Saturday, April 28, 2012

"And for other purposes" - the Four Words that Created Modern Investing


I'm reading Finance and the Good Society by Robert J. Shiller who came to Google earlier this month. Here's a fascinating story from the book about how our contemporary model of investing in companies came about:
"Investment banking received further impetus […] in 1811 with the passage of a corporate law in New York State that made it clear that anyone who satisfied minimal requirements could set up a corporation, without special action by the government, and that clearly established limited liability for corporations. […] By clarifying that shareholders would never be held liable for the debts of the corporation, the law made it possible for the first time for an investor to hold a diversified portfolio, consisting of stocks in many companies."
Prior to this law, investing in a company was far more risky: in case a company went bankrupt, investors could be held liable beyond their investment.
"The framers of the New York law probably did not see themselves as the inventors of a brand new kind of market. Instead they thought of themselves as merely responding in an imaginative manner to an economic crisis. The US Congress had imposed an embargo on trade with Britain starting in 1807, citing grievances related to British behavior toward the United States as Britain fought a war with France. By 1811 the extended trade embargo was causing massive economic pain at home, for America had been an exporter of cotton and other fibers to British textile mills. There was a need to finance US textile mills, but few wanted to start a local mill, thinking it would be hard to compete with Britain when the embargo was lifted. The provisions of the bill were thought of merely as expedients to deal with this crisis. The bill followed a 1784 measure granting automatic incorporation to religious congregations, and similar measures for colleges and academies in 1781, municipalities in 1788, libraries in 1792, medical societies in 1806, and turnpikes in 1807. Yet only by 1811 did general business have the status within New York society to win the same right. Equally important, the bill clarified that stockholders in these new corporations had limited liability: They could not lose more than the money they had put in in purchasing their shares.
The full name of the act was 'A Bill to Encourage the Manufacture of Woolen Cloth, also Cotton, Hemp and Flax, and for other Purposes.' As it turned out, it was the 'other purposes' that would have lasting importance. Once again, dealing with a short-term crisis led to a financial innovation that would change the world, for the New York law became a model for new corporate law all over the world."

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