Equity Finance: Matching Liability to Power

by By C.A.E. Goodhart, and R.M. Lastra

Note to readers: An FCA (Financial Conduct Authority) Insight note will be published subsequently.

The Covid 19 pandemic has once again illustrated the dangers of excessive debt ratios.

Amongst the several causes of such debt accumulation, a key incentive has come from the combination of limited liability plus the bonus culture for senior managers of publicly quoted corporations. Limited liability leads to moral hazard, encourages risk-taking and risk-shifting, while the bonus culture further focusses managers to concentrate on short-term equity price maximisation, notably via dividend pay-outs and buy-backs, rather than longer term survival and growth, via investment.

Under limited liability, a shareholder can participate in the growth of the company but his or her liability is restricted to the amount invested in the company. If the company as an entity endowed goes bankrupt, the shareholders’ liability remains limited to the value of their investments, and shareholders have no personal liability for the company’s debts. Thus the company is liable for the rest of the debt obligations. It was the unfairness of seeing senior managers of failing banks walking away with their massive contractual pensions intact, while the hardest blows, of unemployment and foreclosure, fell on the, blameless, ‘little people’ that really angered everyone, rather than keeping the financial institutions intact at taxpayer expense.

It was not always such. After experiences such as the South Sea Bubble, the early Victorians considered that unlimited liability was the only safe governance mode, and especially so for banks. What changed all that was that the scale of operation of public corporations, railways, factories, etc., became so large as to be beyond the capacity of family and friends, close enough to monitor and control the enterprise, to provide a sufficient equity base. Even then, banks were reluctant to give up the quasi-guarantee of good behaviour that unlimited liability provided for depositors.

But when there were outsiders among the equity holders, as in the City of Glasgow Bank (1878) failure, they too were ruined, and unfairly so. That changed views, and shortly thereafter limited liability became the norm in the UK. Even then, scope was left in the law, until surprisingly recently, to leave the CEO of a company with multiple, or even unlimited, liability, but that was almost never activated, becoming a dead-letter. The same trajectory towards limited liability took place in other countries, such as the USA, where double liability for banks was finally abandoned following the introduction of the Federal Deposit Insurance Corporation in 1933.

But the shortcomings of capitalism now seem so egregious, e.g. excessive remuneration feeding inequality, with no equivalent downside for failure, excessive debt and low investment, despite massively supportive financial policy, that reform is necessary. One set of proposals is to insist on required (legal) changes to the objectives of corporations, e.g. to take account of a wider set of stakeholders, notably employees, and of considerations such as environment and climate change to promote responsible capitalism. But so long as the financial incentives of managers remain largely unchanged, will that actually achieve much? A second set of proposals seeks to defer a proportion of pay and make that subject to clawback. But does that go far enough?

Our suggestion, set out at much greater length in our paper in the Journal of Financial Regulation (JFR), (2020), is instead, to divide up equity holders into two classes, insiders with multiple liability, even perhaps unlimited liability for the CEOs, and outsiders with limited liability for those without the power to monitor and control the corporations. Within the corporation, the division would be based on status and salary; not too difficult.

A more problematical issue arises with institutional investors with shareholdings large enough that they could demand information and capable of influencing policy. We suggest a degree here of self-selection, either choosing insider status with potential downside risk, or, alternatively, to act as an outsider with no attempt to sway policies.

The purpose of our proposal is to shift the costs of failure back towards those who have the responsibility for taking these decisions.

We discuss many of the arguments, e.g. the unfounded suggestion that penalty for failure would deter the best people from becoming managers. Focussing more directly on regulation, an inherent problem for the current setup, is that the constraints on capital adequacy and sufficiency of liquidity run directly counter to bank managers’ incentives to maximise Return on Equity (RoE). So regulation becomes a contest, not a joint endeavour. If the downside for managers because much more severe, there would be more commonality, and regulation for banks with managerial multiple liability, or unlimited liability, like Hoare’s Bank, could be far lighter.

The change-over from unlimited liability to limited liability towards the end of the 19th century was a relatively slow process, over decades. Our proposal would be a radical reform and would also need step-by-step introduction. In the aftermath of the Great Financial Crisis, we would want to start with the large banks and SIFIs. If this experiment was successful, then it could be extended, to other

financial institutions, such as insurance undertakings, and also to FinTech companies. But, ultimately, we hope that it could be applied to all public corporations.