CORPORATE LIMITED LIABILITY AND THE FINANCIAL LIABILITIES OF FIRMS. Jan Toporowski

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1 PLEASE DO NOT CITE OR QUOTE WITHOUT PERMISSION OF AUTHOR(S). CORPORATE LIMITED LIABILITY AND THE FINANCIAL LIABILITIES OF FIRMS Jan Toporowski School of Oriental and African Studies, University of London, and the Research Centre for the History and Methodology of Economics, University of Amsterdam Abstract This paper examines the recent proposal to eliminate the limited liability of company owners, in the context of the overall composition of the financial liabilities of firms. The traditional neo-classical view of the firm holds that the relative price of different financing only affects the way in which firms finance their activities. However, the paper argues that the behaviour of different firms is affected by the composition of their financial liabilities. The elimination of limited liability for equity will tend to shift the structure of corporate liabilities towards debt instruments, which do have limited liability, or towards regular insurance premiums that would reallocate that liability among firms or shareholders. The paper concludes that this shift in liabilities may stabilise financial markets, and this may eliminate some of the increasing concentration on speculation that is a feature of financial market capitalism. Introduction: Definitions and Approaches By corporate limited liability, I mean in this paper the legal principle and practice that limits the liability of shareholders for the debts of their companies to the amount of capital that thy have paid into the company. It should be pointed out that even before shareholders were given limited liability, first by legislation, and then by the Companies Acts of the 1860s (and similar legislation in other countries at around the same time), other providers of finance enjoyed the benefits of limited liability, and continue to do so. These are banks and bond-holders, who are deemed to hold debts of a company, and on the basis of traditional law have never been liable for the residual debts of a company. If I lend my neighbour a pound to buy a newspaper, I cannot thereby make myself liable for my neighbours payment of her mortgage, nor even for her theft, should she decide to steal the newspaper and spend the pound I lent her on drink. In section 3 of this paper, I therefore contrast the effect of eliminating the limited liability of shareholders, against the continuing limited liability of debtholders. I shall not discuss at all the important and related issue of the limited liability of bank shareholders. This is a complex matter whose discussion would not illuminate the general principle to which this conference is devoted. 1

2 The elimination of corporate limited liability, giving shareholders unlimited liability for the debts of their companies, is a radical departure for corporate finance and for modern capitalism in general. In this paper I am not concerned with any social or legal benefits that may accrue to society as a result of such a reform. These are matters on which I am not really qualified to comment. My remarks are focussed on the effects of such a change for the financing structures that underpin business activity in modern capitalism and that, in my view, determine the nature and the dynamics of that capitalism. In this respect, I follow the radical critical finance analysis of capitalism, from Veblen, through Keynes, Kalecki, Niebyl and Minsky, that regards capitalism as changing as the financing of business has become more sophisticated and as financing activity has effectively come to dominate normal productive activity, and the exchange of goods and services. Such domination is what is meant when people business and financial circles talk about capital market disciplining business (although I do not necessarily accept the distributional agenda of such shareholder activism, namely that the key distributional issue is that of whether the surplus that a business generates is allocated to its managers or to its shareholders). This critical finance analysis is put forward in my books The End of Finance and Theories of Financial Disturbance (Toporowski 2000 and Toporowski 2005). I would contrast this view with two alternative approaches to understanding the economic significance of financing structures. The first of these approaches would include the view held by most Marxists, namely that the essential characteristics of capitalist business are determined inside the production process. Money and finance merely express or reflect fundamental features of production, namely the functional distribution of income between wages and profits, the rate of profit and so on. In the mainstream neo-classical view (see section 1 below), the value of companies like any other undertaking is determined by the return on capital, and is independent of their financing. The monetary policy of a government may influence the conditions of that financing, but financial markets merely serve as transmission channels for this policy rather than playing an autonomous role in company financing. The second approach focuses on market imperfections, rather than the whole financial infrastructure of an economy. Those market imperfections are deemed to be deviations from the assumptions of perfect competition that underlie the current mainstream approach to corporate finance. Such a view would regard the question of unlimited corporate liability as an irrelevancy. Under perfect competition perfect foresight ensures that all losses are anticipated and therefore avoided. Even with less than perfect foresight, if losses occur with some predictable probability, then they may be hedged or insured against. True, Keynesian or Knightian uncertainty (where the probabilities of future events are not predictable) then appears as a market imperfection. Unlimited corporate liability would then make shareholders responsible for losses that a company incurs in excess of the capital, including accrued reserves, of the company. This second approach is deeply ingrained in today s corporate finance literature, and therefore warrants some further discussion of it in section 1 of this paper. My own view on this is that the notion of market imperfections reflects somewhat utopian yearnings for a mythical state of perfect competition. A more positive approach is provided in sections 2 and 3 of the paper, where the effects of unlimited corporate liability on financing structures, and hence on business activity are discussed. 2

3 1. Financing structures and business activity In the more mainstream industrial economics derived from the writings of Alfred Marshall, a similar subordination of finance to production and exchange predominated. Firms were supposed to obtain finance in accordance with the financing requirements of productive business, with additional finance going where higher rates of profit were available so that, as in Marx, the directing role of finance is limited to equalising profits rates across firms and industries. Distortions in the system were then supposed to be introduced by distributional factors such as monopoly, externalities, and taxes, or technological factors such as decreasing returns to scale. But finance retained its fundamentally ancillary role in all this. The basis of today s mainstream discussion on corporate finance was laid by the famous Miller-Modigliani theorem, according to which the value of a company is not affected by the composition of its financial liabilities, or its financing in general (if equity or common stock is not considered as a financial liability). This is frequently, and incorrectly, interpreted as suggesting that the financing of a business, specifically, the gearing of a company, that is the ratio of its debts to its equity, is irrelevant to the way in which that business is conducted. The business of a firm is, therefore, held to be determined by supply and demand in the markets in which it operates, and the degree of monopoly in those markets, with the conditions of finance being effectively proxied by the rate of interest set by monetary policy. In this situation of perfect financial intermediation, whether the owners of a firm have limited or unlimited liability should only matter as a risk premium on equity. With unlimited liability, this risk premium would, if markets work perfectly, be equivalent to an insurance premium to obtain cover claims on shareholders in excess of their capital. With limited liability, those claims would be losses incurred which would be actuarially equivalent to premiums which those affected by the activities of firms might pay for insurance against those losses. In other words, in overall social welfare terms, corporate limited liability has no effect on the overall value of production and income in an economy. It can only affect the distribution of losses arising out of that production. This interpretation of the Miller-Modigliani theorem is in fact incorrect. The theorem does not state that in practice the financing of a company does not affect its value. The conclusion of the theorem is that the financing of a company affects its value only in the presence of market distortions. These market distortions include monopolies in the supply of particular types of finance, uncertainty, and differential tax treatment of payments on particular kinds of financing. For example, interest on debt is a business cost and therefore tax-deductable, whereas tax is payable on dividends to shareholders. A company that is debt-financed will therefore have a higher value (because it will pay less tax) than a company that is equity financed. If shareholders have unlimited liability, then this will reduce the value of the company further, by comparison with company conducting exactly the same business, but financed by debt. In fact even debt-financed companies have to be owned by 3

4 someone. It does not take much imagination to see that this residual shareholder will end up having to be compensated for their additional exposure to financial claims, or their expense in periodically bankrupting themselves to get rid of those claims. The Miller-Modigliani reasoning then became the foundation of later developments in finance and economic analysis. New Classical analysis took forward the system of formally deriving theoretical conclusions based on assumptions of perfect competition, foresight etc. in an economy populated solely by individual agents optimising with perfect financial intermediation. As firms and financing structures disappeared out of these models, so too did money and finance. By contrast, New Keynesian theorists emphasised the importance of limited information, market distortions and rigidities. Behavioural finance emerged, emphasising the limited information, and sub-optimal decision-making by agents. The leading behavioural finance theorist, Robert Shiller, has campaigned for the extension of insurance to cover economic losses (Shiller 1993). These might eventually include the losses incurred by shareholders with unlimited liability. Victims of company negligence could also obtain insurance. Such insurance would therefore provide insurance companies (and their shareholders) with a stable premium income against which they would have to pay out insurance to compensate victims of company negligence. The introduction of unlimited shareholder liability would therefore transfer the costs (premium and compensation) of such negligence to shareholders. An important proviso in an economically-differentiated society is that many poorer victims will lack the resources to sue companies and their shareholders, or their rights in this regard may depend upon pro bono commitments by lawyers. Following Miller-Modigliani, mainstream economic analysis has focussed narrowly on optimising outcomes for individual agents, and then attempted to construct a more realistic analysis based on distortions of those outcomes that are created by actual markets. In this kind of analysis, corporate limited liability affects the relative cost of a particular class of financing, equity finance. If, as the crude interpretation of the Miller-Modigliani holds, the financing of a company is irrelevant to its value, and hence the conduct of its business, then firms may be presumed to maximise that value through production, exchange and investment, merely matching up financing to secure that value. In this case, the introduction of unlimited corporate liability merely adds a risk margin, in perfect capital markets equivalent to the insurance premium to cover a company against claims exceeding shareholders capital, to the cost of equity. Any real effects would then depend on what activities or investments are foregone on account of that margin. In a Keynesian state of uncertainty, with volatile expectations of future returns from investment, such real effects may be very little indeed. In sum, then, mainstream finance analysis would suggest that corporate limited liability affects only the relative cost of particular kinds of financing while increasing the cost of capital overall, because costs previously incurred by others are now borne by shareholders. It therefore affects the optimum mix of financing (equity, relative to debt) that a particular firm will choose to finance its activities. However, it only alters the profile of a firm s activities by reducing them at the margin as firms drop the marginal investment projects whose returns are now lower than those of the higher cost of capital. The sections that follow looks beyond the Miller-Modigliani approach and examines how the change in financing structures, entailed by the elimination of corporate limited liability, may change the kind of activities in which firms engage. 4

5 2. Company Financing with unlimited liability Implicit in the neo-classical analysis above is a Marshallian theory of the representative firm, according to which the non-financial corporate sector may be treated as one giant firm, or a series of similarly-financed companies operating in different industries. In this Marshallian view, the only differences in firms financing would occur to take account of differences in the volatility of returns in different industries. So a business with more highly volatile earnings would be financed using more equity, whereas a firm with much more regular profit would be financed using more debt (or makes more use of short-term borrowing if debt-financed business is volatile). With perfect foresight, and discounting of future earnings, one easily gets to the Miller-Modigliani conclusion that the value of the debt or equity financed firm would be the same. In the section that follows, I put forward a view of business and financial markets that developed out of a critique of the Marshallian theory (see Aaronovitch 1955; Baran and Sweezy 1966; Kalecki 1954; Steindl 1954). In this analysis firms are divided into three segments: household firms and the self-employed, using only owners capital; small and medium-sized enterprises, using external capital, usually bank borrowing; and corporations operating with capital consisting of bank borrowing, and bonds and stocks traded in markets for financial securities (Toporowski 1993, chapter 3). This segmentation is fairly common in all capitalist countries, with the difference that, in developing and emerging markets, a fourth segment, that of multinational companies, plays a significant and a distinctive role. However, for the sake of simplicity, we subsume this segment into the more general category of corporations, as effectively happens in the advanced capitalist countries. The different segments also have broadly different macroeconomic functions. In most countries, household firms, the self-employed, and small and medium-sized enterprises account for the majority of employment. However, the dynamics of an economy, i.e., economic growth and inflation, are determined broadly by the scale of investment undertaken by corporations, which account for the vast majority of investment in an economy. (In recent years, public expenditure and consumption stimulated by the wealth effect of rising asset prices may to a degree have replaced business investment as engines of economic growth. But this is not really central to the analysis here.) A further distinction between corporations and the small, medium-sized and household business sector, is in the way in which they operate. The smaller firms sector operates producing goods and services, from the sale of which it accrues revenues to pay its direct costs of production and its financing costs. By contrast, corporations maintain their cash flow not only through production and trade in goods and services, but also through selling productive assets and financial liabilities payable in the future (Minsky 1986, chapters 8 and 9; Toporowski 2006). This approach may be contrasted with the mainstream economic theory of the firm that analyses the productive activities of big corporations as if those corporations were 5

6 small businesses, and the financing of small and medium-sized enterprises as if they were big corporations. The question may now be considered of what difference will the introduction of unlimited shareholder liability make in such a segmented business system. One outcome may certainly be excluded. This is the possibility that unlimited shareholder liability will bring capitalism back to its state before the 1860s Companies Acts introduced limited liability. It should be pointed out that prior to this legislation shareholders did not all have unlimited liability. Limited liability was restricted to shareholders of companies established by act of parliament, such acts being necessary to set aside in the cases of those companies the common law responsibility of persons for their debts. The introduction of limited liability had become necessary as a means of enabling companies to raise capital from stock markets, dominated by insurance companies, for large undertakings that required huge amounts of capital: initially canals, then railways, mines, and so on. Reliance on the own resources of entrepreneurs, or their borrowing (which was limited by the security that they could offer) would have made raising capital for such undertakings impossible. However, limited liability was not a necessary condition for raising the finance for these projects. In continental Europe, an alternative system of finance, based on Saint- Simonian banking with government guarantees proved to be just as effective (Toporowski 2002). Would the abolition of limited liability reverse business history to that period? The plain answer to this question is no. Capitalism today is not operated by individual entrepreneurs with limited resources, but by companies with vast financial resources, and access to further resources from financial markets whose scale dwarfs anything dreamt about before the 1860s. It is quite possible that the over-capitalised corporations of today may simply evade unlimited liability by so organising their balance sheets that inconvenient liabilities are simply transferred through a web of companies into ones that can be easily placed into liquidation without embarrassing the true owners of corporations. In that situation, the eventual actual cost of unlimited liability would fall solely on smaller companies unable to engage in balance sheet transfers of this kind. This must be a serious consideration for would-be company reformers. The majority of shareholders today are institutions, and they may not wish to be burdened by unlimited liability. There would be two ways in which they could avoid this. One would be to require firms whose shares they hold to indemnify them against claims in excess of shareholders capital. Firms in turn would lay off this liability by taking out insurance. Let us suppose that such insurance is taken out with the institutions who are shareholders of the company. In effect the firm is then adding to its operating costs the premiums for that insurance. However, that cost is an additional income for its shareholders. Now if the only shareholders are insurance companies who obtain this premium income, then it is easy to see that: a) unlimited liability has not been avoided, because the insurance companies will have to pay out shareholders liabilities in excess of shareholders capital; b) the insurance company shareholders will have either their dividend income or their shareholders capital, in the form of companies retained profits, reduced by the amount of the premium; but, since that premium is fixed by the insurance companies, rather than by the shareholders companies, 6

7 c) the change amounts to shareholders being able to determine more directly what portion of companies operating profits they pay out to themselves by setting the premiums for insurance against shareholder liability claims. In practice, however, not all shareholders or institutions will offer insurance against excess liabilities of shareholders. The introduction of unlimited shareholder liability would in this case amount to a redistribution of company profits among the shareholders of a company. (Shareholders not wishing to offer such insurance, but wishing to obtain a share of the premium income from it, could obtain such income by holding the shares of companies offering excess shareholder liability insurance.) This does not mean that the reform would be neutral, in the sense that it would not affect the activities of firms. Companies would exchange dividends and retained profits, whose pay-out is de jure at least at the discretion of company shareholders in session at their annual general meeting, for regular premiums paid for excess shareholder liability insurance. Such regular payments would have the character of interest paid on borrowing or bonds. If recognised as a legitimate business cost (as opposed to a shareholder s insurance cost), such premiums would be exactly equivalent to bond interest payments. This makes such insurance, paid for by companies rather than shareholders, similar in effect to the other way of avoiding unlimited liability. This second method is through bond or debt finance. If unlimited liability were introduced for shareholders, this would leave only bondholders or creditors with limited liability. Institutional shareholders might then have an increased preference for holding bonds, rather than shares. Supposing that shareholders themselves paid for insurance against excess shareholder liability. The insurance companies being themselves holders of portfolios, this would amount to the general body of shareholders cross-insuring each other against their liabilities in excess of shareholders capital. The cost of that insurance, or that excess liability, would have to be set against the income obtained from holding shares. It would then be profitable for shareholders to switch to bonds from shares as long as the return from bonds exceeded the return from holding shares, minus the cost of shareholders liability. In theory shareholders would continue this switch, increasing the price of bonds with bond purchases, and decreasing the price of shares with share sales, until the return on bonds, R b, is equal to the return from holding shares, R e, minus the cost of shareholders liability, L e : R b = R e - L e This would be the new equilibrium condition in the capital market where shareholders have unlimited liability. The effect of reduced returns on bonds, relative to shares, is to make bond finance cheaper for companies relative to shares. Companies will then issue bonds and use the proceeds of those bond issues to buy back their shares. Broadly speaking the analysis in this section suggests that excess shareholder liability insurance paid for by companies is equivalent to bond finance. It follows that such insurance has overall the same effects on companies and financial markets as a switch to bond finance. Excess shareholder liability paid for by shareholders themselves would have the effect of increasing shareholders preference for holding bonds. Finally, in this section, it should be pointed out that these changes in company financing would affect companies financing themselves through capital markets. The 7

8 vast bulk of companies, and the majority of employment in most economies, would not be affected by the changes discussed. 3. Unlimited Liability and Capital Market Inflation So far, this paper has followed the standard template of examining the effect that shareholders unlimited liability might have on the relative cost of different financing, and seeing how company financing and shareholders portfolios would adjust to the relatively higher cost of share finance entailed by giving shareholders unlimited liability in respect of their ownership of companies. This section considers the possible effect on capital market dynamics (trends in stock prices) of discouraging equity finance, in favour of debt finance. The common finance textbook view of capital market dynamics holds that the value of a share is determined by its prospective income stream, appropriately discounted, or at least, according to the Efficient Markets Hypothesis, the available information about its prospective returns. Other theorists suggest that recent movements in stock values tend to be projected into the future; Keynesians suggest that market valuations are markets conventions vulnerable to volatile expectations; while the financial accelerator model of Bernanke and Gertler suggests pro-cyclical movements in stock prices. (This is hard to square with the widely-observed counter-cyclical tendency of interest rates). In The End of Finance I put forward a view that stock prices rise in accordance with the inflow of excess liquidity into capital markets, that is the inflow of money into capital markets that is in excess of what companies and governments wish to take out of the capital market (Toporowski 2000, Part I). The standard view is that liquidity inflows into capital markets come from saving out of income, and the rise in security prices encourages firms to increase their productive investment in order to match that saving. However, such excess liquidity could just as easily come from bank credit inflation. For example if a bank buys bonds and offers a deposit in exchange, the additional credit inflow into the capital market is matched by the expansion of the bank s balance sheet. The effect of such excess liquidity is not to raise all securities prices in general. Bonds and debt instruments usually have their value at maturity fixed by the terms of the bond or debt. While a bond may trade above its par value (i.e., the price at which it will be repaid), everyone in the market knows that eventually its price will revert to that par value. Someone buying it at a price above par will therefore make a capital loss if they hold it to maturity. Shares, however, do not have any maturity, and therefore can take whatever value someone is prepared to pay for them in the market. Share prices therefore tend to rise disproportionately when the capital market is being inflated. This is the origin of the well-known view in the markets that shares hold their values more effectively against inflation, and certainly shares give a claim on the windfall profits that companies make in times of inflation (because past costs tend to depreciate relative to revenue from current production). The other peculiarity of share price inflation is that it provides a return that is not payable by the company that issued the share, but by someone else in the stock market. In terms of the equation for capital market equilibrium given above, a portion 8

9 of R e, the return on equity, is the capital gain due to the change in the price of shares. That capital gain will become effective when the shares are sold for a higher price to a buyer in the stock market. By contrast, the much more stable prices of bonds mean that nearly all of the return on them consists of the interest payments and the capital repayments made by the companies that issued them. Bond finance, therefore, tends to keep the capital market stable, albeit the need to turn over debt, i.e., borrow money to repay debts as they mature, may impose some cost on companies. (That cost then depends on how easily companies can refinance their debts with long-term debt issues. A company financing itself entirely with three month company paper will find itself turning over its entire capital liabilities four times a year. However, a company that can finance itself with long-term (five year and more) bonds, might reduce its issuing costs by 95% and more. There is a general tendency in the finance literature to presume that capital markets are intermediate perfectly and costlessly. If this were the case, then indeed share finance and debt finance at all maturities would be available for companies to finance themselves. More importantly, turning over debt finance would not have any liquidity implications for companies. In practice capital markets do not work so perfectly, and debt finance does require internal company liquidity to be set aside as security and to facilitate the rolling over of debt.) Thus a shift towards debt finance would tend to stabilise the capital market, but at the expense of tying up the internal liquidity of companies. Whether this makes a difference in practice to companies other plans is difficult to judge. There have been many countries (for example, in East Asia until the 1990s) in which debt finance predominated through long periods of high company expenditure on fixed capital. Indeed, the Japanese deflation of the 1990s was preceded by a shift towards more equity finance by large corporations. But there are so many other peculiarities of those countries that experienced debt-financed development, that it is difficult to attribute particular virtues to such finance. With a more stable capital market, the reduced return on shares, due to the extension of shareholders liability, would tend to reduce speculation in that market, whether by traders in the market buying shares in order to obtain capital gains, or by companies buying other companies, through mergers and takeovers, for later sale at a higher price. However, this might only reduce speculation for the smaller capital gains up to the cost of shareholders liability. Larger share price appreciation would make speculative share purchases attractive again. Traders who take out generalised shareholders liability insurance are likely to view such insurance as an overhead cost of their speculation and therefore take larger, riskier speculative positions to cover their overheads. Conclusion By making shareholders vulnerable to claims in excess of the capital they hold in their companies, and thereby discouraging equity in favour of debt financing, which would retain its immunity against claims in excess of bondholders capital; and by encouraging insurance against such claims in exchange for regular premium payments; the elimination of the legal limitation on the liability of shareholders may have some marginal stabilising influence on the capital market. However, this may be 9

10 at the cost of companies, from whose cash flow or liquid reserves the insurance premiums or claims would be defrayed and, in the case of a switch to debt finance, any added cost of turning over debt liabilities in the market (i.e., issuing new debts to repay maturing debts). References Aaronovitch, A. (1955) Monopoly: A Study of British Monopoly Capitalism London: Lawrence and Wishart. Baran, P, and Sweezy, P.A. (1966) Monopoly Capital New York: Monthly Review Press. Kalecki, M. (1954) Theory of Economic Dynamics London: George Allen and Unwin. Miller, M. and Modigliani, M. (1961) Dividend policy, growth and the valuation of shares Journal of Business vol. 34, pp Minsky, H.P. (1986) Stabilizing an Unstable Economy New Haven: Yale University Press. Shiller, R.J. (1993) Macro Markets: Creating Institutions for Managing Society s Largest Economic Risks Oxford: Oxford University Press. Steindl, J. (1954) Small and Big Business: Economic Problems of the Size of Firms Oxford: Basil Blackwell. Toporowski, J. (1993) The Economics of Financial Markets and the 1987 Crash Aldershot: Edward Elgar. Toporowski, J. (2000) The End of Finance: The Theory of Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism London: Routledge Toporowski, J. (2002) 'La banque mutuelle: de l'utopie au marché des capitaux. Le cas britannique' (The mutual bank from utopia to the capital market) Révue d'économie Financière September, No. 67, pp Toporowski, J. (2005) Theories of Financial Disturbance Cheltenham: Edward Elgar. Toporowski, J. (2006) Notes on Excess Capital unpublished manuscript. 10