As lawmakers and regulators continue to tinker with the Sarbanes-Oxley Act for U.S. public companies, they could do worse than look to the 14th century, when the budding capitalists of Southern France developed corporate governance institutions for the ages.As detailed in a treatise published some 50 years ago, the well-heeled citizens of Toulouse invented a way to pool their capital, spread their risks and provide a healthy return on their investment. In the process, they created the first public companies, along with pragmatic yet ingenious mechanisms for controlling the greedy impulses of shareholders, employees, suppliers and customers, while keeping the government at bay and enduring for some 600 years.
Beginning in the late 13th century, a group of investors embarked on a quest to ensure a steady and reliable power supply for their growing economy from the mills that harnessed the swift-moving Garonne River to grind wheat into flour, forge iron, and saw timber. At first, they devised a structure for investors to own specific assets, such as land or the grinding stone. But this proved unworkable when owners wanted to dispose of their interests and as costs mounted for maintenance of the physical plant.
During the 14th century, they turned to a form of joint ownership, the societas, which dated back to when the Romans ruled Gaul. Through an audacious leap of faith, they transformed the joint ownership concept into a legal person separate from its owners — a company in the modern sense — having limited liability and whose ownership interests were divided into shares freely transferable on a public market.
Their accomplishments are remarkable when we consider the conditions in a region ravaged by flare-ups of plague and the last vestiges of the Albigensian Crusade, not to mention the periodic famines created by inadequate harvests in an era of global cooling. At the same time, the region’s nobles were preoccupied with maintaining a reliable food supply dependent on wheat ground at the mills, and making sure that the bridges and other improvements erected by the mills could withstand attacks by England’s Black Prince during the Hundred Years War.
Throughout the 14th century, two central themes emerged — the supremacy of shareholders acting through their board of directors, and their commitment to transparency in corporate governance supported by strong internal controls.
Early on, the shareholders had to confront the fact that none of them were inclined to be involved in the messy day-to-day operation of the mills. They needed a way to delegate authority without losing control. Their solution was to elect from among their ranks an eight-member board to hire professional managers having the technical knowledge to keep the mills running while supervising the employees and serving customers. To prevent board members from getting the upper hand and eclipsing the ultimate authority of all the shareholders, they were elected two at a time to two-year terms with term limits. Mill managers were granted one-year contracts, and their performance was reviewed at the annual general meeting of shareholders. They were personally liable for any shortfalls in the accounts, while their reward for a job well done was another one-year contract.
From the earliest records, it is evident that the shareholders recognized the threats to their investment posed by the potential for conflicts of interest. They instituted rules prohibiting employees and their families from dealing in grain or from buying shares in the company. Neither shareholders nor their families could be employees. All transactions were recorded meticulously using a precursor of the double-entry system of bookkeeping. To police expenditures, the person recording an expense on the general ledger could not be the one who authorized it. Demands by employees for profit-sharing were quashed. Shareholders and employees were forbidden to lend money to the corporation, and vice-versa.
One of the biggest challenges was maintaining cash flow. Instead of collecting cash from the farmers who brought their grain to be ground into flour, the mills’ revenue was earned in kind: a one-seventh share of the grain processed. These caches were stored at the mill and distributed several times a month as dividends-in-kind to the shareholders, but not before the natural drying process, along with rats and insects, ate into their profits. The board had to balance the shareholders’ short-term interest in maximizing dividends and boosting the share price against the long-term prospects of the company, dependent on plowing profits back into maintenance and improvements, so that the mills could run more efficiently and avoid costly breakdowns.
It was concern over reliability in determining dividends from the stockpiles of wheat that gave rise to the role of independent auditors. Hired by and reporting directly to the shareholders, they reviewed the accounts, tracked inventory, and for the first time linked the ledgers recording income and expenses. As a result, the shareholders knew what profits to expect and this had a direct impact on the market value of their shares.
This emphasis on cash flow encouraged expansion into ancillary ventures, while offering a practical way to stave off confiscation by the government as the company’s value and importance to the local economy grew. One of the mills’ most lucrative sidelines and sources of cash was fishing rights to the areas around the intake chutes that attracted fish and made them easier to catch. The shareholders gave their overlords a piece of the action in the form of a one-half interest in the cash royalties paid by fishermen. In return, the government eschewed interference, but kept a watchful eye on anti-competitive behavior. For example, it intervened when one mill company sought to merge with its only remaining competitor, sensing that a monopoly would lead to a spike in the price of bread and the likelihood of a rebellious peasantry.
This did not prevent investors from manipulating the legal system for competitive advantage. When an upstream mill company diverted the river’s flow under the guise of maintenance, and decreased water pressure to the point that its downstream competitor could no longer drive its millstone, the downstream company sued. Although it was successful in its suit, the upstream defendant appealed to the government in far-away Paris and dragged out the case for close to 50 years, so the plaintiff was forced out of business and its assets were acquired at pennies on the dollar.
It is easy to dismiss as simplistic the accomplishments of these 14th century pioneers, when today’s companies have millions of shareholders instead of 80 and operate around the globe, rather than in one river valley. But if the institutions founded in the 14th century had been in place during the last decade, it’s tempting to speculate that the transgressions sparking the Sarbanes-Oxley legislation might not have occurred. For example, boards could not have waived conflict-of-interest rules for management to participate in investments with their companies. Auditors could not have become co-venturers with clients, opining on transactions that they concocted. Dealmakers could not have relied on complexity to obfuscate a transaction’s lack of economic substance. Chief executives could not have received huge loans from their companies or bought large blocks of stock on margin. Chief financial officers could not have made adjustments to the books without the auditors blowing the whistle. Boards would not have backed celebrity CEOs with bulging pay packets and $6,000 shower curtains.
Before earnings forecasts, stock options, EBITDA and paper shredders, with nary an MBA in sight, medieval Frenchmen, using common sense and an innate understanding of human nature, embraced self-regulation and transparency to earn the confidence of the investing public. The mechanisms they created stayed in use, virtually unchanged, until the French Revolution, while their companies built the generators powering the industrial revolution.
They would all be with us today had they not encountered an immovable force in the aftermath of World War II — the French government’s nationalization of the electrical grid and the creation of the monopoly known as Eléctricité de France.
Meril Markley is a principal with UHY Advisors.
