I’ve come to the conclusion that we would have been better off if limited liability companies had been disallowed from using debt financing. I think that this would have been fully consistent with the American constitutional concept of “equal protection” and I would expect that this is more in keeping with natural law. So what I’m saying is that you ought to be able to have limited liability and debt financing, but not both at the same time.
This is going to be a hard case to make in the course of a single thread. So I’ll only be scratching the surface.
THE COMPANY AS SIMPLE FREEDOM OF ASSOCIATION.
Corporations in 2008 have to be thought of as, at least in part, creations of government. Government regulates them and was involved in creating the legal framework for them as an historical matter. At least in their latest manifestation. This is an extremely unfortunate state of affairs. The legitimacy of the company ought to be generated INTERNALLY. The legitimacy of the company ought to come directly from its articles of association. In this way companies could be seen as a direct extension of freedom of association. Since the legitimacy of a company ought to be generated internally the entrepreneur and his associates ought to spend immense time and effort drafting and honing these articles of association to a sort of gleaming perfection. Each man a founding father.
The case for companies is not one-and-the-same the case for limited liability.
Now from my point of view, if companies were not horribly regulated, it would probably be a better thing for anyone doing business to form one. Even if you started out as a sole trader or a partnership IN INTENTION it would give you more flexibility later on if you set it all up as a company. But your accountant might advise against this. And the reason is that once you form a company you are subjected to all sorts of laws wherein the directors can be prosecuted for any number of things. These are laws that have been built up over a long period of time. So we will imagine that they are not there. If there were no such laws and charges it would likely be the best course of action to start out your business as a company.
Now supposing everyone did this in practice. Supposing everyone, or nearly everyone, formed a company when they went into business. It could be a non-limited liability company. Or it could be a limited liability company. Which would they choose? Would anyone be willing to choose the protections of the bankruptcy laws over the protections of limited liability?
Obviously given the choice everyone would choose limited liability protection over bankruptcy law protection. Hence if we are in a world where some people were forced into the bankruptcy protection option, while others were able to access limited liability protection these parties would not be equal before the law. So why limited liability in the first place? And how do we resolve this inequality before the law?
Our current answer to this question is CORPORATE LAW. And it is a poxy answer. The regulations that corporations are subjected to cannot possibly be confused with any notions of natural law. And what they do is put a ball and chain around small business as opposed to larger business. These laws tie down the established large businesses COMPETITORS. And so give big business a free ride. This is because compliance costs for these laws are relatively higher for a small business. So big business has tied its competitors down. Sole traders are disadvantaged because they lack limited liability. And smaller companies are disadvantaged through compliance costs.
ANARCHO-CAPITALIST THOUGHT EXPERIMENT.
What ought corporate law consist of? Well in a functioning anarcho-capitalist system with private enforcement of contracts and private redress of grievances we see that the enforcement agency, to make a profit, would have to pay a great deal of attention to how the articles of association were drafted. These articles of association would have to be very clear as to what each party within the corporation might expect from all the others and very clear as to the goals of the company. These articles of association would need to anticipate and pre-empt the sorts of conflicts of interest that might arise within the company. The reason for this is the enforcement agency, to make a profit, would hope to be able to take the insurance premium and seldom have to do anything. Hence in a normal capitalist situation ( ie where there is a government regulator) corporate regulation ought to be to do with the founders having to get their articles of association very clear, and of a nature that problems down the track are easily resolved with reference to these articles.
This is merely an extension of freedom of association and its these articles which are going to set the contractual terms for this association. This is one half of what ought to be corporate law and the other half is really about not letting ones property spill over and despoil the other guys property. And not committing fraud against other persons or corporations. But these latter concerns are not special to the problem of companies. And so would be general and not corporate law.
WHY LIMITED LIABILITY?
We see here that the formation of companies is a natural extension of freedom of association. But limited liability is another matter entirely. In fact its a pretty arbitrary matter and to grant some people this privilege and deny it to others is not acceptable at first blush. So is limited liability necessary at all?
Imagine that there were two types of company. The full-liability company subject to bankruptcy protection only by any of its shareholders. And the limited liability company.
For large projects the full-liability company would begin to become untenable. Since you might have only a few thousand dollars invested in this company and yet if things went wrong you could suddenly face your house being sold. All shareholders big or small would be liable to such a great degree for what the company did. If you had more property to claim you would be more liable than those people who held little property and were renting. So full liability companies are restricted as to the people who could rightly buy their shares and the level of activities they could involve themselves in. This would likely be economically inefficient for those cases wherein it was only natural to grow the business larger to take advantage of economies of scale. And if these full-liability companies were competing with larger foreign competitors then they may be at a disadvantage.
I think that the solution is to give companies a choice. They can have limited liability status if they are 100% equity companies. Or they can be full-liability companies (or sole traders, or partnerships) and be allowed to use debt finance. I think this solves an immense amount of problems that we are seeing now on the corporate scene.
WOULD THIS BE THE END OF LEVERAGE FOR BIG COMPANIES?
No. The leverage would simply be withdrawn from the internal workings of the limited liability companies. So you could borrow money to buy shares in a limited liability company. Thats what would supply the leverage were it needed. The shares would tend to be priced in accordance with their RETURN ON TOTAL ASSETS. And their expected return on total assets down the track.
THE CONFLICT BETWEEN RETURN ON TOTAL ASSETS AND RETURN ON EQUITY.
If you had to choose a single metric that management were to follow, in order to deliver benefits to the wider community, it would be the maximizing of the return on total assets. But this is not now the goal that our current managers seek. Their main goal, after lining their own pockets, is almost officially to maximize the return on shareholders funds. How does this differ from maximizing the return on total assets? Well the main difference is simply through gearing. But with a great many managers working to maximize return on shareholders funds and using gearing to do so, this is not as socially as effective a goal as maximizing the return on total assets. They may be growing their companies larger through gearing than what the goal of maximizing return on total assets would have caused them to grow. And I would say this distortion has come about via an inequality of businesses (and legal entities) before the law as described above.
Supposing the managers, under the new dispensation, knew that their primary goal was to maximize return on total assets? Well this would now be the same goal as maximizing return on shareholders funds since there would be no gearing. So would the shareholder be missing out in any way? No we have already seen that the shareholder can himself employ gearing without distorting the company mission and behaviour, by using loan money to allow himself to purchase more shares.
HOW THIS WOULD ALTER THE EFFECTIVENESS OF THE SHAREMARKET.
The sharemarket is a powerful mechanism for capital allocation in an economy. It is also akin to a casino. It is neither one nor the other. It is both together. We see if a company is using debt-financing the valuation of the company would change a great deal if you expected monetary policy to be one way and then that policy changed. A highly geared companies non-market valuation would bounce around in response to what you thought monetary policy would be. It would bounce around a lot as well in terms of what you expected the future revenues of the company to be. Is it any wonder that the share price bounces around so much when even non-market valuations would themselves bounce around all over the place in accordance to what you were expecting from monetary policy?
100% Equity financing would enhance the ability of the sharemarket to allocate capital effectively by taking some of that casino aspect out of the picture. And of course the elimination of fractional reserve would help that along a great deal as well.
I would like to emphasize again that this in not way detracts from the shareholders ability to take advantage of gearing. It simply quarantines gearing to the outside of the limited liability company.