Update: Roger Pilon’s Corporations and Rights: On Treating Corporate People Justly also has some very good stuff on why limited liability does not give any special privilege to shareholders.

See also: DEFENDING CORPORATIONS, WALTER BLOCK & J.H. HUEBERT

Legitimizing the Corporation

In Defense of the Corporation

October 27, 2005 4:38 PM by Stephan Kinsella | Other posts by Stephan Kinsella | Comments (55)

Piet-Hein van Eeghen’s article “The Corporation At Issue, Part I: The Clash With Classical Liberal Values and the Negative Consequences for Capitalist Practices,” in the latest issue of the JLS, argues that “the corporate form of business organization is inherently incompatible with the principles of classical liberalism.” (Further summary of van Eeghen’s piece reprinted below.)

I have elsewhere posted a brief reply to other libertarian critics of the corporation (that reply is reprinted below), and more or less defended the pro-corporation view of Objectivist Robert Hessen. Part II of van Eeghen’s article, to be published in JLS 19.4, will offer a critique of Robert Hessen’s defense of the corporation, but I will go ahead now and summarize some of my comments on Part I.

I found most of van Eeghen’s arguments to be beside the point, at least for what to me is the basic question, which is: does respecting corporate status violate anyone’s rights?

Van Eeghen implies it does, because of limited liability. It seems to me that the corporation basically says shareholders are not liable for contractual obligations of the corporation. Obviously this could easily be recreated solely using private contracts. The person or company who does a deal with ABC Corp. is in effect agreeing not to pursue the assets of the shareholders if the company owes him money. So whose rights are violated?

As for tort liability–well, I am not aware of corporate law limiting the liability of any person, shareholder or otherwise, for torts he commits. In libertarian law, if you have a complex organization or business, you need to show some given person is responsible for the tort committed by someone else if you want to hold them responsible. It’s a causation question (Pat Tinsley and I go into the issue of causation and responsibility in Causation and Aggression).

If the FedEx truckdriver negligently runs over you, is the shareholder responsible? Well, why would he be responsible in the first place? Because he gave a bit of money to the company? But so do customers! And banks. And suppliers. (And actually, most shareholders never gave money to the company–they bought the shares from a previous shareholder.) Because they control the company’s actions? Well they had no more influence over the concrete decisions of the truck driver, or his direct supervisor, than an influential creditor or customer. The point is if you can make a case that a given person other than the one directly responsible (the truck driver) is causally, jointly liable, fine–then under libertarian principles this person is also liable. In such a case I am not aware that corporate law grants them immunity from suit; and if and to the extent it does, then it should not (I don’t think it does but would need to check this).

If there is a problem with the law in this regard, it is with the law’s failure to assign liability according to sound principles of causation. If some critic of the corporation thinks some managers, and perhaps some directors, in a given incident are causally responsible for the tort, then fine, say so, and make the case. I would not oppose this in general. I believe it’s very difficult in most cases to connect the actions of the shareholder to damage caused by an employee of a company in which the shareholder holds stock. But if it could be shown in a particular case, then fine, he is liable. What has this to do with corporate law, which as far as I know primarily is aimed at limiting the liability of shareholders for contractual debts of the company–which is perfectly libertarian.

***

From Roderick Long’s summary of the JLS issue:

Walter Block has argued in an earlier issue — JLS 16.4 (Fall 2002) — that “Henry Simons Is Not a Supporter of Free Enterprise.” In “The Corporation At Issue, Part I: The Clash With Classical Liberal Values and the Negative Consequences for Capitalist Practices,” Piet-Hein van Eeghen offers a qualified defense of Simons by taking up what he sees as one of Simons’s key insights: that the corporate form of business organization is inherently incompatible with the principles of classical liberalism.The problem with the corporate form is that it grants to private business a distinctive governmental feature — legal personhood, and the accompanying privilege of limited liability — without the correlative burden of democratic accountability; granting such a status, van Eeghen argues, constitutes an un-libertarian surrender of individual responsibility, and confers the benefits of ownership without its corresponding costs, thus enabling corporations to concentrate power and externalize risk in ways to which libertarians should object. (Part II, to be published in JLS 19.4, will offer a critique of Robert Hessen‘s defense of the corporation as an institution.)

***

Legitimizing the Corporation [from LRC blog]Marginal movements tend to draw their share of nuts and cranks; unfortunately, libertarianism is no exception. In addition to claims that we don’t (not “shouldn’t” but “don’t”) owe income tax, or “that hiring an attorney means abandoning personal sovereignty before the law, or that having a yellow-[or gold-]fringed flag in a room means you are under martial [or admiralty/maritime] law,” there are also a fair number of libertarians who view the modern corporation with suspicion. They are concerned that the corporation is viewed as a “person” and believe, erroneously, that corporations shield corporate employees from liability for negligence.

I usually find that the opposition to corporations comes from leftists, or, if libertarians, from ignorance of contract and corporate law…. most people don’t even realize that if a FedEx truck runs you over negligently you can sue the driver. They think he is immune from suit or something. But it is the other way around; if a FedEx truck negligently hits you, it is of course the driver that is responsible. His employer is responsible for its employee’s own negligence and liability only because of the doctrine of respondeat superior; but if the employee is found to be non-negligent, the employer-corporation is off the hook too. This is in fact why corporations usually defend their employee and themselves when sued for the employee’s actions.

But opposition does not always stem from ignorance of the law or leftism: for example, one critique comes from two libertarian-Austrian attorneys: “De-legitimizing the Corporation: An Austrian analysis of the firm”, Jeffrey F. Barr & Lee Iglody, Austrian Scholars Conference 7, March 30-31, 2001, Auburn, Alabama.

Robert Hessen’s (a Randian) In Defense of the Corporation is a good defense of corporations. He shows that they don’t require privilege from the state to exist; they can be constructed from private contracts. One of Hessen’s articles nicely summarizes some of his views. Some excerpts are pasted below. My view is that corporations are essentially compatible with libertarianism. As for voluntary debts being limited to the corporation’s assets; this is no problem since the creditor knows these limitations when he loans money. What about limited liability for torts or crimes? As mentioned, the person direclty responsible for a tort or crime is always liable; sometimes the employer (which is often a corporation) is also liable for the employee’s actions, via respondeat superior. Who else should be responsible? In my view, those who cause the damage are responsible. Shareholders don’t cause it any more than a bank who loans money to a company causes its employees to commit torts. The shareholders give money; and elect directors. The directors appoint officers/executives. The officers hire employees and direct what goes on. Now to the extent a given manager orders or otherwise causes a given action that damages someone, a case can be made that the manager is causally responsible, jointly liable with the employee who directly caused the damage. It’s harder to argue the directors are so directly responsible, but depending on the facts, it could be argued in some cases. But it’s very fact specific. Perhaps the rules on causation should be relaxed or modified, but this has nothing to do with there being a corporation or not–for the laws of causation should apply to any manager or person of sufficient influence in the organization hierarchy, regardless of legal form of the organization (that is, whether it’s a corporation, partnership, sole proprietorship, or what have you).

Excerpts from the Hessen article—

The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state’s role is purely formal and automatic. Moreover, to call incorporation a “privilege” implies that individuals have no right to create a corporation. But why is governmental permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued, holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, that its shares are freely transferable, or if it asserted limited liability for its debt obligations? (Liability for torts is a separate issue; see Hessen, pp. 18-21.) If potential creditors find any of these features objectionable, they can negotiate to exclude or modify them.

Economists invariably declare limited liability to be the crucial corporate feature. According to this view the corporation, as an entity, contracts debts in “its” own name, not “theirs” (the shareholders), so they are not responsible for its debts. But there is no need for such mental gymnastics because limited liability actually involves an implied contract between shareholders and outside creditors. By incorporating (that is, complying with the registration procedure prescribed by state law) and then by using the symbols “Inc.” or “Corp.,” shareholders are warning potential creditors that they do not accept unlimited personal liability, that creditors must look only to the corporation’s assets (if any) for satisfaction of their claims. This process, known as “constructive notice,” offers an easy means of economizing on transactions costs. It is an alternative to negotiating explicit limited-liability contracts with each creditor.

Creditors, however, are not obligated to accept limited liability. As Professor Bayless Manning observes; “As a part of the bargain negotiated when the corporation incurs the indebtedness, the creditor may, of course, succeed in extracting from a shareholder (or someone else who wants to see the loan go through) an outside pledge agreement, guaranty, endorsement, or the like that will have the effect of subjecting non-corporate assets to the creditor’s claim against the corporation.” This familiar pattern explains why limited liability is likely to be a mirage or delusion for a new, untested business, and thus also explains why some enterprises are not incorporated despite the ease of creating a corporation.

Another textbook myth is that limited liability explains why corporations were able to attract vast amounts of capital from nineteenth-century investors to carry out America’s industrialization. In fact, the industrial revolution was carried out chiefly by partnerships and unincorporated joint stock companies, rarely by corporations. The chief sources of capital for the early New England textile corporations were the founders’ personal savings, money borrowed from banks, the proceeds from state-approved lotteries, and the sale of bonds and debentures.

Even in the late nineteenth century, none of the giant industrial corporations drew equity capital from the general investment public. They were privately held and drew primarily on retained earnings for expansion. (The largest enterprise, Carnegie Brothers, was organized as a Limited Partnership Association in the Commonwealth of Pennsylvania, a status that did not inhibit its ability to own properties and sell steel in other states.)

External financing, through the sale of common stock, was nearly impossible in the nineteenth century because of asymmetrical information—that is, the inability of outside investors to gauge which firms were likely to earn a profit, and thus to calculate what would be a reasonable price to pay for shares. Instead, founders of corporations often gave away shares as a bonus to those who bought bonds, which were less risky because they carried underlying collateral, a fixed date of redemption, and a fixed rate of return. Occasionally, wealthy local residents bought shares, not primarily as investments for profit, but rather as a public-spirited gesture to foster economic growth in a town or region. The idea that limited liability would have been sufficient to entice outside investors to buy common stock is counterintuitive. The assurance that you could lose only your total investment is hardly a persuasive sales pitch.

No logical or moral necessity links partnerships with unlimited liability or corporations with limited liability. Legal rules do not suddenly spring into existence full grown; instead, they arise in a particular historical context. Unlimited liability for partners dates back to medieval Italy, when partnerships were family based, when personal and business funds were intermingled, and when family honor required payment of debts owed to creditors, even if it meant that the whole debt would be paid by one or two partners instead of being shared proportionally among them all.

Well into the twentieth century, American judges ignored the historical circumstances in which unlimited liability became the custom and later the legal rule. Hence they repeatedly rejected contractual attempts by partners to limit their liability. Only near midcentury did state legislatures grudgingly begin enacting “close corporation” statutes for businesses that would be organized as partnerships if courts were willing to recognize the contractual nature of limited liability. These quasi-corporations have nearly nothing in common with corporations financed by outside investors and run by professional managers.

Any firm, regardless of size, can be structured as a corporation, a partnership, a limited partnership, or even one of the rarely used forms, a business trust or an unincorporated joint stock company. Despite textbook claims to the contrary, partnerships are not necessarily small scale or short-lived; they need not cease to exist when a general partner dies or withdraws. Features that are automatic or inherent in a corporation—continuity of existence, hierarchy of authority, freely transferable shares—are optional for a partnership or any other organizational form. The only exceptions arise if government restricts or forbids freedom of contract (such as the rule that forbids limited liability for general partners).

Update: See further discussion and my list of resources on this in Sean Gabb’s Thoughts on Limited Liability.

***

Sean Gabb’s Thoughts on Limited Liability

September 26, 2006 10:16 AM by Stephan Kinsella | Other posts by Stephan Kinsella | Comments (47)

A previous post, In Defense of the Corporation, discussed whether “limited liability” of modern corporations is compatible with libertarian principles. This topic was also discussed on Kevin Carson’s “mutualist” [socialist? neo-Marxist?] blog; see the excellent comments there by “iceberg.” Carson also recently promoted some anti-corporate comments by the eloquent libertarian Sean Gabb. I wrote Gabb about this, and he responded to some of my questions in Thoughts on Limited Liability. He quoted most of my substantive comments in his piece, so I won’t reprint them here. My response to his piece follows:

Very reasonable and thoughtful comments, Sean, and a profitable way to pursue this. I do not disagree strongly with much of what you write. I will elaborate more on this later after your post becomes linkable or emailed.

The main differences here would probably be this–first, if you want to show a link between ownership of shares, and liability for acts done by any employee of the enterprise that uses property of the company, then I simply think more needs to be shown. You have provided a sketch of a possible theory that might show a sufficient connection, and I would not be hostile to seeing if it plays out. I am not so confident this can be done from one’s armchair. It seems to me the application of the general principles might need to be left open.

In other words, it seems to me the default libertarian position is that an individual is responsible for torts he commits. If you want to hold others liable for this too, you need to show some kind of causal connection between something done by the third person, and the tort committed by the direct tortfeasor. You seem to assume that this connection is present in the case of a shareholder because he is the “true” or “natural” owner of the company’s assets. This I think is what troubles me the most–it seems too much of an assertion to me. I do not see its basis. And as I alluded earlier, it seems to rest on the notion of respondeat superior. Maybe this legal principle could be justified but I have never been quite sure exactly how or why it is justified under libertarian principles. It seems to me the idea is that the principle of respondeat superior simply is the presumption or finding that the employment relationship necessarily is a sufficient causal connection to hold the employer responsible for torts of his agent-employee. I am not hostile to this conclusion but am not quite sure the case has been made. Maybe there is a presumption, maybe in many or most cases the employer is causally responsible, but I am not sure it is necessarily the case (I have always loved the idea that if the employee goes off on a “frolic” then there is no respondeat superior liability; so you have cases examining whether the employee who deviates from his assigned duties is on a “frolic” or not–ha!). But consider: the basis for respondeat superior (and I bring this up b/c it seems to me something along the lines of this principle must be employed to hold the shareholder liable for acts of employees) has to do with the employer’s practical right or ability to control or direct the actions of the employee (this principle probably underlies the “frolic” exception too). Can we assume that this control is present when we move further back the chain of causation? Say, to the directors, who appoint the managers? Or to the shareholders, who elect the directors? And if practical control is one of the main relevant features that determines whether there is liability, again, why couldn’t lenders, employees, suppliers, customers, etc. at least potentially be held liable? In some cases they exert more control and give more “aid and comfort” or “aid and abet” in more visible and substantial ways than a mere shareholder.

This highlights that you still seem to draw some kind of bright line between the position of a lender and a shareholder. Something about this troubles me–it seems too artificial; too reliant on the state’s own positive legal distinctions. In my view, the general question is one of causation. I cannot say from my armchair that lenders necessarily are radically less responsible for the actions of company employees than are shareholders. It seems to me one needs to say this, however, in order to draw the bright line distinctions you do. In economic or financial terms, for example, it is common to classify shareholders and lenders/creditors on a spectrum, based on who gets paid first: if a company is going bankrupt, say, then out of its remaining assets: first, you pay secured lenders; then unsecured lenders; then, say, preferred shareholders; then finally, common shareholders. Sure, for legal purposes you classify some as shareholders and some as lenders; but financially, in a sense, this is just a way of specifying priority of payout and relative risk of capital. And there is nothing inconceivable about a lender agreeing (for some reason) to be paid only after shareholders receive a certain liquidation preference amount… all kinds of mixtures are conceivable. This would muddy the waters about who is the “natural” owner, it seems to me. The point, to me, is that this shows the limitations of relying on “natural ownership” as a key principle here.

Also I would say that if you had your way, I could see creative commercial lawyers and businessmen thinking of different investment vehicles that are economically similar to the joint stock company (as you even intimate in your comments about bonds being another way to finance endeavors and the “naturally” limited liability of bondholders). You conceive of a shareholder as the “natural” owner of the enterprise. I am skeptical of relying on the conceptual classifications imposed by positive law. To me a shareholder’s nature or identify depends on what rights it has. What are the basic rights of a shareholder? What is he “buying” when he buys the “share”? Well, he has the right to vote–to elect directors, basically. He has the right to attend shareholder meetings. He has the right to a certain share of the net remaining assets of the company in the event it winds up or dissolves, after it pays off creditors etc. He has the right to receive a certain share of dividends paid IF the company decides to pay dividends–that is, he has a right to be treated on some kind of equal footing with other shareholders–he has no absolute right to get a dividend (even if the company has profits), but only a conditional, relative one. He has (usually) the right to sell his shares to someone else. Why assume this bundle of rights is tantamount to “natural ownership”–of what? Of the company’s assets? But he has no right to (directly) control the assets. He has no right to use the corporate jet or even enter the company’s facilities, without permission of the management. Surely the right to attend meetings is not all that relevant. Nor the right to receive part of the company’s assets upon winding up or upon payment of dividends–this could be characterized as the right a type of lender or creditor has.

The main shareholder right that could be latched on is the right to elect directors. This the only “real” factor I see of genuine relevance. That is why I say that the alleged causal connection between the shareholder and the employee has to rest on the shareholder’s control. Which really rests on his right to vote for and elect directors. That is all. So the question is: is this degree of or level of control (due to the right to vote for directors) sufficient to make the shareholder causally responsible for the actions of agents of the enterprise? Again, I do not see how one can maintain there is automatically or necessarily liability here, without opening up a huge can of worms: because, as I noted, it is not only shareholders who exert “control” over which directors are elected, or which managers are appointed, or which employees hired, or which policies or directives are issued by the managers. There are many others–employees, unions/coops, customers, vendors, creditors, landlords…. I am not in principle against holding any of these types of actors responsible for torts of the corporation–if the causal connection can be shown. It has to be demonstrated, in each case, based on the facts and context. I just see no reason why this is not also true of the case of shareholders.

[Incidentally: I am actually not sure whether modern corporate limited liabilty does prohibit a victim of a tort done by personnel of a company from suing shareholders–if he could somehow establish the shareholder played a role. Maybe there is some kind of presumption against this since the state has not provided adequate standards for causation; if this is so (I am not sure) then maybe your argument is really against the inadequate provision of causal responsibility in state legal systems–not the limited liability of corporations, which I believe has more to do with voluntarily acquired “debts” of the company than with tort liability anyway.]

Finally, it seems to me the chief aspect of limited liability that is objected to by the detractors of modern corporations is not the immunity from tort liability, but rather the contractual limited liability aspect (which you accept). It seems to me that a company that is sufficiently capitalized can simply purchase insurance that would effectively immunize shareholders for tort liability–then we’d be back to where we are now (except maybe there would be a greater incentive to have such “shareholder insurance”).

***

Incidentally, for a real-world example of a limited liability provision, see the recently enacted Texas Business Organizations Code, in particular § 21.223, as well as other provisions such as §§ 21.106, 21.107, 21.224, 21.225.

***

Corporations and Limited Liability for Torts

December 10, 2008 11:13 PM by Stephan Kinsella | Other posts by Stephan Kinsella | Comments (72)

There’s been a good deal of discussion lately of the legitimacy of corporations: see my posts Left-Libertarians on Corporations “Expropriating the Efforts of Stakeholders” and In Defense of the Corporation. Various types–anti-industrialists, socialists, left-libertarians–make a variety of criticisms of the corporation. Some oppose it because they oppose “capitalism”; or because it is invariably in bed with the state; or because it exploits workers; or because they dislike “bigness”. Most of these are wrongheaded or off point.

Another very common criticism is that corporations receive special privileges from the state–“limited liability”. This concerns two basic issues: the limited liability of shareholders for contractual liability of the corporation; and for torts committed by employees of the corporation. The former is easily dealt with–see Hessen (more on this below).

The most controversial issue is the tort issue. This is bizarre for a number of reasons. In the typical case, the victim injured by the tort of an employee of the corporation can of course sue the employee who committed the tort; but he usually just sues the company because it has deep pockets. He is not usually affected by the inability to sue the shareholders, since he would not anyway. The corporate assets, or its insurance, would cover it. But it bugs anti-corporate types that shareholders can’t be sued for torts of employees of a company they own shares in.

Lately I’ve begun to emphasize that the anti-corporatists, in characterizing limited liability as a privilege, have to assume that on the free market shareholders should have liability. But this is a dubious assumption. First, it rests on the idea of respondeat superior (master is liable for torts of his servant), which itself dubious. Second, it rests on an undeveloped notion of strict liability which assumes that you are liable for torts committed “with [or by?] your property.” But property does not commit crimes or torts–people do. Property serves as means. If you borrow my car and run over someone, it is not obvious to me that I am responsible for your negligent action–just because I owned the car. Second, as I discussed in The Over-reliance on State Classifications: “Employee” and “Shareholder”, this rests too much on state definitions of ownership. Marriage, shareholder, owner, adult, citizen, money, bank, employer, employee, hobby, …. — so many things are keyed off their classifications. It irks me when libertarians build up their arguments and concepts based on these, as if they are objective and valid distinctions.

Looking at reality: ownership is the right to control a resource–in a company it’s distributed, since shareholders can’t just walk in and use the assets of the company (drives its cars; use its HQ to throw a party). As a practical matter, people with control over property are distributed in complex ways.

Second, it’s often assumed that shareholders are “investors”–people who gave money to the company. This seems to implicitly assume that you are responsible for aiding and abetting the company. Several problems here. (a) shareholders are not necessarily investors (if you buy Exxon stock from another shareholder, you give him money, but not Exxon); (b) other people give Exxon much more money, like customers; (c) the control exerted by shareholders is minimal–they can vote for board members, who in turn appoint officers, who hire managers and employees. Others–creditors, vendors, contractors, employees, unions, “stakeholders”–often exert more influence over what the company does than any given shareholder or even the whole class of shareholders.

I believe the only way to sort this out is to apply a carefully developed and libertarian-compatible theory of causation. Whenever you want to attribute responsibility to A for actions of B, you have to have a good reason. This area is underdeveloped but my approach is laid out in Causation and Aggression. I am not even sure if respondeat superior is justified; much less stretching it to cover shareholders–stretching it so far would make so many other parties potentially responsible for the actions of one tortfeasor. Libertarians want to just point to the rules developed in the common law and take this for granted, as if it’s unquestionably legitimate. It’s not. We are libertarians, not positivists.

I just recalled, in correspondence with Brad Spangler, that there is a great pity excerpt from Hessen, pp. 18-21 of his classic book In Defense of the Corporation. He grants (a bit too generously, perhaps) the application of respondeat superior to the company itself, but argues very concisely–and without a carefully developed theory of causation but with sound insight and good intuition–why shareholders should not be liable for torts of employees. I highly recommend you read pp. 18-21. (N.b. left-libertarians: at pp. 20-21, Hessen explains that if anything, the state takeover of corporate law benefits not large companies, but small, one-man and “close” corporations since they would normally be liable for their actions, unlike shareholders of a large company.)

Bottom line: libertarians who claim that limited liability for torts is a state privilege have the burden of proving that shareholders should be liable for torts committed by employees of a company the shareholder owns a share in–and to show why creditors, suppliers, employees, and other “aiders and abetters” are not liable. And don’t just point to the common law rules and respondeat superior–we are libertarians. Show why this rule is libertarian.

I went over this in a 2004 LRC post, Legitimizing the Corporation, which I excerpt below:

***

… most people don’t even realize that if a FedEx truck runs you over negligently you can sue the driver. They think he is immune from suit or something. But it is the other way around; if a FedEx truck negligently hits you, it is of course the driver that is responsible. His employer is responsible for its employee’s own negligence and liability only because of the doctrine of respondeat superior; but if the employee is found to be non-negligent, the employer-corporation is off the hook too. This is in fact why corporations usually defend their employee and themselves when sued for the employee’s actions.

But opposition does not always stem from ignorance of the law or leftism: for example, one critique comes from two libertarian-Austrian attorneys: “De-legitimizing the Corporation: An Austrian analysis of the firm”, Jeffrey F. Barr & Lee Iglody, Austrian Scholars Conference 7, March 30-31, 2001, Auburn, Alabama.

Robert Hessen’s (a Randian) In Defense of the Corporation is a good defense of corporations. He shows that they don’t require privilege from the state to exist; they can be constructed from private contracts. One of Hessen’s articles nicely summarizes some of his views. Some excerpts are pasted below. My view is that corporations are essentially compatible with libertarianism. As for voluntary debts being limited to the corporation’s assets; this is no problem since the creditor knows these limitations when he loans money. What about limited liability for torts or crimes? As mentioned, the person direclty responsible for a tort or crime is always liable; sometimes the employer (which is often a corporation) is also liable for the employee’s actions, via respondeat superior. Who else should be responsible? In my view, those who cause the damage are responsible. Shareholders don’t cause it any more than a bank who loans money to a company causes its employees to commit torts. The shareholders give money; and elect directors. The directors appoint officers/executives. The officers hire employees and direct what goes on. Now to the extent a given manager orders or otherwise causes a given action that damages someone, a case can be made that the manager is causally responsible, jointly liable with the employee who directly caused the damage. It’s harder to argue the directors are so directly responsible, but depending on the facts, it could be argued in some cases. But it’s very fact specific. Perhaps the rules on causation should be relaxed or modified, but this has nothing to do with there being a corporation or not–for the laws of causation should apply to any manager or person of sufficient influence in the organization hierarchy, regardless of legal form of the organization (that is, whether it’s a corporation, partnership, sole proprietorship, or what have you).

Excerpts from the Hessen article—

The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state’s role is purely formal and automatic. Moreover, to call incorporation a “privilege” implies that individuals have no right to create a corporation. But why is governmental permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued, holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, that its shares are freely transferable, or if it asserted limited liability for its debt obligations? (Liability for torts is a separate issue; see Hessen, pp. 18-21.) If potential creditors find any of these features objectionable, they can negotiate to exclude or modify them.

Economists invariably declare limited liability to be the crucial corporate feature. According to this view the corporation, as an entity, contracts debts in “its” own name, not “theirs” (the shareholders), so they are not responsible for its debts. But there is no need for such mental gymnastics because limited liability actually involves an implied contract between shareholders and outside creditors. By incorporating (that is, complying with the registration procedure prescribed by state law) and then by using the symbols “Inc.” or “Corp.,” shareholders are warning potential creditors that they do not accept unlimited personal liability, that creditors must look only to the corporation’s assets (if any) for satisfaction of their claims. This process, known as “constructive notice,” offers an easy means of economizing on transactions costs. It is an alternative to negotiating explicit limited-liability contracts with each creditor.

Creditors, however, are not obligated to accept limited liability. As Professor Bayless Manning observes; “As a part of the bargain negotiated when the corporation incurs the indebtedness, the creditor may, of course, succeed in extracting from a shareholder (or someone else who wants to see the loan go through) an outside pledge agreement, guaranty, endorsement, or the like that will have the effect of subjecting non-corporate assets to the creditor’s claim against the corporation.” This familiar pattern explains why limited liability is likely to be a mirage or delusion for a new, untested business, and thus also explains why some enterprises are not incorporated despite the ease of creating a corporation.

Another textbook myth is that limited liability explains why corporations were able to attract vast amounts of capital from nineteenth-century investors to carry out America’s industrialization. In fact, the industrial revolution was carried out chiefly by partnerships and unincorporated joint stock companies, rarely by corporations. The chief sources of capital for the early New England textile corporations were the founders’ personal savings, money borrowed from banks, the proceeds from state-approved lotteries, and the sale of bonds and debentures.

Even in the late nineteenth century, none of the giant industrial corporations drew equity capital from the general investment public. They were privately held and drew primarily on retained earnings for expansion. (The largest enterprise, Carnegie Brothers, was organized as a Limited Partnership Association in the Commonwealth of Pennsylvania, a status that did not inhibit its ability to own properties and sell steel in other states.)

External financing, through the sale of common stock, was nearly impossible in the nineteenth century because of asymmetrical information–that is, the inability of outside investors to gauge which firms were likely to earn a profit, and thus to calculate what would be a reasonable price to pay for shares. Instead, founders of corporations often gave away shares as a bonus to those who bought bonds, which were less risky because they carried underlying collateral, a fixed date of redemption, and a fixed rate of return. Occasionally, wealthy local residents bought shares, not primarily as investments for profit, but rather as a public-spirited gesture to foster economic growth in a town or region. The idea that limited liability would have been sufficient to entice outside investors to buy common stock is counterintuitive. The assurance that you could lose only your total investment is hardly a persuasive sales pitch.

No logical or moral necessity links partnerships with unlimited liability or corporations with limited liability. Legal rules do not suddenly spring into existence full grown; instead, they arise in a particular historical context. Unlimited liability for partners dates back to medieval Italy, when partnerships were family based, when personal and business funds were intermingled, and when family honor required payment of debts owed to creditors, even if it meant that the whole debt would be paid by one or two partners instead of being shared proportionally among them all.

Well into the twentieth century, American judges ignored the historical circumstances in which unlimited liability became the custom and later the legal rule. Hence they repeatedly rejected contractual attempts by partners to limit their liability. Only near midcentury did state legislatures grudgingly begin enacting “close corporation” statutes for businesses that would be organized as partnerships if courts were willing to recognize the contractual nature of limited liability. These quasi-corporations have nearly nothing in common with corporations financed by outside investors and run by professional managers.

Any firm, regardless of size, can be structured as a corporation, a partnership, a limited partnership, or even one of the rarely used forms, a business trust or an unincorporated joint stock company. Despite textbook claims to the contrary, partnerships are not necessarily small scale or short-lived; they need not cease to exist when a general partner dies or withdraws. Features that are automatic or inherent in a corporation–continuity of existence, hierarchy of authority, freely transferable shares–are optional for a partnership or any other organizational form. The only exceptions arise if government restricts or forbids freedom of contract (such as the rule that forbids limited liability for general partners).

1. See Brian Doherty, It’s So Simple, It’s Ridiculous.[↩]