How America’s corporations lost their public purpose.
These may be flush times for the American corporation, but the bounty is not being translated into a prosperity that is sustainable or broad. How has the corporation’s vision become so foreshortened? Its largess so narrowly bestowed? Its malfeasance so widespread? Viewed from the perspective of history, the American business corporation has lost its way.
The business corporation got its real start in the 16th and 17th centuries and came fully into its own in the 19th century. It was the offspring of collaboration between government and a growing class of enterprising individuals.
On the one side, the government would see something that it wanted done because of a perceived benefit to itself or to the public — examples include the opening of trade with distant lands, the construction and maintenance of a road or canal, or the provision of insurance. The government would decline to do it itself, for lack of financial resources, administrative capacity or will.
On the other side, private businessmen would see the revenue potential in the activity, but would also decline to undertake it, whether alone or in partnership, perhaps because of insufficient resources or capacity, or the poor prospects of reasonable risk-adjusted returns.
The corporate form of business enterprise was a legal and institutional innovation designed to bridge this gap between public need and private risk. As Henry Carter Adams, then president of the American Economic Association, explained in his 1896 address to the group, “A corporation … may be defined in the light of history as a body created by law for the purpose of attaining public ends through an appeal to private interests.”
Both sides of this formulation are worth underscoring.
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First, the purpose of a corporation was not to maximize the returns to its stockholders, but to attain some specific public end. Arranging for stockholder returns was just the means to get this public purpose financed, and these returns generally took a back seat until the purpose was met.
Second, attainment of the public benefit end did not rely on public-spiritedness on the part of the investors, or even of the managers. It was assumed that most members of both groups would be driven primarily, or even solely, by private interest. This is a sobering fact for those who today call for “corporate social responsibility” while expecting this to come solely, or at least primarily, from investor and managerial commitment. Originally, what was expected to secure these public ends — what would turn private vices into public benefits — was neither investor and managerial intent nor the invisible hand of the market. Rather, it was the visible hand of the corporate charter.
Receipt of a charter is prerequisite to forming a corporate firm. Historically, a charter would be granted only if the proposed corporation’s activity was of clear benefit to the public. Eighteenth-century economist Adam Smith himself recommended being even more stringent. Aware that incorporation was a legal privilege, and doubtful that corporations were as diligently managed as partnerships, he advised granting charters only for undertakings that required capital outlays beyond the reach of partnerships, could be reduced to “routine,” and would, on the “clearest evidence,” bring public benefits beyond the ordinary. In his view, only banking, insurance, canals and waterworks satisfied all three criteria.
The corporation’s beneficial purpose was written into its charter, and to this purpose it had to stick. If a corporation failed to fulfill its purpose (for example, if a bridge company failed to start construction) it was dissolved by the state. Meanwhile, activities outside of this purpose were subject to being struck down by the courts. Finally, if the purpose was consummated — say, the bridge was completed — the corporation would be dissolved. Each corporation was tailored to advance a specific public end, and this end alone.
And what did the incorporators get in return? The benefits of incorporation.
Incorporation bestows a bundle of legal privileges, the most central of which is the charter’s creation ex nihilo of a new legal entity: the “juridical person” that is the corporation in law. This legal entity owns all of the firm’s assets, is the contracting party in all firm contracts, and sues and is sued in court.
Of course, the corporate entity, being a mere legal posit, cannot itself act, but relies on a board or other human agent to act on its behalf. In the language of the medieval jurists, the corporation is a “perpetual minor,” or ward, and the board its guardian, with a fiduciary duty to use the property and personnel of the corporation to advance the corporation’s authorized purposes. This in effect makes the firm a special form of “sole proprietorship,” with the corporation (the legal entity) as proprietor and management as its agent. The stockholders are not the proprietors. They are rather the owners of a financial instrument which, for historical reasons, is still called (misleadingly) a share of “stock” which the corporation is privileged to sell to them to finance the firm.
Having all property owned by the corporation provides the enterprise with two extraordinary benefits: “asset lock-in,” which prevents investors from pulling out assets from the firm, and “entity shielding,” which prevents the personal creditors of the investors from pulling out assets to settle investor debts.
In other words, they secure for the firm a perpetual body of assets — impervious to the deaths, departures and bankruptcies of investors — that can be accumulated across generations. This increases the firm’s realizable scale and longevity. And this in turn allows it to highly specialize its assets and to specialize its workers to these specialized assets, both of which increase firm productivity. The corporation is the business firm of choice for enterprises reliant on large amounts of specialized capital.
It is important to note that this separate legal entity is not something that individuals can create for themselves through private contract. It requires the sovereign’s legal fiat along with the sovereign’s willingness, as vouchsafed by the charter, to recognize this artificial person in court and enforce its property and contract claims. This explains why every single business corporation has been chartered or gone through some equivalent statutory process.
The corporation enjoys other privileges as well, beyond legal personhood, perpetuity and the right to issue shares.
Managers and investors are exempted from liability for company debts, which increases the appeal of leading and investing in them. Corporations are also granted the privilege of centralized management — for example, a board operating by majority vote — which allows for decisions to be made expeditiously without need for unanimity (as classically needed in general partnerships). Finally, every corporation is granted “jurisdictional authority” to enact rules beyond the law of the land, so long as not “repugnant” to the law of the land (for example, the bylaws and work rules of business corporations). In other words, every corporation is its own government with legislative and executive powers.
The corporation is in effect a “replicant” of the state — a Leviathan on a leash, with juridical personhood and legislative authority (like a state), franchised by the state to manage undertakings that, at least historically, the government wanted done but could not or would not do itself.
All of these corporate privileges are good for business, with the result that, in a broad range of circumstances, corporate firms operate at a significant competitive advantage to natural persons, whether sole proprietors or partners. For this reason, issuing a corporate charter was long considered justifiable only if there were some noteworthy public benefits to justify the advantage.
The neoliberal corporation
Today, the scene is much changed. Astonishingly, the most basic feature of the corporate firm — the state-ordained legal entity at its heart, owner of the firm’s property and party to all its contracts — has vanished from common understandings of the corporation, along with any sense that the corporation has a public purpose. Instead, for two generations the reigning wisdom has been that the business corporation is a private contractual association (a mere “nexus of contracts”) to be run in the interest of its shareholders alone.
In other words, the corporate firm is viewed as a glorified private partnership, with the stockholders as the partners. The stockholders, it is said, “own” the corporation, either literally or at least in the minimalist sense that they are its “residual claimants,” receiving what remains from corporate earnings after all contractual obligations of the firm to employees, suppliers, bankers and bondholders have been met. It is thus right, and efficient, that management work for them.
This view has been propagated especially by “Chicago School” (or “neoliberal”) theorists in economics, law and finance who have been anxious to square the corporation with free-market principles of private property, private contract and private profit. As Milton Friedman put the point in an infamous 1970 polemic, “The Social Responsibility of Business Is to Increase Its Profits”:
In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society.
By “owners,” Friedman meant “stockholders.” As a matter of legal fact, this description of the corporate firm is way off the mark:
1. Stockholders own stock, not corporate assets. The latter are owned by the legal entity, this being the main point of incorporating.
2. Stockholders are not the residual claimants of the firm. The corporation is the residual claimant. A portion of this residual may be passed on from the legal entity to the stockholders in the form of dividends, but this is entirely at the discretion of management (as Apple stockholders long rued).
3. Stockholders do not relate to the board as employers to employees, or principals to agents. The charter grants the board original jurisdiction over the firm’s property and personnel. Stockholders elect the board’s members, but this does not establish an agency relationship. The stockholders cannot dismiss the board prior to the next stockholder meeting, nor can they override its decisions or sue it for failure to follow instructions, as true principals could.
Yet while neither law nor history supports Chicago School theory, it has nonetheless gained wide currency and even significant institutionalization through the support of business opinion and legislation. How has this come to pass? And with what consequences?
From affirmative duty to zone of liberty
At the time of the United States’ founding, the public dimension of corporate bodies remained universally acknowledged. Accordingly, incorporation was granted strictly for business activities with a clear public benefit such as road and bridge construction, banking, and insurance, the objective being to erect the physical and financial infrastructure of civil society. Corporations were indirect arms of the U.S. states, chartered as part of public programs for economic and societal development.
But over the course of the 19th century, a number of developments occurred that obscured the corporation’s public provenance.
For example, competition among the states to attract corporations and collect franchising fees induced a “race to the bottom” in charter leniency, eliminating the restrictions and watering down the public benefit requirements that had set corporations apart from ordinary businesses. Corporations were allowed into ever more business lines, of decreasingly clear public benefit, until their range of activity was indistinguishable from that of private businesses. In a further move toward normalization, the purpose clauses of charters were opened up to include long lists of allowable activities, rather than one specific public end, transforming the purpose clause from a statement of affirmative duty into a zone of liberty.
The most important change of all, however, was the shift from individual chartering by the legislature to chartering by the secretary of state under general incorporation laws. This opening of access did much to undo the notion that incorporation was a “special privilege,” and thereby helped square the corporation, at least in the classical legal mind, with the liberal commitment to an economy based on private property and contract with minimal state interference.
In reality, however, this didn’t decrease corporations’ dependence on government one whit: receiving one’s charter — “personhood” — and jurisdictional authority from a secretary of state on authority of the legislature is no less of a government intervention than receiving it from the legislature directly. Incorporation remained, and remains, a government program for economic development. Nevertheless, the change in procedure changed the optics, and it became possible to imagine the corporation as a fully private entity that merely “registered” itself with the government.
On the back of these changes, it became commonplace in the closing decades of the 19th century to think of corporations as private associations not so different from partnerships or private trusts, with the shareholders as their owners and principals, and the board as the shareholders’ agent. Importantly, this “privatization” of the corporation was accompanied by a corresponding shift in the courts’ interpretation of the corporation’s purpose, from the public purpose enunciated in the charter to the stockholder’s purpose of money making — and thus a shift in the courts’ understanding of the fiduciary duty of directors, from a duty to the corporation’s public purpose, to a duty to its stockholders.
This view did not go unchallenged. The “great merger movement” at century’s end, which created monopolistic behemoths in industry after industry, led progressive era scholars to rethink the “privateness” of the corporation. In 1932, Adolph Berle and Gardiner Means published The Modern Corporation and Private Property, a kind of culmination of the new thinking and a “bible” of the early New Deal, with Berle serving in Roosevelt’s “Brains Trust.” Publicly traded corporations, the authors argued, had become semi-sovereign entities, with power comparable to that of national states. This made them “quasi-public.”
Yet, just when responsible control of them was most needed, stockholders, now numerous and dispersed, had become passive owners — mere rentiers, free from liability and exercising no responsibility. The social costs of this were too high to be tolerated. “[B]y surrendering control and responsibility over the active property, shareholders [have] released the community from the obligation fully to protect their property rights and cleared the way for placing the community in a position to demand that the modern corporation serve not [only] the owners or the control [group] but all society.” By the 1930s, the dominant view in legal circles was that directors were trustees for the corporation, but also for the community-at-large. Corporations had a social responsibility to the public.
This remained the dominant view for several decades. And it corresponded with an interval of great corporate success. Indeed, the period from the end of World War II through the 1970s is widely regarded by corporate scholars to represent the zenith of the American corporation — a period of high innovation and productivity in which, it should be noted, managers enjoyed freedom from stockholder pressure. At that time, the Business Roundtable subscribed to the notion of corporate social responsibility (with a helpful nudge from organizations such as unions and consumer groups), and corporate executives were compensated not with stock but with relatively modest salaries.
The view that corporations have a “social responsibility” is precisely what, starting with Friedman’s salvo, the Chicago School theorists attacked, seeing it as a stalking horse for increased state intervention in the economy, which they in turn saw as a slippery slope to totalitarianism. And because progressives had failed to shed the dogma that stockholders “own” the corporation, with “property rights” in it, the door was left open for those theorists to reassert the partnership conception of the corporation, as we have seen, and also to reverse the progressives’ prescription. What the corporate economy really needed, they argued, was for stockholders to be re-empowered, their “control and responsibility” reinvigorated.
The “shareholder primacy” norm gradually gained ground, propelled by Chicago salesmanship, managerial fear of hostile takeover, and the rise of the big institutional investors (mutual funds, pension funds, insurance companies and private equity firms) — investors powerful enough to apply pressure in the boardroom. Eventually, the Business Roundtable signed on (partially in 1990 and fully in 1997), as did the courts, reverting to the notion that the fiduciary duty of directors is to stockholders.
Although the principle of shareholder primacy was not new, its reassertion has been toxic for two reasons.
First, the character of the typical stockholder has changed. Between the decreasing cost of trades and the rise of actively trading institutional investors, the average time that stock is held has plummeted, from six years in the postwar decades to four months today. Such stockholders don’t behave like responsible owners, making improvements for long-term returns, but like renters — or worse, renters with insurance (limited liability) — quickly squeezing what they can out of the company before offloading it. To empower such stockholders — as has been done, for example, by mandating that they vote their shares, allowing them to nominate alternative directors on the proxy ballot, and eliminating staggered boards — is to invigorate irresponsibility.
Second, Chicago theorists model humans as motivated by self-interest, especially pecuniary interest, and not by fiduciary duty or other motives, and thus advocated shifting executive pay from salary to stock, in effect incentivizing CEOs to pursue stockholder enrichment regardless of its damage over the long term. Over the past 15 years, the CEOs of S&P 500 companies have paid out to stockholders (including themselves) on average more than 90% of corporate earnings, in the form of dividends and buybacks. From mid-2015 to mid-2016, it was 128%. How is this possible? By dipping into reserves, borrowing or selling off assets.
The great advantage of the corporate form is that it allows for assets to be accumulated and specialized to the production process. Chicago-inspired reforms undo this, decapitalizing the corporation for the sake of enriching the rentier investor.
One consequence is slowed economic growth, as stockholder payouts bring corresponding cuts to research and development, plant expansion, and worker training — contributions which do not immediately affect stock prices. In the 1950s, for example, 60% of U.S. corporate earnings were retained for R&D and expansion. Under 10% are today.
Another consequence is rapidly widening inequality. Over the last 40 years, U.S. corporate profits as a percentage of GDP have almost doubled, from an average of 5 to 6% to an average of 10%, and stockholders, including executives, are receiving almost all of them. The ratio of CEO pay to average nonmanagerial pay has risen from 20 to 1 in 1965 to (on the most comprehensive calculations) nearly 900 to 1 today.
Rethinking corporate governance
The stockholder-centric corporation of the Anglophone world is far from universal. In Germany, for example, 50% of the supervisory board must consist of worker representatives. In Denmark, the majority of publicly traded firms, including such well-known companies as Carlsberg brewing and Novo Nordisk, are under the control of nonprofit foundations. Both have weathered the globalization of the economy well. The Anglo model — in which stockholders elect the board, can call special meetings, and must approve major decisions — gelled in the 17th century and solidified in the early 19th century. That was a time when capital was scarce, when investments were long-term and illiquid, when major stockholders were familiar with the business, often assuming managerial roles, and when limitation of stockholder liability was the exception rather than the rule. Under such circumstances, it made sense to provide stockholders, whose capital was desperately needed, with extensive control rights, as a form of protection.
In today’s world, all of this has been turned upside down. Thanks to developments in modern banking and finance, we live in an era of investment capital glut, not scarcity. Companies “go public” so that entrepreneurs can cash out, not because they need the capital infusion. Indeed, corporations in aggregate are buying back more stock than they are issuing. Who really needs the stockholder today? The instances are few.
What is more, the stockholder has been transmogrified. The stockholders of today’s publicly traded corporations are the least knowledgeable, least liable, least contributing and least necessary of all the participants in the business. Yet we have re-engineered the corporation so that it attends to their pecuniary interests above all — over the well-being of workers, customers, the community, the environment, or even the long-term wellbeing of the company itself — empowering them to push management to maximize payouts today, and incentivizing management to comply.
No rational person, sitting down to design a governance structure for the modern corporation, would come up with the system we have. Yet the ideological baggage of corporate “privateness” and stockholder “ownership” prevents us from even considering a public remodel. We need to get past that. The legitimate financial interest of stockholders is today well protected by a host of laws and legal actions absent in the corporation’s founding era — such as derivative and class-action suits, and laws against director self-dealing, negligence, and insider trading.
The corporate economy began as a public program for state and national economic development, with corporations tied to public purposes. Shareholder primacy has put this into reverse, creating a slow-growth, high-inequality domestic economy, while sending significant portions of its productive capital abroad. Meanwhile, cuts to the tax rate of corporations have left government with fewer resources to soften the blow to those left behind, or to step into the void left by corporations in research, training and infrastructure upgrades. And in the backlash, democracy itself is imperiled. Realigning corporations with the public interest has become imperative not only for economic welfare, but for the very survival of self-government.
David Ciepley, an Associate Fellow of the Institute for Advanced Studies in Culture at the University of Virginia, is a 2019-2020 Berggruen Fellow at the Center for Advanced Study in the Behavioral Sciences at Stanford University. He is the author of Beyond Public and Private: Toward a Political Theory of the Corporation (2013).
(This article was adapted for Directors & Boards from an article titled “Wayward Leviathans,” that appeared in the Spring 2019 issue of The Hedgehog Review, hedgehogreview.com.)