Limited Liability

by on April 30, 2008 at 7:41 am in Economics | Permalink

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

1 KipEsquire April 30, 2008 at 8:18 am

“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.

2 jn April 30, 2008 at 9:01 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”.

3 Floccina April 30, 2008 at 9:16 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?

4 Robbie April 30, 2008 at 9:19 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.

5 Patrick April 30, 2008 at 9:28 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.

6 Michael Martin April 30, 2008 at 9:50 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.

7 cure April 30, 2008 at 10:26 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.)

8 Zach April 30, 2008 at 11:08 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.

9 cs April 30, 2008 at 12:14 pm

“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.

10 Richard Squire April 30, 2008 at 12:28 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.

11 Mason April 30, 2008 at 12:42 pm

Does providing limited liability provide reasonable grounds for double taxation?

I think so

12 Inquisitor April 30, 2008 at 1:05 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

13 jackscrow April 30, 2008 at 1:32 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.

14 Grant April 30, 2008 at 3:12 pm

Good post, thanks Alex

Bernard, I think a lot of the problem with small businesses and civil suits is the absurd costs of defending against and paying for tort in the US. If we had a more sane system of civil law, I don’t think limited liability would be as necissary. Of course, limited liability to creditors is simply a contractual issue, and not something made possible by state decree.

There are also ways of funding public goods (roads, police, etc) without taxation (I should also note that while governments can provide public goods, they cannot solve the public goods problem, since good government is itself a public good). I would disagree with h-dawg that governments exists out of necessity. I would say they exist because they can exist, unless he would have us believe that government agents aren’t primarily motivated by self-interest. In the same way that firms can exist because they make a profit off of voluntary transactions, governments can exist because they make a profit from taxation. The fact that efficient governments must legitimize themselves in order to survive doesn’t say anything about whether or not they are truly necessary or desirable (I’m not saying they are or aren’t – I have no idea).

15 bernard Yomtov April 30, 2008 at 4:33 pm

I think a lot of the problem with small businesses and civil suits is the absurd costs of defending against and paying for tort in the US. If we had a more sane system of civil law,

Some may be, but after all, there are legitimate torts and legitimate lawsuits, and damages can be large. And of course it’s not only torts, but other types of legal probems as well.

As to debts, it is technically true that these are a contractual matter. In fact, corporation or not, business owners often have to provide personal guarantees on loans to their companies. Outside equity investors generally do not. But it’s not as simple as that. Suppose a loan is already in place and a company seeks equity financing. Under limited liability the lender will have no recourse to the new investor, while without it the lender will have such recourse. That’s not going to be easy to deal with.

As for financing police, etc, without taxes, I think there would be enormous free-rider problems with any non-mandatory scheme. To the extent that police deter crime and react to emergency situations, or even direct traffic, I see no way to exclude any community member from these benefits on grounds of non-payment.

16 Watts April 30, 2008 at 5:02 pm

Jackscrow write:

It would also eliminate Federal pork theft, where you and I pay for some other person in some other states pork.

Maybe, although I think that may be a bit rose-colored, However, if citizens only paid state taxes and the states in turn paid the federal government for rendered services, isn’t there a high risk that you’d actually just be shifting the pork’s locus? I can’t think of any intrinsic characteristic of state government that makes it less susceptible to this than the federal government, and now you’d suddely be handing the state government a lot more money. I gather you’re assuming that this would reduce the size of the federal government, but even if that’s true, I’d think that in the absence of any other controls, most of that size would simply be absorbed by state governments.

17 Rex Rhino April 30, 2008 at 5:43 pm

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.

Voluntary contributions… Service fees… it doesn’t seem like a rhetorical question, but couldn’t you answer this yourself.

18 Bernard Yomtov April 30, 2008 at 7:15 pm

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.

Voluntary contributions… Service fees… it doesn’t seem like a rhetorical question, but couldn’t you answer this yourself.

I think he was looking for a rational answer.

19 Gil May 1, 2008 at 2:44 am

Duh! As I said before – a ‘government body’ that provides services to the paying and can refuse services to nonpayers is simply a private business.

20 Eric H May 1, 2008 at 7:34 am

[Service for fee] won’t work with police or fire protection either. Or roads. Or courts in many cases.

Except that we have real-world examples where it has. Private police & fire protection, private and public toll roads, and private arbitration exist (or existed). Unfortunately, denialists effectively argue for a world in which one very big simple institution would replace complex interlocking sets of institutions.

21 Gil May 1, 2008 at 10:44 am

I haven’t a clue what you mean Robbie. A private landowner could just as easily theoretically use lotsa force against a trespasser or turf out a non-paying tenant

22 Jeremy May 1, 2008 at 12:46 pm

And here I thought the idea was that they should continue to deliver goods (incidentally providing gainful employment) and services so long as they were demanded by consumers, and able to provide them.

But you don’t need to be a corporation if all you want to do is work together to help people. If it’s all about serving the customer, you can do that right now. Nobody’s stopping you.

People form corporations to enable themselves to make decisions they wouldn’t otherwise make. To protect themselves against the dangers of fraud and malfeasance in the management of the group’s assets. To protect themselves from third party liability. To appeal to an organized body of law applying specifically to them to help them sort out difference. Subsidized corporate regulation and inspection. Get to the right size and you can start making some serious campaign donations.

The state inputs are enormous. In fact, one journalist recently claimed that corporations’ consumption of subsidies, privileges, foreign policy “services”, road and rail infrastructure, and more all dwarfed the total profits of corporations by a factor of *five*.

23 Jeremy May 1, 2008 at 6:40 pm

Jeremy, people form corporations for a variety of reasons.

Right, but the ultimate reason is that they want to do business in a manner they can’t as an individual or group of individuals. We should think carefully about that: why do people want legal privileges to do business with others on special terms that everybody, regardless of being party to the business, must agree with? Until we answer that question, we can’t begin to talk about the appropriateness of entity status.

24 Eric H May 1, 2008 at 11:09 pm

Such a limited imagination.

If you want to limit yourself to private security (rent a cops?), I’m not interested in circumscribing the discussion that narrowly. Private police protection is well described in David Friedman’s Machinery of Freedom, where he points out that it doesn’t work for (as I recall) random highway robbery. So, private police for some crimes, public police for those areas where it doesn’t work (unless an alternative can be found).

Fire protection has been done on a contractual basis and through insurance companies and through other arrangements. I’m not sure what you mean by being forced to pay for it; if you are arguing that any fee for service implies that you are being forced to pay for the service, have fun with the Billy Goats.

I’m glad you agree that arbitration has its place. Too bad you’re so resentful that somebody is encroaching on what you seem to consider to be the state’s territory.

If you want to talk empirical evidence, fine. Plenty of evidence of sustainable, polycentric societies, many of which easily outlasted modern societies. If you want to limit the discussion to state capitalist societies, I’m afraid you’re just assuming away all of the alternative structures. Have fun with that.

25 Jeremy May 2, 2008 at 8:24 am

However, corporations have certain rights that groups of individuals certainly would have if they lived in Libertopia (or Rothbardia).

Let’s stop right there. Corporations are legal entities created by government fiat. They are state interventions in the economy. Nobody’s talking about libertopia – my only point is that you cannot talk about corporations without talking about political interventionism in the economy.

Most libertarians simply aren’t interested in this argument because it’s supposedly self-evident that corporations are a net benefit for society. But there are lots of state interventions which liberals and conservatives support which could be argued as net benefits that we oppose. Libertarians stand apart because we argue that individuals come first, and that net benefits should be sorted out by free(d) markets – yet we support the creation of fictional entities on the same terms as flesh-and-blood humans.

For example, groups of individuals cannot sell shares of commonly-owned property on a publicly-traded exchange unless they form a legal entity known as a corporation.

My only point is that corporations are not free market phenomena; they are the very definition of state capitalism, where the rules are written to favor certain scales of capital aggregation. There’s no argument one can make for them except a pragmatic one, and there’s a lot of moral arguments one can make against them.

I’d also caution you against deriding legal entities in general; they can be useful abstraction of groups of individuals, and IMO only become silly when they possess rights that no individuals would have without their entity status.

As an anarchist, my rule of thumb would be that any group of people can contract among themselves to pool assets and do business with others. But the legal entity isn’t just about that: it’s about making third parties to the contracting respect the corporate identity. If you can convince everybody in the purview of the corporation’s business to respect its entity status, then great. But this would be difficult to do for every single person, which is why businessmen appeal to the state for legitimacy they can’t get from their fellow men. Obviously, I have a problem with this.

For the life of me, I can’t see why a libertarian would eschew bureaucracy in government only to embrace it in corporations. Ugh.

26 Bernard Yomtov May 2, 2008 at 12:07 pm

If you want to limit yourself to private security (rent a cops?), I’m not interested in circumscribing the discussion that narrowly. Private police protection is well described in David Friedman’s Machinery of Freedom, where he points out that it doesn’t work for (as I recall) random highway robbery. So, private police for some crimes, public police for those areas where it doesn’t work (unless an alternative can be found).

You, know, if you want to make an argument you should make one, rather than referring me to some book or other. I stated some reasons I think police protection is a public good. If you disagree please explain.

Fire protection has been done on a contractual basis and through insurance companies and through other arrangements. I’m not sure what you mean by being forced to pay for it; if you are arguing that any fee for service implies that you are being forced to pay for the service, have fun with the Billy Goats.

Gee. I didn’t know insurance companies owned fire engines. What I am saying is that if fire protection in an area is a monopoly – and it certainly is a natural monopoly – and all those in the area are required to pay for it, there is little difference whether it is supplied by the state or a private company. And I’m further arguing that it is idiotic to think that making payment voluntary makes the slightest bit of sense. Is the fire dept really supposed to refuse to respond to a nonsubscriber? If you see a fire and call in are you going to know whether the house is entitled to protection?

As for arbitration, I’m not resentful. I just point out that it is not the marvelous all-purpose solution you seem to imagine. It’s of value, but limited value. You really shopuld learn more about it though.

If you want to talk empirical evidence, fine. Plenty of evidence of sustainable, polycentric societies, many of which easily outlasted modern societies. If you want to limit the discussion to state capitalist societies, I’m afraid you’re just assuming away all of the alternative structures. Have fun with that.

Maybe you’d care to point some out. Wait. I know. Medieval Iceland. Right? What a joke.

I’m not “assuming away” alternative structures. I’m pointing out that the most successful, and freest, societies in history are the modern democracies.

You may think I have a limited imagination. I think you have a limited grasp of reality.

27 Grant May 2, 2008 at 2:49 pm

Jeremy,

As an anarchist, my rule of thumb would be that any group of people can contract among themselves to pool assets and do business with others. But the legal entity isn’t just about that: it’s about making third parties to the contracting respect the corporate identity. If you can convince everybody in the purview of the corporation’s business to respect its entity status, then great. But this would be difficult to do for every single person, which is why businessmen appeal to the state for legitimacy they can’t get from their fellow men.

This is where I think you are wrong. People doing business with corporate entities will, in general, voluntary respect the abstraction and its corporate identity. Why? Because it makes nearly everything involved in doing business a LOT easier. Try trading stock futures or options without a corporate abstraction; the contracts will be a lot more convoluted. As I mentioned before, in America businessmen absolutely must use corporations to do some totally voluntary things, because doing them in other manners would be illegal.

I’m sure its true that some businessmen use corporations to gain advantages they wouldn’t be able to get voluntarily, but I really don’t think this is a big problem in practice. As Alex points out, limited tort liability rarely limits tort rewards, and limited debt liability is a contractual matter. Businessmen will of course follow incentives like everyone else, and so will take advantage of what opportunities governments grant them.

Bernard,

But we see few if any such arrangements in the areas we are discussing. One problem, with police specifically, is that their objectives must be achieved within strong constraints. It would probably be easier to catch criminals if we let police search or interogate with no reason, etc., but we need to control their activities. We also need well-defined procedures for criminal trials, punishments, etc. I don’t see how that can be done without a state. Note that a state is not sufficient for this, but I do think it is necessary. If you accuse me of stealing from you you need police to investigate, but I’m not a party to your private contract with your police. Yet I need protection from an abusive investigation, just as your police need some basis to conduct any investigation at all.

Why couldn’t policing constraints be defined in the contract that hires them? Breach of constraints could mean loss of pay or termination of services. When a cop screws up, he should be fired like any other bad employee. Do you think the incentives for private police to behave well would be lesser than the incentives for state police to do the same?

As for my police agency abusing your rights because you aren’t under their protection, that already happens. Politicians have little incentive to respect the rights of groups who do not vote, hold no political sway, or are not favored by their selectorate. The Iraqis, for example, were not consulted or polled on the invasion of or sanctions against their country, despite assertions that American leaders were dedicated to democracy. So I think the question would be: Do governments have more or less incentives to respect the rights of non-citizens than would private defense forces? One group must act to please its selectorate, the other its customers.

28 Eric H May 3, 2008 at 12:18 pm

Wait. I know. Medieval Iceland. Right?

No, actually. 18th and 19th century Great Britain. Name calling doesn’t make these things not exist.

I’m pointing out that the most successful, and freest, societies in history are the modern democracies.

And I’m pointing out that things could be better. Both of us are asserting these things.

29 P.M.Lawrence May 4, 2008 at 5:41 am

“British firms had unlimited liability until 1855” – this is false. Any firm that had obtained a suitable charter or Act of Parliament that conferred limited liability had it, it was just that there was no simpler way to get that status – no Companies Acts enabling it – so the typical firm had to be a partnership or sole proprietorship.

LemmusLemmus, small governments can function on the back of revenues from endowments to pay for their overheads; this is what was suggested in the run up to the Civil War, that “the King should live off his own” (something that had been disrupted by New World bullion inflation).

Bernard Yomtov, there is nothing absurd about fees covering the remainder of government services; this is precisely how, from at least the 16th to the 18th centuries, England (and then the U.K.) provided most of what was taken over by the tax funded Civil Service in the 19th century. Free rider problems are a strong indicator that the “service” provided is spurious, and the remedy is to stop giving the “service”; for the genuine services, they are the “price of doing business” for anyone so presumptuous as to want to rule, and so should be met from endowed funds, not by any of the public who didn’t want to play the ruler/ruled game in the first place. That is, free riders earned their “free” ride by putting up with the government; it’s not free, so let the government pay for its own fun from its own funds.

And if people don’t want to endow a government? Well, they don’t want one then.

Oh, and putting endowed funds into (legally privileged) incorporated companies is just as much a hidden tax as selling (legally privileged) monopolies was in Elizabethan times – and so is printing money to “invest” in an endowment to set one up or to top one up (it achieves a wealth transfer, not an investment).

30 Kevin Carson May 6, 2008 at 1:49 pm

Limited liability against creditors isn’t “just a matter of contract.”

While Hessen might be right that the corporate entity status and limited liability against creditors could be negotiated entirely by private contract, absent a statutory provision for general incorporation the process of negotiating it would have much higher transaction costs. And if it were done on an ad hoc basis, rather than being automatic, creditors would be in a stronger bargaining position to simply refuse, or to demand some sort of default insurance.

By making general incorporation automatically available as a standard business organization, and providing ready made forms and procedure, the state makes the limited liability corporation artificially prevalent and reduces the bargaining power of those who might otherwise rein in its limited liability if it were “just” a matter of contract.

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33 nana May 14, 2009 at 9:34 pm

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35 r4 games March 4, 2010 at 11:58 pm

I also agree that there is nothing wrong in theory about limited liability for contractual debts. The problem is that corporations, as they exist now, are statutorily created privileges, and not a creature of common law. The idea of a fictitious person is the source of much confusion and misapplication of fundamental principles. It would be far better to just call it what it should be – contractually limited liability, and move on.

36 Josh Fulton June 20, 2010 at 10:36 am

“Lowers transaction costs” for the parties doing business (ie company 1 & 2), raises the cost of business for the rest of society, because the risk is now foisted upon their shoulders.

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