Yves here. While this Richard Murphy post correctly fingers the considerable cost of the limited liability regime, omnipresent in modern commerce, he doesn’t suggest a way out. And that’s because the existence of very large enterprises depends on it. No one would be the CEO or sit on the board of an entity of any size if they might be personally liable, particularly since those with the deepest pockets would be cleaned out every bit as much as say a community leader with little net worth. This is why, even with limited liability to shield corporate big wigs, companies of any size also buy directors and officers insurance to further protect those nominally in charge from the consequences of their bad actions or negligence.
Murphy suggests a teardown. This is simply na ga happen. But there are a couple of things that are not totally impossible, just vanishingly unlikely, that could do a lot to make corporate managers and boards more accountable and reduce the dangers and unfairness of our current “heads I win, tails you lose” legal regime.
When I was in Oz (early 2000s) and I believe that standard also applied then in the UK, board members were personally liable if a company was found to be “trading insolvent” as in incurring expenses or other expected liabilities it could not pay. This at a minimum led board members to watch company books, costs, and commitments pretty carefully. And they would put a company into bankruptcy pronto if they thought it was about to stray into “trading insolvent” terrain.
Having said that, it seems just about certain that Big Cos even under a “trading insolvent” stricture buy directors’ and officers’ insurance to shield the higher ups, so this by itself is not much of a remedy.
Second would be to implement a regime suggested, by of all people, former New York Fed president and Goldman Sachs partner to give top executives what Taleb would call skin in the game by making them retain bonuses (which would be defined as anything over a not-all-that-high base pay level), other incentive comp, and deferred pay in the company, for say at least five years. That is the time frame Warren Buffett has long used for executives in his reinsurance business. Buffett does that to make sure any problems with the policies his top team has written have shown up and been charged off before he gives them their profit participation pay. Otherwise he would be at risk of rewarding execs for income not actually earned.
The XX version of this scheme would be for this pool to serve as subordinated equity. It would pay out first in the event of a major litigation loss or insolvency.
An additional approach would be to end the limits on secondary liability. In the US, astonishingly, shareholders and creditors can’t sue lawyers and accountants who gave bad advice that led to a company failing or suffering large losses. Only their client, as in the board or executives, can. As we wrote in ECONNED:
Legislators also need to restore secondary liability. Attentive readers may recall that a Supreme Court decision in 1994 disallowed suits against advisors like accountants and lawyers for aiding and abetting frauds. In other words, a plaintiff could only file a claim against the party that had fleeced him; he could not seek recourse against those who had made the fraud possible, say, accounting firms that prepared misleading financial statements. That 1994 decision flew in the face of sixty years of court decisions, practices in criminal law (the guy who drives the car for a bank robber is an accessory), and common sense. Reinstituting secondary liability would make it more difficult to engage in shoddy practices.
Now to the main event.
By Richard Murphy, part-time Professor of Accounting Practice at Sheffield University Management School, director of the Corporate Accountability Network, member of Finance for the Future LLP, and director of Tax Research LLP. Originally published at Fund the Future
Post summary
Limited liability is a privilege that protects directors and shareholders from personal consequences when their companies incur debts. Historically this has facilitated economic growth by enabling capital accumulation, but is it now fair when it might be overly exploited, particularly by small companies?
In this morning’s video I note that we’ve had limited liability companies in their current form for about 170 years now, but no one back then imagined we’d have more than five million of them. So, are we really doing the right thing giving limited liability to anyone who asks for it now, or should we be more circumspect?
The audio version of this video is here:
The transcript is:
Limited liability is a privilege.
It’s one I’ve enjoyed on many occasions throughout my career because I’ve been a director of quite a lot of companies over the last 40-plus years. They were put in place to undertake an economic activity and we were protected as directors, as shareholders – and I’ve been both – from the consequences of our actions by the existence of limited liability.
Limited liability was a creation that was first known about in the Elizabethan era, but in its modern form, it was created in a way that is readily available to everyone from about the 1850s onwards, when in the UK, companies were first allowed to be registered with limited liability by the prospective shareholders getting together, signing a document to declare that they wished to be a company, applying to have limited liability, and being granted it by a registrar.
That registrar still exists. It’s called the Registrar of Companies in the UK, and they run something called Companies House, which still records all those companies which enjoy this privilege of limited liability which enjoy this privilege of limited liability to this day. There’s over 5 million companies that have that privilege right now.
But I stress this is a privilege. And when you think about it, it is a totally absurd privilege. Just imagine that today somebody came up with this idea that one or two people – and one is enough – can sign a piece of paper and say that they want to be a limited liability company and as a consequence if something goes wrong in the trade that they undertake then, in the vast majority of circumstances, they will not be responsible to the creditors of the company that they have created for the debts that it has incurred, even though those creditors, whether they be employees, or suppliers, or a tax authority, have incurred liabilities with that company in good faith. Everyone would say that this was an abuse of the rights of those employees, those creditors, and that tax authority. And they would be absolutely right to do so, because limited liability is an abuse of the rights of those people.
What it says is that all those people who trade in good faith with the company might be taken for a ride as a consequence, and lose their money, and have very little, and in some cases, no right of recovery whatsoever. And that’s okay. The shareholders can walk away, the loss is suffered by somebody else, and society supposedly benefits.
Well, the truth is that society probably has benefited from the existence of limited liability overall. There is evidence that this capacity to create limited liability companies has permitted the accumulation of capital from a wide range of sources to create undertakings that could otherwise not have existed.
For example, the railways of the UK would not have been built without the existence of limited liability companies, and many other large companies ever since have accumulated capital in this way, and overall, we’ve probably benefited as a result.
But the concept is still used, and well over 95 percent of all companies are tiny, run by one or two people at most these days. Do they need limited liability? Should they be protected from the consequences of their own actions, which only they know about, especially when the accounts that they have to put on public record are very limited in scope and aren’t available until nine months after their year-end, meaning that everyone who is trading with them is at significant risk most of the time.
Is that privilege something that we should still provide to everybody who asks for it? Or should we regulate its availability a lot more tightly?
Should we, for example, make this privilege of limited liability available to people even with regard to their tax liabilities? Why should we do that?
Should we make it available with regard to the obligation that people have to their employees? Why should we do that?
And is it fair to do this with regard to trade creditors as well? People who genuinely supply goods and then lost their money as a consequence.
These are genuine questions that need to be answered because this cost is imposed on society at large. And there’s no real evidence, especially when it comes to smaller companies, that the benefit is significant.
There is ample evidence that the benefit is abused. We do know that there are many companies that are created that never account for what they do.
We do also know that maybe 30 per cent of small companies don’t pay their corporation tax liabilities, and in that case they probably don’t also hand over the VAT that they owe and the PAYE that they also have owing to HM Revenue and Customs in regard to their employees and the deductions that are payable by them.
Do we, therefore, want to do this?
I ask the question in all seriousness because I think the assumption that limited liability is a universal good thing is something that we need to challenge now.
The time has come to question whether we need fundamental reform of the availability of limited liability to make sure that it provides a benefit to society and not a cost.
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