26.

Limited Liability Companies

Nicholas Murray Butler was one of the thinkers of his age: a philosopher, Nobel Peace Prize winner, and president of Columbia University. In 1911, someone asked Butler to name the most important invention of the industrial era. Steam, perhaps? Electricity?

No, he said: They would both “be reduced to comparative impotence” without something else—something he called “the greatest single discovery of modern times.”1 That something? The limited liability corporation.

It seems odd to say the corporation was “discovered.” But corporations didn’t just appear from nowhere. The word “incorporate” means take on bodily form—not a physical body, but a legal one. In the law’s eyes, a corporation is something different from the people who own it, or run it, or work for it. And that’s a concept lawmakers had to dream up. Without laws giving a corporation certain powers—to own assets, for example, or to enter into contracts—the word would be meaningless.

There were precursors to modern corporations in ancient Rome,2 but the direct ancestor of today’s corporations was born in England, on New Year’s Eve, in 1600. Back then, creating a corporation didn’t simply involve filing some routine forms—you needed a royal charter. And you couldn’t incorporate with the general aim of doing business and making profits. A corporation’s charter specifically said what it was allowed to do and often also stipulated that nobody else was allowed to do it.

The legal body created that New Year’s Eve was charged with handling all of England’s shipping trade east of the Cape of Good Hope, near the southern tip of Africa. Its shareholders were 218 merchants. Crucially, and unusually, the charter granted those merchants limited liability for the company’s actions.

Why was that so important? Because otherwise, investors were personally liable for everything the business did. If you partnered in a business that ran up debts it couldn’t pay, its debtors could come after you—not just for the value of your investment, but for everything you owned.

That’s worth thinking about: Whose business might you be willing to invest in, if you knew that it could lose you your home and even land you in prison? Perhaps a close family member’s; or at a push, a trusted friend’s. Someone you knew well enough, and saw often enough, to notice if they were behaving suspiciously. The way we invest today—buying shares in companies whose managers we will never meet—would be unthinkable without limited liability. And that would severely limit the amount of capital a business venture could raise.

Back in the 1500s, perhaps that wasn’t much of a problem. Most business was local, and personal. But handling England’s trade with half the world was a weighty undertaking. The corporation Queen Elizabeth created was called the East India Company. Over the next two centuries, it grew to look less like a trading business and more like a colonial government. At its peak, it ruled 90 million Indians. It employed an army of 200,000 soldiers. It had a meritocratic civil service. It even issued its own coins.

And the idea of limited liability caught on. In 1811, New York State introduced it—not as an exclusive privilege, but for any manufacturing company. Other states and countries followed, including the world’s leading economy, Britain, in 1854.

Not everyone approved: The Economist magazine was sniffy, pointing out that if people wanted limited liability, they could agree to it through private contracts.

As we’ve seen, nineteenth-century industrial technologies such as railways and electricity grids needed capital—lots of capital. And that meant either massive government projects—not fashionable in the nineteenth century—or limited liability companies.

And limited liability companies proved their worth. By 1926, The Economist was gushing that the unknown inventors of limited liability deserved “a place of honor with Watt, Stephenson and other pioneers of the industrial revolution.”3

But as the railway mania demonstrated, the limited liability corporation has its problems.4 One of them was obvious to the father of modern economic thought, Adam Smith. In The Wealth of Nations, in 1776, Smith dismissed the idea that professional managers would do a good job of looking after shareholders’ money: “It cannot well be expected that they should watch over it with the same anxious vigilance with which partners in a private copartnery frequently watch over their own.”5

In principle, Smith was right. There’s always a temptation for managers to play fast and loose with investors’ money. We’ve evolved corporate governance laws to try to protect shareholders, but as we’ve seen, they haven’t always succeeded.

And corporate governance laws generate their own tensions. Consider the fashionable idea of “corporate social responsibility,” where a company might donate to charity or decide to embrace labor or environmental standards above what the law demands. In some cases, that’s smart brand-building, and it pays off in higher sales. In others, perhaps, managers are using shareholders’ money to buy social status or avoid the inconvenience of being personally targeted by protesters. For that reason, the economist Milton Friedman argued that “the social responsibility of business is to maximize its profits.” If it’s legal, and it makes money, they should do it. And if people don’t like it, don’t blame the company—change the law.6

The trouble is that companies can influence the law, too. They can fund lobbyists. They can donate to electoral candidates’ campaigns. The East India Company quickly learned the value of maintaining cozy relationships with British politicians, who duly bailed it out whenever it got into trouble. In 1770, for instance, a famine in Bengal clobbered the company’s revenue. British legislators saved it from bankruptcy by exempting it from tariffs on tea exports to the American colonies. Which was, perhaps, shortsighted on their part: it eventually led to the Boston Tea Party, and the American Declaration of Independence.7 You could say the United States owes its existence to excessive corporate influence on politicians.

Arguably, corporate power is even greater today, for a simple reason: in a global economy, corporations can threaten to move offshore. The shipping container and the bar code have underpinned global supply chains, giving companies the ability to locate key functions wherever they wish. When Britain’s lawmakers eventually grew tired of the East India Company’s demands, they had the ultimate sanction: in 1874, they revoked its charter. A government dealing with a modern multinational must exercise influence far more carefully than that.

We often think of ourselves as living in a world where free-market capitalism is the dominant force. Few want a return to the command economies of Mao or Stalin, where hierarchies, not markets, decided what to produce. Yet hierarchies, not markets, are exactly how decisions are taken within companies. When marketing analysts or accounts payable clerks make decisions, they’re not doing so because the price of soybeans has risen. They’re following orders from the boss. In the United States, bastion of free-market capitalism, about half of all private-sector employees work for companies with a payroll of at least five hundred.8

Some argue that companies have grown too big, too influential. In 2016, Pew Research asked Americans if they thought the economic system is “generally fair” or “unfairly favors powerful interests.” By two to one, unfair won.9 Even The Economist worries that regulators are now too timid about exposing market-dominating companies to a blast of healthy competition.10

So there’s plenty to worry about. But while we worry, let’s also remember what the limited liability company has done for us. By helping investors pool their capital without taking unacceptable risks, it enabled big industrial projects, stock markets, and index funds. It played a foundational role in creating the modern economy.