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Limited Liability Corporations - A Short History of a Most Unnatural Creation

Or 'Where Do Hedge Funds Come From?'

Have you ever given a thought as to the origins of the limited liability joint stock company? They are not a naturally occurring phenomenon but were the artificial creation of a 19th Century British politician shortly before the civil war.

His name was Robert Lowe and he used to be the Vice President of the Board of Trade. But before we get to Mr Lowe playing Frankenstein, first a little bit of corporate history (bear with me, it’s relevant).

In 1719 a piece of legislation called the Royal Exchange and London Assurance Corporation Act, 1719, began its passage through the British Parliament. Its primary purpose, as its name suggest was to form two corporations that would be allowed to write marine insurance, The Royal Exchange and the London Assurance Company. It was passed on April 7th, 1720 and to the delight of one of its three major lobbyists, the two insurance companies it formed, and the South Sea Company, receiving Royal Assent on June 9th.

The South Sea Company, the Enron of its day, formed in 1711 to trade with Spain’s South American Colonies, had had little success due to deteriorating relations between Britain and Spain. In 1717 it bought £2 million of Government debt which it converted in to lower interest more easily traded debt and company shares. In 1719 it offered to buy half the British National Debt, again converting it into shorter term debt and again financed by selling company shares. In order to prevent competitors from entering into this market it lobbied hard, and successfully, to get a provision in the 1719 Act that forbade the formation of any new corporations without a Royal Warrant.

The combined effect of the legislation, with the purchase of half the National Debt and the returns the company was promising had a remarkable effect on their share price. Between January and May of 1720 their share price rose from £128 to £550. With the passage of the Act in June the price hit £890 and by August it was £1,000 a share. Maybe it was profit taking, maybe it was because earlier in the year the company had offered to lend people money to buy its shares and the only way they could make the payments was to sell shares, but people began to sell, and by the end of September the share price had collapsed to £150.

This resulted in a wave of bankruptcies not only of investors, but of banks and goldsmiths who had lent money and taken South Sea shares as security. The resulting uproar ‘led’ to the Bubble Act, 1720, which one could be forgiven for mistaking as a new piece of legislation. Through some almost unbelievable spin it was in fact a rebranding of the Royal Exchange and London Assurance Corporation Act, 1719, which was now being touted as a response to, rather a cause of, the South Sea Bubble. (The change in the year from 1719 to 1720 was achieved by switching from the year the legislation was introduced to the year it passed.) This ‘foresighted’ piece of legislation remained in force for over 100 years until it was repealed in 1825, and prevented the formation of any new companies without a Royal Warrant.

During this time it was possible for business to be conducted by unincorporated associations which could have thousands of members. Any arising litigation had to be conducted in the names of all the individual members which was completely impractical. In 1844 the British Parliament passed the Joint Stock Companies Act allowing anyone to incorporate a company for the princely sum of £10. Limited liability was not introduced until 1855 (Limited Liability Act 1855) and the following year they were consolidated into the 1856 Companies Act, which established the principles for corporate law which are still largely followed today.

Enter Mr Robert Lowe, the then Vice President of the Board of Trade, who in 1856 introduced the legislation with an argument you could hear on Fox News today:

A company formed on the principle of limited liability carries on the face of it something like prudence and caution. Its shareholders seem to say, "we have entered into a partnership, but it is impossible to tell what may happen, and since the company may fail, we will not risk all we possess in the undertaking….

My object at present is not to urge the adoption of limited liability. I am arguing in favour of human liberty - that people may be permitted to deal how and with whom they choose without the officious interference of the state; and my opinion will not be shaken even though very few limited companies be established. Every man has a right to choose for himself between the two principles, and it is ill advised legislation which steps in between him and the exercise of that right. It is right the experiment should be tried; and, in my judgment, the principle we should adopt is this, - not to throw the slightest obstacle in the way of limited companies being formed - because the effect of that would be to arrest ninety-nine good schemes in order that the bad hundredth might be prevented; but to allow them all to come into existence, and when difficulties arise, to arm the courts of justice with sufficient powers to check extravagance or roguery in the management of companies, and to save them from the wreck in which they may be involved”.

The officers of these companies all have a fiduciary duty to run the corporation in such a way as to maximize shareholder return in accordance with the corporations’ Memorandum and Articles of Association. There is some debate as to whether this duty is to the shareholders or to the company itself, but what is certain is that they do not have a fiduciary duty the wider community, the stakeholders, their employees, their customers, or their neighbors. Of course they are bound by the same civil and criminal laws as everyone else, but that is not the same as having a duty t act in anyone else’s best interests.

These days many corporations would argue that they bend over backwards to address the needs and concerns of their stakeholders; that they strive to be responsible corporate citizens. These corporations are not lying; they are speaking the truth, but only some of it. They act, and wish to be perceived, as responsible corporate citizens when doing so has a positive impact on their bottom line. They would in fact be in breach of their fiduciary duty to the corporation and its shareholders if they did not take these actions, with the critical proviso that the cost of doing so must less than the benefit to the corporation.  If the cost of behaving in a corporately responsible manner results in a lesser return than acting within the law but in a manner that would be viewed as corporately irresponsible, then the officers of the company are obliged to put the interests of the corporation and their shareholders ahead of the interests of the wider community. If they don’t they will be in breach of their fiduciary duty and could be sued.

Health insurers are profit making companies. The Officers of the Corporation have a fiduciary duty to their individual corporations’ and their shareholders. These are the interests that they put first. Their first duty is not to maximize the health of the American citizens, except where doing so adds to their bottom line.

Anybody negotiating with them who does not understand this is unlikely to be successful.

Equally a mining company in Nevada has a fiduciary duty to their shareholders not to the people of Nevada. They have a legal obligation to carry out their operations in the manner that complies with the law and produces the biggest profit. If the people of Nevada elect legislators that pass legislation which allows mining corporations to walk away from unprofitable mines without cleaning up the environment, then they should not be surprised if that is what happens.

Don’t get mad at the corporation, get mad at the legislators. The corporation only has to comply with the law, if there are loopholes it has a fiduciary duty to use them if they believe doing so is in the best interests of the company. If the law allows it, don’t be surprised if miners form a corporation, operate a mine in such a manner that all the profits are disbursed to shareholders so there is no money left to pay for the legally mandated clean up, and the state gets stuck with the bill.

Under corporate law, as it stands at the moment, corporations have a duty to lobby for more corporate friendly laws where the cost of the lobbying is justified by the potential return to the corporation. The value to the corporation of corporate friendly law are often enormous, which justifies, indeed requires, significant spending on lobbying.

Quite what Mr Lowe’s view of this would be, we can only imagine.  Have we armed the courts of justice with sufficient powers to check extravagance or roguery in the management of companies? Or have we allowed corporate practice to evolve faster than corporate law?

What might be helpful is to remind ourselves that limited liability joint stock corporations are not a natural creation of God, but invented by 19th century British politicians of questionable ethics and should be treated as such.

This does not mean that all corporations are evil or bad, but it does mean that periodic, systemic review of corporate law is required to ensure that the legal right to limited liability is balanced by legal responsibility in corporate practice. Such a review should have the power to strip certain types of company of their limited liability status if it is being abused. Hedge funds operating without the benefit of limited liability might just take a different approach to risk management. I am aware of the irony that such a review would probably create the all time largest billing opportunity for corporate lobbyists, but that is not reason to avoid it. The feast might be followed by famine.

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