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The Social Contract Is ThreatenedIn 1622, the Pilgrims established the Plymouth Colony as the first settlement in the new world. …

The Social Contract Is Threatened

In 1622, the Pilgrims established the Plymouth Colony as the first settlement in the new world. Its foundation was the social contract, one in which the colonists agreed to form a “Civil Body Politick” to create fair and equitable laws serving the best interests of all the colony’s members.

Much like that Mayflower Compact, the social contract concept of the latter-day corporation has been shaping our country’s economic, social and political fabric. It has helped make America the richest, most successful, most prosperous nation in the world. Today that social contract is under attack. For many companies, workers, and communities, it has already been broken. For many more, it could give way at any moment.

This fear was not allayed by two recent items in the Wall Street Journal that had opposing views on the topic of takeovers and which appeared on the same day.

One item was an essay by Harold Simmons, entitled “Shareholders Don’t Need Protection,” wherein he argued that neither corporate managers nor state governments nor the Federal government should be allowed to interfere in any way with the free-market transfer of stock ownership and, by extension, with the ability of people like himself to engage in hostile corporate takeovers.

The other item-“Japan’s Use Of Hostile Takeovers Abroad Isn’t Likely To Extend To (The) Domestic (Japanese) Scene,” written by Tokyo-based Journal reporters Karl Schoenberger and Christopher Chipello-says that in Japan, hostile takeovers are practically unknown. “A big damper on such activity,” they reported, “is the reluctance to abandon traditional social contracts. A company is held in trust, to be passed on to the next generation, not sold for profit. Corporate takeovers are loathed-and widely described with the same word used for hijacking: Nottori.”

Two articles, same newspaper, same day. A coincidence, I’m sure, yet they could not have more sharply defined the polarities of the takeover debate-and of the larger debate concerning the corporation’s role in society-had their concurrent appearance been deliberate.


Why do you think corporations exist? Is it to create jobs for workers? To create profitable products and services? Or to create wealth for shareholders? I have, over the last few years, asked my businesss friends and have found that about one-third subscribe to the first theory, while about two-thirds chose the third reason. A “mother-in-law” survey, to be sure, but probably representative of current business views.

Well, I agree that a corporation does create gainful employment for hundreds, thousands, even tens of thousands of workers, which is obviously a good thing for the workers employed and their communities. This is the view of a growing number of states with their new anti-takeover statutes. More about this later.

Companies are also around to produce wealth for shareholders in the form of earnings paid out in dividends and rising stock prices. This is what I will call the “Wall Street view.” More about this later, too.

To me, the best answer to the question is primarily-not solely, but primarily-to create profitable products and services.

As for job creation with profitable products and services, I agree with Sir Adrian Cadbury, who said in The Harvard Business Review: “If you believe, as I do, that the primary purpose of a company is to satisfy the needs of its customers and to do so profitably, the creation of jobs cannot be the company’s goal as well.”

In the 16th and 17th centuries, merchants and their rulers had problems in the trading centers of Italy, England, Holland and elsewhere in Europe: They wanted to participate in the expansion of international commerce that the development of new products, markets, and large sea-going vessels had made possible; they also wanted to trade the goods of local manufacturers, farmers and artisans for other goods not available except from abroad; and the governments of those trading centers wanted to reap the many public benefits that foreign trade could deliver-increases in per capita income, tax revenues, loans, living standards, municipal and national wealth and power.

But the merchants who could, in theory, bring all this about were often unable or unwilling to assume the risk of purchasing ships and entire shiploads of goods at personal expense, or to borrow the necessary funds using personal assets as collateral. Suppose the ship sank in a storm while crossing the Mediterranean or the Atlantic? Suppose it went down with a cargo of goods or gold? Those catastrophes took place with alarming frequency. Even the prospect of huge profits from a successful voyage could not always overcome the fear of financial ruin from a voyage that ended in disaster.


To encourage the international trade generally recognized as a public good, municipal and national governments began to charter legal entities known in Italy as Compere and in England as joint stock companies. These entities were the forerunners of modern-day corporations. They could enter contracts and conduct business like anybody, but they offered one unique advantage: limited liability.

The liability of owners of companies was limited to the assets of the corporation itself In the event of disaster, creditors could seize only the corporation’s assets, not the assets of the investors. Thus, an investor in a joint stock company might lose his entire stake in the company if the corporate ship went down, but not necessarily his entire fortune. This concept of limited liability encouraged investment. Making international trade economically feasible, and providing the finished goods and raw materials that growth and prosperity required, was good for society.

And so began the centuries-old traditions in which the corporation, the state, private investors and other private citizens joined in a social contract for the mutual benefit of all concerned. Governments created, or gave, concessions to both quasi-governmental and private bodies for the social and economic ends desired.

It is, as we’ve seen, a social contract whose terms are honored and obeyed in modern-day Japan, but one that is increasingly being bent, breached and even broken in the United States, to the detriment of our national competitiveness, our ability to create and keep jobs for American workers and, ultimately, our high standard of living.

This social contract is being damaged by a new form of monopoly power-held by the managers of pension funds, mutual funds and other institutional holders-which today are approaching ownership of almost 50 percent of the common equity of U.S. stock companies. By law, most institutional fund managers must-as a fiduciary responsibility-chase increases in common stock price, however driven. Today, announced takeovers, rumors of companies in play, LBOs or what have you, drive stock prices upward-which force fund managers to sell.

Institutionalism of the stock market on Wall Street, accompanied with an insistence on short-term stock price performance, can have a chilling effect on capital spending and research and development at many companies. Many corporate managers are asking themselves: Why should I maintain high levels of capital investment on plants and equipment and particularly on R&D-and even increase those levels-if by so doing I’m putting my company’s independence on the line? Divestiture or restructuring is more often the road taken. Some of it is necessary, but a lot of it is harmful.


The first studies of the effect of takeovers on R&D are now in. A National Science Foundation (NSF) report shows that R&D has suffered in those companies which have merged or have been restructured. In manufacturing, company after company has seen market share drop. Reduction of R&D can only accelerate this trend.

Fearing corporate raiders, some U.S. companies are hoping to drive them off by loading up their balance sheets with debt. In 1986 alone, $263 billion of new debt was added to corporate balance sheets. Much of this debt is non-productive, used only to finance corporate takeovers or to prevent them from taking place through removal of equity. Debt incurred for these purposes does not increase corporate effectiveness, and may actually hurt it by limiting opportunities to modernize plant and equipment, increase production capacity, develop new products and services, or exploit new market opportunities.

Moreover, in the event of a recession-which has to come sooner or later-the impact of this debt on heavily leveraged corporations could be catastrophic.

The U.S. economy is losing thousands of manufacturing jobs. According to the U.S. Labor Department, roughly 2.2 million American workers a year lost jobs through plant closings from 1981 to 1986; most of those jobs were in manufacturing. Since 1986, job creation has been in the services sector of the U.S. economy. A forthcoming General Accounting Office study says 427,000 manufacturing workers were laid off as a direct result of foreign competition in 1983 and 1984 alone.

Seeing all this and the social contract threatened, governments at the local and state levels are beginning to fight back. It’s no coincidence that states are fighting back more than the Federal government because the states are closer to the empty plants or the threat of empty plants.

According to the GAO study, one out of every three workers displaced in 1983 and 1984 from firms with 100 or more employees received no notice of the impending shutdown. Less than 20 percent of large employers give workers more than one month’s notice of a plant closing, with a median notification of only seven days.

Anti-takeover laws and plant-closure laws are what I would call regrettable necessities. It would be far better if the social contract were to be restored to the point where companies did not have to take extraordinary measures to defend themselves against corporate raiders, and government did not need to step in and thwart a practice that is so clearly detrimental to society.

It would be better if, instead of plant-closure notification laws, U.S. competitiveness were restored to the point where national and legislative attention were focused not on how to shut plants down but on how to open more of them up.

It would also be better if the Federal government, recognizing its obligation under the social contract and to create an environment conducive to national competitiveness, focused on how to stop the erosion of the contracts while not unduly interfering with the free flow of constructive capital.


We have dealt with society-threatening monopoly power in this context before. At the turn of the century, monopolies or so-called “trusts” were growing rapidly in large industrial sectors such as steel and oil; congressional reaction led to passage early in the century of the first of our antitrust or anti-monopoly laws, including the Sherman and Clayton acts. They worked.

The time is fast approaching when similar action should be taken regarding our latest form of monopoly on Wall Street. Our country, through its Constitution, has a carefully crafted system of checks and balances. We will have to act again to correct this newest form of imbalance. The old democratic capitalism-with its assumptions of an infinite number of stockholders with an infinite number of buying and selling transactions-is no longer valid.

We need to restore in this country the vital and mutually beneficial relationship that for centuries linked corporations, shareholders, government and the general public in a social contract for the common good. We need to restore it soon.

If we don’t-and fast-the next few years won’t be good ones for America‘s corporations, or for America. And the national leaders we have just elected will have a much tougher job getting Americans ready to meet the challenges of the next decade, let alone the next century.

A retired chairman and chief executive of Bell & Howell, Frey was a professor of engineering at the University of Michigan. He currently teaches industrial engineering and management science at Northwestern University.

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