{"id":1503,"date":"2018-02-05T01:46:21","date_gmt":"2018-02-05T01:46:21","guid":{"rendered":""},"modified":"2020-09-15T14:44:17","modified_gmt":"2020-09-15T18:44:17","slug":"corporations","status":"publish","type":"cee","link":"https:\/\/www.econlib.org\/library\/Enc\/Corporations.html","title":{"rendered":"Corporations"},"content":{"rendered":"
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C<\/span>orporations are easier to create than to understand. Because corporations arose as an alternative to partnerships, they can best be understood by comparing these competing organizational structures.<\/p>\n<\/div>\n<\/div>\n

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The presumption of partnership is that the investors will directly manage their own money rather than entrusting that task to others. Partners are \u201cmutual agents,\u201d meaning that each is able to sign contracts that are binding on all the others. Such an arrangement is unsuited for strangers or those who harbor suspicions about each other\u2019s integrity or business acumen. Hence the transfer of partnership interests is subject to restrictions.<\/p>\n<\/div>\n

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In a corporation, by contrast, the presumption is that the shareholders will not personally manage their money. Instead, a corporation is managed by directors and officers who need not be investors. Because managerial authority is concentrated in the hands of directors and officers, shares are freely transferable unless otherwise agreed. They can be sold or given to anyone without placing other investors at the mercy of a new owner\u2019s poor judgment. The splitting of management and ownership into two distinct functions is the salient feature of the corporation.<\/p>\n<\/div>\n

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To differentiate it from a partnership, a corporation should be defined as a legal and contractual mechanism for creating and operating a business for profit, using capital from investors that will be managed on their behalf by directors and officers. To lawyers, however, the classic definition is Chief Justice John Marshall\u2019s 1819 remark that \u201ca corporation is an artificial being, invisible, intangible, and existing only in contemplation of law.\u201d1<\/a><\/span> But Marshall\u2019s definition is useless because it is a metaphor; it makes a corporation a judicial hallucination.<\/p>\n<\/div>\n

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Recent writers who have tried to recast Marshall\u2019s metaphor into a literal definition say that a corporation is an entity (or a fictitious legal person or an artificial legal being) that exists independent of its owners. The entity notion is metaphorical too and violates Occam\u2019s razor, the principle that explanations should be concise and literal.<\/p>\n<\/div>\n

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Attempts by economists to define corporations have been equally unsatisfactory. In 1917 Joseph S. Davis wrote: \u201cA corporation [is] a group of individuals authorized by law to act as a unit.\u201d2<\/a><\/span> This definition is defective because it also fits partnerships and labor unions<\/a><\/span>, which are not corporations. Economist Jonathan Hughes wrote that a corporation is a \u201cmultiple partnership\u201d and that \u201cthe privilege of incorporation is the gift of the state to collective business ventures.\u201d3<\/a><\/span> Economist Robert Heilbroner wrote that a corporation is \u201can entity created by the state,\u201d granted a charter that enables it to exist \u201cin its own right as a \u2018person\u2019 created by law.\u201d4<\/a><\/span><\/p>\n<\/div>\n

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But charters enacted by state legislatures literally ceased to exist in the mid-nineteenth century. The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state\u2019s role is purely formal and automatic. To call incorporation a \u201cprivilege\u201d implies that individuals have no right to create a corporation. But why is government permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued or holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, or that its shares are freely transferable, or if it asserted limited liability<\/a><\/span> for its debt obligations? (Liability for torts is a separate issue; see Hessen 1979, pp. 18\u201321.) If potential creditors find any of these features objectionable, they can negotiate to exclude or modify them.<\/p>\n<\/div>\n

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Economists invariably declare limited liability to be the crucial corporate feature. According to this view the corporation, as an entity, contracts debts in \u201cits\u201d own name, not the shareholders\u2019, who are not responsible for its debts. But there is no need for such mental gymnastics because limited liability actually involves an implied contract between shareholders and outside creditors. By incorporating (i.e., complying with the registration procedure prescribed by state law) and then by using the symbols \u201cInc.\u201d or \u201cCorp.,\u201d shareholders are warning potential creditors that they do not accept unlimited personal liability, that creditors must look only to the corporation\u2019s assets (if any) for satisfaction of their claims. This process, known as \u201cconstructive notice,\u201d offers an easy means of economizing on transactions costs. It is an alternative to negotiating explicit limited-liability contracts with each creditor.<\/p>\n<\/div>\n

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Creditors, moreover, are not obligated to accept limited liability. Professor Bayless Manning observed that \u201cas a part of the bargain negotiated when the corporation incurs the indebtedness, the creditor may, of course, succeed in extracting from a shareholder (or someone else who wants to see the loan go through) an outside pledge agreement, guaranty, endorsement, or the like that will have the effect of subjecting non-corporate assets to the creditor\u2019s claim against the corporation\u201d (1977, p. 7). This familiar pattern explains why limited liability is likely to be a mirage or delusion for a new, untested business, and thus also explains why some enterprises are not incorporated despite the ease of creating a corporation.<\/p>\n<\/div>\n

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Another myth is that limited liability explains why corporations were able to attract vast amounts of capital from nineteenth-century investors to carry out America\u2019s industrialization. In fact, the industrial revolution<\/a><\/span> was carried out chiefly by partnerships and unincorporated joint stock companies, and rarely by corporations. The chief sources of capital for the early New England textile corporations were the founders\u2019 personal saving<\/a><\/span>s, money borrowed from banks, the proceeds from state-approved lotteries, and the sale of bonds<\/a><\/span> and debentures.<\/p>\n<\/div>\n

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Even in the late nineteenth century, none of the giant industrial corporations drew equity capital from the general investment public. They were privately held and, to expand, drew primarily on retained earnings. (The largest enterprise, Carnegie Brothers, was organized as a limited partnership association in the Commonwealth of Pennsylvania, a status that did not inhibit its ability to own properties or sell steel in other states.)<\/p>\n<\/div>\n

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External financing through the sale of common stock was nearly impossible in the nineteenth century because of asymmetric information<\/a><\/span>\u2014that is, the inability of outside investors to gauge which firms were likely to earn a profit, and thus to calculate what would be a reasonable price to pay for shares. Instead, founders of corporations often gave away shares as a bonus to those who bought bonds, which were less risky because they carried underlying collateral, a fixed date of redemption, and a fixed rate of return. Occasionally, wealthy local residents bought shares, not primarily as investment<\/a><\/span>s for profit, but rather as a public-spirited gesture to foster economic growth<\/a><\/span> in a town or region. The idea that limited liability would have been sufficient to entice outside investors to buy common stock is counterintuitive. The assurance that one could lose only one\u2019s total investment is hardly a persuasive sales pitch.<\/p>\n<\/div>\n

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No logical necessity links partnerships with unlimited liability or corporations with limited liability. Legal rules do not suddenly spring into existence full grown; instead, they arise in a particular historical context. Unlimited liability for partners dates back to medieval Italy, when partnerships were family based, personal and business funds were intermingled, and family honor required payment of debts owed to creditors, even if it meant that the whole debt would be paid by one or two partners instead of being shared proportionally by them all.<\/p>\n<\/div>\n

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Well into the twentieth century, American judges ignored the historical circumstances in which unlimited liability became the custom and later the legal rule. Hence they repeatedly rejected partners\u2019 contractual attempts to limit their liability. Only near midcentury did state legislatures grudgingly begin enacting \u201cclose corporation\u201d statutes for businesses that would be organized as partnerships if courts were willing to recognize the contractual nature of limited liability. These quasi corporations have nearly nothing in common with corporations financed by outside investors and run by professional managers.<\/p>\n<\/div>\n

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Any firm, regardless of size, can be structured as a corporation, a partnership, a limited partnership, or even one of the rarely used forms\u2014a business trust or an unincorporated joint stock company. Partnerships are not necessarily small scale or short-lived; they need not cease to exist when a general partner dies or withdraws. Features that are automatic or inherent in a corporation\u2014continuity of existence, hierarchy of authority, freely transferable shares\u2014are optional for a partnership or any other organizational form. The only exceptions arise if government restricts or forbids freedom of contract (such as the rule that denies limited liability for general partners).<\/p>\n<\/div>\n

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As noted, the distinctive feature of corporations is that investment and management are split into two functions. Critics call this phenomenon a \u201cseparation of ownership from control.\u201d The most influential indictment of this separation is presented in The Modern Corporation and Private Property,<\/i> written in 1932 by Adolf A. Berle Jr. and Gardiner C. Means. Corporate officers, they claimed, had usurped authority, aided and abetted by directors who should have been the shareholders\u2019 agents and protectors.<\/p>\n<\/div>\n

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But Berle and Mean\u2019s criticism overlooked how corporations were formed. The \u201cFortune 500\u201d corporations were not born as giants. Initially, each was the creation of one or a few people who were the prime movers and promoters of the business and almost always the principal source of its original capital. They were able to \u201cgo public\u201d\u2014sell shares to outsiders to raise additional equity\u2014only when they could persuade underwriters and investors that they could put new money to work at a profit.<\/p>\n<\/div>\n

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If these firms had initially been partnerships, then the general partners could have accepted outside investors as limited partners without running any risk of losing or diluting their control over decision making. (By law, limited partners cannot participate in management or exercise any voice or vote, or else they forfeit their claim to limited liability.) A far different situation applies to corporations. Shareholders receive voting rights to elect the board of directors, and the directors, in turn, elect the officers. Although new shareholders could play an active role in managing these corporations, this happens only rarely.<\/p>\n<\/div>\n

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When a corporation is created, its officers, directors, and shareholders usually are the same people. They elect themselves or their nominees to the board of directors and then elect themselves as corporate officers. When the corporation later goes public, the founders accept a dilution of control because they value the additional capital and because they expect to continue to control a majority of votes on the board and thus to direct the company\u2019s future policy and growth.<\/p>\n<\/div>\n

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That the board of directors is dominated by \u201cinsiders\u201d makes sense. The founders are the first directors; later, their places on the board are filled by the executives they groomed to succeed them. This arrangement does not injure new shareholders, who buy shares of common stock because the corporation\u2019s record of performance indicates a competent managerial system. They do not want to interfere with or dismantle the system; on the contrary, they willingly entrust their savings to it. They know that the best safeguard for their investments, if they become dissatisfied with the company\u2019s performance, is their ability to sell instantly their shares of a publicly traded corporation.<\/p>\n<\/div>\n

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Berle and Means challenged the legitimacy of giant corporations when they charged that corporate officers had seized or usurped control from the owners\u2014the shareholders. But the control is never seized. Instead, investors make choices along a risk-reward continuum. Bondholders are the most risk-averse; then come those who buy the intermediate-risk, nonvoting securities (debentures, convertible bonds, and preferred shares); the least risk-averse investors are those who buy common shares and stand to gain (or lose) the most.<\/p>\n<\/div>\n

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Just as one may assume that investors know the difference between being a general partner and being a limited partner, so too they know that shareholders in a publicly traded corporation are the counterparts of limited partners, those who make passbook deposits in a bank, or those who buy shares in a mutual fund. All hope to make money on their savings as a sideline to their primary sources of income.<\/p>\n<\/div>\n

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To look askance at executives who supply little or none of the corporation\u2019s capital, as many of the corporation\u2019s critics do, is to condemn DIVISION OF LABOR<\/strong><\/a> and specialization of function. Corporate officers operate businesses whose capital requirements far exceed their personal savings or the amounts they would be willing or able to borrow. Their distinctive contribution to the enterprise is knowledge of production, marketing, and finance; administrative ability in building and sustaining a business, in directing its growth, and in leading its response to unforeseen problems and challenges.<\/p>\n<\/div>\n

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Some critics equate large corporations with government institutions and then find them woefully deficient in living up to democratic norms (voting rights are based on number of shares owned rather than one vote per person, for example). Thus shareholders are renamed \u201ccitizens,\u201d the board of directors is \u201cthe legislature,\u201d and the officers are \u201cthe executive branch.\u201d They call the articles of incorporation a \u201cconstitution,\u201d the bylaws \u201cprivate statutes,\u201d and merger agreements \u201ctreaties.\u201d<\/p>\n<\/div>\n

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But the analogy, however ingenious, is defective. It cannot encompass all the major groups within the corporation. If shareholders are called citizens or voters, what are other suppliers of capital called? Are bondholders \u201cresident aliens\u201d because they cannot vote? And are those who buy convertible debentures \u201ccitizens in training\u201d until they acquire voting rights? A belabored analogy cannot justify equating business and government.<\/p>\n<\/div>\n

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Millions of people freely choose to invest their savings in the shares of publicly traded corporations. It is far-fetched to believe that shareholders are being victimized\u2014denied the control over corporate affairs that they expected to exercise, or being shortchanged on dividends\u2014and yet still retain their shares and buy new shares or bid up the price of existing shares. If shareholders were victims, corporations could not possibly raise additional capital through new stock offerings. Yet they do so frequently.<\/p>\n<\/div>\n

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Particular corporations can be mismanaged. They are sometimes too large or too diversified to operate efficiently; too slow to innovate; overloaded with debt; top-heavy with high-salaried, and sometimes dishonest, executives; or too slow to respond to challenges from domestic or foreign competitors. But this does not invalidate corporations as a class. Whatever the shortcomings of particular companies or whole industries, corporations are a superb matchmaking mechanism to bring savers (investors) and borrowers (workers and managers) together for their mutual benefit.<\/p>\n<\/div>\n

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About the Author<\/h2>\n
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Robert Hessen, a senior research fellow at the Hoover Institution, taught American business history at Columbia and Stanford universities from 1966 to 1995.<\/p>\n<\/div>\n<\/div>\n

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Further Reading<\/h2>\n

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Bromberg, Alan R. Crane and Bromberg on Partnership.<\/i> St. Paul, Minn.: West Publishing, 1968.<\/div>\n
Conard, Alfred F. Corporations in Perspective.<\/i> Mineola, N.Y.: Foundation Press, 1976.<\/div>\n
Easterbrook, Frank, and Daniel Fischel. The Economic Structure of Corporate Law.<\/i> Cambridge: Harvard University Press, 1991.<\/div>\n
Hessen, Robert. In Defense of the Corporation.<\/i> Stanford, Calif.: Hoover Institution Press, 1979.<\/div>\n
Hovenkamp, Herbert. Enterprise and American Law, 1836\u20131937.<\/i> Cambridge: Harvard University Press, 1991.<\/div>\n
Manning, Bayless. Legal Capital.<\/i> Mineola, N.Y.: Foundation Press, 1977.<\/div>\n
Roe, Mark J. Strong Managers, Weak Owners: The Political Roots of American Corporate Finance.<\/i> Princeton: Princeton University Press, 1994.<\/div>\n

 <\/p>\n<\/div>\n

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Footnotes<\/h2>\n
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1.<\/a> Dartmouth College v. Woodward, 4 Wheat. 518, 636, 4 L.Ed. 629, 659, 1819.<\/div>\n<\/div>\n
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 <\/p>\n<\/div>\n<\/div>\n

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2.<\/a> Essays on the Earlier History of American Corporations, vol. 1 (Cambridge: Harvard University Press, 1917), p. 5.<\/div>\n<\/div>\n
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 <\/p>\n<\/div>\n<\/div>\n

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3.<\/a> American Economic History, 2d ed. (Glenview, Ill.: Scott Foresman, 1983), p. 129.<\/div>\n<\/div>\n
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 <\/p>\n<\/div>\n<\/div>\n

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4.<\/a> The Economic Transformation of America (New York: Harcourt, Brace, Jovanovich, 1977), p. 99.<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n

 <\/p>\n

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Related Links:<\/h3>\n

Corporate Financial Structure<\/a>, from the\u00a0Concise Encyclopedia\u00a0of Economics.\u00a0<\/em><\/p>\n

Corporate Taxation<\/a>, from the\u00a0Concise Encyclopedia\u00a0of Economics.\u00a0<\/em><\/p>\n

Market for Corporate Control<\/a>, from the\u00a0Concise Encyclopedia\u00a0of Economics.\u00a0<\/em><\/p>\n

Stock Market<\/a>, from the\u00a0Concise Encyclopedia\u00a0of Economics.\u00a0<\/em><\/p>\n

Richard Mahoney, Sarbanes-Oxley (SOX), Belts, and Suspenders: The Regulatory Aftermath of the Corporate Accounting Scandals<\/a>. February 2004.<\/p>\n

Dwight R. Lee, Socially Responsible Corporations: The Seen and the Unseen<\/a>. February 2013.<\/p>\n

Munger on the Nature of the Firm<\/a>. EconTalk, January 2008.<\/p>\n

Munger on Franchising, Vertical Integration, and the Auto Industry<\/a>. EconTalk, June 2009.<\/p>\n

Munger on Love, Money, Profits, and Non-Profits<\/a>. EconTalk, April 2010.<\/p>\n

Skeel on Bankruptcy and the Auto Industry Bailout<\/a>. EconTalk, July 2011.<\/p>\n

Michael Munger on Crony Capitalism<\/a>. EconTalk, February, 2019.<\/p>\n

Tyler Cowen on Big Business<\/a>. EconTalk, August 2019.<\/p>\n

Rebecca Henderson on Reimagining Capitalism<\/a>. EconTalk, June 2020.<\/p>\n","protected":false},"featured_media":23331,"template":"","class_list":["post-1503","cee","type-cee","status-publish","has-post-thumbnail","hentry","cee_category-corporations-and-financial-markets","cee_category-economics-of-legal-issues"],"yoast_head":"\nCorporations - Econlib<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.econlib.org\/library\/Enc\/Corporations.html\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Corporations - Econlib\" \/>\n<meta property=\"og:description\" content=\"Corporations are easier to create than to understand. Because corporations arose as an alternative to partnerships, they can best be understood by comparing these competing organizational structures. 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