Eighty pragmatic French shareholders in the
14th century laid the foundations of modern corporate governance while ensuring
their companies’ survival for some 600 years.
Their accomplishments resonate today as corporations develop and
implement their own approaches to corporate governance and as the reasons
behind recent corporate failures are examined.
entrepreneurial spirit, a group of well-heeled citizens of Toulouse crafted a
way to pool their capital, spread their risks and provide a healthy return on
their investment. In the process they
created a system of corporate governance, risk and compliance focused on
mastering the fundamentals. A treatise
published some fifty years ago, based on the original medieval records,
chronicles how they did it – a process of trial and error coupled with an
ingenious system for controlling greedy instincts. What follows are some of the challenges they
faced and how they overcame them, along with what abruptly ended their 600
year-old enterprise in the middle of the 20th century.
For the operators
of water-powered mills in the Middle Ages along the Garonne River, risk was
writ large – England’s marauding Black Prince destroying infrastructure and
crops, recurring bouts of the Black Death decimating the work force and
customer base, iffy harvests and frequent famines making earnings forecasts
difficult, a physical plant prone to breakdown and in constant need of costly
maintenance, cash flow drying up when droughts slowed the river’s flow, and
weak regulation by a central government in far-off Paris – all at a time when a
mill was essential to daily life and to the local economy.
Not only did the
mills provide power to grind wheat into flour for making bread but also to saw
timber into boards for construction and to power machines to do what would
otherwise be back-breaking work in a world knowing little innovation since
Roman times. Mill companies were
essential to the infrastructure and commerce of the region, building dams to
increase the speed of the water driving the waterwheel and erecting bridges
atop the dams, making it easier to get people and goods to the other side of
the river. Uniting self-interest and
social responsibility, nascent capitalists banded together to form companies
and undertake what no one could accomplish alone, while earning an enviable
return on their investment of up to 25% per year.
As early venture
capitalists, the owners of the mill companies were the movers and shakers of
Toulouse society, both landed gentry and wealthy merchants. They were not looking to give up their
day-jobs of overseeing vast property holdings, operating banks or weaving
cloth, to run a mill. Rather, they were
seeking further enrichment by pooling capital and limiting risk while sharing
in the profits without day-to-day responsibility for running the business.
In evolving the
first governance model, the owners of the mill companies were pre-occupied with
the same fundamentals today’s investors would recognize. They appreciated that success depended on
wielding their power as owners while confronting and balancing the selfish
inclinations of shareholders, employees, suppliers and customers. They attacked this challenge head-on by
eliminating what they viewed as one of the biggest risks to their investment –
the potential for conflicts of interest born of natural yet greedy
impulses. Controls and procedures to
keep conflicts at bay, supported by transparency in all aspects of operations
and record-keeping, yielded confidence in the companies and steady growth over
Beginning in the
late 13th century, budding capitalists hit upon joint ownership as a way to
pool capital and spread risk, but each investor owned a specific mill asset
such as land or the grinding stone. This
proved unworkable when owners wanted to dispose of their interests and as costs
mounted for maintenance and improvements.
During the 14th
century, another attempt was made, this time using the “societas,” a joint
ownership arrangement dating back to when the Romans ruled Gaul. Through an audacious leap of faith, it was
transformed into a legal person separate from its owners – a company in the
modern sense – continuing its existence beyond the lives of shareholders,
limiting shareholders’ liability to their paid-in capital, centralizing
management in persons empowered to contract on behalf of the entity, and
dividing ownership into units of freely transferable shares.
Early on, the
shareholders had to confront the fact none of them was inclined to be involved
in the messy day-to-day operation of a mill.
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 and supervise a general manager. To prevent the board from gaining the upper
hand and eclipsing the interests and ultimate authority of all the
shareholders, board members were elected two at a time to two-year terms with
Having put in
place the basic legal framework to make their enterprise work, the shareholders
faced a challenge familiar to today’s investors – legal disputes and the
attendant role of government. For
example, the government 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 despite any
short-term windfall for investors. This
did not prevent certain mill owners from becoming adept at manipulating the
legal system for competitive advantage.
When an upstream mill 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 in
court and won. But the upstream defendant
appealed to King and Parliament in far away Paris and succeeded in dragging out
the case for close to fifty years so the plaintiff was forced out of business
and its assets acquired by the defendant at pennies on the dollar.
shareholders invested for long-term growth with shares passed down through
generations, and because managers were not rewarded based on quarterly earnings
per share, there was little motivation to forego maintenance or skimp on
capital expenditures in the name of short-term gain. As a result, the mill companies kept growing
and commerce in the region took off with Toulouse becoming one of the early
industrial centers of Europe, particularly in textiles whose manufacture came
to depend on power generated by the mills.
machinery running was a constant challenge in an era when engineering in the
modern sense was just beginning to take hold.
A top priority was generating cash flow to fund repairs and capital
improvements. Because farmers paid in
kind (one-seventh of their grain) to have their wheat ground into flour, the
mills’ customers were not a source of cash.
To raise cash, the shareholders could authorize a reinvestment of these
profits-in-kind that, when ground into flour, were sold to local bakers. But investors wanted a better alternative. In an early example of business
diversification, the mills generated cash by charging local fishermen for the
right to fish at the dams built by the mills, where fish were plentiful and
easier to catch. This revenue became so
lucrative that the mills came to the attention of the King, who was given a
one-half interest in the profits, a “royalty,” in the hope of averting a
challenge became how to preserve the grain until it could be doled out as a
dividend to shareholders. Although it
was measured and distributed several times a month as a dividend-in-kind, the
volume of what went out was always less than what came in, owing to the natural
drying process along with rats and insects that ate into profits. While this problem was not resolved in the
Middle Ages, it led to increased emphasis on accountability and accelerated
distribution of dividends, which continued to be paid in-kind until 1840.
concerns about not getting their fair share of profits gave birth to
innovations still at the heart of modern business and corporate governance –
transparency, internal controls, and the independent auditor.
The board had to
balance the shareholders’ short-term self-interest in maximizing dividends and
boosting the share price against the long-term prospects of the company,
dependent on plowing profits into maintenance and capital improvements so the
mills could run more efficiently and avoid costly breakdowns. This sparked the need for a reliable way to
measure income and expenses. Adopting a
method developed in Genoa, all transactions were recorded meticulously using a
precursor of the double entry system of bookkeeping and combining, for the
first time, the ledgers recording income and expenses to arrive at profit.
the receipt of revenue was important, it was in the area of expenses that the
greatest number of controls was instituted.
For example, to remit a payment, the instructions had to be detailed and
in a writing, including the address of the payee and the reason for the
payment. All disbursements had to be
approved by at least four authorized co-signers. Then the person receiving the payment had to
sign for it, or if illiterate, had to find a notary to sign on his behalf. To further police outlays, the person
recording an expense in the general ledger could not be someone who had authorized it.
It was concern
over reliability in tracking revenue and expenditures that gave rise to the
role of the independent auditor. Unlike
today, auditors were hired by and reported exclusively to the shareholders –
not to the board or to management. They
reviewed the accounts, insisted on back-up for each transaction, and stood
behind the financial statements. As a
result, the shareholders knew what profits to expect and this had a direct
impact on the market value of their shares and the companies’ ability to
attract new, long-term investors.
Without access to
global financial markets, the shareholders remained responsible for raising
funds by reinvesting profits, contributing supplemental capital, and
authorizing the sale of additional shares.
Shares were issued only to individuals.
They had to be sufficiently well off to take the risk of contributing
additional funds when more capital was needed, since shareholders and other
related parties were prohibited from lending money to the companies. While occasional short-term borrowing from
unrelated lenders was permitted for emergency repairs, there was no such thing
as a line of credit or an overdraft facility.
The mill companies did not invest in other enterprises nor did they
mortgage their real estate to obtain funds.
Financing expansion and improvements depended solely on profitability.
finances were helped by the County of Toulouse in a form we would recognize
today as a property tax abatement. In
exchange for the mills’ role in infrastructure and defense, as well as the
importance of flour for making bread and feeding the local populace, the
companies were granted exemptions from the tax on real property and so had more
cash to invest in maintenance for improving reliability and being good
It was a
challenge for the board to find and retain professional managers having the
technical knowledge to keep the mills running while supervising the employees
and serving customers. Mill managers
were kept on a short leash to maximize profits but also to avoid abusing
workers who were tough to replace.
Granted one-year contracts, managers’ performance was reviewed at the
annual general meeting of shareholders.
Managers were personally liable for any shortfalls in the accounts,
while their reward for a job well done was another one-year contract.
interest, deemed among the most significant threats to the enterprise, were
averted through a set of simple yet effective mandates. Rules were instituted prohibiting employees
and their families from dealing in grain or from buying shares in the
company. Neither shareholders nor their
family members could be employees. The
board was limited to shareholders, with no seats for management or outside
directors. Demands by employees for
profit-sharing were quashed.
Shareholders and employees were forbidden to lend money to the
corporation, and vice versa.
In an era before
labor unions, management had the upper hand even though workers could be scarce
during a period of global cooling when harvests failed and the Black Death
recurred, resulting in an average life expectancy of just 30 years. Working hours were from dawn to dusk. Strikes were prohibited. Employees had to swear an oath at the
beginning of each year to abide by company regulations, and if they failed, to
pay a fine.
From the records,
it appears that information technology was focused primarily on financial data
such as the shareholder registers, ledger books, and meticulous records of
receipts and expenses preserved to this day.
Creating and maintaining an audit trail, along with the ability to
monitor compliance with procedures and policies, were key to supporting the
transparency shareholders demanded.
At a time when
land transportation was perilous and slow, the rivers and waterways of France
were the information superhighways of their time. Particularly during the Gothic building boom,
knowledge sharing and innovation were based on itinerant architects and masons
moving from town to town and bringing with them their models and tools. This technology had its impact on the mills
as well, whose infrastructure had to withstand attack. Attached to dams supporting bridges across
the rivers that powered them, the mills were strategic military assets that had
to be sturdy and defensible within the context of the 14th century arms race. This meant constant inspection and paying for
upgrades based on improved technology whenever it happened to become available.
One area where
there is little information in contemporary records is sales and marketing.
Given the efforts that went into keeping competitors from operating in close
proximity and disrupting or distorting the flow of the river to a mill,
marketing took a back seat to maintaining market dominance and to being the
only mill in town. Depriving consumers
of choices prevented the need for much effort or expense to increase sales.
satisfaction was, however, a significant aspect of the business. At a time when flour was easily contaminated
by insects and by rat droppings, or could be adulterated with fillers, mill
managers were charged with ensuring purity and the reliable measurement of the
farmers’ sixth-sevenths share of the grain being ground. Shareholders recognized the importance to the
bottom line of customers’ perceptions and confidence, driving their board and
managers toward zero tolerance for error.
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 and third-party
It may be easy to
dismiss as simplistic the accomplishments of these medieval 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 corporate governance established
in the late Middle Ages had been in place during the last few years, it is
tempting to speculate that fiascoes sparking the Sarbanes-Oxley legislation and
the more recent turmoil in global financial markets might not have
occurred. In a time before EBITDA,
collateralized debt obligations and credit-default swaps, with nary an
investment banker 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 the mill companies built the generators powering
the industrial revolution and eventually the hydro-electric plants of 20th
century France. They would 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
monopoly known as Electricité de France.
*Meril Markley has retired but at the time of this speech was
International Tax Principal at UHY Advisors TX, LLC in Houston, Texas and Chair
of the Tax Special Interest Group for UHY International. A.B. Vassar College (Phi Beta Kappa); J.D.
University of Cincinnati College of Law; LL.M. Transnational Business and Tax,
McGeorge School of Law (Sacramento, CA and Salzburg, Austria).
This paper was
prepared to accompany a presentation delivered at the McGeorge
International Law 2012 Conference in Rome, Italy on May 26, 2012. It is based on Aux Origines des Sociétés
Anonymes – Les Moulins de Toulouse au Moyen Age by Germain Sicard (Centre de
Recherches Historiques, 1953).