Alex Tabarrok:
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.
... 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.
The libertarian critique of limited liability has always struck me as a bit odd. Taken to its logical extent, it would delegitimze the entire concept of a corporation. In the eyes of the law, after all, the corporation is a legal person separate from its various constituencies that is created by state action. Hence, we see such screeds as
this:
Corporations are pure-bred progeny of Leviathan. You can't have one without the other.'No libertarian principle can pretend to excuse their existence. Nothing from the lexicon of liberty can be said in defense of the corporate concept.
The answer, of course, is that the corporation's legal personhood is just a useful fiction. Properly understood, the corporation is a
nexus of contracts. As I explained in
Abolishing Veil Piercing:
Thinking coherently about limited liability, as with so much else of corporate law, requires us to toss out this out-dated reification of the corporation. In the last three decades, law and economics scholars have devoted considerable attention to developing a comprehensive account of the origin and nature of the business firm. This effort fairly can be traced to Ronald Coase?s justly famous article, The Nature of the Firm. Among the many insights therein, perhaps the most influential was Coase?s observation that the essence of the firm is a long-term relational contract by which each factor of production is affiliated with the other factors contributing to the enterprise. As refined by subsequent scholars, this aspect of Coase?s argument led to the now-dominant nexus of contracts model.
In brief, the nexus of contracts or contractarian model conceptualizes the firm not as an entity, but simply as a legal fiction representing the complex set of contractual relationships between many constituencies providing, or serving as, inputs for the corporation?s productive processes. In other words, the firm is not a thing, but rather a nexus or web of explicit and implicit contracts establishing rights and obligations among the various inputs making up the firm. Employees provide labor. Creditors provide debt capital. Shareholders or partners, as the case may be, initially provide equity capital and subsequently bear the risk of losses and, at least in the partnership context, monitor the performance of employees and coordinate the activities of all the firm's inputs. The firm is simply a legal fiction representing the complex set of contractual relationships between these inputs. Contractarianism?s dominance within corporate law scholarship has been widely recognized by diverse jurists and scholars, including some who are not enthusiasts of the genre. ?
Accordingly, contractarianism contends that the basic guiding principle for picking default rules should be transaction cost minimization. More specifically, contractarian scholars contend that the default rules normally should be the rules to which most parties would agree if they could bargain (the so-called ?majoritarian default?). Parties for whom the default rules are a good fit can take the default rules off the rack, without having to bargain over them. Parties for whom the default rules are inappropriate are free to bargain out of the default rules, of course. So long as the default rules are properly chosen, however, the majoritarian default reduces transaction costs because most parties will be spared the need to reach a private agreement on the issue in question.
In my judgment, the correct approach to limited liability thus treats it as one of the many terms in the set of contracts making up the corporation. Refusing to hold shareholders personally liable for firm debts thus is the precise equivalent of enforcing a standard form sales contract. Nothing more and nothing less.
Sensible libertarians don't object to the state enforcing contracts, do they? As
Gary North wrote in a critique of Murray Rothbard's argument against limited liability:
Let us say that I want to join a church. As a future member of this local church, I wish to avoid legal liability for anything the elders do that might inflict damage on someone else in the name of the church. For example, if they decide to excommunicate someone from membership, and that person then sues the church in a civil court, I do not want to have all of my assets at risk in that court. This is not a hypothetical situation. Churches do get sued by excommunicants. This undermines the authority of churches. The state's authorities are sometimes happy to do this. It increases the power of the state.
The church can specify this arrangement in writing before anyone joins. Members agree to this as a condition of joining. This contract ? called a church covenant ? can also specify that the church's judicial decisions not be matters of future lawsuits in a civil court.
What libertarian principle is violated here? What Christian principle is violated here?
Over time, civil law in the West formally recognized the existence of an implicit agreement with respect to the legal immunity of church members. The state does not create this legal immunity. On the contrary, the state has recognized a previously existing legal immunity. To argue that the state should no longer recognize this immunity in the name of a universal principle of full liability without any exceptions is to grant enormous power to the state to undermine both custom and contract.
Today, investors in corporations are governed by commercial limited-liability law. Critics of limited-liability law argue that this is a grant of privilege by the state. But would they also argue that a comparable grant of immunity from lawsuit for church members is a state-granted privilege? The existence of such immunity long preceded the modern nation-state. Conclusion: it is not a grant of privilege.
In the late nineteenth century, Anglo-American civil law began to acknowledge a right of contract that had always governed churches. In doing so, the state made possible the modern economy, which is marked, above all, by increasing per capita investment.
As I explained in
Abolishing Veil Piercing:
Viewed from this contractarian perspective, the interesting questions are: (1) why would creditors agree to insulate the corporation?s residual claimants from personal liability?especially given that the partnership?s residual claimants are denied that benefit; and (2) what restrictions would creditors place on the limited liability term of the contract.
For answers to those questions, go read
Abolishing Veil Piercing.
Update: An emailer asks: "Is your argument limited to limited liability for contract claims, or are you also discussing limited liability for tort claims?" Both. Back to my article one more time. The argument about tort creditors therein is very long, but this excerpt from the discussion of why a
hypothetical bargain (remember that we're not talking about actual bargaining, which is obvious not available in most tort settings) between shareholders and tort creditors of closely held corporations would result in limited liability:
Why then does the default rule remain one of limited liability in the tort context? ... As with tort claims against public corporations, ... it may be socially undesirable to force close corporation shareholders to internalize all tort risks generated by their firm?s activities. In the first place, limited liability does not allow investors to get off scot-free. If the firm is bankrupted by a tort claim, the shareholder will lose all funds invested in the venture and, most likely, his or her livelihood. Reputational considerations may also provide incentives for people to pay their debts. This especially true in small close knit business communities (or small communities of important business folk). As such, the shareholder is not without incentives to insure and take precautions. ? In the second place, contract creditors frequently demand that the corporation retain substantial unencumbered assets. Tort creditors thus effectively free ride on the contract creditors? monitoring of the corporation.
In light of such considerations, few commentators support abolishing limited liability for close corporations even with respect to tort claims.
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