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Information, institutions and agency: the crisis of railroad finance in the 1890s and the evolution of corporate oversight capabilities

Accounting History, Jul 2005 by Chandar, Nandini, Miranti, Paul J

Abstract

Using a broad socio-economic conception of capital markets' agency relationships, this study analyses an important economic transition in US economic history. It focuses on the institutional and informational changes that attended the reform of corporate governance and regulation in the railroad industry during the three decades after the depression of 1893 which was marked by extensive bankruptcy in the nation's largest business sector, the railroads. Institutional and social responses to this crisis provide a rich source in understanding the evolution of property rights and of institutional arrangements for enhancing corporate transparency and capital market efficiency. This study emphasises the notion of path-dependent learning as a driver for institutional evolution and shows how institutional responses were not limited to simple short-term firm-specific owner-manager relationships as is often usefully addressed by modern agency approaches. It also encompasses a variety of social, institutional and environmental factors that are often more important in explaining the dynamic nature of organisations, capital markets and financial reporting.

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Keywords: Railroad bankruptcy; path-dependent learning; agency relationships; institutional evolution; railroad history.

Introduction and background

The American railroad industry underwent a massive financial reorganisation after a devastating wave of financial bankruptcies in the 189Os. The institutional and informational responses to this crisis were far-reaching, varied and fundamental. This study examines these responses with a view to better understanding the evolution of capital markets, and the development of institutions for regulating industry. It considers the long-term agency dynamics that were involved as financial equilibrium was sought to be restored.

Research in economics and its allied fields of accounting and finance has long focused on the problem of the uneven distribution of information between business managers and investors. Adam Smith worried about this dilemma as early as 1776 in his classic The Wealth of Nations, which had criticised the great trading monopolies, like the English East India Company, believing that the informational asymmetries associated with such large enterprises contributed to inefficiency and corruption (Smith, 1776). A century and a half later, Berle and Means in The Modern Corporation and Private Property (1932) echoed this concern by contending that the risk associated with informational asymmetry was corrosive to the efficient operation of the broad, anonymous financial markets that had emerged in the US by the 1920s. In their view, financial agency could best be addressed through greater transparency in the form of accounting disclosure certified by public accountants (Berle & Means, 1932). And since the 1970s, the creative theoretical works of Alchian and Demsetz (1972), Jensen and Meckling (1976), Watts and Zimmermann (1983, 1986) and others have greatly increased scholarly understanding of how agency relationships influence managerial, financial and accounting decision processes.

Although the predominant, contemporary emphasis on logico-mathematical modes of analysis has successfully advanced modern agency theory, constraints inherent in the methodologies applied in these research programs have limited their effectiveness in evaluating the significance of long-term, dynamic socio-economic processes. First, this empirical approach has generally considered agency questions in the narrow context of direct, dual-dimensional interactions between investor principals and their corporate agents.1 second, due to the emphasis on internal validity and the need for computational efficiency, modern agency approaches rely on static equilibrium analyses that limit comparisons against real world circumstances. Third, such lines of inquiry embrace a neoclassical view of the economy where individual units are essentially price takers and exert little market power individually. While such an assumption may help to satisfy the population homogeneity requirement necessary for valid statistical analysis, it is at a variance with the predominantly oligopolistic structures that dominate modern business and finance. Finally, economic agency models abstract the conception of the firm as essentially a nexus of contracts capable of diminishing agency risk through the adaptation of institutional arrangements from a bounded range of alternatives such as the distribution of ownership rights, incentive compensation contracts and the monitoring by boards of directors and independent accountants (Robbins, 1932; Friedman, 1953; Papandreou, 1958; Jensen & Meckling, 1976; Blaug, 1985, 1992; Whitely, 1986).

These circumstances suggest the need for a broader perspective in comprehending the nature of agency and its relationship with institutional and informational dynamics. Adapting Baskin and Miranti's (1997, p.304) framework to this context will enable us to more fully understand the rich interplay between environmental and firm-specific factors. Drawing on Galambos (1983) and Berniger (1986), the dependence of capital markets agency relationships (A) on short-term and long-term factors may be depicted as:

Financial Services Industry

Information, institutions and agency: the crisis of railroad finance in the 1890s and the evolution of corporate oversight capabilities

Accounting History, Jul 2005 by Chandar, Nandini, Miranti, Paul J

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