Tuesday, November 6, 2007

Understand the true meaning of a corporation

“The Corporation”

While it is common to list various typical corporate features, such as entity status, limited liability and perpetuity, there is really only one defining feature: entity status. Entity status means
that certain legal rights and duties are held by the corporation as a separate, impersonal legal entity. In the case of the private business corporation, entity status implies that title to the firm’s assets is held by the corporation in its own right, separate from its shareholders.
Illustrative of the fact that the corporate form of private enterprise deviates from traditional forms of private property, entity status renders the legal position of both corporate shareholders and managers (directors) awkward and ambiguous. As for corporate shareholders, they are commonly regarded as the owners of the corporation, but they are owners only in a limited sense. Shareholders do not have title to the assets of the corporate firm, but merely possess the right to appoint management and to receive dividends as and when these are declared; title to the firm’s assets reverts back to shareholders only when its corporate status is terminated. The lack of ownership rights over assets is illustrated by the fact that, in contrast to partners in an unincorporated partnership, corporate shareholders cannot lay claim to their share of the assets of the corporate firm nor do they have the right to force their co-partners to buy them out. Corporate shareholders can liquidate their investment only by selling their shares to third parties. In short, the ambiguity in the legal position of shareholders lies in the fact that, while certain traditional ownership rights rest with them (profit accrual and power to appoint agents to manage the firm for them), other traditional ownership rights are exercised by the corporation as a legal entity separate from them (title to the firm’s assets).

As for corporate management, their legal position is equally ambiguous. Managers are appointed by directors who are the representatives of shareholders. Ultimately, management is thus the agent for shareholders, managing the corporation as their representative.
This, however, is only part of the picture. While management is the agent for shareholders in the sense of being ultimately appointed by and accountable to them, it is also the agent for the corporation itself. After all, in order to manage the corporation’s assets, management must legally represent the corporation as the titleholder to these assets. And because the corporation is an impersonal legal entity, agency for the corporation lends a significant degree of autonomy to the position of management, which is precisely why it has proved so difficult to make shareholder control over management more effective, despite the many legislative measures aimed at enhancing management accountability to shareholders.
To sum up, the position of management is ambiguous because management acts as agent for two principals, the shareholders and the corporation.

Other typical features of the corporation like limited liability and perpetuity are not independent, original attributes, but are derived from its entity status.
Shareholders possess limited liability because they do not own the corporation’s assets and are, consequently, also not liable for claims against these assets. Responsibility for corporate debt rests with the corporation in its own right rather than with them. Corporate creditors cannot, therefore, lay claim to the personal possessions of corporate shareholders, as they can to the personal possessions of partners in an unincorporated partnership. The most shareholders can lose is their initial investment when buying the shares, which happens only when the corporation goes bankrupt and the shares lose their value. Such is the origin of limited liability for shareholders. The corporate feature of perpetuity can also be traced back to the corporation’s entity status. It is because assets are owned by the corporation in its own right rather than by shareholders that the death or departure of shareholders does not affect its continued existence.

While unincorporated partnerships need to be legally reconstituted each time partners leave, die, or are added, corporations continue irrespective of who holds their shares. The corporation’s entity status
thus gives it a life independent of the life of its shareholders, which is the sense in which it is commonly said to possess perpetuity or immortality. This kind of immortality should, of course, not be
understood as if corporations literally go on forever, since they can most certainly cease to exist, for example when they go bankrupt or lose their corporate status.

According to people should not only be granted the freedom to make their own decisions, but they should also carry the full positive and negative consequences of these decisions. Otherwise, rights get given without the accompanying responsibilities, which inevitably has the effect of stimulating irresponsible behavior.
Corporate law has been designed to facilitate a legalized flight from responsibility by those who nominally own the corporate system.”
Corporate shareholdership is a licentious and irresponsible form of ownership because it is granted privileges of ownership (accrual of profits and the appointment of agent-managers) without carrying
the obligations of ownership (payment for losses). If shareholders receive the full benefit of enterprise when things go well, why should they not also carry the full cost of enterprise when things turn awry?
Similarly, corporate management is not efficient because it enjoys the privileges of ownership (control over assets by virtue of being the agent for the corporation) without having to face the burdens of ownership (payment for acquisition or loss bearing) and without being accountable to natural persons who do carry the full extent of these burdens, as shareholders don’t do either. As already mentioned, insofar as management is accountable to shareholders, such accountability is difficult to make effective especially when shareholdership has become highly diluted.

One must not deny the tremendous productivity advantages of the corporate form of the private business firm, for which there are two closely interrelated reasons.
First, the capital base of the corporate firm is potentially much larger than that of the unincorporated partnership. Because a partner in a partnership carries personal responsibility for the assets and
debts of the firm, there will be a stronger incentive for such a person to be intimately involved in its management so as to ensure that risks remain within proper limits; absentee ownership of unincorporated partnerships is just too hazardous. Given that a firm can only be effectively managed by a limited number of fully liable owner-managers, the capital base of partnerships will thus be limited to what that limited number of partners can contribute. The corporation is free from such limitations to the number of capital-contributing shareholders, because shareholders enjoy limited liability and need not be involved in the running of the firm at all. Moreover, given that partners in an unincorporated partnership have a shared legal right to its assets, they also have the right to force their co-partners to buy them out. As a result, the larger the capital contribution of each partner, the greater the potential strain on co-partners to find the necessary capital to buy each other out, should one or more of them die or wish to leave, which is a further way in which the capital base of unincorporated partnerships is naturally limited. By contrast, because title to its assets rests with the corporation in its own right (the corporation enjoys entity status), corporate shareholders have no legal right to force their fellow-shareholders to buy them out ,with the result that such limits to its capital base do not apply to the corporation.

For these reasons the corporation hardly knows any capital restriction on size whatsoever and is thus
able to reap all the economies of scale, and the technological innovations that normally go with them, which were previously out of reach of proprietorships and partnerships. Second, limited liability provides a measure of systematic risk protection for shareholders which will enable corporations to take on more risk. This increased ability to carry risk stimulates technological innovation as well as economic activity in general. Against the productivity advantages of the corporate form stand
a number of disadvantages :

(a) Increased Speculative Instability
Because incorporation separates ownership from control, shares in a modern corporation can be traded without necessarily affecting the management nor the capital position of the firm. As a result, an active market in such shares develops more easily. By contrast, the shares in an unincorporated partnership are less marketable because they are more strongly linked to the risks and responsibilities of managing the firm, which old owners are more reluctant give up and new owners accept. Moreover, partners normally have the right to consultation in ownership transfers, which also reduces the marketability of ownership stakes in unincorporated businesses.
Unfortunately, marketability and the potential for speculative trading are intimately linked. Since incorporation significantly increases the marketability of ownership stakes, it thereby also enhances the opportunities for speculative activity in share markets.
In addition, many of the participants in speculative markets are corporations themselves and thus enjoy a degree of risk protection in the form of limited liability. Because the balance between risk and reward is tampered with, speculative activity is artificially stimulated— which is not to say that there is anything inherently wrong with such activity. The excessively speculative nature of modern stock markets adds a further source of unnecessary instability to modern capitalist practice, which has the potential of seriously disrupting the real economy. And the ease and speed with which inordinate amounts of wealth are created and destroyed on the stock exchange is surely not one of the
more attractive features of modern capitalist practice

(b) Increased Market Concentration and Concentration of Control
Because the corporate form increases the average firm size, it will also increase the degree of concentration in any given market. Furthermore, because incorporation enhances the marketability of shares as well as the ease with which capital can be raised, it also creates better opportunities to gain market share by mergers and take-overs. While gaining market share through the stock market by mergers and take-overs is a matter of persuading investors that the combination is more profitable, gaining market share through the goods market is solely a matter of persuading buyers that the quality/price of the product is better than that of competitors.
Although the one does not exclude the other and superior profit may be realized through superior price/quality with the interest of investors and goods buyers overlapping, the general buying public is ordinarily better protected against market power abuse by sellers when the stock market route to increased market share is virtually blocked, as would be the case when unincorporated business
forms are dominant once again. But it should always be remembered that the corporate firm, through its potentially larger capital base, is in a better position to realize scale economies where they
exist, which may, on balance, benefit buyers in spite of reduced competition in the relevant goods markets and the greater potential for exploitation by sellers which it entails. Put differently, corporate capitalism does generally make the broad population more prosperous, but it makes shareholders and managers disproportionately more prosperous as well as more powerful.

The problem with corporate capitalism is not only one of increased market concentration but also
of increased concentration of control. Control has become more concentrated under corporate capitalism for two reasons. First, because of the greater potential for increased firm size already discussed and, second, because of the conglomeration potential. The conglomerate firm, through pyramidal ownership structures, facilitates extensive control with relatively little ownership for the parent firm. Such ownership structures can be ascribed to the ability of firms to own other firms, which is directly attributable to the corporate form. Without incorporation only people can own firms. And because the law, since the abolition of slavery, does not allow people to own people, pyramidal
ownership structures become an impossibility. The problem with increased concentration of control is that, for a given size of the total economy, fewer people make the relevant decisions: whether and where to invest, what to buy from whom, et cetera. As a result, fewer people are likely to benefit from these decisions, which are also likely to involve larger amounts of money. After all, increased size and concentration of control reduce competition , through the increased buying power of the relevant firm, which particularly affects local labor markets and markets for investment location. Because of the relative mobility of capital, the relative immobility of labor and the scarcity of job in any given locality (especially in Third World settings), the potentially excessive size of corporate firms causes them to obtain a potentially large bargaining advantage over local labor and government, which is why the latter often bend over backward to accommodate corporate investors through tax concessions and low wage policies and why large corporations are often in a position to exercise considerable leverage in their dealings with government.

(c) Increased Strength of the Profit Motive
Since corporate shareholders are normally so diversified that they become an wide spread mass, only the lowest common denominator of their wishes can be attended to, which is to maximize return
on investment—the wish which the greatest number of shareholders have in common. Put differently, the profit motive is given additional impetus, because it has to perform the additional function of
bridging the gap between management and an estranged ownership.
The divorce of ownership from control also stimulates the development of a large, impersonal market in corporate control, which makes it even more difficult for management to moderate the pursuit
of profit, as they live under the constant threat of losing their position through take-overs—and recall how take-overs are already made easier by the corporate form. That is why corporate behavior tends to be more strongly profit-driven than people tend to be when acting in their private capacity.

(d) Loss of Personal Morality
The possession of personal responsibility enhances personal morality, because the necessity of having to face the (positive and negative) consequences of one’s freely chosen actions and commitments stimulates responsible and thus moral behavior.

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