Sunday, February 24, 2013

V: The Transformation of the American Corporation

(This post is the fifth in the series--see links below for previous posts)

During the second half of the nineteenth century, the American corporation underwent a dramatic change.

The early American corporations, while important, were not going to dominate business. The reason: the existence of a corporation required a specific grant from a governmental body, called a “charter.”

Since a corporation is a legal entity, not a natural one, its existence requires a legal act. “The charter is a grant of authority from the sovereign. It specifies the powers, rights, and duties of the corporation.” (2), p.129.

The nature of that legal act, the charter, changed dramatically toward the end of the nineteenth century. Until this change occurred, charters were granted one by one, by legislative acts, to establish corporations to do particular things. “Approval of a charter was a political issue, involving lobbying, campaign contributions, and worse.” (3), p. 13.

Yet, corporations had an advantage over other business forms. A corporation could raise capital quickly from a wide variety of sources. The purchasers of a corporation’s shares risked no more than the cost of the shares, while they stood to gain from the corporation’s success. The corporation did not need to rely solely on the wealth of a few people. Instead, it could obtain capital from numerous less wealthy sources, and the accumulated amount of this capital could easily exceed that available from one or two wealthy investors. To fund the industrialization of the nineteenth century, such capital was essential.

In the eighteenth century, most corporations were chartered for educational, religious or charitable institutions, or to create municipalities: cities and boroughs. (See the previous post.)  In that entire century, only 335 business had received charters in the U.S. (2), p. 129.

Industry in America began its enormous growth beginning around 1825, not coincidentally the year the Erie Canal was completed. Transportation and banking infrastructure were essential to this growth. Railroads began to expand, eventually connecting the Atlantic and the Pacific coasts. Banks went from small clubs of merchants providing credit to one another to chartered institutions that were essential players in the industrial expansion. The chartering of corporations one by one was a clumsy process that needed streamlining to keep up with and expand this growth.

This need was met by state legislatures, which, beginning around 1850, began to replace the one-by-one chartering process with general laws that simply required that a corporation can be created by filling out and filing the appropriate forms. “Under a general corporation law, anybody who wanted to could incorporate, and without wasting the time of the legislators.” (2), pp. 390-91. Any restrictions on the corporation were stated in the general law for all to see. Different states imposed different restrictions, but in the beginning of this process, all states who had such laws exercised some control over what corporations could and could not do. Massachusetts and New York, for example, placed upper limits on the size of the capitalization of any corporation incorporated in its state. Some of these provisions controlled the price of shares and specified what the corporation could or could not do without shareholder approval. States also charged fees to incorporate. (2), pp. 398-99.

In spite of these restrictions, the move from one-by-one chartering to a general law of incorporating evolved into a revolutionary change that enabled corporations to become the dominant business institution of the twentieth century, as they still are today.

Once a corporation came into existence, it was not restricted to operating solely in the state of incorporation. Court decisions essentially supported the idea that the U.S. Constitution, in particular the Commerce Clause and the Fourteenth Amendment, protected the right of a business to operate across state lines. This meant that, if a corporation wanted to do business in New York, it could incorporate in another state with friendlier incorporation laws, set up a storefront in the incorporating state, and do practically all of its business in New York. (2), pp. 396-98.

The states, in turn, had an interest in drawing business to within their borders. Businesses not only paid the states’ incorporation fees, they also provided a source of income for the states through taxation, and they potentially provided jobs. One way for states to attract businesses was by removing restrictions on corporations and lowering the fees. The states began to compete to be the least restrictive. Some other states simply did not enforce the restrictions on their books. New Jersey was the first to remove all significant restrictions. In its 1896 law, “a corporation could be formed for ‘any lawful business or purpose whatsoever.’” (2), p. 396. New Jersey quickly became the preferred home of corporations. But New Jersey then took a step “backward” and increased regulatory control over corporations. (3), pp. 13-14.

In 1899, Delaware passed its liberal incorporation law and did not step “backward.” It then became the favorite state for incorporating businesses. (2), p. 399. Even though many other states followed with equally liberal incorporation laws, Delaware’s prior success allowed it to establish itself as the source of developed corporation law and judicial expertise, thus adding more certainty and stability to corporate law than other states could achieve. Delaware remains the favorite home of corporations.

By the turn of the century, the American “corporation had torn free of its past--it could be formed almost at will, could do business as it wished.” (2), 399. This was possible only because states changed their laws. But the same reasons that led them to change their laws remain as reasons they are unlikely to reverse course and change them in the future to regulate corporate power. They could but, most likely, won’t.

Still, the existence of corporations and the scope of what they can do depend on the laws of the governments that enable corporations to exist.


References (the numbers correspond to the numbers above):

(1) John Micklethwait and Adrian Woolridge, The Company: A Short History of a Revolutionary Idea: Modern Library, 2005

(2) Lawrence M. Friedman, A History of American Law, 3rd ed.: Simon & Schuster (Touchstone), 2005

(3) Robert W. Hamilton, The Law of Corporations, 4th ed.: West Publishing Co., 1996.

Links to previous posts in this series: