Friday, March 19, 2010

Limited Liability

Limited liability is so much a part of the furniture these days that we risk forgetting how radical an idea it is.

Before limited liability, owners of companies were directly and fully responsible for damage caused by the company to customers or the general public.   Even if you only had a few bob invested in a company, your legal exposure was far greater;  a small shareholder in a collapsed coal-mine could find themselves bankrupted by claims from the bereaved, for example.  Enterprise was being held back due to the fear of litigation.

And so, in the mid-19th century, the British government introduced the concept of limited liability and gradually extended it to cover most industries with one or two notable exceptions (e.g. the legal profession).  The Americans picked up the idea and it gradually spread to other jurisdictions as well.  From that point on, the maximum amount that plaintiffs could seek from a shareholder in respect of the actions of a company was the value of their shareholding.  Personal assets were, for the most part, off limits.

So why am I rattling on about arcane points of commercial law?  Because the balance between responsibility and liability is out of kilter.  I can set up a discount airline, rent all my assets rather than own them and as a result maintain a tiny balance sheet and hardly any capital.  I can sell lots of tickets in advance to customers who assume that my airline's finances are sound (and who wouldn't be able to figure out if they weren't).  I forget to hedge my fuel costs; the price of aviation fuel rises suddenly.  Within a month, I'm out of business and my customers are using their tickets to wallpaper their houses.

For me it's no big deal.  I hardly invested any money in the company and while it was running I was able to extract some nice dividends.  For my customers and suppliers, however, its a disaster.  Families have had their holidays ruined and a catering company collapsed because I failed to pay them for the packaged meals they were loading on my planes.

The fact is, under limited liability in its current form, management and (if they are in control) shareholders get the rewards but bear a disproportionately small amount of risk.  Most of the enterprise risk is borne by customers and suppliers.

I don't think the answer is to dump limited liability altogether.  Some degree of risk-sharing is appropriate considering that the economy and its health is in a sense a common good.  The field does, however need to be levelled a bit.

What I propose is that companies of all forms should maintain a minimum capital level which is a percentage of assets / exposures or a percentage of revenues, whichever is greater.  Furthermore, part of this capital should be held in trust at a bank and invested in safe and liquid assets.  A regulator should step in and take firms into administration when capital levels are breached.  Shareholders could regain control by pumping in more capital within an agreed period, otherwise the administrator would wind up the company in the best interests of creditors.

This 'shared liability' approach would have three beneficial effects:
  1. Shareholders would have more skin in the game and hence a higher degree of interest in risk management and in the long-term health of their business.
  2. Problems with the business model would be flagged earlier (i.e. when the minimum capitalisation level is breached, rather than when shareholders' funds are already negative and nothing can be done).
  3. There will be more money available to pay out creditors, meaning that suppliers and customers are treated more fairly and systemic effects are limited.
The downside is that business plans will need to be a bit more cautious and that shareholders will have more capital tied up in the business.  But those aren't necessarily bad things.

You can't legislate away risk.  You can, however, ensure that it is borne by the right people, understood and managed well.

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