Adam Smith surveys overseas trading companies in the last part of his 1784 pamphlet (Part #13). I went over the first five paragraphs of this part of Smith’s 1784 pamphlet in my previous post. The rest of Smith’s pamphlet is devoted to what today we refer to as “corporate governance” (see here, for example). To begin, Smith explains how an overseas trading company can be organized in one of two ways: either as a regulated company or as a joint stock company.

“When those companies do not trade upon a joint stock, but are obliged to admit any person, properly qualified, upon paying a certain fine, and agreeing to submit to the regulations of the company, each member trading upon his own stock, and at his own risk, they are called regulated companies. When they trade upon a joint stock, each member sharing in the common profit or loss in proportion to his share in this stock, they are called joint stock companies. Such companies, whether regulated or joint stock, sometimes have, and sometimes have not, exclusive privileges.” (Smith 1784, para. 6 on pp. 49-50)

The main difference between both types of company is thus this: the members of a regulated company have to invest their own private capital into the company and abide by the private rules of the company, but they may compete with one another under their shared corporate charter; by contrast, the members of a joint stock company pool their money into a single corporate fund and share joint profits or losses, but it is the directors of the company who control how the fund is spent. So, which of these two forms of corporate governance is best? Alas, Smith has absolutely nothing good to say about regulated companies:

“Regulated companies resemble, in every respect, the corporations of trades so common in the cities and towns of all the different countries of Europe, and are a sort of enlarged monopolies of the same kind. As no inhabitant of a town can exercise an incorporated trade without first obtaining his freedom in the corporation, so in most cases no subject of the state can lawfully carry on any branch of foreign trade, for which a regulated company is established, without first becoming a member of that company. The monopoly is more or less strict according as the terms of admission are more or less difficult; and according as the directors of the company have more or less authority, or have it more or less in their power to manage in such a manner as to confine the greater part of the trade to themselves and their particular friends. In the most ancient regulated companies the privileges of apprenticeship were the same as in other corporations, and entitled the person who had served his time to a member of the company to become himself a member, either without paying any fine, or upon paying a much smaller one than what was exacted of other people. 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.” (Smith 1784, para. 7 on p. 50, my emphases)

Although Smith uses a sliding scale to describe the extent of a regulated company’s monopoly over a given trade or line of business (“The monopoly is more or less strict according as the terms of admission are more or less difficult; and according as the directors of the company … have it more or less in their power to manage in such a manner as to confine the greater part of the trade to themselves and their particular friends”), Smith concludes that such companies “always” try to “confine the competition to as small a number of persons as possible” and to “subject the[ir] trade to many burden some regulations.”

As an aside, do these negative and monopolistic features of so-called regulated companies sound familiar? They should, for such companies have all the negative features of our pernicious and pervasive system of occupational licensing today. In both systems of economic governance (i.e. regulated companies and occupational licensure), workers have to obtain the previous permission of a corporate body before they ply their trades. (In California, for example, one in six workers requires a state license!)

Next, Smith surveys several specific examples of regulated companies: the Hamburgh Company and the Russian Company (para. 9), the Turky Company (para. 10), and the Royal Africa Company (paras. 12, 13, & 14). Amid this survey (para. 11), Smith compares and contrast the incentive structure of the directors of a regulated company with that of the directors of a joint stock company. Here (para. 11), Smith presents a favorable picture of the governance of joint stock companies. More specifically, in the process of explaining why overseas trading companies organized as regulated companies did not invest in “forts and garrisons”[*] to protect its business interests, while trading companies organized as joint stock companies did make such investments, Smith makes a deeper and more timeless observation about economic incentives:

“First, the directors of a regulated company have no particular interest in the prosperity of the general trade of the company for the sake of which such forts and garrisons are maintained. The decay of that general trade may even frequently contribute to the advantage of their own private trade; as by diminishing the number of their competitors it may enable them both to buy cheaper, and to sell dearer. 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.” (Smith 1784, para. 11 on p. 54, my emphasis)

In addition, Smith provides another reason why the incentive structure of joint stock companies is more conducive to long-term investment decisions (e.g. the building of forts and garrisons overseas):

“Secondly, the directors of a joint stock company have always the management of a large capital, the joint stock of the company, a part of which they may frequently employ, with propriety, in building, repairing, and maintaining such necessary forts and garrisons. But the directors of a regulated company, having the management of no common capital, have no other fund to employ in this way but the casual revenue arising from the admission fines, and from the corporation duties imposed upon the trade of the company. Though they had the same interest, therefore, to attend to the maintenance of such forts and garrisons, they can seldom have the same ability to render that attention effectual. The maintenance of a public minister requiring scarce any attention, and but a moderate and limited expense, is a business much more suitable both to the temper and abilities of a regulated company.” (pp. 54-55)

In short, joint stock companies has a better incentive structure than regulated companies have. Now, what about partnerships? How does the incentive structure of a partnership measure up to that of a joint stock company? I will turn to this governance question in my next post. (To be continued …)

[*] A point of order is in order! Why would a private company in Smith’s day, regardless of whether it was organized as regulated company or as a joint stock company, ever build a fort or garrison overseas? Why shouldn’t it be the government who builds and pays for the fort? To answer this question, we must remember that the private companies we are talking about are overseas trading companies — i.e. private firms that are doing business in foreign countries — so the government back home would not have the legal jurisdiction to build or operate a fort overseas.