| Law
professor's musings - some theory:
I cannot let the
subject of limited liability pass by without offering my own
comments. As a number of participants have argued it seems highly
unlikely that people engage in risky behavior because they are somehow
insulated from liability whether by insurance or limited liability.
But it seems even more
unlikely in the setting of an LLC or other small business entity.
Aside from the fact that in a single member firm the single member
will ordinarily be personally liable anyway as the tortfeasor, it will
often be the case -- in both single member firms and somewhat larger
firms -- that the members have much of their wealth tied up in the
fortunes of the firm. How likely are they to engage in behaviors that
will increase the risk of losing it all even if they do not lose the
house and car in the bargain? Not very.
It is really only in
the publicly traded firm that the temptation to take big risks arises
because the owners are mostly diversified stockholders who are
indifferent to risk as long as the return is adequate. To be sure,
the managers of the publicly traded firm may have a large part of
their wealth tied up in stock options, which may make them reluctant
to manage as diversified stockholders would want, but that's for
another symposium. (Anyone who would like to pursue that thread
should feel free to do so on bizlaw.)
In the end then,
limited liability is mostly about shifting the burden of contracting
to voluntary creditors who are probably better able to diversify the
risks of default among numerous small business debtors. Why, after
all, should we require someone who wants to start a business to risk
everything? On the average and over the long haul, business makes
more money than it loses (though I suppose we could argue about how
one measures the results).
If business was more
likely to generate net social costs than gains, I might be inclined to
rethink limited liability. But given that business seems to generate
net social gains, we should help it along with a contracting rule that
removes an important barrier to reaching an efficient arrangement with
creditors. In other words, without limited liability, creditors would
often refuse to negotiate over limitations. With it, they must insist
on personal guaranties or other forms of security. The only real
worry is that managers of marginal firms that are already circling the
drain will use limited liability as a way of looting the business.
But that's where veil piercing comes into play.
At the risk of being
dismissed as just another self-promoter (among the many who will read
this) see my piece at 89 Nw. L. Rev. 140 (1994).
In a slightly
different vein, I am gratified to see that the phrase "moral hazard"
raises hackles with at least a few others. Again, I seriously doubt
that people buy insurance to take advantage of insurance companies
(though a few may do so especially with regard to things like
annuities). But for most people there is no incentive to buy any more
insurance than is necessary, and if one can self-insure it usually
makes sense to do so. Anyway, I get no particular charge out of paying
insurance premiums, and I suspect that the insurance industry uses the
phrase "moral hazard" and its connotation as a show-stopper argument
to justify a variety of classification schemes and even refusal to
insure certain groups for certain risks. I realize that I have failed
to stay on message here, but I'm not running for anything.
Richard Booth |
Practitioner's retort - a war story:
About 15 years ago a
sunglass company was started by an entrepeneur who did not have
anything except good contacts and excellent sales abilities. He
raised $500,000 from friends and relatives to buy his beginning
inventory and get things going. He used an S Corp and I venture to
guess that in today's climate he would have used an LLC.
The company borrowed
significant sums from the bank to fund its growth, but only three of
the 25 initial investors were required to guaranty the loan. The
company experienced some rough times, was nearly bankrupt at one
point, but grew into a market leader, eventually did an IPO and is
now very successful company. The original investors have done quite
well for their initial $500,000, but more importantly this company now
has over 100 employees and sales of tens of millions of dollars every
year. It has also been a market leader in developing and distributing
cost-effective coatings which block out UV rays.
Two years ago a women
was wearing a pair of the company's sunglasses while playing golf.
She hit her tee shot off a rock wall and the ball came back and hit
her in the face causing the sunglasses to break. She has lost her
sight in one eye, which is very sad, but she has sued the company for
millions of dollars, in excess of the policy limits. What will a jury
give her? (The company has maybe 2 or 3 product liability claims per
year.)
One of the initial
investors (for $40,000) is a wealthy and very well-respected attorney
who definitely understands the risks involved in small businesses.
Would he have invested in this business 15 years ago if all of his
wealth would have been subjected to the claims of the bank or this
type of tort victim? I do not believe that he would have, and I do
not believe that many of the other investors would have invested.
The company is sorry
that this women lost her sight in one eye, but there have been over
100 jobs directly created by this company (who knows how many other
jobs by its suppliers and customers), which never would have been in
existence if it had not been able to raise the capital. Bausch & Lomb
would probably be the only sunglass company in the US and your
sunglasses would cost $200 per pair. However, this woman may not have
lost her sight in one eye and the two or three other possible victims
may not have incurred their injuries.
Gordon, it is not the
cost to the small business owner or its investors that is the issue
here, its the impact on the economic system of shifting the
risk/benefit analysis a few points toward the risk side for small
business investments. Most companies that start out with a handful of
investors do not achieve the kind of success that this company has
achieved, but they do create jobs and keep the economy from
stagnating.
In my opinion,
restricting limited liability to only publicly traded companies would
have a devastating impact on the benefit/risk analysis of investing in
small and startup businesses. It would make publicly traded
securities relatively more attractive than small business
investments. It would severely restrict growth of a significant part
of the economy. We certainly do not have any empirical data, but I do
not believe that losses of the tort victims, lenders or accounts
receivable creditors would outweigh the benefit to society of a
vibrant small and startup business sector.
Tony Mallgren |
