Wednesday, August 01, 2007

Limited Liability Does not Protect Incompetence or Criminality

Nick Smith writes a trenchant article in (1 Aug 07):

Fair Markets - Challenging a bedrock concept

Limited liability, argue academics and historians, entrenches wealth and power at the expense of a free society.

“The Business Round Table would be appalled. It, after all, published Te Oranga o te iwi Maori, a Maori language version of Adam Smith's seminal tome, The Wealth of Nations, to encourage free market principles among the tangata whenua.

Yet Smith, as British academics Dr Dan Plesh and Dr Stephanie Blankenburg point out, would have decried today's modern corporates.
This prophet of free trade was scathing in his denunciation of the 18th Century equivalent of limited liability entities, joint stock companies. He was, in the modern sense, an economic heretic.

"This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery," wrote Smith.

"The directors of such companies, however, being the managers rather of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own."
In other words, investors who stood to lose everything if things went pear-shaped tend to make better decisions than those who merely pocket their regular dividends and stand to lose only the amount they invested in their shares

There have been recently a number of articles raising the issue of limited liability of business entities, adding to a long history of criticism of the ‘legal person’ status of companies. Most, if not all of this, is hostile to these legal arrangements continuing. The anti-capitalist ‘left’ has added them to their critiques of capitalism, such as:

As the consequences of ruinous behaviour aren't borne by shareholders (beyond their financial stake), they contend, there's no incentive to improve corporate governance.”

Apparently, it is claimed, ‘limited liability’ and ‘legal person’ are corruptions of accountability and responsibility. The usual remedy, it is suggested, is make businesses, of all sizes, return to the principles of ‘co-partnery’, as described in the Wealth of Nations, usually along with misunderstood criticism of the 18th century joint stock trading corporations, made by Smith, as if he was talking about institutions remotely equivalent to joint-stock corporations of today.

I think it is more of a case of the critics amusing themselves by quoting the icon of modern neoclassical economists against the policies of those they influence, not that they know necessarily that much about Adam Smith.

Briefly, Adam Smith’s critique was against Chartered Joint Stock Trading Companies operating under Royal warrant issued by King George or by an Act of Parliament that granted them territorial monopolies, backed by laws that were enforced, sometimes brutally. They were ‘managed’ from London and operated thousands of miles away in India, Africa, northern Canada, Turkey, and the Baltic. They were monuments to corruption, poorly supervised and mendacious to the highest degree. It took over a year for messages to be exchanged between London and India, and at home, political influence was bought and used to protect them. They were major instruments of mercantile political economy, with which he was more than critical. There the similarities end.

Adam Smith did not oppose joint stock companies totally. He approved of them where the prudence of the proprietors was transparent, as in the cases he named of, for the Bank of Scotland, the Royal Bank of Scotland, and the Bank of England, and he recommended them for insurance, canals, and large capital projects, and businesses where routine not wild discretion predominates.

The problem of large capital requirements in Adam Smith’s day was that there was insufficient capital held in private hands making them suitable for co-partnery based businesses. That left the choice of the State funding such projects, and the state’s record in such projects was not good (corruption, theft, and maladministration). The British state needed vast sums to fund its wars and instituted joint-stock companies for banks and insurance. They worked well.

When capitalism appeared in the mid-19th century the need for capital was paramount. It remains the problem for developing economies today. Shareholder funding sources was an efficient way of raising the capital. Doing so on a strict co-partnery basis was slower (much of the capital flowing into the United States in the 19th and early 20th century came from Europe, as was the case for Australia and New Zealand). Co-prtnery was also riskier, if each shareholder was held to the full extent of the debts a firm occasions.

Given the vast sources of capital today that come from the savings of individuals through their pension funds, I often wonder if the ‘academics and historians’, and occasional politicians, realise the implications for themselves and for millions of pension savers if they were made responsible for the debts of the firms in which their pensions are invested! If all of the pension funds of a shareholder pension fund were vulnerable to be taken by a firm’s creditors in which these funds are invested, the disruption costs would be unimaginable. This acts as a severe constraint on reckless investments and requires the most cautious and constant vigilance in how these firms perform.

The only option for pension money in the absence of shareholder capitalism under the current arrangements would be to invest in government bonds, with all that implies, plus the government being flooded by extra billions of funds when things go well and and for billions of liabilities when things go wrong.

What on earth would they invest in? - silly question! No government will ever run out of things to spend taxpayers' money on; the problem being that most of it would unproductive, like Saddam Hussein's many palaces.

The notion that managers are irresponsible (some may be incompetent or criminal) and act recklessly with shareholders’ money is risible. The number of court cases and convictions of managers (Enron!) for criminality is a good sign and likely to be heeded by managers tempted to turn a blind eye to their responsibilities.

When a firm goes bust the shareholders lose their investments; if they have borrowed on the basis of their share values, they lose a lot more too, including their property assets. Other firms do not hire persons who bankrupted their previous business recklessly.


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