By Nicholas Benes
(also published in the Harvard Law School Forum on Corporate Governance)
The Birth of the Corporation: Public Interest Organizations
The evolution of the modern corporation is the fascinating story of a series of self-serving legal and societal mutations over hundreds of years, which have morphed the original concept and endowed corporations with freedom of activity, rights, and limitations on liability that would shock their original “inventors”.
As we all know, for many years most corporations were established by way of an exceptional “charter” by a sovereign, granted only in specific cases where: (a) large amounts of capital were needed (b) to conduct investments and activities that served public or national interests and had good profit potential, but (c) where the risks were so large that few parties would invest if their risk were not shared with many others and/or limited to the amount of money they invested.
In the 1600s and 1700s, the activities that sovereign nations felt met those requirements were the exploration of foreign lands on the other side of the globe, the creation and administration of colonies there, and conducting lucrative trade on long (and dangerous) sea routes to and from those colonies. Thus, the most well-known early corporations include organizations such as the British East India Company (the original “too-big-to-fail company), The Dutch East India Company, the Hudson’s Bay Company, and companies to construct the Erie Canal.
As the industrial revolution gathered steam, the need to raise large amounts of capital increased many times over. Driven by this need, the immense benefits of corporate status for raising financing became increasingly obvious and desirable to investors and managers: easy stock transferability vs. rewriting partnership agreements, separation of ownership from control, legal personhood that simplified large transactions such as loans and large investments (a single counterparty to deal with and sue), and the possibility of receiving a charter that conferred “limited liability” on shareholders. All of these made it much easier to raise funds in large amounts than any other form of business organization.
“Anyone Can Form a Corporation! Limited Liability for Free!”
Therefore, during the 1800s U.S. states started to loosen the requirement that corporations must serve some sort of public interest (such as building a canal), and the first true “enabling” corporate statute came into being at the end of the century. As the wording suggests, with “enabling” statutes, the law abandoned the pretense that the activities permitted by a corporate charter must serve some sort of public interest or even a specifically permitted purpose. The law existed in order to “enable” investors to structure a corporation in any manner that they desired, as long as it met very minimal structural requirements and the proposed activities were not illegal. There were no requirements related to the distribution of risks, rewards, or the creation of a safety net for society or external parties who might be affected by the corporation.
The age we now live in had been born: a time when any group of investors can establish a company for any legal purpose whatever, and receive “for free” the immense benefits of stock transferability and limited liability, even if they do not appreciate just how large those benefits are and do not design the company’s incentive structure accordingly. (After all, if a firm can raise much larger amounts of capital, it might end up externalizing much more damage.) Stock markets have multiplied those benefits many times over—again, essentially “for free”—but like corporate law, they also have done little to alter or limit the self-serving incentive structures that shareholders and managers build into corporate articles and policies.
More than one hundred years ago, on balance this “trade” made good sense for society and the global economy. To nations as well as investors, the benefits of accelerating industrialization were huge, and the number of corporations was still very small. To be sure, present and future regulatory deficiencies might exist in areas such as child labor, pollution, business practices, securities law, and the like, but it seemed reasonable to assume they could be dealt with,—if indeed they were envisaged at all. Therefore, the possibility of any downside risks to society posed by enabling statues seemed to pale by comparison to the very tangible “upside” benefits of increasing capital flows by removing the transactions costs of corporate establishment and facilitating the market’s ability to attract and allocate financing. Why waste time insisting on the need for some sort of “public interest” or narrow purpose when most investments (taken in the aggregate) indirectly seemed to be making a net positive contribution to economic growth if they could simply raise more money for profitable investments?
Being a “Legal Person” Doesn’t Mean You Have a Conscience
Normally, one wouldn’t think of automatically extinguishing liability for a real person unless that person went through personal bankruptcy proceedings and would therefore have to deal with reputational risk in the future. But for the reasons mentioned above, and because of the political power held by persons with a lot of money to invest, very similar benefits of “limited liability” were conferred to the owners of “legal person” corporations with the wave of state and national legislative wands, for the price of a minimal registration fee.
This created an issue that was to fester and impact society more over the next hundred years, but which had been clairvoyantly predicted by numerous deep thinkers many years earlier. As Edward Thurlow, the Lord High Chancellor of Britain said more than 200 years ago, “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?”
The Conditions of Today are Vastly Different
Fast forward to 2020, and one can easily see that the conditions that originally justified the promulgation of simple “enabling statutes” on grounds of economic policy no longer exist. Different from 1900, the vast majority of economic activity by all developed economies is now conducted by limited liability corporations which frequently externalize risks and inflict significant damage upon third parties, —but all too often, no one has to pay the piper for it, at least not in full. To appreciate this, one only need reflect upon the ongoing Opioid crisis settlement, the BP blowout in the Gulf of Mexico, Enron, the asbestos crisis, or the “too-big-to-fail” outcomes enjoyed by investment banks and AIG in 2008.
In the 21st century, capital is so much easier to raise that we should no longer have to sacrifice other public goods or the collective common interest in order to facilitate fund-raising. Our corporate laws should reflect this fact, but do not.
With the “free” tailwind of today’s easy capital-raising, corporations have become massive in size, but greater size and numbers have brought with them zero greater responsibility in corporate law. Corporations have few hard incentives (other than industry regulations) that are different from what existed in 1900 to look far ahead and prioritize their long-term profitability. They also have few direct incentives to contribute to the very global sustainability and trust in markets (and stock markets) that they themselves benefit from so greatly.
Companies benefit immensely from limited liability—it is the reason they can raise so much money so easily and sometimes end up causing more harm than they would have otherwise—but do they pay anything for its advantages? Companies benefit greatly from the existence of public equity markets, but the listing fees they pay are miniscule compared to the benefits they and their shareholder receive in return.
Large corporations also influence our political processes, and even our individual opinions as citizens in a democracy, to a degree that would have been unimaginable in 1776. Executives are overpaid to an extent that can only be called “out of control”, despite “advisory” votes. They jump to the next higher-paid position with little sense of loyalty to a mission (whether corporate or societal), and show no apparent public shame when they bail out from companies about to implode. In today’s “money culture”, described by Michael Lewis in a book by that name, the thing that determines one’s identity and sense of pride is mainly how much money one makes (or made), not his or her public reputation as a citizen of society. Those of us who are paid by corporations may not like to admit it, but that pay often binds us to be more loyal to our employer than to society and the improvement of public policy, and to not give voice opinions that we in fact think as private citizens.
Should corporate statutes be “enabling” self-servingly structured limited liability and the diffused, minimal, and short-termist accountability that frequently comes with it?
Redesigning the Corporation for Today’s Needs
How might we design corporations if we were inventing them anew today, in an age of huge capital pools, global warming, and an increasing number of other large externalized risks driven by accelerating global and technological trends?
We might start by re-considering and debating the following issues:
- Limited liability is a privilege of immense value. It is a gift from the state, not a birthright. Do serial abusers of bankruptcy court deserve to receive this right at the expense of others?
- Does it really make sense that shareholders be able to escape all future risks just by selling the stock? Didn’t they elect the current board, which oversaw present policies and will continue on after they sell? Insider sellers present similar issues.
- Regulations and liability will likely become stricter in the future, to address risks such as climate change. Funds will be needed to pay for fines and damage awards. If funds not available, more and more damage will simply be externalized and borne by unrelated parties or persons in the future…namely, society and our children. Why should those who own no stock at all bear most of the risk that will result from allowing limited liability?
- Luckily, unlike 1900, we now have much larger pools of capital that can absorb risk, since 80% of stock is now held by institutions, instead of individuals. Shouldn’t larger pools of capital facilitate the ability to effectively provide a degree of insurance to society for collective risks to which the firm has contributed?
- Trading and turnover have increased rapidly, but wouldn’t blockchain technology allow us to trace back accountability to all culpable parties, including to each beneficial owner in each fund?
Today, we need stronger incentives for shareholders to vote wisely now, and for directors to act wisely now, regarding things that will affect the future over the long term. ESG is an attractive concept as far as it goes, but in reality its incentive driver is very weak because most executives and directors will not be around in 15 years, their compensation is not at all aligned any of with its multiple variations, there are no standard disclosure criteria, and subjective bias enters the “integration” equation. Moreover, the plain fact is that when judging matters from the outside looking in, investors really don’t know what factors will most affect a particular company’s long-term sustainability. Clearly, we need better internal incentives as well as external incentives.
An Example of Redesigning Incentives
As a thought exercise, let’s put aside the problems posed by path-dependency for now, and imagine that corporate statutes were changed in the following manner:
- A levy of 0.20% will withheld from the amount of all purchases, sales or issuances of stock, of any form.
- Each director or senior executive must invest 50% of his or her total compensation in a special subordinated class of the company’s stock….and must continue to hold that stock for five years after leaving the firm. Similarly, all share-based executive compensation can only be based on this subordinated class of stock, with similar holding requirements.
- The 0.20% funds that are withheld go into an “externalization/bankruptcy trust fund” set up for that company, which are invested in Treasury bills. The more often the stock is issued or traded, the larger this fund will become. The more the company’s shareholders enjoy the benefits of liquidity in the market, the larger the fund will become.
- Each single share of stock is a unique digital “currency” that keeps track of all prior owners, and their trades of that share, using blockchain or any other system for recording each individual trade and its beneficial owner. (I realize this technology would need to be developed and refined.)
- Non-insider investors can sell the stock anytime they like, but for five years after selling, each stands to potentially “lose” a certain percent (or all) of the total amounts they have “paid” into the fund, in the event of bankruptcy. Those funds will be available to creditors and victorious lawsuit claimants in the event of bankruptcy or liquidation of the company. The escrow interests would not be transferable other than in exceptional circumstances.
- The exact percent subject to potential loss depends formulaically on how long during the prior five years each investor held the stock, which is to say, the approximate time span during which they could have voted or engaged with management differently. For example, investors who held stock for five years would be penalized more than investors who held for only one year, since they had more opportunity to monitor and correct the behavior that may have led to bankruptcy. However, to prevent “gaming” of the system, in this calculation all stock will be presumed to have been held for at least one year.
- If there is no bankruptcy in five years, each investor will receive back its 0.20% amount(s), plus interest. Non-insider shareholders can also vote to use the portions that they themselves have paid into the fund for settlements that are needed to avoid bankruptcy. In the case when non-insider shareholders vote to liquidate the company, if there are funds left over after paying creditors, shareholders will receive the remaining portions of the funds in escrow, depending on their percent allocation and share class. However, the entire portion withheld from directors and executives will tapped first, before any other portion.
Realizing that I have just shocked the reader by describing a corporate structure that probably seems other-worldly, I would submit that the following benefits might arise from corporations designed in this way:
- Investors, directors, and executives alike would have much greater actual incentive to think, act, and vote for the long-term interests of the company… diligently preparing in advance to cope with new regulations and changes in customer/societal expectations.
- Incentives will be better balanced and aligned than they are in today’s unduly “upside-tilted” world: there will be larger rewards for good behavior, oversight, and engagement,… but also larger disincentives for the opposite, or for “free-riding” as a shareholder in the voting process. Executives will think more like true residual owners, as they should, rather than elite insiders entitled to getting a better deal than other shareholders.
- There will be greater demand by shareholders and beneficial owners for industry-specific and value-relevant ESG data that is better defined, standardized and comparable. There will also be more demand for analysis of voting data by funds. For example, a fund manager voting not to encourage an oil company to present a more detailed strategy for addressing greenhouse gases might be viewed as risking not only the value of a stockholder’s current equity but a beneficial holder’s escrow account.
- The stock price of those companies where investors are not sufficiently engaging with management and actively confirming policies on those ESG issues that will eventually directly affect the corporation’s value, where investors elect boards that do not “act for the long term”, will drop. The stock prices of companies where investors are sufficiently engaged in electing good directors and requiring high-quality disclosure, will rise. Stock prices will become much more sensitive to these “non-financial” factors, because investors will have much more confidence that incentives are aligned.
I am not writing this post as a tree-hugging idealist. Indeed, I have devoted much of my life to the cause of improving corporate governance policy and board practices in Japan, for the purpose of making companies here more shareholder-conscious and profit-minded. On a relative basis, those aspects are lacking in Japan, in general. But even as I believe much more needs to be done in Japan in these areas, I also believe that in the interests of profitable sustainability and price discovery that reflects it in a virtuous cycle, capitalism around the world is at a turning point where it needs to think out of the box and re-examine received wisdom about the legal structure of corporations, with a forward-looking view. In doing so, we need to squint closely at the underlying incentives. Unless we do that, the “investment chain” will continue to be a cascading series of agency problems without much accountability at the top of it. If the example I set forth seems like nonsense, by all means make your own proposal.
Redesigning Corporations: Incentives Matter (in the Harvard Law School Forum on Corporate Governance)
Nicholas Benes is founder and Representative Director of The Board Director Training Institute of Japan, and proposed Japan’s Corporate Governance Code.