In an earlier article, I argued that shadow banking--the provision of financial services and products outside of the traditional banking system, and thus without the need for bank intermediation between capital markets and the users of funds--is so radically transforming finance that regulatory scholars need to rethink their basic assumptions. This Article attempts to rethink the corporate governance assumption that owners of firms should always have their liability limited to the capital they have invested. In the relatively small and decentralized firms that dominate shadow banking, equity investors tend to be active managers. Limited liability gives these investor-managers strong incentives to take risks that could generate outsized personal profits, even if that greatly increases systemic risk. For shadow banking firms subject to this conflict, limited liability should be redesigned to better align investor and societal interests.
In a prior article, I argued that shadow banking is so radically transforming finance that regulatory scholars need to rethink their basic assumptions. (1) In this Article, I argue that the governance structure of shadow banking should be redesigned to make certain investors financially responsible, by reason of their ownership interests, for their firm's liabilities beyond the capital they have invested. (2) This argument challenges the longstanding assumption of the optimality of limited liability.
Shadow banking is a loose term that refers to the decentralized provision of financing outside of traditional banking channels, and thus it is without the need for traditional modes of bank intermediation between capital markets and the users of funds. (3) The shadow banking system is immense, recently estimated at sixty-seven trillion dollars worldwide. (4) Numerous types of firms make up the shadow banking system. They include special purpose entities (SPEs), used in securitization and structured finance transactions to raise financing indirectly through the capital markets, (5) as well as finance companies, hedge funds, money market mutual funds, nonbank government-sponsored enterprises, securities lenders, and investment banks. (6)
Limited liability, this Article contends, is not always optimal for firms that make up the shadow banking system (hereinafter "shadow banking firms"). Limited liability can sometimes make the governance structure of these firms uniquely subject to a market failure that externalizes the systemic costs of taking a risky action. To repair this failure, managers of shadow banking firms should sometimes be required to put more "skin in the game," in order to better align incentives (7) between their firms and society. (8)
This Article proceeds as follows: In Part I, the Article sets forth the background for its analysis, including a short history of how corporate limited liability became the norm and an overview of the general academic debate on whether it should be the norm. In Part II, the Article analyzes whether limited liability should be the norm for the governance structure of shadow banking. The Article starts that analysis by proposing a normative framework for rethinking the corporate governance assumptions about limited liability. It then applies that framework to shadow banking. Although limited liability has always been a potential source of externalities, the Article finds that it is a uniquely fertile source of systemic externalities for shadow banking firms, and that current law does not--nor are adaptations to traditional legal remedies likely to--adequately internalize those externalities. To mitigate those externalities, limited liability should be redesigned for shadow banking firms that are governed by conflicted investor-managers. Part III of the Article explores how limited liability could be redesigned, establishing goals for the redesign and testing redesign proposals against those goals. Annex I to the Article provides practical guidance for assessing the costs and benefits of any particular redesign.
This Article does not directly engage whether--or the extent to which-- shadow banking should be subject to substantive capital and solvency regulation, or even prohibited. As to the first, it has not historically been customary, at least in the United States, to engage in solvency regulation of firms that are not traditional banks. (9) The Dodd-Frank Act is beginning to change that, with its regulation of certain systemically important financial institutions. (10) Nonetheless, even though the limited-liability rule of corporation law can cause externalities, the government does not generally "take a more active role in assuring the solvency of corporations." (11) In part, this is because government micromanagement of the private sector is not always efficient. (12) Likewise, it might well be unwise to attempt to prohibit shadow banking. Even if that were feasible, shadow banking "has the potential to create both benefit and harm. Empirically, we do not yet know which effect is likely to dominate." (13) Therefore, "financial regulation of shadow banking should... strive to examine ... how to mitigate the potential harm while preserving the potential benefit." (14) That is this Article's goal.
As background for this Article's analysis of limited liability in the context of shadow banking, the discussion begins by examining, from a historical standpoint, how corporate limited liability became the general norm and then, from a scholarly standpoint, whether it should be the general norm.
History of Limited Liability
Limited liability has been called "a distinguishing feature of corporate law--perhaps the distinguishing feature" of corporate law. (15) Yet early corporations did not have limited liability. Because their histories are different, first consider the evolution of limited liability for shareholders of nonbank corporations, then consider that evolution for shareholders of banks. Finally, compare these with the evolution of limited liability outside the United States.
During the early nineteenth century, for example, unlimited shareholder liability was the norm. (16) The rationale for such unlimited liability was that creditors assured of repayment from shareholders would lend the corporation additional capital. (17) Indirect shareholder liability, which resulted from the corporate power to make assessments, was also a common feature of early nineteenth-century corporations. (18)
Legislators initially were willing to allow corporations performing public functions, such as operating turnpikes, toll bridges, and canals, to organize under corporate charters with limited shareholder liability. (19) But they were unwilling to permit limited liability for shareholders of manufacturing corporations. (20) The movement toward general limited liability started in the courts when judges had to determine "whether shareholders were directly liable for corporate debts if the [corporate] charter was silent on shareholder liability." (21)
By the mid-nineteenth century, most courts "presum[ed] limited shareholder liability in the absence of any legislative rule." (22) Different courts had different rationales. Some courts, for example, reasoned that because some corporate charters contained express statements imposing direct liability, the absence of those statements in a charter implied an intent not to impose such liability. (23) Other courts wanted to avoid an injustice to shareholders who were both innocent and ignorant of a corporation's mismanagement. (24) Federal courts often relied on a trust fund theory: shareholders are merely residuary owners, reimbursed only after the corporation pays its debts; (25) thus a corporation is like a trust fund in which the capital stock is used for the payment of corporate debts while stockholders are liable only for the amount of capital stock they contribute. (26)
Around the same time, legislatures began allowing limited liability, even for shareholders of manufacturing corporations. (27) This change appears to have been more driven by pragmatic factors. In part, it was responsive to the increasing political influence of industrialists, resulting from the rapid growth of the manufacturing industry. (28) In part, it was responsive to a "flight-of-capital argument" that states failing to legislate limited shareholder liability would suffer a flight of corporate capital to other states that had limited liability. (29)
Limited liability did not become universal in the United States, however, until a century later. California, for example, imposed pro rata shareholder liability for all corporate debts and obligations until 1931. (30) This pro rata liability did not appear to cause a flight of corporate capital to other states or otherwise impede California's economic growth. (31)
Unlike nonbank corporations in which shareholders initially were subject to unlimited liability, bank shareholders initially were subject to (only) double liability--liability for corporate obligations in an amount equal to the par value of their shares. (32) States imposed double liability either by express provisions in state bank charters or in their state constitutions. (33) Congress followed the example of the states and provided for double liability in the National Banking Act of 1863. (34) According to the senator who proposed the provision, its purpose was to provide additional protection to bank creditors and, in effect, to also prevent the bank from engaging in excessively risky operations. (35)
Double liability for bank shareholders quickly fell out of favor, however, following the Great Depression. Several factors contributed to its rapid fall from grace, (36) including a perception of unfairness caused by liability of bank shareholders who did not contribute to management decisions (37) and public questioning of its ability to reduce...