The evolution of shareholder voting rights: separation of ownership and consumption.

• Author: Hansmann, Henry
• Position: Introduction through I. Corporate Ownership and Voting Rights in Early U.S. History B. Financial Infrastructure 1. Banks, p. 948-981

ARTICLE CONTENTS INTRODUCTION I. CORPORATE OWNERSHIP AND VOTING RIGHTS IN EARLY U.S. HISTORY A. Physical Infrastructure 1. Turnpikes 2. Bridges 3. Canals 4. Railroads B. Financial Infrastructure 1. Banks 2. Insurance C. Manufacturing II. ULTRA VIRES AS CONSUMER PROTECTION III. THE DECLINE OF VOTING RESTRICTIONS A. Governmental Provision of Infrastructure B. Separation of Competition Law from Corporation Law C. Evolution and Differentiation of Standard Corporation Statutes D. Increased Competition E. Ease of Evasion F. The Interests of Small Versus Large Shareholders G. Mixed and Muddled Motives IV. VOTING RESTRICTIONS IN COMPARATIVE PERSPECTIVE A. The Dutch East India Company B. Nineteenth-Century Voting Restrictions in England, Brazil, and France CONCLUSION APPENDIX: PATTERNS OF RESTRICTED VOTING ACROSS INDUSTRIES, STATES, AND DECADES INTRODUCTION

Adam Smith, an early critic of business corporations, identified two principal shortcomings of that form of organization. The first was that corporations were commonly monopolies, to the disadvantage of their consumers. (1) The second was what we would now label as agency costs. (2) Today, the latter problem-the costs imposed by managers acting opportunistically toward shareholders, or by controlling shareholders acting opportunistically toward non-controlling shareholders--dominates discourse about corporate governance. (3) Recently, scholarship in both economics and law has also come to view agency costs as the major element shaping the historical evolution of the corporate form, interpreting the peculiar features of corporate law and practice in earlier periods as means to protect small shareholders from exploitation by managers or controlling shareholders. (4) This is particularly true of the nineteenth century-the era that established the principal forms of enterprise organization in their modern garb, including conspicuously, the business corporation. (5) Some scholars have even suggested that corporate governance practices from the early nineteenth century might usefully be adopted today in developing economies that, like even the most advanced economies of the nineteenth century, lack strong legal institutions for shareholder protection. (6)

This approach, however, is anachronistic. In the late eighteenth and early nineteenth century, the main economic evil linked to the corporate form was not managerial or controlling-shareholder opportunism toward small shareholders, but rather Adam Smith's first concern: monopoly. Prior to 1860, most corporate charters were granted by special acts of the state legislature, and as a consequence often had a degree of monopoly power conferred on them. (7) More importantly, many corporations were natural monopolies due to economies of scale. The peculiar features of early corporate law and practice were frequently designed to minimize the abuse of that market power. They did not seek to protect the corporation's shareholders as investors, as is conventionally assumed today, but rather to protect them as consumers.

To understand this, it is important to recognize a critical but underappreciated feature of corporate enterprise in the early Republic--namely, the lack of separation between ownership and consumption. In many corporations of the time, the principal shareholders were also the firm's principal customers. These customers were the owners of businesses--farmers, merchants, and manufacturers. And the corporations were commonly providing infrastructural goods and services that were critical for the success of those local businesses.

There were two reasons for this pattern of ownership. First, for many corporations, local merchants and farmers were apparently the most effective source of capital at a time when capital markets were poorly developed and governmental financing was not generally available. Second, by controlling their service providers, the consumers protected themselves from monopolistic exploitation. Early American business corporations were often, in effect, consumer cooperatives. And, as is generally the case with cooperatives, (8) they served to protect their consumer-owners from the exercise of monopoly power.

Appreciation of this ownership pattern illuminates important features of early business corporations that have recently attracted attention from scholars in both economics and law. Most prominent in this respect are the peculiar rules of shareholder voting in this era. In the late eighteenth century and much of the nineteenth century, U.S. corporations frequently had schemes of shareholder voting that deviated from the one-share-one-vote rule that subsequently became the norm. (9) In particular, many nineteenth-century corporations restricted voting in ways that made it difficult for a single shareholder to obtain control of the firm. Such voting schemes were of three types: graduated voting, in which the number of votes exercisable by a single shareholder increased less than proportionately with the number of shares owned; capped voting, in which a ceiling was imposed upon the total number of votes that a single shareholder could exercise regardless of the amount of stock he or she held; and per capita voting, which is the rule of one shareholder, one vote.

These restricted voting rules first came clearly to the attention of legal scholars through the work of David Ratner (10) and Colleen Dunlavy, (11) both of whom documented the frequency of the phenomenon and offered a similar interpretation of it. That interpretation did not focus on economic factors such as agency costs and monopoly, but instead saw restricted corporate voting rights as driven by, as Dunlavy put it, a "social preference for particular types of governance." (12) In particular, they reflected a "social conception of the corporation" that was more "democratic" than the "plutocratic" approach to governance represented by the rule of one-share-one-vote. (13) We will call this "the democracy theory."

Subsequently, the reasons for the restricted voting rules have been taken up by a number of other scholars, all of whom have--in contrast to Rather and Dunlavy--emphasized explanations rooted in economic considerations. Specifically, reflecting the contemporary emphasis on agency costs, these authors almost uniformly interpret restricted voting rules as "designed to attract the participation of small shareholders by offering them some measure of protection from dominance by large shareholders." (14) Under this view, restricted voting--which was usually imposed by the corporation's own individual charter--was "the most important protection offered to early-nineteenth-century small investors," thus compensating for the weakness of the corporate law of the time in affording adequate minority shareholder rights. (15) We will call this "the investor protection theory."

However, both the democracy theory and the investor protection theory have difficulty explaining two important elements of corporate voting patterns in the nineteenth century. First, why did restricted voting appear in certain industries--such as turnpikes, canals, railroads, banks, and insurance companies--while they were largely nonexistent in other industries, such as manufacturing? Second, why did restricted voting largely disappear from all types of corporations by roughly the end of the nineteenth century? (16)

We seek to shed light on these questions by offering an alternative explanation for the observed pattern of restricted voting in the nineteenth century. Our interpretation is essentially economic in character, attributing changes in shareholder voting schemes to the different economic purposes and problems associated with business corporations in the early nineteenth century compared to their present-day counterparts. In short, we argue that voting restrictions generally served as a consumer protection device in corporations that were, in a rough sense, consumer cooperatives.

This "consumer protection theory" goes far to explain the relative incidence across different industries and firm ownership structures. Nineteenth-century transportation companies (turnpikes, canals, and railroads), as well as banks and insurance companies, commonly had substantial market power; manufacturing firms, by contrast, did not. Moreover, the firms adopting voting restrictions were typically local monopolies that provided vital ancillary services to local merchants. With surprising frequency, those merchants were at the same time the principal customers and the principal shareholders of early business corporations, for two important reasons. First, local merchants had an interest in helping form and finance an element of economic infrastructure that would be important to the success of their businesses. (17) Second, this ownership pattern served to ensure that control over such an infrastructure element did not fall into the hands of profit-oriented investors who would charge the merchant monopoly prices for its use, or into the hands of one of the merchant's competitors, who would use their control to discriminate in favor of their own businesses and against others in terms of the price, quantity, or quality of services provided.

The consumer protection theory also helps explain why voting restrictions effectively disappeared from business corporations in the late nineteenth century. By then, local and state governments had taken on the primary responsibility for constructing and maintaining physical infrastructure such as roads and bridges. Railroads had become too long and capital intensive to be financed and controlled by essentially voluntary organizations, while capital markets developed to provide the necessary financing for private enterprise. Improvements in transportation and communication increased competition in banking and insurance, while governmental regulation made investor-owned firms increasingly viable. Exploitation of market power came to be...