Bonding Limited Liability

Robert J. Rhee - University of Maryland School of Law

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Limited liability is the essential attribute of the corporate form. Although abolishing limited liability is politically infeasible, the rule is troubling as to tort creditors. Unlike contract creditors, they are not factors of production in the “nexus of contracts.” Tort law is the wrench in the smooth machinery of the contractarian explanation of limited liability. With perfect information, no reasonable society would grant the right of limited liability if a firm would produce merely a transfer payment from tort victim to shareholder, or worse, the firm’s activity would impose a net social cost. Such a society would be morally or economically bankrupt. With uncertainty as the reality, the ex ante assumption must be that every firm would be socially productive. Limited liability marches in tandem with the spirit of enterprise—the expectation of profit, a residual gain after all liabilities are paid. A good faith belief that one will not externalize the cost of liability is implied.

Although subsidization by tort creditors is a problem, scholars have argued that this liability creates wealth and that an alternative scheme of unlimited personal liability would impose greater costs on economic production, including an increase in contracting cost, cost of capital, and monitoring cost. 1 Other scholars have argued with equal vigor that these costs are overstated and that the balance of the cost-benefit analysis favors unlimited liability. 2 Without empirical proof of the theoretical arguments, the academic debate has largely been engaged in abstract, absolute terms. This is the wrong way of looking at the problem. The goal is to capture the undeniable benefits of limited liability while at the same time curtail its negative effects. Neither absolutism nor marginalism is inevitable. Reform can be sweeping and yet maintain fidelity to the core idea of limited liability. The problem is essentially one of financing.

The idea of bonding limited liability is simple: shareholders should be protected by limited liability, but conferral of the rule should be financially bonded by mandating corporations to contribute a small sum toward the capitalization of a compensation fund. The ex ante expectation of profit should not be taken for granted. Embedded in the rule of limited liability is a put option, which per the operation of law, tort creditors must issue to shareholders at zero premium. Society should require firms to financially bond their good faith in the corporation’s ability to pay liabilities. Two theoretical justifications support the idea of bonded limited liability. First, the principle of enterprise liability expresses the maxim that those who profit from the imposition of risk should bear the costs of the accidents. Second, bonding limited liability is based on the insurance principle of risk retention. Similar to insurance policyholders, the unfortunate shareholders find the rule of limited liability a financial savior; the fortune ones have no need for salvation. In an uncertain world, a bond creates a risk retention arrangement akin to group self-insurance against excess liability.

I. Bond Attributes

Limited liability is believed to be efficient because its benefits are seen to outweigh the adverse effects of cost externalization. The rule’s efficiency does not mean it is equitable; the Kaldor-Hicks criterion of efficiency does not require actual compensation. 3 A scheme of bonded limited liability promotes equity by delivering actual compensation. The following four important attributes are important.

1. Small amount — The bond should be small enough to not deter the engagement of enterprise, but large enough to capitalize a compensation pool. A bond in the range of capitalized administrative fees or franchise taxes does not substantially burden businesses, because firms routinely bear these expenses. With mandatory participation, a low price for a bond is possible.

2. Fixed value — The bond should be fixed. With a small, predictable sum, the firm’s cost of capital is unaffected and it precludes the cost of individualized assessment. There are two ways to assign a fixed bond value: either a fixed dollar amount for private firms, or a fixed percentage based on market value for public companies.

3. Single obligation — The bond is not in the nature of recurring administrative fees, taxes, or liability insurance premiums. It is a one-time reserving of an asset, forfeitable upon insolvency.

4. Redeemable — The bond is a return-free capital to capitalize a fund. It is subject to redemption by the obligor upon its voluntary dissolution. Tort victims have a claim on the earnings from the bond.

Structuring the bond in this manner preserves the “benefit” side of the cost-benefit ledger. That is, the wealth created from the rule of limited liability remains the same because shareholders are protected, but the distribution of wealth as between shareholder and tort creditor changes.

II. Potential Objection and Response

There are several obvious objections to the idea of bonded limited liability. These objections are more apparent than real.

First, one may object that bonded limited liability would adversely affect corporate finance. This is not an issue. Since no additional uncertainty is injected into the investment decision, it does not affect the firm’s cost of equity. The true economic cost of bonded limited liability is simply the opportunity cost of capital used to fund the small bond amount. For example, assume the bond amount is $2000, the average life of a firm is 10 years, and the cost of equity is 12 percent. The present value of bond redemption is $644. Thus, the true cost of bonding to the firm is $1356. This is the cost of providing return-free capital to the fund, or seen differently, the cost of the premium on the embedded put option, which the law currently requires tort creditors to issue at no cost.

Second, one may object that bonding limited liability would mandate an inefficient use of capital. The compensation fund must be invested conservatively to protect the bond principal and ensure sustainability. There may be a yield differential between the opportunity cost and the target return. Assume that the target return is 6 percent and that the opportunity cost of capital for the average firm is 12 percent. This yield differential can be seen as inefficient. However, bonded limited liability produces two positive benefits. It deters abuse of limited liability by making more costly the strategy of liability avoidance (asset partitioning), which imparts social cost. Liability avoidance should not be the goal of the rule of limited liability, but is instead a necessary evil. It reduces the secondary costs of accidents including social benefits from the state, family, and informal social networks, and lost opportunities arising from a lack of full compensation. When these benefits are added to the accounting of the cost-benefit, the actual yield differential must narrow, perhaps to a point where it is insignificant. To the extent that there remains a yield differential, such a difference can be justified as a tradeoff between efficiency and equity.

Third, one may object that the bond amount would not reflect individualized risk assessment. Low risk firms could be seen as subsidizing high risk firms. This subsidization does not pose a moral hazard because the bond does not insure the firms. Bonding limiting liability is bankruptcy neutral. The argument for risk classification is not principally an economic one, but instead one of fairness. The fairness argument is not just between bond obligors, but rather the principal issue of fairness is between tortfeasors and tort victims. The degree of unfairness is outweighed by the high cost of individualized assessment. The potential misapplication of actual risk and cost assignment is a minor issue. Because the bond is small, there is no serious asset misallocation problem. 4

III. Administration

A scheme of bonded limited liability must be feasible and cost effective. Practical questions concern collection method, bond amount, principal preservation, claimant eligibility, limitation periods, fund disbursement, and bond redemption.

1. Bond amount — A variable bond amount requires underwriting and is quite costly. For private companies, a fixed sum is best. The value of public companies is more accessible and transparent. The bond obligation can be pegged as a percentage of the market capitalization.

2. Allocation considerations — Public firms present a problem of allocating the bond between a parent and its subsidiaries. Allocation down to the lowest subsidiary level may be akin to slicing potato chips—not worth the effort. Allocation should be limited to a specified level of ownership. An insolvency of a subsidiary below this level results in a forfeiture of the allocated bond amount at that level and below. This rule does not result in gaming of corporate structure because reconfiguring corporate organization, presumably based on important business reasons, to game a small bond allocation at minute levels is not worth the effort.

3. Claimant eligibility and priority — Most of the administrative cost piggybacks on the civil litigation system, which must determine the tort liability. Eligibility is met only if the action was filed before insolvency and the plaintiff prevailed on the merits. Because collusive settlement is conceivable with the potential for veil-piercing, a favorable judgment on the merit should be required.

4. Limitation periods — An important aspect of managing a fund is to preclude frivolous, fraudulent, or collusive claims. The best solution is to install a set of three limitation periods. First, a claim should be allowed only if an action was filed prior to insolvency. Second, to preclude long-tail liability, a scheme should install a front-end limitation period between final judgment in the tort action and claiming on the fund. Third, to preclude a backlog of claims, a scheme should install a back-end limitation period between claiming on the fund and the expiration date upon which the claim expires, if the fund cannot pay the claim for lack of surplus.

5. Disbursement, forfeiture, and redemption — Upon presentment of a claim and certification, priority should be given to claimants based on the order of claim presentment. Upon insolvency, the bond is forfeited. The bond is redeemable only upon dissolution without an unmet liability claim.

6. Surplus only rule — The principal of the bond should be protected, and compensation can only be had from a surplus.

Administering this scheme is ministerial. There are none of the expenses associated with private insurance, such as underwriting and claims adjustment.

IV. Political Challenges and Feasibility

Limited liability cannot be seen purely from the viewpoint of legal and economic policy. Politics is the reason why the rule will not be abolished. We must consider whether a scheme to create a compensation fund is politically feasible. Despite the powerful influence of managerial and shareholder interest groups, there is a tangible reason why states may wish to implement bonded limited liability, and it is the same reason why states engage in the competition for corporate law—money.

Assume the following: the vast majority of companies are private firms; states require private firms to post a modest $2000 bond on limited liability; and earnings on the principal are conservatively estimated at 6 percent. Absent excess liability, which forfeits the principal, the true financial burden is the provision of return free capital to the fund. Based on the number of corporations and LLCs in California, Delaware, and New York at the end of 2008, these states would have collectively held over $7 billion in bond principal and would earn over $400 million per annum, which would be available to compensate tort victims.

The benefits to states are apparent. Greater compensation promotes equity and justice. It reduces the secondary cost of torts. Politically, states may also have a selfish financial motive. They could have permanent financial access to the monies in the fund to use as working capital. Of course, if a state accesses the fund, it should assume the fund’s liabilities, including payouts to tort victims and bond redemptions by dissolving firms, as well as minimum guarantees of earnings equivalent to a conservative market return.

A significant concern is a “race to the bottom,” or more precisely, a race to zero. The implementation of bonded limited liability could be seen as a competitive disadvantage for states seeking to attract and keep businesses. This is both a collective action problem and a prisoner’s dilemma. This difficulty is not impossible to overcome. There are several potential strategies. The most expedient solution is a federal mandate. But the enactment of bonded limited liability would require a conscious-raising event like a mass tort and liability avoidance to galvanize national political action. Absent a federal mandate, important commercial states, such as California, Delaware, or New York, could implement a scheme of bonded limited liability as to private companies. They can then institute defensive measures by modifying the internal affairs doctrine. If a foreign firm has not bonded limited liability because the state of charter does not require it, the foreign state can mandate bonding or otherwise not afford the protection of limited liability in its courts as to activities primarily engaged in the state or affecting state residents. Practically, this means that the businesses that reside in its state would be bonded in the state irrespective of the state of charter. Such states can trigger a “race to the top” in that other states would not want to lose the proceeds from bonding for firms that choose to charter in them. If each state enacts such a defensive provision, every other state would have an incentive to enact a fund.

Conclusion

The rule of limited liability is justified on the basis of a cost-benefit analysis. The middle ground in the debate on limited liability should retain the benefits of limited liability but mitigate the negative effect of involuntary subsidization by tort creditors. The essential idea of bonding limited liability is that the good faith belief in the firm’s ability to pay its obligation should be financially bonded. Structured properly, bonding limited liability satisfies the Kaldor-Hicks criterion. An accounting of the benefit and cost is important. The “benefit” of limited liability is preserved because the limit of liability is known. As far as the “cost,” there are two: the yield differential on capital and the minimal administrative cost of collection, maintenance, and disbursement. These costs are offset in whole or in part by the additional benefits inuring from bonding. Fuller compensation reduces the secondary costs of accidents. Bonding the enterprise’s good faith also deters liability avoidance schemes. These effects enhance efficiency. The net effect is that bonding limited liability is approximately neutral as to efficiency. Beyond the economic consideration, bonding limited liability substantially advances equity and justice considerations at the crossroad of corporation and tort laws.

Acknowledgments

Robert Rhee is a Professor of Law and Co-Director of the Business Law Program at the University of Maryland School of Law.

A version of this article appeared in the March 2010 issue of the William and Mary Law Review: Robert J. Rhee, Bonding Limited Liability, 51 WM. & MARY L. REV. 1417 (2010)

Copyright © 2010 William and Mary Law Review.

  1. See FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 41-44 (1991).
  2. See Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J. 1879, 1880 (1990).
  3. ROBERT COOTER & THOMAS ULEN, LAW & ECONOMICS 47 (5th ed. 2008).
  4. See Guido Calabresi, Some Thoughts on Risk Distribution and the Law of Torts, 70 YALE L.J. 499, 515 (1961).

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