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Corporations and the State

April 26, 2011

“Corporation, n. An ingenious device for obtaining individual profit without individual responsibility.”
— Ambrose Bierce (1842 – @ 1913)

The Wall Street Journal had a front page article today (Tuesday, 4/16/2011) about the government’s threat to exclude a company – with a history of marketing violations and fines – from doing business with the government unless the company’s chief executive stepped down.   Part of the government’s effort to hold business executives accountable, and recognition that corporate fines had little impact on management or management behavior, this move was seen as game-changing.   Some called it an expansion of government interference in business; others thought it logical, with the potential to expand beyond health care.  Before there is a rush to judgement in either direction, it may be helpful to review the history of the corporation.   Please note, this isn’t about business in general, but it is about the particular legal entity called “the corporation.”

The corporation has had a checkered existence from its first emergence in the late sixteenth century. Contemporary businessmen and politicians had been suspicious of it. Rather than the mutual accountability of a partnership – small groups of men, connected via personal loyalties and trust who pooled their resources to both own and run a business, corporations separated ownership from management.

Many believed it a foolproof recipe for scandal and corruption, including Adam Smith. At one time, the corporation was banned in England for over 100 years (1720 to 1825) due to scams. Railroads helped bring it back. Railways were huge initiatives requiring mammoth amount of capital investment, more than most partnerships could muster. Corporations made their way back as a way of raising enough capital to carry out such infrastructure investments. One of the arguments for bringing it back was that it would encourage the “common man” to invest and to thereby understand more about the trials and tribulations of owning a business. This was made possible with the concept of limited liability….. that a stockholder could be held accountable for no more than what he had invested in the company.  In England, the understanding was that the corporation owed the State a “duty of care,” the grant theory of incorporation.  That is, incorporation was a special privilege granted by the proper level of government (the “State”) for the pursuit of public purposes.   Under that theory, the corporation was an artificial entity, created by the State, with powers strictly limited by its articles of incorporation.

In the United States there were initially significant regulations, too. Initially, there were tight state controls, but this too was abused, this time by politicians:  the “special charter” process was thought to encourage bribery, political favoritism and monopoly.   The concept of “free incorporation” – accessible to all – gained momentum, and incorporation came to be considered as the normal way of conducting business, rather than a privilege granted by the State.   This weakened the connection between incorporation and public obligation.  Beginning in the 1890s, regulatory protections began their “race to the bottom” when states, notably Delaware and New Jersey, decided to attract the incorporation business to their areas by eliminating or relaxing many restrictions to corporations, among them:
o  The rules requiring businesses to incorporate only for narrowly defined purposes, limited durations, and only in particular locations;
o  Relaxed controls on mergers and acquisitions;
o  Elimination of the rule that one company could not own the stock of another company.

This started a race among other states, strangely reminiscent of today’s special tax incentives, as other states sought to offer equally attractive regulations to corporations.

So began a wave of consolidations….. some 1,800 corporations were consolidated into 157 in the six years prior to 1904.  In 1912 due to a perceived corporate abuse of power, a congressional committee was empowered to investigate the financial control that a small group of Wall Street bankers had over the nation’s finances.  One ancillary conclusion of that effort was that a corporation’s stockholders were relatively powerless, none had been able to overthrow an existing management or even to have an existing management investigated to determine if it were honestly managed.   The committee’s report led to a finding that a group of financial leaders had abused the public trust, and created a climate of public option that lead to the Clayton Antitrust Act of 1914, and to the Federal Reserve  Act of 1913.  In essence, stockholders and board members were incapable forcing management to operate in ways aligned to the public interest, and the national government had to step in.

Just a little earlier, courts – through convoluted chains of logic – had endowed corporations with “entity status,” even granting it protection under the 4th amendment in 2005.   Another tendency was clear:  the shifting of power away from the shareholders and directors to the professional managers.

That is a very brief history, but it should help readers see the complexity of the issues.  The State, meaning national – and in the U.S., state  governments used to have much more influence over corporations than they do now.   Corporations have often earned additional governmental scrutiny through scandals, and have repeatedly demonstrated that they are not capable of regulating themselves consistently in a way that is aligned to the public interest.

The corporation is a powerful legal and economic entity.   Our nation’s government was founded on the idea of checks and balances.   Corporations were not so designed, and depend on governments to regulate and to appropriately assign costs to protect the public interest.  This latest initiative – to hold corporate leadership individuals responsible for the pattern of corporate violations – is the latest evolution of strategies to protect the public.

Is it an inappropriate expansion of governmental powers?  Do you want your tax dollars supporting a corporation that repeatedly violates the rules, and puts other companies at a disadvantage as well as the public?   Food for thought.

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