by Michael S. Rozeff
by Michael S. Rozeff
A real free market does not allow one person to damage another person with impunity. For this reason, there can be no limited liability in a free market, a conclusion already reached by both Bob Murphy and Frank van Dun and anticipated by Murray Rothbard's conclusion that "A libertarian society would be a full-liability society where everyone is fully responsible for his actions and any harmful consequences they might cause."
An article in Mother Jones, also against limited liability from another side of the political fence, tells us: "This limited liability corporation is the bedrock of the market economy. The markets would deflate like a punctured balloon if corporations were stripped of limited liability for shareholders." Views like this have been widespread among historians. In 1911, the President of Columbia University wrote "The limited liability corporation is the greatest single discovery of modern times...Even steam and electricity are less important..."
If the libertarian free-market dream comes true and full liability is assessed on the individuals who own companies, will we see a dramatic drop in stock market values? Will we all, or a great many of us, become terribly poorer? If this is thought to be so, a good many people will write off the libertarian dream as a nightmare. It is not hard to find supporters of laissez-faire capitalism who blanch at the thought of disturbing laws like limited liability that they think are "why we saw such an enormous growth of wealth in the 20th century."
Libertarians are caught in a dilemma. If we do not support limited liability, we will scare away practical-minded and possibly sympathetic people worried about values being destroyed or capitalism being destroyed. If we support limited liability, then we compromise a fundamental principle. I will resolve this dilemma by showing that market values will not be undermined if limited liability disappears.
Limited liability at present is a State-granted privilege which works like this. Suppose that Happy Drug Company (HDC) has $100 market value financed solely by stock (equity). If HDC puts out a drug that unintentionally harms people, they or their survivors can sue the company but not the stockholders or manager-owners of the company. The liability of the latter two groups is limited. That means that the most that can be recovered depends on the worth of the company's assets that can meet the claims. The two main possibilities are that the company has enough assets to pay off the claims and that it does not have enough.
For example, if the company used up $40 of its value in paying off claims, the stockholders might be left with $60. In this case, the limited liability would not hurt those who were harmed because the company had enough to pay off. If the claims came to $135, however, then the company could pay at most $100. (I am intentionally simplifying the situation in a number of ways.) The people damaged could not legally assess the individual stockholders or the manager-owners for the other $35. They would lose $35. This situation is clearly unjust, and this is why libertarians do not favor a State-imposed limited liability law for companies. In a real free market, those damaged could sue the owners for the full amount of damages.
The effect of State-imposed limited liability on stock value seems to be non-negative. It allows shareholders to supply capital to the company without worrying about being assessed on their personal assets if the company creates damage claims. This raises the stock value by the amount that might be assessed weighted by the chance of this occurring.
But the customers face a greater chance of being damaged, because the company has a lower incentive not to do harm. And they face an upper limit on what they can collect if they are damaged. These two effects reduce their demand for the product, and this offsets, to some extent, the increased stock value.
This argument suggests that there are inherent opposing valuation effects from limited liability, so that the net effect need not be the large amount that has been supposed. If limited liability disappears, stock values will decline because damage costs will rise, but they will increase as customers are more willing to buy the product.
There is another way to look at this. These effects are bounded in size by what it costs for the parties to obtain limited liability privately. Suppose there is no limited liability. The owners of the company could buy insurance against damage claims beyond a deductible determined by market value. The value of State-imposed limited liability can't exceed the cost of such insurance. Product buyers can also buy insurance against damages in excess of the $100 that they can obtain. They could buy life insurance, for example, against the peril of being harmed by a product. The value of limited liability to the company can't exceed these costs.
Here again we see that market values need not greatly depend on limited liability because it is unlikely that insurance costs for these perils will be high. Before an owner could collect on the insurance, the entire market value of the company would have to be paid over to those damaged. The chances of this occurring are typically not great, although the asbestos cases seem the exception. However, we can seriously question whether most of these cases would ever have seen the light of day in a well-behaved justice system.
As a factual matter, companies typically buy liability insurance against a number of perils including the fees and costs incurred by paying off on lawsuits against them. They do not routinely allow the business to be bankrupted by claims, at which point the limited liability sets in. Instead, they try to prevent the claims from interrupting the operations of the business at all! They try to stem losses in stockholder equity from the first dollar of claims or some sensible deductible. (A damage suit may destroy the company's goodwill and reduce stock value greatly by that route, but that is another matter.)
If a company buys liability insurance, and most do, then the value of limited liability to them cannot possibly weigh heavily in stock market value. The company is voluntarily seeing to it that it never gets into a situation where limited liability has a value to the owners. By their own actions, companies are revealing that the worth of the business is far more important than being able to invoke the privilege of limited liability.
The value of most successful businesses hinges overwhelmingly on current and future profitable sales to customers, not on limited liability. Owners have strong incentives to protect that franchise by insurance and other means such as insuring product quality at the outset, care in packaging, testing, etc.
There is evidence on the question of how much the limited liability provision supports market values. Mark Weinstein has examined two situations in which companies changed from unlimited to limited liability, one involving companies in California when in 1931 that state adopted limited liability, the other involving American Express Company's switch in 1965. In neither case did market values change detectably upon the adoption of limited liability. Michael Smart points out that British companies were slow to switch to limited liability after the 1855 law was passed, suggesting that the benefits were not perceived as large.
If we repeat the analysis for a company that is financed by both bonds and stock, we will reach the same conclusion even more clearly. When the equity has limited liability and owes money to bondholders, the bondholders cannot assess the stockholders' personal wealth to pay off their claims. Since bondholders know this before they contract to lend money, they charge a higher interest rate to compensate for the chance they will not be repaid fully. As a consequence, the debt becomes risky and the stock less risky. But the total market value of the company does not change. Limited liability does not cause an increase in the total market value of the firm at all in this case. It simply shifts risk from one group of capital-suppliers to another.
In free markets, companies (entrepreneurs) may still want to raise large amounts of capital. Will shareholders be scared off by the prospect that they may be assessed if the company incurs damages that the assets will not cover? Surely the risks of the venture itself are many and the risk of damages is one more in a long list of risks. At present, shareholders show little or no reluctance to shoulder these risks. If they are concerned and withhold capital, entrepreneurs can contract for insurance, or stockholders themselves can do this, according to their own assessments of these risks. Owners of companies can also shift risk to others in many, many legitimate ways that are the equivalent of insurance.
I conclude that the dire scenario forecast by Mother Jones is highly unlikely to occur. There will be no huge drop in values if limited liability disappears, because market values do not depend on limited liability in an important way. Supporters of laissez-faire are mistaken to think that its benefits rest upon limited liability. They need not fear a real free market on this account.
Libertarians need not be placed on the defensive in advocating a free market in which State-imposed limited liability is absent.
September 27, 2005
Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.
Copyright © 2005 LewRockwell.com