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Transcript: Is the Limited-Liability Corporation a Great Free-Market Device?

By Vinay Kolhatkar

January 17, 2024

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Date of recording: November 22, 2023, The Savvy Street Show

Host: Roger Bissell. Guest: Vinay Kolhatkar

 

Editor’s Note: The Savvy Street Show podcast transcripts may get edited for removal of repetitions, pause terms, and for clarity. References are added in parentheses. Material edits are advised to the reader as edits.

 

Roger Bissell

Is a corporate device essentially pro-capitalism, pro-the free market?

Welcome everybody to this new episode of The Savvy Street. And this is a new experience for all of us. I am your host this evening. My name is Roger Bissell and our guest and victim of my relentless questioning is our own Vinay Kolhatkar. And he has a very interesting subject he’s going to speak on and answer some questions. Is a corporate device essentially pro-capitalism, pro-the free market?

Well, that’s a good question right off the bat. And so let’s just start with that. And I do have a follow-up to that, but it’s not a gotcha follow-up. It’s just a flip side of the question. So go ahead Vinay and tell us your thoughts on that.

 

Vinay Kolhatkar

Okay, well, thank you for having me on the show on the other side. A corporate device, to put it very bluntly and in short, enabled enormous large-scale economies of scale, when it was coupled with limited liability, which I’ll come to very shortly. So in the beginning, you had sort of let’s say ancient Greece where if a man couldn’t pay off his debts, he became kind of a lifelong slave trying to repay his debts. Not technically a slave, but he was in debt all the time and his creditors became masters and if he couldn’t repay it, his wife, his children, everyone got trapped under a mountain of debt. A very sorry state of affairs.

Then we had joint stock corporations where the shareholders of those corporations were liable for beyond what they risked in that venture. So you start a shipping company, the ship sinks, it’s the Titanic, and you might have put in several million dollars already, but then you’re up for another tens of millions of dollars that could bankrupt you. That device was not a great idea for corporations to grow. Firstly, a whole large middle class, even poorer-than-middle-class people can now own shares in limited-liability corporations. So limited means the liability is limited to what they have invested. At worst, those shares would drop to zero and they get nothing back. But what doesn’t happen is…

You know, you’ve got a mortgage and you and your wife have worked very hard. You paid off the mortgage in 35 years and then you bought, I don’t know, $700 worth of shares in a mining company. And all of a sudden you got creditors banging on your door, taking away your house and cars and everything you own because the corporation committed a mistake.

It’s not a corporation that you’re an executive or a director of. You have no control of how it is run. And that’s a terrible situation. So there is this device under law in virtually every jurisdiction in the world that I know of, which is to form a limited-liability corporation. You can also form a general partnership in most jurisdictions, where the liability doesn’t stop at the amount invested.

In a [general] partnership, they can invade your personal assets. You can opt to do that. It’s a choice. It’s a free market choice. But what the free market has found is that the limited-liability corporations became very large, very multinational. To give you a little instance, you know, the market capitalization of a company is not exactly its net assets because it’s a judgment by the market of what the company is worth. [Roger Bissell: Right.] And it can differ very significantly from the book net assets in the accounting statement. But today, you know, Microsoft and Amazon (Amazon was corrected to Apple in the next episode), to my belief, are very close to $3 trillion in market cap.

Alphabet, the parent company Google is one and a half trillion. There’s Saudi Aramco, I think in third position, Google or Alphabet is number five. Amazon is number four for 1.7 trillion or thereabouts of market capitalization. But the share prices move every day. Now you compare that with the GDP of someone like Japan and Germany, they’re in the four trillion mark. The United Kingdom and France, they’re around the three trillion mark. India is also around the three trillion mark. So you have corporations the size of very, very large countries. So only China at 17 trillion and the United States at 25 trillion are still significantly above the large corporations. So it has been good for capitalism, this device.

In 1976, we had, what I think is a brilliant paper which should have won the authors a Nobel Prize. It is the most popular paper in the theory of the corporation.

And the reason I also say it’s pro individualism is that you’ve got to understand the nature, the true nature of the corporation. Milton Friedman once said that the corporation exists only for their shareholders and to earn a profit. And he was opposed by John Mackey of Whole Foods and a whole lot of other people.

I believe Mackey was completely wrong when he said, “No, it actually exists for everyone, including its executives and investors. The executives are entrepreneurs. And we, as in Whole Foods, we hired our investors.”

And there’s a gentleman by the name of Roger Donway and you might know him. He wrote an article in which he stated: “Where is Howard Roark in all this? Where does Howard Roark fit in? Where is this…if the executives are mere servants of the shareholders, where is the entrepreneurial vision? Maybe Mackey’s right.”

And in actual fact, neither Donway nor Mackey are right. And even Friedman was partially right. Friedman was interpreted by the New York Times as saying, “the executives are servants of the shareholders,” but he didn’t actually say that. He just said the duty of the executives is to earn a profit and that’s their only duty. But in following that duty, you automatically have to assuage and look after your other stakeholders. I mean, let me take an illustration. Let’s say you have an aluminum extrusion company and you depend…for those aluminum products, the raw material is aluminum, say, all of it you get from one provider, say Alcoa. Well, you got to keep them on your good side. You got to negotiate long-term contracts, meet them often, you just got to do it because if you lose them, you lost your business. So it’s part and parcel, keeping employees satisfied and happy, keeping at least the key ones, keeping customers happy is all part of the same game of earning a good return.

Then, in 1976, we had, what I think is a brilliant paper which should have won the authors a Nobel Prize in Economic Finance. It is the most popular paper in the theory of the corporation. And it’s a paper by Jensen and Meckling, Robert [later corrected to William] Meckling, Michael Jensen.

Among other things, this paper says that the corporation is a nexus of contracts.

Among other things, this paper says that the corporation is a nexus of contracts. So you have this ABC limited and it’s a limited liability public corporation say, but that entity is able to contract with directors, shareholders, investors, suppliers, employees, the whole lot. Now remember in a public company that is listed on the stock exchange, the shareholders are constantly moving around by buying and selling, and neither do they have any control over the corporation. So someone’s got to stand in for the corporation. And it doesn’t matter if the shareholder body changes daily. You get all these synergies in that corporation. Neither do they [the directors] have day-to-day control of the corporations. So you get all these synergies in that corporation but each individual contract, if we have free contracting in the free economy, each individual contract is negotiated between two or more parties.

Parties might be the legal entity corporation and the cleaning company, which sends cleaners every night to clean the office. So now the legal entity has to be represented by certain employees, executives who are themselves also contracted on a salary, bonuses, conditions of employment basis with that legal entity. So that’s how that nexus of contracts actually works and it comes together. I think it’s a really brilliant insight. It’s individualistic because each individual that deals with the company has every right to negotiate that contract and walk away from it. Depending on the terms of contract, you may have to give a three-month notice if you’re a key employee, but that’s what you signed up for.

So nobody’s a slave, nobody’s superior, nobody’s master, nobody’s a servant. Investors are not servants, like Mackey said.

If an executive has a brilliant vision, say if you had a brilliant vision of a new metal like Henry Rearden, Rearden metal, and you have a patent, you have a process, but you don’t have the means to construct a factory that can deliver a hundred tons of the metal every day.

So you go to investors, sell them your business idea, you contract with them, negotiate with them, and they’re neither your masters nor your servants. So everybody’s different, everybody’s free, contacting person. That’s how it’s pro-individualism.

 

Roger Bissell

So I do see the individualistic aspect of it. Everybody is a free agent.

I see my own career as a freelance musician very similarly. I think of myself almost like a CEO, and I have all these contracts with different people who hire me for this engagement or that engagement or this project and so on. So I do see the individualistic aspect of it. Everybody is a free agent. They can deal or not deal. The difference is that if I do something wrong, wham, you know. I’m [done] unless I have an LLC, which I shouldn’t say this, but I don’t have one. But I think the LLC is almost like GoFundMe, in a way. It’s like saying, well, you know, I really need some money, so would you please give me some money? And then everybody chips into GoFundMe, and then you’ve got a bunch of money. And those people who sent you money on go fund me, they’re not going to be legally liable in case you take the money and use it to commit some heinous crime. You know, it’s just, easy come, easy go. They are only out the amount of money they gave to GoFundMe, which they thought was for a good purpose, but it turned out to be misused. So otherwise, I really do see the advantage in letting investors not be on the hook for that for whether if the business isn’t run well…I’m sorry, go ahead.

 

Vinay Kolhatkar

But let me just clarify one thing. If you misuse the funds on the GoFundMe and you go buy a nice new car instead of producing some music or whatever, yes, the investors have a right to sue you and recover their money. And it’s the same in a corporation. If the funds are misused, the executives can be sued for what we call in at law bad boy acts: deceit, fraud. [Roger Bissell: Oh.] They can be sued and they have been sued many, many times and investors get some money back depending on how much is left.

 

Roger Bissell

Well, if there’s any left. But what about Enron, for instance?

 

Vinay Kolhatkar

There is a fiduciary duty at law to do the right thing by the shareholders and you cannot escape that.

Well, the Enron executives did land in jail and so executives and directors are always liable for negligence. There is a fiduciary duty at law to do the right thing by the shareholders and you cannot escape that. What you couldn’t do generally is to go home into the, you know, Enron CFOs and CEOs house and grab their individual assets. Unless, and that’s the big one, unless there has been deceit on a large scale in which you can enjoin them at a personal level into the lawsuit, which becomes quite complicated. But that has happened. I mean, in Australia, for instance, directors are personally liable for the debts taken on of a corporation if they had a suspicion that the corporation was already insolvent and could not repay its debts. So there are very stringent laws.

 

Roger Bissell

So have we already answered my next question? I was going to ask if putting a legal limit on liability under anything less than the corporation’s total assets, potentially, doesn’t that invite risky or even potentially dangerous or fraudulent behavior?

 

Vinay Kolhatkar

It can, but why would you say so? I mean, there are individual sophisticated creditors who agree with individual corporations in a free market saying, I’m going to lend you X money. And my only collateral is this mine here. And let’s say it’s a mining conglomerate. And a lot of companies will fund [through] special recourse companies only. So they have a subsidiary which only controls one copper mine in Argentina, for instance. And you as a lender have access only to that mine if things go wrong and not to the entire company. But it’s a matter of negotiation. You might agree to that. And as, as again, if the business simply fails, it’s a risk you take as a banker.

But if the business fails because you were deceived, you have other legal avenues to chase down your money.

 

Roger Bissell

Okay. Many years ago, I hate to say how many, I had the opportunity to hear Robert Hessen, who is kind of a historian and he also writes on economic related issues. At that time or before then perhaps he was associated with Ayn Rand.

And one or two of his pieces are even in the book she wrote on capitalism. And he himself wrote a book called In Defense of the Corporation. And there was an attack on limited liability by some economists. I think Murray Rothbard [corrected in part two] made an attack on it. And the idea was it was a grant of monopoly privilege. It was a grant or it was a grant of exemption from full responsibility for the damage you might cause. And, and he said that if there’s laws that mandate limited liability, this is not a good thing, but if limited liability is something that is negotiable as an option to business, then that was good. And so in fact, in effect, he was denying or he was rejecting that, uh, that critique that Rothbard I think is the one was making. So do you have a comment on that?

 

Vinay Kolhatkar

There is no legal privilege granted by the government. There is no monopoly right granted by the government.

I do. Firstly, there is no legal privilege granted by the government. There is no monopoly right granted by the government. All we have at law is we have different structures. You can be like Howard Roark, a sole proprietorship. You can be a general partnership where you allow your creditors to invade your home, so to speak, your personal assets beyond the assets of the partnership. And you may be compelled to do so because the partnership is small and you can take the money out of the partnership. If you are forming a whole new company with limited liability, with a bunch of other, you know, entrepreneurs, the banks may insist if you go to them for a loan to get some security from your personal assets because the company is so brand new, it just doesn’t have enough assets for them to be happy. And then we have a limited-liability corporation. Some of them are very large, like Pfizer has, I believe somewhere around 250 billion in assets.

And the banks couldn’t care less if they have somebody else’s car or house in addition to the 250 billion. When we’re talking large corporations, their assets are generally more than suffice for recovery of your debts. If you’re a smart lender, unless you have been deceived, and if you, like I said, if you have been deceived, there are avenues at law to raise the corporate veil and go behind, sue the directors, sue the executives.

So the corporation is, I want to give you a new definition actually of the corporation because Jensen and Meckling had this fantastic insight. And they say the corporation is a nexus of contracts. And my definition only applies to a publicly limited, privately-owned corporation. Doesn’t have to be even privately owned. [Roger Bissell: Okay.]

So I’d say a corporation is a synergistic bundle of contracts, alienable from the current owners whose liability is limited to the sunk cost or the investment.

So I’d say a corporation is a synergistic bundle of contracts, not just a bunch of contracts, but it’s a synergistic bundle of contracts. Alienable from the current owners whose liability is limited to the sunk cost or the investment that’s already contracted for. So if they’re partly paid-up shares you got a contract for, then you got to pay up the remainder, and it’s assignable as a bundle. So when I say it’s…It’s alienable from the current owners. It’s liabilities are limited to the sunk amount. And it’s assignable. So when I say it’s alienable from its current owners, I mean shareholders, who are the owners, are changing every day on the stock exchange. [Yet] you can sell the company, and it’s got its synergy within itself. It should be synergistic and the assignment bundle is what the corporation is that’s being sold. So it’s kind of a more detailed definition of cooperation. And you can see that there is a lot of synergy in the bundle of contracts, economies, and so on. It says, really, for yourself, your career is a synergistic bundle of projects consistent with a long-term professional vision of yourself. If it is consistent, say if you’re a truck driver for six months, a music recording artist by night and then you have a schoolteacher job in mathematics, where is the synergy? But if you are synergistically building your career, that should be good for you.

 

Roger Bissell

That’s really smart. I like that definition. Good job. Speaking of Pfizer, though, and speaking of how a person who has been harmed, there is the issue of: can you actually get. Redress at law in a practical sense? I mean, if the mechanism exists, there are still sometimes so many hoops to jump through and do you have standing? How do you get satisfaction? And I was wondering about the recent pandemic issue, and the zero liability that the U S government gave to Pfizer and Moderna on the premise that everything was done completely scrupulously, but they just didn’t have time to do it in the…there was not five years to work with. They wanted the vaccines in five or six months. And so they said, well, we can provide it, but we can’t guarantee you that it’s going to be completely great. And so we need to be off the hook for this because otherwise it could destroy us. So the government said, okay, sure. And as long as you’re being honest with us and there’s nothing that we should know that we don’t know about, then fine. But now more details are coming out. And so what I’m wondering is since there is opening up the possibility for such lawsuits now and not just a hypothetical, but there are injured people. How do they get, how do they get what they need? Which they wouldn’t have gotten if everything were just simply zero liability, and everything was scrupulous. If that’s not too wordy a question, go ahead.

 

Vinay Kolhatkar

Okay, I’ll unpack the several questions in that one question. So I’ll unpack them and answer them one by one. [Roger Bissell: Right, right. That’s what I do.] So firstly, we are digressing from the limited liability aspect of the corporation. This was a historic world first of granting an indemnity to a corporation of zero liability. Whereas Pfizer would be [otherwise] risking their $250 billion of assets. So if a million people got injured and they were able to show that in a court of law and they each deserved half a million dollars each, if my mathematics is correct, in the top of my head, Pfizer would have to pay [$500 trillion] roughly and you won’t be able to get that. There is another government scheme, as I understand it, but people have found it extremely difficult to gain any compensation from them. And that’s got nothing to do with the limited liability of a corporation. It’s the government scheme. Where the difficulty lies, as far as I know, is proving the vaccine caused that.

 

Roger Bissell

What made it difficult for me, you know, there are a number of diseases that happen without a vaccine. How do you prove that in your body it was the vaccine that caused it? And that’s not easy.

 

Vinay Kolhatkar

The other aspect to this is, you’re right, I believe. I mean we weren’t party to that negotiation, but I believe that you know the vaccine manufacturers saw an opportunity. They said, look, it normally takes us six to eight years. You can wait six to eight years but if you want a vaccine in six to eight months you indemnify us, and so the government did, which I think it was a huge mistake on their part, especially because there were a number of simple inexpensive remedies that held a big promise. You know, there was the HCQ and Zinc, there was Methylene Blue that was claimed to cure several viral diseases and COVID in some other parts of the world. There was Ivermectin. And then there’s another South American solution. So none of them got a fair trial. Everybody in government assumed that the only hope for humanity is a fast-tracked mRNA vaccine by the big pharma manufacturers. And so they gave in. But here’s where we are at the moment.

I presume you can also try and get a lawsuit against the government on a different basis, which is to do with the lack of aspiration [of hypodermic needles prior to injection] that the government encouraged, which may have contributed to injuries, if not wholly caused them. So it was no aspiration before vaccination, which the manufacturers didn’t recommend. It’s the government who did that, right?

Again, it’s going to be very hard to prove in court. That’s the problem.

 

Roger Bissell

Haven’t corporations gotten much larger than they would have in a limited government, a small, limited government setting?

Well, all right. This is a wild card question. So we have about five minutes to go here, and I think you would have plenty to say on this, but you haven’t heard this question yet. So this is not on our list. Haven’t corporations gotten much larger than they would have in a limited government, a small, limited government setting? We know there’s a lot of fiat money, welfare state spending, subsidies, credit money creation. Isn’t this a wasteful system that subsidizes larger businesses at the expense of small and medium sized ones? And isn’t the advantage of scale that you mentioned earlier, at least in large part an artifact of massive government involvement in the economy? Before 1900, when the progressives and the big business started getting cozy with each other, the politicians and the corporations, did such large entities exist to the extent that they do today?

 

Vinay Kolhatkar

Okay, good question. There are two offsetting effects. And the first effect is there’s hubris in government. And as the government gets larger, they want money from big corporations to run their World Economic Forum type NGOs to finance their campaigns. And so it is in their interest in a sense, not in their rational interest, but it is in their interest to gain more power and more fame and prestige for themselves, to invite corporations to become cronies, they wield more power. When they wield more power, big corporations also use that power. For instance, the bigger airlines wanted to have extra regulations to prevent the small airlines from entering into the business and therefore there was a barrier to entry, in which the government helped the big corporations. But the solution is not to do away with the limited liability of a corporation. The solution is to do away with the government involvement in the economy. I think the United States needs a 28th amendment, which says Congress shall take no part and or get involved in the economy, [Roger Bissell: Right.] health, education, and you can add a whole lot of to that. Then, then we have a really truly free economy. And mind you, one of the other things that governments have done is their so-called anti-monopoly practices. Rand mentions they attacked Alcoa, they did attack Microsoft. [Roger Bissell: Right.] They can attack large corporations and force a breakup in those corporations too.

The more efficient, the good ones would have become even larger, I suspect. And the bad ones that are cronies wouldn’t have become as large.

So would they have been larger? , which would have been good for the economy. The size of a corporation itself is not a threat. They said, okay, if Apple has got three trillion market capitalization, so what? I mean, you know, the federal budget now on the spending side of the US budget is $6 trillion. I mean, that’s too much, certainly. And we shouldn’t be worried about corporate size at all.

 

Roger Bissell

I had another question which is very closely related, and I think you partly answered it, but I’ll just toss it out here toward the end. Don’t corporations have a temptation to use connections they would have with the government, particularly the federal government, to outlaw low-cost alternative technologies? And I’m thinking, not only in the energy industry, but also in medicine and agriculture, isn’t there a tendency to put their research and their expenditures more on products that they have some reason to expect that the politicians would want to mandate like vaccines rather than the market? In the market, we have all these low-cost things that we were forbidden to use, and doctors were forbidden to prescribe during the pandemic. But in a market, a free market, people would have been able to choose what they wanted.

 

Vinay Kolhatkar

Okay, and it’s a good question. Ask yourself, who was interfering in the market? Who was saying, well, the doctors can’t even prescribe this. On paper, the pharmaceutical industry had no such power to stop you from going to the local chemist, buying Ivermectin from your local physician, from prescribing it. It’s a government orchestrated scheme of interference in the free market. And so it’s not about cutting Pfizer down to size, it’s about cutting the government off the economy. So then, you know, you each person has a choice maybe for the elderly, especially taking the Pfizer vaccine, despite the side effects, as long as you took it with aspiration was the right thing to do. In addition to stocking their cabinet with whatever, either Ivermectin or whatever. And maybe for some especially younger people should have stayed away from it, but every human being should have had a free choice. And the choice was taken away by the government, not by Big Pharma.

 

Roger Bissell

So what you’re saying is, I think, is that when government is doing something other than what it really should be doing, it’s just a gigantic moral hazard.

 

Vinay Kolhatkar

Absolutely. That’s really where the hazard comes from. There’s absolutely no hazard in limited liability. I mean, I was in banking/investment banking/funds for about 25 years. And it was a matter of routine when you were dealing with large corporations. Nobody remotely thought, oh, there’s a bunch of assets, some more that we can go after. Because remember, I wanted to emphasize this phrase, there is actually no such thing as unlimited liability. And I’ll explain that shortly. What limited liability means is the liability of a corporation is limited to its assets, so you can’t sue the directors unless they’ve done something wrong and you can’t bring a personal lawsuit against them for a business failure that occurred out of just bad judgment, you know, we can’t predict the future. Some businesses fail. So if the business fails for legitimate reasons, you can’t go and grab the director’s car and the executive’s house and other things. Not that those are meaningful in a large corporation anyway.

Now, even if you had a partnership and you could grab the partner’s assets, if you think there’s a class action that is entitled to a trillion dollars in damages, they won’t get it. We don’t live in ancient Greece. We live in a civilized world where someone can seek bankruptcy and have their debts dissolved, including corporations can and individuals certainly can. Your debts don’t pass on to your children and then you start your life anew, you know, in that context.

Let me mention Donald Trump. He, as far as I know, he has never, ever filed for personal bankruptcy. He’s used the US bankruptcy code four times, but in respect of his resorts and hotels and casino businesses. And he’s used, as far as I know, a Chapter 11 restructuring, which is a court-mandated restructuring, which is a real drawback of the US system, because here in Australia and the UK, we don’t have Chapter restructuring, a court-mandated restructuring. The bankers, the creditors, and the owners, and they get together and negotiate a restructuring anyway. We don’t need the court to oversee them. But it is what it is. So yeah, that was my concluding comment on that.

 

Roger Bissell

Yeah. Well, by the reasoning that you’ve given here, it sounds like there’s not really any such thing as unlimited government either, that everything in the universe is inherently limited, but it’s just a matter of how tightly or loosely limited it is. And I think that’s more of the concern, not that, you know, corporations are where their liability is going to explode to infinity, but just that it may become more than their assets and they’d be wiped out. And, and if they’re unscrupulous, then maybe being wiped out would be what the doctor ordered.

 

Vinay Kolhatkar

Their liability is not really limited. Your career can take a huge nosedive. You can go to jail.

There is a little danger of that because of chapter 11 in the United States, but in general, a corporate executive doesn’t want to drive his company into the ground just because the liability is limited. First of all, if they are reckless and negligent, they can face personal lawsuits, they can face jail time as insiders and executives are finding out. So it’s a risky business. There are certain other factors at work which encourage reckless behavior from executives, mainly hubris of wanting to be a CEO or CFO for a much larger company. So let’s go and acquire more and more and grow that way rather than, you know, well, my liability is limited anyway. Their liability is not really limited. Your career can take a huge nosedive. You can go to jail. You know, there are many other problems that come from…reckless behavior and which work to constrain or not to constrain reckless behavior. We also need shareholders who are way more activist than they are. They’re not in public companies. So that’s another drawback. But again, it’s got nothing to do with the government and limited liability.

 

Roger Bissell

Well, you’ve made a good case during this discussion here that the corporations are something that’s pro-individual and pro-capitalist. And I imagine by the same token or by the reverse token or some token or other, that socialists and collectivists probably don’t like corporations too much unless they can get their hands on them and run them from the halls of the government. So I hope our viewers have enjoyed this. I enjoyed pushing back against your comments. You have a lot of knowledge and a lot of experience and it was good to hear your thoughts on this subject. So thanks very much and I think that’s it for this session of the Savvy Street.

 

Vinay Kolhatkar

Thank you and thank you for hosting the show.
 

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