The Modern State and the Rise of the Business Corporation

Taisu Zhang and John Morley are Professors of Law at Yale Law School. This post is based on their recent paper, forthcoming in the Yale Law Journal.

The two great institutions of modernity are the corporation and the state. Together, these twin behemoths account for much of the bureaucracy, market-based exchange, impersonal social interaction, centralized power, and formal equality that characterize the experience of modern life.

In a new paper forthcoming in the Yale Law Journal, we ask why these two institutions tend so often to appear together. We show that throughout history, the rise of the modern state has almost always been a necessary precondition for the rise of the modern business corporation. In many different societies at many different times, businesspeople were unable to successfully form and operate modern business corporations until they have gained the support of modern states.

We argue that the linkage between the corporation and the state is a consequence of the modern state’s extraordinary capacity to enforce the law uniformly among a corporation’s many shareholders. In a modern corporation, large numbers of strangers from different social communities share ownership of residual claims in a single enterprise with guarantees of asset partitioning. This pattern of organization requires the rules of the corporate bargain to be enforced uniformly across the many stranger-owners. Because ownership of a corporation is zero sum, if one shareholder bends the law in order to take more, the other shareholders must necessarily suffer the consequences by taking less. Many prospective owners will therefore only cooperate if they believe the rules of the corporate bargain will be enforced uniformly.

Enforcing the corporate bargain across the many strangers who own a modern corporation, however, is not an easy thing. It presupposes the power to coerce people across unconnected families, neighborhoods, cities, and even nations. It requires extensive geographical reach, powerful administrative muscle, and a formal commitment to neutrality.

Fortunately for modern business corporations, these are the very features that define a modern state. A modern state is good at enforcing bargains among strangers because exerting power over strangers is one of the most basic things a modern state does.

The power of a modern state stands in contrast to the limits of less formal modes of rule enforcement. Customary law among close-knit communities, commercial networks such as the Law Merchant, and social norms generally do not suffice for a modern corporation because these other modes of rule enforcement depend on mutual social connections. The reputational and social sanctions used by these rule enforcement mechanisms are only effective when applied to people who share overlapping social relationships. This makes these mechanisms ineffective in a modern corporation, whose distinctive feature is the bringing together of large numbers of strangers.

This is the other central argument of our paper: that, as a matter of economic theory, corporate legal technologies are primarily useful as ways to mitigate the costs of doing business with strangers. In particular, asset partitioning—both limited liability and entity shielding—are mechanisms that shift risk away from business partners onto an innumerable set of third-party creditors, including both financial creditors and tort creditors. Such risk shifting is of fairly limited value when business partners know each other well and can therefore plan around each other’s economic circumstances, but absolutely essential when they do not.

Many legal institutions, including most forms of property and contract, are useful both in closely knit communities and in relationships among strangers, but corporate legal technologies are unique in appealing overwhelmingly to relationships among strangers. As a result, corporate law relies unusually heavily on the state.

We illustrate the plausibility of this hypothesis by offering six case studies of historical societies: late Imperial China, the 19th century Ottoman Empire, the early United States, early modern England, the late medieval Italian city states, and ancient Rome. We focus especially on the experience of late Imperial China, which adopted a modern corporation statute, but failed to witness much growth in modern, diffusely owned corporations until the state developed the capacity and institutions necessary to enforce its corporate law uniformly.

Our thesis complicates existing historical accounts of the rise of the corporation, which often emphasize the importance of economic factors over political and legal factors and view the state principally as a source of expropriation and threat rather than support. Our thesis has extensive implications for the way we understand corporations, private law, states, and the nature of modernity.

The complete paper is available for download here.

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