It’s been a while since this blog has featured Con’s incisive thinking.
This article calls into question the capacity of shareholders to have their returns and have someone eat the risk.
There’s a lot of easy talk about the “governance” in ESG, few are asking the important questions about accountability.
One of the sessions at the recent Professional Pensions investment conference consisted of a panel of eminent ESG practitioners. They were asked an apparently radical question, which from their responses had apparently not been considered previously. The question was: “Given that many of the problems we are attempting to resolve have their roots in the limited liability nature of corporate equity, should we consider limiting the domain of application of this important legal concession for public companies?”
The most extreme action of this type might be to return the status of equity to one of unlimited liability, that shareholders could be held responsible for the obligations of the company in distress.
Limited liability endows equity with the properties of a call option. The incentive for shareholders is to have the company take high levels of risk since they stand to gain when this is successful but do not bear the full losses when this fails. In that circumstance, the losses are borne by other stakeholders, the employees, creditors and often the public at large. The management of limited liability companies have similar incentives to take excessive risk, particularly so when their compensation is linked to the performance of equity.
The origins of limited liability were in the mid-19th century, when the development of the industries and infrastructure of the industrial revolution required capital on a scale beyond the resources of most entrepreneurs. their families and close associates. Stock exchanges developed to co-ordinate this large-scale capital formation. However, this is now a minor role for exchanges; they are now predominantly places used by entrepreneurs to realise or cash out their earlier private investments.
Since that Professional Pensions conference, two leading finance academics, Charles Goodhart and Rosa Lastra have published a paper proposing variation of the limited liability of banks and systemically important financial institutions, and in particular using this to discipline the directors and officers of these institutions by providing them with more balanced incentives.
Of course, the widespread adoption of unlimited liability would represent a significant redistribution of risk within a firm and within an economy. It could go far in addressing many of the criticisms of capitalism, which have become prominent in the post-crash era, such as the growing inequalities in our society.
The Goodhart and Lastra paper discusses the historic development of limited liability, and show that in some aspects it is a very recent affair – they note that it was only in 2009 that a section of the Companies Act dating originally from 1948 was repealed; that section read: “In a limited company the liability of directors or managers may, if so provided in the memorandum, be unlimited.”
Unlimited liability brings with it many issues, not least the collection of the assessed debts from capital suppliers post insolvency – the extended litigation by “names” following the Lloyd’s market meltdown provides a prime example, and was extremely costly. Another issue: the shareholders of a company would have an interest in the probity and financial capacity of other shareholders; rather in the manner of private partnerships, it might prove advisable for an admissions approval process to be established.
The idea of extended liability is nothing new. It exists in the callable capital of the multilateral development banks and in the concept of part-paid callable equity.
Risk-taking is essential to commerce; without this there can be no profit. It is excessive and unbalanced risk-taking, along with unfair distribution of the returns, that are problematic. Under unlimited liability, along with the redistribution of risk, we may expect higher returns to equity and lower to debt.
The idea of restricting unlimited liability is worth pursuing. It really should be analysed, discussed and debated comprehensively, and perhaps even implemented more broadly than the financial services sector.
Con Keating is head of research at Brighton Rock Group
This article was first published in Professional Pensions and is published with the permission of the author.
Let’s hope that the debate on the “G” in ESG focusses on the issues raise by Con Keating and asks fundamental questions around accountability and liability.
As the article intimates, ESG is already in danger of becoming another opportunity for the fund management marketing community to exploit to no good purpose other than the improvement of fund management margins.
While I don’t think I’ll see reversion to unlimited liability in my lifetime, I understand and support the sentiments behind Con’s thoughts on this.
I’ve heard some older professionals also express a preference for a return to unlimited liability partnerships, or at least ones with joint and several liabilities, so that fellow partners take much more of an aligned interest in what other individual partners get up to in the firm’s name and with the firm’s clients.
I think two things are getting mixed up here.
1) Penalties for directors and officers of a company for reckless risk-taking.
2) Unlimited liability of shareholders for company debts.
The first is reasonable enough. But where does the second end? With the legal owner, often a nominee, with no assets other than shareholdings in other companies, possibly with other beneficiaries? With the beneficiary, perhaps a pension fund, penalising the end-beneficiary who perhaps has no knowledge or control over the investment?
A can of worms. Perhaps better tackled by looking at (1) directly, rather than indirectly via (2).
The problem we face in corporate governance is that our actions are inherently ex post interventions and the reason for that is that there are incentives intrinsic to limited liability for both shareholders and management to take risk on a grand scale. Against these incentives, moral suasion or even explicit and public voting policy are relatively weak tools. I wonder if we would see so many share buy-backs if we did not have limited liability – these are a fine example of risk acquisition engineering and when we see buy-backs being financed by the issuance of debt (see Appple) we have it in spades.
Ther are issues here no doubt, but this is not an indirect approach – it is limited liability which is causal in these behaviours.
I am most interested in opening the debate and looking at these problems – might the answer lie in equity capital consisting of two (or more) classes of share – perhaps non-voting with full limited liability and unlimited with voting and control rights. The thing to understand is that this is not a simple reorganisation of existing risk it is a reduction of the total risk. There would also be some significant winners – bond holders would face far lower credit risk, for example.
Unlimited liability could be a good idea for private equity investments, to discourage the loading-up with excessive debt and taking large dividends.