Limited liability: Profit without responsibility

Jomo Kwame Sundaram

KUALA LUMPUR: Limited liability protection for shareholders in joint stock companies was introduced to encourage investments in them. However, it has encouraged irresponsibility, causing much harm while generating profits without responsibility.

Limited liability limits responsibility

Columbia Law School’s Professor Katarina Pistor has extended her critique of the legal system to emphasize the implications of such limited liability. Limited liability encourages shareholders not to pay attention to the harm corporations they invest in may do.

Instead, as emphasized by Milton Friedman, shareholders should focus on returns to investment, and not be distracted by other considerations, especially the notions of corporate social responsibility and stakeholderism.

Chicago University’s Professor Luigi Zingales has emphasized that companies are not just value-neutral institutional or contractual arrangements. Instead, they have obligations to serve the public good or otherwise benefit society, to reciprocate for privileges provided by the state.

“Historically we know that corporations were born as public institutions with a special privilege granted by the state... Even today, ... the privilege of limited liability, especially with respect to tort claims, is an extraordinary privilege granted by the state.”

The limited liability of these companies has allowed them to pursue profits with impunity, and to blatantly violate ethics and moral restraint, with little accountability to other ‘stakeholders’, i.e., with interests in the company’s activities and operations, including their consequences.

Limited liability effectively provides a legal guarantee to prospective shareholders intended to encourage investments in joint stock companies. Legal protection thus exempts shareowners from responsibility for the harm their corporations cause.

Limited liability companies

This amounts to a privileged legal exception granted by the state, effectively tantamount to an economic subsidy. Indeed, limited liability has long lay at the heart of the joint stock company. The corporation itself may face liability, but not shareholders who get to keep the profits they get.

Shareholders can, of course, lose money on their shareholdings, but they also profit without liability even if their companies harm others, cause ecological damage -- e.g., water or air pollution, or greenhouse gas emission -- and deliberately conceal and deny the dangers and costs of corporate practices which may involve corruption or other abuses, whether legal or otherwise.

In effect, shareholders bear virtually ‘no liability’ legally, and have no legal responsibility to other ‘stakeholders’. Unintended beneficial ‘side effects’ or ‘externalities’ for others were acceptable, but corporate governance should not be distracted and undermined by such considerations.

Shareholders are shielded from the consequences of the harm -- or ‘negative externalities’ -- that corporations inflict on others and on nature with the protection of ‘limited liability’. Under this legal dispensation, company shareholders are absolved of liability, regardless of the human and environmental costs caused by their activities, products or services sold.

Hence, limited liability has long been at the very core of their business models. Those running such limited liability companies have been quite aware of at least some of their ‘negative externalities’, or harm they cause, as such externalities are actually at the core of their profit maximizing strategies.

Thus, cost-saving or efficiency considerations typically involve skirting legal regulations, ‘passing on’ or ‘socializing’ costs, minimizing tax exposure, extracting non-renewable valuable resources, otherwise harming the environment, and other ‘socially irresponsible’ conduct.

Off the hook

In case after case of corporate crime, shareholders have been let off the hook: from the 1984 gas leak at the Union Carbide plant in Bhopal, India, which killed hundreds of thousands, to the health consequences of the use of tobacco, asbestos and other toxic and carcinogenic substances.

More recently, shareholders of Boeing, responsible for two airplane crashes in Indonesia and Ethiopia that killed 346 people, made US$43 billion from share repurchases during 2013-2019 when the firm ignored safety standards in order to cut costs. Meanwhile, the families of those who died will be compensated from a US$50 million disaster fund, i.e., about under US$150,000 per victim, much less than 0.2 per cent of the share repurchase gains.

A lawsuit against the Sackler family, which owns Purdue Pharma, the company believed to have profited most from the US opioid epidemic, is trying to hold beneficiaries of corporate misconduct accountable. Apparently, Purdue hired McKinsey as consultants to “turbocharge” opioid sales, willfully encouraging addiction, knowing it would lead to many deaths.

Nevertheless, fearing liability, some family members have reportedly moved much of their money to Switzerland. However, they need not fear as US courts have long protected influential shareholders from the victims of such corporate abuses, a norm unlikely to be reversed by senior judicial appointments in recent years.

Internalising externalities

Limited liability has often been criticised for preventing markets from properly pricing risks posed by corporate activities known to or suspected of causing substantial harm. But this, of course, presumes that assessing and pricing risk and harm by markets is straightforward, unproblematic and uncontroversial.

Property rights, it is claimed, increase efficiency by ensuring that owners bear the costs of the profit-seeking activities their assets are engaged in. Yet, limited liability protects investors from having to bear the full costs of their consequences while retaining profits so generated. Unsurprisingly, shareholders will defend such privileges and resist efforts requiring them to bear such costs.

‘Command and control’ or top-down regulation is dismissed as ineffective, costly and inefficient by the ideology of shareholder market capitalism. Meanwhile, market deterrents, e.g., via taxation, are opposed as governments are dismissed as incapable of setting optimal tax rates.

Shareholders also try to avoid liability by locating assets in safe havens, and by persuading governments to protect them, even threatening sanctions against those seeking to undermine such protection. But laws that allow investors to do harm with impunity also undermine the very legitimacy of the economic and legal system besides the very conditions for humanity’s survival.

Milton Friedman versus stakeholder capitalism

Jomo Kwame Sundaram

KUALA LUMPUR: Milton Friedman was arguably the most influential economist of the second half of the 20th century, associated with promoting ‘neo-liberal’, free-market, shareholder capitalism.

Friedman’s monetarist economics is now widely considered irrelevant, if not wrong, especially with the low inflation associated with ‘unconventional’ monetary policies following the 2008-2009 global financial crisis.

Friedman’s doctrine challenged

Nevertheless, Friedman’s ‘shareholder capitalism’ doctrine remains influential in most financial markets, especially emerging ones in the developing world.

His doctrine, prioritizing short-term profit maximization, has long dominated Anglo-American corporate governance despite chatter about ‘stakeholder capitalism’ and ‘corporate social responsibility’ (CSR).

Chicago University’s Raghuram Rajan claims that long-term share value maximization can advance almost everybody’s long-term interests.

But even Glenn Hubbard acknowledges that long-term shareholder-value maximization cannot address many problems faced by firms, let alone societies. Having served George W. Bush’s conservative administration, he recognizes the need for public policy interventions.

Friedman’s shareholder primacy principle can also become absurd. Rajan’s former co-author Luigi Zingales argues, “if you take Friedman to an extreme, I should sue a CEO who doesn’t buy off all the members of Congress”.

More importantly, Zingales points out that corporations have duties as public institutions with special privileges granted by the state such as “limited liability, especially with respect to tort claims, is an extraordinary privilege granted by the state”, implying reciprocal obligations.

Friedman’s manifesto insisted that companies focus on making money, leaving ethical matters to individuals and government. US law enshrines shareholder rights as owners able to challenge or replace boards whose members stray from their fiduciary duty.

Stakeholder capitalism?

Friedman vehemently opposed stakeholder capitalism, whose proponents argue that companies have responsibilities to all stakeholders, not only shareholders, but also employees, customers, society and even nature.

He argued that ‘stakeholders’, typically ill-defined, will insulate directors from shareholders, reduce their accountability, and compromise corporate performance. This would allow executives to pursue their personal priorities or cover up their own failures.

Straying from Friedman’s singular focus on profit maximization would mean that corporate executives are no longer loyally and exclusively serving shareholders, worsening the ‘principal-agent’ problem.

For Friedman, government and other stakeholders should not be allowed to interfere with shareholder corporate governance in any way, or worse, undermine incentives for investors to risk their capital. In his doctrine, profit alone should be corporations’ sole motive.

Joseph Stiglitz has noted that US courts have ruled that firms are obliged to maximize profits and shareholder value, excluding all other objectives. Hence, ‘stakeholder capitalism’ is not rooted in US law as corporate executives are not accountable by law to the communities in which they operate, or even to society at large, let alone to nature.

What a wonderful world?

Friedman also presumed market imperfections did not exist, or would be fully taken care of by regulation. However, the rule of law has never really been adequate to such challenges.

Thus, he effectively gave companies ‘moral cover’ to be ruthless, free and unregulated to pursue their own interests, at the expense of the public good, while not worrying about society’s larger interests.

Friedman also criticized business leaders for straying from maximizing profits and worrying about their public image, the social good and public welfare.

While dismissing talk of stakeholders as attempts by company directors to be free to run companies as they like, and for public relations, Friedman approved of companies that “generate good will as a by-product of expenditures that are entirely justified in its own self-interest”.

But he was conspicuously silent about business interests lobbying, rigging elections, making campaign contributions, compromising research and public discourse, while reputation laundering with philanthropy and public relations.

Friedman’s world view is remarkably simplistic, typically ignoring broader, ‘longer term’ consequences. For him, business efficiency -- due to shareholder primacy, not undermined by company directors, managers, government taxes and regulations -- can and will solve all problems.

Stakeholderism challenged

Friedman’s neoliberal ‘doctrine’ shaped major economic reforms the world over from the 1980s until the 2008-2009 global financial crisis. Lacklustre growth since then has given rise to various new challenges to shareholder capitalism, not least in the name of other stakeholders, and appeals for corporate governance reform and CSR.

Multi-millionaires, even some billionaires and chief executive officers (CEOs), have joined the dissent, whom influential businessman writer Andrew Ross Sorkin would have us believe represent the future.

To be sure, many have undoubtedly turned away from Friedman’s thinking in recent years.

In 2019, the influential Business Roundtable, which had long advocated shareholder primacy, issued a pro-stakeholder statement. It replaced its Friedmanite Statement on the Purpose of a Corporation with “a fundamental commitment to all of our stakeholders”.

A few months later, the World Economic Forum issued a similar 2020 Davos Manifesto, embracing stakeholder as well as environment, social and governance (ESG) principles.

Nevertheless, legendary investor Warren Buffett remains sceptical of ‘purpose-over-profit’ stakeholder advocacy. “In representing your interests, business-savvy directors [will] seek managers whose goals include delighting their customers, cherishing their associates and acting as good citizens of both their communities and our country.”

Meanwhile, most advocating a stakeholder approach to corporate governance argue that considering the interests of employees or other stakeholders is good for company profits and shareholders. Yet, they privately acknowledge that profits must come first, even if they feel constrained to say so in public.

Corporate social responsibility?

Some argue they are defending capitalist free enterprise in the long term by having a ‘social conscience’ and taking responsibility for providing employment, avoiding pollution and pursuing other trendy CSR reforms, ostensibly in companies’ ‘enlightened self-interest’.

Others insist that many contemporary problems are too urgent for slowly meandering political processes. Instead, they argue, CSR “is a quicker and surer way to solve pressing current problems”.

CSR is said to be a useful, if not necessary complement to government policy and regulation. Friedmanite critics object that CSR involves spending shareholder money for a typically vague public interest, reducing company returns and spending ‘other people’s money’.

Friedman warned that the doctrine of ‘social responsibility’ would take over if not checked. But the converse is more true today as ‘greed is good’ and the ‘short-termist’ shareholder mentality is clearly hegemonic.

Others object that CSR involves the ‘socialist’ view that political, not market mechanisms are better for allocating scarce resources to alternative uses. But CSR has also been invoked to justify wage curbs against trade union demands, ostensibly for some higher public purpose.

CSR has also been invoked when philanthropy and charity have been abused to minimize tax liability, and for public relations and marketing, e.g., by ‘greenwashing’ products and services.

W(h)ither capitalism?

Embarrassingly, US corporations that signed the ‘stakeholder capitalism’ statement have been more likely to lay off workers in response to the COVID-19 pandemic, and less likely to donate to relief efforts.

With growing opposition to neoliberal capitalism, ‘stakeholderism’ and CSR have been invoked to save capitalism by offering a more sensitive ‘human’ face.

As capitalism may well be the only ‘show in town’ for some time to come, popular demands for more thoroughgoing reforms, checks and balances are likely to grow as the realities of stakeholder capitalism and CSR become increasingly apparent.

Stop blaming industrial policy

Vladimir Popov, Jomo Kwame Sundaram

BERLIN, KUALA LUMPUR: Industrial policy – or the promotion of particular investments, technologies, industries, regions and enterprises – has been practiced by a variety of governments to try to accelerate economic growth and transformation.

The ascendance of the Washington Consensus, inspired by the neoliberal counter-revolution in economics, focused on alleged national macroeconomic mismanagement in developing countries and later, transition economies. This was typically blamed on ‘soft budget constraints’ (SBCs) in socialist states and enterprises, macroeconomic populism and industrial policy.

Blaming industrial policy

Enterprise-level SBCs have also been wrongly blamed on industrial policy to promote certain economic activities, usually manufacturing with more advanced technologies. In practice, most industrial policy was quite selective, i.e., involving support of some industries, regions and enterprises at the expense of others.

While such selective support may or may not have been successful in promoting targeted industries, industrial policy has been wrongly, and sometimesdeliberately blamed for both enterprise and national level fiscal SBCs. Fiscal SBCs have been wrongly blamed on enterprise-level SBCs in socialist states, macroeconomic populism and industrial policy.

But contrary to many economists’ presumptions, in most economies, including many centrally planned ‘socialist’ ones, few enterprises were exempted from budgetary discipline. SBCs were therefore the very rare exception, not the rule, to promote desired new economic activities.

Enterprise-level SBCs did not “permeate all organizations” in socialist countries, as often claimed and assumed, but were instead quite selective, i.e., subsidies were provided to some enterprises, industries or regions, typically at the expense of others.

All centrally planned economies had both explicit and implicit subsidies. In most Eastern European and Soviet countries during 1989-1992, on the eve of transition, direct subsidies in the government budget amounted to 10-15% of national income.

In addition to direct subsidies for public utilities, housing and food, there were implicit price subsidies, particularly for users of fuel, energy and raw materials. Besides explicit subsidies from government budgets, rents from unsustainable, non-renewable resource extraction were shared with industries and consumers via lower prices.

Dwarf infant industries

The fiscal problem was not due to subsidization per se, or even to subsidization of manufacturing – at the expense of resource industries, trade and financial services. Rather, the problem was in the way such subsidization was carried out, i.e., by maintaining higher domestic prices for manufactured goods.

Such import-substituting industrialization (ISI) typically created industries which rarely became internationally competitive and viable. There have been all too many examples of failed ISI requiring ongoing subsidization of ‘infant industries’ incapable of ever becoming internationally uncompetitive.

These industries were exposed as unviable and unsustainable with trade liberalization and the end of Soviet era trade arrangements in the 1990s. Soviet industrialization from the 1930s had survived before that due to its insulated economic environment, with the ratio of Soviet exports to GDP not rising until fuel sales abroad rose with higher prices from the 1970s.

Perestroika reforms, initiated by reformist Soviet leader Gorbachev after the mid-1980s, failed to accelerate needed enterprise reforms or economic growth, but instead led to the ‘transformational recession’ of the 1990s, greatly exacerbated by the reforms during Boris Yeltsin’s first presidential term.

Many other enterprises – mainly in heavy industries, and often relying on Soviet technology, advice and aid – in other ‘socialist’ economies and developing countries subject to Soviet influence, experienced similar fates.

Thus, nations which tried to challenge Western hegemony met similar fates despite trying to make a virtue of ‘self-reliance’ compelled by the need to cope with Western-led trade and investment sanctions.

Successful industrial policy

Most countries trying to industrialize or to accelerate industrialization started with ISI, with effective protection enabling new enterprises to produce for domestic markets by keeping out imported foreign substitutes with prohibitively high tariffs and non-tariff trade barriers.

But many IS enterprises continued to survive, even profit from such supposedly temporary tariff protection and other government support, never becoming internationally competitive as promised by the ISI strategy.

In more successful ‘late developing’ economies, government support was conditional on meeting performance criteria which effectively attracted private investments. Such investors sought more handsome ‘rents’ by accelerating technological progress, productivitand international competitiveness.

Thus, for example, ‘effective protection conditional on export promotion’ enabled the emergence of internationally competitive enterprises in some East Asian economies. Export orientation has been especially important in improving output quality to meet internationally competitive product quality and performance standards while achieving cost competitiveness.

Without more effective means for disciplining enterprises to accelerate development, export-orientation – promoted by government policy, incentives and other support – has contributed to successful catch-up growth. East Asian economies subsidized competitive export-oriented industries which accelerated economic growth and transformation, some more successfully than others.

In China, for instance, exports compared to GDP increased from 5% in 1978 to 35% in 2006, before declining to 20% in 2018, while its GDP grew at an average of 10% annually, with its population rising slower than in most other developing countries due its ‘one child’ policy.

Appropriate industrial policy needed

Budget constraints in socialist economies were generally stronger than in developing countries and no less strict than in developed countries on average. SBCs in socialist economies were never pervasive, as widely believed, but selective, i.e., subsidizing some enterprises or industries at the expense of others.

Such selective support, while typical of industrial policy, may or may not successfully promote internationally competitive enterprises, but certainly provides no empirical support for the claim of pervasive SBCs in ‘socialist’ economies.

With state-owned enterprises, strict fiscal and enterprise-level discipline, including budget constraints, have led to restructuring, and more rarely, closures. But even when budget constraints have been less than strict, they have not been pervasive, as fiscally disciplined ‘socialist’ economies could not afford otherwise.

National-level macroeconomic mismanagement in developing countries and transition economies has all too often by ideologically defined by neoliberal economics. In so far as macroeconomic challenges are real and demand pragmatic policy attention, they should not be defined by distracting neoliberal chimera of alleged SBCs variously blamed on socialism, populism and industrial policy.

Unfortunately, the mythology surrounding SBCs has been used to throw the industrial policy baby out with the bathwater of ISI cul de sacs. Much more appropriate, yet pragmatic industrial policy is needed for developing countries and transition economies to ‘catch up’, as achieved by some East Asian and other economies.