No limited liability for speculative financial market transactions

No limited liability for speculative financial market transactions

John A. Mathews writes: The recent global financial crisis has brought sustained attention to the problems arising from a financial system where the ‘pricing of risk’ seems to have been abandoned in the search for quick and easy profits, and where the rules of business conduct were apparently jettisoned. This resulted in the wiping out of billions of dollars of shareholder value and the use of large sums of taxpayers’ funds to salvage financial entities that were considered ‘too big to fail’. One can sympathize with views expressed by bodies such as the UK-based Association of Chartered Accountants, to the effect that ‘ACCA believes that underlying much of the credit crunch has been a fundamental failure in corporate governance.’[1] Likewise the OECD (2009) examination of the financial crisis concluded that there were ‘severe shortcomings in corporate governance’.[2]

That would be putting it mildly.

The real issue in bringing the financial sector to heel is sheeting home liability for losses to the governors of the financial firms that started taking exorbitant risks with other people’s money in the 1990s and 2000s. The basic shield behind which boards of directors are able to seek refuge from creditors is ‘limited liability’ which is surprisingly recent as an institutional business innovation.

Limited liability is now ubiquitous in the business world – it lurks behind every Pty Ltd company (plc in the UK, Gmbh in Germany, NV in The Netherlands or Sarl in France). Yet its provenance is relatively recent. It was first adopted as a general feature of incorporation in 1811 in New York State, and then, after the report of the Mercantile Laws Commission of 1854, in Britain and then in other European countries. Under the impact of these various Joint Stock Corporation Acts that were passed, industrial companies ceased to be partnerships or other ‘unlimited liability’ entities, and with this change in the law, a major barrier to their growth was removed, and they rapidly took over the business landscape.

Reflecting its traditionally small scale relative to the industrial economy, the financial sector did not experience widespread ‘corporatization’ until very recently. Goldman Sachs, for example, was a partnership until 1999 when it staged its own IPO, offering 12.5% of its stock to the general public, and changing its articles of association from a partnership (where the partners are personally liable for losses) to a corporation, where liability is passed to the shareholders and the ‘corporation’ itself. Other investment banks like Salomon Brothers, Lehman Brothers, Kuhn, Loeb & Co had all been small partnerships prior to their rapid expansion after incorporation with limited liability.

The explosion in risky financial activity, where exotic instruments like credit default swaps (CDSs) and collateralized debt obligations (CDOs) became prominent, all emanating from the toxic sub-prime mortgage market, can be dated to this emancipation from personal liability on the part of directors or managing partners. With personal liability removed, they were suddenly eager to undertake the riskiest investments, and inflate their portfolios with high-risk commercial paper – as described vividly in books such as Michael Lewis’ The Big Short. For example, Moody’s revenues expanded from $800 million in 2001 to $2.03 billion in 2006, just before the crash -- much of it derived from sub-prime mortgage derivatives.

So the obvious question is: why not reinstate personal liability for managing partners and directors of financial entities like investment banks and hedge funds?

Why not, indeed? This provision would resolve the single biggest obstacle to financial market reform. The trade-off would be: if you want limited liability, then you submit to stringent regulation (no exemptions, no loopholes). If you do not want regulation, then you can avoid it – by giving up limited liability, and with it, any prospect of public funds being used to rescue you.

This measure would solve at a stroke the issue of regulation of exotic derivatives and the endless financial innovations that are designed to get around regulation. If financial entities wish to play that game (and who are we to stop them?) then let them do so – but without the protection of limited liability. If they expect to continue to have limited liability, then let them submit to a form of regulation that renders their trades transparent and where systemic risk can be discerned by regulatory bodies, without exemption.

The US legal regulation of securities trading in the lead up to the meltdown of 2008-09 reveals several episodes of intense debate over liability, particularly liability of professional advisers (accountants, auditors, lawyers, credit ratings agencies) for their professional advice. The Revised Uniform Limited Liability Partnership Act was passed in 1976 in an attempt to settle these questions of liability, and the various business incorporation forms have evolved to the ‘limited liability company’ and ‘limited liability partnership’ and other such entities. To bring the issues into sharp relief, there was a long and involved process in the passage of the Private Securities Litigation Reform Act of 1995, which attempted to regulate the means available to defrauded investors to seek remedies through private legal actions, over and above the regulatory powers of the Securities and Exchange Commission. Unlike the earlier reforms, which all appear to have been motivated by the desire to shield managing partners or directors from liability, this Act appeared to be motivated by the need to make them more vigilant. It was vetoed by President Clinton (over-ridden by Congress).[3]

Subsequent to the financial meltdown, reform of the US financial system, as embodied in the Dodd-Frank Act which passed into law in mid-2010, skirted this issue of limited liability. And under intense lobbying pressure from Wall Street firms, the Dodd-Frank Act contains certain exemptions from regulatory oversight that will probably be used as gateways for unsupervised risky trading all over again. Tackling the issue of limited liability in full frontal fashion is a way of avoiding such endless skirmishing.

Banks and financial institutions are different from industrial corporations, where limited liability serves a purpose in liberating investment in industrial activities. A financial system where the firms are partnerships with unlimited liability would serve the needs of the wider economy much more efficiently than one where risk is borne recklessly, because liability is limited. Correspondingly, if limited liability is sought, it must be in exchange for the most rigorous scrutiny. And rigorous in this case must mean ‘rigorous’ – daily oversight of all transactions, no exemptions, no loopholes. To escape from this rigorous oversight (but subject of course to all the other legal obligations applying to the securities markets) would entail partners running the risk of unlimited liability for their own and their fellow partners’ actions.

Limited liability is not a right but a privilege, imparted by the social organism to a private actor to encourage activities such as investment and production. It is something to be earned, and to be respected. It carries obligations, of which the highest is the obligation to behave fairly and responsibly. If financial houses such as Goldman Sachs were required to reconvert back to partnerships (turning back the clock by only a decade or so) they would have an inbuilt incentive to curb their appetite for excessively risky financial instruments, and to limit their own size. Both features would be extremely positive developments for the economy as a whole, and for the society which supports these financial firms.

John A. Mathews is the Eni Chair of Competitive Dynamics and Global Strategy at

LUISS Guido Carli University in Rome.

This article is part of the NSFM opinion series, in which participants propose specific steps towards real and sustainable market reform. Contributors write in a personal capacity. NSFM participants are invited to comment on blogs articles and contribute to the series. Please contact Ebba Schmidt or Frank Jan de Graaf for further information.

[1] See Association of Chartered Certified Accountants, 2008, Climbing out of the Credit Crunch, p.4, available at:

[2] OECD, ‘Corporate governance and the financial crisis’, Directorate for Financial and Enterprise Affairs, reports available at:,3746,en_2649_34795_42192368_1_1_1_1,00.html.

[3] See John W. Avery, Securities litigation reform: The long and winding road to the Private Securities Litigation Reform Act of 1995, Business Lawyer, 51: 335-378.