Bonding limited liability.

AuthorRhee, Robert J.

ABSTRACT

Limited liability is considered a "birthright" of corporations. The concept is entrenched in legal theory, and it is a fixed reality of the political economy. But it remains controversial. Scholarly debate has been engaged in absolute terms of defending the rule or advocating its abrogation. Though compelling, these polar positions, often expressed in abstract arguments, are associated with disquieting effects. Without limited liability, efficiency may be severely compromised. With it, involuntary tort creditors bear some of the cost of an enterprise. Most other proposals for reforming limited liability have been incremental, such as modifying veil-piercing. However, neither absolutism nor marginalism is inevitable. Reform can be sweeping and yet maintain fidelity to the core idea of limited liability. The essential problem is one of financing. This Article stakes a middle ground in the debate: liability should be limited against all creditors, but cost externalization to tort creditors can be substantially minimized, if not eliminated, through mandatory bonding that in the aggregate capitalizes a compensation fund. A bond would be minimally burdensome on individual firms, but business enterprise is made to bear risk more fully. Importantly, bonded limited liability is practically administrable and politically feasible. The idea is based on well developed intellectual foundations of enterprise liability and risk retention. This scheme does not substantially undermine the efficiency of limited liability since the rule is preserved, but it promotes equity and justice.

TABLE OF CONTENTS INTRODUCTION I. THE DEBATE ON LIMITED LIABILITY A. Justification of Limited Liability B. Critique of Limited Liability 1. Ordinariness of Personal Liability 2. Cost Externalization 3. Administrative Feasibility of Personal Liability C. Assessment of the Debate D. Purpose and Regulation of the Rule II. THE MIDDLE GROUND A. Efficiency and Equity B. Bonded Limited Liability C. Enterprise Liability and Risk Retention D. Potential Objections and Responses 1. Corporate Finance 2. Efficiency of Capital 3. Actuarial Risk E. Efficiency Assessed III. ADMINISTRATION AND FEASIBILITY A. Sustainability of Fund B. Mechanics of Administration 1. Bond Amount and Collection 2. Allocation Considerations 3. Claimant Eligibility and Priority 4. Limitation Periods 5. Disbursement, Forfeiture, and Redemption C. Political Challenges and Feasibility CONCLUSION INTRODUCTION

Limited liability is the essential attribute of the corporate form. (1) Once the entitlement of corporations, limited liability is rapidly becoming a standard benefit of business enterprise as evinced by the increasing prominence of limited liability companies as a preferred organizational form of many private enterprises. (2) Most corporate law scholars have not only accepted limited liability as a standard term in the law of business organizations, but have forcefully justified it. They have argued that limited liability should be countenanced because an alternative scheme of unlimited liability would impose greater costs on economic production, including an increase in agency and capital costs. (3) But some scholars have argued with equal force that these costs are overstated and that the balance of the cost-benefit analysis favors greater personal liability for tort claims. (4) The question of limited liability is still debatable because the merits of the theoretical arguments cannot be empirically confirmed. (5) Without such proof, the academic debate has largely been engaged in abstract, absolute terms of defending the rule or arguing for its abolition with each side advancing compelling arguments. (6) The debate on limited liability must be properly framed, lest it be only academic. It must focus on pragmatic proposals so that policymakers can consider them. Pragmatism requires the acknowledgement of an important baseline: at this point in time and society, it is hard to imagine the abrogation of limited liability as a political possibility. (7) The belief in the efficiency of limited liability, however unverifiable, is generally accepted. Indeed, there seems to be an efficiency axiom of limited liability.

Although limited liability is a practical reality, the concept is still troubling. No one disputes that corporations should ideally internalize the cost of their activities. With perfect information, no reasonable society would grant the right of limited liability if a particular firm would produce merely a transfer payment with a private gain to the shareholder and an equal private loss to the tort victim, or worse, the firm's activity would impose a net social cost. Such a society would be morally or economically bankrupt. Limited liability marches in tandem with the driving force of enterprise--the expectation of profit after satisfaction of all liabilities. A good faith belief that one will not invoke the rule is implied. (8) Society confers limited liability to mitigate the well-known, generally accepted understanding of the costs associated with imposing unlimited personal liability. The implied social bargain is clear. If limited liability presents a social problem, there must be a practical, politically feasible response. The goal should be to explore a middle ground in this debate. (9)

The debate on limited liability has been framed as whether shareholders should be personally liable in excess of their prior fixed equity investment. This presumes that the only private alternative is to revoke the rule. This is the wrong way of looking at the problem. The question should be framed as whether the activity of investing in stock, the assumption of residual income and risk, can be made to internalize a greater portion of the cost of corporate activity within the constraint of the rule. Is there a way to capture the undeniable benefits of limited liability, while curtailing its negative effects? The problem is essentially one of financing.

A middle ground is feasible. This Article advances a simple idea: a firm should internalize more cost and risk of its tortious activities through a mandatory bonding of limited liability. The bond serves as an additional asset reserved to satisfy liability and is redeemable by the obligor firm only upon dissolution without excess liability. Under this scheme, the liability calculus changes only slightly: the scope of liability is expanded from a claim on corporate assets to a claim on corporate assets plus bond. Since the bond amount should be set relatively low to avoid deterring the engagement of enterprise, the principal itself does not materially relieve the burden on tort creditors. Rather, the aggregate bond capitalizes a compensation fund. With mandatory participation, the earned surplus can substantially, if not fully, compensate tort victims. Similar to insurance, limited liability is a backstop against unexpected business failure, and just as most policyholders are fortunate to not claim on the insurance, most firms are either profitable or dissolve before excess liability accrues and they do not invoke the rule of limited liability. For them, the bond is essentially a mandated return-free capital, and the true cost of bonding limited liability for most firms is the opportunity cost of capital on the principal.

The idea of bonded limited liability is supported by sound theoretical principles from tort law and insurance. First, the principle of enterprise liability justifies a scheme to spread the losses caused by business activities. Business enterprise is better able to bear the risk so long as liability is certain and predictable, and each participant in the enterprise should be made to share a small portion of that risk. The idea of enterprise liability need not be confined to tort doctrine, or defined by industry or product differentiations. Second, bonded limited liability is essentially a mandated risk retention arrangement. If adverse selection and information collection problems are eliminated through mandatory participation, self-insurance is a feasible policy response. In insurance, most policyholders do not claim the benefit of insurance, and thus they subsidize the cost of the unfortunate few. A mandatory bond creates a risk retention arrangement akin to group self-insurance against liability in excess of corporate assets (hereinafter excess liability).

This Article is presented in three parts. Part I presents and critiques the arguments for and against limited liability. Part II advances the idea of bonded limited liability, the theoretical foundation underlying the scheme, potential objections to the idea, and responses to those objections. Part III shows how a compensation fund is administrable. With the benefit of data received from the corporation commissions of Delaware, California, and New York, (10) Part III provides pro forma calculations of the potential size of the compensation funds and annual surpluses. These calculations are also relevant to the political feasibility of bonded limited liability.

  1. THE DEBATE ON LIMITED LIABILITY

    1. Justification of Limited Liability

      The rule of limited liability is generally understood to concern the scope of shareholder liability. This Article does not examine the liability of creditors, employees, and managers beyond their culpability under current tort and agency laws. (11) Some scholars have asked why we focus on shareholders for personal liability. If shareholders can be found personally liable as a general rule, the principle could be extended to contract creditors or employees. (12) The inference is that imposing unlimited liability on shareholders vis-avis other contractual claimants would be arbitrary and unprincipled.

      This argument is facile, but unpersuasive. It tugs at our intuition that imposing vicarious liability on contract creditors or employees for excess liabilities would be unacceptable. (13) The reason for holding...

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