Limiting limited liability

by John Quiggin on February 4, 2004

Via Lawrence Solum, I found this interesting post from Professor Bainbridge arguing that corporations should not be compelled to pay reparations for past wrongdoing (in this case, complicity in slavery). He says

Punish the wrongdoers, you say? Sorry, but the corporation’s legal personhood is a mere legal fiction. A corporation is not a moral actor. Edward, First Baron Thurlow, put it best: “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?” The corporation is simply a nexus of contracts between factors of production. As such, there is no moral basis for applying retributive justice to a corporation – there is nothing there to be punished.

So who do we punish when we force the corporation to pay reparations? Since the payment comes out of the corporation’s treasury, it reduces the value of the residual claim on the corporation’s assets and earnings. In other words, the shareholders pay. Not the directors and officers who actually committed the alleged wrongdoing (who in most of these cases are long dead anyway), but modern shareholders who did nothing wrong.

This seems plausible. On the other hand, the obvious implication (one that was clearly implicit in Thurlow’s original point) is that the principle of limited liability is untenable, at least in relation to civil and criminal penalties for corporate wrongdoing. The wrongdoers are, as Bainbridge says, the officers and shareholders at the time the wrong is committed, and they should be held personally liable. The law has moved a bit in this direction in recent years, but Bainbridge’s argument implies that it should go a long way further, restricting the principle of limited liability to the case of voluntarily contracted debts.

I doubt that the Professor would want to go that far, but I think it’s hard to make his general case without doing so (there are, of course, more specific defences that might be used in relation to reparations for slavery).

There are a number of counterarguments that might be offered. If you accept strong versions of the efficient markets hypothesis, the share price should discount the expected penalty associated with wrongdoing when it takes place, so that the penalty falls on contemporary shareholders. Since I don’t accept the efficient markets hypothesis (except in the very weak form that information about the past history of share prices alone can’t be used to predict future prices) I won’t push this any further.

A second, more practical, argument is that the collective nature of corporate activity makes it hard to prove individual wrongdoing even when the fact of corporate malfeasance is clear – the current crop of corporate trials is making this point pretty clearly. The options for punishing such malfeasance are therefore rather unattractive. They include extending the law of conspiracy (which has frequently been misused) and expanding the scope of special-purpose provisions such as the US RICO laws (ditto). If there’s no easy way of punishing guilty individuals, it seems preferable to hit the corporation in the only place it hurts – the bottom line.

It’s good that we seem to be getting away from the silly idea that limited liability and the corporate veil represent some sort of fundamental human (or maybe legal-fictional-human) rights. They are 19th century pieces of government intervention, widely disputed at the time by economic liberals, and justified (to the extent they are justified) on the same kinds of pragmatic grounds as social security systems. But it’s still probably best, except in cases of egregious personal wrongdoing to treat corporations as if they were individuals, responsible for their own actions, past and present.

{ 19 comments }

1

John 02.04.04 at 7:43 am

Just for some background, Lord Thurlow was a Tory Lord Chancellor of the 18th century. The 1911 Encyclopedia Britannica comments:

Thurlow’s public life was as factious as his youth had been daring. His hatred of the American colonists, and his imprudent assertion that as Attorney-General he might set aside by scire facias as forfeited every charter in America; his speech in aggravation of punishment in the case of Home Tooke, when he argued that the prisoner ought to be pilloried, because imprisonment was no penalty to a man of sedentary habits and a fine would be paid by seditious subscription; and his opposition to all interference with the slave trade are characteristic.

and further

Lord Thurlow was a master of a coarse caustic wit, which habitually in his private and too frequently in his public life displayed itself in profanity. He was a good classical scholar and made occasional translations in verse from Homer and Euripides. His judicial and his ecclesiastical patronage were wisely exercised; he was the patron of Dr Johnson and of Crabbe, and was the first to detect the great legal merits of Eldon.

Thurlow’s personal appearance was striking. His dark complexion, harsh but regular features, severe and dignified demeanour, piercing black eyes and bushy eyebrows, doubtless contributed to his professional and political eminence and provoked the sarcasm of Fox that he looked wiser than any man ever was. Yet he was far from being an impostor. By intense though irregular application he had acquired a wide if not a profound knowledge of law. Clear-headed, self-confident and fluent, able at once to reason temperately and to assert strongly, capable of grasping, rapidly assimilating, and forcibly reproducing minute and complicated details, he possessed all the qualities which command success. His speeches in the trial of the Duchess of Kingston for bigamy are vigorous and effective, while his famous opening in the Douglas peerage case and his argument for the Crown in Campbell v. Hall show that he might have rendered high service to the judicial literature of his country had he relied more upon his own industry and less upon the learning of Hargrave and Kenyon.

Hurray for Lord Thurlow!

2

Dwight Meredith 02.04.04 at 5:33 pm

Someone, I forget who, once commented that the prupose of a corporation is to allow a gentleman to decide which of his debts he intends to repay.

I think that is exactly right.

3

Sebastian holsclaw 02.04.04 at 6:10 pm

I suspect the real reason most corporations shouldn’t pay reparations has to do with the fact that they were engaging in acts that were not only wholly legal, but actively encouraged by the government.

4

Bill Carone 02.04.04 at 7:00 pm

If we abolish limited liability, couldn’t we replace it with a better solution? Say, for each share sold, you also sell a “share” of liability insurance? This would solve the problem for the small shareholder, and make it mostly transparent.

Are there problems with this that I don’t see?

5

mrkmyr 02.04.04 at 7:25 pm

I think it is also useful to look at corporate wrong-doing from the prospective of those injured.

Where there has been an injury who should bear the cost? Should it be the person who was wrongly injured, or the owner of a company who committed the injury?

The current owner may not have been alive during the crime, or even aware of the events, but such an owner takes that risk in acquiring a stake in the company. Such an owner may also receives unknown benefits from past behavior (like, say, buying up mineral rights thought to be worthless that turn out to be very valuable).

The modern corporate form protects owners from unlimited liability, and allows them a peice of profits in which they have invested little, if any time. Part of the price you pay for having the luxuary of agents (directors and executives) acting for you is paying for the wrongs they have committed.

It might also be noted that the fictional entity of a corporation gets protections as a person under the US constitution. This may be a bad call on the part of the Supreme Court, but if they get free speech, they can also pay for their wrongs.

6

Decnavda 02.04.04 at 7:42 pm

Can we use this to discuss the morality of corporate taxes as well? Many on the right claim corporate taxes unjustly put a second tax on income that would otherwise only be taxed once, and we are therefore “punishing” a choice of business entity. But things like limited liability show that the corporate is not a tax on income, but a fee for a government-granted priviledge – and the fact that you can conduct business without the corporate form, but people choose to do so, shows that the benefits of corporate existence are worth the price.

7

Katherine 02.04.04 at 8:13 pm

Ah, this was the only interesting topic in Corporate Law. (Though why it’s called “veil piercing” is beyond me.)

I’m ok with limited liability on utilitarian grounds, but I think there should be exceptions for:
1) tort creditors.
2) parent-subsidiary corporations–right now it’s way too easy to structure things so that you’re totally unaccountable–not only indiviudals but the main corporation itself.

And the government ought to be able to impose certain restrictuions in return for the huge privilege of limited liability.

By the way, how does this work in other countries?

8

Leo Casey 02.04.04 at 9:02 pm

When the fiction of corporate personhood no longer entails corporations to the same rights of freedom of expression as flesh and blood individuals, as it now does under US law, then we might also consider that it no longer should hold them liable for past wrongs of the corporation.

9

limberwulf 02.04.04 at 10:09 pm

I would love to see individuals who engage in illegal activities be brought to justice. The issue is, in many cases the need for protection has nothing whatsoever to do with illegal activity.

Corporations get sued very frequently for things that someone in their organization did (not refering to the top management in this case). One reason to incorporate is to make a lawsuit, brought against your company for negligence by an individual in your company, not directly take all of your assets. Ideally, the action would be taken against the individual that caused the issue, but the suit is not brought to them, because that person does not have the resources to cover for their mistake. This is particularly true in many modern cases where the suit is little more than a lottery winning and the courts are finding for ridiculous sums to be paid to plaintiffs.

I am sure there are cases of criminal activity being done by those that run the company and then the “corporation” being used as a sheild, but in many more cases the corporation is used as a protection for those in the corporation that did not engage in illegal acts. In fact, the initial reasoning behind the corporation was to allow people to invest in a good business idea, and to have ownership of said company, without being held liable for improper actions carried out by officers of the company. If I as a worker wanted to invest in my own company, I should not be held liable for more than what I have put into the company, jsut because some big-wig at the top did something wrong.

Illegal activities carried out by individuals should be punished, but only the individuals that engaged in it should be punished. Limited liability allows for this, and it allows for a company with poor monetary policy to go under without taking the assets of the individual owners, i.e. stockholders.

When “corporate taxes” are levied, what is not understood is that they are in fact taxes on individuals. The taxes are paid for by the owners of the company through lost profits, the workers of the company through decreases wages, and the consumers of said companies’ products and services through price increases. Taxes are always levied on individuals. There is no way to be taxes and have that tax not affect each of us in the form of lost assets or increased cost of living. The complaint is that the corporation has no soul to damn or pants to kick, but it also has no individuality to tax, any and all added costs (taxes included) trickle down to we the people.

10

Jon H 02.04.04 at 11:26 pm

Sebastian writes: “I suspect the real reason most corporations shouldn’t pay reparations has to do with the fact that they were engaging in acts that were not only wholly legal, but actively encouraged by the government.”

By which logic slave labor until death would be perfectly fine, as long as it were legal.

The “I did nothing illegal” defense didn’t go over very well in a certain Israeli courtroom when a certain European was tried. And that was a military officer, not just a businessman with no obligation to follow orders.

Unless the government forces the corporation to engage in evil acts, the corporation should be liable, even if the wrongdoing was technically legal.

11

Decnavda 02.04.04 at 11:35 pm

limberwulf-

First, let me refer you to professor bainbridge’s response, which you can click at the trackback. He states that he was discussing retributive justice, which can only apply to individuals, but that ecconomic restitution and deterrence CAN be served by holding Corps liable. Good utilitarian reasons for limited liability certainly exist, but it creates a pervers way in which actors can escape responsiblity for their actions. Killing (or just punishing) corps that do not prevent individuals from breaking laws on its behalf would quite soon result in most corps that still exist incouraging individuals to obey the law.

As for your response to the tax issue, you are committing serious zero-sum thinking. Corporations are created by government and individuals because the individuals can produce more ecconomically with the corp than they can without it. The question then arrises, how is this extra sum to be split among the creators? I am simply suggesting that the community/government act like any other self-interested participant and get as much of the extra as it can. If you really believe that the government contributes no extra benefit by passing laws that create corporations, then please explain why people choose to do business in the corporate form when it costs them money to do so in the form of corporate taxes, and it is possible to conduct all of the same business activities without the corporate shell.

12

Decnavda 02.04.04 at 11:44 pm

To clarify my point:

Limberwulf wrote: “When “corporate taxes” are levied, what is not understood is that they are in fact taxes on individuals.”

What I am suggesting is that corporate taxes are not paid for by individuals, but they are paid out of the extra wealth created by the existence of the corporation. I suggest this is obviously true, for otherwise no one would bother doing business in the form of a corporation. Is there a flaw in this argument?

13

msg 02.05.04 at 9:05 am

Punishment is barbaric. Whether of corporations or of individuals, it’s an internalized barbarity, taken in by children so deeply and so early they grow up to think it’s natural law.
The application of force or pain or unpleasant consequences as a means of preventing further offense is not punishment. Punishment is viewed by its adherents as a kind of cause and effect, a settling of accounts. Prisoners somehow “pay their debt to society” by spending time behind bars. Punishment leads to absurdities like fixed penalties and mandatory sentencing, and the odd and dysfunctional violence of the American judicial system.
Which is not to say there is no place for civil force. Social living means order and rules, and rules will have to be enforced; but not as theater. Justice is not, and should not be, cathartic vengeance.

Typical how no one seems to see the corporatization of the descendants of slaves in the case of reparations. We see the innocent shareholders and the innocent executives prevented from going about their necessary, if inherited, business, even though they none of them had anything to do with the long-past crime.
But the potential beneficiaries of reparations are themselves mere inheritors, yes?
Where are those shackled unfortunates today? Their children are, too many of them, in the privatized penal institutions of America. Being used as a virtually unpaid labor force.
But none of the contemporary relatives of the slaves have a clear case for reparations as economic retribution. None of them can be said to have been directly involved. Those days are long over.
So the whole thing’s a wash and let’s get back to divvying up the spoils of a now victim-less and perpetrator-less, though still highly remunerative in its manifiold dividend, crime.

My grandfather robs your grandfather of a million dollars, they’re both dead, I’m keeping it.

As far as I know there is no statute of limitations on murder in the United States. Add in kidnap, rape, child molestation, and that the same responsible parties were simultaneously participating in the genocidal disenfranchisement of Native America as well.
The assertion that the passage of time alone can have cleansed the economic concerns of the men responsible is beneath refutation; the bloody guilt will be there forever; there is in fact no way possible to remove it, not through time or reparation, not even remorse will cleanse it; there is nothing to be done but shoulder the guilt and allow it, in its fulness, to change the hearts and minds of those who inherit what was left by those God-forsaken souls – ill-gotten fortune and shame.
In the long meantime, listening to the mewling rationalizations of those privileged heirs is an intolerable annoyance.

14

Luc 02.05.04 at 5:52 pm

This quote from prof. Bainbridge is pointing to where I think he’s wrong:

“Not the directors and officers who actually committed the alleged wrongdoing (who in most of these cases are long dead anyway), but modern shareholders who did nothing wrong.”

The shareholders did something wrong. They profited from slavery.

Buying and selling shares involves morals, and society/government has made laws governing these transaction. A certain M. Stewart is currently on trial for this.

Thus it can be perfectly reasonable that it is demanded of the shareholder that he verifies that the corporation is a legitimate business not involved in amoral and/or illegal behaviour.

If the corporation is involved in behaviour that can be expected to become illegal in the future it should be considered a liability.

An example could be child labour in third world countries or prison labour in China. These things are not illegal, but it can be expected from a shareholder that he knows these things can become future liabilities. And future shareholders should know the past of a company so they also cannot be freed of these liabilities.

Thus someone who buys shares in a company that has profited from slavery should know this is a liability and if society/government acts upon this fact he should face the consequences.

Since morals change, this factor is a risk assesment from an investor. And risks chan change in time. And therefore the argument that at the time when slavery was accepted it was not known to be a risk is not an overriding argument against retribution.

But aside from the principal argument, the only practical reason I see for financial retribution for slavery is the fact that it asserts the moral obligation of shareholders.

Which gets you back to square one if you disagree with a moral responsability of shareholders.

15

limberwulf 02.05.04 at 9:50 pm

decnavda,
I see two issues in your argument. One is the assumption that the corporate model is being chosen only for the sake of increased profit. I have seen many corporate models (worked for some of them) that could have made more money as a sole proprietership, but chose the corporate model as a rick management move. As it turned out, this company was indeed hit with a lawsuit that bankrupted the company, but, fortunately, did not take the personal assets of the founder. He was able to start over and is currently doing well.

The second issue is that the corporate model actually has CHEAPER taxes than partnerships and sole proprietorships when all monies are not distributed as income. Before I knew this, I had a business of my own. I set aside a portion of business profits to put into capital growth, but had not used all of it for business equipment at the end of the year. The tax rate on that money was equal to my personal income tax, around 25% at that time. Equivalent corporate tax on those funds would have been 15% at the time. Because of the sum of money I had set aside, 15% tax on total profits would have been a savings even though it would have double taxed the profits going to payroll.

So, yes, perhaps a greater capital growth can be had in a corporate model, but the taxation of this money, particularly the sums that end up being double taxed, are still a decrease in the profits of the corporation. Those profits would have otherwise gone to: a) business growth and capital investment, a benefit to the economy. b) employee payroll, a benefit to the economy through job creation and/or increased disposable income. c) increased payout to shareholders, a benefit to the economy through increased disposable income. d) decreased consumer prices, and benefit to the economy by providing a good or service at a lower rate, allowing an effective increase in disposable income. The fact that the corporate model may allow increased profitability does not mean the monies taken by the government could not have been better spent by individuals. All taxes are a tax on individuals, there is no way to escape this. Money doesnt just appear, it is created through the efforts of people.

16

Decnavda 02.05.04 at 10:47 pm

limberwulf-
1. Risk managemant IS a profitability issue.

2. The service of risk management through limited liability obviously has value to those who use it. Why should the government not charge for this service in proportion to the amount of investment protected from risk?

3. Limited liability does NOT explain the continued dominance of the ecconomy by corporations in the past decade. Thanks to LLCs (Limited Liability Corporations), which as taxed as parternships, limited liability can now be had for free. Those who chose C corps do so to take advantage of the other benefits of corporate existence, presumeably because these increase profitability.

4. Your point about retained corporate earnings being taxed at a lower rate than parternship profits passed through to rich partners is, I admit, a good theoretical answer to my question about why anyone would choose to pay corporate taxes if the corporate form does not increase profits. This suggests an empirical test of my hypothosis: Would C corporations cease to dominate the ecconomy if the corporate income tax was higher than the individual income tax? I believe tha answer is no, just as giving out limited liability for free did not end corporate dominance, but I am willing to be proved wrong.

5. Your arguments about the social goods that would result from leaving the profits with the corporation rather than taxing them are empirical utilitarian arguments that I simply disagree with for reasons far beyon this thread. At any rate, these are arguments for a LOW corp income tax, but not for NO corp income tax. Presumeably, for example, the government could do many good things with the revenue from a 1% corp income tax without interfering with any of the positive externalities you mention. Beyond that 1%, we are just negotiating.

6. “Money doesnt just appear, it is created through the efforts of people.”

Oh, please! *I’M* the one making the positive sum argument here. Wealth is created through the efforts of individuals AND the community (government). Assume PI is the production of individuals and C is the existence of corporations. I’m saying:
PI=x.
PI+C>x.
The > is created by the C, which is created by both the government and the individuals, and therefore the both the government and the individuals should split the >.

17

JRoth 02.06.04 at 2:45 am

msg-

Sadly, I have a coworker, who believes every brilliant tenet of modern American Republicanism, who believes firmly that he should be able to keep whatever his grandfather stole.

Did I mention he’s a devout “Christian?”

18

limberwulf 02.06.04 at 10:12 pm

decnavda,
do you have a formula for determining the quantity of the “>” in your formula? If I were to agree with the concept of splitting that between the government and the rest of us (which I dont for reasons that go beyond this post) there would still need to be a quantity defined that could be split. Does 1% split it? How about 10%, or 25%? I understand your point that we are simply negotiating, but to do so we need to know what we are negotiating over.

Risk management is indeed a profitability issue, but it is indefinable in exact terms. It is much like the value of insurance. My insurance does me no good at all if I never have to use it. It becomes a complete waste of money. However, if I do have to use it, its value is enormous. How do you quantify risk management into exact taxable dollars?

LLC’s do not issue stock for public ownership. The dominance of C corporations as far as I know is directly tied to their ability to raise very large sums of capital from a far broader base of people to accomplish goals of production that require immense startup sums. I currently work for an LLC. We can get investors, but we can not issue stock on public markets. There may be LLC’s that can, I have not fully researched this.

19

Decnavda 02.07.04 at 12:46 am

limberwulf –
1. “How do you quantify risk management into exact taxable dollars?”
Beats me, but people in the insurance industry do it all the time. This may sound like a cop-out on my part, but it is not. If you were to ask me how I could possibly build an internal combustion engine, I would say that I would hire one of those people who build those that I see all over the roads. The expersis to do this rather precisely is out there for hire.

2. Personally, I would set the percentage the same way that Scholastic decides how much to charge for a Harry Potter novel. Recognizing that demand goes down as price goes up, charge what ever will bring in the most revenue. Again, assuming my theory that corporate taxes are paid out of increased revenue due to corporate existence is correct, this rate will represent the best “deal” the government can get.

A reasonable conservative position would be to set the rate at what will maximize social goods, which means public revenues plus the net of positive externalities over negative externalities. I would still disagree with this though, because I do not think the public should be any more willing ot count the birds in the bushes any more than corporate investors do.

3. “The dominance of C corporations as far as I know is directly tied to their ability to raise very large sums of capital from a far broader base of people to accomplish goals of production that require immense startup sums.” Bingo! Now you’re giving me support for my position. The C corps *DO* provide economic advantages that are confered by the government granting corporate existence. Thanks.

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