Social Innovation Centre
The Legal Ontology of the Corporation as a Description of its Goal, And its Role in Society
______David RONNEGARD 2009/09/ISIC
The Legal Ontology of the Corporation as a Description of its Goal, and its Role in Society
by David Ronnegard*
* Post -Doctoral Fellow of Ethics and Social Responsibility at INSEAD, P.O.Box: 48049, Abu Dhabi, U.A.E; Ph:+971 2 446 08 08; Email:, [email protected]
A working paper in the INSEAD Working Paper Series is intended as a means whereby a faculty researcher's thoughts and findings may be communicated to interested readers. The paper should be considered preliminary in nature and may require revision.
This working paper was developed using funds made available through the Abu Dhabi Education Council, whose support is gratefully acknowledged.
Printed at INSEAD, Fontainebleau, France. Kindly do not reproduce or circulate without permission. ABSTRACT
The purpose of the corporation in society has been an issue of contention ever since the Berle-Dodd debate in the 1930’s and still resonates as part of the “basic-debate” in the field of business ethics today. Prescriptions on the purpose of the corporation should be argued in relation to a robust description of the purpose it actually has so that we know what change is being argued for. As the corporation is a manifestation of law it provides a privileged perspective for describing the purpose of the corporation.
This paper provides a description of the purpose (the goal and role) of the corporation in society through an analysis of four primary attributes of the corporate legal form. These attributes are the shareholder primacy norm; that the corporation is a separate legal entity from the shareholders; the transferability of corporate shares; and the limited liability of shareholders.
The paper explicates these legal attributes and describes their development in the
UK and the US. The function of these attributes is then analysed in the context of the industrial revolution when they arose. It is maintained that the attribute of shareholder primacy provides a description of the goal of the corporation which is to serve the interests of shareholders mainly through profitable production of goods and services. The role of the corporation is provided by the four attributes taken together. The paper maintains that the attribute of shareholder primacy serves the function of allocating resources efficiently while the other three (non-governance related) attributes function to ease capital solicitation and enable stock markets. Therefore, as a point of pure description, the purpose (the goal and role) of the corporation in society is to serve as a vehicle for production and economic growth.
2
I. INTRODUCTION
Ever since the Berle-Dodd debate in the 1930’s the purpose of the corporation has been an issue of contention. Adolf Berle argued that corporate law should be regarded as essentially a form of trust law thus placing focus on the fiduciary obligations of managers to run the corporation in the interest of shareholders.1 Merrick Dodd on the other hand thought that corporate law was rightfully heading in the direction of allowing corporate managers to take into account the interests of a wider set of constituencies in their decision-making.2
The issues at the heart of the Berle-Dodd debate still resonate today in the field of business ethics. What is known as the “basic debate” in business ethics concerns whether the corporation’s purpose should be to further the interests of its shareholders or whether it should have responsibilities to a wider constituency of stakeholders. This is usually referred to as the Freidman – Freeman debate due to Milton Freidman’s advocacy of what has been called Shareholder Theory,3 which is usually considered opposed to Edward
Freeman’s Stakeholder Theory.4 These theories are primarily seen as prescriptive in business ethics arguing for the purpose the corporation should have.5
1 See, Adolf A. Berle, Corporate Powers as Powers of Trust, 44 HARV. L. REV. 1049, (1931); Adolf A. Berle, For whom are Corporate Managers Trustees: A Note. 45 HARV. L. REV 1365, (1932). 2 See, Merrick E. Dodd, For Whom are Corporate Managers Trustees?, 45 HARV. L. REV. 1145, (1932). 3 See, Milton Friedman, The Social Responsibility of Business is to Increase its Profits, in ETHICAL THEORY AND BUSINESS, (Tom. L. Beauchamp, & Norman E. Bowie eds. 2003). 4 See, R. Edward Freeman, STRATEGIC MANAGEMENT: A STAKEHOLDER APPROACH, (1984); William M. Evan & R. Edward Freeman, A Stakeholder Theory of the Modern Corporation: Kantian Capitalism, in ETHICAL THEORY AND BUSINESS, (Tom. L. Beauchamp, & Norman E. Bowie eds. 2003); R. EDWARD FREEMAN, JEFFREY S. HARRISON, & ANDREW C. WICKS, MANAGING FOR STAKEHOLDERS: SURVIAVAL, REPUTATION, AND SUCCESS, (2007). 5 Although these theories about the purpose of the corporation in society are primarily prescriptive they can also have descriptive interpretations. See, e.g. Thomas Donaldson & Lee E. Preston, The Stakeholder 3
Corporate law has an important contribution to make to the field of business ethics by offering a solid foundation for a description of the purpose of the corporation in society.
The purpose of the corporation can be divided into two perspectives, its goal and its role.6
The goal of a corporation is its purpose seen from the perspective of the corporation, while the role of the corporation is its purpose seen from the perspective of society.7
The Berle-Dodd debate was primarily a discussion about the goal of the corporation looking at whose interest’s managers should represent. This is also a central concern in business ethics although it often gets intertwined with the role of the corporation. The subject of corporate law is not much considered by those who engage in the field of business ethics; however it is occasionally discussed with regard to the goal of the corporation because some scholars claim that the shareholder primacy norm in the common law constrains managers from considering the interests of non-shareholder stakeholders in their decision-making.8 On the other hand corporate law has been absent from any discussion on the descriptive role of the corporation in society.
Theory of the Corporation: Concepts, Evidence, and Implications, 20 ACADEMY OF MANAGEMENT REVIEW 65, (1995) 6 Please note that I will use the term “purpose” throughout this text to collectively refer to the terms “goal” and “role”. 7 An example of this type of goal vs. role distinction is how the goal of each actor in a competitive market is to further their own interest, but the role this competitive behaviour plays in society is to achieve efficient allocation of resources. Note that the goal and role of the corporation are not independent from each other. In particular the goal of the corporation will influence how corporations operate with regard to their stakeholders and thus affect the role of the corporation in society. Conversely, given the role that we desire the corporation to have in society one may then evaluate what this requires from the goal of the corporation. 8 See, John R. Boatright, Fiduciary Duties and the Shareholder-management relation: Or, what’s so Special about Shareholders?, 4 BUSINESS ETHICS QUARTERLY 393, (1994); John L. Campell, Why would Corporations Behave in Socially Responsible Ways?: An Institutional Theory of Corporate Social Responsibility, 32 ACADEMY OF MANAGEMENT REVIEW 946, (2007); Evan & Freeman supra note 4; Robert C. Hinkley, How Corporate Law Inhibits Social Responsibility, 62 THE HUMANIST 26, (2002); Phillips, Freeman & Wicks supra note 4; Kellye Y. Testy, Linking Progressive Corporate Law with Progressive Social Movements, 76 TUL. L. REV. 1227, (2002). It has however been convincingly argued 4
Friedman prescribed that the corporation should “use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game”9 whereas business ethics scholars like Freeman prescribe that the corporation should be a vehicle for managing stakeholder interests. It is unclear whether Freidman and Freeman intend their prescriptions to apply to the goal or role (or both) of the corporation, they simply do not make this distinction. Irrespective of where one stands in the prescriptive debate it is clear that the corporate legal form is a manifestation of law and therefore a descriptive account of the legal ontology of the corporation can be given. The purpose here is to provide a description of both the goal and the role of the corporation. This is not only interesting as a descriptive insight in itself, but importantly it provides a starting point for any prescriptive argument about the purpose of the corporation. These prescriptions should be made in relation to the goal and role the corporation actually has because it is only then that we understand what potential change is being argued for.
Looking at the purpose of the corporation in society through its legal attributes does not merely provide yet another descriptive perspective. The basis for the corporation’s existence is the corporate legal form which places the description of the purpose of the corporation in society through this perspective in a privileged position.
Any other descriptive perspective should at least not be inconsistent with this description.
that the shareholder primacy norm is no longer efficacious as a legal norm. See, D. Gordon Smith, The Shareholder Primacy Norm., 23 J. CORP. L. 277, (1998) (argues that the shareholder primacy norm is muted by the business judgment rule). 9 MILTON FRIEDMAN, CAPITALISM AND FREEDOM 133 (1962). 5 I will give an account of the legal ontology of the corporation by explicating its primary legal attributes. In turn, understanding the economic function of these attributes through the historical context under which they arose provide us with a description of the purpose of the corporation in society.
The corporate legal form has four fundamental legal attributes. They are the shareholder primacy norm; that the corporation is a separate legal entity from the shareholders; the transferability of corporate shares; and the limited liability of shareholders.10 Nowadays these attributes are unique to the corporate legal form in most jurisdictions in the world as a default position upon the act of incorporation.
The historical development of these four attributes have been discussed separately before,11 but not synthesised. Furthermore, drawing on these legal developments in the light of their economic and social effects in order to yield a descriptive account of the purpose of the corporation in society is new. I will argue that the purpose of the corporate legal form is to serve as an instrument for production and economic growth. Although business enterprise in any legal form is beneficial to production and economic growth the corporate legal form has proven to be particularly well suited for the task and dominates the business landscape of free market democracies. In making the argument of this
10 See, REINIER. R. KRAAKMAN ET AL., THE ANATOMY OF CORPROATE LAW 5 (2004). Note that I account for Kraakman et al’s attributes of “delegated management” and “investor ownership” through the attribute of shareholder primacy as it is involves the relation of management to the owners if the corporation. Also note that Kraakman et al’s characteristic of “corporate personality” is equivalent to my characteristic of “corporation as a separate legal entity”. 11 See, Smith supra note 7 (on the shareholder primacy norm); Murray A. Pickering, Company as a Separate Legal Entity, 31 MOD. L. REV 481, (1968) (on the development of the corporation as a separate legal entity); Paddy Ireland, Capitalism Without the Capitalist: The Joint Stock Company Share and the Emergence of the Modern Doctrine of Separate Corporate Personality,17 J. LEGAL HIST 41 (1996) (on the development of the transferability of corporate shares); Frank Easterbrook & Daniel Fischel, Limited Liability and the Corporation, 52 U. CHI. L. REV. 89, (1985) (on the development of limited liability). 6 instrumental purpose of the corporation it is important to note that we are discussing the corporate legal form and not the purpose that any single corporation may have. In other words we are discussing the purpose of the corporation as a constructed legal institution in society.12
In the first part of the paper (The Legal Ontology of the Corporation) I shall start with a brief historical look at the development of the corporate legal form from the first corporations that were granted Royal Charter in 15th century England. I will then in turn explicate the four attributes of the modern corporate legal form by looking at their legal development and their economic function. I will be focusing on the legal development of the corporate form primarily in English law because the corporate form is by and large an
English development. I will also to some extent be looking at American corporate law because America adopted the English law of corporations without change at the end of the American Revolution (1784), and provides insight into the reasoning behind the genesis of the modern corporate legal form.13
In the second part of the paper (The Goal and Role of the Corporation: The
Corporation as an Instrument for Production and Economic Growth) I will place the significance of the corporate legal attributes in the context their development, the
12 One might reasonably ask how this argument is different from simply saying that business enterprise in general is beneficial to production and economic growth. The important difference is to view the goal and role of the corporation in society from a legal and economic perspective rather than a merely economic one. Business enterprise is not conducted in a legal vacuum; all types of business enterprise are conducted through one legal form or another. The corporate legal form dominates the business landscape and by viewing the corporation through this legal perspective it allows us to describe the role of the corporation in society as an intentional construct for society to make use of, rather than focusing on the individual corporation as our unit of analysis. In particular, as a legal construct the corporation exists to serve our purposes, and as such it can be augmented if we so desire it. 13 Where there is a significant difference between UK and US law this will be explicitly addressed. 7 industrial revolution, in order to show how the corporate legal form as a whole serves as an instrument for production and economic growth. I will consider the shareholder primacy norm as part of a legal description of the goal of the corporation because it directly deals with the governance of the corporation. I will maintain that the shareholder primacy norm is today no longer efficacious as a legally enforceable norm, but is still alive as a business norm among managers due to the structure of corporate law that vests sole voting rights for the board of directors with shareholders. The other three attributes will be considered as part of the role of the corporation in society because they have important financial effects that are primarily of significance on the aggregate. I shall maintain that the goal of the corporation is to serve the interests of the shareholders through profitable production, while its role is to serve as a social instrument to facilitate economic growth.
II. THE LEGAL ONOTOLOGY OF THE CORPORATION
A. The First Corporations
The first corporations were craft guilds and trading companies to which the
English crown granted Royal Charters in the 15th century.14 It was through charters that the crown transferred its powers to groups and individuals (for example Magna Carta, simply means “great charter”). The chartering of a company was known as
“incorporation” because it united the members into one body under the charter. The monarch would call upon a guild or company to perform a public task, such as building a
14 See, PILLIP I. BLUMBERG, THE MULTINATIONAL CHALLENGE TO CORPROATE LAW: THE SEARCH FOR A NEW CORPORATE PERSONALITY (1993). 8 bridge, and would grant it a Royal Charter throughout the duration of the task. (The public role of the corporation was at this time fairly straight forward.) The granting of
Royal Charter often carried with it several privileges which were written into the charter itself for each company. These privileges were granted because the corporation was meant to contribute to the public good and because it sometimes assumed public responsibilities as part of its operations. For example a charter could confer the privilege of monopoly status to a company stating that company X had the sole right to trade goods
Y in territory Z. A legendary example is the English East India Company which was granted Royal Charter in 1600 to trade in the East Indies and eventually ended up governing large parts of India. A Royal Charter often brought with it the benefit of transferable shares and limited liability. This was in contrast with partnerships which did not allow the free transfer of one’s stake in the company and held each partner legally liable to the full extent of his wealth.
With the growth of power of the English Parliament it eventually also became possible to obtain a charter through a Special Act of Parliament, which essentially could confer the same rights and privileges as a Royal Charter. It is however important to point out that Royal Charters and charters through a Special Act of Parliament were by no means commonplace. During the entire 18th century there were only about a dozen charters issued for corporations in England.15
Joint stock companies emerged in the 16th century as a form of partnership. In
1688 there were only 15 joint stock companies in England, but they started growing in
15 Id. 9 numbers in the 18th century when charters were exceptionally difficult to come by. Up until the 18th century and for much of the 19th century the term “company” was used as an abridgement of “joint stock company” and denoted an association of a particular economic type rather than a particular legal status.16 Griffiths and Taylors write: “These companies were treated in law as partnerships, and whilst the capital holdings of the members were transferable, their liability for the debts of the company was unlimited.”17
In the 18th century joint stock companies were the type of association that would usually seek a charter, but they were unpopular because they were often associated with fraud and consequently few charters were granted.
It is important to point out that English corporation law and English company law
(the law applicable to Joint Stock Companies) were separate legal domains towards the end of the 18th century. As mentioned, Joint Stock Companies were unincorporated associations and were treated legally as a form of partnerships. However, because incorporation was so rarely granted, Joint Stock Companies became the common mode of economic association which consequently led to modern English business law developing as company law rather than corporate law.18 As we shall see the Company Acts that were enacted between 1844 and 1862 laid down the fundamental pillars of the modern corporation as we know it today and it was done as a legal augmentation of the Joint
Stock Company (not the chartered corporation).19 For one, the 1844 Joint Stock
Companies Act provided for general articles of incorporation, which meant that any
16 Ireland, supra note 10. 17 O. GRIFFITHS & E. MILES TAYLORS, THE PRINCIPLES OF COMPANY LAW , 3 (1949). 18 Blumberg, supra note 13. 19 The Acts between 1844 and 1856 are generally referred to as the “Joint Stock Companies Acts” while the 1862 Companies Act and onwards are referred to as the “Companies Acts”. When referring to the Acts collectively, both prior and after 1862, I will simply be using the term “Companies Acts”.
10 association of individuals could now become incorporated by a simple act of registration, eliminating the need for a Royal Charter or a Special Act of Parliament.
Nowadays virtually all enterprises in Britain are incorporated by registration under the Companies Acts and generally one would assume that the layman’s use of the term “corporation” is a reference to such a registered entity. However, one should note that corporations that are created by Royal Charter or a Special Act of Parliament are not subject to the provisions of the Companies Acts,20 although the rights and duties governing such corporations are often similar in content.
Although there have been several influential corporations pre 19th century, there were not very many and they did not have the all pervasive economic and social influence that they have in most of our societies today. The big rise of the corporation started with the Industrial Revolution in England at the end of the 18th century and quickly spread to the newly independent United States. As we shall see, the Industrial
Revolution in Britain sparked a demand to start Joint Stock Companies and the growth of these companies in turn created pressure to augment the legislation governing such companies resulting in the Companies Acts 1844-1862.
Next we shall go on to look at the legal development of the fundamental legal attributes of the corporation, starting with the primacy of shareholders.
20 The 1844 Joint Stock Companies Act says: “[T]his Act shall not extend to any Company incorporated or which may hereafter [be] incorporated by Statute or Charter.” An Act for the Registration, Incorporation, and Regulation of Joint Stock Companies, 1844, 7 & 8 Vict., c. 110 (Eng.). 11 B. Shareholder Primacy
Historically, in both UK21 and the US, the common law has recognized that the interests of shareholders are primary among corporate constituents. This has come to be known as the shareholder primacy norm and is the part of the fiduciary duty of directors and managers to make decisions that are in the best interest of shareholders.22 The fiduciary duties of directors and managers arose due to early judicial depictions of their relationship with shareholders as one of trust. That is to say, the directors and managers were seen as trustees for the shareholders who were the owners of the corporation.
Perhaps the most famous articulations of the norm comes from the US case Dodge v.
Ford Motor Co in 1919. In delivering the opinion of the court (in favor of the Dodge
Brothers) Chief Justice Ostrander said:
“A business corporation is organized and carried on primarily for the profit of the
stockholders. The powers of the directors are to be employed for that end. The
discretion of directors is to be exercised in the choice of means to attain that end,
and does not extend to a change in the end itself, to the reduction of profits, or to
the non-distribution of profits among shareholders in order to devote them to
other purposes.”23
21 See, Lord Wedderburn of Charlton, The Legal Development of Corporate Responsibility, in CORPORATE GOVERNANCE AND DIRECTORS LIABILITIES 3-54 (J.K Hopt and G. Teubner, eds,, 1985). 22 Smith supra note 7. 23 Dodge v. Ford Motor Company, 204 Mich. 459, (1919). 12 In furthering the interests of shareholders the fiduciary duty of directors and managers is seen as consisting of a duty of loyalty and a duty of care.24 The duty of loyalty means that directors and managers should further the interest of shareholders but also that they should not put themselves in a compromising position where their incentives might diverge from those of the shareholders. An example would be if a manager were to receive direct remuneration from a corporate contract, as would be the case in for bribes and kickbacks. The fiduciary duty of care means that directors and managers are expected to make decisions that ordinary, prudent individuals in a similar position would make under similar circumstances for the benefit of shareholders.25 The norm of shareholder primacy is manifest in that they are, in the normal course of events,26 the only corporate stakeholders to receive fiduciary protection by the courts.27
However, the shareholder primacy norm has become significantly diluted. In the US the
“application of the shareholder primacy norm to publicly traded corporations is muted by the business judgment rule”.28 The business judgment rule is the presupposition that directors and managers have not violated their fiduciary duty of care. In the event of a lawsuit against directors or managers by shareholders for not furthering shareholder interests the rule essentially implies that the court should not engage in evaluations of the
24 Lynn S. Paine, The Fiduciary Relationship: A Legal Perspective (2003) (Note prepared for class discussion. Published Online at Harvard Business Publishing.) 25 Id 26 It is generally accepted that an incentive problem occurs when a corporation is near insolvency. This is because the closer the corporation is to being insolvent, the less the corporation is worth, and therefore due to limited liability the corporation has “nothing to lose” in making very risky decisions. In the US, this has been addressed by directing fiduciary duties to creditors when the corporation is near insolvency. 27 Jill E. Fisch, Measuring Efficiency in Corporate Law: The Role of Shareholder Primacy, 31 J. CORP. LAW 637, (2006). 28 Smith supra note 7, at 280. 13 business judgment of the corporate leadership.29 The quality of business decisions would generally be the primary evidence for a lack of care and therefore the business judgment rule in effect makes the fiduciary duty of care unenforceable.30
Furthermore, the shareholder primacy norm is constrained in both US and UK due to the
(relatively) recent introduction of non-shareholder constituency statutes. These corporate statutes make explicit provisions allowing directors and managers to consider the interests of other stakeholders in their decision making. In the UK this development occurred with the Companies Act of 1985, where Section 309 makes a statutory augmentation to the primacy of shareholders.31 It states that directors must take into account the interests of employees when performing their functions for the company and that this duty is to be regarded as a fiduciary duty owed to the company. However, the act does not give employees the right to challenge decisions of the directors in court if they feel that their interests have not been taken into account. Because employees do not have a right to challenge the decisions of directors this legal development would seem to indicate that directors still only have fiduciary duties to shareholders, although they are now also at liberty to take into consideration the interests of employees.
In the US the incorporation statutes of most states have also adopted non-shareholder constituency statutes.32 The state of Pennsylvania was first to adopt such a statute in
1983, and states such as New York and Nevada have subsequently adopted such statutes,
29 The courts have found that it is not their place to evaluate the quality of business decisions as this is not their primary competence. Rather such judgments are best left to the market to decide. 30 It is generally only the duty of loyalty that courts will consider when derivative suits are brought against directors or managers, and then courts will primarily consider whether any self-dealing has occurred. 31 Companies Act, 1985, c.6, §309 (UK.) 32 Brett H. McDonnell, Corporate Constituency Statutes and Employee Governance, 30 WM. MITCHELL L. REV. 1227, (2004). 14 although Delaware has notably not done so. These statutes do not require managers to consider the interests of non-shareholders, but they make it explicit that they are not prohibited from doing so.
Although the shareholder primacy norm is muted by the business judgment rule in the
US, and constrained by non-shareholder constituency statutes on both sides of the
Atlantic, the primacy of shareholders still remains strong. This is because the structure of corporate law is geared towards shareholder primacy manifest by shareholders sole right to vote for the board of directors.
The voting rights of shareholders gives them the power to elect and dismiss the board of directors, which provides leverage for shareholders to exercise indirect control over directors.33 This incentivises directors to consider the interests of shareholders as primary among corporate stakeholders; quite simply, if they do not they may be dismissed.
Kraakman et al. write: “… the board of a corporation is elected – at least in substantial part – by the firm’s shareholders. The obvious utility of this approach is to help assure that the board remains responsive to the interests of the firm’s owners”.34 The shareholder primacy norm may by and large be mute as a legally enforceable norm, but so long as shareholders are the sole constituency that are afforded voting rights directors will place them in a privileged position among corporate stakeholders.
33 The legal concept of “agency” implies a relationship in which the principal has the power to control and direct the activities of the agent. See, Robert Charles Clark, Agency costs versus fiduciary duties, in PRINCIPALS AND AGENTS: THE STRUCTURE OF BUSINESS, 63 (John W. Pratt & Richard J. Zeckhauser eds., 1985). Shareholder voting rights do not therefore provide sufficient control to characterize directors as the legal agents of the shareholders. 34 Kraakman et al. supra note 9, at 12. 15 To summarize, shareholders are afforded primary consideration among corporate stakeholders. This is not because of the shareholder primacy norm which affords fiduciary duties solely to shareholders as this norm is muted by the business judgement rule in the US, and is further constrained by non-shareholder constituency statutes in both the US and the UK. The primacy of shareholders is manifested through the structure of corporate law which gives sole voting rights for the board of directors to shareholders which ensures that their interests are given primary consideration by the corporate leadership.
C. The Corporation as a Separate Legal Entity & the Transferability of Shares
In law the corporation is considered as a completely distinct entity from the shareholders who incorporate the company. This means that the corporation is an independent legal subject before the law. As we shall see this has led to the important legal development of corporate shares being regarded as property in their own right, which in turn has influenced the popularity and economic importance of the corporate legal form.
The corporation was conceived as a separate legal entity several decades before
Solomon v. Solomon Co. Ltd (1897), but Lord Macnaghten’s articulation is the most famous:
16 The company is at law a different person altogether from the subscribers to the
memorandum; and, though it may be that after incorporation the business is
precisely the same as it was before, and the same persons are managers, and the
same hands receive the profits, the company is not in law the agent of the
subscribers or trustee for them.35
Nowadays, it is often assumed that the complete separation of corporation and shareholder is a direct consequence of the act of incorporation. This was however not the case in the late 18th century and only developed towards the middle of the 19th century.
Ireland writes: “[W]hile incorporation had very important legal consequences, for many years [early 19th century] a complete separation of company and members was not among them.”36 Interestingly Ireland also mentions that the legal development of the corporation as a separate legal entity was also followed by a similarly linguistic development. The corporation nowadays is usually referred to in the singular “it”, but in the early 19th century when shareholders were still regarded as forming the corporation it was referred to in the plural “they”. Up until the 1856 Joint Stock Companies Act corporations were referred to in the plural and said that persons “form themselves into an incorporated company” with the implication that the persons were the company and thus made of them. It was not until the 1862 that corporations were said to be made by people and not of people.37 The 1862 Companies Act clearly indicates that the corporation is to be regarded as a completely distinct legal entity and this was rendered 25 years before
Solomon v. Solomon & Co. Ltd.
35 Solomon v. Solomon Co. Ltd, [1897] A.C. 22 (H.L.) (U.K.). 36 Ireland, supra note 10, at 45. 37 Ireland, supra note 10. 17
Lee v. Lee’s Air Farming Ltd (1961) is an interesting case to illustrate the corporate status as a distinct legal entity.38 Lee was the sole director, the main employee and the controlling shareholder of Lee’s Air Farming Ltd in New Zealand. Lee’s role as an employee was as a pilot. Following Lee’s accidental death his widow brought a claim against the company. The question before the court was if Lee could be considered as a
“worker” for the purposes of the New Zealand Workers’ Compensation Act of 1922. It was ruled that Lee’s duties as director were owed to the corporation itself and that Lee’s contract of employment as a pilot was with the corporation itself. These were considered two separate contracts with the corporate entity and therefore Lee was not considered to be controlling himself as a director. Rather, it was deemed that legally speaking Lee was being controlled by the corporation through its director, and consequently Lee’s widow’s claim was successful. The example shows how an incorporated one man company is at law nevertheless a completely distinct legal entity from its only member who is at once director, employee and shareholder.
Alongside the legal development of the corporation as a separate entity was the development of the corporate share as property in its own right. The first development to this end was that the corporate share ceased to confer any right to the assets of the corporation. The court’s decision in Bligh v. Brent (1837) set the tone that the shares of a corporation did not constitute a direct interest in the corporation’s assets. This meant that shareholders had no legal title to any of the corporation’s assets and had no right to control how those assets were to be used. Justice Walton put the point clearly with the
38 Lee v. Lee’s Air Farming Ltd [1961] A.C. 12 (P.C.) (N.Z.) 18 following truism: “The property of the company is not the property of the shareholders; it is the property of the company.”39
The fact that shares no longer constituted a right to the corporation’s assets was important with regard to the transferability of shares. It meant that the identity of the shareholders was of considerably less importance than previously because they could not make claims on corporate assets, which facilitated the transferability of shares to new shareholders. As we shall see later, the granting of limited liability to joint stock companies in 1855 also greatly helped to reduce the significance of the identity of the shareholders and thus assisted the transferability of shares. These two developments together with the growth of a proper stock market meant that shares were rapidly becoming commodities that could be easily bought and sold. This in turn made corporate shares considerably more attractive to investors and further helped contribute to the spread of the corporate form. By the mid 1850s corporate shares were becoming truly liquid assets. It was this trading of shares that above all else “established shares as an autonomous form of property, independent from the assets of the company.”40 Once shares were being readily traded and they no longer conferred any rights to corporate assets it was fairly uncontroversial for shares to be regarded as legal property in their own right, which they clearly were by the 1860s. A corporate share is now itself a form of legal property that primarily confers a right to dividends and voting rights.
The separation of the corporation from its shareholders led to a greater independence and empowerment of directors and managers. This in turn led progressive
39 Bligh v. Brent (1837) 2 Y & C Ex 268. 40 Ireland, supra note 10, at 68. 19 thinkers in the 20th century, such as Dodd, 41 to regard corporate boards as possessing a great deal of autonomy from the shareholders. This postulated autonomy led to the development of different positions advocating the dawn of a new “socially responsible” corporation. The hope was that a corporation would emerge that on managerial initiative would set the goal to satisfy a variety of different interests and not primarily those of the shareholders. These hopes never quite materialized, but they are still resonating in the
CSR movement of today.
At first sight the empowerment of management makes it seem plausible that the corporation would try to satisfy several different stakeholders simultaneously without giving primacy to shareholders. However, on closer inspection the separation of the corporation from its shareholders would seem to further entrench the primacy of shareholders. The central reason for this is that the greater autonomy of management stretches to the running of the business, while the shareholders still have voting rights and thus have decision-power over who sits on the board of directors. Further, when the corporation is a separate legal entity and the corporate share itself is regarded as property, then the interest of the shareholder is mainly to receive dividends. Previously shareholders might have had an interest in the actual assets of the corporation, but a consequence of downgrading of the rights of shareholder is that the interest in holding corporate shares becomes primarily financial.
When the interest in holding shares is primarily financial it seems reasonable that investors are unlikely to hold shares unless they are afforded primacy among corporate
41 Dodd, supra note 2.
20 stakeholders, otherwise there might not be sufficient residual for any dividends. With such primacy in place the separation of corporation and shareholders merely grants managers the autonomy of choosing the means to realize the ends chosen by the shareholders.
To summarizes, the corporation is an entirely separate legal entity from its members, which has led to corporate shares as being regarded as property in their own right. These legal developments have greatly contributed to the transferability of shares, which in concert with the development of stock-markets has led shares to become readily traded commodities. Although the separation of the corporation and shareholders led to a greater autonomy for directors this was only an autonomy of decision-making pertaining to the daily running of the business. In other words directors have the autonomy of choosing the means but not the ends of the business enterprise.
D. The Limited Liability of Shareholders
Nowadays all corporations registered under the Companies Act are granted limited liability. This means that the liability of the shareholders is limited to the value of their shares so that a person who purchases a share in a corporation does not stand to lose more than the value of his or her share. In other words if the corporation incurs large debts the creditors cannot access the personal wealth of the shareholders to cover these debts. So to speak, the debts of the corporation are not the debts of the shareholders, they are the debts of the corporation.
21
Limited liability is by many considered the most important feature of the corporate legal form. In particular it is one of the most significant distinctions between the corporate form and a legal partnership where the shareholders have unlimited liability. However, limited liability was a relatively late characteristic to be granted to corporations. When tracing the evolution of limited liability it is important to distinguish between on the one hand corporations chartered by the Crown or incorporated by a
Special Act of Parliament, and on the other hand joint stock companies incorporated under general incorporation statutes.
Corporations chartered by the Crown or incorporated by a Special Act of
Parliament could be granted limited liability but it varied from one corporation to another. Nevertheless, with the passage of time limited liability became progressively more associated with the act of incorporation and by the late 18th century “it became increasingly accepted that were the charter was silent, shareholders had the benefit of limited liability.”42
The Joint Stock Companies Act of 1844 which introduced general incorporation statutes for companies did not confer limited liability. It was not until the Limited
Liability Act of 1855 and the Joint Stock Companies Act of 1856 that limited liability was conferred to joint stock companies upon incorporation in Britain. The years between
1844 and 1855 were characterised by a long political struggle regarding whether or not the state should grant limited liability to joint stock companies. Blumberg says that “the
42 Blumberg, supra note 13 at 9. 22 political struggle over limited liability involved joint stock companies, not the handful of existing corporations that already had such protection.”43
The issue of limited liability caused controversy both in England and in America.
In England it created heated debates in parliament and in America it was debated state by state. However, England’s adoption of limited liability in 1855 came three decades after it was generally adopted in America.44 So what was all the fuss about?
Bakan writes: “On both sides of the Atlantic, critics opposed limited liability on moral grounds. Because it allowed investors to escape unscathed from their company’s failures, critics believed it would undermine personal moral responsibility.”45 People were concerned that if anyone and everyone could start an incorporated company with limited liability through a simple act of registration this would lead to people making decisions without concern for negative consequences. Although this concern has proved to be legitimate under certain circumstances,46 by and large these fears have been unfounded. This is probably because limited liability does not mean that there is absence of liability as many seem to mistakenly think. Shareholders are liable to the extent of the entire value of their shares. The self-interest of shareholders should bring them to demand corporate investment decisions that are expected to be profitable. This by itself means that corporations will strive to retain and increase the value of shares rather than make
43 Blumberg, supra note 13 at 15. 44 See, Blumberg, supra note 13. 45 JOEL BAKAN, THE CORPORATION, 12 (2004). 46 Supra note 23.
23 decisions that may be harmful to others which in turn may damage share-value through litigation or loss of customers.
A complaint that is often levied against limited liability is that a great share of the risk of business failure is shifted onto creditors because they may not get paid in the event that the corporation is declared bankrupt. This is usually referred to as a negative externality of the rule of limited liability. However, this rests on a misconception.
Voluntary creditors (e.g. banks, bond holders and suppliers) are compensated for the greater risk that the corporation might default on its payments prior to any such potential default, therefore there is no externality. Easterbrook and Fischel write: “The creditors assume some of the risk of business failure, just as they would if they were ‘insurers’ as well as creditors. The legal rule of limited liability is a shortcut to this position, avoiding the costs of separate transactions”.47 The general idea is that because creditors are exposed to a greater risk of payment default they will demand a higher rate of return on their credit to compensate for the extra risk they assume.
Despite some heated opposition to limited liability, it eventually emerged in England in 1855 as a political reaction to rapid industrialization that was taking place at the time.
Limited liability proved to bring with it several benefits to shareholders and the economy as a whole. Five of the major benefits are:48
47 Easterbrook and Fischel, supra note 10 at 102. 48 These five points are inspired by points made by Easterbrook and Fischel supra note 10 at 94 - 97.
24 1. Lower Cost of Monitoring Managers: It is in the interest of shareholders that their
managers do not make poor decisions that might put the corporation into debt.
With unlimited liability corporate debt is a serious threat because the shareholders
may lose not just their corporate shares but also their personal wealth. With the
rapid progress of industrialization in the 19th century corporations were becoming
larger so those running and those owning corporate shares were increasingly
becoming different groups of people. This meant that the shareholders were
incurring significant monitoring costs to make sure that poor decisions that might
endanger their personal wealth were not made. The introduction of limited
liability significantly reduced the costs of monitoring shareholders because now,
although managers might still make poor decisions, those decisions could not
affect the personal assets of shareholders.
2. Removal of the Cost of Monitoring other Shareholders: Without limited liability
the identity of the other shareholders was of financial importance. The reason is
that in the event of corporate bankruptcy, creditors would turn on the assets of the
shareholders to regain the payments they were due. This meant that it was
important to know the personal wealth of one’s fellow shareholders, because the
wealthier the other shareholders were the less likely it was that one would have to
shoulder the debt burden on behalf of other shareholders that could not pay. The
introduction of limited liability meant that the personal wealth of other
shareholders became irrelevant because creditors could no longer make any
claims on the personal wealth of shareholders. In turn this meant the removal of
the cost of monitoring other shareholders to make sure that they did not sell their
shares to people with little wealth.
25 3. Facilitates Pricing of Corporate Shares: Without limited liability the price of
corporate shares depends in part on the personal wealth of the current and
prospective shareholders. This is because the personal wealth of the existing
shareholders influences the risk of investment that a new shareholder incurs upon
his purchase. Limited liability makes corporate shares into homogenous
commodities because the market price of a corporate share is the same
irrespective of who owns them. This makes shares more easily transferable by
reducing information gathering costs that would be required for each purchase,
which in turn helps the stock market to be more responsive.
4. Enables the Diversification of Risk: Nowadays it is common for shareholders to
reduce the risk of investing in the stock market by holding a market portfolio of
shares. 49 This eliminates the industry specific risk of a shareholder’s investment
and leaves only the general market risk. However, this is only possible with a rule
of limited liability. With unlimited liability a diversified portfolio would mainly
serve to increase rather than decrease the risk incurred by the investor, because if
any one of the corporations went bankrupt the investor could stand to lose all his
personal wealth. Under a rule of unlimited liability investors are therefore unable
to avoid investment risk that could have been avoided under a rule of limited
liability.
5. Gives Managers the Incentive to Make Efficient Allocation of Resources: Some
investments that managers expect to be profitable may be dismissed as too risky
under a rule of unlimited liability. For example, some positive net present value
investments may bankrupt the corporation if they go wrong. Therefore
49 A market portfolio of shares is a portfolio that mirrors the proportions of all the shares in the market.
26 shareholders would not wish such investments to be made because it could result
in claims on their personal assets. Positive net present value investments are
regarded as an efficient allocation of resources and consequently to pass up on
such an investment would be a social loss. However, with a rule of limited
liability the personal assets of shareholders are out of reach from creditors and
therefore rational shareholders would endorse risky positive net present value
investments.50
The corporation as a completely separate legal entity from the corporate members emerged at about the same time as that of limited liability in the mid 19th century. As previously mentioned, this was a time of rapid industrialization when due to the size of corporations it was becoming increasingly common to have a functional division between professional managers running the firm and shareholders supplying the necessary investment capital. The functional separation of management and investment influenced the call for a separate corporate entity with limited liability and the granting of limited liability further entrenched this separation. As we have noted above, this functional separation implies monitoring costs for shareholders to guard against corporate debts.
The introduction of the rule of limited liability helped remove some of these costs and encourage the efficient allocation of resources. Further, it was probably not a coincidence that the corporation as a separate legal entity emerged in concert with limited liability. It is difficult to consistently maintain that the corporation is a completely separate legal
50 Arguably a risk neutral rational investor would not pass up on a positive net present value investment irrespective of the risk and possibility of having claims made against his personal assets. However, it seems reasonable to assume that real investors are not risk neutral about their personal assets in a way that they might be about their shareholdings. People tend to regard their shareholdings as assets disposable for speculation while personal wealth is needed for living.
27 entity from the shareholders if the courts at the same time are accessing the personal wealth of shareholders for debts incurred by the corporation. In other words, it seems inconsistent to hold the view that the assets belong to the corporation while the debts belong to the shareholders.
The rule of limited liability is now an accepted and ingrained characteristic of the corporate form having been available though a simple act of registration for a century and a half. The rule generally protects the personal assets of shareholders from any claims that might arise out of debts incurred by the corporation. However, over the years there have been several rare occasions when the courts have gone behind the veil of incorporation and held shareholders personally liable. There are no general or well established rules for when courts may “pierce the corporate veil”,51 but one situation in which courts have disregarded the limited liability of shareholders is when it has been intentionally abused. This has almost always involved close corporations where there is often considerably less functional separation between management and investment. Close corporations are often characterised by a dominant shareholder who is also the director of the corporation. When the dominant shareholder and the director are the same person then limited liability does not afford any extra advantage in the reduction of monitoring costs. Further, the incentive for directors to engage in overly risky activity is considerably greater in close corporations. The main reason is that if directors are also the main shareholder they stand to gain handsomely if one of their risky investment decisions pays off, but their potential losses are limited by limited liability if the investment goes wrong.
On occasion when the courts have deemed that overly risky investment decisions have
51 Easter brook and Fischel, supra note 10. 28 been made by deliberately abusing the protection of limited liability, they have decided to pierce the corporate veil and allow access to the personal assets of the shareholders.
To summarize, the emergence of limited liability as part of general incorporation statutes came into effect only after much heated debate in both England and America.
The rule of limited liability implies that the liability of shareholders is limited to the value of their shares. It was feared that such restrictions on liability would lead to grossly irresponsible behaviour. Although such fears did hold some substance, the many economic benefits of limited liability were regarded to be of greater importance. In particular limited liability helped to turn the stock market into a truly liquid market.
The rule of limited liability implies that creditors end up bearing a greater risk of business failure, but this is not an externality because they are compensated upfront for this risk in terms of a higher rate of return. It seems reasonable that creditors should bear this risk rather than shareholders if we are to regard the corporation as a separate legal entity. Therefore it is probably not a coincidence that the corporation as a separate legal entity emerged at the same time as limited liability. The debts of the corporation belong to the corporation itself, and if it cannot pay, this cost should be borne by those who gave it credit.
III. THE GOAL AND ROLE OF THE CORPORATION: THE CORPORATION AS AN
INSTRUMENT FOR PRODUCTION AND ECONOMIC GROWTH
29 The aim of this section is to show how the corporate legal form, through the four legal attributes discussed in this paper, provides a description of the goal, and role of the corporation in society. I will first maintain that the goal of the corporate legal form is tied to the corporate governance attribute of shareholder primacy. The corporate legal form thus serves as a vehicle for furthering the interests of shareholders and these interests are primarily taken to be profitable production of goods and services. I will then argue that given this goal of profitable production combined with the three other (non-governance related) attributes provides a description of the role of the corporation in society as a instrument for production and economic growth. I will start the description of the corporate role during the early years of the industrial revolution, which not coincidentally is also the time period for the genesis of the modern corporate legal form.
A. The Goal of the Corporation
The goal of the corporation in society is its purpose seen from the perspective of the corporation itself. There are two ways in which the corporate legal form provides a description of the goal of the corporation. Firstly and primarily it does so by indicating which stakeholder groups’ interests set the primary agenda for which the organization should commit its efforts. Secondly it does so implicitly by the way it differs from other legal forms of organization.
As we saw earlier the directors and managers of the corporation are bestowed with fiduciary duties of loyalty and care to be directed to furthering the interests of shareholders. The fact that these duties are owed solely to the shareholders of the corporation is the shareholder primacy norm. Although the SPN is muted by the business
30 judgment rule in the US, and further constrained by non-shareholder constituency statutes in the UK as well as a majority of US states, the primacy of shareholders is still maintained due to the structure of corporate law which grants shareholders the sole right to vote for the board of directors. The structure of corporate law vests ultimate control for deciding who should direct the corporation with the shareholders, and therefore their interests will carry primary importance. It is this primacy of shareholders among corporate stakeholders which provides the goal of the corporation.
The goal of the corporation is therefore to satisfy shareholder interests. This does not necessarily mean that the goal of every corporation must be profit maximization.
Shareholders may have any number of interests. However, the law does distinguish between for-profit-corporations from non-profit-corporations (primarily for tax purposes) and it is seems reasonable to assume that most entities registered as for-profit- corporations actually have the goal of seeking profit. Whether profit should not merely be sought but also maximized is also up to the interests of shareholders, but standard economic theory suggests that any investor, qua investor, would rationally prefer a greater return on investment over a lower return on investment.
It might seem obvious, but it should be pointed out that the corporation generates its profits through the production and sale of goods and services. While the ultimate interest of shareholders might be dividends on profits that the corporation generates, these profits need to be generated by producing an output of goods and services that is valued by customers by more than the cost of the inputs. In other words, the corporation is a vehicle for furthering the interests of shareholders and those interests involve the profitable
31 production of goods and services. Therefore, as a point of pure description, based on the attributes of the corporate legal form, the goal of the corporation is to satisfy the interests of shareholders primarily through profitable production of goods and services.
B. The Role of the Corporation in Society
The role of the corporation is its purpose seen from the perspective of society. In order to determine this role we may look at the function that the four primary legal attributes serve in society. I shall here explain the functions that these attributes serve primarily by showing the need for their development during the industrial revolution.
It is generally acknowledged that the industrial revolution began in the third quarter of the 18th century in Britain and was characterised by a widespread replacement of manual labour by machines, which led to an enormous increase in productivity. One might say that it was technological innovation that sparked the industrial revolution.
Examples of the most important innovations in Britain at the time were the steam engine and the spinning frame. However, several social, political and legal conditions were also present to enable and encourage that these innovations be used for productive and commercial purposes. For example, Britain had a stable political system with a functioning judiciary which reduced the risk that the sovereign might arbitrarily seize private property. Further, the security of private property and the existence of patents for innovations meant that investors could plan long term which is crucial for economic growth. Finally, there existed a developing corporate legal form that enabled the factors of production, land, labour, and capital to come together for commercial production. The
32 combination of the political, legal and innovative climate led to a brisk expansion of commercial activity on a scale of mass production.
The economic success of Britain attracted a lot of attention and several European countries tried to follow suit. However the most successful imitator came from the other side of the Atlantic in the form of Britain’s ex-colony, America, which had newly gained independence. America was quick to follow in Britain’s footsteps and jumpstarted its own industrial revolution.
Now, where does the corporate legal form fit into this story of economic change and growth? The industrial revolution would never have gotten started had it not been for the possibility of engaging in business through collective enterprise, and the corporate legal form in particular was instrumental to this process. Corporations achieve their goals by organizing and directing the factors of production; land, labor and capital. The factors of production achieve very little on their own and most certainly do not bring about an industrial revolution. We shall now look at the role that the four primary legal attributes of the corporation have played.
Let us start with the attribute of shareholder primacy which provides the goal of the corporation. What is the role of the goal of the corporation? In other words what function does the goal of the corporation serve in society? The primary benefit of a private property free market economy is that it allocates resources where they are most valued. Corporations’ contribute to this by producing goods and services that are valued by customers at more than the cost of production, thus demonstrably allocating resources
33 efficiently by creating value. Therefore by having a goal of profitable production to serve the interests of the shareholders, the corporation fulfils a role as an economic actor that allocates resources efficiently in society.52 Although a free market economy can exist without corporate actors (with only individuals engaging in economic exchanges), we shall see there are economic benefits to be had in coordinated goal oriented organization related to the reduction of transaction costs.
The early corporate legal form that existed at the start of the industrial revolution was shareholder focused and suitable for coordinating land and labor efficiently, but suffered from a lack of capital. It is with regard to the addressing the issue of capital solicitation that the three non-governance related attributes of the corporation play their primary role. The industries that drove the industrial revolution were very capital intensive, for example the textile and mining industries. Therefore a lack of capital was a great hindrance for continued economic growth. Above anything else it was this that applied pressure for reforming the corporate legal form, which led to the release of vast sums of capital.
The Industrial Revolution sparked an increased demand to start Joint Stock
Companies as a form of association in which recourses could be pooled and commercial enterprise carried out. As we shall see the growth and success of these companies in turn created pressure to augment the legislation governing such companies resulting in the
Companies Acts 1844-1862.
52 See, Michael C. Jensen, Value Maximization, Stakeholder Theory, and the Corporate Objective Function, 18 BUSINESS ETHICS QUARTERLY 253, (1994). 34 Ronald Coase is one of the few economists that have specifically written about why companies exist in economic terms. His theory will help us understand why the growth of Joint Stock Companies during the industrial revolution exerted such economic pressure for corporate reform. Coase’s theory can be put quite briefly as: “[I]n the absence of transaction costs, there is no economic basis for the existence of the firm.”53
Transaction costs are “search and information costs, bargaining and decision costs, policing and enforcement costs.”54 Coase explains: “[T]he fact that it costs something to enter into these [economic] transactions means that firms will emerge to organize what would otherwise be market transactions whenever their costs were less than the costs of carrying out the transactions through the market.”55 In other words people come together to form a company in order to reduce the transaction costs that exist in the market.56 The absence of economic transaction within a company in effect implies that internal company transactions involve a suppression of the price mechanism.
The need to suppress the price mechanism indicates that there is a cost involved in using it. One of these costs is the very act of finding out what the relevant prices are.
Another important cost is the making of contracts with all parties that are to be involved in an enterprise. In the open market each actor must make a contract with every other actor with which he or she is cooperating. In this economic sense the company is a cost efficient way of eliminating the nexus-of-contracts that otherwise would need to be bargained as independent market transactions.
53 RONALD H. COASE, THE FIRM THE MARKET AND THE LAW, 14 (1988). 54 See, Id at 6. 55 See, Id at 7. 56 A consequence of this is that the theoretical ideal of a perfect market (characterized by an absence of transaction costs) would not have any companies.
35
The company’s economic raison de être is founded on reducing transaction costs.
The pressure on the state to ease the transferability of shares and grant limited liability towards the middle of the 19th century can be viewed in terms of reducing transaction costs. Clark concurs with this view and says: “[S]tructural features of the corporate form of organization, such as limited liability of stockholders and free transferability of shares... result from (fairly slow, crude) processes of legal evolution that favour rules that reduce transaction costs.”57 At the start of the industrial revolution it was possible for virtually any group of people to start a Joint Stock Company. This in itself created many benefits with regard to reducing transaction cost for coordinating land and labor.
However, the Joint Stock Company had practical limitations with regard to its ability to pool funds for investment.
The 1844 Joint Stock Companies Act provided for general articles of incorporation and allowed shares to be transferred without the express consent of all the co-partners.58 This by itself increased the transferability of shares and thus reduced the transaction cost of anyone wishing to transfer a share in a Joint Stock Company. This enabled newly formed corporations to obtain funds for the commencement of an enterprise far easier than was the case when the Joint Stock Company was considered a form of partnership and thus the potential transfer of shares required the consent of all the co-partners. Many of the companies being formed under the industrial revolution were very capital intensive and thus this new legislation helped companies obtain more capital.
57 Clark, supra note 32 at 55. 58 See, supra note 18. 36 Although the 1844 Joint Stock Companies Act was a manifest improvement for pooling resources it still had limitations. Without limited liability investing in a Joint
Stock Company was very risky for investors as their personal wealth was accessible in the event of bankruptcy. This meant that in practice only people of great wealth, who could bear the potential consequences of unlimited liability, would be willing to part with their financial resources. Industrialisation meant that companies were growing larger and needed further capital to expand and so the pressure to confer limited liability upon incorporation increased. In Britain this was finally granted with the Limited Liability Act of 1855,59 and the Joint Stock Companies Acts 1856.60 This presented a significant decrease in the risk of investment and thus decreased the transaction cost for the further pooling of resources. Corporations were thus able to solicit more financial resources from a wider public to finance their capital intensive investments.
Limited liability was by no means an essential component of the industrial revolution, shown by the fact that English industry expanded enormously during the first hundred years of the revolution without it.61 However, by the middle of the 19th century
Britain had come to a point in its industrial development were limited liability was sorely needed if its economic growth was to continue. Further, limited liability also provided a host of other benefits. Among the most important being that it firmly cemented the separation of the corporation from shareholders which allowed the corporate share to develop into a form of property in its own right. Without this development we may never
59 Limited Liability Act, 1855, 18 & 19 Vict. C.133 (Eng.). 60 Joint Stock Companies Act, 1856, 19 & 20 Vict. c. 47 (Eng.) 61 Blumberg, supra note 13. 37 have seen the liquid stock markets of today.
Each legal attribute has served and continues serve an important economic function. The primacy of shareholders sets the goal of the corporation and serves the role of allocating resources efficiently. The three attributes of separation of the shareholders from the corporation, the transferability of corporate shares, and limited liability have all served to reduce transaction costs and greatly ease capital solicitation. When these attributes are taken together the corporate legal form has and does serve as an instrument for production and economic growth.
From a legal perspective this descriptively is the purpose of the corporation in society. If CSR advocates (or anyone else) wish to prescribe a different purpose they should do so with regard to the goal and role it has. In particular any prescriptive argument should reflect on how the prescription will affect its current goal and role and whether that change is on the whole preferable.
For example, advocates of Stakeholder theory, such as Freeman, want the role of the corporation to be a vehicle for organizing stakeholder interests rather than primarily furthering the interests of shareholders. To achieve this, the primacy of shareholders would need to be removed which would require changing the structure of corporate law such that shareholders’ right to vote is removed.62 By changing the attributes of the corporate instrument you can change its purpose. However, whether or not such a change is desirable will depend on what benefits it brings (e.g. stakeholder empowerment) versus
62 Alternatively, shareholder primacy could theoretically be removed by giving all “relevant” stakeholders an equal right to vote, although in practice this would seem to be unrealizable. 38 the potential cost (e.g. diminishing the effectiveness of the corporate form as an instrument of production and economic growth). Such an argument should be made in relation to the descriptive goal and role it has. Only then can we analyze and understand what the potential costs and benefits are of changing its role. Only then can we make an informed choice.
39 IV. CONCLUSION
I have aimed to explicate the development of the four fundamental attributes of the corporate legal form and show how these provide a description of the goal and the role of the corporation in society. I have maintained that the goal of the corporation is provided by the attribute of shareholder primacy which is manifest through the structure of corporate law that extends sole voting rights for the board of directors to shareholders.
The goal of the corporation is to satisfy the interests of shareholders, which primarily involves profitable production of goods and services.
The role of the corporation in society is provided by the function of all four attributes.
The role of the goal is to direct the efficient allocation of resources in a private property free market economy. The role of the attributes of transferability of shares, the separation of the corporate entity for the shareholders, and the limited liability of shareholders serve to ease capital solicitation for investments for individual firms, but more significantly enable stock markets that provide a forum for capital solicitation. The efficient allocation of resources together with the facilitation of raising capital for investment suggest that the role of the corporation is to serve as a vehicle for economic growth. Combined with its goal, the purpose of the corporation (goal + role) is to serve as an instrument for profitable production and economic growth.
I have not argued for a particular purpose of the corporation, but merely described the purpose it has through its fundamental legal attributes. These attributes have been instrumental to the process of industrialization and economic growth of nations, and
40 today the corporate legal form continues to serve as a vehicle to facilitate business enterprise. A consequence of realizing that the goal and role of the corporation is contingent on its legal attributes is that these attributes can be augmented with the strike of a legal pen should we opt for a different purpose of the corporation in society. Let the current prescriptive debate about the purpose of the corporation in society make its argument in relation to the purpose it has; only then will we know what change is being argued for.
41