Bryan Mercadente

The Illiberal Nature of Limited Liability: A Libertarian Critique

The question I have been set is why, if it is as wonderful as I claim, capitalism produces immense inequalities and waste? Why is it so harmful to the environment? Since the purpose of the question appears to be a requirement for me to explain in more detail certain points I have argued in class, I hope I shall be forgiven for putting aside its exact wording in favour of what I think a more productive question. Before doing this, even so, I will make some effort to deal with question as set—even if my effort here will be brief.

The argument from inequality is easily answered. If one looks at the Lorenz curves for those countries that have economies based even slightly on free market principles, they show more equality than those countries that do not allow free markets. The correlation between economic freedom and prosperity is undeniable. Consider, for example, Switzerland and South Korea—two countries where markets are moderately free. Both have high GDP per capita and a large middle class. Compare them to command economies such as North Korea or Venezuela, where wealth is concentrated in the hands of the political elite, and the general population is impoverished. To be precise, capitalist countries, by any honest measurement, both richer and more equal than non-capitalist countries.

As for the environment, I will not answer the question in detail except to say that many of the claims made by environmentalists are based on junk science. Since at least 1990, there have been repeated predictions of imminent climate catastrophe. The Maldives, for example, were supposed to be underwater by 2018. They remain above sea level. The Arctic was supposed to be ice-free by 2013. It still has plenty of ice. The reality is that doomsday environmental predictions have consistently failed to materialise. I could say much more here. I could discuss why these false claims about the environment are made, and why the are accepted by the authorities, and preached in the schools and media, and who actually benefits from them. But the claims are so plainly false in themselves, that I see no present reason for discussing them other than to dismiss them with contempt.

This has been a brief discussion. But I do believe these formal parts of the question have now been discussed with all the attention they deserve. I will therefore pass to what I consider the more interesting generality of the question. Rather, I will write the answer that I would have written had I been free to set the question. This is to what extent actually existing capitalism—that is the legal and economic order of countries called capitalist—corresponds to what I mean when I talk about free markets. As said in class, I define myself as a free-market libertarian.

Now, libertarianism, as I understand it, is a political philosophy insisting that all actions between consenting adults should be legal, except those involving fraud or the initiation of force. It is a doctrine of individual sovereignty, of voluntary exchange, of personal responsibility. Since it is often misunderstood or conflated with other political ideologies, it is necessary to clarify the distinctiveness of libertarianism. Unlike statist conservatism, libertarianism does not seek to use the state to enforce social norms or moral codes beyond preventing force and fraud. Unlike state socialism, it does not believe that economic inequality is a problem to be solved through coercion. Instead, libertarianism holds that all peaceful interactions between consenting adults should be free from government intervention. In brief, conclude, libertarianism is not in its essentials an extrapolation from arguments about economic progress—though economic progress is one of its natural effects. It is an argument about the nature of man, and about what his rights are, or ought to be.

This having been said, I turn to the question as I have rewritten it. All those countries that are loosely called capitalist allow the existence of what used to be called joint stock limited liability corporations, otherwise called limited companies. These are organisations that have three main features. They are “artificial persons”—that is they are treated by the law as entities separate from those who own shares in them: they can own and use property in their own right; they can make contracts for the acquisition and use of property. They are, leaving aside accidents of insolvency or some external shock, immortal. Following from the first, their owners are liable for the debts of the organisation only up to the amount they have invested: beyond that, they are not jointly and severally liable for the debts of the organisation. These organisations were first routinely enabled in England by the Limited Liability Act 1855 in England, which allowed companies to incorporate with limited liability provided they met specific capital requirements. This was followed by the Joint Stock Companies Act 1856, which simplified and extended incorporation rights, making limited liability more widely accessible. The principle was further entrenched by the Companies Act 1862, which allowed limited liability to apply to all companies by registration, leading to the modern corporate structure.

Before these acts, business partnerships and sole proprietors were fully liable for all debts and obligations incurred by their enterprises, meaning creditors could claim against their personal assets, including homes and savings, to settle unpaid debts. Limited liability altered this dynamic by ensuring that a limited company’s own assets alone were at risk in the event of insolvency. The utilitarian argument for this change was that it reduced personal financial risk for investors. This made investment more attractive and enabled the growth of large enterprises, better able than small enterprises to develop new products and take advantage of economies of scale.

Though I doubt if these advantages are as great as claimed, I am not presently interested in the utilitarian argument. What does interest me is whether the general status from which limited liability follows could exist in a libertarian free market. Would a libertarian free market be “Tesco minus the State”? Or would it be a society of small and often informal economic interactions between consenting individuals?

Some libertarians, such as Stephan Kinsella, claim that limited liability would emerge in a libertarian free market. For Kinsella, it is a matter of contract:

[S]omeone loaning money to, extending credit to, or engaging in a contract with a corporation is implicitly agreeing to pursue only the assets of the corporation itself in case of a claim, not the personal assets of shareholders (unless it insists on some shareholders personally guaranteeing a loan or contract, as if often the case for smaller companies). (Kinsella, 2011)

This is true. If creditors voluntarily choose to lend money to limited liability companies, they must be assumed to know the risks involved; and they should have no right to complain if they are unable to collect. But this defence covers only contractual matters. It does not cover torts—that is, harms done to third parties who never agreed to any limitation of liability. Unlike contractual creditors, who knowingly engage in transactions with a limited company, victims of corporate negligence or misconduct are not given a choice in the matter. If a limited company injures an individual—whether through defective products, workplace accidents, or corporate malfeasance—the shielding of shareholders from complete liability means that the costs of the injury are often externalised. They are shifted to the victim himself, or to the state, rather than carried those who ultimately benefit from the company’s profits.

Let us take this case as an example of how limited liability works. Let us imagine that I and a friend set up a limited company and offer our services as builders to the public. Let us imagine that we negligently harm a customer’s property. The customer sues for compensation. Because we acted as the servants of a limited company, the customer must sue the company, not us. The company may have no assets. My friend and I walk away from the case with no costs but those of setting up another company to replace the one that has been made insolvent.

And this is what happens on a larger scale with limited liability. In a system without limited liability, shareholders would have to ensure that officers and employees of a limited company acted prudently, as their entire assets would be at risk. I repeat that limited liability allows those having it to externalise costs onto those who have no say in the risk-taking. This creates moral hazard, encouraging greater risk-taking without accountability, which ultimately harms market efficiency. Above all, it contradicts the basic libertarian principle that individuals and organisations should bear full responsibility for their actions.

Kinsella’s answer is to divert the argument into two channels that I do not think involve a proper answer. The first is to take issue with the legal doctrine of vicarious liability, which holds employers liable for the torts of their employees. He argues:

The problem with this theory is the assumption that in a private law society, “shareholders” should be vicariously liable for the negligence of others…. In this situation, some employee of a firm has committed some tort—a negligent act (such as a FedEx truck driver negligently crashing into some victim). Here the victim has a right to sue the negligent employee-tortfeasor…. But holding employers—or shareholders—vicariously liable for actions of their employees relies on the offensive, paternalistic, feudalistic  concept of respondeat superior—a master is responsible for his slaves’ or servants’ transgressions (Kinsella, 2011)

It may be that the doctrine of vicarious liability has been taken too far. But I do not see how it is in itself an illegitimate doctrine. An employer takes on workers only because he hopes to benefit from their labour. An employer has control over the actions of employees and the way work is performed. This being so, he should be reasonably responsible for any harm done by employees in the course of their employment. As said, the doctrine may have been taken too far in some judgments of the courts. But, according to the Roman lawyers, qui facit per alium facit per se—“he who acts through another, acts himself”—and I do not see this as an unreasonable claim in principle.

Moreover, in the course of a debate with Sean Gabb in 2013, Kinsella appears himself to have accepted some principle of vicarious liability:

In some cases, the directors and even the shareholders should be vicariously liable for the torts of their servants. (Gabb, 2013)

These are not his exact words, but a report of them. However, Gabb is usually considered an accurate reporter of what others say in debates with him, and I am not aware that Kinsella, though aware of this report, has disclaimed what he is reported to have said. So much, then, for his first argument.

Kinsella’s second approach is to claim that shareholders do not in fact have control over the acts of the companies in which they own shares:

[T]he shareholder may have a vote in electing directors. But then again, he may not; not all shares are voting shares. Further, the shareholder might not exercise his right to vote; and if he does, he might vote against the directors who win; and even if his choice wins, his vote is almost never decisive; and, in any case, rarely is it the case that the director campaigns on a platform of directing managers to permit employees to engage in torts and negligence…. [P]ossessing a right to vote for directors does not obviously imply vicarious liability for torts committed by employees hired by officers appointed by those directors. (Kinsella, 2011)

Sean Gabb took issue with the main part of this during the debate with Kinsella:

Stephan, I deny your claim, that shareholders cannot be regarded as the owners of a corporation, because their ownership consists solely in the right to elect directors and share in the profits. You are confusing rights possessed with rights exercised. The shareholders of a corporation have the undeniable legal power to change the articles and memorandum of association, so that they must be consulted on all management decisions. They could also allow shareholders to take and use the property of the corporation—perhaps to the value of the shares they own—for their personal use.

It might not be consistent with good management for a company to be directed by something like the Assembly of democratic Athens. It would certainly be inadvisable for the shareholders to remove assets for their own use. But practicality is beside the point. They have the power to do this, and much else besides. If they do not choose to make use of the power, that is their choice, and possibly their negligence. As such, they are as much the owners of a corporation as the proprietor in a sole tradership is the owner of his business. (Gabb, 2013)

In short, shareholders have the legal right to run the business like a Greek democracy, voting on every matter. If they decline to do so, this is negligence, not a lack of ownership. I will do short work with Kinsella’s further claim that a shareholder may not be aware of the character of the managers he elects, or he may be aware, but be outvoted. This is a poor defence. He has a natural responsibility to make reasonable enquiries and inferences. If he does not, he should bear the same consequences as if he were to buy a house without a survey, and then find that the roof was collapsing. Or, if he is outvoted in the election of officers he considers unsuitable, he should sell his shares if he wants to avoid responsibility for what he fears likely to happen.

This is, on the face of it, an argument between believers in an ideology that is not accepted by most people, and so may seem irrelevant to most people. But the effects of limited liability are profound, and they affect everyone. Because investors do not need to fear unlimited personal liability, limited companies grow larger than they otherwise would. Some of these corporations operate on a global scale, spanning multiple jurisdictions and influencing economic policy across nations. Many have existed for centuries, surviving changes in ownership and management. They can do this because of limited liability allows for a shifting cast across generations of shareholders and managers, ensuring continuity when individuals come and go. This insulation from personal risk fosters the growth of oligopolies that would not exist in a truly free market. They create vast bureaucracies of employees who think like state functionaries rather than entrepreneurs. According to Gabb:

Anyone who works for any length of time in one of these big corporations tends to become just another “human resource”—all his important life decisions made for him by others, encouraged into political and cultural passivity. He is essentially a bureaucrat. He knows nothing of how real business is transacted. He cares nothing about laws and taxes that stop others from transacting real business, and so consents to the further expansion of an already bad system. (Gabb, 2006)

Moreover, the owners of limited liability companies are often drawn from the same class as the political elite. This leads to an incestuous relationship between big business and the state. The wealthiest businessmen do not operate in a free market; they operate as the economic wing of a single ruling class. Or, as Gabb says, “[limited liability] allow[s] the emergence of a ruling class in which political and economic power is as impersonal and as interlocked as in the despotisms of the ancient world.” (Gabb, 2006) This is not a feature of free market libertarianism. It is corporate socialism.

All this having been said, I turn briefly to the utilitarian arguments for limited liability. Could railways and motorways be built without a limited company to raise the necessary capital and wait long enough for its investment to bring a return? Possibly not. Could these companies raise capital without selling shares to the public? Again, possibly not. Would anyone buy shares in these companies if they had no immediate control over their investment but could still be held personally liable for its use? Probably not. Do you know enough about the transportation market or the competence of the Directors to risk all your possessions on shares in Eurotunnel? I do not. If, then, we want large infrastructure projects and large-scale manufacturing, it may be convenient to limit the liability of shareholders to the value of their shares.

But convenience is not the same as necessity. It is possible that large ventures could instead be financed through bonds, in which case investors would be lenders with liability naturally limited to the value of their holdings. Or it may be that industries like telecommunications could be sustained through subcontracting, franchising, and other voluntary arrangements between sole traders and partnerships. Or it may be that the economies of scale said to justify limited liability are often exaggerated—that the example given by Adam Smith of the pin factory is misleading; that, rather than employ many workers to do parts of a job, the job can be done just as well by one worker who breaks the job into parts and does these himself in sequence.

But these are matters not central to my argument. I will conclude by saying that, while actually existing capitalism is superior to all other economic systems that have so far existed, and is therefore to be preferred to these systems, limited liability is not a natural feature of a free market. It is a state-created privilege that fosters economic centralisation and promotes corporate socialism. A truly free market would not allow businesses to externalise their risks onto the rest of society. The solution is to abolish limited liability and restore full responsibility to business owners, as would be the case in a truly libertarian order.

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