the internal governance and external regulation of corporations today. Business leaders as well as policymakers have forgotten the conditions under which corporations thrive and the circumstances in which they are likely to flail or fail. That memory lapse has caused Americans some serious consternation recently—in the form of Enron, Lehman Brothers, Comcast, Fannie Mae, Bernie Madoff, and others too numerous to mention—and, I fear, will cause even more serious trouble in the relatively near future. Until they relearn to govern themselves, corporations will continue to face two major risks: increased government regulation and the withdrawal of investor demand. Either outcome could injure the economy, while the occurrence of both—if investors widely believe that new regulations would burden corporate profits without improving governance—could prove economically devastating. Think dangerous drop in liquidity, withdrawal of foreign portfolio investment, stock market meltdown, and ultimately decreased incentive for entrepreneurs to innovate due to an anemic IPO market. Such a disaster scenario is not unrealistic. Money, it is said, "stays where it is well treated," and currently, it is regularly abused by the nation's regulators and its largest corporations. Currently, the public has more confidence in gas-station attendants than in bankers and more confidence in auto repairmen than in investment advisers.
Corporate governance malfeasance has raised the cost of capital in the past and could do so again. After the Civil War, shady railroad managers frightened "legitimate investment," nearly killing "the goose which lays the golden egg" in the words of one critic. "Worthy stock enterprises," complained another, "languish from public distrust in stock companies." In the late nineteenth century, investment gurus regularly cautioned individuals not to buy common stocks because good information about corporate financials was lacking. Legal reforms aimed to change that; but in the wake of numerous scandals, their success appears doubtful.
Despite all the disclosure laws passed since, financial information remains of dubious quality. According to Jonathan Macey, one of the world's leading experts on all things corporate, stockholders must "trust" that corporate executives will treat their money right because "shareholders have . . . virtually no contractual rights to corporate cash flows." Most investors today don't know that, and they overestimate the power of regulators to monitor executives on their behalf. When investors realize that what they get in return for their hard-earned money is at the whim of overpaid corporate executives, not the rule of law, there will be economic hell to pay. "If the confidence of the public in great corporations is destroyed," noted one scholar during the Great Depression, "as it has been already sorely shaken in numerous recent instances of gross lapses from duty, the entire stability of our institutions will be thereby undermined." Disgruntled investors today could also withdraw from the equities markets, some scholars warn. "The fundamental problem of the corporation," noted economists Charles Calomiris and Carlos Ramirez in the mid-1990s, "is to secure funding from people who are not directly in control of the use of those funds." Without safeguards, managers can, and will, bilk investors to the point that "suppliers of funds may not find it worthwhile to transfer their savings to corporations." And because a majority of Americans now own stock, if only indirectly via their retirement accounts and other mutual fund holdings, the economic, political, and social risks of a "capital strike" are greater than ever. Even if such a strike were not widespread enough to result in economic meltdown, any sizable change in investor sentiments away from corporate securities would likely raise the cost of corporate capital and hence slow economic growth.
Before the Civil War, investors in U.S. corporations enjoyed much more security than they do today. Many of the "glaring abuses" and "evils" of modern corporations, a Depression-era corporate critic argued, "are due to the transformation of small, closely held, personal business corporations of the type which existed in the earlier days of the Republic, into nationwide companies whose stock is widely held in many dispersed hands and which too often are characterized by loose, careless management and control." The concomitant erosion of traditional governance checks and balances, this book will show, played perhaps an even larger role in the demise of investor security after the Civil War.
Action is necessary because the corporation is too economically important to be allowed to wither. Within a few years of adoption of the Constitution, the corporation was ingrained in almost every aspect of Americans' economic lives, from finance to transportation, as Joshua Gilpin discovered when he set out from Philadelphia "to the Western parts of Pennsylvania" in 1809: "After crossing the Schuylkill permanent Bridge [a corporation], we took the Lancaster turnpike [another corporation]," used money issued by corporate banks, and even slept in a hotel owned by a corporation. In 1835, a pundit noted that the great internal improvements of the period, "the roads, canals, tunnels, are the result of those laws which permit, and those systems of government which do not trammel, the association of wealth." As another corporate booster put it that same year, "almost every instance of valuable public improvement that meets the eye, is to be traced directly or indirectly to the agency of that much-decried monster—Corporation!" Still another, writing two years later, noted that if contemporaries looked in "different directions" they could not "but see their beneficial influences upon the condition of the country." If anything, corporations are even more important to the nation's economic health today.
Miller claimed that history provided "no convincing answers" for why America became the consummate corporation nation before the Civil War (1861-65). This book shows that a generally effective system of internal governance allowed early corporations to raise (what were then) significant sums of equity capital at start up without the aid of investment banks or other intermediaries. Americans did not invent the for-profit business corporation, but they did perfect the form—and far earlier than most believe—in the first half of the nineteenth century, surpassing the British and other precedents (discussed in Chapter 2) quickly and completely, despite the misgivings expressed by corporate critics detailed in Chapter 3. As Chapter 4 shows, by the early nineteenth century, the young nation had chartered more corporations than any other country on earth and sustained its lead throughout the antebellum period. As shown in Chapter 5, corporations proliferated widely throughout the nation, north and south, east and west, because the benefits of creating them generally outweighed the costs. Corporate privileges like the ability to sue and be sued in its own name, perpetual succession, use of a corporate seal, limited liability, entity shielding, share transferability, and relatively clear laws concerning the operations and governance of joint-stock companies allowed corporations to grow much bigger, much faster than they could have as traditional partnerships or sole proprietorships. That, in turn, allowed them to achieve scale economies (lower production costs per unit produced), the most profitable (Coasean) degree of vertical integration, and market power (some degree of control over prices and quantities). As eighteenth-century British political economist Sir James Steuart correctly noted, "by uniting the stocks of several merchants together, an enterprise far beyond the force of any one, becomes practicable to the community."
Incorporators had to pay postage, publishing, and other lobbying costs and were not assured of receiving a charter, but the expected direct costs of incorporation were typically minimal, especially after the passage of general incorporation acts in many states in the 1840s and 1850s. "The difference, in point of delay, trouble and expense, between forming a private corporation under a general law, and obtaining a special charter," a late nineteenth-century jurist claimed, "may be likened to that between modern traveling by railroad and the old fashioned stage coach." But the chartering of more than 22,000 businesses by special act before 1861 suggests that the "stagecoach" approach to incorporation was more an inconvenience than a barrier to entrepreneurs.
The indirect costs of incorporation and large size—the so-called agency costs of having numerous agents and employees complete important work tasks on behalf of the owners—were more substantial but could be mitigated by screening, employee incentives, and other governance principles, which are discussed in Chapter 6. A few early corporations survive to this day, but most eventually exited via bankruptcy, a deliberate winding down of their affairs, or merger (then typically called "amalgamation"). Most failed companies were driven out of business by more efficiently managed competitors, but a few were extinguished by corporate governance failures (various types of fraud), such as those detailed in Chapter 7. As described in Chapter 8, defalcations spawned regulatory responses that more or less prevented the exact repetition of earlier frauds but did little or nothing to prevent new types of expropriation from taking place. Chapter 9 takes up that theme by tracing the history of corporate governance and regulation from the Civil War to the present. The book concludes in Chapter 10 with the suggestion that a new approach to regulation is needed if the number and severity of corporate financial scandals are to be significantly reduced. Returning to the governance principles of our forebears is a good place to start.
Restoring internal governance to a semblance of health and improving external regulation will not be easy; nothing of such crucial importance ever is. Retaining investor confidence in corporations is essential to the nation's continued material prosperity. Corporate precocity helped the early U.S. economy to grow and develop more rapidly than any other in the world. "The limited liability corporation," Columbia University president Nicholas Murray Butler argued in the late nineteenth century, "is the greatest single discovery of modern times," a sort of "technology" that unleashed more familiar technologies like steam and electricity. Without corporations, reformer Henry Wood wrote in 1889, "science, invention, art, and production would fail to find wide and general expression, and material, commercial, and even intellectual progress would be turned backwards." If anything, corporations are even more important today.
It simply is not true, as some earlier economic historians believed, that the U.S. economy did not "take off" until sometime after 1830. The best available evidence indicates that per-capita incomes began increasing soon after the ratification of the Constitution and have continued unabated, save for the undulations of the business cycle, until the present time. The same goes for industrial production. America grew wealthy because of the solidity of its institutions, not its great expanse, a point that nineteenth-century Americans well understood. "A broad land is not necessary to a great people," one noted in 1845. "An earnest industry, a bold enterprise, a comprehensive wisdom, have made" the nation "what it is, and are able to make it all it could wish to be."
Nineteenth-century Americans realized that the business corporation was one of the most important of those growth-inducing institutions. "The surprising influence of these institutions, in promoting the general Improvement of the Country," Massachusetts governor Levi Lincoln proclaimed, "may be witnessed wherever they are situated. Look but to the villages of Lowell and Ware, places where the very wastes of nature, as if by the magic of machinery, have suddenly converted into scenes of busy population, of useful industry, and of wealth." "On a spot where a few years ago there was but two or three houses," aspiring pastor Ephraim Abbot noted in 1812, "there is a village of 64 families and 500 people in some way employed about the factory." "By their [corporations'] aid," a committee of New York legislators noted in 1826, "the spirit of improvement has marched into the wilderness with a rapidity of advance that has astonished the world, and new commercial towns have sprung up amid the haunts of the savage as if by the work of magic, where the wants of trade have been called for and been gratified with new establishments." Corporations, especially commercial banks, were believed to help farmers, a major contingent of the economy throughout the antebellum era, to bring "their lands into good order" and make them "very productive" by allowing them to erect "proper buildings," to use "clover and plaster" to restore tired lands, and to achieve economies of scale in livestock production. Banks and networks of transportation corporations also helped farmers to receive good cash prices for their crops far from major markets.
Corporations also lifted overall living standards. Railroads, for example, boasted that they could provide "ready and cheap access" to "beautiful rural district[s]" with their "healthful attractions to all who desire to seek them . . . to enjoy the invigorating air of the country . . . during the summer months." Businessmen could even commute daily by taking "the cars in the evening and retire to some cool retreat in the country . . . returning by an early train the following morning. It is needless to say, that this would be a convenience and a luxury that would be appreciated by a large class of the community." The Staten Island Railroad drew the "wealthy population" of Philadelphia and New York to the island "as a summer resort for sea-bathing" and served as the "center of delightful union between the refined and intelligent families of the two chief cities of this country."
The poor also benefited, primarily when they purchased low-cost goods produced by corporations that did not possess undue market power. Manufacturers "reduced the price of cloth to the consumer," a contemporary claimed, "more than two-thirds" without yielding more than 6 percent profit on average. At the same time, nails dropped from fourteen cents to less than five cents per pound, and many other goods also became more affordable. Many low-income individuals also received wages from corporations, but that benefit must be balanced with the fact that corporations displaced many tradesmen and other small businesspersons.
Corporations were not merely a convenient means of improving economic efficiency and living standards; they were often indispensable to those lofty goals because they provided unique ways for people to cooperate. As Butler claimed in 1911: "[C]ooperation . . . has come to stay as an economic fact . . . . It cannot be stopped . . . . This new movement of cooperation has manifested itself . . . in the limited liability corporation." "Perhaps the primary feature of a corporation," another early corporate historian explained, "is that it exists to further certain purposes, particularly purposes which those persons who have associated themselves with it—usually voluntarily, would find it difficult or impossible to achieve merely as individuals." "Large sums have in many instances been raised for carrying on private business, as well as improvements of great public utility," an anonymous author pointed out in 1829, "which could never probably have been carried through successfully without corporations." "Extensive experience," another wrote in 1852, "as well as observation, establishes the fact, that combinations may accomplish what individual cannot; what one may fail to accomplish for himself, the many may accomplish for each other."
In the early nineteenth century, private capital would go where even governments feared to tread. "The undertaking was deemed so hazardous that the State declined adventuring in it" was then a common refrain in corporate histories and charter petitions. With the exception of the large state canal systems, most of which ended disastrously, governments allowed pioneering entrepreneurs, such as investors in the Schuylkill Navigation Company, to bear the risk of spending too much on too little. "This, however," noted a contemporary, "is the history of every new business, large or small."
But people will invest only in enterprises that promise them a fair return, something many corporations today have trouble doing because of the shoddy ways in which they are governed. Pundits often claim that Americans do not save enough, but they rarely trace the cause to an underlying distrust of corporations—or rather, the individuals charged with managing them. As argued in the final chapter of this book, business and policy leaders can improve corporate governance by understanding and building upon past governance arrangements and thus reinvigorate a sagging U.S. economy.