The Open Corporation

The compact economic structure of the classical capitalist firm is responsi­ble for significant transactions cost efficiencies. This naturally raises the question of how or why any other organizational form could survive in a competition with this organizational form.

The open corporation is characterized by the following five distinctive features:

1. The amount of capital it controls is generally too large for one individ­ual to supply.

2. The primary suppliers of capital are the residual claimants and have ultimate decision-making authority with regard to the assets that the firm controls. Let us say that anyone who simultaneously occupies all three of these roles (primary supplier of capital, residual claimant, and ultimate decision making authority) is an equity owner of, or has an equity ownership stake in, the firm.¹² Typically, this amounts to pro­portional ownership of the firm’s assets, a proportional claim on the fir­m’s residuals, and a proportional vote on who serves on the board of directors, which, in turn, hires management. Individuals with all these rights are called stockholders.

3. The managers are neither the primary providers of capital nor the pri­mary residual claimants, though they may have some equity stake in the firm.

4. Shares of equity ownership are freely alienable on a securities market.

5. Equity owners’ liability for the obligations of the firm is limited to the amount of capital invested.

There are transactions cost advantages to all of these features, advantages that preclude opportunities for exploitative exchange that would otherwise exist. Let us begin with the first of these, large capital requirements.

Large Capital Requirements

It is widely believed that technology and/or mass markets dictate the need for large corporations in advanced industrial societies. This, however, con­fuses the physical requirements of production with ownership require­ments. Modern mass production does indeed require large, expensive pro­duction facilities, but technology does not dictate that the facilities should all be owned by one firm. As was pointed out in chapter 4, the capital goods required for mass production could be separately owned by individ­uals and/or small groups, instead of a single firm. Why, in general, doesn’t this happen? Why isn’t every technologically separable stage of production separately owned? Indeed, why isn’t every piece of equipment—or even every pipe and valve in a factory—owned by a separate individual or group? What is the principle of gravitation that explains the ownership of capital in a free enterprise system? Transactions cost analysis attempts to explain this phenomenon by arguing that the costs of organizing transac­tions involving large production facilities across markets exceed the costs of bringing those transactions within the firm. What are the costs of markets?

In his seminal article “The Nature of the Firm,” Coase mentions the costs of gathering information about prices and negotiating contracts with the owners of cooperating factors of production as the main costs of using the market to organize transactions (1937, 336-37). Though this is part of the answer, it is not the whole story.

This point bears further elaboration. Transactions cost analysis has been preoccupied with explaining the determinants of vertical integration, both backward into the supply stage and forward into subsequent stages of pro­duction or distribution (e.g., Klein, Crawford, and Alchian 1978; Williamson 1985, chaps. 4-7). Part of the reason for this is that this aspect of transac­tions cost analysis has important and immediate implications for antitrust policy.¹³ But it also explains why large firms exist at all. To see why, notice that firms that control a number of stages of production (and the associated capital) have a number of transactions cost efficiencies in comparison to a sequence of firms and/or independent contractors in the production-distrib­ution chain. The most important of these is that when unforeseen contin­gencies arise, contracts do not have to be renegotiated in a climate in which one party is highly vulnerable to exploitation by the other. Instead, those in charge can simply make whatever adjustments are required.

Suppose that firm S (the supplier firm) has a long-term contract to sup­ply firm P (the purchasing firm) with an input that P cannot easily get else­where. After some time has gone by, the demand for P’s product falls off precipitously, unexpectedly, and permanently.

The transactions cost efficiencies involved when large amounts of capi­tal are owned by one firm (the open corporation) preclude or obviate opportunities for exploitative exchange that would otherwise exist. Intuitively, the idea is that under vertical integration, there are fewer firm­market borders that must be protected against potentially opportunistic input providers and customers. For this reason, fewer resources have to be expended to protect the quasi-rents of specialized assets when those assets are brought into the firm than would have to be expended if those assets directly supported market exchanges.

This point can be appreciated by imagining the passage of a law pro­hibiting firms from controlling more capital than any one individual or family could supply. What would happen as a result of the passage of this law (aside from a rash of adoptions of the owners of some firms by the aged parents of the owners of other firms)? The most important result would be that owners of specialized capital goods or ensembles of specialized capital goods (i.e., owners of these smaller firms) would face a risk of having their quasi-rents appropriated by their customers or input suppliers, or both. Some of these risks would eventuate, resulting in the exploitation of these owners. For the rest, costly safeguards of some sort would have to be devel­oped (e.g., arbitration procedures to deal with unforeseen contingencies or even the renewal of long-term contracts). If such safeguards could not be developed, the only other alternative would be for those facing these expropriation hazards to charge a premium in the form of higher prices for their products to compensate for the risk of exploitation they face. Regardless of whether the safeguards were developed or the compensating premium was paid, the products these firms produce would be more costly than the cheapest alternative, namely, vertical integration, which has now been prohibited by law. Products would sell for more than their competi­tively efficient market price, and since other firms would face similar restrictions, buyers would effectively have nowhere else to go. In short, these exchanges would be exploitative. Either in this way or by way of the straight appropriation of the quasi-rents of the equity owners, exploitative exchanges would take place in this system that would have been precluded if the law had permitted firms to control large quantities of capital.

As with other transactions cost efficiencies, there is no need to suppose that those who invented the large corporation were responding to a recog­nition of the transactions cost efficiencies of vertical integration (notably, the avoidance of expropriation hazards).

The large corporation, far from being the main source of exploitation in the modern world (as the opponents of a free enterprise system would have it), is, in point of fact, a bulwark against exploitative exchanges that would take place in a world comprised exclusively of smaller organizations and independent suppliers and contractors.

These observations about the transactions cost efficiencies of bringing large amounts of capital under one decision-making roof lead to the ques­tion, Why aren’t all economic organizations large corporations? In particu­lar, why do classical capitalist firms (not to mention other types of organiza­tions) survive—and indeed thrive—in a free enterprise system? A full answer to this question would go further into the details of transactions cost analysis than is necessary for the purposes of this chapter, but an out­line of an answer can be sketched. Both environmental and organizational factors have a role to play in explaining the survival of the classical capital­ist firm. When asset specificities are low or quasi-rents are well protected by competition and when there are no economies of scale to be realized, there are no transactions cost advantages to dissolving the firm-market boundary by amassing large quantities of capital within one firm.¹⁵ Moreover (as will be explained later in this section), there are inefficiencies that attend the separation of management from equity ownership, and there are inevitable inefficiencies—bureaucratic inefficiencies—that go with large size in any organization. These include credit stealing, blame shifting, and in general, misrepresenting the nature or value of one’s own contribution or the con­tributions of others.¹⁶ The superior incentive alignments of the classical cap­italist firm and its relatively nonbureaucratic nature give it efficiency advantages over its larger rivals that are decisive in some ecological niches.

There is no guarantee that the size of firms in a given industry is opti­mal. To put it another way, there is no guarantee that the boundary between the firm and the market is always—or even ever—drawn optimal­ly. Nor is there any guarantee that the division of labor between different types of organizations is optimal in a free enterprise system. All that can be said is that there are competitive forces at work and that there is a tendency for those forces to select out the more efficient organizational modalities among existing competitors in a given economic environment.

The main purpose of this subsection has been to identify the transac­tions cost efficiencies of bringing together large amounts of capital under one decision-making roof. To summarize, the primary advantages are two. First, it allows capital to be deployed with a minimum of discussion, consul­tation, and negotiation; however many equity owners there are, there is an essential identity of interests among the owners of these large amounts of capital, an identity of interests that does not hold when transactions take place across markets. Second and relatedly, this capital structure eliminates the expropriation hazards (opportunities for exploitation) that would have to be faced if firms and individuals with highly specific assets—and poten­tially exposed quasi-rents—had to deal with each other in the marketplace.

Equity Ownership

A distinctive feature of the open corporation is that the primary suppliers of capital are also the residual claimants with ultimate decision-making authority over the assets of the firm. In practical terms, ultimate decision­making authority in the open corporation amounts to no more than a pro­portional vote on who shall serve on the board of directors. Despite the fact that this vote is rarely exercised in anger (so to speak), it is nonetheless an important right because, principal-agent problems to one side, it is the ulti­mate decision maker’s interests that shape and constrain the firm’s activi­ties. What needs to be explained in this subsection are the transactions cost efficiencies of joining this ultimate decision-making authority to two other key roles in the open corporation: the role of residual claimant and the role of provider of most of the firm’s capital. Consider first residual claimancy. On the face of it there is an obvious efficiency advantage to joining residual claimancy to ultimate decision-making authority: If the ultimate decision maker is the residual claimant, he has—or those who act in his interests have—an incentive to economize on all costs of production. In a competi­tive environment, this tends to result in factor providers’ getting the value of what they contribute, which, in turn, minimizes exploitation.

The efficiency advantages of this arrangement can be further appreciat­ed by supposing these two roles to be separate. What would this situation look like? The residual claimant is the ultimate risk-bearer in the firm. She gets the positive profits due to good fortune and/or successful entrepre­neurship, and she suffers the losses due to bad luck and/or unsuccessful entrepreneurship. In order to suffer the losses, however, the residual claimant must pledge some assets that may be lost if a venture fails. Since it is difficult to pledge one’s labor as security, the most plausible scenario is for the residual claimant to provide capital. Suppose now that this residual claimant-capital provider did not have ultimate decision-making authority in the firm. This scenario creates an obvious opportunity for the exploita­tion of the residual claimant-capital provider by the ultimate decision maker. After all, the latter controls the firm’s assets (its capital), and the firm is managed in his interests, but by supposition, he gets none of the residu­als and none of the returns to capital. However, because he is the ultimate decision-making authority, he would be in a position to siphon pure profits from the residual claimant and quasi-rents from the capital provided by the hapless capital provider into his own pocket (perhaps in the form of inflat­ed payments for decision-making services). A real-world example of this might be American nonprofit hospitals. Whatever their legal status, they often make enormous profits, which are funneled into the pockets of the top echelon of decision makers in the form of inflated salaries, perks, and other forms of on-the-job consumption.¹⁷

An example of a profit-making organization in which rights to the residuals are held by people without any decision-making authority is the limited partnership. In this organizational form, the limited partner puts up an equity stake in exchange for a claim on the residuals but has no deci­sion-making authority. What protects her assets, however, is that the person with decision-making authority, the general partner, is also a residual claimant, so that in theory at least, a harmony of interests is achieved.¹⁸ One final example, this one hypothetical: imagine an economic system in which the state provides all the capital and is the residual claimant for cer­tain firms and yet top management, answerable to no one, has ultimate decision-making authority in each of these firms. No one that this author is aware of has ever proposed such a system—and with good reason. This type of system would encourage widespread exploitation of capital providers by top management and would be an economic disaster.

These are the efficiency advantages—and the implications for exploita­tion—of joining ultimate decision-making authority to residual claimancy in the open corporation. What needs to be explained next are the transac­tions cost efficiencies of making those who jointly occupy these roles the primary suppliers of capital. In addition, something also needs to be said about why and under what circumstances corporations would raise sub­stantial amounts of capital through the issuance of debt.

Making the residual claimant-ultimate decision maker the primary sup­plier of capital serves the same functions that it does in the classical capital­ist firm. One of these is that it serves as a bond to other input providers in that if the ultimate decision makers are also the primary providers of capi­tal, then, by pledging to idle some of their own resources in the event that they lay off workers or otherwise cancel contracts, they are giving some assurance to other input providers that this will happen only under serious­ly adverse economic conditions; it will not be part of a “holdup attempt” in which they try to appropriate some of the quasi-rents of other input providers by forcing the renegotiation of contracts once the latter are locked into the situation. In this way, the asset specificities committed to the firm by these other input providers are protected from exploitation by the residual claimants (Barzel 1987, 114).

There are other transactions cost efficiencies to be found in the residual claimants-ultimate decision makers’ also being the primary providers of capital. To understand what they are, suppose once again that the former are not the primary providers of capital. Consider the extreme case in which the residual claimants with ultimate decision-making authority sup­ply none of the capital that the firm uses. (Later, this assumption will be relaxed.) Under these circumstances, the firm is effectively leasing all of its capital. Whether the capital providers supply concrete capital goods or finance capital, these lessors are like bondholders in that they are promised a fixed rate of return in exchange for allowing their capital to be used. The capital providers in this scenario would be contractually on a par with other input providers, such as suppliers of raw materials and semifinished products. Call this Apure rental firm.¹®

Unlike firms that own their capital, the pure rental firm would be unable to pledge its capital to bond short-term obligations, such as those commonly incurred with suppliers and banks. Instead, it would have to pay a premium in its dealings with suppliers, banks, and possibly even work­ers—a premium that Brms that owned their own capital could avoid. By contrast, when the ultimate decision makers are putting their own capital on the line, they are able to avoid this premium. To understand the true significance of this problem, it is necessary to identify who is de facto liable for the corporation’s obligations in the pure rental firm, that is, who gets stuck if the firm does not show a profit. Suppose sales slow down and inventory piles up. What happens? After any undistributed residuals are used up, what do the residual claimants-ultimate decision makers do? Since they control management, they will order managers to look for ways to cut costs and raise revenues. One obvious way to cut costs is to cut back on scheduled maintenance of facilities and equipment. This way of meeting short-term obligations results in lowering the value of the capital goods that they control. On the revenue side, revenues could be raised by shifting working capital into high-risk, short-term ventures.

Suppose these measures fail. The residual claimants-ultimate decision makers are told by those to whom they owe money or have other obliga­tions that since these decision makers have ultimate authority in the firm, the assets they have contributed are liable to execution for all outstanding debts. This is fine with the decision makers because, by hypothesis, they have contributed no assets at all to the pure rental firm. They are simply residual claimants with ultimate decision-making authority. And because this is a limited liability firm, their personal assets have not been pledged. Indeed, no one’s personal assets have been pledged; the pure rental firm owns virtually no assets at all! The assets they employ are owned by some­one else—capital providers, laborers, and other input suppliers. Some of the value of these assets (primarily the capital) will have been siphoned off, to the extent that it is possible, in hopes of keeping the firm going. And, of course, part of what is required to keep the firm going is to pay the ulti­mate decision makers and to make periodic payments to the residual claimants. One may suppose that those in charge will conform to Trotsky’s dictum, “Those who have something to distribute seldom forget them­selves.”

The possibility of making these payouts is a consequence of the fact that firms must be able to make payments to residual claimants before all debt, long-term and short-term, has been discharged (Manning 1977, 9-10). This is especially true of the pure rental firm, which never really discharges its long-term debt. As Manning has pointed out, the only thing the firm can distribute to residual claimants are assets that it controls. As long as there is continuing debt, equity owners will receive payments before all debt is dis­charged. Indeed, the notion of a residual is something of an accounting fic­tion (1977, 33). It is not something that is automatically extruded by the firm at regular intervals but instead represents a decision made by man­agement to turn over some of the firm’s assets to a certain class of people, namely, the residual claimants. Even when the firm is in trouble, the ulti­mate decision makers in the pure rental firm can make payments to the residual claimants (i.e., to themselves), and they can get the money by siphoning value from the capital that the firm controls. If they are not imaginative enough to think of ways to do this, firms and individuals would undoubtedly set up shop to explain to them how they can get access to the value of the capital they effectively control. Clearly, in an ownership arrangement like this, the residual claimants-ultimate decision makers can exploit the capital providers.

Obviously, the capital providers can and will take steps, in the form of monitoring, to prevent or limit these opportunities for exploitation. The most obvious step would be to insist on a say in major corporate decisions, but that violates the supposition that outside capital providers are not the ultimate decision makers. Besides, even if they have a say on some delineat­ed category of decisions, residual rights of control (as they were called ear­lier) remain with those who are the ultimate decision-making authorities, who are also the residual claimants. Finally, monitoring has costs associated with it, and there may be forms of exploitation of capital owners that are not cost-effective to prevent. Once again, one comes up against the fact that complete, unambiguous, and costlessly enforceable contracts cannot be written. These forms of exploitation are precluded if the role of capital provider is joined to the other two roles.

This discussion illustrates a peculiarity in the structure of the pure rental firm that merits some additional attention. It seems natural to define the residual claimant as the one who gets what is left over after all input providers have been paid, whether those residuals are positive or negative. The problems inherent in letting those with no assets at stake determine what is “left over” are apparent. There is, however, a more fundamental problem with this conception of residual claimancy. To say that a person gets the negative residuals is to say that that person is liable to execution of debt. However, that liability cannot be personal liability, since that is incon­sistent with the status of corporations as limited liability organizations. If these individuals put up no capital at all, their role as negative residual claimants is—quite limited. In actual fact, as the discussion indicates, the capital providers (and to a lesser extent, other input providers) would be de facto liable for any obligations the firm incurs, which is another way of saying that the assets they have lent the firm are unsecured. If these lenders also lack decision-making authority, one has a situation in which there is a group of people with ultimate decision-making authority who will receive all of the positive profits—and suffer none of the losses—asso­ciated with the business. It is completely obvious that this situation creates significant opportunities for exploitation.²⁰ These opportunities are fore­closed if the exchange between the capital providers and the residual claimants is eliminated by combining these roles. If the residual claimants- ultimate decision makers are the primary supplier of capital, then they have accumulated wealth to lose if they act unwisely. For all of these rea­sons, there are significant transactions cost efficiencies to equity ownership, that is, to uniting the roles of ultimate decision maker, residual claimant, and capital provider.

An objection that might be raised to this account is that it does not explain the existence of substantial debt financing by corporations, such as lever­aged buyouts. Indeed, it is unclear why there is any debt financing at all. Consider the latter question first. When the ratio of debt to equity is rela­tively low, it is not difficult to see the attractions of debt financing, as com­pared to equity financing, from both borrower’s and lender’s perspective. The borrowing firm gains leverage to pursue profit opportunities that would otherwise be beyond its reach. If those opportunities are ephemeral or if the firm is reluctant to share its prospective good fortune by taking on additional equity owners, it is in its interests to Rnance new or expanded ventures by issuing debt instruments that pay a fixed rate of return to the debt holder.²¹ The lenders, if the firm has a relatively thick equity cushion, have some protection against loss, since in bankruptcy proceedings, debt holders are paid off before equity owners. Unlike the pure rental firm, a well-capitalized firm has substantial assets to secure the debt instruments that it issues.

Corporations that are highly leveraged are another matter.²² Suppose a manager of a division of a large corporation seeks debt financing to take his division private through a leveraged buyout. The incentive for the man­ager to take on all this debt is that he believes there are significant profit opportunities that he can seize if he is out on his own. For example, he may believe that there are (transactions cost) inefficiencies in the bureaucratic structure of the parent company that would be avoided if the division were a freestanding entity. But doesn’t this arrangement pose significant risks for the lender—risks of having the value of his assets dissipated in an unsuc­cessful venture or even appropriated by the manager-entrepreneur(s) who have only a small equity stake? Indeed it does, and to cope with these risks, the lender will insist on some ultimate decision-making authority (e.g., veto power on major decisions) and will incur a variety of other monitoring costs to protect his investment (Jensen and Meckling 1976, 337-42). Moreover, in return for all these risks, the lender will demand and receive a risk premium. This is what “junk bonds” are all about. This sort of arrangement makes sense, however, only when both sides are convinced that there are large entrepreneurial profits to be made and that they can only be made by a particular manager or management team. Otherwise, safer investments are indicated, either in the form of debt or equity.

The general point is that there are advantages and disadvantages to debt versus equity financing; in a free enterprise system, there will be a tendency for the transactions costs associated with each to be minimized. However, there is no guarantee that in the real world, the debt-equity structure of an industry or in any particular firm will be optimal. Indeed, it often will not be, given the bounded rationality and other imperfections of the human beings who make the relevant decisions.

The main purpose of this subsection has been to explain how and why there are significant transactions cost efficiencies to equity ownership, that is, to tying together ultimate decision-making authority, residual claimancy, and the provision of capital. Though it is sometimes advantageous to have some capital provided by outsiders through debt financing, it is rarely effi­cient for all or nearly all capital to be borrowed. Equity ownership is a way of reflecting the consequences of the actions of ultimate decision makers back onto themselves in a way that cannot be accomplished if residual claimancy is radically separated from the provision of capital. However, there is an apparent problem with this arrangement in the open corpora­tion in that the equity owners do not exercise strategic or operational con­trol of the firm’s assets. Prima facie, this seems to create opportunities for exploitation in the open corporation. Let us turn, then, to the third distinc­tive feature of the open corporation—the separation of ownership and control—to see whether or not these opportunities do exist and if so, how they are dealt with.

The Separation of Equity Ownership and Managerial Control

One of the most important distinctive features of the classical capitalist firm is its concentration of management functions (monitoring and entrepre­neurship) in the hands of the individual who is the primary residual claimant, the ultimate decision-making authority, and the provider of capi­tal (i.e., the equity owner). This eliminates the need to monitor these hard to monitor functions. These transactions cost efficiencies of the classical capitalist firm preclude exploitative exchange between the managers and the capitalist-residual claimant of the firm by precluding the exchange itself. By contrast, the open corporation reintroduces the exchange rela­tion—and thus, at least, the potential for exploitative exchange—between management and the equity owners. What, then, is the advantage in this separation of management and equity ownership?

Part of the answer is implicit in the large capital requirements of the modern open corporation. Those requirements are so substantial that many equity owners have to be involved; obviously, not all of them can be managers. For reasons discussed previously (see pp. 137-42), bringing large amounts of capital under one decision-making roof has significant transactions cost efficiencies and, by implication, precludes a significant range of opportunities for exploitative exchange that would otherwise exist. The separation of equity ownership and management and what that entails is simply the price that must be paid for these efficiencies.

These considerations are suggestive as far as they go, but they say noth­ing about whether or how exploitative exchange takes place between equity owners and managers as the result of the separation of these two roles and how it might be prevented. In particular, something has to be said about how management is monitored in the open corporation. This is especially pressing in light of the fact that management consists of essentially two tasks that are very difficult to monitor: (1) the monitoring of other input providers and (2) entrepreneurship on the input and output interfaces between the firm and the market. This would seem to open the door for management to exploit the equity owners, a door that the classical capitalist firm closes by joining these tasks to equity ownership.

A further difficulty with the open corporation is that equity owners, who have the right to hire the managers, seem to be in a poor and weak position to judge the value of the managerial services they are purchasing. How, then, can equity owners monitor management and prevent the latter from appropriating some of the value of the firm or its assets (i.e., some of its quasi-rents)? If they cannot and if all firms of comparable size have the same basic structure, these equity owners effectively have nowhere else to go. Under these circumstances, if management appropriates some of the quasi-rents of the firm, that appropriation would meet both of the condi­tions for exploitative exchange. This is a stylized picture of what many crit­ics of the free enterprise system believe, in fact, happens.²³ A defense of the free enterprise system on this point requires an explanation of how man­agement can be effectively monitored in the large corporation to minimize the proportion of the firm’s quasi-rents that go into managers’ pockets.

It might seem that the obvious solution to this problem is to make the managers stockholders; indeed, that is usually done, up to a point, by mak­ing stock or stock options part of the pay package. This would make pay reflective of entrepreneurial contribution and would provide an excellent incentive for management not to shirk. But it is not the entire solution for two reasons.

First, the basic problem of shirking (or more generally, opportunism) in an environment of team production still exists, only now the team has been enlarged to include the monitor. As before, the opportunist gets all of the benefits but suffers only a fraction of the costs. In a very large corporation, that fraction of the costs that residual claimants-managers must pay for their opportunism might be vanishingly small, especially in comparison to the benefits. Opportunism is not limited to shirking in the provision of an input: it can take the form of on-the-job consumption (lavish offices and various other perks), buying inputs from friends who may not be the best suppliers, hiring one’s friends and relatives, and so on. The costs that these activities impose on a corporate executive in his role as stockholder of a large company are likely to be vanishingly small in comparison to the bene­fits he receives from these forms of opportunism.

Second, there is the problem of risk diversification. The performance of a firm is not entirely determined by the actions of its top management, and the idea that the latter completely controls what goes on in the firm is as much a myth as the idea that the top management in any large organiza­tion (e.g., a large government agency, the military) exercises complete con­trol. If top management’s pay were strictly determined by the firm’s profits, they would be unable to diversify the risks they face. As Fama and Jensen point out, “Risk aversion tends to cause them to charge more for any risk they bear than security holders who can diversify risk across many organi­zations” (1983a, 330). As Arrow (1964) has shown, one of the advantages of the open corporation is that it allows for the diversification of risk by equity holders. So, if managers’ entire pay were determined by their status as residual claimants, risk would be inefficiently distributed, and managers would have to receive extra compensation for bearing the full risk conse­quences (though obviously not the full wealth consequences) of their entre­preneurial decisions. In consequence, they would likely shirk in the provi­sion of entrepreneurial services by acting much more cautiously than condi­tions warrant. This problem is addressed by paying managers a basic salary and giving them bonuses in the form of stock and stock options on top of that salary. Tying management’s pay to firm performance is one way of miti­gating the moral hazard (and thus the potential for exploitation) inherent in the separation of equity ownership and managerial control in the open cor­poration, but it does not eliminate the problem. Moreover, it not appropri­ate or efficient as an exclusive instrument to deal with the opportunity for exploitation presented by this separation of ownership and control.

Fortunately, there are other factors that play a role in mitigating this moral hazard. Perhaps the most important of these is the board of direc­tors. Elected by the stockholders, the board of directors hires, fires, and sets the pay of management. Because members of the board are much more knowledgeable than ordinary stockholders about the market for manageri­al services, they are better positioned to set management’s pay at about the market-determined rate. The board also plays an important role in moni­toring management’s performance. One way this is accomplished is through the audit committee of the board. The internal audit department reports directly to the audit committee, not to management. In addition, the audit committee also hires a public accounting firm to audit the firm’s financial statement. The primary concern of the public accounting firm is to certify that the financial statement management prepares gives an accu­rate picture of the firm’s financial condition to the board, the stockholders, and other interested parties (e.g., securities analysts and government agen­cies such as the Securities and Exchange Commission). Though auditors will detect large-scale misuse of funds, they will not detect fraud below a certain level of materiality or significance, nor is that the purpose of the audit. When audit differences are posted by the public accounting firm, they are saying to these audiences that management is trying to make the firm’s financial condition look better than it really is. Misrepresentations of this sort at the margins are much more common than outright fraud. Finally, the public accounting firm also makes recommendations to the board and to management about ways to improve internal controls (i.e., monitoring).²⁴

Another way that the board monitors management’s performance is through what Fama and Jensen call decision control. They identify four steps in the decision-making process:

1. initiation—generation of proposals for resource utilization and structur­ing of contracts

2. ratification—choice of the decision initiatives to be implemented

3. implementation—execution of ratified decisions

4. monitoring—measurement of the performance of decision agents and implementation of rewards, (1983b, 303)

They call steps 1 and 3 decision management and steps 2 and 4 decision control. Decision management roughly corresponds to entrepreneurship and is exercised by the firm’s managers. The board of directors, however, moni­tors the major entrepreneurial moves that management makes by exercis­ing the decision control functions of ratification and monitoring.²⁵

The exercise of decision control functions does not require that man­agement be excluded from the board. In his discussion of corporate gover­nance, Williamson identifies three benefits to management membership on the board of directors: (1) the board has access to the decision-making process as well as the results; (2) management’s participation on the board can give the board access to more and better information than would be forthcoming in a more arm’s-length relationship; (3) management partici­pation on the board can serve to protect the otherwise-difficult-to-protect employment relation between the firm and management—for example, top managers usually have no formal grievance procedures if the board disciplines or dismisses them (1985, 317).

Participation by management on the board of directors is sometimes accompanied by the participation of other board members in the manage­ment of the firm; this allows the firm to draw on the expertise and connec­tions of well-placed outsiders. However, the dangers of both management participation on the board and board participation in management is that the monitoring function of the board will be compromised and manage­ment or the board (or both) will engage in self-dealing or otherwise exploit the stockholders.

Indeed, though the board has superior information and expertise to monitor management, Juvenal’s question once again obtrudes: ‘Quis custodi­et ipsos custodes?’ The principal-agent relationship between the board and the equity owners is itself in need of monitoring. How can this can be accomplished? Harold Demsetz has suggested that this may be the role of the large shareholder, that is, the individual—or even an organization, such as a pension fund—that has a substantial proportion of its own wealth tied up in a particular firm. Demsetz says, “No owner of a trivial fraction of equity has enough interest or power to take the problem of control [i.e., monitoring] seriously; leaving this task to someone else makes more sense. However, this someone, if he or she is to exist, must own a large personal stake in the firm. An undivided large equity stake requires considerable personal wealth when the efficient size of the firm is large” (1988a, 231).²⁶ Often, of course, this individual is on the board of directors. And whether he or she is on the board or not, that individual has substantial power and a strong incentive to oust poor managers and/or colluding directors. In this manner, the monitoring problem is addressed—if not completely solved— in the same general way it is solved, for the classical capitalist firm, namely, by making the monitor a residual claimant.

Another part of the solution to the monitoring problem is to be found in the market for corporate control (Manne 1965). If the management of one firm (or a wealthy individual) believes that the management of another firm is not making good use of its assets, they have the incentive to buy up enough shares of the Rrm to take control and oust ineffective management and/or board members.²⁷

An insufficiently appreciated player in this game, who provides valuable information for the equity owners, is the securities analyst. Securities ana­lysts for brokerage firms make it their business to know what managers are doing (or, at least, what they have done in the recent past) with the corpo­rate assets that they control. Because of their connections to players in the securities markets, analysts’ judgments of corporate decision making are reflected in the price of stock in the corporation. Corporate managers have been known to make moves (e.g., layoffs, restructuring) to “satisfy the ana­lysts.” If a firm’s management makes a series of poor decisions, it is usually reflected in the price of the firm’s stock on the securities exchanges in short order. Capital markets are like other markets in their knowledge-transmit­ting properties. A fall in share prices sends a message to all of those who want and need to know—in particular, to equity holders, who are having the value of their assets dissipated. This provides a signal for them to bail out or to get more involved in monitoring than they otherwise might. This service is provided by the securities markets at a nominal cost.

None of this operates perfectly and without opportunistic behavior on the part of all concerned. Indeed, in recent years it seems that many man­agers of large American corporations have been exploiting stockholders by getting paid — paying themselves — much more than they are worth (though there is some dispute about this). Small investors can get out before they have had too much of the quasi-rent value of their contribu­tions (i.e., equity) leached out by opportunistic corporate executives, but large pension funds and other institutional investors may effectively have nowhere else to go. So the exploitation can continue until and unless the law or the evolution of the open corporation puts a halt to it. On the other hand, this problem does not seem to be endemic to free enterprise systems, since Japanese and German firms do not make the kind of inflated pay­ments to management that their American counterparts do. This suggests that there is something peculiar to the American system that permits this problem to fester. In general, much of what goes under the heading of monitoring management has the form of damage limitation, which is what one would expect in a world of asset specificities, informational asymme­tries, and opportunistic players. However, this discussion has identified the means by which the management of large corporations can be monitored in the most effective way possible—by tying the monitoring function to equity ownership.

Free Alienability and Limited Liability of Equity Ownership

All these processes presuppose an effectively functioning securities market in which equity shares are easily tradable. Unlike partnerships, where other equity owners must approve the sale of ownership shares, shares in an open corporation may be freely bought and sold. The buying and selling of shares in the securities market helps to create an informed (though tempo­rary) consensus as to how well a company (i.e., its management) is doing in managing its assets. The securities market also plays a crucial role in the institutional mechanism by which someone or some group can pull the plug on bad management. The lure of entrepreneurial profits that goes with residual Uaimancy provides the incentive for players with proven abil­ity (viz., those who have won big profits in the past or who have risen to positions of power and authority in other corporations) to act expeditiously to rid the firm of bad management and begin to realize the full potential of the firm’s assets.

The limited liability of equity holders consists in the fact that their liabil­ity to execution of corporate debt and other obligations is limited to the amount of their investment. By contrast, partners in a partnership are fully liable for all the debts incurred by the partnership. It would not be sensible for individuals with a normal degree of risk aversion to entrust their entire wealth to hired managers without engaging in very extensive monitor­ing—monitoring that would have to be duplicated by other investors. Moreover, investors would have to investigate how deep their coinvestors’ pockets were in order to assess the extent of their potential liability and thus the risk that they face as investors. Limited liability solves both of these problems in a single stroke (Jensen and Meckling 1976, 331; Demsetz 1988b, 114). It also significantly reduces the litigation costs Ofbankruptcy that would have to be borne by someone if each investor’s liability were unlimited. The problems that limited liability creates (primarily, the threat of opportunism from management) are dealt with in the ways already out­lined.

This completes the discussion of the transactions cost efficiencies of the open corporation. The cumulative account of these transactions cost effi­ciencies explains how various role occupiers (capital providers, monitors, etc.) eliminate or limit their exposure to exploitation by others when capital requirements are too large to be met by one individual. What remains to be done is to consider the three additional organizational forms mentioned at the outset of this section: the multidivisional corporation, the closely held or closed corporation, and the partnership. The rationale for discussing these types of organizations is that each would be effectively banned in a market socialist system.

The multidivisional corporation is an open corporation composed of Semiautonomous profit centers. A central office monitors the management

of the divisions, allocates cash flows among them, and engages in strategic planning.²⁸ Top management is freed from operational responsibilities and can concentrate on major entrepreneurial and personnel decisions. The divisions themselves are responsible for implementing major decisions, and monitoring of the divisions is largely carried out by a general staff (Williamson 1985, 278-90). This type of corporation represents a kind of scaled-up version of the open corporation. Top management plays a role analogous to a board of directors, though it may take a more active role in what Fama and Jensen call the initiation and ratification steps in the deci­sion-making process (1983b, 303-11). It is a way of bringing still larger amounts of capital under a more spacious decision-making roof while keeping the divisions and divisional managers directly accountable to the market.

To close this section, it would be appropriate to take a brief look at the transactions cost efficiencies of two other types of organizations commonly found in a free enterprise system: the closed corporation and the partner­ship. The closed corporation is one in which residual claims are restricted to a few individuals who have some special relationship with the main deci­sion agents (e.g., blood or family relations). These relationships either per­mit better monitoring or lessen the need for monitoring—though when business conditions deteriorate, these very relationships often exacerbate monitoring problems, for familiar reasons.

Because the main decision agents are substantial residual claimants yet do not supply all of the capital, the closed corporation has many of the advantages of both the classical capitalist firm and the open corporation. For example, as in the classical capitalist firm, the chief executive officer bears a considerable proportion of the wealth consequences of his deci­sions. On the other hand, the closed corporation allows access to larger amounts of capital than the chief executive officer can provide. This per­mits the firm to realize the transactions cost efficiencies that can attend bringing together large amounts of capital under unitary management. However, as Fama and Jensen point out, the closed corporation also suffers the disadvantages of both these organizational forms (1983b, 306). Restricting residual claims to a small number of individuals forgoes some of the benefits of risk diversification. In addition, restricting decision making to those with wealth who are willing to bear risks limits the pool of decision makers. Finally, minority stockholders, like stockholders in larger corpora­tions, are subject to the usual expropriation hazards (e.g., on-the-job con­sumption by managers) that go with attenuating the connection between monitoring and residual claimancy.

Partnerships involve consensual decision making by a number of coequal decision agents who share in the residuals. Partnerships have effi­ciency advantages over alternative organizational forms when most of the firm’s capital is human capital embodied in the partners themselves, the deployment of which is difficult to monitor. This organizational form is most common among professionals in fields such as consulting, law, medi­cine, engineering, and accounting, although medicine may be headed toward the open corporation form as treatments become more standard­ized and the physical capital requirements associated with advanced med­ical technology grow increasingly large.

A common feature of partnerships is that there are significant comple­mentarities that each partner brings to the partnership. In these situations, the quasi-rents of the human assets that partners bring to the firm are sub­stantial; without partnership status, those quasi-rents would be highly vul­nerable to appropriation. For these reasons, management and residual claimancy are limited to and spread among the partners. It is not com­pletely clear why liability is unlimited in the partnership. Perhaps what is going on here is that the partners are effectively pledging the value of their human capital (which constitutes most of the firm’s assets) as a bonding device, that is, as a way of assuring clients and input suppliers (e.g., profes­sional staff who are not partners) that they will fulfill their contractual obligations. In this respect, it plays the same role as nonhuman capital does in a more traditional firm.

The classical capitalist firm, the open corporation, the closed corpora­tion, and the partnership are not the only organizational forms to be found in free enterprise systems. However, existing free enterprise systems are dominated by the first two, and there are numerous instances of the other two types. All four would be essentially prohibited in a market socialist sys­tem. From an organizational standpoint, this is the crucial difference between a free enterprise system and a market socialist system. The pur­pose of this and the preceding section has been to explain the transactions cost efficiencies of these organizational forms as a way of explaining how they preclude or limit opportunities for exploitative exchange. The points of contrast with the worker cooperative are implicit in this discussion; they will be made fully explicit in the next two chapters.