Adam Smith, father of corporate governance

The second half of Article 1 of Part 3 of Chapter 1 of Book V of The Wealth of Nations (WN, V.i.e.1-40) is ostensibly about “Public Works and Institutions [that] are necessary for facilitating particular Branches of Commerce”, such as the Royal African Company (WN, V.i.e.19-20), the Hudson’s Bay Company (WN, V.i.e.21), the South Sea Company (WN, V.i.e.22-25), and the English East India Company (WN, V.i.e.26-28). In addition, Adam Smith also compares and contrasts “regulated companies” with a new form of private governance — new, that is, in Smith’s day: the “joint-stock company” or limited liability corporation.

By way of background, a regulated company was a privately-owned business that was authorized by a royal government charter to operate in a specific foreign market. The owners of the regulated company thus had the right to trade in that foreign market under company rules, but they did so using their own individual capital. A joint-stock company, by contrast, had the ability to issue shares of ownership in the company to private investors and to limit their financial risk to the amount invested in the company. But unlike traditional regulated companies, a joint-stock company was not run by its owner-investors. It was run by a small group of directors. This structure not only allowed the owners of a joint-stock company to pool their capital and minimize their legal risks; it also separated ownership and control.

With this historical background in mind, we can now proceed to Smith’s analysis of “regulated companies” and “joint-stock companies.” To begin, Smith has nothing good to say — and rightfully so, as we shall see in the passages below — about regulated companies:

“The usual corporation spirit, wherever the law does not restrain it, prevails in all regulated companies. When they have been allowed to act according to their natural genius, they have always, in order to confine the competition to as small a number of persons as possible, endeavoured to subject the trade to many burden some regulations. When the law has restrained them from doing this, they have become altogether useless and insignificant.” (WN, V.i.e.7)

“In all trades, the regular established traders, even though not incorporated, naturally combine to raise profits, which are no-way so likely to be kept, at all times, down to their proper level, as by the occasional competition of speculative adventure.” (WN, V.i.e.10)

But what about joint-stock companies? What does Smith have to say about them? In short Smith has mixed feelings about joint-stock companies. On the one hand, the incentives of a corporation’s directors are aligned with that of the company itself:

“The directors of a joint stock company, on the contrary, having only their share in the profits which are made upon the common stock committed to their management, have no private trade of their own of which the interest can be separated from that of the general trade of the company. Their private interest is connected with the prosperity of the general trade of the company, and with the maintenance of the forts and garrisons which are necessary for its defence. They are more likely, therefore, to have that continual and careful attention which that maintenance necessarily requires.” (WN, V.i.e.11)

But at the same time, the incentives of the directors and those of the shareholders might not be aligned, after all. In fact, they might even be diametrically opposed:

“This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of…. The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” (WN, V.i.e.18)

How does Smith resolve this internal tension in corporate governance? In short, he imposes a two-part litmus test of sorts:

“To establish a joint stock company, however, for any undertaking, merely because such a company might be capable of managing it successfully; or to exempt a particular set of dealers from some of the general laws which take place with regard to all their neighbours, merely because they might be capable of thriving if they had such an exemption, would certainly not be reasonable. To render such an establishment perfectly reasonable, with the circumstance of being reducible to strict rule and method, two other circumstances ought to concur.” (WN, V.i.e.36; my emphasis)

So, what are these two circumstances or conditions? Here, Smith draws a distinction between (a) large-scale “undertaking[s]” or ambitious projects that will require a lot of capital to get off the ground and (b) presumably small-scale “common trades” that can be carried out by one person — Smith’s famous butcher, baker, and brewer immediately come to mind — or a small group of partners:

First, it ought to appear with the clearest evidence that the undertaking is of greater and more general utility than the greater part of common trades; and secondly, that it requires a greater capital than can easily be collected into a private copartnery [partnership]. If a moderate capital were sufficient, the great utility of the undertaking would not be a sufficient reason for establishing a joint stock company; because, in this case, the demand for what it was to produce would readily and easily be supplied by private adventures.” (ibid.; my emphasis)

Smith thus reveals his legalistic side — for his litmus test requires the “clearest evidence”, a heightened standard of evidence that reminds me of “the clear and convincing standard” used in certain types of law cases (e.g. punitive damages) — as well as his utilitarian side. Smith’s litmus test, however, has a blind spot: who is the judge or arbiter who is supposed to apply this test? Why not leave the question of utility to the market, to the investors themselves?