Origins of the Speculation Economy:
Lawrence E. Mitchell is Theodore Rinehart Professor of Business Law at the George Washington University Law School. After practicing corporate law for several years on Wall Street, Mitchell entered academia and has been a leading corporate and business law scholar for 20 years. He is the author of The Speculation Economy: How Finance Triumphed Over Industry (2007). Other of his publications include: Progressive Corporate Law (editor, 1995); Stacked Deck: A Story of Selfishness in America (1998); and Corporate Irresponsibility: America's Newest Export (2001).
Multinational Monitor: What are the modern origins of the corporate form and corporate law in the United States?
Lawrence Mitchell: A blend of forms, mostly the British joint stock company and ecclesiastical corporations, created the structural characteristics of the American corporation which ultimately assumed its own unique form. It was used primarily for things we would ordinarily consider to be public works — toll roads, canals, that sort of thing, as well as for churches. As America industrialized, and especially as the railroads began to grow and be financed mostly with debt, the corporate form became especially useful because it protected its shareholders with limited liability — meaning shareholders were not personally liable for the harms caused or debts owed by the corporation. Of course this also led significant numbers of railroad promoters to suck off the debt into their own pockets and leave the railroads without enough operating capital.
At first, the railroads were financed by their founders with some equity, but debt rapidly became the major form of permanent finance. Railroads have huge fixed costs. You've got constant track maintenance and repair, constant needs for rolling stock and the like, and that kind of money just wasn't available in the United States. A lot of railroads, especially right after the Civil War, began issuing bonds abroad. Europeans were comfortable financing railroads; there was something to secure the collateral. And the corporate form gave the founding shareholders limited liability, so they could raise all this debt and if the railroad went under — as many did — the shareholders wouldn't be liable for the consequences. That's really the original, significant use of a corporation.
The corporation doesn't really become important industrially until after the Civil War.
Industrial businesses adopted the corporate form for several different reasons. They were typically very closely held, their financing was local, and they lived principally off retained earnings, even though they may have had 10, 15, 20 shareholders who contributed to basic equity, so the same financial incentives didn't exist as they did for the railroads. But ease of management, a corporate life that lasted beyond its founders, and similar characteristics made the corporate form attractive to industry. Eventually, industrial businesses began to issue debt and appreciate limited liability as well.
MM: In that earlier period, and also running up to the 1880s, what were the legal restrictions on what corporations were allowed to do?
Mitchell: They were fairly intense. New York passed the first general incorporation law in 1812, and states began to follow after that. The general means of incorporation was special chartering: you'd go to the legislature, you'd ask for a charter, you'd get it if you had buddies on the legislature, with fewer restrictions on things like maximum capital, life of the corporation, corporate purpose and other typical limitations. But even with general incorporation laws, the restrictions were fairly tight. They tended to insist upon maximum and minimum capitalization requirements — the maximum was more important because of the lingering, characteristic American fear of monopoly power, and so they tried to prevent corporations from growing too big. Sometimes the corporation was only allowed to exist for a limited life.
These corporations were very, very severely restricted in purpose and powers. If a corporation wanted to do something, it had to say in the charter that it could do it. Although there developed judicially a doctrine of implied powers, it tended not to be very expansive. Well into the nineteenth century, corporations could not own stock in other corporations. They couldn't merge. They couldn't transcend their narrow line of business. If you incorporated to run a railroad and that's what you said in the charter, you could run a railroad, but you couldn't build a railroad. You couldn't finance the railroad unless the charter said it,
MM: What was the process by which those restrictions were peeled away?
Mitchell: Again, it starts with the railroads. As the railroads built, they sometimes began to vertically integrate, creating coal yards and storage facilities, for example. The courts began to accept certain kinds of implied powers that were incidental to the businesses.
But the driving force was the creation of industrial corporations. The earliest industrial businesses were principally extractive — petroleum, mining, that sort of thing. They began to want to vertically integrate.
With Standard Oil, Rockefeller initially started out in refining, but then began to acquire the wells, pipelines and means of transportation. Courts began to be a little more generous in allowing corporations to have powers that were more broadly implied, because of business need. The history of corporate law, as far as I read it, was always a history of legislative and judicial accommodation to business needs or desires.
Another important factor was significant overbuilding in the railroads resulting in punishing competition. At one point in the 1880s, you could take 20 separate lines from St. Louis to Atlanta, which doesn't make for survival of anyone in particular. They engaged in terrible rate wars. At the same time, growing companies like Standard Oil were so big that they could dictate their own shipping terms even to the biggest railroads like the Pennsylvania. Railroads that failed to meet those terms were going to go under. In this context, cooperation among businesses became a predominant theme, starting in the early 1870s with the railroads and growing in the 1880s with the growth of Standard Oil.
A few state legislatures — West Virginia, Delaware, Maine are the big three — loosened their statutes, allowing corporations to hold stock in other corporations. This was the most effective way of cooperation. American jurisprudence at the time maintained traditional English prohibitions against restraints of trade, but interpreted them more harshly. As a result, in the United States you couldn't cooperate in any legally enforceable way. You might establish a community of interest among businesses, where businesses could and would defect as soon as it became profitable to do so. The ability to hold stock in other corporations, to acquire competitors, became the real lever for loosening up the law.
West Virginia, Maine and Delaware were the first movers, but these were not heavily industrial states. And this was at a time when corporations had significant restrictions on whether they could hold property outside their state. So these states' moves were not that useful to corporations. Then New Jersey came along and changed everything.
MM: What did New Jersey do?
Mitchell: Jersey started first by copying in 1888 and modifying in 1889 the Delaware-West Virginia statues that allowed corporations to hold stock in other corporations.
At that point, New Jersey was completely dominated politically and economically by the Camden and Amboy Railroad, which basically controlled all the transportation in the state. Transportation was New Jersey's principal industry. It connected New York to Philadelphia and the West. The Amboy had extraordinary privileges, including complete exemption from tax. This railroad grows, they buy the legislators and they keep other railroads from being built, or if they're built they buy them out quickly, and then you get the Civil War.
New Jersey, like other states, incurred a huge amount of debt during the Civil War, but Jersey didn't have any tax revenue to pay it back because its principal industry was tax free. For a couple decades, Jersey was in a really shaky financial position.
A New Jersey lawyer who practiced in New York, James B. Dill, came up with the idea that Jersey could make money by marketing charters. About a decade before, Jersey had passed a franchise tax so that any corporation chartering in New Jersey had to pay for the privilege, but it wasn't really producing much. Dill looks at this and says, "If we can get a lot of revenue from this, then we might be in good shape." So over a period from 1888 to 1896 and finally completing in 1899, various changes take place in New Jersey law, all designed to make the state an attractive place to incorporate.
First, corporations were allowed to hold stock in other companies. It took them four or five years to get this right; the statute kept being amended to be absolutely clear that corporations could in effect form what was then an illegal trust, by buying up all the stock of other companies and voting that stock. That was monumental.
But even more important were several other changes. It had been the case in New Jersey and most states that directors had discretion to buy property using their corporation's stock. But from the 1870s through early 1890s, courts were fairly rigorous about director's valuations to ensure they did not overpay for property. The property directors bought with stock had to be paid for at its fair cash value. New Jersey changed all that. Jersey said, "Directors valuations are final, period." This let directors and corporate promoters buy other corporations and pay as much stock as they wanted for it. Stock didn't cost them anything; diluting the value of stock could hurt them, yes, but it's not cash, and they managed to avoid being hurt by much of the dilution that resulted from overvaluation by selling their stock quickly on the market. This particular statutory "reform" is to me the key that caused the giant corporation to be formed.
Jersey had a couple other tricks up its sleeve, too. Jersey says you can incorporate for any lawful purpose. In particular, it allowed promoters to form holding companies whose only purpose was to buy up and hold the stock of other companies.
All of this together, plus a couple of other changes, created a situation where you could pay stock to buy companies, put together lots of businesses, and then dump the stock and get rich.
This starts a little bit in the early 1890s, after New Jersey's first innovations, but businesses don't do much during the huge depression from 1893 to 1897. All of a sudden in 1897, gold and wheat production soar in the United States. There's a crop failure in India, crop failure in Russia, Europe needs what America's producing. So there's a ton of surplus cash coming in. Here's where Dill's genius really paid off. And here's where J.P, Morgan begins to move from being a fairly conservative railroad reorganizer and bond guy into a speculative equity guy.
The Wall Street deal makers looked around and said, "Gee, we have all these businesses that are overbuilt and competing with each other." I mentioned the railroads, but at this time you also have it in a lot of other industries, particularly industries with a lot of high fixed costs, "We buy these companies using our stock. We pay whatever we have to pay to get them. We and the guys who sold us the company can take that stock, dump it on the market and walk away. Whatever happens to the company happens to the company." Morgan was more responsible than most about it, but that's sort of the attitude that a lot of the promoters had. And it didn't stop Morgan's syndicate from taking a $1.4 billion fee (in 2006 dollars) in stock for putting together U.S. Steel and dumping the stock on the market before Steel missed a few dividend payments and the stock price collapsed. The changes in corporate law allowed the finance guys to create these megacorporations. It would cost them practically nothing to do it, and they would get rich in the process.
MM: A lot of that sounds not so surprising because it's not at all different from the state of affairs today.
Mitchell: That's why we have the state of affairs today.
MM: One response to these developments was proposals for federal incorporation. What is federal incorporation, what was the logic behind the proposals and what was the outcome of those efforts?
Mitchell: There were several motivating factors behind federal incorporation. As these huge corporations began to grow in the last decade of the 19th century, the fear was that they were really outrunning the size of any state to regulate them. They were getting bigger than the states and the fear was that they would politically dominate the state and get the state to allow them to exercise privileges that would be hurtful to small businessmen and to consumers. William McKinley, the President at the time, didn't really care. He was a business president and he paid no attention whatsoever to this problem.
But Congress couldn't be quite so complacent. They started studying the issue. Two kinds of proposals emerged. One was the idea of federal licensing. This was meant to evade the constitutional question of whether the federal government had the constitutional authority to regulate through federal incorporation. The licensing proposals hold that corporations could incorporate in a state but there would be an overlay of regulations for interstate corporations. Interstate corporations would have to get licenses and live by these regulations or be subject to antitrust prosecution. That was probably the predominant model.
The other, more aggressive model was that corporations with interstate business had to literally incorporate with the federal government. The regulations largely looked the same. For the most part, they were variants of antitrust laws and they dealt with monopoly. They grew out of a series of failed legislative proposals, proposed between the passage of the Sherman Act in 1890 and the beginning of the 20th century. Some provisions were designed to control this finance run amok. For example, there were provisions that said if you buy a corporation or issue stock to buy property, the property really has to be the value of the stock — the old New Jersey rule before the "reforms." There were some legislative proposals that would have required a federal official or committee to actually determine the actual value of the property so you couldn't "over-capitalize." Those were the primary concerns.
There were add-ons like some early federal campaign finance regulation. Some bills had sanctions for misbehaving officers and directors. Some bills had protections for minority share-holders, but it wasn't corporate law in the way we think about corporate law. It was really antitrust in this federal incorporation guise.
MM: What happened with these proposals?
Mitchell: In 1903, the House of Representatives passed legislation that would have created federal incorporation, but it was killed by the Senate. For a variety of political reasons — not the least of which was Teddy Roosevelt's screw ups in his own power grab — the effort floundered and turned into the Department of Commerce and within it a Bureau of Corporations. The Bureau of Corporations was designed to be an investigatory agency, to gather information. At this point, there was nothing resembling mandatory disclosure and precious little voluntary disclosure. The Bureau was to report the information to the President, formulate legislative proposals and the like.
A year after the Bureau of Corporations was formed, it came out with its first report and it recommended a federal licensing law. It was actually a very modest law. But as modest as it was, it got shouted down all over the country and went nowhere.
This occurred even though there were business supporters of the proposal. A lot of major financiers and businessmen were very much in favor of some kind of federal incorporation law, because they didn't want to deal with all the different laws of the different states. But for a variety of reasons — not the least of which was a fear of Roosevelt's power grab and the role of the Southern Democratic bloc, which was very much in favor of regulation but very frightened of any diminution of states' rights — it didn't go anywhere.
Over the course of the next decade there were other bills presented, but none of them even got to a vote. Gradually the idea began to die away.
MM: One of the themes of The Speculation Economy is that while some modest antitrust laws — the Clayton Act and the FTC Act — are enacted, the focus on antitrust diminishes and the frame changes to investor protection.
Mitchell: This is probably the most important part of the story. Until this merger movement at the turn of the century, most Americans don't buy stock. But there's this incredible prosperity as we come out of the depression of 1893 and the merger wave starts. A very significant bubble in the stock market ensues. The press is full of people getting rich. Still, the general understanding was if you were an ordinary person and wanted to invest, you bought bonds, not stock. Stock was considered to be purely speculative. People didn't buy it.
But over the course of the decade, people start putting their feet in. There are panics in 1901 and 1903, but that doesn't dissuade people.
Over time, there begins to be a shift from thinking about stock as purely speculative to some stock being seen as investment worthy. You see this in the newspapers, especially in investment advice columns and the like. Regular, dividend-paying stock, with a corporation that has real solid assets behind it, begins to become acceptable. Then the Panic of 1907 hits.
The Panic of 1907 was largely a banking panic, although there was a stock market crash too. Part of the reason for the banking panic is that a lot of trust companies speculated in a lot of stock. What the episode showed was that the stock market, which has just mushroomed in a very short period of time, was potentially destabilizing the entire American financial system.
After 1907, for reasons that I explain at some length in The Speculation Economy and for some reasons I can't explain at all, ordinary investors start really buying up stock in relatively big amounts. The number of common stock holders rises dramatically. By 1911 or 1912, the number of small investors in the market is really remarkable.
Then WWI happens. Once the United States gets into the war, you have the Liberty Bond drives. This was a massive attempt by the federal government, using the brokerage industry, which had grown up during this period of time when middle class Americans were buying stock, to peddle federal bonds to finance the war. All of a sudden, there were 25 million new investors. The government used prominent citizens to claim it was unpatriotic not to buy bonds. Brokers were selling bonds in an installment plan and in portions, so that almost everybody could own a piece of a Liberty Bond.
The brokers knew what was going on. They realized they were building client lists. Once the war ended, the brokers urged bond holders to cash in their low-return Liberty Bonds and then buy stock. The economy slumps for a year after the war, but everybody is ready now to make the 1920s market. And this is where the stock market transforms into the modern market.
MM: There's an interesting seeming paradox in the period of the focus of the book. The cultural understanding about what is speculation changes and investing becomes viewed as much safer and not speculative. Yet you've titled the book The Speculation Economy.
Mitchell: The answer is that speculation becomes investing. And so speculation and investing merge into one. I titled the book The Speculation Economy precisely because while common stock comes to be seen as a legitimate form of investment, the common stock itself is no less speculative.
When you move from bonds to stock, you move from virtually no upside to unlimited upside, and that's true whether you call stocks speculative or investment. A shareholder can make as much as a corporation earns. The overwhelming majority of stock in the United States was dividend paying until the 1980s but, for the first time in the 1920s, price appreciation becomes an important consideration and an important concern for American stockholders.
That creates an atmosphere in which you pay less attention to whether the corporation can produce a dividend, and start caring more about whether the stock price will go up. Once this switch in emphasis occurs, at some point stockholders start to care a lot less about fundamentals. They forget that high stock prices have to be supported by corporate profits.
What happens in the 1920s is people ignore fundamentals completely. They'll buy stock based on the name of a company. If it has "radio" in it, if it has "aeronautical" in it, they just assume that the stock is going to go up in price and they can sell it to anyone they want to. There's an interesting parallel in both the end of the 20th century and in the late 1920s — people talked about them as being economic "new eras." The fundamentals didn't matter, the rules of economics had changed, you didn't have to worry about hard value, even though 20 years earlier it was all about hard value, you only had to worry about what the stock was going to be worth tomorrow. And that, as you can readily see, becomes speculation.
If people continued to invest in bonds, that wouldn't have happened because there is no upside to bonds. But once you're investing in stock, all bets are off, everything changes, and that's why I call it The Speculation Economy. An economy that is grounded in a basically unrestrained, widespread common stock market, is an economy that is intrinsically speculative. And that affects the way business managers think about how they run their businesses.
In this type of economy, where the sky is the limit, managers are pushed to produce for the stock market. They're not pushed to produce for consumers, they're not pushed to produce for the long term, they're not pushed to produce for sustainability, they're not pushed to care about their workers very much, they are pushed to get the stock price up.
MM: Which suggests that everything now about trying to align managerial interests with shareholder interests may not actually be in the public interest.
Mitchell: That's a disaster! The alignment of managerial incentives with shareholder incentives was not a good idea, at least not the way it's structured. I can think of ways where you could structure it so it wouldn't be damaging, but certainly, the dumping of unrestricted stock options on CEOs and senior executives, this growth of institutional investor activism and hedge fund activism, has been a disaster. People are moaning now, but they haven't seen the worst of it if this continues. What we've just seen is only a prelude. The 2000-2001 crash was a prelude as well. What I'm talking about is building an economy on clouds.
In 2006, 32 percent of American GNP came from finance. Twenty percent came from manufacturing. Those are extraordinary figures. What does that say about the future?
If you look at the balance of the economy between production and finance, you see that it's overwhelmingly dominated by finance. What is finance?
I think what is happening in the American economy, in this speculation economy, is that finance, and particularly finance driven by creation of financial derivatives, has had nothing to do with financing corporate production. Finance and especially the hedge funds are becoming completely removed from production and are engaged in this almost circular financial game where they are moving money around from one pocket to the other, but it's got very little to do with increasing or stimulating production in any way, or producing anything meaningful, A significant question, it seems to me, is to how sustainable that is.
MM: You end The Speculation Economy by saying the speculation economy is ours, it's what we make of it. That is to suggest there are ways to control or redirect it?
Mitchell: In the foreseeable future, I don't think we can change what our economy is about. You couldn't do it politically, there's far too much profit coming out of what we have now. But it can be controlled, by changing the incentives of the investor.
I've recommended a Tobin tax on stock profits, with a punitive tax for short-term trading, with a sliding scale of reduced capital gains taxes over what we would define as a long term per industry, with ultimate tax forgiveness if you hold for the long term. That tax structure would build the incentive for concern about long-term business health into the investment decision itself. If you did that, and that alone, it seems to me that you could harness this speculation economy and turn it more into an investment economy.
© Multinational Monitor May/June 2007