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.

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