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Limited Liability
I will pinch hit for Tyler on a few questions of interest to readers beginning with, "What's up with limited liability corporations?" A common libertarian argument is that groups do not possess rights beyond those of individuals. If it is wrong for A, B and C to steal from D then it is wrong for A, B and C to call themselves a government and tax D. Similarly, we might ask if A, B and C must pay for any injuries that they negligently cause D then how can they justly combine together to form a corporation and limit their liability? For this reason a consistent libertarian like Murray Rothbard rejects limited liability in tort as illegitimate. (Critics of limited liability from the left, however, do not seem to carry their argument over to taxation.)
Do note that limited liability in tort is the crux. Limited liability of shareholders to creditors is innocuous because this is just a matter of contract and regardless of the default law can be modified.
The economic argument against limited liability (JSTOR) is that it socializes risk. But many people on both the right and the left think that limited liability is the acme of capitalism (see the extension for some quotes) without which capital markets would fall apart - thus at least some people think limited liability is important and necessary.
Empirical research, however, indicates that limited liability is just not that big a deal. British firms had unlimited liability until 1855, California firms had unlimited liability until 1931, banks had double liability until the 1930s and American Express had unlimited liability until 1965. None of this seemed to matter very much.
One reason why unlimited liability may not matter very much is that most of the time capital more than covers tort risk so unlimited liability is usually moot. Insurance requirements, Basel-like capital requirements and other such laws cover externality problems when this is not the case. Most of the time we are not on the bubble where tort does pay and even on the bubble managers can be found criminally liable for truly egregious torts.
Even in an enhanced tort risk environment unlimited liability may not be worth the candle because it can be gamed - assets can be shuffled around to judgment proof investors, and firms can decentralize.
Unlimited liability also raises transaction costs. In a joint and several regime, for example, Bill Gates would be liable for all tort expenditures simply by owning one share of a corporation - that makes Bill Gates less likely to invest and more concerned with who else owns shares in the corporation. And which shareholders should pay, the ones who own the stock when the tort claim is brought or the ones who owned the shares when the tort happened? These problems can be solved but is it worth the hassle?
In my view, the bottom line is that limited liability lowers transaction costs and has few negative effects in part because torts usually do not bankrupt firms and other institutions (such as insurance) substitute for unlimited liability and in part because the advantages of unlimited liability would mostly be gamed away in anycase.
Addendum: Bainbridge has more.
“The limited liability corporation is the greatest single discovery of modern times. Even steam and electricity are less important than the limited liability company”.
Professor Butler President of Columbia University, 1911.
"This limited liability corporation is the bedrock of the market economy…And what do we, the citizenry, get in return for this generous public grant of limited liability? Originally, we told the corporation what to do. You are to deliver the goods and then go out of business. And then let humans live our lives. But corporations gained power, broke through democratic controls, and now roam around the world inflicting unspeakable damage on the earth."
Russell Mokhiber and Robert Weissman, Mother Jones 1999
Posted by Alex Tabarrok on April 30, 2008 at 07:41 AM in Economics | Permalink
Comments
"Similarly, we might ask if A, B and C must pay for any injuries that they negligently cause D then how can they justly combine together to form a corporation and limit their liability?"
You're playing fast and loose with the word "they."
1. If A commits a tort in his capacity as a a principal of "ABC, LLC" then he still has unlimited personal liability no different than if he operated as a sole proprietor --the LLC structure does NOT shield him. The LLC form only shields B and C from liability for the tort that THEY DID NOT COMMIT.
2. If A and B jointly commit a tort in their capacity as a a principals of "ABC, LLC" then they still have unlimited personal liability no different than if they operated as a traditional partnership --the LLC structure does NOT shield them. The LLC form only shields C from liability for the tort that SHE DID NOT COMMIT.
The idea that this is somehow a libertarian abomination is absurd.
Posted by: KipEsquire at Apr 30, 2008 8:18:35 AM
Here's something I've never understood about libertarianism.
Libertarians are not anarcho-capitalists: They say that there is a role for government - at minimum, defense (military) and inner security (police). How, then, can you say that "tax is theft". In other words, how is the government supposed to perform those tasks without collecting taxes?
I'd be grateful if someone could answer that; thanks in advance.
Posted by: LemmusLemmus at Apr 30, 2008 8:53:11 AM
I'm not sure where you got the claim that lack of limited liability "didn't matter very much." Certainly the availability of corporate forms affected what types of companies were formed. On the Continent, the use of the commandite en actions (or Kommandit in Germany) was important in the absence of unlimited liability. [The commandite allowed for two classes of investors with the owners having unlimited liability but a non-voting class having limited liability] Huge amounts of capital were raised as a result. Allowance of full, limited liability firms [e.g. in France] quickly allowed for a variety of companies to form that would not have seen the light of day otherwise. Perhaps at the margin, all these new firms "didn't matter" but I seriously doubt that empirical research on this issue has been extensive. Certainly not enough to claim, "it didn't matter".
Posted by: jn at Apr 30, 2008 9:01:28 AM
Limited liability may not matter to American Express or Microsoft, but it certainly matters to entrepreneurs starting small companies. That's risky enough without facing unlimited liability, and without the limit finding investors would become even more difficult than it already is.
Note also that limited liability creates liquidity. It's one thing to buy some stock when the most you can lose is your investment, and quite another when you may face all sorts of claims. In the second case you will be much more cautious, hence stock holdings will be less liquid than they are today.
As to the really silly "taxation is theft" idea, maybe the distinction is that A,B, and C don't just get to call themselves a government the way they get to call themselves a corporation, at least not in modern democratic countries.
Posted by: Bernard Yomtov at Apr 30, 2008 9:14:34 AM
One reason why unlimited liability may not matter very much is that most of the time capital more than covers tort risk so unlimited liability is usually moot.
So why don't more corporations become partnerships?
Posted by: Floccina at Apr 30, 2008 9:16:05 AM
Regarding the argument that torts don't typically bankrupt firms, doesn't it kind of matter what point of maturity your has attained? I'd worry, without any hard evidence to be sure, that companies seeking to raise capital for their initial expansion would be vulnerable.
Posted by: JasonL at Apr 30, 2008 9:16:34 AM
LemmusLemmus:
My view is that compulsory taxation is always theft and so government revenue should be collected voluntarily. If government were shrunk to a respectable size then I don't think that free-riders would be a significant problem. Especially if people who didn't pay the voluntary fee were denied whatever services government did provide.
Other libertarians might view the very-low tax needed to support a minarchist state as a necessary evil. Certainly paying a flat tax of 5-10% would be 'more just' than what we pay now.
Posted by: Robbie at Apr 30, 2008 9:19:43 AM
Robbie,
thanks. The "deny people who don't pay service" might work with police services, it won't work with defense (military).
Posted by: LemmusLemmus at Apr 30, 2008 9:27:51 AM
KipEsquire, that might be true in the US, but it certainly isn't in the rest of the Anglo world.
In your first example, A, if acting in his capacity as the company (for example, product liability tort; workplace safety torts) is only liable to the extent of the corporation's assets - not his own. Banks contract around this, as Alex notes. But tort victims can't, usually.
OTOH, people can, and often do, shelter their assets from bankruptcy anyway.
Posted by: Patrick at Apr 30, 2008 9:28:33 AM
The "deny people who don't pay service" might work with police services, it won't work with defense (military).
It won't work with police or fire protection either. Or roads. Or courts in many cases. Or bank regulation. Or environmental protection. Or...
Posted by: Bernard Yomtov at Apr 30, 2008 9:49:43 AM
Alex,
You should check out the work by Hansmann and Kraakman on affirmative asset partition theory as an explanation for limited liability also:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=261371
It's interesting stuff.
Posted by: Michael Martin at Apr 30, 2008 9:50:10 AM
I am not a critic of limited liability, but I wouldn't have any problem with pass-through taxation of corporate income (taxing every corporation like a partnership or an S corp). I don't think that most corporations would like it though, because it would make shareholders more anxious for profits to be distributed, and generally corporations seem to like to hold onto them.
Posted by: matt wilbert at Apr 30, 2008 10:16:28 AM
Lemmus,
Most moderate libertarians don't object to *all* taxation, per se, but rather redistributive taxation. For instance, around 50% of the US Federal budget is redistributive in nature, and another 35% or so is military and debt service (debt service, in many ways, is intergenerational redistribution). There are many historical instances of state power in history which, after expanding, serves not to provide public goods but instead to shift money and capital from one group to another.
(Note that more moderate libertarians, myself included, don't even object to all of the redistribution: I think we'd be worse off in a world without unemployment insurance, for a number of reasons.)
Posted by: cure at Apr 30, 2008 10:26:26 AM
There is a position in between the current practice of limited liability and the alternative of unlimited liability for shareholders. It is "proportional liability," where each shareholder is on the hook only for the percentage represented by their stake in the company. That way shareholders don't get a free ride, but a deep-pocketed investor can't lose his entire fortune based on owning a tiny amount of shares in a corporate defendant.
Posted by: RottedOak at Apr 30, 2008 10:29:33 AM
When I was reading about the history of Standard Oil, I was struck by how quickly the LLC idea spread in the US, and how quickly the size of firms grew after it was introduced. Quick adoption and big changes in the size of firms after adoption would seem to argue that *something* important was changing.
Posted by: Zach at Apr 30, 2008 11:08:32 AM
Without limited liability isn't a corporation just a oversized partnership? I likewised put forward the argument of 'why the hell would I buy shares when I am potentially liable for all the business' debt?' before. There were cases in the '80s in particular (and it probably still goes on) where a partner takes all the money of the business and leaves the other partners high and dry with the debt. Likewise what of personal limited liabilty in an unlimited scenario whereby the guy claims to be broke and 'assetless' because everything he supposed owns belongs to his wife?
P.S. Yes there are indeed anarcho-Libertarians who believe all taxes are theft and every government service could and should be privatized in its entirety they usually follow the teachings of Murray Rothbard. On the other hand - a voluntary tax-paid government where those who don't volunteer to pay taxes get denied the services?!?! Isn't that simply a private enterprise??
Posted by: Gil at Apr 30, 2008 11:16:04 AM
"Limited liability of shareholders to creditors is innocuous".
Innocuous as it may be from the point of view of libertarians, it is precisely the limited liability to creditors that was revolutionary and led to a dramatic increase in willingness to take risks with borrowed funds.
It enabled the growth of huge firms -- and arguably fundamentally undermined the very foundations of a competitive economy. (How many partnerships do you personally know of that broke up in acrimony? Without limited liability, partnerships are extraordinarily unstable -- because of the ability to impose huge costs on your partners.)
When competitive theory was born the world was full of mom and pop stores and a 500 person firm counted as remarkably large. Now we live in a world of oligopolies with all the consequences that may be expected of ubiquitous market power and lobbying efforts to generate favorable legislation. Of course, we also live in a world with millions of products that would never have been brought into existence without limited liability.
Limited liability definitely matters -- but whether on balance it is a good thing or a bad thing is anybody's guess.
Posted by: cs at Apr 30, 2008 12:14:20 PM
When combined with the prior claim that corporate creditors enjoy in corporate assets, limited liability generates wealth by promoting monitoring of debtors by creditors, enabling creditors to economize on appraisal costs, and speeding bankruptcy proceedings. See these two articles:
http://www.harvardlawreview.org/issues/119/march06/hansmann_kraakman_squire.shtml
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095430
Alex's "transaction costs" argument is not a benefit of limited liability per se; pro rata liability for shareholders, as opposed to joint and several liability, would provide the same benefit.
Posted by: Richard Squire at Apr 30, 2008 12:27:56 PM
When combined with the prior claim that corporate creditors enjoy in corporate assets, limited liability generates wealth by promoting monitoring of debtors by creditors, enabling creditors to economize on appraisal costs, and speeding bankruptcy proceedings. See these two articles:
http://www.harvardlawreview.org/issues/119/march06/hansmann_kraakman_squire.shtml
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095430
Alex's "transaction costs" argument is not a benefit of limited liability per se; pro rata liability for shareholders, as opposed to joint and several liability, would provide the same benefit.
Posted by: Richard Squire at Apr 30, 2008 12:28:25 PM
This post is way off the mark. Several respondents have interesting points on the subject of limited liability, but the social justice aspect of limited liability that this post attempts to take on is a phantom.
"Limited liability" of corporations does not mean that they have some cap on damages, as this article seems to imply, rather that the company is deemed to have a legal existence separate from the individuals who own it. As the first respondent notes, if AB&C or (or any subset thereof) individually or collectively commit a tort against D, then they can still each be held fully accountable. The limitation applies when an agent of a business venture owned by AB&C becomes a tortfeasor, and it limits the amount of liability of AB&C to their interest in the business venture (i.e., excludes their personal assets).
The agency problems associated with having AB&C be completely liable for all of their employees are horrendous. Without chasing down the fine points of when liability extends from an employee to his employer (i.e., acting in the line of work, etc.), limited liability seems like a reasonable compromise in that it inflicts a risk on AB&C (as owners) that is proportional to the value of the business.
Posted by: Angus at Apr 30, 2008 12:35:11 PM
Does providing limited liability provide reasonable grounds for double taxation?
I think so
Posted by: Mason at Apr 30, 2008 12:42:46 PM
"limited liability is the acme of capitalism"
...or the acne of capitalism--sometimes ugly, but necessary, especially for firms in their rapid growth phase.
As to the "taxation is theft" notion, there is no pat answer. Taxation is plainly more coercive than market transactions. Everyone resents taxation at least to some degree because they have no appreciable say about the product/service bundle that presumably comes with the purchase. That bundle is undeniably unwieldy, wasteful, and sometimes abhorrent to our personal beliefs (like funding abortion clinics, or unprovoked wars).
Whether or not society is possible without taxation is, I think, a pointless debate. Governments exist in this world by necessity, and a common attribute of all governments is the power to tax. The only real debate is the mechanism.
Posted by: h-dawg at Apr 30, 2008 12:43:36 PM
This article covers the same topic... it should be of interest to those posting here, as should be the ensuing discussion that took place on the blog.
http://blog.mises.org/archives/007577.asp
Posted by: Inquisitor at Apr 30, 2008 1:05:35 PM
In general, limited liability is probably the only legal device that we ever produced which truly promotes tha spread of innovation throughout the economy. I am in favour of it.
However, the problem with regulated finacial institutions is not that they innovate too little, but that they have an effective incentive to pass risk onto public authorities. It seems to me that there is a case for either unlimited liability or only very limited protection of their assets for those legally responsible for the affairs of these institutions, as a condition of the institution enjoying the protection of regulation. Ideally (as I now see it, but hoping someone will come up with a better idea), I would like to see a system which allowed these Directors and suchlike to protect themselves by insuring the last few million dollars of their liability, but not more. The combination of personal risk and insurers pricing the risk of the liability being called should be sufficient to change the incentives in the key parts of the world's finance industry.
Posted by: David Heigham at Apr 30, 2008 1:30:43 PM
Most LLCs carry insurance for this sort of thing.
As far as the tax issue: it's only theft when it's the Feds.
I think the whole tax structure is upside down.
I don't know if it's workable, but imagine everyone paying ONE tax to the local city or county where you live. That county then pays "tribute", or whatever you want to call it, to the State, which in turn sends a payment (an allowance if you will) to the Fed.
Sure would cut down on the size of the Fed.
Posted by: jackscrow at Apr 30, 2008 1:32:56 PM
