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Corporations and Limited Liability for Torts

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There's been a good deal of discussion lately of the legitimacy of corporations: see my posts Left-Libertarians on Corporations "Expropriating the Efforts of Stakeholders" and In Defense of the Corporation. Various types--anti-industrialists, socialists, left-libertarians--make a variety of criticisms of the corporation. Some oppose it because they oppose "capitalism"; or because it is invariably in bed with the state; or because it exploits workers; or because they dislike "bigness". Most of these are wrongheaded or off point.

Another very common criticism is that corporations receive special privileges from the state--"limited liability". This concerns two basic issues: the limited liability of shareholders for contractual liability of the corporation; and for torts committed by employees of the corporation. The former is easily dealt with--see Hessen (more on this below).

The most controversial issue is the tort issue. This is bizarre for a number of reasons. In the typical case, the victim injured by the tort of an employee of the corporation can of course sue the employee who committed the tort; but he usually just sues the company because it has deep pockets. He is not usually affected by the inability to sue the shareholders, since he would not anyway. The corporate assets, or its insurance, would cover it. But it bugs anti-corporate types that shareholders can't be sued for torts of employees of a company they own shares in.

Lately I've begun to emphasize that the anti-corporatists, in characterizing limited liability as a privilege, have to assume that on the free market shareholders should have liability. But this is a dubious assumption. First, it rests on the idea of respondeat superior (master is liable for torts of his servant), which itself dubious. Second, it rests on an undeveloped notion of strict liability which assumes that you are liable for torts committed "with [or by?] your property." But property does not commit crimes or torts--people do. Property serves as means. If you borrow my car and run over someone, it is not obvious to me that I am responsible for your negligent action--just because I owned the car. Second, as I discussed in The Over-reliance on State Classifications: "Employee" and "Shareholder", this rests too much on state definitions of ownership. Marriage, shareholder, owner, adult, citizen, money, bank, employer, employee, hobby, .... -- so many things are keyed off their classifications. It irks me when libertarians build up their arguments and concepts based on these, as if they are objective and valid distinctions.

Looking at reality: ownership is the right to control a resource--in a company it's distributed, since shareholders can't just walk in and use the assets of the company (drives its cars; use its HQ to throw a party). As a practical matter, people with control over property are distributed in complex ways.

Second, it's often assumed that shareholders are "investors"--people who gave money to the company. This seems to implicitly assume that you are responsible for aiding and abetting the company. Several problems here. (a) shareholders are not necessarily investors (if you buy Exxon stock from another shareholder, you give him money, but not Exxon); (b) other people give Exxon much more money, like customers; (c) the control exerted by shareholders is minimal--they can vote for board members, who in turn appoint officers, who hire managers and employees. Others--creditors, vendors, contractors, employees, unions, "stakeholders"--often exert more influence over what the company does than any given shareholder or even the whole class of shareholders.

I believe the only way to sort this out is to apply a carefully developed and libertarian-compatible theory of causation. Whenever you want to attribute responsibility to A for actions of B, you have to have a good reason. This area is underdeveloped but my approach is laid out in Causation and Aggression. I am not even sure if respondeat superior is justified; much less stretching it to cover shareholders--stretching it so far would make so many other parties potentially responsible for the actions of one tortfeasor. Libertarians want to just point to the rules developed in the common law and take this for granted, as if it's unquestionably legitimate. It's not. We are libertarians, not positivists.

I just recalled, in correspondence with Brad Spangler, that there is a great pity excerpt from Hessen, pp. 18-21 of his classic book In Defense of the Corporation. He grants (a bit too generously, perhaps) the application of respondeat superior to the company itself, but argues very concisely--and without a carefully developed theory of causation but with sound insight and good intuition--why shareholders should not be liable for torts of employees. I highly recommend you read pp. 18-21. (N.b. left-libertarians: at pp. 20-21, Hessen explains that if anything, the state takeover of corporate law benefits not large companies, but small, one-man and "close" corporations since they would normally be liable for their actions, unlike shareholders of a large company.)

Bottom line: libertarians who claim that limited liability for torts is a state privilege have the burden of proving that shareholders should be liable for torts committed by employees of a company the shareholder owns a share in--and to show why creditors, suppliers, employees, and other "aiders and abetters" are not liable. And don't just point to the common law rules and respondeat superior--we are libertarians. Show why this rule is libertarian.

I went over this in a 2004 LRC post, Legitimizing the Corporation, which I excerpt below:

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... most people don't even realize that if a FedEx truck runs you over negligently you can sue the driver. They think he is immune from suit or something. But it is the other way around; if a FedEx truck negligently hits you, it is of course the driver that is responsible. His employer is responsible for its employee's own negligence and liability only because of the doctrine of respondeat superior; but if the employee is found to be non-negligent, the employer-corporation is off the hook too. This is in fact why corporations usually defend their employee and themselves when sued for the employee's actions.

 

But opposition does not always stem from ignorance of the law or leftism: for example, one critique comes from two libertarian-Austrian attorneys: "De-legitimizing the Corporation: An Austrian analysis of the firm", Jeffrey F. Barr & Lee Iglody, Austrian Scholars Conference 7, March 30-31, 2001, Auburn, Alabama.

Robert Hessen's (a Randian) In Defense of the Corporation is a good defense of corporations. He shows that they don't require privilege from the state to exist; they can be constructed from private contracts. One of Hessen's articles nicely summarizes some of his views. Some excerpts are pasted below. My view is that corporations are essentially compatible with libertarianism. 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. What about limited liability for torts or crimes? As mentioned, the person direclty responsible for a tort or crime is always liable; sometimes the employer (which is often a corporation) is also liable for the employee's actions, via respondeat superior. Who else should be responsible? In my view, those who cause the damage are responsible. Shareholders don't cause it any more than a bank who loans money to a company causes its employees to commit torts. The shareholders give money; and elect directors. The directors appoint officers/executives. The officers hire employees and direct what goes on. Now to the extent a given manager orders or otherwise causes a given action that damages someone, a case can be made that the manager is causally responsible, jointly liable with the employee who directly caused the damage. It's harder to argue the directors are so directly responsible, but depending on the facts, it could be argued in some cases. But it's very fact specific. Perhaps the rules on causation should be relaxed or modified, but this has nothing to do with there being a corporation or not--for the laws of causation should apply to any manager or person of sufficient influence in the organization hierarchy, regardless of legal form of the organization (that is, whether it's a corporation, partnership, sole proprietorship, or what have you).

Excerpts from the Hessen article--

The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state's role is purely formal and automatic. Moreover, to call incorporation a "privilege" implies that individuals have no right to create a corporation. But why is governmental permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued, holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, that its shares are freely transferable, or if it asserted limited liability for its debt obligations? (Liability for torts is a separate issue; see Hessen, pp. 18-21.) If potential creditors find any of these features objectionable, they can negotiate to exclude or modify them.

Economists invariably declare limited liability to be the crucial corporate feature. According to this view the corporation, as an entity, contracts debts in "its" own name, not "theirs" (the shareholders), so they are not responsible for its debts. But there is no need for such mental gymnastics because limited liability actually involves an implied contract between shareholders and outside creditors. By incorporating (that is, complying with the registration procedure prescribed by state law) and then by using the symbols "Inc." or "Corp.," shareholders are warning potential creditors that they do not accept unlimited personal liability, that creditors must look only to the corporation's assets (if any) for satisfaction of their claims. This process, known as "constructive notice," offers an easy means of economizing on transactions costs. It is an alternative to negotiating explicit limited-liability contracts with each creditor.

Creditors, however, are not obligated to accept limited liability. As Professor Bayless Manning observes; "As a part of the bargain negotiated when the corporation incurs the indebtedness, the creditor may, of course, succeed in extracting from a shareholder (or someone else who wants to see the loan go through) an outside pledge agreement, guaranty, endorsement, or the like that will have the effect of subjecting non-corporate assets to the creditor's claim against the corporation." This familiar pattern explains why limited liability is likely to be a mirage or delusion for a new, untested business, and thus also explains why some enterprises are not incorporated despite the ease of creating a corporation.

Another textbook myth is that limited liability explains why corporations were able to attract vast amounts of capital from nineteenth-century investors to carry out America's industrialization. In fact, the industrial revolution was carried out chiefly by partnerships and unincorporated joint stock companies, rarely by corporations. The chief sources of capital for the early New England textile corporations were the founders' personal savings, money borrowed from banks, the proceeds from state-approved lotteries, and the sale of bonds and debentures.

Even in the late nineteenth century, none of the giant industrial corporations drew equity capital from the general investment public. They were privately held and drew primarily on retained earnings for expansion. (The largest enterprise, Carnegie Brothers, was organized as a Limited Partnership Association in the Commonwealth of Pennsylvania, a status that did not inhibit its ability to own properties and sell steel in other states.)

External financing, through the sale of common stock, was nearly impossible in the nineteenth century because of asymmetrical information--that is, the inability of outside investors to gauge which firms were likely to earn a profit, and thus to calculate what would be a reasonable price to pay for shares. Instead, founders of corporations often gave away shares as a bonus to those who bought bonds, which were less risky because they carried underlying collateral, a fixed date of redemption, and a fixed rate of return. Occasionally, wealthy local residents bought shares, not primarily as investments for profit, but rather as a public-spirited gesture to foster economic growth in a town or region. The idea that limited liability would have been sufficient to entice outside investors to buy common stock is counterintuitive. The assurance that you could lose only your total investment is hardly a persuasive sales pitch.

No logical or moral necessity links partnerships with unlimited liability or corporations with limited liability. Legal rules do not suddenly spring into existence full grown; instead, they arise in a particular historical context. Unlimited liability for partners dates back to medieval Italy, when partnerships were family based, when personal and business funds were intermingled, and when family honor required payment of debts owed to creditors, even if it meant that the whole debt would be paid by one or two partners instead of being shared proportionally among them all.

Well into the twentieth century, American judges ignored the historical circumstances in which unlimited liability became the custom and later the legal rule. Hence they repeatedly rejected contractual attempts by partners to limit their liability. Only near midcentury did state legislatures grudgingly begin enacting "close corporation" statutes for businesses that would be organized as partnerships if courts were willing to recognize the contractual nature of limited liability. These quasi-corporations have nearly nothing in common with corporations financed by outside investors and run by professional managers.

Any firm, regardless of size, can be structured as a corporation, a partnership, a limited partnership, or even one of the rarely used forms, a business trust or an unincorporated joint stock company. Despite textbook claims to the contrary, partnerships are not necessarily small scale or short-lived; they need not cease to exist when a general partner dies or withdraws. Features that are automatic or inherent in a corporation--continuity of existence, hierarchy of authority, freely transferable shares--are optional for a partnership or any other organizational form. The only exceptions arise if government restricts or forbids freedom of contract (such as the rule that forbids limited liability for general partners).

Stephan Kinsella is an attorney in Houston, director of the Center for the Study of Innovative Freedom, and editor of Libertarian Papers.

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