It is now widely recognized that legal entity status fulfills important economic functions by separating a firm’s business assets and the personal assets of its founders, directors, or shareholders, and that this separation is stronger in corporations than in partnerships (Hansmann et al. 2006). Corporate assets are controlled by an independent board and are literally locked in, in the sense that neither firm founders nor subsequent shareholders can withdraw all or part of their equity shares or force a partial liquidation to satisfy the claims of their personal creditors. This institutional arrangement, which cannot be achieved by contract alone, mitigates collective action and commitment problems and helps foster surplus-enhancing specific investments (Blair & Stout 1999).
What is less known is that an early statement of these ideas appears in an important but widely neglected book by Ernst Freund, The Legal Nature of Corporations, published in 1897. Some historians of American corporate law (e.g. Horwitz 1985, Harris 2006) have characterized Freund’s book as a brilliant exposition of the theoretical underpinnings of corporation law that was well ahead of its time, but to date references to it remain rare, and a systematic assessment of its contributions remains unavailable. I address this lacuna in a recent paper.
I argue that although it was written at the time of the rise of large business corporations, Freund’s book was more than an attempt to come to terms with a new reality. While his fellow law professors relied almost exclusively on case law and authorities from the past, Freund engaged in what might be called, to paraphrase Oliver Wendell Holmes (1897), the “rational study of corporate law,” namely the study of the ends sought by corporate law and the reasons for desiring them. In the process, he formulated the first modern theory of the corporation.
The generalization of the incorporation by simple registration in the decades preceding the publication of his book had weakened the view that corporations were creatures of the state. In the 1880s, as the existence and actions of corporations came to be understood as products of private rights and freedom of contract, many influential observers, including Victor Morawetz, the author of the decade’s hit corporate law textbook (Morawetz 1882), claimed that corporations were not very different from partnerships: Corporate rights and duties, particularly as related to property, were in reality the rights and duties of a corporation’s stockholders.
Freund took issue with this view because it failed to explain why individuals forming a business association would choose the corporate form over the partnership and ignored the indisputable fact that law treated corporations as holders of rights and duties that are entirely distinct from any of the individuals involved. Contrary to Otto von Gierke and others in Europe, Freund did not accept the idea that a corporation held rights because it had a will of its own. (Some commentators have mistakenly portrayed Freund as the leading American exponent of Gierke’s theory.) Metaphysical speculation of this kind was unnecessary. The twin questions of the legal nature and desirability of the corporation could be tackled by focusing on the practical requirements of property law.
Freund reasoned that a key problem faced by business associates pooling their resources together in the hope of superior gains was how to safeguard their mutually beneficial interest in the face of disagreements and other failures of cooperation. The consequences of dissent were greatest in forms of association where control was jointly exercised and concurrent action necessary, but even when neither was strictly necessary because representatives had been nominated and a majority decision rule adopted, the problem of internal defection remained. To be truly protected from this threat, associations had to exercise control over the combined resources in a manner that ensured the continuity of the tie binding remaining and incoming members together.
Freund understood that contractual stipulations were insufficient and turned his attention to the main legal forms of association available. Contrary to partnerships, which were unable to prevent dissent and ensure undivided control over the combined resources, incorporation vested ownership of the combined resources in the legal entity and attributed unified control over corporate property to a board whose binding powers could survive changes in the association’s membership. This ensured the association’s continuity and helped secure transactions with outside parties. This, therefore, was the reason for choosing the corporate form over the partnership or other forms of collective holding of property.
The board’s position was such that it was easy to attribute actions to the corporation without resorting to dubious theories about the corporation’s supra-individual acting capacity. Corporate actions occurred vicariously in and through specific individuals in specific corporate positions. This was true in cases where the corporation’s rights had been enforced in court. And it remained true in cases where courts deemed corporate defendants liable for torts, nuisances, and non-compliance with regulation.
Overall, while Freund’s analysis was rudimentary by today’s standards, it seems that he had an intuitive understanding of comparative institutional analysis, and this enabled him to anticipate what we now know about the economic functions of legal entity status. Partly because Freund’s decidedly analytical approach stood in sharp contrast with the scholarly habits of his fellow academic lawyers, and partly because Freund himself turned to other matters and never revisited the topic of corporate theory, Legal Nature of Corporations was quickly forgotten. One can only wonder what course the literature on corporations might have taken had Freund remained an active player in the field.
Blair, M. M. & L. A. Stout (1999). “A Team Production Theory of Corporate Law.” Virginia Law Review 85(2): 247-328.
Freund, E. (1897). The Legal Nature of Corporations. Chicago: University of Chicago Press
Hansmann, H., R. R. Kraakman & Richard Squire (2006). “Law and the Rise of the Firm.” Harvard Law Review 119(5): 1333-1403.
Harris, R. (2006). “The Transplantation of the Legal Discourse on Corporate Personality Theories: From German Codification to British Political Pluralism and American Big Business.” Washington and Lee Law Review 63(4): 1421-1478.
Holmes, O. W. (1897). “The Path of Law.” Harvard Law Review 10(8): 457-478.
Horwitz, M. J. (1985). “Santa Clara Revisited: The Development of Corporate Theory.” West Virginia Law Review 88(2): 174-224.
Morawetz, V. (1882). A Treatise on the Law of Private Corporations Other Than Charitable. Boston, MA: Little, Brown & Co.
This post comes to us from David Gindis, a senior lecturer in economics at the University of Hertfordshire, UK. This post is based on his recent paper, “Ernst Freund as Precursor of the Rational Study of Corporate Law,” published in the Journal of Institutional Economics and available here. A previous version of this post appeared on the JOIE Blog.