“Joint stock companies, established by Royal Charter or by Act of Parliament, differ in several respects, not only from regulated companies, but from private copartneries.” (Smith 1784, p. 58)

Thus far (see here and here), we have surveyed the first 14 paragraphs of the last part (Part #13) of Adam Smith’s pamphlet Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations (Smith 1784). This last part deals with overseas trading companies, which (as we saw in my previous post) can be organized as a “regulated company” (i.e. a state-sanctioned cartel) or as a “joint stock company” (the precursor of the modern corporation).

Now, let’s pick up where we left off. Next, Smith compares and contrasts the main features of “joint stock companies” with those of “private copartneries” (or general partnerships) in paragraphs 16 and 17 of Part #13:

“First, in a private copartnery, no partner, without the consent of the company, can transfer his share to another person, or introduce a new member into the company. Each member, however, may, upon proper warning, withdraw from the copartnery, and demand payment from them of his share of the common stock. In a joint stock company, on the contrary, no member can demand payment of his share from the company; but each member can, without their consent, transfer his share to another person, and thereby introduce a new member. The value of a share in a joint stock is always the price which it will bring in the market; and this may be either greater or less, in any proportion, than the sum which its owner stands credited for in the stock of the company.

“Secondly, in a private copartnery, each partner is bound for the debts contracted by the company to the whole extent of his fortune. In a joint stock company, on the contrary, each partner is bound only to the extent of his share.” (Smith 1784, pp. 58-59)

Furthermore, in the first part of the next paragraph (para. 18), the Scottish scholar identifies the main reason why — from an investor’s point of view — a stock certificate makes for a far more attractive investment than a corresponding equity stake in a traditional general partnership: the separation of ownership and control. Or in the immortal words of Adam Smith:

“The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. 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.” (Smith 1784, p. 59, my emphasis)

Adam Smith then cites in passing two spectacular examples of joint stock companies that were able to attract massive amounts of capital — the venerable Bank of England and the ill-fated the South Sea Company: “The trading stock of the South Sea Company, at one time, amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds.” (Id. at pp. 59-60)

(As an aside, The Bank of England was founded on 27 July 1694 as a private joint-stock company named “The Governor and Company of the Bank of England”. It was created to raise a £1.2 million loan for the government to fund a war against France, and it operated as a private corporation with shareholders for over 250 years until it was nationalized in 1946!)

But for Smith, these three innovative features of joint stock companies — i.e. the transferability of shares, limited liability, and the separation of ownership and control — do not mean that such companies are a better method of corporate governance than a traditional general partnership. In the second half of paragraph 18 of Part #13, Smith delivers a stunning rebuke:

“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. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.” (Smith 1784, p. 60, my emphases)

Simply put, Smith is suspicious of the separation of ownership and control because the board of directors of a joint stock company is playing with other people’s money! But does history and experience vindicate Smith’s scathing critique of joint stock companies? As we shall see when I resume my Adam Smith series next week, Smith will survey four specific examples of overseas trading companies that were organized as joint stock companies. What was their collective track record? Did they make Britain more wealthy in the long run? Or poorer? Stay tuned! (To be continued …)