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Corporations
By Robert Hessen
Corporations are easy to create but hard to understand. Because corporations arose as an alternative to
partnerships, they can best be understood by comparing these competing organizational structures.
The presumption of partnership is that the investors will directly manage their own money, rather than en-
trusting that task to others. Partners are "mutual agents", meaning that each is able to sign contracts that are
binding on all the others. Such an arrangement is unsuited for strangers or those who harbor suspicions about
each other's integrity or business acumen. Hence the transfer of partnership interests is subject to restrictions.
In a corporation, by contrast, the presumption is that the shareholders will not personally manage their
money. Instead, a corporation is managed by directors and officers who need not be investors. Because mana-
gerial authority is concentrated in the hands of directors and officers, shares are freely transferable unless oth-
erwise agreed. They can be sold or given to anyone without placing other investors at the mercy of a new
owner's poor judgment. The splitting of management and ownership into two distinct functions is the salient
corporate feature.
To differentiate it from a partnership, a corporation should be defined as a legal and contractual mechanism
for creating and operating a business for profit, using capital from investors that will be managed on their be-
half by directors and officers. To lawyers, however, the classic definition is Chief Justice John Marshall's 1819
remark that "a corporation is an artificial being, invisible, intangible, and existing only in contemplation of
law". But Marshall's definition is useless because it is a metaphor; it makes a corporation a judicial hallucina-
tion.
Recent writers who have tried to recast Marshall's metaphor into a literal definition say that a corporation is
an entity (or a fictitious legal person or an artificial legal being) that exists independent of its owners. The entity
notion is metaphorical too and violates Occam's Razor, the scientific principle that explanations should be con-
cise and literal.
Attempts by economists to define corporations have been equally unsatisfactory. In 1917 Joseph S. Davis
wrote: "A corporation is a group of individuals authorized by law to act as a unit". This definition is defective
because it also fits partnerships and labor unions, which are not corporations. A contemporary economist, Jona-
than Hughes, says that a corporation is a "multiple partnership" and that "the privilege of incorporation is the
gift of the state to collective business ventures". Another, Robert Heilbroner, says a corporation is "an entity
created by the state", granted a charter that enables it to exist "in its own right as a “person” created by law".
But charters enacted by state legislatures literally ceased to exist in the mid-nineteenth century. The actual
procedure for creating a corporation consists of filing a registration document with a state official (like re-
cording the use of a fictitious business name), and the state's role is purely formal and automatic. Moreover, to
call incorporation a "privilege" implies that individuals have no right to create a corporation. But why is gov-
ernmental permission needed? Who would be wronged if businesses adopted corporate features by contract?
Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued,
holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of
its officers or investors, that its shares are freely transferable, or if it asserted limited liability for its debt obliga-
tions? If potential creditors find any of these features objectionable, they can negotiate to exclude or modify
them.
Economists invariably declare limited liability to be the crucial corporate feature. According to this view
the corporation, as an entity, contracts debts in "its" own name, not "theirs" (the shareholders), so they are not
responsible for its debts. But there is no need for such mental gymnastics because limited liability actually in-
volves an implied contract between shareholders and outside creditors. By incorporating (that is, complying
with the registration procedure prescribed by state law) and then by using the symbols "Inc." or "Corp. ", share-
holders are warning potential creditors that they do not accept unlimited personal liability, that creditors must
look only to the corporation's assets (if any) for satisfaction of their claims. This process, known as "construc-
tive notice", offers an easy means of economizing on transactions costs. It is an alternative to negotiating ex-
plicit limited-liability contracts with each creditor.
Creditors, however, are not obligated to accept limited liability. As Professor Bayless Manning observes:
"As a part of the bargain negotiated when the corporation incurs the indebtedness, the creditor may, of course,
succeed in extracting from a shareholder (or someone else who wants to see the loan go through) an outside
pledge agreement, guaranty, endorsement, or the like that will have the effect of subjecting non-corporate assets
to the creditor's claim against the corporation". This familiar pattern explains why limited liability is likely to be
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