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  • Robert Hinkley

Corporate Design: A History




Big corporations thus become the worst kind of citizen—one armed with all the rights of citizenship but freed of its obligations.



By Robert C. Hinkley[1]

3 March 2023


Any analysis of the corporate system must start with the recognition that a corporation is just a concept, a fiction recognized by law. The law provides that a business, which follows certain rules, will be recognized as a separate person (even though the business isn’t really a person at all). When businesses follow these rules, the law recognizes them as having special status and confers certain benefits, including primarily a benefit to their investors known as limited liability.


Why do governments create this fiction? To understand this, we need to go back to the time before corporations. This was not so long ago. Some say it was at the beginning of the 17th century; others say it was one hundred to two hundred years earlier. In any event, human beings had been on this planet tens of thousands of years before they found it necessary to invent corporations.


The reason they were finally invented has to do with how the law worked without them. Under the law, everyone is responsible for the damage he or she wrongfully causes other people. If I harm someone either intentionally or negligently, that person can sue me for the damage caused. If she wins, she can force the sale of my assets to pay the amount of her award. I may have to seek protection under the bankruptcy laws to settle with her and my other creditors.


Similarly, when an employee harms someone else in the course of his employment, the victim can sue both the employer and the employee. If she wins, she will be entitled to recover the full amount of her award from either of them. Usually, the business is the deep pocket and therefore the primary target of the lawsuit.


If a person goes into business with someone else, a partner, and one of their employees causes harm in the pursuit of the partnership’s business, the victim may sue either partner (or both) for the damage caused. Under the law, both partners are liable, and the victim may obtain satisfaction from either of them. The partners are said to be “jointly and severally liable.”


Before the corporate law came along, investors who owned a business together were treated as partners and were jointly and severally responsible for the obligations of the business. If the business caused a catastrophe, the people harmed could sue individual investors for the full amount of their damage.


This acted as a deterrent to business investment. Investors didn’t want to face the possibility for being personally responsible for the business’s debts. This made it difficult to start any business that needed a sizable amount of capital.


For example, some of the first businesses that required large amounts of capital were shipping companies that were exploring the new world. Ships cost a large amount of money to build, outfit and operate.


Consider a 5% investor in a company engaged in the shipping business. One day the captain of the company’s ship gets drunk and runs the ship up on a reef losing (i) the ship, (ii) its cargo and (iii) its crew.


In the days before corporations, each investor would be personally liable to the bank that financed the ship, the owners of the cargo and possibly the families of the crew. Each investor could be personally liable for the full 100%. (A 5% investor might have a right to recover the other 95% from her fellow investors, but that would be little consolation if they had no money.)


To overcome this problem, entrepreneurs of the early 17th century convinced the monarch of the time to create a fiction in the law. The crown simply issued the entrepreneurs a charter incorporating their business. This charter was the equivalent of a new law. It provided that if the business caused harm to anyone, the person harmed could sue the business, but not its individual owners.


Essentially, the charter created a new person that could be sued under the law. That person was the corporation. A victim could sue the company to recover for harm caused. However, any suit against the company had to stop at the corporate level. The victim couldn’t sue its individual owners.


Corporate investors cannot be sued for the acts and debts of the corporation. If the corporation has sufficient assets to satisfy the plaintiff’s judgment, then the plaintiff will receive full compensation. However, if the corporation doesn’t have insurance and sufficient assets to satisfy the victim’s claim, then the plaintiff will not receive the full amount of her claim and she will not be allowed to pursue investors for any deficiency.


The invention of the corporation thus eliminated the deterrent to capital formation under previous law by providing co-investors with limited liability. Individual owners of a corporation can lose the full amount of the money they put into the enterprise, but no more.


One way of looking at the corporation is that it is a government sponsored risk management tool. This tool works well for almost everyone.


It is a great deal for investors. They can now invest in a business without the risk that they will become jointly and severally liable. By establishing a corporation to conduct their business, investors establish a firewall between themselves and anyone the company might harm. The corporation limits the investors’ downside, while their upside remains unlimited.


The corporation also has benefits for the public. It provides a way for aggregating capital to fund a vast array of businesses. These businesses generate wealth, provide jobs, fund the development of new technologies, and (hopefully) pay taxes.


The corporation and the principle of limited liability caused capitalism to flourish. For some time, the corporation seemed like a win/win for everyone.


If there was a downside, it wasn’t readily apparent. Environmental damage was either insignificant or not yet fully understood. No one worried about the dignity or human rights of employees. It was a world before labour reform, where employers made the rules and, if you wanted a job, you obeyed them.


Finally, monarchs still had corporations under control. They had the power to revoke charters just as easily as they granted them.


The corporate law of today is the functional equivalent of the monarch’s charter. Its primary purpose is to provide limited liability for investors. It does this the same way as charters did four hundred years ago--by providing that, if a company incurs a debt or its employees cause unjust harm to others, it is only the company that is responsible for paying the debt or redressing the harm; not the investors.


Each of the fifty states in America has a corporate law providing for the creation of companies and the recognition of companies formed elsewhere. These laws all grant investors the protection afforded by the principle of limited liability.

In other countries similar laws have been enacted either by state, provincial or national legislatures. Again, if it were not for these laws, corporations would not exist, and investors would face the possibility of unlimited liability for the debts and actions of the businesses in which they invested.

Post-colonial corporations

In the early days after the American Revolution, Americans largely distrusted corporations because of their experience in dealing with the corporations of King George III. Few Americans today realize this, but in some of the colonies, the Revolution was as much an attempt by the colonists to rid themselves of British corporations, as it was an attempt to get out from under the rule of the King and British Parliament.


With the surrender of General Cornwallis at Yorktown and signing of the Treaty of Paris ending the Revolutionary War, the colonies were free of King George’s corporations. With no King, the power to charter new corporations fell primarily to America’s state governments. The only way to form a corporation under the law was for investors to convince a state legislature to pass a special law granting them a charter.


This was simply the legislature doing what the King had done before. Each corporation that existed back then had its own specific law that created it. The new law would provide that a business had a charter and was entitled to treatment as a corporation under the law. The company’s shareholders would enjoy limited liability.


If the situation were the same today, Citigroup would have its own law on the books of some state (probably Delaware or New York) setting it up and providing how it was to operate. So would Coca-Cola, McDonalds, DuPont, Tesla, Microsoft, and every other company that exists in the world. Legislators would spend most of their time considering the formation of new companies. Special laws setting up individual companies would make up the largest portion of our statute books.


Early state legislatures were leery of corporations from their experience with King George’s corporations. Because of this, they used the chartering process to impose prohibitions on company behaviour that might harm the public interest.


The early charters restricted the activities in which companies could become involved. Most provided that the corporation was to have some public or quasi-public purpose. They also limited the size of companies and the type of assets they could own. The charters usually had expiration dates after which the corporation would no longer exist (unless it came back to the legislature to renew). Often, a charter had terms providing for the dissolution of the company if it damaged the public interest.


These provisions meant that legislatures had corporations on a very short leash. Investors knew their company owed its charter to the state legislature. They also knew that getting on legislators’ wrong side could result in their charter’s revocation or non-renewal.


In other words, the company not only had to obey the law, but it also had to make sure it was not doing something that would harm the public interest or upset legislators. This made companies, as compared with their modern-day counterparts, relatively self-regulatory (and thereby much easier to govern).



General corporation laws


The problem with only forming companies by special legislation was that it made incorporation very difficult. To obtain a corporate charter, a new law had to garner enough support for a bill to pass the legislature and become law. Without such a law, there was no charter, no corporation and, most importantly, no limited liability.


In 1811, the State of New York came up with a better idea. It introduced the first general corporation law. Instead of having to go to the legislature and ask for a charter, all anyone had to do to form a corporation under this law was file a charter with the state and pay certain minimal fees. The charter had to specify only the company’s name, the amount of its initial capital, its purpose, its address within the state (which could be the address of an agent), its initial directors and the name of the person or persons who are incorporating it.


New York’s idea quickly spread and soon every state had its own general corporation law greatly simplifying the process of forming companies.


The new laws changed the relationship between government and corporations. No longer did investors have to go hat in hand to the legislature to obtain a charter. Anyone could incorporate their business at any time. Incorporating a company became the right of every citizen.


This did not mean that companies no longer had to be good citizens. Most of the early general corporation laws retained provisions designed to safeguard the public interest. Many still had provisions allowing the state to revoke the charter if they found the company to be acting in a manner that was contrary to the public interest.


Race to the Bottom


In the mid-to-late 19th century, the Industrial Revolution started to get traction and the world of corporate law started to change. State legislatures perceived that there would be advantages to having companies organize in their state. They expected (mistakenly, as it turned out) that companies incorporating in their jurisdiction would also build factories and create jobs there.


The response was an unofficial competition entered into by the states to modify their corporate laws to make them more attractive to people who wanted to incorporate. One by one, legislatures repealed the provisions in the general corporate laws that protected the public interest. Some commentators refer to this competition as the “Race to the Bottom.”


Legislatures gave companies perpetual life, thereby eliminating the need for them to get permission to renew or extend their charters. The power of the state to revoke a charter if the company acted contrary to the public interest was also abandoned--if not by amending the law, at least in practice by state regulators refusing to enforce it.


The Race to the Bottom again changed the relationship between government and corporations. Afterwards, government no longer had companies on a short leash. Corporations were freed of the need to stay on the good side of legislators. The profit motive was no longer balanced by any obligation to protect the public interest. Companies no longer had to be good citizens (i.e., do more to safeguard the public interest than merely obey the law).

If legislators thought about it at all, they must have reasoned that government could still protect the public interest by passing new laws restraining abusive corporate behaviour after it became evident. Besides, government didn’t require individuals to be good citizens, why should it require corporations? While this rationale may have made sense 150 years ago when corporations had little capacity to harm the public interest, it no longer makes sense today.


Modern Corporations


The Race to the Bottom removed the disincentives for corporations to harm the public interest. Since then, companies have grown much larger. They operate not just locally, but globally. The technologies they employ are much more sophisticated. All this gives them much greater capacity to cause harm. The increased capacity to cause harm, together with the increased inclinationresulting from the Race to the Bottom, has become a lethal combination.


Probably because of corporations’ extensive involvement in politics, government also began to change its views regarding the acceptability of anti-social corporate behaviour. The Nobel Prize winning economist Milton Friedman suggested that companies should even break the law if it resulted in them making more money.


Beginning with the Reagan Revolution, governments started to question if the regulation of corporations was wise in any form. Soon, any new regulation had to pass an express or implied hurdle that it would not adversely affect the economy. This was a dangerous change.


Now, business is only required to obey specific business regulations (e.g. environmental laws, workplace safety laws, product liability laws, etc.) enacted largely in response to its anti-social behaviour. Such regulation only limits specific behaviour in specific jurisdictions. In other words, it only curtails anti-social corporate behaviour one abuse, one jurisdiction at a time.


For example, if the law in one state says that a company can only discharge a certain toxic chemical up to ten parts per million, it can still discharge up to that amount. Also, it can discharge an unlimited amount of other unregulated chemicals which it (alone) knows are toxic.


Furthermore, in all places that don’t have an equally restrictive law, companies can discharge greater amounts of the regulated chemical. The ability of companies to move their operations from one jurisdiction to the next gives them an upper hand in lobbying legislatures to go softly on corporate regulation.





A Bad Bargain


In case you’re wondering, the pot of gold the several states were chasing in the Race to the Bottom turned out to be an illusion. Just because a company incorporates in a state does not mean it will build its factories there.


Delaware won the Race to the Bottom. Today it is the state of incorporation of close to 60% of the companies in the Fortune 500. However, only a tiny percentage of those corporations have any significant operations there. Delaware has the distinction of sponsoring these companies, but it doesn’t get a similar percentage of factories or jobs as a result.


Neither did the states reap a windfall in terms of incorporation taxes and ongoing franchise fees. Companies, having learned to play states off against one another in the Race to the Bottom, used the same strategy to get their taxes and fees reduced.


Today, Delaware is the only state to receive more than a negligible portion of its revenues from the incorporation of new companies and ongoing franchise fees. The reason such levies make up a significant amount of Delaware’s annual revenues has more to do with the relatively small size of that state’s budget than the significance of the annual revenues it generates from corporations.


Personhood


In 1886, something else happened in the history of the modern corporation that is worth mentioning. In the Santa Clara v. Union Pacific Railway case, the Supreme Court of the United States first recognized that corporations are entitled to rights under the Constitution. This means companies are entitled to free speech, fair trials, due process, and equal protection under both federal and state law.


The wisdom of this decision has often been criticized, but never overruled. Indeed, the Supreme Court expanded the shield of corporate constitutional rights in 2009 in the infamous United Citizens case. There it held that government could not pass laws that infringe upon a corporation’s freedom of speech in connection with elections.


Over the 100 plus years that followed the Santa Clara decision companies learned to use their constitutional rights as a shield from government intervention (e.g., new laws) which would require them to stop abusing the public interest. They also learned how to lobby, set up political action committees, get access to, and influence democratically elected representatives.


They thus become the worst kind of citizen—one armed with all the rights of citizenship (because of the Santa Clara and now Citizens United decisions) but freed of citizenship’s obligations (by the Race to the Bottom).


The Santa Clara decision marks an important step in the evolution of the modern corporation, but its effect should not be overstated. Big companies use their constitutional rights to keep government from prohibiting their continued abuse of the public interest, but constitutional rights are not the source of this abuse.

Companies don’t continue abusing the public interest because they have the right to do so. They continue because their managers understand it to be in their company’s best interest and the law no longer balances that pursuit with an obligation to protect the public interest (even when the harm the company is causing is severe).


Conclusion


America’s form of government was designed to govern human beings alone. It now must also protect the public interest from modern corporations. It is ill equipped to do so. Liberal democratic governments all over the developed world find themselves in a similar situation.


As originally conceived, the corporation had obligations of citizenship. It was required to safeguard the public interest to maintain the benefits of having corporate status.

More than 100 years ago, America’s state legislatures, in a bid to attract more business, decided these safeguards were no longer necessary and engaged in a legislative Race to the Bottom. Legislatures in other jurisdictions throughout the world made similar decisions.


The Race to the Bottom resulted in the goal of corporations-- making money--becoming untempered by any need to protect the public interest. This is why, today, the public interest is under constant attack from big companies. The most pressing examples of this are the corporations which continue to emit huge quantities of greenhouse gases even though their management knows the adverse effect it is having on the environment.


The question citizens of every country now must ask is how much longer are corporations going to be allowed to operate in this manner? To stop the destruction of the environment and other elements of the public interest, the flaw in corporate design created by the Race to the Bottom must be corrected.

[1] Adapted from Time to Change Corporations: Closing the Citizenship Gap, by Robert C. Hinkley (2011).

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