Business/Finance

Who should be held responsible? BP, Sovereignty, Personhood and the Corporation – Part 2

Settling the blood feudOn 23 November 2009, the family of a challenger to the incumbent governor of Maguindanao province in the Philippines were on their way to file his certificate of candidacy. They were accompanied by some 34 journalists, lawyers and aids. They were brutally massacred.

Blood feuds are not some medieval throwback. Modern vendettas continue in parts of Europe, the Middle East, and the Philippines.

In places such as this, one bad business experience will be avenged down the generations. This keeps people perpetually looking over their shoulders rather than investing and getting on with things.

Limited liability, as a concept, allows people to know in advance the full extent of their liability so that they can manage the degree of risk they are willing to take on. The purpose of limited liability is to allow an individual investor in a joint stock company to be held responsible for that company’s risks only up to the value of his financial contribution to that company.

Limited liability was created by an act of the UK parliament in 1855 (Limited Liability Act of 1855) which followed on from the Joint Stock Companies Act of 1844. The Companies Act of 1862 followed.

This was more revolutionary than you can imagine. While Britain was governed by a Parliament it was still headed by an unelected hereditary peer. Few countries in the world were parliamentary democracies and the US was heading in and out of civil war.

Up to that point creditors would hold individuals infinitely liable for debts both severally or individually. Poorer investors went to debtors gaol and the wealthier lost everything. Creditors were worried that companies would get away with debt through limited liability and so investors were held to “partly paid” shares which limited their liability up to a certain multiple of the share price they initially paid (partial but capped limited liability). That didn’t work too well and by the 1880s shares were fully-paid and liability capped to that.

The consequence of this new law was a little something known as the Industrial Revolution or, more rightly, the Second Industrial Revolution which saw the explosion of investment in rail, steam ships and the globalisation of trade.

Investment is more than money

Limited liability had lots of spin offs that go well beyond the context of investment and entrepreneurship.

Newspapers thrived as limited liability meant that they could report without fear of the owners being financially destroyed for the newspaper’s speaking truth to power. Millions of people who had never engaged in commerce joined into the excitement of investment through shares. Money that is free to move is free to move foolishly… bubbles followed, including on those new railroads.

However, limited liability allowed for diversified investment portfolios. You didn’t have to put all your wealth and effort in one place. Portfolio theory gave rise to better insurance and the potential for retirement planning through pension funds.

Let’s go back a bit. Limited liability is a short-hand, a way of simplifying transactions. Up to the creation of a limited liability company doing business with business was unnecessarily complicated.

Any business with more than one investor was a partnership. If a business wished to buy something on a contract then every owner would have to sign that contract. If one partner wanted to cash out his investment (or died) then the business would have to dissolve itself, pay out, and then be reconstituted. If the owners wanted to leave as a block then the business would just end. Succession planning and continuity was unnecessarily complicated.

Lots of stuff was just difficult, unpleasant or horribly expensive. Any economist or investor will tell you that true wealth is set on the margin. When you reduce complexity then lots of new and exciting things happen. Including railroads.

Oh, and democracy.

Wars of succession erupt in many countries, and throughout history, where a strong leader dies and leaves no clear heir. In a democracy all citizens are shareholders in their own nation. As shareholders the executives have to ask the owners to set the agenda and nominate a chief executive.

You may not think of countries as really just a big corporation but that is what they are: sovereign corporations.

The idea of limited liability and incorporation allows for sophisticated labour and investment collaboration. A contract can be drawn up which binds all shareholders uniformly. You no longer need to create a new contract for each person or handle each case separately.

Consistency of law and consistency of risk and liability ensure that each participant knows both the upside and downside of engagement.

Where an individual acts against the interests of the corporation then that individual can be punished without the liability extending to others. Where a corporation acts against the interests of other corporations and against the laws that govern the interactions of all corporations then that corporation can be dealt with as an entity.

It’s a short-hand. It has implications.

The sovereign individual and the sovereign organisation

Prior to the acceptance of incorporation a business could not get very big. Partnerships would be limited to people who knew each other and would be willing to stand personal surety for all debts.

These sorts of relationships have their modern counterparts in impoverished parts of the world in lending clubs and savings circles. Much research has been conducted on optimum sizes for such groups and 50 people seems to be about the maximum size.

A modern corporation can have tens of thousands of individual investors.

The problem with a society where individuals are limited by personal bonds from forming cooperative societies is that their world will be dominated by the entitled and hereditary wealthy.

If a group of people could not from a legally recognised body that can negotiate on their behalf, and sign a contract on behalf of the collective without having each person within that contract negotiating their own terms, then what? Unionisation was a natural consequence of incorporation, not the other way round.

Of course, once you recognise that a corporation can sign contracts then a lot of other things follow. Ownership of property is just a contract between the state and the title holder in which the state agrees to recognise and protect that property right. Where the property is expensive and requires numerous owners then passing ownership via a corporation is the best approach.

Farmers often pass the family estate down to their children via such a vehicle. If a farm had to be wound up every time the patriarch wanted to retire then children would rapidly lose access to the family property.

Such recognition also enabled corporations to transact with each other. Whether those corporations be your local municipality purchasing water in bulk on your behalf, or whether it be a pension fund buying shares in an energy company.

The benefit of this is the democratisation of wealth.

Concluded in Part 3

11 replies »

  1. There seems to be no argument against the concept of limited liability structures in principle, and you do a good job explaining why. At the same time, they represent a platform for abuse that can be as large as their potential for creating wealth and opportunity. It’s a simple function of scale. If your system doesn’t provide for the establishment of large entities, then you go without the benefits of large entities.

    However, large entities produce larger problems than small ones, as well. Think about Chernobyl, Bhopal, the current Gulf disaster and Three Mile Island. And Love Canal and Buffalo Creek Valley and the Amoco Cadiz. And Freddie Mac and Goldman and we could go on and on. Our society has obviously decided that the benefits outweigh the risks (or at least the corporatists making the decisions for the rest of us have done so – then again, the limited liability concept means that they don’t really face any risk…)

    I guess the point I’m getting at is that we don’t often look closely enough at Dr. Frankenstein’s magnificent limited liability monster. And even if we do conclude that it’s better than living in caves, or whatever smaller-scale society and economy turns out to be the alternative, there’s still this nagging sense that there has to be a middle way. A way that provides for the benefits of limited liability businesses while nonetheless recognizing that such structures cannot be impenetrable shields for those whose abuses go above and beyond the call of duty.

    I don’t have that solution in hand, but maybe you’re heading in that direction?

  2. Nice post….I couldn’t have said it better myself. The rise of the LLC is directly responsible for all the industrial revolutions, increased standard of living, increase in availability of products, and on and on. I like your likening of the state to that of a sovereign corporation. The only difference is that the state controls the currency and tends to default on its debts and debase its currency every century or so screwing the lenders. Which brings me to another thing….It would be great if the government did not have a corner on the issuance of money. The private sector could probably do a better job of issuing and controlling specie and letting the free market determine the value vis a vis the other competing currencies and private monies. von Mises did groundbreaking work on this, and his work on the inherent value of LLC’s was brilliant. Hayek, although he didn’t agree with Mises also has some interesting things on LLC’s which should be read by anyone before they attempt to formulate an opinion regarding the value of such organizations.

  3. I’ve mentioned the idea of dynamic tension before; that any action should be scrutinised and be seen to be scrutinised by impartial observers against a set of unbiased rules. Infractions can then be dealt with.

    It doesn’t help if the scrutineers are incapable of doing the job (note how many of the people supposedly watching the banks were actually enjoying online porn). Oversight organisations must do their jobs, not be seen as some high-paid dumping-ground for the incompetent scions of the ruling class.

    Sam, many of the events you mention happen to be caused by countries and they haven’t always been run by accountable governments, so “bad things” isn’t the exclusive prevail of limited liability.

    The short answer is this: limited liability with complete transparency. And, since much of the information these days is extremely complex (from the mathematics behind insurance risk, to the physics behind deep-ocean oil drilling) we need professionals who are paid to pay attention.

    Bernie Madoff was committing outright fraud, not some risky but legal trading. He should never have gotten away with it for as long as he did. That he did posits the question: how exactly does one expect the regulator to then pay attention to the legal, but extremely hazardous, behaviour of the credit markets?

    And maybe it will turn out that the regulators for the oil industry are similarly incompetent. I was horrified to see that that regulator is responsible both for collecting rents as well as for enforcing compliance. That is as much of a moral hazard as banks rating their own specie. The first step is to split these two activities and I think that is a necessary first step.

  4. Oversight organizations are just as often the training grounds for future consultants and board members of the industry they regulate.

    But the underlying issue is with that apparent impossibility: an unbiased set of rules created and enforced by people with a vested interest in a “least-liability” outcome. True, many of the events Sam mentioned were caused by countries; most of those countries with oversight organizations firmly in place and doing precisely nothing… or worse. And if the regulations created for private industries are the product of undue industrial influence on government, it makes no difference at all how conscientious or competent an individual agent might be.

    Perhaps it’s because my family has a long relationship with several of the regulatory agencies and the primary industry you’re discussing, but it’s hard for me to believe that anyone is surprised by this pervasive, incestuous relationship. What do FAA agents do after their 20 years? Become airline safety consultants and lobbyists. NRC investigators? Join the nuclear energy biz. NTSB… well, you get the picture.

    • When I bitch about corporatism, I’m not bitching about business or corporations. Sure, there are businessfolks who need hanging, but I can find you assholes in whatever organization you want to talk about.

      The problem is when corps and governments become more or less the same thing. As Ann says, the issue is a system that puts the fox in charge of the henhouse. Regulation is necessary, and often self-regulation isn’t going to happen because of the basic incentives that businesspeople deal with.

      So we need healthy oversight, and we haven’t had it in a long, long time.

  5. I’m pretty sure that the Constitution (being a good example for this case) says “a more perfect union” rather than “a more perfect incorporation”. But i realize that using “union” to describe nations is probably bad voodoo since unions are like socialism or something and socialism is bad or something…same as Hitler really. Of course, the historical precedents for unions goes back much further than limited liability corporations, with guilds in the Middle Ages…but we shouldn’t let something like that get in the way of a good story without any basis in fact.

    That is, nations are not like sovereign corporations. Common shareholders don’t vote for executives, the board of directors does that. What you’re describing (or maybe wishing for) is oligarchy dressed up as democracy.

    So maybe you’re right, the modern nation is a sovereign corporation that extracts the surplus labor value from its workers for distribution amongst the upper echelon. But i can guarantee that the founders of the US did not envision the nation as a sovereign corporation. The Articles of Confederation, maybe because that gave each state limited liability within the loose affiliation. And that didn’t work (or maybe it was just the need for a Navy to take care of the Barbary Pirates).

    • Lex, your comment about guilds being like unions does you a disservice. It was about them that Adam Smith wrote: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” They were a monopoly business practice that deliberately met to raise prices, exclude innovative competitors and keep indentured artisans in slavery.

      And countries are like businesses. They issue debt, get ratings on that debt and have to repay the interest and capital. Sometimes they go bankrupt leaving their citizens in penury. They have board meetings and project their interests into the world. They offer special pleading for favour at global get-togethers. They act to protect insiders from outsiders. Hmm, maybe you’re right, countries ARE more like guilds and could do with a bit of incorporation to free them up a bit.

  6. Smith’s quote is a fine description of the “business community” isn’t it? The modern labor union movement was founded as a reaction to the behaviors of the business community conspiring against workers. Other than a few exceptions that prove the rule, the limited liability corporations did not willingly give people a living wage, any protection against injury, time off to do something other than work, etc.

    This is, of course, why limited liability corporations would much rather set up shop in the third world than the first.

    I wouldn’t, outside of this series, suggest that the founders of the United States were emulating a labor union in constructing the national charter. Obviously, they were emulating the Roman Republic. Which means that they obviously weren’t emulating the limited liability corporation.

    I wouldn’t, necessarily, have a problem with your comparison, except that you’re working entirely within theory and that theory doesn’t even come close to matching reality. In some terrible ways, you’re right in the comparison. The US does behave in much the same was as, say, WalMart: to the detriment of the many for the benefit of the very few. (And no, the “low” prices of WalMart are not a benefit to the many because the come on the backs of horrible labor practices in China, in the US and up and down the supply chain. Those low prices cost more in the long term than they save when one figures in tax breaks to get the company to locate in a city, giving WalMart employees food stamps and health insurance for the destitute, etc. etc.)

    And you didn’t address my statement about the power that common shareholders have over executive decisions within a corporation. If i own a handful of BP shares i don’t have any say in how the company operates.

    • I’d also argue that we have this bad habit of romanticizing the Framers. To be sure, they were glorious men, enlightened thinkers, and the architects of probably the most remarkable political document ever constructed.

      But they were NOT enlightened 21st Century thinkers. The system they crafted I don’t believe ever imagined that the rabble would be allowed to vote (most days I think this is a point in their favor, but that’s another argument). In their world, all decisions were to be made and all offices to be held by … say it with me … rich white men.

      The corporation, as we now know it, wasn’t something they had to consider, but I believe our colleague Bonesparkle has suggested that if we dug up Jefferson, reanimated him, and showed him how things have turned out, his most likely reaction would be “yeah, that looks about right.” In most meaningful respects, he seems to be a lot closer to Dick Cheney than to Alan Grayson.

      Just sayin’….