Comments on the Modern Corporation

Capitalism is a system built around private property. Market forces in this system include the risk/reward system. The limited liability corporation, however, is a state-created institution of the mid-late nineteenth century. It is intended to increase rewards and reduce personal risks. Prior to the period of general incorporation laws, chartered corporations that sheltered investors from the consequences of their actions were rare and only created by special legislative acts. Lloyd's of London, dating to an earlier era, for example, is a private mutual association without such limited liability. The limited liability feature is a primary source of moral hazard in modern capitalism, because the owners and managers of a modern corporate enterprise bear no personal responsibility for the actions of the institution beyond the amount of their investment (if any). Banks may require the owners of small corporations and sole proprietorships to put their personal assets on the line for loans, but not so with larger institutions.

It is fair to say that much of corporate regulation over the past century and a half has been a history of the problem of corporate structure creating some unhealthy incentives. The first major expansion of regulation was the antitrust regulation. The need to combat monopolies and trusts is now so widely accepted that even some libertarians think it is "natural." In the 1930s, another set of failures led to the creation of the SEC. A major problem that led to the SEC was stock price manipulation and forms of insider trading, and when the market finally crashd it was dizzying, with a total loss of confidence of investors in the marketplace. The SEC was intended to provide real information to investors in order to permit investors to make informed choices without having to invest additional time and money in acquiring information. This expanded the pool of available investors. What developed, however, in the SEC and in counterparts around the world, was largely a system of self-reporting that relied on third party auditors.

This system is now falling apart before our eyes. I expect the only sensible response will be a dramatic change in the SEC from occasional enforcement of self-reporting violations to aggressive inspection and auditing. The basic problem, as I see it, is that nobody wanted the costly enforcement role in the system. That costly enforcement role would cut the enforcers out of the massive profit potential of corporate capialism.

In the wake of the Enron scandal, Sarbanes-Oxley tried to turn attorneys into the whistleblowers. Unfortunately, that solution is unworkable because it is wholly incompatible with the lawyerly profession. Auditor as whistleblower also failed, because - among other things - big auditing firms simply got too invested in their relationships. I have read most of the deposition testimony from a major corporate scandal (all confidential, so I will not say which - like Enron but not Enron) which shows just how intent the corporation was in manipulating the accountants, and how a handful of well-placed partners at a major accounting firm could use their connections with the client to advance within the auditing firm (gaining praise, reputation, and wealth) in exchange for protecting the client's secrets. That's not what an auditor is supposed to do, of course.

But accountants didn't want that role of enforcer either. I have gotten the sense from work I've done in accounting defense that the accounting profession developed over time a set of deniability rules that made their work less useful for spotting harm. Gradually, it seems to me that accounting profession developed the habit of saying "the numbers add up right, but I can't take responsibility for where the numbers come from." This is a natural evolution of the profession which did not want the enforcement function. The result today is that nobody has that enforcement function in the corporate system.