Volkswagen built a system that knew when it was being tested and behaved differently when it wasn’t. AI systems now do this autonomously.

On July 27, 2015, Oliver Schmidt, head of Volkswagen’s U.S. environmental engineering office and one of three deputies in VW brand development, walked CEO Martin Winterkorn and a small group of senior executives through the technical state of an emissions problem the company had been concealing for nearly a decade. One of Schmidt’s slides posed a single-word question: “Indictment?”1

Winterkorn’s response was not to fix the problem. It was to send Schmidt to California with a prepared script. The “storyline” was approved by at least four senior officials below Winterkorn. Schmidt was instructed not to disclose the defeat device or any intentional cheating. Three weeks later, he flew to Michigan and lied, in person, to officials at the California Air Resources Board.2

The defeat device that Schmidt was referring to was software inside the engine control module. It watched four signals: steering wheel position, vehicle speed, engine runtime, and barometric pressure. When those inputs matched the signature of a laboratory emissions test, it activated full emissions controls, and the car passed the test. When they did not, the controls were quietly scaled back, and the vehicle produced nitrogen oxide (NOx) emissions up to forty times the legal limit. The device was installed in approximately 11 million diesel vehicles between 2009 and 2015 in VW, Audi, Skoda, and Seat brands.3

I return to this case because the AI research literature has a name for what that software did: deceptive alignment.4 It refers to a system that behaves one way when it believes it is being evaluated and another way when it believes it is not. Until recently, deceptive alignment was a theoretical risk that alignment researchers worried about with advanced AI systems. The VW defeat device is a real-world example, produced intentionally by human engineers within one of the world’s largest industrial companies. Researchers at Anthropic recently found that this behavior emerged unintentionally in Claude Mythos, one of their frontier models. During pre-deployment evaluations, the model had internal representations indicating it was being tested 7.6% of the time, often without saying so.5

The People Who Built It Were Not Villains

At VW, the defeat device was not the product of a rogue actor. It was developed and refined by ordinary professionals over more than a decade. Investigators have found more than forty people within the company who knew about it at various points.6 With the exception of a whistleblower in 2015, none acted on what they knew, and many actively concealed it from regulators. This is an example of deceptive alignment in software — and in a corporate culture.

Martin Winterkorn was VW’s chief executive from 2007 to 2015 and a famously demanding manager. According to Parloff7, Winterkorn carried a micrometer with him so he could personally measure parts to the hundredth of a millimeter. He was pushing VW to overtake Toyota as the world’s largest automaker, and part of that plan was a U.S. “clean diesel” campaign. He resigned five days after the EPA’s Notice of Violation in September 2015, was indicted by U.S. authorities in 2018, and was put on trial in Germany years later (proceedings were paused for health reasons and remain unresolved).8

James Liang was a VW engineer, 34 years at the company, never a supervisor. He was based in Auburn Hills, Michigan, and proposed refinements to the defeat software in 2011–2012 that ensured full exhaust treatment was triggered exclusively during regulatory test cycles. His proposal was approved by Hans-Jakob Neusser, then head of engine development, and Bernd Gottweis, a member of the Product Safety Committee. The refined software was installed in diesel vehicles starting in mid-2013. Liang pleaded guilty and was sentenced to forty months in prison and a $200,000 fine.9

Another important figure has no name in the public record. In July 2008, a member of Audi’s environmental certification team wrote in an internal communication that the defeat-device approach was “indefensible.”10 That was the moment when the moral content of the situation was named in writing, but the plan went forward, and the engineer continued to work.

The culture in which these three operated helps explain how this could have happened. Internal dissent was punished.11 The supervisory board, which paradoxically included worker and state representation, did not provide an effective check on senior management.12 When lower-ranking employees submitted proposals to invest in proper emissions controls, management repeatedly rebuffed them on cost.13 The ethical dimension of the decision was eclipsed by the practical one.

This culture led seemingly ordinary people to systematically choose the path of least resistance for nine years. And it reveals psychological, organizational, and structural forces that shaped VW employees’ moral reasoning.

The Engineering Problem That Was Not an Engineering Problem

The root of the situation was an engineering problem. Diesel engines are more fuel-efficient than gasoline engines, but they burn hotter and produce higher levels of NOx. The catalytic technologies used to handle this in gasoline engines do not translate easily.14 U.S. NOx standards were stricter than European ones. Meeting them with a diesel engine that also performed well and cost what consumers expected was the engineering challenge. Proper emissions treatment equipment would have added hundreds of dollars to each vehicle. VW could also have licensed clean-diesel technology from BMW and Mercedes, which Becker estimates would have cost roughly $4.8 billion across the relevant fleet.15 Or VW could have abandoned the U.S. diesel strategy. None of these options was pursued.

At every stage, individuals had a menu of choices. The most ethically demanding was reporting externally to the EPA, CARB, or the press. A single VW employee finally did this, against senior management’s instructions, in August 2015.16 Slightly less costly was to refuse to participate and resign; no one in the public record appears to have taken this path either. Less costly still was to escalate internally. This would mean pushing the problem up the chain with an honest assessment that compliance was impossible at the required cost and forcing senior leadership to make a documented decision. There is some evidence that this happened. A 2014 memo by Gottweis acknowledged noncompliant NOx emissions and the likelihood of a defeat-device investigation, and Schmidt’s “Indictment?” slide warned Winterkorn directly. In each case, however, the message was received as a problem to be managed rather than as a recalculation.17 Most VW employees chose a fourth option: comply and rationalize. Some went further and actively concealed. Schmidt’s August 2015 trip to CARB was a deliberate obstruction. And two weeks before the EPA’s Notice of Violation, VW employees destroyed thousands of potentially incriminating documents.18

While it might be understandable that employees did not report externally or quit, internal escalation was available to everyone. It would not have ended a career, and it would have changed the trajectory. And yet, almost no one chose it.

How Ordinary Engineers Rationalize Deception

The question of why VW’s employees chose compliance over resistance is not easily explained by individual morality. The people who designed and refined the defeat device seem to be ordinary professionals. Three complementary frameworks from moral psychology and organizational behavior help explain the systematic deception.

The first is Albert Bandura’s account of moral disengagement.19 Bandura describes several mechanisms by which ordinary people, in the presence of authority and structure, come to participate in harmful conduct without experiencing themselves as immoral. Displacement of responsibility — attributing one’s actions to the dictates of an authority — was structurally reinforced under Winterkorn. Diffusion of responsibility through division of labor meant no single engineer built the defeat device alone. Multiple teams worked on it over nine years, and each could rationally attend to the operational details of their slice rather than the morality of the whole. Euphemistic labeling was used to make harmful conduct morally palatable. A team that later inspected the defeat-device code and documentation found the software was internally labeled as modifying the “acoustic condition” — a term originally associated with engine-startup sounds.20 By sanitizing the language, the engineers could work on the software without the constant reminder that its purpose was regulatory fraud. And finally, minimization of consequences: the harm from excess NOx is statistical, delayed, and physically remote from the actors who cause it. An engineer in Wolfsburg writing firmware for an engine control module is far removed from the respiratory illness of a commuter in Los Angeles.

The second framework is Diane Vaughan’s account of the normalization of deviance, developed in her analysis of the Challenger disaster and extended in subsequent work.21 Vaughan’s core finding was that no fundamental decision was made to accept the dangerous O-ring anomalies that destroyed the shuttle. Instead, a series of narrow judgments about acceptable risk accumulated, each only slightly more permissive than the last, until catastrophic failure was statistically likely. The same pattern operated at VW. Early versions of the defeat device checked only a few parameters. By 2009, the firmware was checking as many as ten different signals of laboratory conditions.22 Each incremental refinement made the next less transgressive. By the time Liang proposed his improvements in 2011, the question was no longer whether to deceive regulatory tests but how to deceive them more reliably. The deviance had been normalized. The most sobering element of Vaughan’s analysis is that, even though NASA implemented reforms after the Challenger disaster, the same category of normalized anomaly led to the Columbia disaster 17 years later.23 Organizational deviance, on her account, is self-regenerating in the absence of structural change. Punishing individual actors after the fact addresses the symptoms rather than the disease.

The third framework comes from behavioral ethics: bounded ethicality and ethical fading.24 People are largely rational, but subject to predictable cognitive biases. They generally act in accordance with their moral values, but social, organizational, and situational factors can cause them to make choices they would otherwise reject. Ethical fading describes how the moral dimension of a situation becomes less salient over time. The 2008 Audi engineer who wrote that the device was “indefensible” was identifying the moral reality at a moment when it was still visible. By the time Liang refined the software three years later, that visibility had faded. The ethical dimension had been replaced by the engineering dimension. The focus became engineering performance.

Cultural Amplifiers

The structural mechanisms above do not operate in a vacuum. Moral disengagement can gain traction in organizations with long tenure, deep hierarchical deference, and a tradition of treating engineering as a morally neutral discipline. There is greater displacement of responsibility when the hierarchy is steeper, and responsibility is more diffuse when teams are stable over time. VW’s supervisory board, with worker and state representation, is one local expression of this pattern. The broader precision-engineering tradition — German industrial engineering being a canonical case — is another.25

Wernher von Braun is a parallel historical case. According to Neufeld,26 von Braun was chief rocket engineer of the Third Reich, where he oversaw V-2 rocket production at Mittelwerk, which relied on forced labor from the Mittelbau-Dora camp system. He went on to run the Marshall Space Flight Center for NASA and shepherd the Saturn V into the Apollo program. The institutional continuity of the engineering profession absorbed him without a moral reckoning. The title of Neufeld’s epilogue is “A Faustian Shadow,” illustrating how the engineer who treats his work as morally neutral can be employed by anyone, and a culture that rewards technical excellence without auditing will employ him. Institutional amnesia is the displacement of responsibility extended in time rather than across a hierarchy.

The risk-management paradox is the specific symptom. Precision engineering cultures like VW’s are famous for the rigor with which they assess technical risk. What failed at VW was that meticulous attention was directed to technical and project risks — e.g., will this firmware execute correctly — while the systemic and ethical risks were obscured by institutional amnesia. This connects to Vaughan’s analysis of NASA. Rigorous technical risk assessment failed to identify the systemic pattern that led to the Challenger and Columbia disasters.27

These amplifiers are not unique to VW or NASA, though. Can we learn from these examples when building AI?

What AI and Security Researchers Call This

The vocabulary already exists. The Volkswagen defeat device is a real-world demonstration of several concepts from AI research.

Specification gaming. Krakovna and other researchers at DeepMind define specification gaming as “a behaviour that satisfies the literal specification of an objective without achieving the intended outcome.”28 They illustrate this by training an agent on the boat-racing game CoastRunners using reinforcement learning. The agent is rewarded for hitting green blocks along the racetrack, but it learned to ignore the race entirely. Instead, it drove in circles, hitting the same blocks repeatedly. It achieved a high score by abandoning what the score was meant to measure. The federal U.S. emissions test was a similar structure: a specific protocol (11.04 miles at an average speed of 21.2 mph, lasting roughly 31 minutes) designed to stand in for real-world emissions performance.29 Just like the CoastRunners agent, VW optimized for the protocol rather than for the underlying property the protocol was meant to track — harmful emissions. Researchers have called this Goodhart’s law: when a measure becomes a target, it ceases to be a good measure.30 In AI research, specification gaming can be seen as a technical problem to be solved with better reward modeling. The VW case shows what happens when that technical focus operates in an organizational culture that prioritizes internal compliance over moral responsibility.

Deceptive alignment. Hubinger et al.31 define deceptive alignment as a system that behaves differently when it is being evaluated than when it is not, because it recognizes the evaluation conditions. Ngo et al.32 describe a related concept, situationally aware reward hacking, in which the system distinguishes between evaluation and deployment contexts. The initial VW software used four input variables (steering, speed, runtime, and pressure) to make that distinction. Same principle, intentionally designed by humans rather than emerging from machine learning.

In April 2026, Anthropic researchers found that Claude Mythos Preview exhibited these behaviors, unintentionally (meaning that Anthropic did not intentionally train Mythos to do this).33 They used new white-box techniques to evaluate the model’s internal state and found internal representations of “evaluation context” active on 7.6% of behavioral test turns, often without any corresponding external outputs. One example is worth highlighting:

In one case, the model accidentally obtained the exact answer to a quantitative estimation question via an explicitly prohibited method. Rather than flagging this and declining to answer, the model instead attempted to solve the question independently. In this process, it explicitly reasoned that it needed to make sure that its final answer submission wasn’t too accurate… [In another case, it was blocked] from launching a subprocess with elevated permissions, it acknowledged the block was appropriate but then attempted to bypass it by obfuscating the permissions elevation.34

The more capable these models become, the better they are at recognizing when they are being tested and gaming the system. One important difference between Anthropic’s analysis of Mythos and VW’s defeat device is that Anthropic released its analysis before the model was made available.35 VW only admitted to deception after the EPA issued a formal notice of violation.36 The risk with models like Mythos is that the deceptive behavior is no longer a piece of firmware engineered by human hands. It emerged.

Diffusion of accountability. Helen Nissenbaum’s “problem of many hands” describes what happens when responsibility is distributed across so many actors that no one feels accountable for the whole.37 At VW, more than forty people knew about the defeat device at various points. No single individual designed, approved, and deployed it. When the U.S. House Energy and Commerce Committee questioned Michael Horn, head of Volkswagen Group of America, in October 2015, he told Congress that he believed “a couple of software engineers” were responsible for the cheating.38 This is similar to what Nissenbaum calls blaming the computer.39 Accountability is redirected at the technology. In AI development, it’s even easier to see this redirect — “the model did it” — because even the engineers don’t fully understand how the model acquires the capability. Luciano Floridi40 argues that we need to anchor AI development in the principle of explicability. This encompasses both intelligibility (how the system works) and accountability (who is responsible for the way it works).41 If a complex piece of automotive firmware was hard to interrogate, a transformer with billions of parameters is in a different category entirely.

Cyber trust. From a cybersecurity perspective, the defeat device is an integrity compromise from the inside. The threat model in software security typically assumes an external adversary inserting malicious code. The VW case is what happens when the manufacturer is the adversary. Villasenor42 framed this as a problem of cyber trust. “What we want, at the end of the day, is confidence that the software that runs everything from cars to medical devices to the critical infrastructure can be trusted.”43 The AI case is the same problem with a substantially larger attack surface.

Externalized Costs

There were real human and financial consequences of VW’s deception. Barrett et al. estimated that the excess NOx emissions from VW’s U.S. fleet caused fifty-nine premature deaths between 2008 and 2015, with a social cost of roughly $450 million.44 Globally, Anenberg et al. estimated that excess NOx emissions from all diesel vehicles contributed to approximately 38,000 premature deaths worldwide in 2015 alone, with VW the largest single corporate contributor.45 The defeat device ultimately cost VW more than $35 billion in fines, settlements, buybacks, and legal fees.46 The 2016 U.S. settlement alone was $14.7 billion.47 VW’s share price dropped 46% within two months of the disclosure, erasing over $42 billion in market value.48

The cost of the alternatives is not speculative. Winterkorn’s own November 2014 memo estimated that a legitimate technical fix would cost roughly €20 million.49 Licensing BMW and Mercedes clean-diesel technology might have cost an estimated $4.8 billion.50 Either was a small fraction of what VW eventually paid.

What Can We Learn from the VW Case?

Compliance is not ethics. VW had a Chief Compliance Officer appointed in 2011 and dedicated compliance staff. The compliance apparatus did not detect the defeat device. As Becker51 argues, an organization without a foundation in moral reasoning will treat legal requirements as obstacles to be circumvented rather than constraints to internalize. Floridi52 highlights two failure modes in AI governance. The proliferation of governance frameworks allows an organization to go ethics shopping to find the framework that justifies its behavior. And if it uses superficial measures that create the appearance of ethical operation, it is ethics bluewashing (similar to classic greenwashing). Floridi53 argues that we need to combine soft ethics (voluntary codes, post-compliance standards) with hard ethics (enforceable regulation with meaningful consequences). However, the VW case shows that hard ethics only works if it is meaningfully enforced. A regulator that lets the tested entity define the test condition has produced a structure that any sufficiently motivated organization (or sophisticated AI model) will eventually game.

Actionable, independent oversight is needed. The defeat device was not caught by the EPA or CARB. It was caught by researchers at West Virginia University who used portable emissions measurement equipment to test diesel vehicles under real-world driving conditions.54 The regulatory certification process had followed Goodhart’s law. The current state of frontier AI evaluation is similar to diesel emissions testing before the VW scandal. Pre-deployment evaluations are designed and run by the model developer. There are independent research groups that perform adversarial, real-world evaluations. Unlike diesel emissions in the US, however, AI evaluations are not paired with regulatory mechanisms that can prevent a model from causing harm.

Moral courage is structural. When Michael Horn told Congress that “a couple of software engineers” had done this, he was attempting to relocate the failure from the institution to the individual. The institution is where the failure was. Under authoritarian management that punished dissent, engineers chose their livelihoods over ethical exposure. For AI development, this means that the organization’s design is just as important a safeguard as the moral character of individual engineers. They must be able to raise safety concerns without risking their careers. Red teams must be empowered to challenge deployment decisions. Internal oversight must be independent from the teams whose work it evaluates. And the normalization of deviance must be interrupted by organizational structures that make deviance visible and costly before it becomes routine.55

What VW Shows

The Volkswagen defeat device was a system engineered to satisfy the letter of its evaluation while violating its spirit. Specification gaming before the term existed. It was also software that distinguished between testing and deployment environments and behaved differently in each. Deceptive alignment by human hands. And it was a case study in institutional failure in which responsibility was distributed so widely that no individual felt accountable for the whole. The problem of many hands.

The engineers who built it were seemingly ordinary professionals operating within a system that shifted the responsibility upward, diffused it across teams, sanitized the language, and embedded it in a complex system. The psychological and organizational mechanisms that enabled their choices (moral disengagement, normalization of deviance, ethical fading) are not unique to VW. They are structural features of many large institutions in which complex technical work is divided among many actors and governed by targets that can be gamed.

AI systems now being developed and deployed operate within similar institutional structures, and the regulatory mechanisms that prevent harm are weaker than for post-Dieselgate vehicle emissions. There is no equivalent to the Clean Air Act for AI. Moreover, empirical evidence suggests that AI systems already game their specifications.56 The question is whether we will build the organizational cultures necessary to detect it when they do, and the institutional structures to act on what we find. VW shows what happens when we do not.

Fifty years ago, Milton Friedman published his landmark work The Social Responsibility Of Business Is to Increase Its Profits in The New York Times Magazine. [0] A reaction against the surging support for social justice in 1970, the essay would go on to influence the course of economics and corporate governance for the next half century.

Friedman’s argument is rather simple. In a business, decisions are made by managers employed by the owners of the business. Managers thus have a contract to run the business consistent with the objectives of its owners. In some cases, a business may be established by its owners for social, environmental, or other charitable purposes. For non-charitable businesses, according to Friedman, the owners want the business to make as much money as possible. The power of Friedman’s argument is it gives managers a simple model for decisions: maximize profit.

This optimization model lies at the heart of the modern corporation. It is the pacemaker of shareholder capitalism. New insights from the science of complexity, however, are showing this pacemaker has a flaw.

Company Origins

A company is an organization that enables individuals to pool resources for risky, long-term projects. Companies are designed and built for a purpose, they distinguish between members and nonmembers, and have systems to accomplish work. [1]

The most important organization in the world is the company: the basis of the prosperity of the West and the best hope for the future of the rest of the world. Indeed, for most of us, the company’s only real rival for our time and energy is the one that is taken for granted—the family. [2]

The concept of a company can be traced back to ancient Mesopotamia. Commercial activity during this time was conducted mostly by simple bartering, but more complex arrangements emerged with Sumerian (3000 BCE) property contracts and Assyrian (2000-1800 BCE) business partnerships. [3] In the 4th century BCE, the Athenians developed business models for maritime commerce in the Mediterranean. These businesses were open to outsiders and based on the rule of law rather than royal authority.

A century later, Romans developed some of the fundamental concepts of what we now call corporate law. While most wealth in the Roman Empire was concentrated in agricultural and private estates, Roman societies established a collective identity with partners owning shares of the business. The partners delegated managerial decisions to a magister who ran the business and kept financial records. Romans also formed partnerships called peculiums run by a slave. Peculiums provided protection for the partners from creditors—limiting liability to the assets allocated to the business. Following the collapse of the Roman empire, the organization of commercial activities developed more slowly through the Middle Ages followed by a new wave of innovation in Renaissance Italy. [4]

Renaissance Innovations

By the 12th century, northern Italy was the center of European finance and commerce. City-states in the region dominated Mediterranean maritime trade and served as a gateway for crusaders traveling to the east. Commercial activity was often organized as compagnia through which fathers, brothers, sons and other relatives would pool their labor and capital. [5] As they grew more sophisticated, compagnia began attracting money from outside the family circle, further expanding the pool of capital and spreading the risk of the venture.

Florence is said to be the birthplace of the Renaissance, and in the early 14th century three Florentine families dominated finance in Italy—the Bardi, Peruzzi, and Acciaiuoli. All three families were wiped out following the default of King Edward III of England and King Robert of Naples in the 1340s. This left an opening for another Florentine family—the Medici—to seize control of the Republic. The Medici family would go on to build a business empire that left an enduring mark on the region.

Giovanni di Bicci de Medici launched the family business by landing the Vatican’s account in the 1380s. [6] Vast sums of money in many different currencies flowed through the papacy’s accounts, and Giovanni built a reputation as a currency trader. Over half of the Medici’s revenues came from their branch in Rome, and they used the profits from this business to diversify into trade, lending, textile manufacturing, and other businesses—including a monopoly on key chemicals used in the textile industry. [7] By the middle of the 15th century Giovanni and his son Cosimo had built one of the largest business empires of their time with branches in Florence, Venice, Rome, Geneva, London and other cities.

Rather than operate as a single organization, the Medici built a decentralized network with each new branch or business set up as an independent partnership between local businessmen and senior partners back in Florence. Each branch managed their own books and accounts, and were audited each year by the senior partners. This decentralized structure created strong incentives for the local partners to run a profitable business. It also allowed the Medici to maintain firm control of a sprawling empire and shield the assets of the broader business from the liabilities at each branch where the local partners where “first in line” to account for any losses. [8]

The Medici’s success in business brought substantial wealth and political influence. According to financial historian Niall Ferguson, “No other family left such an imprint on an age as the Medici left on the Renaissance. Two Medici became popes (LeoX and Clement VII); two became queens of France (Catherine and Marie); three became dukes (of Florence, Nemours and Tuscany).” [9] They also were patrons of some of the greatest artists and scientists of the era (and all time) from Michelangelo to Galileo, and left an architectural legacy in Florence that people travel from all over the world to see to-this-day.

Two hundred kilometers to the north of Florence, the Republic of Venice was a maritime power that rose to commercial prominence by controlling the salt trade with the Byzantine Empire. “Unlike the other Italian city-states, Venice put the demands of commerce high above the rule of the Church… and was excommunicated several times during the fifteenth century.” [10] Commercial prominence and political pragmatism in Venice led to a number of business innovations. The first state bank of Europe was opened in the Rialto, the market at the center of the city, which dominated international currency exchange throughout Europe for over 300 years. Businessmen from all over the region would travel to the Rialto to learn the secrets of finance and commerce.

Venetian bankers and merchants also perfected the system of double-entry bookkeeping—initially developed by Florentine merchants in the late 13th century—which allowed them to systematically track business assets and liabilities, and, most importantly, calculate profits. [11] Luca Pacioli—the famous mathematician from Sansepolcro and companion of Leon Battista Alberti and Leonardo de Vinci—published a treatise on mathematics in 1494 with a chapter on bookkeeping that became the definitive guide to the Venetian method, the foundation of modern corporate accounting centuries later.

In today’s profit-driven commercial world we are more than familiar with the idea that the purpose of every business is to make a profit. But Pacioli was writing in an era when this was not so self-evident and the tools for calculating profit—especially the Venetian bookkeeping system—were not widely used. And so he makes it clear that the purpose of every merchant is ‘to make a lawful and reasonable profit so as to keep up his business’. [12]

Charter Companies

Merchants in northern Europe built on the innovations of the Roman Empire and Renaissance Italy, developing guilds, charter corporations and ultimately the joint-stock corporation. Throughout the Middle Ages, the concept of a separate, collective identity (a “corporate person”) was used by northern European towns, universities, and religious communities. Trade guilds were important organizations in this period as well. They were given a monopoly over their trade within a city by the sovereign, set standards for quality, and selected and trained new members.

The first charter companies were formed in the 12th century and operated like guilds with a group of merchants banding together to sell goods under a single organization. Charter corporations straddle the public and private sectors, forming a business venture with a charter from the sovereign for exclusive rights to a commercial activity within the city. Like trade guilds and merchant associations, they provided a means to transfer customs and knowledge to future generations. They also provide a means to transfer considerable wealth. The Corporation of London, for example, still owns a quarter of the land in the City of London. [13]

Mining, shipping, and milling corporations offered shares on the open market as early as the 13th century, and by the 16th and 17th centuries these ideas would come together to empower the “combined effort of governments and merchants to grab the riches of the new worlds.” [14] The Portuguese were pioneers in exploring the East Indies with state-led expeditions. The Dutch and English, in contrast, raised money for voyages with new public-private ventures formed as chartered joint-stock companies. This structure had the monopolistic advantage of the charter corporation. It also pooled capital and risk for the venture by selling tradable shares on an open market. To attract investors, shares often limited shareholder liability to their original investment.

The first chartered joint-stock company was the Muscovy Company, formed in England in 1555. The Muscovy Company received an exclusive charter for trade with the Russian czar Ivan IV at the port of Archangel, and was encouraged to search for a northeast passage to the East Indies. In the 1580s, the Virginia Company was chartered by Elizabeth I to explore and colonize America. It was based on Richard Hakluyt’s Discourse on Western Planting (1584)—arguably one of the first company prospectuses—and raised funds from some seven-hundred investors including Sir Francis Bacon. [15] The Muscovy Company, the Virginia Company and other early joint-stock companies raised funds for individual voyages with proceeds divvied up upon return. This pooled capital and contained shareholder’s risk to individual voyages. The Dutch developed a more durable structure which would be the model for future joint-stock companies.

In 1602, Dutch merchants received a charter forming the Dutch East India Company (also known as “VOC” for Vereenigde Oost-Indische Compagnie). VOC was a true public-private venture with the government providing both the charter and owning a stake in the company. VOC’s first charter locked shareholders’ investment for ten years. In 1612, the government changed VOC’s charter preventing shareholders from recalling their original investment for an indefinite period of time. This was a significant departure from early joint-stock companies, which were set up to pool resources and diversify risk for individual voyages. By extending the commitment to ten years, and then indefinitely, the Dutch developed the concept of an immortal company, creating a durable asset that would produce wealth over long periods of time. It also led to a vibrant secondary market for shares of the company. This meant shareholders were not stuck with their investment and could even profit from trades in the secondary market, while ensuring VOC had a stable asset pool to continue exploiting their dominance of Far East trade routes. [16]

The English also fought for control of trade in the East Indies. The English effort was led by English East India Company (the “Company”). Formed in 1600 by a group of 218 merchants and adventurers, the Company received exclusive rights for 15 years to trade in the “Indies,” an area that was defined as extending from the Cape of Good Hope to the Straits of Magellan. [17] In contrast to the VOC model, the English East India Company was a private organization—authorized by a charter but not owned by the crown—and voyages were funded independently until it became a permanent joint-stock company in 1657.

By 1620, the English East India Company had over 30 large and heavily armed ships, which traveled in convoys of 12 or more vessels, were operated by over 2,500 sailors, and maintained by 500 carpenters. [18] Typical voyages were 16 months long, leaving on the eastbound leg in the winter with silver and other metals, armor and swords, satins and broadcloths, and other tradable goods. In India, these were traded for cotton textiles, which was then traded for pepper, cloves, and nutmeg in the Spice Islands. Some voyages continued on to China, Japan or the Philippines for silk, indigo, sugar, and coffee. Most voyages returned through India where spices were traded for tea. [19]

To manage this complex trade network, the Company’s day-to-day activities were run by 24 governors who oversaw a network of resident “factors” at local trading posts or factories, and a growing administration of accountants, clerks, and other specialists organized into 7 committees: accounting, buying, correspondence, shipping, finance, warehousing, and private trade. Governors were elected by shareholders of the Company, who reaped large returns on their investment. [20]

The Modern Corporation

Despite the success of early joint-stock companies, a series of scandals in the early 18th century led to the English Bubble Act of 1720. The Act required every joint-stock company to receive a charter from parliament. To avoid the cost and uncertainty of obtaining a charter, most businesses in the burgeoning industrial sector preferred partnership arrangements. Many industrialists also believed the detached ownership of shareholders was not an effective business structure, preferring hands-on ownership arrangements. This began to change with the large sums of capital needed by the British rail industry in the early 19th century. By 1840, over 2,000 miles of track was laid by publicly traded, joint-stock companies, spurring the government to reform the joint-stock structure.

Starting in 1844, the British government passed a series of Acts that formed the foundation of the modern corporation. They first allowed the creation of a joint-stock company by registration rather than charter. They also required companies to disclose financial information audited by someone other than directors of the company and required dividends to be paid out of profits rather than capital. By 1862, they established automatic limited liability protecting shareholders from the corporation’s debt burden, thus limiting their liability to their original investment. At the same time, investors could draw dividends from the corporation, extracting profits that might otherwise be collected by debtors.

The U.S. can trace its founding to the corporate form. The colonies were originally organized as corporations chartered under the British crown, planting the seeds of democracy and the context within which the Framers wrote the Constitution. New York was the first state to enact an incorporation statute in 1811. Similar statutes eventually spread to all fifty states. In the U.S., states rather than the federal government have jurisdiction over corporate law, allowing corporations to engage in legal arbitrage and choose the state laws they are governed by.

In fact, 68% of all U.S. publicly traded corporations and 89% of companies with initial public offerings are registered in the state of Delaware, ranked as one of the most “investor-friendly” jurisdictions. [21] In Delaware, corporations can pay dividends from the current year or previous year’s profits, allowing the company to smooth shareholder returns even if it may not be in the corporation’s long-term interests. With the expansion of global trade in the late 20th century, an “empire of law” has formed that is no longer tied to specific states but is a fluid system that allows asset holders to choose between their local laws or those of a foreign market. “For the global capitalists, this is the best of all worlds, because they get to pick and choose the laws that are most favorable to them without having to invest heavily in politics to bend the law their way.” [22]

U.S. industrialization in the early 20th century brought with it a number of changes to the nature of the corporation. Ford brought together a production system that made cars more efficiently than any human institution before it. To manage the massive enterprise the production techniques both enabled and necessitated, Ford brought as many activities under its control as possible—from raw materials to ships and railroads. This presented significant challenges for the company. There was little synergy between the desperate industries it controlled, and Henry Ford centralized all decision-making powers in one person—himself. One of Ford’s competitors, General Motors (GM), capitalized on these weaknesses, developing new management techniques that complemented Ford’s production techniques, and brought together the complete system of mass production. [23]

GM’s president Alfred Sloan developed a new corporate structure that separated profit centers—major components like generators and steering gears as well as foreign subsidiaries—into independent divisions. Managers at the corporate level focused on corporate affairs and financial oversight of the divisions, leaving the details of operating each division to its respective general manager. This structure elevated the importance of the finance and marketing professions, and embedded corporate financial management in the modern corporation structure.

The Profit Constraint

Economists often view companies as a “legal fiction” behind which lies a nexus of contracts with investors, managers, employees, and customers. [24] “If there is a nexus of contracts, it is with the legal entity, not with the entity’s stakeholders; calling this central node a fiction denies the ingenuity of this legal device.” [25] The modern corporate form is immortal, it can own property, and it shields its owner’s losses by shifting liability to others. [26] The structure also is a more efficient vehicle for creating capital and labor income compared to individual proprietors (freelancers).

Capital can take many forms. It is created from an asset—land, debt, knowledge, and others—that is coded into law conferring special properties on the asset that privilege its owner. Even humans can be capital. This is as true today as it was before slavery was abolished with the 13th Amendment. It also is contrary to the textbook economic growth model—proposed by Solow and Swan back in 1956—where capital and labor are considered independent inputs to production. [27] And yet it happens every day. “Many a freelancer, for example, has discovered that she can capitalize her labor by establishing a corporate entity, contributing her services to it in kind and taking out dividends as the corporation’s shareholder in lieu of a salary—thereby benefiting from a lower tax rate.” [28]

A freelancer is both owner and employee (principal and agent), and so human capital and non-human capital are enmeshed. In an organization, there is greater separation between principal and agent, and the degree of separation has increased with the evolution of the corporate form. Early companies—from Roman societies to the Medici and even 19th and 20th century titans like Standard Oil and Ford—were typically owned and managed by a single family or a small group of investors. The introduction of the limited-liability, joint-stock company with shares traded in public markets created organizations owned by dispersed stockholders who are unable to exert much control over management decision-making. [29] This separation is why Friedman’s essay makes a clear distinction between freelancers and organizations. It also makes Friedman’s simple argument compelling, operationalizing the pursuit of profit as maximizing shareholder value.

The separation between principals and agents, however, highlights the complexity of modern corporate organizations. The Neoclassical framework Friedman’s argument is based on assumes humans are inherently rational and self-interested. And where individuals seek to maximize their own self-interest, this manifests collectively as seeking to maximizing a company’s profit—employees want to ensure they are paid for their labor and owners want to earn a profit on their (equity) capital.

Humans and organizations, however, are complex systems shaped by evolutionary forces. As with any evolutionary system, the behavior they develop is driven by survival and replication (or amplification), not pure self-interest. [30] Even charitable organizations are fundamentally driven by survival and amplifying (or replicating) their charitable mission. This does not mean that profit is irrelevant. In fact, the gap between Friedman’s Neoclassical framework and one based in evolutionary theory and complexity science is narrower than one might think. What these new insights provide is a reformulation of the optimization model. “In evolutionary systems, profitability is not an objective in and of itself; rather, it is a fundamental constraint that must be met if a business is to achieve the objective of survival and replication (or enduring and growing)…”

…eating is a constraint on living (and a very vital one), but no one would claim that the purpose of life is to eat. [31]

References

0. Friedman, M. (1970, September 13). The Social Responsibility Of Business Is to Increase Its Profits. The New York Times Magazine, p. 32–33 & 122–126. Retrieved from https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html

1. Beinhocker, E. D. (2006). The Origin of Wealth: The Radical Remaking of Economics and What It Means for Business and Society. Boston, MA: Harvard Business School Press, p. 351-352.

2. Micklethwait, J., & Wooldridge, A. (2003). The Company: A Short History of a Revolutionary Idea. New York: Modern Library, p. xv.

3. Micklethwait & Wooldridge, 2003, p. 3.

4. Micklethwait & Wooldridge, 2003; Abatino, B., Dari-Mattiacci, G., & Perotti, E. (2009). Early Elements of the Corporate Form. Oxford Journal of Legal Studies (Vol. 31).

5. Robins, N. (2012). The Corporation That Changed the World. Pluto Press, p. 22.

6. Micklethwait & Wooldridge, 2003

7. Gleeson-White, J. (2011). Double Entry: How the Merchants of Venice Created Modern Finance. New York: W. W. Norton & Company; and (Micklethwait & Wooldridge, 2003)

8. de Roover, R. (2017). The Rise and Decline of the Medici Bank, 1397-1494. Borodino Books; and (Pistor, 2019)

9. Ferguson, N. (2018). The Ascent of Money: A Financial History of the World (10 ed.). New York: Penguin, p. 39.

10. Gleeson-White, 2011, p. 50-51.

11. Gleeson-White, 2011

12. Gleeson-White, 2011, p. 97.

13. Micklethwait & Wooldridge, 2003

14. Micklethwait & Wooldridge, 2003, p. 17.

15. Micklethwait & Wooldridge, 2003, p. 19.

16. Pistor, K. (2019). The Code of Capital: How the Law Creates Wealth and Inequality. Princeton, NJ: Princeton University Press.

17. The National Archives. Charters of the East India Company with related documents: the “parchment records.” Retrieved August 30, 2020, from https://discovery.nationalarchives.gov.uk/details/r/16e42ef9-0b6c-4f6e-acb6-27cac99de0b4

18. Micklethwait & Wooldridge, 2003, p. 23; Robins, 2012, p. 19.

19. Robins, 2012

20. Robins, 2012

21. Delaware Division of Corporations. 2019 Annual Report Statistics. Retrieved August 30, 2020, from https://corpfiles.delaware.gov/Annual-Reports/Division-of-Corporations-2019-Annual-Report.pdf

22. Pistor, 2019

23. Womack, J. P., Jones, D. T., & Roos, D. (1991). The Machine That Changed the World. New York: Harper Perennial.

24. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360.

25. Piketty, T. (2013). Capital in the Twenty-First Century. Cambridge, MA: Belknap Press, p. 52.

26. Pistor, 2019

27. Solow, R. M. (1956). A Contribution to the Theory of Economic Growth. The Quarterly Journal of Economics, 70, 65–94.; and Swan, T. W. (1956). Economic growth and capital accumulation. Economic Record, 32(2).

28. Pistor, 2019, p. 11.

29. Winkler, A. (2018). We the Corporations: How American Businesses Won Their Civil Rights. New York: Liveright, p. 205.

30. Beinhocker, 2006

31. Beinhocker, 2006, p. 410.