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Hummel on Moss on Limited Liability

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San Jose State University economist Jeffrey Rogers Hummel sent the following capsule review of David A. Moss, When All Else Fails: Government as the Ultimate Risk Manager (Cambridge: Harvard University Press, 2000). Jeff writes:

Limited liability remains a subject of slight controversy among libertarians. Some free-market advocates believe that it played a role in the excessive risk undertaken by investment banks prior to the financial crisis. So I want to recommend a book that contains a fascinating, informative chapter on the origins of limited liability within the U.S.

By David A. Moss of the Harvard Business School, it is an economic history entitled WHEN ALL ELSE FAILS: GOVERNMENT AS THE ULTIMATE RISK MANAGER (Cambridge: Harvard University Press, 2000). Moss is definitely not a libertarian and applauds government intervention, but he provides a historically informed discussion of the development of limited liability, bankruptcy, deposit insurance, workers' compensation, and the myriad other ways that national and state governments attempt to mitigate risk.

Some highlights from Chapter 3 on limited liability: Early state chartered corporations did not usually enjoy limited liability: joint and several liability (where each shareholder was individually liable for the corporation's entire debt), proportional unlimited liability, and double liability were all instituted at one time or another. New York was the first state to institute limited liability for manufacturing firms only in its general incorporation law of 1811, the first in the country, but the state courts fifteen years later reinterpreted the act as requiring double liability. Meanwhile other northeastern states embraced limited liability, with Massachusetts finally falling into line in 1830 over concerns about capital flight to other states, but again with limited liability for manufacturing corporations exclusively. In subsequent years, a large number of states instituted general incorporation with limited liability and extended the coverage to a widening circle of economic enterprises. California in 1931 (yes, 1931) became the last state to adopt limited liability.

Britain itself did not copy limited liability from the U.S. until 1855. The editors of The Economist opposed its adoption as "of little practical importance," because shareholders could achieve the same protection through contract. Moss provides an economically sophisticated discussion of this argument and of the current work of several legal scholars who oppose limited liability, along with accounts of the pro and con debates over the issue that occurred in various U.S. states. Some lawmakers were quite explicit about limited liability providing protection from involuntary (tort) creditors, although Moss finds this to have been a minor motivation. He concludes his theoretical analysis by stating that "there is no way to know for sure exactly why limited liability law was necessary. The existing historical record offers but scant clues about the failure of private solutions to emerge on their own. But the record is abundantly clear on one point: something was standing in the way." He seems to gravitate toward a Coasian-Posnerian (or possibly a behavioral Thaler-Sunstein) explanation where the legal default makes an enormous difference. Whatever your own views on limited liability, you will find his chapter enlightening.

For those interested in free banking, Moss's chapter on money includes a detailed discussion of pre-Civil War banking in New York. Although he accepts some of the standard myths about antebellum banking, his account is still valuable.

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COMMENTS (3 to date)
Ray Lopez writes:

Happy New Year. I've added this blog to my favorites. This passage from Simon Johnson's book "13 Bankers" is relevant to this post: "The average equity-asset ratio—the share of lending financed by owners’ or shareholders’ capital rather than borrowed money—had already fallen from 50 percent in the 1840s to around 20 percent early in the twentieth century as informal cooperation mechanisms developed among banks. But due to the double liability principle (which made bank shareholders potentially liable for up to twice the money they had invested), this meant that over 20 percent of bank assets were backed by shareholders’ capital—a stunningly high cushion against loss for creditors by modern standards. After the creation of the FDIC backstop in 1933, the equity-asset ratio fell below 10 percent for the first time in history.102 In other words, banks took on significantly more debt and, in the process, generated higher returns for their shareholders"

Floccina writes:

I often wonder why more corporations do not become partnerships to avoid the corporate tax.

Mark W writes:

"I often wonder why more corporations do not become partnerships to avoid the corporate tax."

It's a risk mitigation strategy. Generally speaking, partners are individually liable for the debts of the partnership, while corporate shareholders are only liable to the extent of their ownership interest (i.e., value of their shares). Many business owners don't want to be liable for the debts run up by a partner, and none want to be impoverished by an adverse tort judgment against the partnership. Paying a little more in corporate tax is a price a corporate shareholder pays for avoiding the liablity exposure of being a partner.

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