Incorporating Responsibility

Limited liability is the rule that investors in a business entity are not liable for its debts. Limited liability stokes heated opinions because it prioritizes the beneficiaries of a harmful business at the expense of its victims. A company can harm millions of people and then file bankruptcy – its victims get almost nothing while its shareholders keep their profits. Yet what else can be done? Businesses create jobs, research new technologies, and generate wealth. Without limited liability, investors would be hesitant to finance businesses.

Limited liability’s divisiveness is premised on a dilemma: we can protect investors or victims, but not both. In a forthcoming article, I argue that the dilemma is only apparent. We can protect both investors and victims. Shareholders can feel safe, and victims can recover, so long as someone other than the investors pay them. What is needed is a responsible guarantor.

In fact, there is a guarantor that can justly and efficiently compensate the victims of corporate harm. That ideal guarantor is a corporation’s state of incorporation, the state that grants it a charter. Thus, if a Delaware corporation files bankruptcy unable to pay $1 million owed to its tort victims, the State of Delaware could pay $1 million to those tort victims. If incorporating states pay, then we don’t have to decide between helping investors and victims.

Of course, sending the bill to incorporation states is not a free lunch. Taxpayers in the state underwrite these recoveries. Allocating costs to them may seem unfair. These citizens did not cause the victim’s harm, nor could they directly prevent the corporation from undertaking the harmful acts. Nevertheless, incorporation state responsibility is both efficient and fair.

It is fair that states should pay for some harms of their corporations because incorporation states are in the business of selling indulgences. States reap billions in incorporation fees by designing laws that systematically cut off recovery for victims.  State competition in corporate law has been likened to a product market. When someone designs a product in such a way as to cause preventable harm, and then profits from indiscriminately sale, it is fair that they should pay to remediate some of the harm.

It is also efficient for states to take on this new function. The “genius” of American corporate law is that it encourages states to experiment with improvements to their corporate law. Good laws draw more incorporations (or allow higher fees for existing incorporations), so states’ incentives are largely aligned with corporations and their investors.  Yet nothing currently aligns states’ interests with corporations’ victims. To the contrary, entities enjoy cheaper capital with limited liability, and may pay more in incorporation fees in gratitude, precisely because victims’ losses are nowhere in the state’s calculation. States do not experiment to find new and effective ways to balance the benefits of limited liability against social cost; instead, interstate competition now uniformly leads to maximal limited liability, regardless of whether that rule is socially deleterious. It is widely recognized that limited liability leads corporations to create negative externalities; yet states are also externalizing, by designing products fine-tuned for externalization.

My article’s proposal converts a race to the bottom into a race to the top. Once states become liable for a portion of corporate harm, they will have an incentive to take that harm into account. States will respond accordingly. Some states may raise incorporation fees to cover their expected losses. Other states may keep their current fees but redesign their corporate law to encourage probity; they may return to familiar solutions, like mandating the purchase of liability insurance; or states may experiment with new ideas, like mandating an annual risk audit or the inclusion of stakeholder representatives in risk committees. If any of these ideas stick, we can expect that the result will be more efficient than the status quo, which permits states to ignore the obvious social costs of their incorporation decisions.

Incorporation responsibility supports justice and efficiency without leading to many of the problems readers might predict. Importantly, this proposal does not exacerbate moral hazard. Corporations will take excessive risks if states insolate shareholders from liability, as incorporation responsibility likely would – but states already encourage this exact form of excessive risk-taking by granting limited liability. Incorporation responsibility never makes this problem worse that the status quo and it provides a powerful incentive for states to make this problem better.

Nor does this proposal saddle states with unpayable debts. States have numerous options for addressing their new liabilities – from risk-control rules, to mandatory insurance, to higher franchise fees. State liability for small businesses could make a large difference to victims without a large budgetary impact.

While incorporation responsibility would be new to corporate law, it is far from radical when viewed with a wider lens. Incorporation responsibility is basically a form of mandatory insurance. It obliges corporations to buy insurance from their incorporation state, and it obliges the state to sell it.

That is a strategy that the legal system often uses to overcome some injustice or market failure. Consider just a few: When privately owned nuclear powerplants cause damage greater than their owner can pay, the state containing the powerplant must pay the cost of remediation. When banks fail, the federal government pays the unpaid claims of depositors. When polluting firms fail, the federal government will pay the price of remediation. When any corporation is unable to pay its pension obligations to retirees, the federal government will vindicate those pensioners.  When privately owned objects (such as satellites) fall from space and injure people or property on the earth, international treaties attributes liability to the nation from which the object was launched. A transubstantive perspective reveals an attractive legal principle: when governments wish to allow or support a risky category of business activity, they accept responsibility for the residual costs of that activity. From this perspective, corporate law is currently an outlier, and incorporation responsibility is a step toward coherence.