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A sensible approach to limited liability

I have noticed from some libertarians, such as “left libertarians” such as Roderick Long, a hostility to the idea of limited liability corporations. I understand and even sympathise with such opposition to statutory limited liability. It can and does foster corporate structures that become so unwieldy that they are indistinguishable from the State in key respects. But the key word to remember here is statutory. Consensual Limited Liability of a sort that can be arranged without an explicit statutory power is, in my view, no different from say, other consensual commercial transactions that are recognised in law, such as via Common Law. Of course, limited liability firms may be far less common under such a system but it is unwise to bet on it disappearing. And given all the benefits of limited liability: the ability to get large pools of investors to finance large ventures, it seems an issue worth examining in detail.

The reason some free marketeers, particularly of the more radical sort, get angry about limited liability is that they see ownership and control torn asunder, creating a serious misalignment of interests. Case in point being an argument made by Kevin Dowd and Martin Hutchinson, in their book that analyses the recent credit crunch, Alchemists of Loss. They take the view that listed banks, protected by limited liability, have, unlike old partnership-owned banks with unlimited liability, made dangerous bets. A problem that is, of course, made much worse by corporate welfare via bailouts, central bank funny money, the usual. In the same way, you could argue that limited liability companies in general exhibit negative behaviours when politics intrudes.

But one of the High Priests of libertarian capitalism, Murray Rothbard no less, made it clear that there is nothing in principle wrong with the idea of limited liability. His argument strikes me as pretty solid:

“Finally, the question may be raised: Are corporations themselves mere grants of monopoly privilege? Some advocates of the free market were persuaded to accept this view by Walter Lippmann’s The Good Society. It should be clear from previous discussion, however, that corporations are not at all monopolistic privileges; they are free associations of individuals pooling their capital. On the purely free market, such men would simply announce to their creditors that their liability is limited to the capital specifically invested in the corporation, and that beyond this their personal funds are not liable for debts, as they would be under a partnership arrangement. It then rests with the sellers and lenders to this corporation to decide whether or not they will transact business with it. If they do, then they proceed at their own risk. Thus, the government does not grant corporations a privilege of limited liability; anything announced and freely contracted for in advance is a right of a free individual, not a special privilege. It is not necessary that governments grant charters to corporations.”

39 comments to A sensible approach to limited liability

  • I agree with you, and Rothbard.

    It reminds me of the similar argument about fractional reserve banking. You may think it unwise. If you think that, don’t do it. It should only be illegal if it is fraudulent, i.e. if a bank says it isn’t doing it, but is.

  • lukas

    That works as far as limited liability for debts is concerned, but you cannot eliminate limited liability for torts in such a consensual matter.

  • Johnathan Pearce

    Lukas, it may not be possible to eliminate tort unlimited liability that way. Depends who brings the tort.

  • John B

    I have seen so many people slip from limited liability company to limited liability as soon as the debts of the first one pile too high that my general perception is that they are part of the unaccountability culture that has caused havoc in western, and thus global, economies.
    Yes, similar to the disaster that has been foisted on less than financially-trained in all the swings and roundabouts of financial wheeling dealing, ordinary folk, of fractional reserve. It is a con or soon becomes part of one.
    Why create loopholes?
    Interesting phrase “High Priest”. A concept of initiates and priesthood may be part of the problem. It leads to the superiority of the elites where it does not become the common nod-wink of the lower classes?

  • Shirley Knott

    Where you, Rothbard, and the rest of the limited liability by contract crew seem to go wrong is in the leap from the individual to the group. This is evidence in your starting premise wherein a group of individuals pool their resources and announce to the world that this is all they are willing to risk.
    Does an individual have the right to say ‘this is all the resource I am willing to risk, choose to do business with me or not as you please’? If not, whence cometh the alleged right of the group to do so?
    If the individual does have such a right, why do we not see it exercised?
    And how is it that the circumstances which prevent it from being exercised by the individual do not apply to the group?

    no hugs for thugs,
    Shirley Knott

  • Johnathan Pearce

    Where you, Rothbard, and the rest of the limited liability by contract crew seem to go wrong is in the leap from the individual to the group. This is evidence in your starting premise wherein a group of individuals pool their resources and announce to the world that this is all they are willing to risk.

    Well of course. If a group of 10 investors form a LLC, then it is pretty obvious that anyone who deals with them knowingly cannot then later claim to an unlimited degree. This is not about “leaping” from one position to another.

    Does an individual have the right to say ‘this is all the resource I am willing to risk, choose to do business with me or not as you please’?

    Yes. Provided there is consent, he or she can say and do what they want. End of subject. to ban people from making such agreements would be wrong. No hugs for thugs, indeed.

  • Does an individual have the right to say ‘this is all the resource I am willing to risk, choose to do business with me or not as you please’? If not, whence cometh the alleged right of the group to do so?

    This is a bit like saying “does anyone have the right to offer to enter into a voluntary contractual relationship with anyone else?”

  • John B

    I would agree that a person should be free to go into business and say: this is all I am willing to risk just as long as that person does not take on debt more than they are willing to risk!

  • Johnathan Pearce

    I don’t see any real difference, where the consent issue is involved, in someone betting at cards or on the horses while limiting their overall exposure to a set amount. In spreadbetting, for example, firms that set up accounts routinely require speculators to stipulate points at which they can get out.

    Limited liability is in some ways an attempt, by law, to address the fact that while we want to take risks in pursuit of wealth, that we also have limits, for our own peace of mind and sanity. I fail to see why, in a sophisticated business world, that it should not be possible for people to make consensual arrangements that take account of these things. To say otherwise seems bizarre, almost destructive of any serious business, large or small.

  • Cousin Dave

    I completely agree that there has to be provision for people who wish to take ventures to set bounds on their risk. If engaging in any kind of venture required the acceptance of unlimited risk, very few people would do to. This is a bad thing, unless you’re a socialist who believes that all enterprises should be run by the government (which, of course, never accepts any risk).

    There is a legitimate complaint to be made today about setups where individuals gain ownership and control shares that are out of proportion to the risk that they have accepted. We have the situation where the principal owners of several USA banks have succeeded in transferring most of their risk to the taxpayer, while retaining almost full control. I would argue that that’s not a feature of corporate law; it’s a bug, and one that should be fixable once we can get the politicians responsible out of office.

    A more subtle situation is the one where corporations divide their common stock into classes, such that the insiders hold special shares with supernumerary powers. I believe it’s still the case that the NYSE and NASDAQ will not list such stocks, but some companies do it anyway. You can make a case that that as long as full disclosure exists, this should be legal, but I’ve had a bit of personal experience with this and it’s often the case that only a securities lawyer can unravel the disclosure to figure out what is actually being disclosed. Brokers in these stocks often don’t reveal to clients that these disclosures exist until after the sale. Therefore, I do think the existence of such split common stock classes is borderline fraudulent, and I don’t understand why the securities industry doesn’t take more interest in cleaning this up.

  • Cousin Dave: it’s not as if anyone is forced to buy it?

  • Pooter

    What about third party damages? No corporate apologists can answer this challenge to the legitimacy of limited liability. Who would consent to owning a portion of a chemical company (cough, Union Carbide, cough) and derogate control to a revolving clique of directors if they will be personally and financially responsible when the shit hits the fan.

    Of course, when the shit does hit the fan and the victims come for compensation, the state is all too willing to hand it out whilst bemoaning the irresponsibility of “unregulated free markets”.

    Some libertarians are happy to be their accomplices by agreeing that yes, corporations really are creatures of the free market. Meanwhile, any reasonable person thinks: “if that’s the free market, then I’m against it”.

    Libertarians: shooting themselves in the foot since 1957.

  • Johnathan Pearce

    What about third party damages? No corporate apologists can answer this challenge to the legitimacy of limited liability. Who would consent to owning a portion of a chemical company (cough, Union Carbide, cough) and derogate control to a revolving clique of directors if they will be personally and financially responsible when the shit hits the fan.

    Cool it. I guess anyone who forms a corporate entity – like any individual trader – will need to take out insurance or set aside funds to deal with such third party claims.

    As I said in my original posting, I am making no specific claims for the exact nature of LL as it would work in the absence of statutory privilege, but I think Pooter, and others, have such an ideological hatred of the very concept that they cannot think of how it could occur without the hand of the state. What I am saying is don’t be so sure.

    1957? The publication date of Atlas Shrugged. Quite what the point you are making is unclear.

    In many ways this debate is a bit like the ones we had about intellectual property rights. Some opponents of statutory IP cannot even imagine any other kinds, either.

  • Pooter

    Johnathan: That makes no economic sense. Think about it. In your scenario one group of individuals (shareholders) are not willing to risk unlimited damages, so they buy a policy from another group of individuals who are willing to accept unlimited damages. How much would that policy cost? Even if they could find a collective of clinically insane billionaries to issue such a policy, it would be so astronomically expensive that the company would be inefficient when compared to traditional enterprises where the owners maintain day-to-day control and consequently are able to control and mitigate the risk of unlimited personal damages.

    But, aside from being able to demonstrate that LLCs would be rare in a true free market, you know what: yes, I admit it, I do hate corporations. I’m not a libertarian because of some autistic devotion to consistency, but because I think genunine human autonomy leads to individual and collective happiness and contentment.

    My experience leads me to believe that an economy dominated by a combination of corporations and the public sector decrease human autonomy: essentially you are free to choose which microcosm of soviet bureaucracy you want to work for. Team building, best practice, workshops, taskforces, appraisals, “human resources” departments: is this really your vision of a free society?

  • RAB

    Yeah what about third party damages Pooter?

    This is how the State handled it back in the 60′s. They wanted the damages very limited indeed, almost to the point of…” Nothing to see here, move along”.

    http://en.wikipedia.org/wiki/Aberfan_disaster

    And we were all shareholders in that, being a nationalised Industry.

    Read it and weep!

  • The notion that limited liability absolves directors and operators entirely from potentially unlimited liability is a fiction, Pooter. For example in cases of fraud or indeed any criminal actions, it should not be possible to limit the liability of people found guilty of criminal malfeasance.

    Likewise in cases of negligence, liability is often assigned personally regardless of a company’s status.

  • Cousin Dave

    So Pooter, the two messages that you are putting across are:

    1. People should never be permitted to form groups or teams of any kind, for any purpose. (Your contention that in a free market no one would ever do so is ludicrous… the only way such a mandate could be enforced would be through a very heavy-handed state entity. And guess what? The state is an organization too! So under your own reasoning, the state that would enforce this no-partnerships mandate cannot exist.)

    2. All individuals should face unlimited liability for every single thing they do. Does that sentiment extend to blog comments?

  • Jonathan,

    with regard to the Rothbard quote, there is a very significant footnote he attached to the paragraph:

    It is true that limited liability for torts is the illegitimate conferring of a special privilege, but this does not loom large among the total liabilities of any corporation.

    So, contrary to what he implied with the bulk of the comment, he did actually acknowledge that LL is an illegitimate privilege, but attempted to downplay the extent of the privilege.

    Personally, I don’t find his downplaying convincing. The issue with torts is not that they are routinely a big item on the balance sheet, but that they present one of the biggest risks of a sudden, large and unaffordable cost.

  • Pooter

    Perry: I am aware that directors are occassionally thrown to the dogs after some big cock-up, but it is the exception rather than the rule, you have to admit. Are you suggesting the state should modify the rules so that directors can be bankrupted by third-party compensation claimants in the same way a sole trader can be?

    Cousin Dave: I don’t understand your point 1 relates to anything I’ve written. I am not against partnerships, co-operatives or any other form of organisation or team that is accountable for unintented consequences of its business activities. I’m also not sure what your cryptic comment about blog comments means. How have I harmed anyone with my comments?

  • Laird

    The problem with this topic (at least, as laid out in Johnathan’s essay) is that it conflates a number of very different issues. He asserts that limited liability “can and does foster corporate structures that become so unwieldy that they are indistinguishable from the State in key respects.” Limited liability of itself does not foster such structures; that’s more an artifact of other features associated with the corporate form, such as perpetual life, the separation of ownership from control/management, and easy transferrability of ownership, as well as moral hazards created by governmental action (i.e, deposit insurance, bail-outs of failing enterprises, price supports, etc.). These really need to be deconstructed and discussed separately.

    I have not yet read “Alchemists of Loss”, although it has been on my reading list for quite a while. However, from the extracts I have read, it is not my understanding that Dowd and Hutchinson were arguing against limited liability per se, any more than they were arguing against fractional reserve banking per se. Rather, my understanding is that they were addressing the pernicious effects of deposit insurance, which removed (or at least minimized) the incentive for depositors to keep the excesses of “cowboy bankers” in check. (See the extract appearing as a SQOTD last year.) I completely agree with that position, but deposit insurance is a separate topic.

    As to limited liability, a few commenters here have properly separated it into contractual versus non-contractual (i.e., tort) relationships. No one seems to have a problem with knowingly entering into a relationship with a company which has limited liability; it’s the tort aspect which causes people problems. While it is certainly possible (and appropriate) to insure against tort liability, that does not provide absolute protection; all insurance policies have caps and exclusions, as they must. In a limited liability system, damages collected are limited to the amount of insurance plus the net worth of the company. Some people view that as wrong, that the personal assets of the owner should also be at risk. I understand the point, but unfortunately in modern society it is completely unworkable. It’s not just that so much of our economy is based on large capital-intensive industries, which would simply not be possible without the protections afforded to non-manager owners, although that’s certainly true. It’s also a result (in the US, anyway) of our out-of-control legal system. Where lawsuits are filed (and won) on the most frivolous bases, and jury awards are functionally unlimited (especially in class-action suits), no rational person would start a business of any size were it not for some limitations on personal liability. Unless you radically change the tort liability system limited liability is absolutely necessary.

    Also, if you fail to follow the proper formalities, treat the company as your personal piggy-bank, or organize it with capital insufficient to the reasonable need of the business, the protections of the corporate form will be forfeit anyway. But with an adequately capitalized company, that should be sufficient for any reasonable tort award.

    Remember, there is always a limit on the damages that can be collected from a company, even if it’s simply the result of the owner’s personal bankruptcy. Statutory limited liability simply codifies that. It’s fundamentally a good system, and rarely causes any other than theoretical problems. Most real-world problems are the result of other factors, principally government-created.

  • Perry: I am aware that directors are occassionally thrown to the dogs after some big cock-up, but it is the exception rather than the rule, , you have to admit.

    In criminal cases (including criminal negligence), no it is not at all unusual… nor should it be).

    Are you suggesting the state should modify the rules so that directors can be bankrupted by third-party compensation claimants in the same way a sole trader can be?

    If a sole trader is not expressly limiting his liability, then he is not, er, expressly limiting his liability… if directors are, then you trade with them on that basis… and any differences for third parties are only relevant if the ‘cock up’ in question falls outside the normal realm of operating risks (as if the loss is ‘typical’ obviously you are just going to sue the company).

    There are all sorts of situations where third parties can go after directors personally if their decisions have caused harm to said third parties (most obviously in criminal negligence cases)… there is vast case law on that, particularly in the USA

  • Johnathan Pearce

    Lots of good feedback here. I will begin with C. Pooter:

    Think about it. In your scenario one group of individuals (shareholders) are not willing to risk unlimited damages, so they buy a policy from another group of individuals who are willing to accept unlimited damages. How much would that policy cost? Even if they could find a collective of clinically insane billionaries to issue such a policy, it would be so astronomically expensive that the company would be inefficient when compared to traditional enterprises where the owners maintain day-to-day control and consequently are able to control and mitigate the risk of unlimited personal damages. But, aside from being able to demonstrate that LLCs would be rare in a true free market, you know what: yes, I admit it, I do hate corporations. I’m not a libertarian because of some autistic devotion to consistency, but because I think genunine human autonomy leads to individual and collective happiness and contentment.

    Well people buy insurance against catastrophes all the time. Your argument would be an argument against insurance in general.

    Look, I am not saying that the tort issue is not significant – it plainly is. Take the case, say, of a chemicals manufacturer; the business owners will, at the outset, realise there are risks of things such as pollution, and lots of nasty lawsuits as a result. In a world without statutory LL, they would have to be able to be as sure as they could that they could deal with any torts, or, if not, they’d face ruin. So obviously with more “dangerous” types of business, the issues would become more difficult. I am not making firm predictions: I say, let the market sort it out.

    Perry: I am aware that directors are occassionally thrown to the dogs after some big cock-up, but it is the exception rather than the rule, you have to admit. Are you suggesting the state should modify the rules so that directors can be bankrupted by third-party compensation claimants in the same way a sole trader can be?

    Perry can answer for himself, but again, as far as I am concerned, if we get rid of statutory LL and leave it to the Common Law, then the principle of consent would apply, as far as claimants are concerned. If I deal with a firm knowing it to be LL, then my claims are limited. It is the same as what Brian Micklethwait said about a fractional reserve bank: if I deposit cash in a FRB bank, I am taking a risk, but doing so with my eyes wide open. I cannot later complain if I lose some or all of my money.

    Paul Lockett, thanks for the additional quote. However:

    So, contrary to what he implied with the bulk of the comment, he did actually acknowledge that LL is an illegitimate privilege, but attempted to downplay the extent of the privilege. Personally, I don’t find his downplaying convincing. The issue with torts is not that they are routinely a big item on the balance sheet, but that they present one of the biggest risks of a sudden, large and unaffordable cost.

    As far as I read it, Rothbard regarded LL – when arrived at without state privilege – as an arrangement that could still be vulnerable in law where torts were concerned, but I don’t think he saw it as a “priviledge” (he was an anarcho-capitalist, after all). My defence for consensual LL is hedged with an acknowledgement that catastrophic torts can still ruin a business and its owners. Rothbard thought the same, clearly.

    Laird: as far as I recall, Dowd and Hutchinson do criticise the concept of LL in fairly fundamental terms, in fact. I strongly recommend that you read the book. It’s excellent in many respects but I also think they need to work through the LL issue a bit more.

    The problem with this topic (at least, as laid out in Johnathan’s essay) is that it conflates a number of very different issues. He asserts that limited liability “can and does foster corporate structures that become so unwieldy that they are indistinguishable from the State in key respects.” Limited liability of itself does not foster such structures; that’s more an artifact of other features associated with the corporate form, such as perpetual life, the separation of ownership from control/management, and easy transferrability of ownership, as well as moral hazards created by governmental action (i.e, deposit insurance, bail-outs of failing enterprises, price supports, etc.). These really need to be deconstructed and discussed separately.

    Not quite; I say that I agree with some of the arguments made by people – such as Roderick Long – that parts of LL can lead to things they dislike, but I’ll readily grant that some of the things they claim to hate about Big Business are not intrinsic to LL but due to other things. After all, Mr Pooter says he hates many of the features of big business, but imagine if a big business were to be run on an unlimited partnership basis. One might find that such a firm, terrified of the dangers of torts and so on, would insist on an incredibly anti-risk, cautious corporate culture with lots of bullshit to contend with.

    As Laird said, LL, and its advantages in terms of raising funds for large-scale enterprises, are so strong that any opponents of statutory LL cannot just blithely assume that the outcome would be broadly benign. Many of the large firms that have produced products and services of great value might never have existed. I know this sounds like a consequentialist argument for LL, but we need to be careful before we screw around with an aspect of corporate law that has been around for more than 100 years or more.

  • JP:

    As far as I read it, Rothbard regarded LL – when arrived at without state privilege – as an arrangement that could still be vulnerable in law where torts were concerned, but I don’t think he saw it as a “priviledge” (he was an anarcho-capitalist, after all).

    That’s a fair comment. I should have been more precise in my comment and said “So, contrary to what he implied with the bulk of the comment, he did actually acknowledge that LL as it is current granted by the state is an illegitimate privilege, but attempted to downplay the extent of the privilege.”

    My defence for consensual LL is hedged with an acknowledgement that catastrophic torts can still ruin a business and its owners. Rothbard thought the same, clearly.

    I think you’re being overly kind to Rothbard by implying that he is making the same point as you. In my experience, Rothbard’s writing has a tendency to get sloppy around issues which present difficulties for his argument.

    What you appear to be saying is that:

    1. Statutory LL is essentially consensual LL, plus LL for torts.
    2. LL for torts provides a state granted protection against potentially ruinous liability.
    3. Therefore, statutory LL is materially different to consensual LL and an argument in favour of the latter doesn’t automatically justify the former.

    If I am not mis-representing your position, then I tend to agree with you.

    What Rothbard says is:

    1. Statutory LL is essentially consensual LL, plus LL for torts.
    2. LL for torts is essentially irrelevant.
    3. Therefore, statutory LL is materially the same as consensual LL and an argument in favour of the latter automatically justifies the former.

    That I disagree with.

  • AndyJ

    I wish those who advocate rules would have experience in the real world and would be able to demonstrate that they have started and run a successful business by these same rules/principles.

    Most lenders seek a personal guarantee. This pierces the limit of liability limitation. Trade creditors don’t always seek the personal guarantee, altho, some do.

    Regarding a monopoly; No private enterprise can abuse it’s natural monopoly position i the marketplace without compliance and assistance from the government. Natural monopolies occur as companies seek to maximize their market and economies of scale. The consumer is the winner. Any consumer abuse of this position without protection from a government agency brings competitors. No monopoly position can be held against changes in technology.

    as the old silicon Valley wag said “When the paradigm shifts we all go to zero.” witness Microsoft, IBM, Netscape, AOL, Yahoo, etc.

    Without protection these companies have to scramble to continually improve the value they provide to the consumer. Yes, Microsoft has a dominant position, but don’t tell Google, Facebook, Twitter, etc… News Corp bought MySpace and despite all its wealth and talent has not been able to compete against Facebook.

    The marketplace winnows the winners and losers without lots of govt interference and despite the desire of so many to redistribute, rather than re-invest, the profits of the successful…

    Humans only need a few rules to assure a level playing field for all participants to innovate and succeed. The rule makers like to pick and choose based on some criteria that usually doesn’t consider the consumer. This is not open or free competition responding to a perceived need. It is cronyism and assumes a limited and restricted marketplace. When the market is open to entry the providers do not need protection nor fear any new entrants.

  • mdc

    Liability can be limited consensually in the case of a loan. This already happens for mortgages, for instance – if you default you lose the house, but nothing more, even if the house was worth less than the outstanding balance of the loan.

    But liability also encompasses potential recompense owed for hurting other people. Under the current system you can make a holding company, do something reckless, and if you get sued, simply declare bankruptcy with the holding company that contains no assets.

    So to say that ‘consensual limited liability’ is fine is a bit like saying that just because you don’t want an NHS doesn’t mean you want to outlaw hospitals. Plainly, but they’re not the same thing at all.

  • mdc:

    Liability can be limited consensually in the case of a loan. This already happens for mortgages, for instance – if you default you lose the house, but nothing more, even if the house was worth less than the outstanding balance of the loan.

    I’m not sure where you’re commenting from, but that isn’t true in the UK. Any shortfall remains a liability which the borrower is liable for. On the flip side, if the house sells for significantly more then value of the loan, the borrower is entitled to the surplus.

  • AndyJ

    In the US home mortgages are non-recourse; meaning the mortgage holder gets the property and note holder owes no more.

    In the case of the whole meltdown, I’m surprised that nobody has noted the responsbility of the Financial Accounting Standards Board. In Nov 2007 the enacted the “mark-to-market” requirement for all public company assets. In the financial industry this requirement meant that the notes held should be priced at the “market rate” or what the last known similar note sold for. This essentially trashed the balance sheet holdings and made even performing notes worth less because someone had sold one at a discount. In January Bear-Stearns hit the wall…and of course, their holdings were marked down-further depressing the value of the remaining holdings. Notes that were bundles of notes, both good and bad, but still performing were called into question and the world’s financial structure collapsed.

    If your personal balance sheet was similarly restricted and a neighbor underwent a divorce. The couple decided to sell at fire sale rates simply to get away from the other party. Your house would then be valued at that fire sale price. Your banker would be calling asking for additional collateral as your home value was now less than the “market rate”… You would need to sell some assets, usually your best ones to get quick cash, or surrender the house. If that happened the rest of the homes in the neighborhood would be further depressed in value- despite no change in payments and no intent to sell on your part.

    When the FASB rescinded their ruling in April 2009 suddenly the crisis was over. The June 30 (second quarter financial s) reported a boost in values…

    Jumping up and down about this manufactured crisis is cute and fun. The manufactured part could have been rescinded quicker -but- by the time anyone understood what went wrong govt agencies and political careers were being built and winners were being rewarded while losers were being punished…

    Most people do not know the difference between a checkbook, an operating statement, a balance sheet and a cashflow statement. Yet, the propose quick and easy simple solutions to punish someone-somewhere-for something…

    Basic Education should include business finance and simple business law. The level of ignorance is rising and unfortunately, even those charged with teaching have no clue how little they know…

    Nobody can form a corporation with no assets and then get credit of a loan. No lender is that foolish. A “holding company” with a huge liability and no assets but a huge liability is a money-laundering scam. I’d be looking at illegal and nefarious activities… and so would the authorities. Most scams have been created and perpetrated long ago. Laws were enacted and investigators trained.

    Ultimately, -All- business is based on trust. If the other is untrustworthy-why- would anyone do business with them-?

    NOTE: my pronouns are impersonal and collective. -NO- person or personal focus is intended.

  • Laird

    AndyJ, I agree with most of your last post (especially the FASB issue, but that’s very far O/T and eminently worthy of its own thread). However, you’re simply wrong about US mortgages being non-recourse. That is true in some states (notably California), but in many states (probably most, although I haven’t done the research to be certain) it is entirely possible to seek a “deficiency judgment” if the house sells for less than the balance due on the mortgage. Many lenders don’t bother to do so (and I believe that Fannie and Freddie forbid their servicers from pursuing deficiencies, although that’s merely a policy decision), but a significant number of lenders, and especially investors who specialize in buying “distressed debt”, aggressively pursue that remedy. (And some lenders who don’t pursue deficiencies will nonetheless sell them to “bottom feeder” collectors; they’re generally worth anywhere from a few cents on the dollar down to fractions of a cent.) Once the creditor has a deficiency judgment it can be used to levy against other assets of the debtor. Also, generally it can be renewed (usually every 5 years), so it follows the debtor around until it is either paid or discharged in bankruptcy.

  • A recurring problem I see with both sides of this argument is that the arguers routinely neglect the costliness of information, and the consequent habit of people to use heuristics—or, worse, information asymmetries.

    The problem with saying that merely doing business with an LLC equals consent is that often, whether a firm is limited-liability or not is hardly clear to the average market participant. Life is short, and I buy many things; I have no desire to investigate the corporate structures of hundreds of firms and base my purchasing decisions on the result. To what degree should I be stripped of my right of compensation because of it?

    On the unlimited-liability side, insiders who anticipate large losses can simply sell out to uninformed speculators. This is not a hypothetical; Australian banks used to be unlimited liability for their shareholders, and when facing the first major real-estate crash in the mid-1800s, bank shareholders quickly unloaded their shares on the open market. How can you prevent owners from escaping liability by selling out? By making them responsible for a firm they no longer own?

  • Johnathan Pearce

    Paul Lockett:

    1. Statutory LL is essentially consensual LL, plus LL for torts.
    2. LL for torts provides a state granted protection against potentially ruinous liability.
    3. Therefore, statutory LL is materially different to consensual LL and an argument in favour of the latter doesn’t automatically justify the former.

    Not sure I agree with all of this. Statutory LL is only consensual to the extent that such firms have been around for so long that most people don’t really think about it and anyway, we haven’t had much of a choice. If statutory LL were scrapped, no doubt some of these firms would have to radically change, and we’d see whether people wanted to go on dealing with them. I guess this is impossible to predict.

    2. LL for torts provides a state granted protection against potentially ruinous liability.

    LL for torts would have to arranged so that any party to it would consent. For instance, if a firm damages a third party not previously involved in any business dealings with the firm, and court ruled that was the case, then the LL would be pierced.

    It would be interesting to see how such tort test cases would evolve. My guess is that firms would want to be pretty damn sure that the risk of tort was low, depending on the nature of their business, before embarking. It might lead to some quite radical changes in how firms operate.

    On point 3, yes, that is my view.

    Rgds

  • Laird

    With regard to Mastiff’s comment about not knowing whether he is dealing with a limited liability entity (his rebuttal to the “doing business equals consent” argument), it’s a safe bet that any business of any size will have a limited liability structure; it’s the only rational thing to do, given our litigious society. Only the smallest of local businesses will be anything else (and their proprietors will likely be “judgment-proof”, a legal term which basically means that they have no significant assets worth going after). Also, at least in the US (in all states of which I am aware), business entities having a limited liability structure are required to have “Inc.”, “LLC”, “Ltd.”, “LLP” or some similar designation in their name. The purpose of this is precisely to Mastiff’s point: it puts the general public on notice that you’re dealing with a LL entity. A look at the name will tell you.

    Incidentally, what’s missing from this discussion is an acknowledgement that this is almost entirely a hypothetical issue. It’s extremely rare for the limited liability of a company to effect the ability of tort claimants to collect on their judgments; that only happens in mass tort situations (i.e., Union Carbide’s disaster in Bhopal). Where it comes into play is almost exclusively in the consensual area, where trade creditors (and sometimes even secured creditors) receive less than full value in a bankruptcy. Those creditors knew they were dealing with a limited liability company and took the risk. (That’s why they carry loss reserves on their balance sheets.)

  • Thanks for the link, but I’m not sure why I’m picked out here as someone against limited liability; my officially stated position is:

    “It is unclear who owns the corporation, given that there is no identifiable group whose relationship to the corporation involves the usual characteristics of ownership such as unlimited liability (in tort). Note that I’m not claiming that shareholders ought to have unlimited liability; at any rate, I see the point of the argument that their separation from direct day-to-day control makes their exemption from liability reasonable. (I’m undecided as to whether I agree or disagree with that argument, but at any rate I don’t automatically dismiss it.) But the case against regarding them as fully liable seems like an equally good case against regarding them as full owners; it turns them into something more like clients of the corporation, leaving it unclear where the real ownership lies.”

  • Laird:

    Incidentally, what’s missing from this discussion is an acknowledgement that this is almost entirely a hypothetical issue. It’s extremely rare for the limited liability of a company to effect the ability of tort claimants to collect on their judgments; that only happens in mass tort situations (i.e., Union Carbide’s disaster in Bhopal).

    They may be rare events, but that doesn’t mean they aren’t significant or worthy of consideration.

  • Laird

    Paul, that’s certainly true, but by the same token extremely rare events shouldn’t be the basis for determining what’s right for the general rule of things. If something works 99.99% of the time, sometimes you just have to live with the 0.01% failure rate.

  • AndyJ

    Laird;
    I apologize for being off-topic. That was not my intent. I thought I was adding information and perspective that is so often overlooked as the world examines the causes and seeks new rules to prevent a repeat.

    I am not aware of any states where the state laws require any lenders to make up any deficiency in a foreclosure. I think this is more a private contractual matter between the parties.

    The IRS will seek a payment on any shortfall between the amount owed and the amount paid before any foreclosure or surrender. That deem that shortage as a taxable benefit.

    I am not aware of any lenders who will advance any funds or supply material unless the lender has demonstrated an ability to pay or sufficient assets to satisfy any default. The usual loan committee is comprised of the storied flinty-eyed bastards who discount, distrust, and disregard even the most pessimistic forecasts.

  • Laird

    AndyJ, all I was doing was taking issue with your erroneous asertion that all residential mortgages in the US are non-recourse. They’re not. But since we’re O/T, I’ll point out that you’re mixing up several things:

    (1) No state law requires a lender to “make up any deficiency in a foreclosure”. What I said is that many states permit the lender to pursue the borrower for any deficiency remaining after the foreclosure and sale have been completed. Whether lenders actually do so is, of course, their decision.

    (2) You are correct that if the deficiency is forgiven (either by operation of state law or because the lender chooses to write it off with no effort to collect) it becomes “foregiveness of indebtedness” income which is taxable to the borrower. (Some collectors use that threat as leverage to extract a settlement from the borrower). Lenders are technically required to send a 1099 form to the borrowers (with a copy to the IRS) informing them of the amount of imputed income. Whether they actually do so I can’t say.

    (3) I guess you weren’t paying attention during the recent mortgage crisis in the US. A large part of the problem was specifically the making of loans to people who couldn’t demonstrate the ability to pay (“stated income loans”, “liar loans” and “no income loans”) and/or who showed no assets (“no-asset loans”). That practice certainly has changed (thanks to all those losses, plus some new regulations), but it was very much the case pre-2008. There was no loan committee (of “flinty-eyed bastards” or otherwise) passing on those residential mortgage loans (that only happens with commercial loans); they were approved by underwriters with delegated authority or, more often, by the Agencies’ automated underwriting systems (DU and LP).

  • Paul Marks

    Clubs, societies, cooperatives, churches……

    In all one sues the organization (the corporate body) not the individual members, in a commercial dispute (say over an unpaid bill).

    Otherwise such things as churches could not exist. And nor good athiest associations.

    So it is not just Exxon-Moblie or the Ford Motor Company.

    These “limited liablity is a monopolistic thing granted by the state” people are just wrong.

    Attack corporate WELFARE (direct subsidies, or indirect subsidies via central banking) not the “wicked crime” of a group of people forming a trading company by putting money into a trading pot and getting other people to VOLUNTARILY AGREE to trade with this enterprise.

  • Rich Rostrom

    “Mark-to-market” was a driver of the 2008 crunch.

    But it was adopted for what seemed very good reasons – corporations such as Enron inflating their balance sheets by carrying worthless securities on the books at cost.

    Without “mark-to-market”, it was possible for a corporation to lie about its condition while still nominally keeping to GAAP.

    The crunch was a product of four converging factors:

    1) excessive issuance of mortgages including mortgages granted to unqualified borrowers.

    2) securitization of mortgages through intricate and grossly under-recorded transactions.

    3) intense leveraging by companies holding or dealing in securitized mortgages.

    4) mark-to-market rules.

    1) generated a lot of bad mortgages. 2) spread ownership of those mortgages through the financial industry, commingled the bad mortgages with sound mortgages, and made it impossible to separate them. 3) made large companies very vulnerable to problems in the mortgage market. 4) ensured that once the problem arose, it would compound.

    But 4) (mark-to-market) didn’t create the problem.

  • Laird

    I mostly agree with you, Rich. I have only minor quibbles with your points (2) and (4). As to (2), the “spread” of ownership throughout the financial industry, and especially the separation of both duration and credit risk through “tranching” (which you didn’t specifically mention), was a very good thing. I hope the securitization market becomes vibrant again, and that we don’t throw out the baby with the bathwater. Even the comingling of “bad” loans with good ones wasn’t all bad. Keep in mind that even with subprime loans the vast majority will perform; it’s just that a higher percentage will default than with conforming loans. So the real problem was the failure to adequately assess what percentage of the loans in those pools would go bad, which lead to inadequate credit enhancements (subordination and/or reserve levels) for the “AAA” tranches. In my opinion the primary culprits for this were the rating agencies, who have never received the amount of blame they truly deserved.

    And as to (4), I would submit that although mark-to-market accounting might not have created the problem in the first place, it greatly exacerbated it. When the secondary market for MBS’s froze up, forcing banks to write down the carrying value of those bonds to largely fictitious “fire-sale” prices was wholly irrational. It represented the triumph of ivory-tower academics, obsessed with theoretical perfection, over the realities of the business world. The FASB’s retreat from that position was a welcome development, if unreasonably late in coming.