Comm101 Principles of Responsible Commerce Topic: The Historical Development of Modern Business Enterprises

Objectives for this lecture
• Consider a brief historical account of the development of modern national and multinational business organisations. • Consider, in particular, the benefits and costs of two major characteristics of such organisations: increased size and separation of ownership and control. • Discuss some of the processes by which firms have tried to reduce the incidence of opportunistic behaviour by management. • Briefly consider a recent Australian example of a significant business management failure.
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Why is knowledge of historical developments important?
• Understanding historical developments helps us to: • Apply lessons from the past: are there commonalities between past and the present? • Understand the importance of path dependency, i.e. that some past decisions have had long term ramifications (e.g. convict settlement of Australia), and so current period decisions may also affect future generations (e.g. CO2 emissions). • Appreciate the inevitability of continual economic and social evolution, but understanding that we have some influence on how and when such changes should occur. • So a sound understanding of history brings empowerment to 3 the debate about current business practices.

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Important historical developments
• Pre about 1850, in industrialising UK, the typical business firm was: • Small scale, mostly catering to local demand. • Concerned with a single function or product, e.g. blacksmith, baker, butcher. • Established at a single geographic site only. • Of uncertain legal status, e.g. it was unclear whether a business could be prosecuted/sued, rather than the owners. • Owner(s) managed, perhaps part family run. Hence no real bureaucracy. • There were a few exceptions.
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Exceptions…
• A few government owned enterprises e.g. UK military shipyards and arsenals. • The odd large non government firm granted monopoly trading rights over a part of the British Empire. • For example, the English East India Company. • These were essentially an extension of British imperialism. • Additionally there were transient opportunities for rapid expansion for some private sector businesses, e.g. suppliers to UK military in war times. • But these were very much exceptions. The vast majority of trading volumes were by small businesses.
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• Main driver? New transportation technologies. • 1. Railways: this entailed major construction of rolling stock and the infrastructure, requiring large land acquisitions. • By 1850, 19 British railway operators had each raised > $15m in financial capital, at a time when virtually all firms were $2m or less in capitalisation. • By 1904, top ten British firms were all railways owners/operators. • US railway forms were even larger due to the greater distances. • Example: Pennsylvania railway employed > 100,000 by 1890’s. • By 1896 in Japan, 8 of top 12 firms were railways. • In Australia, railways were publicly (govt) owned and dwarfed 6 private firms.

First phase of development of modern corporations.

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First phase continued…
• 2. Shipping (steam). • Similarly capital intensive and so also resulted in the development of very large firms. • NYK, Japan’s second largest firm. • British giants were P&O and Cunnard. • Australia: Adsteam and Huddart Parker. • 3. Automobiles (by early 20th century). • By 1937, GM is the world’s largest manufacturing firm. • This initial phase of development in railway, shipping and automobile transportation stimulated further related industrial expansions. • Large scale suppliers of minerals/metals, petroleum oil and 7 engineering products and services, etc.

Second phase…
• Early/mid part of 20th century, due to changing demographics and ongoing scientific discoveries. • Populations expanded rapidly due to increased birth survival rates, improving nutrition, increasing life expectancies. • Populations becoming increasingly urbanised: ready workforce for industrial complexes. • Universal educational attainments increased which produced increased skills and disposable incomes. • Households became increasingly wealthy. • Subsequent increase in demand for ‘consumerism’.

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Second phase continued…
• 1. Consumer products and durables: housing, food, drink, tobacco, clothing, automobiles (again), etc. • 2. Consumer services: utilities: gas, electricity, water, post, • telecommunications (widespread installation of landlines). • 3. Finance/banking services: branch retail banks and investment banks begin to expand rapidly. • Each of these expansions in demand for new products and services by increasingly affluent societies generated forces that resulted in much larger national and, eventually, multinational corporations. • Firms grew in SCALE but also in BREADTH and COMPLEXITY.
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Increased scale, breadth and complexity of modern businesses

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These changes required more complex forms of ‘control’.
• Note the internal developments: legal incorporation and organisational/bureaucratic structures for reporting and control. • These two developments have been both a blessing and a curse. • 1. Separation of Ownership and Control: the Problem of Agency. • In earlier period, legal status not important. • Small firm with single proprietor means that owner/manager could be sued easily enough to settle personal debt. • As firms expanded during later half of 19th century, with multiple partners/owners, this became increasingly costly and time consuming. • This unclear legal status of firm also constrained further 11 expansion.

psitive firms can become more efficient negative: opportunity for mis managment

Problem of Agency
• Owners carried unlimited personal liability for debts incurred whilst trading: these could be enormous. • Separation of ownership from control/management unlikely: few investors would risk their entire personal wealth by trusting others who did not share their liability. • This severely restricted opportunity to raise funds from investors and hence expansion options. • By contrast, a separate and legal corporate identity for the firm: • Gives firms the ability to pursue debtors, • Gives individual investors limited liability (liability limited to actual shareholding, not other personal wealth), • Allows public trading of shares in the firm.
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Problem of Agency
• Perhaps not surprisingly, banks and other investors were initially sceptical about ‘limited liability’. • Would this promote lack of responsibility for management actions? • Would this encourage misinformation? • These concerns were compounded by the lack, until the mid 20th century, of public reporting and accountability standards. • These legitimate concerns highlight the dichotomy of imperatives in a ‘limited liability’ world (still relevant today). • Economic imperative: the need to attract greater investment for expansion. • Moral imperative: the importance of holding owners and/or managers fully responsible for their actions. 13

Problem of Agency
• Not surprisingly, the economic imperative wins out!! • By late 19th century, stock markets become more dominant source of fund raising. • Initial scepticism wanes or is ‘buried’ beneath tide of optimism. • Interestingly, some companies prefer to retain sensitive commercial information and so owners do not publicly trade their shares: private companies. • Stock markets themselves become potential source of agency problem. • Company promoters, investment advisors etc. have potentially valuable role on bridging informational asymmetries between firm and investors. • But some opportunistically exploit such asymmetries for 14 personal gain.

Examples of Agency Problem 1
• Ernest Hooley, British company promoter in 1890’s. • Strategy? Recruited titled figures (e.g. Lords, Barons etc.) for reputational effect. • Enlisted journalists to write favourable articles about his enterprises. • Enhanced personal reputation via charity work and social connections. • Bankrupted four times during his lifetime. • Described as a serial fraudster.

enlisted: paid

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Examples of Agency Problem 2
• Charles Ponzi, 1920’s US. • Originator of Ponzi style pyramid schemes. • Promised high returns for existing investors, but paid for by contributions of new investors. • Claimed large commissions for himself. • In good times, reputational effect increased demand. • But in downturns, when new investors dry up, the scheme collapses.

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Examples of Agency Problem 3
• Bernie Madoff: ponzi scheme that unravelled in 2008 USA. • Defrauded investors of $50b. • Largest financial fraud in US history. • He employed his brother, granddaughter and two sons. Sons informed authorities. • He was sentenced to 150 years, his brother to 10 years. • One of his sons eventually suicided.

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2.Organisational structure and Agency problem.
• Individual owners or managers can not effectively control large complex organisation. • So development of large corporations has increased demand for specialist managers, e.g. finance, marketing, personnel. • US business schools begin training specialist managers in late 19th century. • Result? Widespread emergence of professional executive (non owner) managers and a market for the recruitment of these skills. • Large companies restructure so that responsibilities are shared via established lines of reporting. • For example, see next slide. • This structure identifies information flows and areas of 18 individual authority and responsibility within the organisation.

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Organisational structure: one example

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Organisation structure and Principal Agent problem
• We now have another potential conflict between economic and moral imperative. • How to motivate professional managers (agents) to pursue best interests of the shareholder owners (principals) rather than own interests. • How to prevent laziness, fraud, career building at expense of shareholders. • Internal control measures. • 1. Intense use of information systems to monitor managers: resentment? • 2. Designing incentive structures (salary + share holdings) so that opportunity cost of under performance is large. So firms 20 pay managers more than they really need to . But this is costly.

Internal control measures continued…
• 3. Build and maintain a positive corporate culture e.g. Google, but this may be difficult if workforce is dispersed. • 4. Selection of managers based on membership of network, kinship, religion, social standing, etc. ‘Insiders’ only. Historically important but limits access to new talent/ideas/visions. • External control measures. • 1. Formal reporting requirements e.g. annual statements, but these can be difficult to decipher and/or fraudulent. • 2. Independent board for oversight and scrutiny, but is this group really independent, or just members of the ‘club’? • 3. Critical independent press. This is crucial but unfortunately it has been argued that www and concentration of power (News 21 Corp) is diminishing investigative capacity of press.

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External control measures continued…
• 4. Takeover market in public corporations: poor/fraudulent management will tend to decrease share valuation and hence make firm more likely target of hostile takeover. • 5. Public regulators charged with monitoring performance of (especially) large corporations. For example, ACCC, ASIC. But can these effectively ‘compete’ with powerful private sector players? • 6. Industry associations: self regulation, moral oversight, etc. • Unfortunately there is no panacea. It is a constant battle where vigilance is necessary and morality is sometimes lacking. • So in this sense nothing has changed in last 200 years. • Human nature is unchanged: is greed even more widespread? • New methods have provided added control, but complexity has 22 also increased greatly.

• Short run performance, which can be boosted by acquisitions, job shedding etc., is seen as more important than long run performance: Qantas? • Regulators may be too slow to react, may lack the information or resources to prevent bad behaviour, and in some cases have been corrupted by private sector players under scrutiny. • Corporate auditors have been especially discredited. • Modern economies seem to be subject to cyclic behaviour: in boom times the economic imperative becomes even stronger. • Booms sometimes produce asset price ‘bubbles’ via dubious business practices. Latest example? Lending practices leading up to GFC. • Individuals who promote caution at these times are seen as ‘getting in the way’ of economic growth and development. 23

Has anything really changed?

Australian example of corporate failure.
• Alan Bond started as sign writer. • Property transactions in WA made him millions. • Businessman of year 1978. • Team Captain, successful America’s Cup challenge, 1983. • Order of Australia 1984. • Australian of year 1987. But… • Bankrupt 1992. • Gaoled 1993 for deception & fraud.
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Bond Corporation
• • • • • • • century accounting and reporting standards failed to protect investors and creditors. Complicated conglomeration of acquired companies often based on inflated valuations. Cultivated close personal relationship with key banking figures who failed to maintain prudential standards. Complexity was beyond comprehension of regulators, lenders. Regarded partly owned companies as his own property and stripped significant assets as ‘management fees’. Much of his business empire was very heavily geared, i.e. high level of debt to assets. When Bond Corp. tried hostile takeover of Lonrho Group, the ensuing battle made public the real status of Bond Corp. 25 20th

A lack of personal morality and ethics?
• A justice examining large Australian company collapses remarked:

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Future?
• After 200 years of corporate and monitoring /reporting developments, opportunistic behaviour persists. • But remember, so too do those who want to believe that there exists a ‘free lunch’. Is this an innate part of being human? • Arguably, most societies are more materially orientated today than in the past. Obsession with fame and fortune? • People, organisations and governments forget quickly and don’t easily learn lessons from history. • Nevertheless we must continue to reflect on our behaviour. • Hence subjects such as this are an important part of process of examining and promoting moral and ethical principles in business. • Some of you will be business leaders of tomorrow. END. 27

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