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debt and the trade against risk

October 28, 2005

Tags Financial MarketsMoney and BanksCapital and Interest TheoryMoney and Banking

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.

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