While I continue to revise and re-revise and re-re-revise my tech-oriented congestion-control post in my head, here are some thoughts on the other topic that has been rattling around in there recently. I got into a discussion recently about corporate liability protection. I call it “liability shedding” because I think that saying “the buck stops here” when “here” a legal fiction created for the express purpose of not allowing people to be held accountable for their actions is unnecessary and evil. Yes, that really is the express purpose of corporations. It’s why the institution was created, and the main thing that distinguishes it from any other kind of partnership or contractual relationship. The theory is that in certain situations, there is a thing that needs to be done, where the business risk from potential liability precludes its being done by the private sector under normal conditions, but the benefit to society is large enough to justify offering an inducement in the form of protection from that liability. As I wrote almost three years ago, the building of the Erie Canal is an example of this theory being put into practice. As I also wrote, the theory no longer applies to modern corporations which are still given liability protection plus many other novel benefits of legal personhood without any requirement that the public good be served either initially or on a continuing basis. It’s a totally one-sided deal. If it were considered as a contract, the standard of mutual consideration would not be met and the contract would be considered invalid.

Of course, we’re not going to eliminate corporations. What we can do, though, is address the evil that is liability shedding. The real problem with limiting corporate liability to the current assets of the corporation itself is that it screws up the incentive system upon which capitalism and free markets (not quite the same thing BTW but that’s a different topic) rely. A reasonable incentive system colocates risks and rewards. You take the risk, you reap the rewards. With a corporation in the way, though, you’re matching limited risk with unlimited reward. It’s a sweet deal for those hiding behind the liability shield – which is all many “shell” corporations are really intended to be – but it comes at the expense of those who actually create value by building and inventing and so on. My very simple solution is to restore the connection between risks and rewards. Instead of associating liability – i.e. risk – with the assets of the corporation, associate it with the profits. In other words, not with what went in but with what went out. Similarly, apportion that liability not based on who holds stock (what’s in) but based on who took profits (what’s out). If you choose to partake of profits, you partake of risks as well.

In more concrete terms, if you have ever bought stock in a corporation and then sold it at a profit, then you remain responsible for a share of its liability proportional to that profit divided by the total profit (or current value) associated with that corporation. If that doesn’t sound good to you, don’t buy the stock. Don’t take that risk. That association of risk with profit is unavoidable when you purchase more tangible products or services, and there’s no reason it shouldn’t apply to stock as well. It might be reasonable to have people’s share of risk expire after a certain time as a book-keeping simplification (more about that in a moment) or as a statute-of-limitations sort of thing, but not because it’s inherently unfair for those who profit to share in risk proportionally. I’d like to make a couple more observations about the practical consequences of this change as well.

  • The book-keeping would not be particularly complex or burdensome. In database terms it’s a simple table: transaction X, person Y, profit Z. To determine a person’s share of liability, all you need to do is add up the profits in all records for person Y and divide it by the total. Corporations and financial institutions have to deal with calculations that are orders of magnitude more complicated every single day. If mutual funds and hedge funds and other intermediate holders of stock want to pass either profit or liability on to their respective stockholders, that’s their problem and one they already know how to address in the case of profit so it doesn’t add a burden either.
  • In addition to restoring the proper incentives in the form of a balance between risk and reward, this idea would also discourage non-value-creating speculation. The effect on “buy and hold” would be minimal, but frantic flipping of stocks to profit from momentary fluctuations might not be so tempting if liability accumulates in the process. I think that’s a good thing, as I believe such speculation is parasitic: it benefits a very few while harming the companies in which they speculate and the markets themselves.
  • This would not kill incentives to invest, because there would still be far more upside than downside. If you gain no money by investing in a risky venture, you gain no liability either. On the other hand, if that venture generates more profit than liability, then you gain both. Since the amount of profit generated in the economy is far larger than the amount of liability, and the amount of profit for a particular company has no limit, that’s still a very large potential upside. But wait, you say, the company could be liable for more than was invested. That means investors could lose more than they put in. Damn right. If the company does more damage than it’s worth, then why shouldn’t the victims have that recourse? That’s kind of the whole point here. You can’t limit liability to the corporation itself (or its value) without denying recourse to those who are harmed, and that’s unfair to them. Again, if investors don’t feel comfortable with that risk then they shouldn’t buy the stock – or they should buy insurance, just as they do against other risks. In fact, many kinds of private partnerships and practices already purchase such insurance. Some are even required to carry such insurance, either by regulation or as a requirement to receive private (non-stock) investment, and it doesn’t prevent them from pursuing their entrepreneurial goals.

In short, I think this fairly simple change would be a very large step toward truly free markets, removing one of the major distortions in the markets we have by restoring the incentives that everyone since Adam Smith has recognized as essential. I think I’ve managed to address most of the more predictable objections. What did I miss?