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Source link: http://archive.mises.org/4272/debt-and-the-trade-against-risk/

debt and the trade against risk

October 28, 2005 by

This post is in response to Stephan’s. My objection to limited liability is actually one that he passes over quickly, and is not quite the same as van Eeghen’s. He says, “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.”

This is a bit of legal positivism snuck in the back door. For instance, we might agree that the same sort of thing can be said for bankruptcy laws — a credit union knows that some percentage of debts will become bad, and adjusts its interest rates or origination fees accordingly. But bankruptcy laws still violate natural law.
Now, I am not particularly concerned about those who purchase the stocks of a corporation. Those are entrepreneurial investments, and rightly subject to risk. I am instead concerned about customers of and employees of corporations, who specifically trade their money for certainty, and then have their status as creditors eliminated by limited liability laws. On this trade of money against risk/certainty, see Pascal Salin’s The Firm in a Free Society: Following Bastiat’s Insights.

Just to be clear, while bankruptcy laws are usually used to nullify certain debts corporations owe to employees (such as this) or customers (such as this) or even plaintiffs (such as this), we must realize that in many cases, customers and employees prefer use of bankruptcy laws to reorganize the corporation and nullfiy some debt, since the alternative — liquidation of the corporation and limited liability of creditors to the corporation — always threatens worse outcomes. For some support to this, see here.

In many ways, the popular support for bankruptcy laws for corporations rests on the fact of limited liability laws.

So, to round out this point, let me answer Stephan’s specific challenge: how does limited liability law violate natural rights?

Imagine that customers purchase widgets with warranties from XYZ. XYZ becomes insolvent and unable to continue production of widgets, and cannot continue to honor the warranties (which may simply be cash payouts in case that the widgets cease to function within a decade of ownership). The rights of customers are violated when their warranties are not upheld.

If this firm were a sole proprietorship, then the man who invested his initial sum of money will have lost all of his investment, and under natural law, also owe an amount equal to the warranties promised.

The customer stands in the same relation to the firm regardless of the organization of the firm.

If this firm were a joint stock corporation, I suggest that each investor owes a pro-rata share. For those that specifically did not undertake this risk, I suggest that the corporation would not give full rights to its returns on investment. That is, I do not think the same applies to bondholders, or other creditors.

We might imagine a private property anarchy where people forming joint stock companies are not protected by limited liability laws. Then, there would be a clear distinction between those who invest at risk and those who do not, returns would be paid accordingly, and the risks of insolvency would not be forcibly imposed upon employees, customers, or other creditors.

{ 12 comments }

David J. Heinrich October 28, 2005 at 8:54 am

Gil,

It seems to me that all of this could be dealt with by simply notifying anyone with whom transactions are done that you are a limited liability corporation.

Gil Guillory October 28, 2005 at 9:11 am

It could be dealt with in that way. It could also be claimed that any contract made with a limited liability concern today has a legal background that is clear. But, this begs the question a bit.

In the absence of limited liability legislation, and in a contract that did not have this background, what would be the proper ruling in a case where a customer or other creditor wanted his contract fulfilled? If the contract was made with no stipulation of limited liability exception, then should the creditor’s claim be upheld? I say it should, Stephan (implicitly) says it shouldn’t.

billwald October 28, 2005 at 10:00 am

The problem is the legal standing of the corporation. It should not have equal standing with humans. What does “natural law” law say about corporations? I suppose next step is for someone to claim a computer is a person.

David White October 28, 2005 at 1:31 pm

Billwald,

It is indeed, as the present estimate is that with another 20 or so doublings of computing power (30 years or so), computers will have achieved superhuman intelligence, the runup to which will bring the question of their personhood to the forefront of human discourse.

Google the “technological Singularity” to find out more.

Phil October 28, 2005 at 11:17 pm

A couple of points:

“The rights of customers are violated when their warranties are not upheld.”

But the customers knew, when they bought the widgets, that limited liability laws were in effect. That is, their rights cannot be violated because they never assumed they had that right, and the price they paid for the widget was made with that assumption. What the limited liability law did is prevent a contract from being formed that both parties might have preferred — thus preventing the best market solution — but both parties made the contract, and negotiated a price, taking into account the law as it stands. Or am I missing something?

Secondly, is there anything preventing the owners of the company for personally guaranteeing the warranty? I am the sole owner of a corporation, and I have been asked to sign personally to guarantee the loans to my company. Is this not legal for the widget company? Can the largest stockholder not sign a personal guarantee? If this does not happen, couldn’t it be because the cost is too high and limited liability is the market solution?

tz October 31, 2005 at 12:38 pm

There are too many assumptions. Just because we have limited liability laws doesn’t mean that anyone considers their implications. If we tried we couldn’t complete any transaction with the combinatorial explosion of possible circumstances.

I could also say that if I cheat you, it is not really fraud because you know the population has a certain percentage of thieves, and that I might be one of them. That would be silly. It is no more silly to assume rights or liabilities, or that everyone understands every point of the Federal Register.

But here is the point. We often “forgive” misfortune, but not fraud. The collapse of a company might be due to an unforseen (and uninsured for) event which not even the most prudent and paranoid person would expect. Or it can be through risky behavior that burned the owners. Or it can be due to outright fraud. We treat such circumstances differently and ought to.

(A person has a will in addition to intelligence. Computers already are more “intelligent” in the sense of certain symbolic manipulations – they can calculate faster than any human. Even if they can “understand”, how can they desire one or another outcome. They might calculate them, but will one over the other?).

Stephan Kinsella November 2, 2005 at 10:58 am

Gil, I completely disagree.

A group of people have a right to pool assets and have a group-contract that specifies how these assets are to be used. They can also appoint certain agents to manage the assets, and to make contracts regarding them. There is nothing unlibertarian about such a firm selling a product to a customer with a warranty under the understanding that this warranty is backed up only by certain identifiable assets “of the firm”. CUstomers are free to buy or not to buy under this condition; their rights are not violated.

To the extent corporate law simply recognizes and effectuates this, it is not libertarian. Remember, the shareholders *do have a choice*: they can choose to implement or mimic the contractual regime they have a right to do, by using the convenient mechanism of “incorporation”–and other parties such as customers, vendors, etc, can choose to deal with them on this basis, or not; OR, the founders/investors of the business may choose to subject themselves to contractual liability for the liabilities of this “firm” or business enterprise–either by use of an entity form other than the corporation (such as partnership), or by personally guaranteeing some of the contracts or debts of the corporation.

There is nothing whatsoever unlibertarian about this, and your analogy to bankruptcy law is flawed. The problem with bankruptcy law is that a given individual *cannot opt out of it*. There would be nothing in principle wrong w/ an individual refusing to sign a contract unless the other party contractually gives him an out in case of insolvency. THis is not unlibertarian. WHat is unlibertarian is that the law restricts the individual’s right to waive his right to declare bankruptcy. If he were able to waive this right, he might be able to borrow more money, or have a better chance of borrowing money, for example. So bankruptcy laws are like the minimum wage: the primary victim of both laws are the parties whose choice they restrict.

So to take an example: the victim of a bankruptcy law is not employers, but employees: it is employees’ right that are restricted–they cannot agree to work for $1/hour. But the employer’s rights are not technically violated: they have no right to hire a worker for $1/hour–a prospective employee would have the right to refuse to work for $1/hour, just at the min wage law requires. It is when he chooses to waive this right, so to speak, and the law prevents him, that his rights are violated.

Likewise with bankruptcy. From the lender’s perspective (for example), a given debtor could insist on a bankruptcy clause, or not. The lender would normally probably not want such a clause–or would be willing to loan more money or at lower interest rates, if there were no bankruptcy possibility. It is the borrower who would prefer to have the right to waive the bankruptcy law protection, but he cannot. THis is why bankruptcy law is unlibertarian: It restricts the rights of borrowers. (this applies to corporations too, who can also file for bankruptcy)

Now notice that by the state recognizing incorporation no one’s rights are restricted in this manner. Shareholders are perfectly free to personally guarantee the corporation’s debt; or to invest or do business in a way that they are personally responsible. Corporation law and incorporation does not violate anyone’s rights in this respect; does not restrict anyone’s contratual freedom, as other federal regulations like bankruptcy, minimum wage, etc., do. The analogy to bankruptcy is therefore utterly inapt. I have no idea what you mean by bankruptcy laws resting on limited liability. Who cares? How does this vague observation demonstrate that incorporation itself violates any rihgts? It does not.

Imagine that customers purchase widgets with warranties from XYZ. XYZ becomes insolvent and unable to continue production of widgets, and cannot continue to honor the warranties (which may simply be cash payouts in case that the widgets cease to function within a decade of ownership). The rights of customers are violated when their warranties are not upheld.

This is socialist/maternalistic talk. Who cares about the crybaby customers here? Screw ‘em! They knew they were buying from a corporation and had no claim on the shareholders’ assets; if they didn’t know it’s because of pure ignorance of the *meaning* of dealing with someone who labels themselves “Inc.” and I say, caveat emptor. These whining crybaby customers are free to purchase products from a mom and pop sole proprietorship, or a non-limited-liability partnership, if they can find any.

If this firm were a sole proprietorship, then the man who invested his initial sum of money will have lost all of his investment, and under natural law, also owe an amount equal to the warranties promised.

Right. But the customer chose to deal w/ a corporate business form, with certain implied limits on the warranty.

The customer stands in the same relation to the firm regardless of the organization of the firm.

Bah. Ridiculous. The relation depends on the contract, the nature and terms of which differ.

If this firm were a joint stock corporation, I suggest that each investor owes a pro-rata share. For those that specifically did not undertake this risk,

Where is this new standard of having to “specifically undertake a risk” come from? Wouldn’t the *default* rule be caveat emptor? If so, the warranty promised is an extra provision–and there is no reason it has to be all or nothing, completely unlimited. It can of course be limited. And the words “Inc.” on the company name means “the warranty and any other contratual promises are backed up only by the assets held by “the company” and no by those of the investors of “the company”".

David J. Heinrich November 2, 2005 at 12:10 pm

Stephan,

quote:
——
“Inc.” on the company name means “the warranty and any other contratual promises are backed up only by the assets held by “the company” and no by those of the investors of ‘the company’.”
——

I agree with you on this; but I think one thing needs clarifying. If “the company” purposefully transfers its assets to (say) its major shareholder, or shareholders (e.g., dividends) with the purpose of defrauding those who buy from it, this is not legitimate.

E.g., an incorporated company sets out to sell defective products under warrantee, and then aftewards distributes all of the revenues as dividends. Later on, the customers complain, and demand adherence to the warrantee; the company then says, “well, the warrantee only gives you claim (collateral) on the company’s assets”, but we distributed our assets to our shareholders as dividends. I think the customers who brought the products under warrantee can claim to have been defrauded, as that dividend distribution was done with the purpose of avoiding paying one’s obligations. Hence, the transaction, as a fraudulent transaction, can be rolled back.

Any shareholder harmed by the rolling back of that transaction (because, say, he’d already spent the money) could sue the managers of the company too.

What do you think?

Stephan Kinsella November 2, 2005 at 1:48 pm

Heinrich:

If “the company” purposefully transfers its assets to (say) its major shareholder, or shareholders (e.g., dividends) with the purpose of defrauding those who buy from it, this is not legitimate.

I do not know what you mean by “legitimate”. But of course, limited liability should not be a shield against “fraud”–but a carefully worked out theory of *what fraud is* needs to be employed. As I have pointed out elsewhere (here, p. 61; and here, p. 34), fraud should be a crime only to the extent that it describes a type of theft or trespass: where the false or fraudulent desription of goods or services to be rendered makes nullifies the receipt of other goods in exchange, so that acceptance of and use of these goods by the defrauding party is nonconsensual. If I give you a rotten bucket of apples in exchange for your pig, what happens is that the transfer of title to the pig is conditioned on your not defrauding me as to the status of the apples; so if you take the pig you are in possession of property you do not own and have no right to dispose of. It is a species of theft in such cases. Laymen however are overly imprecice in their use of “fraud”, which they use to desribe basically any situation where you deceive or lie to someone. However, not every case where you deceive or lie to someone gives rise to a case of theft as specified in a fraudulent exchange.

E.g., an incorporated company sets out to sell defective products under warrantee, and then aftewards distributes all of the revenues as dividends. Later on, the customers complain, and demand adherence to the warrantee; the company then says, “well, the warrantee only gives you claim (collateral) on the company’s assets”, but we distributed our assets to our shareholders as dividends. I think the customers who brought the products under warrantee can claim to have been defrauded, as that dividend distribution was done with the purpose of avoiding paying one’s obligations.

This is not clear at all. I do not think there is an apriori answer to who owns an asset of a malfeasor when it’s not enough to satisfy all their claims. And why single out the shareholders? After all, in the meantime, the corporation paid not only dividends to shareholders, but it paid vendors for their invoices, it might have donated money to charity, etc. It is not automatically obvious that the money can be retrieved from the hands of those people. You would have to argue that the money was owned by the customers at the time the company transferred it to shareholders.

Any shareholder harmed by the rolling back of that transaction (because, say, he’d already spent the money) could sue the managers of the company too.

Sure, IF he has to give it back. But that begs the question: does he have to?

Adem Kupi November 7, 2005 at 5:23 pm

Stephan:
1. If I write a contract that says that I am not liable in event of fraud, and get my customer to sign it, am I liable if I then defraud him?
2. I think that in the same way that in a free banking situation, most people would refrain from using fractional-reserve banks after a while, people would probably prefer not to buy from or work for LL companies in a free market economy, once enough tort situations developed for people to see the danger. Or at the very least, their insurance premiums would be quite high, relative to a full-liabiity company.

Wolf DeVoon November 8, 2005 at 4:13 am

most people would refrain from using fractional-reserve banks after a while

Then there would be no banks.

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