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 (see here) because corporate assets are locked in and controlled by an independent board. This institutional arrangement, which cannot be achieved by contract alone, mitigates collective action and commitment problems and helps foster surplus-enhancing specific investments (see here).

In a recent paper I show that an early statement of these ideas appears in an important but widely overlooked book by Ernst Freund, The Legal Nature of Corporations, published in 1897. Some historians of American corporate law (eg here, here) have characterized Freund’s book as a brilliant exposition of the theoretical underpinnings of corporation law that was well ahead of its time. Yet to date references to it remain rare, and a systematic assessment of its contributions remains unavailable.

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 on case law and past authorities, Freund engaged in the ‘rational study of corporate law’ (to paraphrase Oliver Wendell Holmes), 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.

General incorporation laws 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), 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 business associates would choose the corporate form over the partnership and ignored the fact that law treated corporations as holders of rights and duties that were 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. He believed that insights into the legal nature and desirability of the corporation could be found 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 where control was jointly exercised and concurrent action necessary, but even when neither was required because representatives had been nominated and a majority decision rule adopted, the problem of internal defection remained. To eliminate 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 was why the corporate form was chosen 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 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 to be enforced in court and remained true where courts deemed corporate defendants liable for torts, nuisances and non-compliance with regulation.  

While Freund’s analysis was rudimentary by today’s standards, it seems he had an intuitive understanding of comparative institutional analysis, which enabled him to anticipate the thrust of today’s scholarship on corporations. Partly because Freund’s analytical approach departed from the scholarly habits of his fellow academic lawyers, and partly because Freund himself never revisited 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.

This post was originally published on the Journal of Institutional Economics Blog and on the Columbia Law School Blue Sky Blog.

David Gindis is a senior lecturer in economics at the Hertfordshire Business School, University of Hertfordshire.