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SOS Corp. – Part 1

Here’s a heretic hypothesis: in the not so distant future, the limited liability corporation as construed and constructed throughout the last few centuries may well become as extinct as a Norwegian blue in a Monty Python sketch? SOS Corp. What if, with it dies a big chunk of the stock market, as we know it? Wall Street RIP. (As if these days those guys need any help). Born is a parallel system of flexible, self-organizing endeavours where constantly changing groups of people voluntarily contribute with their time and talent.

On the importance of institutional innovations

Often, people underestimate the importance of institutional innovations. A dictionary would tell you that institutions are “structures and mechanisms of social order governing the behaviour of a set of individuals within a human collective”. Sounds fun, right. Unlike their technological siblings, they rarely come gift-wrapped in a shiny little box with a red ribbon tied around it. When was the last time a new institution gave you a WOW-experience? They are no iPads. Like the air that we breathe and the water that we drink, most of us take our institutions for granted.

But significant they are. What they lack in coolness they make up for in criticality. On a fairly recent list of the 100 greatest innovations ever, published in Business Week, five out of the top ten ones were institutional innovations (some people would include also number two on the list).

  1. Weapons
  2. Mathematics and the number zero
  3. Money
  4. Printing
  5. Free markets and capital markets
  6. Domesticated animals and agriculture
  7. Property ownership
  8. Limited liability
  9. Participatory democracy
  10. Anesthetics and surgery

Like many of you, I have a slightly different POV than those who were responsible for this list. (On a personal level, I would add the football and the remote control. On a somewhat more professional level, among other things, I would like to suggest the birth-control pill, which 2010 celebrated its 50-year anniversary and potentially made one heck of a difference for at least 51% of the world population – an interesting discussion can be found in Time Magazine May 3, 2010 – read it).

You may of course also question if the efforts behind the stuff that ended up on this top-ten list have really helped us in getting any closer to realizing the ancient dream of a good life, especially in less materialistic terms (number-crunching capitalists with pet cats who undergo plastic surgery and trade arms may lead to “demi-crazy” rather than democracy... - and at arm’s length (no pun intended) the person you envision seems to bear a slight resemblance to a classic James Bond adversary). But, what none of us can neglect is the pivotal importance that institutional “advances” have played throughout the course of human history. It’s also interesting to note that out of the top five institutional innovations on this list, 80% are directly related to commerce and wealth-creation and the final one (democracy) indirectly so.

Many of these institutional innovations are fairly old, but only one, I believe, may be somewhat dated. The ancient Greeks gave us democracy as well as ideas about the importance of property rights. The history of money started even earlier, in Mesopotamia around 3000 BC. Allegedly, back in the 1680s, it was a group of French businessmen who introduced the concept of “laissez-faire” policies to the powerful French minister of finance Jean-Baptiste Colbert, a strong advocate of mercantilism. (The actual “phrase” as such was not coined until 1774, however). About a century later, Adam Smith was the first person to document the value of free trade in his epic book from 1776, The Wealth of Nations.

The conception of the corporation

The history of the limited liability company is quite recent, but to my mind this is also the institutional innovation facing the most risk of being eliminated from the top-ten list – the Spice Girl of the institutional world. Its history is closely linked to that of the corporation (from the Latin word corporare – “form into a body”). The first corporations saw the light of day at least as early as during the 16th century. (The original ones appear to be somewhat older, though. The Swedish firm Stora Kopperberg, which still exists and is often claimed to be the oldest one in the world, was founded already in the 13th century. Similar institutional arrangements existed already during the days of the Romans and the Maurya Empire in ancient India, however.)

The establishment of the corporation transformed the economy from one based on personal debt to one sponsored by the state. Prior to the birth or the corporation, debt was not only individual but also transcended generations. What you owed when you passed away was automatically passed on to your descendents. In some cases, these guys (and back then only guys inherited stuff – or in this case the absence of stuff) had to serve time in prison as a result of the bad business judgement of their ancestors.

Things changed radically when the state started to hand out charters (a nicer word for monopolies) for corporations to do business. According to the pundits, the main motive would seem to have been to sponsor explorations of the New World and trade with the Far East – risky businesses, indeed. As a trigger, technological development was crucial. Navigation (the compass – invented by the Chinese) opened up for the corporation. No charter – no commerce. Economic historian Paul Hawkin notes that if ships “did not sail under the charter of a state corporation, they and their families could be ruined for life if bad weather or piracy struck en route.”

As noted above, a corporation literally means a separate body. The institutional innovation (or gift from the state, if you so may) was based on the idea of separating personal risk from professional risk. The new body – the corporation – became a separate legal entity with its own liabilities and privileges, separate from those of the investors.

This new innovation dramatically transformed the world economy and made Europe a force to be reckoned with. (Prior to this European innovation, the Chinese were in charge – ergo today…) The corporations, hardly surprising, were more willing than individuals to accept risk (kind of limited risk since you had a de facto monopoly), and the State (back then another word for His and Hers Royal Majesties) could collect tax returns from the monopoly profits reaped by the companies, e.g., the investors.

If you want to understand the incredible impact of the new institution, the early history of the British East India Company provides a great case in point. On New Year’s Evening 1600, Queen Elisabeth granted the company a fifteen-year charter (monopoly – I, insist) on trade to and from the Africa continent and the East Indies. A little more than 10 years later, the shareholders of this corporation were earning close to a 150% return on their investment.

The Corporation 2.0

Despite what some people might claim given the current success of the Chinese economy, history, I believe, proves that governments (even if democratically elect) are rarely the best ones to determine who should be allowed to do business. Over time, decentralized systems of intelligence and ignorance tend to beat those where smartness and stupidity have been centralized (for a deeper discussion see The +Factors). During the 19th century, this fact became increasingly evident to those in charge in Europe and the United States. Moreover, this time, we’re in most cases indeed looking at people who didn’t inherit the power vested in their position. While the original corporation (classic C) benefited the elite (those well-connected to the Royal family), it was not that efficient from a societal perspective (government granted monopolies rarely are).

Something had to be done. In effect, the modern limited liability corporation was created – the Corporation 2.0. If the birth of the original corporation meant a great deal to the few who got the monopoly rights (and the kings and the queens who could enjoy the tax proceeds), the improved institutional innovation would have an even greater impact on all our lives. In fact, it still does.

In 1844, the British Parliament passed something called the Joint Stock Companies Act. This decision allowed companies to incorporate without getting a royal charter. Some 10 years later, the Limited Liability Act was passed. The new law established the principle that corporations could enjoy limited legal liability by registering as a “limited” company with the proper government agency. Competition, although still limited in scope and space compared to today’s standards, suddenly became a fact of life.

From now on, temporary monopolies, the Holy Grail of business, had to be earned. The role of Government would slowly change from one of handing out charters, to instead focusing on securing competition. The introduction of democracy (remember, it was after all No. 9 on the Business Week list of innovations) and downfall of dictators with a personal interest in getting their piece of the profit pie probably played a central role (admittedly, in some parts of the world, people are still waiting for this to happen).

Here’s another telling tale. As I’ve pointed out, on more than one occasion we’ve severely underestimated the importance of institutional innovations. Then, consider this. According to an unknown Wikipedia contributor, the passing of the Limited Liability Act of 1855 prompted the English magazine the Economist (still around, and typically a beacon of light in the general darkness of business journalism) to note that “never, perhaps, was a change so vehemently and generally demanded, of which the importance was so much overrated.” Our unknown Wikifriend proceeds by noting that “the glaring inaccuracy of the second part of this judgment was recognized by the same magazine more than 75 years later, when it claimed that, "[t]he economic historian of the future . . . may be inclined to assign to the nameless inventor of the principle of limited liability, as applied to trading corporations, a place of honour with Watt and Stephenson, and other pioneers of the Industrial Revolution.”

Hate to say I told you so, but the best institutional innovations rule.

The virtues and limitations of the limited company

The limited liability corporation of the 19th century did not appear out of a vacuum. In addition to the influence of the democratic movement, again, technological development played an essential role (recall the importance of the compass in triggering the birth of the classic C). The Ltd Corporation was set up in response to the enormous capital requirements that arose when trying to utilize the full potential of the new technologies that opened up for the industrial revolution. If access to more physical capital, in the form of raw materials and cheap labour (we do like our euphemisms – let’s be honest and call it colonization and slavery) had once given birth to the classic corporation, now, access to hard cash suddenly became critical. Financial capital, rather than physical capital, was the new scarce resource.

The beauty of Ltd. Corp was that by minimizing individual risk (limiting it to the money invested), it maximized risk-taking on the societal level (and now this level was no longer restricted to those who could get the State charters, though we’re still not talking about the huge masses of anonymous capitalists that we’re looking at today). Since its birth, the limited liability company has, by and large, served us well. If you don’t believe me, I can provide you with some contact details for people in North Korea and Cuba. Heck, these days, even the folks in Beijing seem convinced.

But, and this is a bootylicious but, here are some big Qs;

  • What if for many modern organizations financial capital is no longer the scarce resource it used to be?
  • What if, in some cases, capital has been replaced by competence (or perhaps even something more ephemeral) as the new bottleneck for wealth creation?
  • What if the limited company was built on a whole bunch of assumptions that are no longer as valid as they once were?

Perhaps the time has come to realize that we need a new institution – particularly in industries that are not that capital intensive? Or, at least, don’t we need to have a discussion about the implications of sticking to an institution that doesn’t match the realities of the business world as well as it used to? Indeed, what if some of the recent corporate scandals, from Enron to Lehman, can be explained, at least in part, by the limitations of the limited liability company when dealing with competence based corporate activities and brain-based business models? How do we build an institution around a scarce resource – information – that wants to be free?

In a second part of this thought-piece, I’ll do my best to answer these questions – and pose some new ones.

Copyright © 2010-2015 Jonas Ridderstråle