Limited Liability and the Right of Contract

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Within the
camp of free market advocates there is a tiny subgroup that takes
a stand against the corporation. The central feature of the corporation
is limited liability. This feature is what the anti-corporationists
oppose.

Here is
what they oppose. A group of people invest money in a legally
separate entity, sometimes called a fictitious person. This entity
is legally separate from the founders’ assets. The corporation
is liable up to the value of its assets, but creditors or plaintiffs
cannot extract wealth from the investors beyond the value of the
assets in the separate legal entity. You can lose your investment;
you can’t lose what you did not put into the joint pot.

Limited
liability is a means of risk-sharing. By placing “Inc.” or “Ltd.”
— which stands for limited liability — in the organization’s
name, investors are telling the public that this entity is not
a partnership. In a partnership, the investors’ entire net worth
is at risk. If your partner goes bankrupt for any reason and still
owes money, the creditors or plaintiffs can take your assets in
settlement of the claim.

Partnerships
are exceedingly risky. They are also small. Nobody wants to pool
his assets in a partnership that includes poor people or strangers
whose net worth statements are not shared with everyone in the
partnership. A partnership is the economic equivalent of a co-signed
debt: if the borrower defaults, the co-signer must pick up the
tab. This arrangement used to be called “surety.” About 3,000
years ago, the author of the Book of Proverbs warned:

He
that is surety for a stranger shall smart for it: and he that
hateth suretiship is sure (Prov. 11:15).

A man void
of understanding striketh hands, and becometh surety in the
presence of his friend (Prov. 17:18).

A corporation
has the potential to become large through the addition of new
capital, not just through retained earnings. If a company requires
more capital for expansion, it can invite investors to purchase
a portion of ownership. Nobody hesitates to invest because of
a threat of being jointly involved with people of limited means.

That’s what
it boils down to: limited liability or unlimited means.
A corporation reduces the risk of associating with “the likes
of them.” For those of us who are “them,” this opens up investment
doors that would otherwise be closed to us. Lloyds of London,
a series of high-return partnerships, does not want us around.
We’re just too risky. But the New York Stock Exchange thinks we’re
great. (Frankly, I’m not sure I want to associate with the New
York Stock Exchange.)

A general
principle of life is this: responsibility accompanies power.
With greater wealth or benefits comes greater responsibility.
But it is possible to transfer some of this responsibility to
others by means of a contract. A risk-aversive individual may
be able to persuade another person to accept some of his responsibility
for a price. A person who is willing to accept more risk — at
the margin, of course — can enter into an agreement with someone
who is trying to avoid risk — again, at the margin. They exchange
assets/risk at a price. The risk-aversive person sells some of
his risk — risk that offers a possibility of future gain — to
the risk-buyer.

MORTGAGES,
COLLATERAL, AND SLAVERY

Consider
a home mortgage. There are two ways to arrange one. The first
way is to use the house and land as the exclusive collateral for
the loan. In case of default, the lender gets the property. The
other way is for the debtor to agree to pay the difference between
the debt owed and the market price received by the creditor for
the sale of the property in case of the debtor’s default.

Most home
buyers would shudder at the prospect of being personally liable
for the entire debt, should they default. (It pays to read the
contract — maybe some buyers have signed the more risky kind.)
They are willing to agree in writing to surrender the property,
but they are not willing to be sold into slavery, for example,
to pay off the debt. Yet this is what was done to debtors who
defaulted in Mosaic Israel (Lev. 25).

Lenders
know that they will not be able to persuade most prospective home
buyers knowingly to sign a mortgage contract that puts them personally
at risk for the entire debt. Wise borrowers insist on limited
liability. The house must serve as the exclusive collateral.

Lenders
want to make loans. This is how they save for the future. So,
to increase the number of willing borrowers, mortgage lenders
agree to a limited-liability contract. The debt is collateralized
solely by the market value of the property.

It is possible
that a family may move in and trash the house. Then they may stop
paying. It may take months to get a court to agree to let the
lender evict them and repossess the house. There is risk. But
the economic reality is this: a mortgage loan on a family-occupied
house is the safest long-term loan imaginable, unless you trust
a government bond even more. Lenders know that a husband uses
the home to demonstrate publicly his economic success. He does
not want to have his house repossessed. He would lose face. A
wife treats the house as a means of self-expression. It reflects
her tastes. She also does not want to be evicted. A family will
make the monthly mortgage payment first. Lenders know this. Risk
of default is low.

So, the
lender considers the motivations of the borrowers, and he concludes:
“I don’t need to get the loan collateralized by the bodies of
the husband and wife and children. The parents do not have to
agree sell their children into slavery in case of the parents’
default.” This was not true in Mosaic Israel. Children were sold
into slavery to pay off their parents’ debts (II Kings 4).

I suspect
that most libertarians would recoil in horror at the arrangement
in Mosaic Israel. “What? Slavery? To repay a debt? This is a moral
outrage!” Honest rulers agreed; it was a moral outrage . . . if
Israelites were enslaving other Israelites, and if the
debt was emergency debt (Nehemiah 5:1-12). But Mosaic law nevertheless
made such enslavement legal, for up to 49 years (Lev. 25:25-28).
This was because debt is a means of getting through hard times.
Debt and collateral are matters of contract, of supply and demand
for loans. The borrowers were not in a strong bargaining position;
the lenders were. Mosaic law acknowledged this.

Here is
the bottom line, ideologically speaking: you cannot logically
deny the legitimacy of enslavement for debt without becoming a
defender of limited liability. The question then becomes:
“What kind of limited liability?”

This is
what mortgage contracts spell out in detail. Virtually all of
them today are limited-liability documents. Nobody thinks twice
about this, including dedicated anti-incorporationists.

The limited
liability contract known as a house-collateralized mortgage is
a familiar and widely accepted means of transferring risk. Risk
is not extinguished. Rather, it is distributed. The lender bears
the risk of a default. He also bears the risk of house-trashing.
The buyer bears the risk of public humiliation through eviction
and also the loss of equity. The lender owes a defaulting borrower
nothing in case of a default. Through risk-allocation, a mutually
beneficial arrangement becomes possible.

INCORPORATION
AS SHORTHAND

Let us move
from a limited-liability mortgage contract to a limited liability
contract to purchase something. I agree to sell you a ticket to
a Broadway show. You agree to pay me in advance. The performance
we agree to is a month away.

Let’s talk
about risk. The star may sprain her ankle. You will see an understudy.
The understudy may turn out to be something less impressive than
the understudy in 42nd
Street
. Do I owe you a partial refund? I can spell out
the details in a long contract, which you will sign and perhaps
have notarized at your expense, or we can go by court decisions
in the past as to who owes whom what, if anything, or we can go
by tradition, which is appropriate if the show is a revival of
Fiddler
on the Roof
.

What if
the electrical system goes kaput in the middle of Act 2? Do I
owe you anything? By tradition, I owe you a replacement ticket.
We have a name for this: a raincheck. But you will have come back
to New York City to see the show. To return to the show in a month
will cost you a bundle. Do I owe you the cost of another round-trip
plane fare plus hotel and food?

And so it
goes. Case by case, contract by contract, there is an exchange
of risk. Buyers bear some of it; sellers bear some of it. We have
a phrase for this: “Let the buyer beware.” In short, don’t count
on limited liability if you’re a buyer.

To speed
up transactions, societies rely on tradition, which in turn rests
on court decisions and possibly legislation. The lengthier the
contract, the fewer the transactions. The more the paperwork,
the higher the cost per transaction. The more the details must
be spelled out to buyers, the higher the cost per transaction.
The more lawyers involved, the more likely that the deal will
fall through.

So, instead
of going through reams of paperwork that spell out the details
of risk-allocation, modern society has an alternative: incorporation
papers. The rules are known in advance in much the same way that
the rules of New York Broadway show ticket sales are known. The
rules boil down to these: (1) “Let the buyer [from the corporation]
beware.” (2) “Let the seller [to the corporation] beware.”

Corporation
law is all about the allocation of risk. It is about making deals
possible where fewer deals or no deals at all are likely. It is
all about “let’s make a deal.” It is therefore quintessentially
American.

Instead
of reams of paper to read and sign in triplicate, we have corporation
law. Whatever a corporation achieves in terms of risk-allocation,
a contract could achieve. But it is cheaper for everyone concerned
to file incorporation papers and put “Inc.” on the company’s letterhead
stationery than it is to fill out all those forms every time there
is a transaction.

Critics
of incorporation usually invoke a higher morality — undefined
and undefended — to challenge the corporation’s right to exist.
But every criticism boils down to this one: “The right of contract
has limits when it comes to risk-allocation.” Every criticism
of the corporation is inherently and necessarily a criticism of
the right of contract.

This is
why it is so strange to read critiques of the corporation written
by people who affirm their commitment to libertarianism. They
say, sometimes openly, that the corporation is immoral and therefore
should not be allowed to exist because people who invest in the
corporation do not bear all of the risks associated with doing
business. The critics never admit, let alone praise, the economic
fact that such a legal prohibition is discriminatory against outsiders
who want to make a deal and who are willing to bear some of the
risk associated with the deal.

Critics
of the corporation are necessarily critics of contracts. They
are promoters of legalized restraints on trade. They are saying,
not simply that limited liability for corporations is wrong, but
that limited liability is itself wrong. “The seller cannot legally
transfer responsibility to the buyer.” Why not? “It’s just not
right!”

Here is
the problem: both parties are sellers and both are buyers. Sellers
of goods are buyers of money (or other goods in barter). Buyers
of goods are sellers of money. What the critics of the corporation
are saying is that, because of some moral principle, the seller
of money must not be allowed to bear more than a small fraction
of the risk associated with default by the seller of goods. Instead,
investors in the corporation must bear the lion’s share of the
risk. Why? The critics do not say. By what theory of mutually
beneficial exchange? They do not say. They do not say in print
what their policy recommendation requires: there must be restrictions
on the sale of and investment in risk.

In short,
risk is seen as somehow unique among economic transactions: one
group of transactors — non-board member investors in a corporation
— are morally bound to bear most of the risk, right down to their
last penny and even to slavery, if the critics’ principle of risk-bearing
is followed to its logical conclusion.

I ask this:
What is so unique about risk that courts must not recognize the
legitimacy of contracts that allocate risk away from shareholders
and to buyers and sellers? Second, if individual risk-allocating
contracts are legitimate, then why isn’t a corporation legitimate?
A corporation is merely a form of shorthand regarding the allocation
of risk. The word “Inc.” is shorthand for one of those ten-page
contracts that transactors hate and lawyers love. Transactors
want to make a deal. Lawyers want to modify boilerplate contracts
at $200/hour, even at the risk of killing the deal.

A corporation
is said to be a legal fiction. But it is not a special creation.
It used to be a special creation by legislatures — wonderful
opportunities for political payoffs. But today, it costs under
$300 to create a corporation through a company like the Company
Corporation. It is a matter of filling out printed forms, paying
fees and then taxes to a state, usually Delaware or Nevada, and
hiring a local agent. This is cheap shorthand.

THE
ASSAULT ON CONTRACT

When you
hear an attack on the concept of the corporation, immediately
think: “Assault on contract.” When you hear that investors are
morally bound to bear the risk of failure, right down to their
last penny, think: “Home mortgage secured by both property and
personal assets.” When you hear that it is immoral for sellers
to pass any risks of failure to buyers, think: “$500 for a balcony
seat at a Broadway show.”

Risks are
a fact of life. Someone must bear them. Contracts are capitalism’s
way to enable buyers and sellers to come to terms regarding the
allocation of risks. The free market principle of the right of
voluntary contract is the principle governing liability.

There is
no way to legislate risk out of transactions. It is possible to
reduce the transaction costs of allocating risks. The most cost-effective
way is by contract. Incorporation is a shorthand form of contract.

The argument
for efficiency is not the best argument for the right of contract.
The best argument is the defense of individual liberty. But efficiency
is still an adequate defense. The fact of decentralized knowledge
among the population supports the right of contract. Those parties
who stand to benefit from a transaction should bear the risks
associated with the transaction. They are best equipped to decide
who should bear what degree of risk.

There is
an argument that rejects the corporation because third parties
who have not entered into a contract with a corporation may be
harmed in some way, such as by pollution. They assume that harmed
individuals cannot sue the senior managers of a corportation beyond
the corporation’s assets. But courts need not prohibut tort law
compensation for the decision-makers. The economic issue is the
protection of investors who were not decision-makers, as I have
already written.

CONCLUSION

I
sometimes quote Mises or Hayek, but this time I will quote Pearl
Bailey: “It takes two to tango.” Let each couple decide how best
to reduce the likelihood of toes being stepped on, and whose.
The rest of us on the dance floor should concentrate our attention
on keeping from bumping into each other.

November
1, 2004

Gary
North [send him mail]
is the author of Mises
on Money
. Visit http://www.freebooks.com.

Gary
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