Wednesday, January 14, 2004

Defining corporations...

A few days ago I came across this definition of a "corporation" in Easterbrook and Fischel's The Economic Structure of Corporate Law. Before reading this definition, I would invite you, reader, to briefly attempt to define a "corporation" in your owns words. Got it? Now compare:

"A corporation is characterized by a statement of capital contributions as formal claims against the firms income that are distinct from participation in the firm's productive activities."

This is not how I imagine most people define corporations. Stereotypically it seems that people point to characteristics such as unlimited life, limited liability, legal life, etc. (Or at least this is how my high school economics teacher described corporations, so this is the rudimentary definition I imagine most people adopt.) But as Easterbrook / Fischel (hereafter E/F) point out, these facets of a corporation don't distinguish it from many other entities. Trusts, for example, can sue and be sued and have infinite life. As for limited liability, E/F note that this is a function of most investments - not just corporate investments. For example, a bondholder never puts all of his or her wealth at risk when buying a debt investment - so why should an equity investment be any different? Rather, the E/F definition (which may have come from someone else first) is much more accurate, as in encapsulates the exact feature of corporations that differentiates it from other forms: capital contributions (i.e. investments) that are distinct from productive activities (i.e. investors don't run the company).

The definition is particularly interesting because it is so innocuous. I can't imagine Ralph Nader saying, "we have to reign in the legal forms in which capital contributors are distinct from productive activities!" I've heard many liberals complain that corporations owe a "duty" to society because they are given corporate forms and the attendant "privileges." I think there's something to be said for the E/F definition simply because it highlights that what makes a corporation a corporation is not really that "special." As a historical matter, however, corporations were not particularly warmly welcomed. Rather, corporations had to receive corporate charters approved by legislatures - and even then, they were limited in function (e.g. corporation formed to build a railroad) and size (e.g. with a capitalization of $10 million). At the time, corporations could not act outside their legislative grant (otherwise known as acting ultra vires - a ground for vitiating any contracts or activities undertaken outside the grant). These were pretty severe restrictions and almost certainly caused losses in social wealth (limitations keep the corporation from functioning at an efficient size).

Obviously we've become much more relaxed in our approach to corporations, but it still seems (at least from my experience) that conservatives tend to be much more comfortable with corporations, while liberals tend to distrust corporations (and oftentimes exhibit tremendous animosity towards them). It could be that that assessment is way off - I sometimes make assessments that are way off - but such is my experience. This is not to say that conservatives tend to view corporations as bland investment-type vehicles (that is, adopt the F/E definition of corporations), but I do think they distrust them less.

The problem, for those who distrust corporations, is that it's nearly impossible to do anything about them. It is possible to legislatively remove limited liability, but parties to the corporation would simply bargain around this (with nonrecourse loans, for example, rather than equity investment through stock). Total welfare would go down because transaction costs would go up. No one would be better off in the long run. Others have argued for controlling corporations by requiring them (or, in a weaker instance, simply allowing them) to take social welfare (rather than investor wealth maximization) into account. This is also an indefensible position, even if reasonable in spirit. If management is beholden to both investors (who want wealth maximization) and society (which wants social welfare maximization), it is beholden to no one and can do whatever it wants. Any attempt to reign in corporations would result in a total lower social welfare because of increased monitoring costs and increases in capital costs (investors will be wary and want to watch over managers more carefully).

I've digressed a long way from where I started, I suppose, but I think the issue is interesting (and hopefully I got some interesting issues on the table). Obviously there's lots more to say -- but point was simply: What does your definition of corporations say about your approach to their regulation and their role in society?

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