We are pleased to print below Prof. Henry Manne's testimony on June 17, 1976, before the Senate Commerce Committee hearings on Federal chartering of large corporations. While he defends corporations here, Manne has pointed out to us that "this piece is not a summary of [his] theories on corporation law or corporate structure." Thus, for example, he does not take up the issue of limited liability of corporations. For libertarians, holding that people should bear responsibility for their actions, this issue makes a defense of corporations problematic. People have the right to contract with one another to limit their liability, of course, but in incorporation as currently practiced, people set up an organization and get the State to limit the extent to which they are liable for actions affecting third parties, who are not party to the contract. (For a criticism of libertarianism because of this aspect of corporation law, see REASON's interview with Nicholas von Hoffman, August 1976, p. 16.) In response to the editors' raising this point, Dr. Manne has promised a future article dealing with the issue. For now, he dears away some common misconceptions about corporations and examines the competitive advantages of state versus Federal chartering.
Before addressing specific aspects of this subject, it seems important to me to dispel certain misunderstandings surrounding the notion of Federal chartering and indeed a very widespread misunderstanding about the nature of the corporate system itself. On the first of these I believe it is fair to conclude that the phrase "Federal chartering" misleads the public about what proponents of this idea actually have in mind. While proponents do evidence some concern with the inappropriateness of state chartering of corporations operating across state and national boundaries, it does not seem to be the procedural or administrative aspects of incorporation, connoted by the word "chartering," that concern them. Rather, under the resurrected rubric of Federal chartering, we are again—or still—being offered more Federal regulation of large corporate enterprise.
By focusing on the concept of chartering rather than upon the performance of companies, and seeming to emphasize jurisdictional aspects of the question, these advocates imply that they are advancing a new idea and that they need not rigorously demonstrate why the present system needs correction or even prove the evils our largest corporations are alleged to be perpetrating. This is a clever strategy, since they would find it extremely difficult if not impossible to demonstrate any correlation between corporate size and their accusations about large companies. For example, no economist has yet demonstrated correlation between monopoly power and the size of a particular corporate enterprise. In fact, the evidence strongly suggests a correlation between size and economic efficiency.
Unfortunately, the constant repetition of unproven and untrue claims about large corporations has seriously diminished the ability of the broader public to understand the nature of the issues and the costs they may incur if ill-advised remedies are taken for imaginary ailments.
Such characterization of the corporation can never do more than confuse the difficult analytical problems raised by the complex phenomenon that is the modern corporation. If we allow ourselves to address the problem simply in terms of the powers of a large, artificial being, we are certain to miss the essential economic and market characteristics of the American corporate system. For the corporation is, fundamentally and quintessentially, a product of free-market forces. The growth and survival of this organization form, comprised as it is of an incredible number of individual contractual relationships, is itself strong evidence both of the market origins of the corporation and of the social benefits that emanate form this device.
It has been pointed out that there is literally no aspect of "corporateness," with the possible exceptions of suing and being sued in a corporate name, that could not be achieved through private contract rather than through the provisions of general incorporation laws. Indeed, English entrepreneurs, during the greatest period of industrial growth known in the history of the world, managed the organization of large business enterprises, with little or no involvement by the State, through the use of a business form known as the joint stock association. This form, which was the 18th- and 19th-century English version of the modern American corporation, was constructed almost exclusively from the common-law concepts of trust and private contract.
But it does not serve the purposes of those with the modern anticorporate mentality to understand the corporation as a market phenomenon. After all, how could anyone deprecate or despise something called a "complex congeries of interacting private contractual arrangements?" And how could one shudder or tremble at the very thought of "capital market managerial displacement mechanisms?" Technical precision simply does not lend itself to vituperation. It is so much easier to draw emotional support for an attack on something called a "giant corporation."
Let's look more closely at some aspects of the current attack on large corporate enterprise. First, there is the issue of corporate structure, the internal organizational arrangements of a corporation. Second, there is the behavior of corporations in society, though I will not include here a discussion of the monopoly question. This last matter seems too tenuously related in economic logic to the subject of Federal chartering for treatment here.
Adolph Berle, in his classic work, The Modem Corporation and Private Property, coauthored with Gardner Means, referred repeatedly to the "traditional theory of corporations." Oddly, however, nowhere in the literature of that time can one find any statement of such a theory. One can only infer from his stated concern with this "theory" that Professor Berle created a strawman out of a list of disconnected legal and political notions about the corporation.
The first of these analogized the position of shareholders to that of voters in a democratic, political institution. These voters, theoretically well-informed through disclosures required by law, would elect representative officials to govern their corporation. The behavior of these officials was, in turn, "constitutionally" controlled by the provisions of the certificate of incorporation or charter, state corporation laws, and later by Federal regulatory provisions.
As Berle examined each of these notions, he found them seriously wanting. Shareholders were not an informed or powerful electorate; elections did not occur with regularity or with the hoopla and paraphernalia we associate with political campaigns; the directors seemed to be in perpetual control of the large, diffused-ownership corporations; and there were neither governmental nor market forces constraining the powers of those controlling the corporations.
Certainly what Berle described was a blueprint for a great many abuses, both social and economic, and he proposed various devices to make large corporations appear more democratic from the shareholders' viewpoint and more legitimate in the exercise of their power. I shall return later to Berle's own resolution of the problem he described. For now, however, it is important to note that the ensuing 43 years of research and analysis of the problems Berle described have only demonstrated their ethereal, if not their totally mythological, existence. For Berle, like a great many writers before and after him, did not comprehend the fundamental role played by market forces in the design, the structure, and the performance of the modern corporate enterprise.
By the use of analytical and empirical tools that became available after Adolph Berle had done most of his writing, economists have developed new, complex theories to explain the corporate system. This newer work has enabled us to achieve a level of sophistication in our understanding of this complex organizational mechanism that still has not permeated the popular or journalistic, or the more narrowly legal, writings on the subject.
The economics of the corporate form recognizes shareholders, not as political citizens, but rather as economic decision makers who have determined on a certain type of investment. The corporate form allows masses of individuals to invest small parts of their total savings'in large, professionally managed enterprises without risking the loss of all their wealth in the event one venture goes sour. These shareholders constantly make decisions to buy or not buy shares, or to sell or hold shares, thus automatically generating the market price. This market has now been demonstrated, by perhaps the most exhaustive and conclusive series of empirical studies done on any aspect of modern economic theory, to reflect with extreme accuracy and speed all information that would influence a share's price. This is the now-famous "efficient market hypothesis."
If the stock market is as efficient as these studies uniformly indicate, then all shareholders are receiving tremendous external benefits in the form of correct pricing of their investments at no additional cost to themselves, and the rest of society as well achieves tremendous economic benefits at no cost. Now we can begin to understand more clearly why the status of shareholding is an economic and not, in any relevant sense, a political phenomenon.
Once we reach this understanding, a number of implications follow. The first of these is that any effort to "democratize" the corporation is solving a nonexistent problem, since shareholders are not adopting their status with any view to political power, but rather with a view to maximizing their net worth positions. Furthermore, efforts to gain representation for other constituencies, to the extent that this can be accomplished at all, can only damage the economic position of shareholders and either destroy or distort the market mechanisms that developed, as we shall see, to protect the shareholders' investments.
This brings me to a second fundamental aspect of an economic analysis of corporations. If, as indicated, the stock market correctly discounts the future flow of income from corporations to establish market prices, and individuals continue by the tens of millions to invest in corporate enterprise, some market mechanism must be available for assuring efficiency on the part of corporate managers and for replacing less productive ones with more efficient ones.
Manifestly this is not done through anything like the political elections that characterize the selection of government officials. We now know that in the main this function is performed by individuals or representatives of individuals who have substantial wealth positions at stake.
The crucial role played either by outside directors when they are a majority, or by some group outside the formal corporate structure when outside directors are not a majority, is to monitor the efficiency with which the actual corporate managers perform their tasks. The classic analysis of this function was done by Professors A. Alchian and H. Demsetz in "Production, Information Costs, and Economic Organizations" (American Economic Review, 1972).
In the vast number of instances of declining managerial efficiency, a subtle, interpersonal mechanism apparently works quite satisfactorily. On occasion, however, a crucial back-up system, which Professor Oliver Williamson of the University of Pennsylvania calls a "capital market displacement mechanism," must be used instead. The most obvious of the market displacement mechanisms is the tender offer for shares. The proxy fight, by comparison, has numerous disadvantages and is accordingly only rarely used. Still a third device that may serve the purpose of replacing corporate managers in the absence of personal shareholder control is the merger, which is often a cover for a decision to quit by existing managers who have been forcefully made aware of market realities.
A rigorous economic analysis of the corporation, only the rudiments of which can be described here, demonstrates the futility, if not the actual damage, that can attend efforts to "constitutionalize" a corporation by specifying who should sit on its board of directors. The board may serve a variety of marginally valuable consultive purposes, but in the last analysis, if it does not perform the management monitoring function, the market will provide a substitute device, and shareholders' interests will be served.
This approach also demonstrates the absurdity of focusing on what are conjectured to be the true directorial responsibilities of members of the board, a misconception pithily alluded to many years ago by former Associate Justice William O. Douglas as "directors who do not direct." Unfortunately, in recent years this belief that the directors of corporations should play an active role in managing the affairs of corporations (as opposed merely to monitoring the performance of actual managers) has gained considerable credence with the SEC and with courts seemingly bent on establishing totally inappropriate standards of care for corporate directors. As Lord Keynes so aptly stated in the General Theory: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
Another aspect of the current discussion of Federal chartering relates to the social performance of large corporate enterprises. Not the least part of this topic has been the much-discussed and little-understood notion called corporate social responsibility. It was in this connection that Adolph Berle, in an important work of the early fifties entitled The Twentieth Century Capitalist Revolution, found to his own satisfaction an answer to the problems raised by the large corporation. Berle concluded in that work that large American companies, free as he thought they were from market constraints and government supervision, were in fact appropriately managed from society's point of view.
Managers, he concluded, were meeting their responsibilities by producing or developing the material resources appropriate to our society, by keeping prices at a fair level, by dealing justly with employees and others, and in general, by refraining from abusing the vast powers they had. Berle seems to have concluded that the soulless corporation had found and saved its soul by virtue of good works. In the process, he demonstrated again how little he understood the impact that market forces have on the behavior of individuals operating large corporations.
The immense literature of recent years on the subject of corporate social responsibility can be simply summarized pro and con. Proponents basically assert what can only be called a personal preference to have corporations behave as they would like them to, though they are by no means in agreement on what is correct social behavior for a "corporation." The response literature in this field, to which I have contributed perhaps more than my share, is devoted to the proposition that corporations neither can nor should try to engage in real social welfare activities (apart from obeying the laws of the land).
The most significant argument is that a corporation is not such an entity or being that can logically have ethical attributes, or an altruistic spirit, or a social responsibility. The second line of argument is that in a competitive milieu the funds that corporations actually have available for altruistic purposes are so insignificant as to make the very concept chimerical. To whatever significant extent corporations can engage in altruistic behavior, they must be realizing monopoly profits, thus evidencing that other aspects of the government's program for dealing with the economy are not succeeding.
As a corollary to this notion, it should be noted how ironic it is that the very corporate executives whose motives and goals are now so mistrusted should be asked to adopt and implement our social goals. Business executives, after all, are not specialists in representing broad public interests. That is the elected politician's legitimate responsibility. But I believe that the advocates of corporate social responsibility are fooling the public into believing that corporations should do these things voluntarily, when in fact these advocates understand full well that they are actually generating more government supervision and regulation. Consider, for example, such areas of concern for corporate social responsibility as racial employment policies, pollution controls, safety of employees, consumer safety, and a variety of other matters, all initially identified as corporate social responsibilities and all now firmly in the domain of government regulation.
In one area, however, socially acceptable behavior is not a matter of dispute. Adherence to the laws of our land is an obligation of corporate executives acting personally and on behalf of those they represent.
The recent issue of the bribery of foreign officials seems, on the other hand, to raise a different kind of question. We cannot specify, under our own political powers, what the real or de facto laws of another country are, and consequently we cannot blithely or universally assert the impropriety of behavior accepted de facto as appropriate in other countries and cultures. Furthermore, attempts to distinguish bribes in one country from the taxes or expropriations in another become extremely difficult, if not impossible, in the real world. And attempts here to police foreign behavior and customs has been repeatedly demonstrated, in business, military, and diplomatic contexts, to generate perverse results in this country.
One more thing should be noted in this connection. The bribes headlined in recent months have always gone to government officials, and we can reasonably surmise, by looking at the countries involved, that this behavior results when government has intervened so much into commercial activities that such behavior can no longer be constrained. This is precisely why the analogy of the bribe and the "spite tax" is so pertinent, since, in the countries involved, the bureaucracy accepting the bribes in fact constitute the government of those lands.
One further aspect of the performance of American business should be touched upon in any discussion of Federal chartering. Clearly, a competitive market system has many of the same virtues as political federalism, a concept whose popularity, while cyclical, is unmistakably on the rise. True federalism denotes a large number of power centers, each offsetting and competing with the others to some degree, but none being able totally to dominate a sector of society. There is still substantial agreement among our political savants that a principal reason democracy has survived for 200 years in the United States is our diffusion of political power.
In no small measure this diffusion of power has also resulted from a competitive free-market economic system. Whatever fears each of us harbors of a totally centralized, authoritarian government, so these fears must grow as we contemplate increasing regulation of even the largest or our private corporations. After all, even if a proposal to limit Federal chartering to only the hundred largest corporations were adopted, this would still result in the weakening of twice as many competing power centers as exist among all the states in the United States.
We have been too quick to believe that, because 100, or 700, corporations produce a large percentage of manufactured goods in this country, the number must be too small. Viewed in the broader context of the entire political economy, even 100 is still a very large number compared to that single concentration of power that has become our national government.
And if comparisons are in order, it is hard to believe that so-called market failures have been as common, as dangerous, and as costly to society as the much less heralded, and not yet cleverly titled, failures of government. One need only compare the efficiency of the United States Post Office to that of any of the hundred largest corporations, or the Federal government's administration of foreign affairs in Vietnam to any corporation's handling of its intercorporate diplomacy, or the mess that we have made of almost every major city in the United States to the financial and managerial situation of these same companies. Then we may quickly realize that at least a part of the current concern with the performance of large corporations very likely represents the use of a scapegoat to distract the public from the far greater injuries it suffers at the hands of government.
One of the oddest, or most revealing, aspects of recent discussions about the evils of large corporations has been the total absence of even a scintilla of recognition of the incredible record of production, employment, and honesty of American business. I do not intend to cite statistics or make quantitative comparisons to other lands. I should merely like to point out that there is a growing awareness—not merely on the part of the business community but, more significantly, on the part of the electorate-at-large—that government is now threatening to kill the goose that lays the golden eggs, that government regulation of business is costing the public considerably more than it is benefiting them, and that all of this results from the seemingly insatiable desire of officials in Washington and in the states to regulate more, more, and more of the private sector.
Finally, we turn to a consideration of the actual chartering of corporations. The discussions of the consequences of state chartering occasion much less disagreement about the facts than about their significance. Throughout the last third of the 19th century and the early part of the 20th, legislatures of various states did vie with each other to attract incorporations by making the state's laws more attractive to entrepreneurs. That is, of course, precisely and exactly the process for which the Federal system of the United States was designed. The Commerce and the Full Faith and Credit clauses of the Constitution, to mention only two, guarantee that. But each state, within specified limits, is allowed to adopt its own internal regulatory laws, though these laws must not inhibit what in effect amounts to a national common market in the United States.
This open market for commerce and for laws proved the states with relatively fewer regulatory laws to be more suitable to national economic needs than those with more regulation. But there was, after all, nothing to stop any state from adopting a variety of corporate regulations, and certainly many did, continuing to this day to do so. Examples like the legalization of holding companies, voting rule requirements, qualifications for directorships, rules regarding offerings of new shares, rules regarding financial practices, and many others quickly demonstrate the variety and range of powers left to the states.
But, the advocates of Federal chartering point out, the corporations of one. state could then cross over state lines and do business in another state without concern for its restrictive incorporation provisions. And so they may, for such is the very essence of a federal political system with a common economy. Still, erroneous inferences seem regularly to be drawn from this description. At no time has any state been prevented from exercising its authorized police powers by virtue of the "common market producing" provisions of the U.S. Constitution. Any undesirable behavior by a given corporation that is properly the subject of a state's police power can be regulated or forbidden if the government of that state so decrees. Thus, states may establish rules regarding the employment practices of corporations, what they may or may not manufacture, pollution control standards, and the conditions under which securities may be sold to or bought from the citizens of that state.
But, it is alleged, these poor little states and their naive politicians are simply not up to the task of exercising the states' police powers over sophisticated giant corporate ogres. The argument is either disingenuous or dishonest. The message really seems to be impatience with states that are unreceptive to demands for whatever regulation is being popularly espoused at the moment.
But the argument is really deceptive for another reason. For who can deny that when any problem of truly national significance has been detected (and, unfortunately, in many cases where the detection seems more fictional than real), the Federal government has stepped in with its concurrent police powers to deal with the situation. Consider in this connection that mushrooming regulatory apparatus of the Securities and Exchange Commission, the Federal Trade Commission, the Antitrust Division of the Justice Department, the Internal Revenue Service, the Department of Commerce, the Interstate Commerce Commission, regulatory provisions relating to government contracts, the Federal Communications Commission, OSHA, the Environmental Protection Agency, and a vast multitude of other offices, agencies and bureaus presumably performing the kinds of tasks requested by advocates of Federal chartering.
Somehow, this request for still more Federal intervention provides perhaps the strongest argument against granting any additional Federal regulatory powers. For the Federal government of the United States has been unable, with this vast panoply of powerful bureaucratic organizations, to satisfy the demands now being made by would-be Federal charterers. I can see no possible reason to believe that anyone will be happier to have even more of this job-generating work for bureaucrats and members of the bar.
Actually, as so often occurs, much of the regulation presently on the books has had an impact exactly opposite to what it was supposed to accomplish, and the same thing would likely be true if regulation were extended further via Federal chartering. The explanation of this phenomenon involves a simple application, to a political marketplace, of the fundamental law of demand. When states lowered the real cost of incorporation because of the competition fomented by the federalist system, they increased the total market demand for the particular government service involved, and more incorporations occurred. However, as soon as this competition, and the resulting lower real costs, began to be inhibited by Federal regulation, like the ICC or the SEC, the cost of this same government service began to rise.
The necessary result of this process is to decrease the number of incorporated firms entering the market and therefore to diminish the very competition that lowers prices and increases production for the consumers of this country. Though we have no direct data on this subject, the analytics of the situation strongly suggest that the existence of competing state incorporation acts contributed significantly to the development of a highly competitive market system in the United States.
Thus, the centralization of this function must necessarily decrease the amount of competition in the industrial sector. If a cost-raising law, such as that proposed for Federal chartering, were to become the law of the land, there would still always be 700 largest corporations. The 701st corporation, however, would find it ill-advised to compete efficiently with the larger ones for fear that it would join their ranks and become one of them. In other words, such a law would create a number of companies operating at suboptimal size, offering less competition to larger, established companies, inhibiting their own initiative and development, and in general behaving contrary to the public's interest.
This is not a mere guess about what would happen. There is ample evidence that precisely this process has already been set in motion by our large amount of Federal regulation. To give a simple illustration, consider safety devices and emission control equipment on automobiles. Each of these devices requires an auto manufacturer to incur both a capital cost and a per-unit or variable cost. We may assume that the variable and fixed or capital cost per unit produced is about the same for large as for small companies. The larger the volume of production, however, the greater the number of units over which a company can spread its capital costs. Thus, the effect of every regulation, whether it be safety devices, securities regulation, environmental controls, labor laws, or what have you, is to some extent to make production for smaller companies more expensive per unit than for larger ones. And unit cost is the name of the game in competition.
This may, to some extent, explain why larger corporations in this country often find that they can "live with" new regulations. And in some cases they are even the most active proponents of such measures. Smaller companies may find it difficult to organize resistance to or to cope with this regulation; but, perhaps more significant, if harder to measure, are the real interests of potential competitors. These may even be totally unidentifiable if such costs have the effect of actually preventing new entry into a particular market. We are already in great danger of regulating corporations to the point where only large corporations can survive, a situation that is presumably the exact opposite of what proponents of Federal chartering want.
A little knowledge of the workings of our economic system, particularly by lawyers and law professors, could go a long way to counter simplistic thinking about further politicization of the private business sector. What we should really be concerned with are the problems of size and power in government as it relates to the private sector. Attention to these problems is urgently needed.
Dr. Henry Manne is distinguished professor of law and director of the Law and Economics Center at the University of Miami Law School. He has studied extensively and written widely on the subject of the economic implications of laws relating to American corporations.
Some lamentable, and then strange, events surrounded Dr. Manne's appearance before the Senate Commerce Committee. Federal chartering of corporations had been most notably proposed by Ralph Nader, and he was the committee's star witness. Manne was among others invited by the committee to testify. On June 17, the day both Nader and Manne were to appear, Vance Hartke was the only Senator in attendance. Missing, among others, were ranking minority Senator James Pearson and Republican committee members Griffin, Beall, and Buckley. A sizable crowd showed up.
Nader had not yet arrived when the day's proceedings began. Of all the witnesses invited, Manne had come the greatest distance, and it was known to the committee that he had a return flight to catch. Two witnesses were called. Nader arrived, was called, and gave his testimony about all the evils that corporations allegedly perpetrate (referring to· Dr. Manne in passing as "that academic from South Florida"). Senator Hartke and his aides put some questions to Nader, none of them challenging his theory of economics or, really, his evidence. When Nader left, most of the spectators went also.
More witnesses were called, until finally Manne got his turn. A few sentences into his remarks, however, and Hartke exited, leaving Manne speaking to Hartke's aides and a few spectators. Halfway through, the Senator returned, proceeding to interrupt with questions showing he hadn't read the testimony in advance (for which purpose copies are supplied). Moreover, the questions "demonstrated an embarrassingly small knowledge of economics and were phrased in rude and abusive language." This is not according to Manne, but according to the September 1976 Bulletin, Economic Education and Research Forum. Manne responded politely, they report, to Hartke's accusations of callousness toward human life and advocacy of breaking the law. But, "Since Senators Buckley, Beall, Griffin, or Pearson had not troubled to attend the hearings, there was nothing to be done." Could this sort of negligence, asks the Bulletin, and not the simple propensity of most legislators to pass economic regulation, explain why free-market supporters are fighting an uphill battle?
So much for the lamentable events. Strange ones were to follow. A Commerce Committee staff member telephoned Dr. Manne the next day to offer a personal apology for Senator Hartke's treatment of him. Yet reports were circulating that it had been the other way around—Manne had been flip and rude toward the Senator! Meanwhile, Manne received a summary of the hearings, distributed by a Washington-based business group, in which the account of his testimony was garbled. Disgusted, he tossed it out, a move he regretted in light of the reports, now getting back to him, about his allegedly bad conduct in Washington. Attempts to obtain another copy of the summary from the outlet that had distributed it were unsuccessful.
An interesting case study in political intrigue? Yet the "moral" for libertarian activists is unclear. Is the conclusion that, with this sort of bizarre goings on, it's useless to attempt to "work through the system" bit by bit? Or is the conclusion that the free-market position is finally getting on the map, since only people who are getting scared pull such shenanigans?