Private Equity's Abuse of Limited Liability
08/28/19
One of the central features of the Stop Wall Street Looting Act that was introduced by Senator Elizabeth Warren and a number of co-sponsors is a targeted rollback of limited liability. This provision, more than any other, has gotten some commentators’ hackles up, even those who are willing to admit that there are real problems in the private equity industry and welcome some of the other reforms in the bill. (See also here and here, for example.)
The idea that limited liability is a sine qua non of the modern economy is practically Gospel to most business commentators. These commentators assume that without limited liability, no one will ever assume risks, such that any curtailment of limited liability is a death sentence for the private equity industry.
They're wrong. Limited liability is a substantial, regressive cross-subsidy to capital at the expense of tort creditors, tax authorities, and small businesses. Limited liability is a relic of the underdeveloped financial markets of the Gilded Age and operates as an implicit form of leverage provided by law. But it’s hardly either economically efficient or necessary for modern business activity. It's a fairly recent development in the western world, there are numerous exceptions to it, and a number of notable firms have prospered without it (JPMorgan & Co., Lloyds of London, American Express, and many leading law law firms).
In any event the Stop Wall Street Looting Act rolls back limited liability solely for private equity general partners in a surgical manner such that doesn’t affect limited liability more broadly. All the Stop Wall Street Looting Act will do is reveal which private equity firms have real managerial expertise, and are thus able to thrive without limited liability, and those that don’t and require the legal subsidy to be profitable. Far from undermining the private equity industry, it is a restoration of a central tenet of honest American capitalism: reward should be commensurate with risk.
Limited Liability
Let’s start with what how limited liability works, then turn to what the bill does, and finally why the critics are wrong. The first thing to understand is how limited liability works. Limited liability comes from state law. It means that an investor is liable only for the amount of his investment, not for the liabilities of the firm in which he invests.
So, if I buy a share of IBM, I’m liable for the purchase price of my shares—they could loose all their value—but I am not liable for IBM’s obligations.
Limited liability doesn’t only shield natural person investors, however. It also operates within corporate structures. Thus, IBM Corp. (the parent company) benefits from limited liability vis-a-vis its subsidiaries, as the parent corporation is the shareholder of the subsidiaries.
Limited liability is a characteristic of modern corporations, as well as limited liability companies and limited partnerships and trusts (beneficiaries are not personally liable for the trust’s liabilities). General partnerships and sole proprietorships do not benefit from limited liability, and the general partner in a limited partnership does not benefit from limited liability.
Limited Liability in the Private Equity Context
Now in the private equity context, we’ve got several layers of corporate structure. At the bottom there is the target company that is acquired by a private equity fund. The acquisition likely takes place through a special purpose acquisition vehicle (probably a corporation), not the fund itself. So, the target is owned by the acquisition vehicle, which is owned by the private equity fund.
The private equity fund is itself structured as a limited partnership. This means that it has both a set of limited partners, and a general partner. The limited partners are institutional investors, such as pension plans, endowments, insurance companies, funds of funds, etc. The general partner is the private equity firm (e.g., Apollo, Bain, KKR, TGP, Thomas H. Lee Partners). The private equity firm will be the general partner in multiple private equity funds; the limited partners in those funds will not all be the same.
The private equity firm may be structured in any number of ways. Some are publicly traded corporations, while others are various types of limited partnerships. The limited partners enjoy limited liability for the obligations of the private equity fund; the general partner does not. The GP is answerable for all of the private equity fund’s liabilities. Transactions will generally be structured, however, so that there are few actual liabilities at the fund level. Instead, liabilities will be at the level of the acquisition vehicle, and the private equity fund (limited partners and general partner) will be shielded by limited liability through the fund’s ownership of the acquisition vehicle’s stock. What this all means is that it is at least a few of levels of corporate entities before one gets to an actual natural person.
Why Limited Liability Is a Particular Problem in Private Equity
Here’s where the Stop Wall Street Looting Act comes in. The premise of the bill is that private equity firms have abused limited liability to engage in excessive risk-taking at the expense of American workers and communities, as limited liability creates a lopsided investment risk: all of the upside, but only limited downside.
Now, that is the case whenever one buys corporate stock (and there is much to say about that below), but private equity firms have taken this to a new level by combining limited liability with extreme leverage. First, there is the leverage in the acquisition of the target company—the private equity fund might put in only 20-40% of the acquisition price, with the rest borrowed by the target company itself and secured by the target company’s assets. But then there is additional leverage in the structure of the private equity fund. The private equity firm itself contributes only a small amount of the capital to the fund, but gets a much larger slice of the return. This extreme leverage, when combined with (1) limited liability and (2) corporate control produces an incentive for private equity firms to saddle target companies with extremely high and often unsustainable debt burdens.
This is a totally different situation from when I invest in IBM. First, I usually have to pay full freight for my IBM stock. I don’t get it at 20-40¢ on the dollar. Even if I buy on margin, I’m still going to pay at least 50¢ on the dollar, and likely far more. Second, when I buy the IBM stock, I don’t get the extra leverage that exists from the private equity GP structure. Third, my acquisition of IBM stock is not inherently connected with IBM taking on massive debt itself. And fourth, I don’t have control over IBM, such that I’m not able to loot the company or starve it of R&D resources or reinvestment to pay the LBO debt, etc.
So to recap, the problem with private equity isn’t limited liability per se. The problem is limited liability combined with other unique and unavoidable features of private equity. Limited liability plus extreme leverage means that there is a seriously lopsided risk/reward tradeoff that incentivizes excessive risk-taking. This means that if you are serious about curbing private equity abuses you have to do one of two things. Either you curtail limited liability for private equity GPs (increase risk) or you impose leverage limitations on private equity acquisitions (reduce reward).
The Stop Wall Street Looting Act: Curtailing Limited Liability for Private Equity General Partners
The Stop Wall Street Looting Act provides that general partners of private equity funds have joint and several liability for all liabilities of a target firm, just for the liabilities of the fund itself. It also provides that the control persons of the general partners have joint and several liability for all liabilities of a target firm. That means that the ultimate natural persons (i.e., .0001%ers who control the GP) are personally liable. Thus, Eddie Lampert would be personally liable for Sears' liabilities.
Critically, under the Stop Wall Street Looting Act, the limited partners in the private equity fund continue to have limited liability, as long as they remain passive investors. Your pension fund will not have increased liability for its private equity investments.
Leverage Limitations: the Road Not Taken
Another route to fix private equity abuses is to limit acquisition leverage. If target firms are less leveraged, they won’t have to go on starvation diets to service their debt at the expense of R&D and reinvestment in stores, etc. Leverage limitations are easier said than done. First, how does one define leverage? What sorts of debts count? Trade debt? Tax debt? How is that defined? Second, once one defines leverage, what is the proper level of leverage? The issue is a lot like usury laws—there isn’t an obvious answer and it might well vary by industry, etc.
Even if one can legislate an acquisition leverage limitation, it's an incomplete solution because it doesn't address all of the leverage that affects GP incentives: there is also the leverage inherent in the fund structure itself. So, to really address incentives via leverage limitations would also require limiting GP returns. A surgical curtailment of limited liability is a much simpler and more administrable solution. It’s easier to “level up” risk than to “level down” reward.
The Sacred Cow (or Golden Calf) of Limited Liability
Now that we’re clear on what the Stop Wall Street Looting Act does and why it’s doing so, it’s time to address the concern that curtailing limited liability is a death sentence for private equity. Commentators assume that private equity cannot function without limited liability because they believe that limited liability is essential for modern financial markets. That’s just wrong.
(btw, notice the assumption baked in here—that a death sentence for the private equity industry is obviously a bad thing. I'm agnostic. Unless we think there’s clear social benefit from private equity, then the industry should sink or float like every other industry—without a massive, regressive subsidy through law via limited liability.)
In any event, would a loss of limited liability for private equity general partners spell the end of private equity? The answer is no. It would doom the posers in the private equity industry—the firms that have no real managerial expertise, but are simply buying purchasing diversified portfolios with massive leverage and then looting those portfolio companies—but the good private equity firms—the ones with actual expertise would continue to thrive (and would face less competition for investments). The stupid money will fail, the smart will rise, even without a regressive cross-subsidy.
There Are Lots of Exceptions to Limited Liability
As an initial matter, limited liability is not nearly as absolute as commentators often assume. There are numerous statutory, equitable, and contractual exceptions to limited liability.
Among the statutory exceptions, there is no limited liability vis-a-vis the federal government for employer failure to withhold taxes. The Consumer Financial Protection Act’s “related person” liability makes shareholders who materially participate in the conduct of a covered firm liable for the activities of the firm. Likewise, the PBGC’s single-employer plan lien slices right through limited liability within the holding company structure (see here regarding the application to private equity). So too does the source of strength doctrine for bank holding companies. Affiliated insured depositories are all co-liable with each other to the FDIC. And historically, shareholders in national banks were liable for twice the amount of their stock. These are example just from statutes I regularly encounter; I suspect others exist in other fields of regulation.
There are also equitable—that is non-codified—exceptions to limited liability. Corporate veil piercing is the best known, but there is also successor liability and substantive consolidation (a bankruptcy doctrine).
Finally, limited liability is waived all the time as a contractual matter. It’s just waived selectively for financial creditors and occasionally tax authorities. Corporate cross-guaranties are standard in loans and bonds—virtually the entire corporate group will guaranty borrowing done by just one member. That’s a waiver of limited liability as to that financial creditor. Likewise, corporate tax sharing agreements accomplish the same vis-a-vis tax authorities. And springing guaranties from control persons (I’m looking at you, Jared Kushner…) are par for the course in real estate finance. In short, there are all sorts of exceptions to limited liability that suggest that all sorts of businesses manage to operate without it.
Limited Liability Is Actually Pretty Recent
Many commentators assume that limited liability has been around since time immemorial, that it is foundational to capitalism. It ain’t. Limited liability is a relatively recent invention, much less in its current form. While one can point to older English antecedents (East India Company, e.g.), the first modern limited liability law for general business corporations was from New York in 1811. Prior to that statutory, creation of a limited liability corporations required a special act of the legislature or were allowed for very limited classes of entities (libraries, turnpikes, colleges, etc.).
Although the possibility of limited liability existed in the 19th century, there just weren’t many limited liability entities (or incorporated businesses of any sort) until the 20th century. Larger businesses were often organized as trusts (hence “anti-trust”), which had effective limited liability for trust beneficiaries, but trustees themselves were personally liable for the trust’s obligations until well into the 20th century.
Critically, limited liability, as first created, protected only natural person shareholders. This limited existed for a simple reason—corporate holding structures did not exist until New Jersey laws from the late 1880s and 1890s authorized them. (In the absence of corporate holding company structures, trusts were used for controlling conglomerates—again, “anti-trust".)
All of this is to say that a huge amount of industrial development in the Western world was done without limited liability of any sort and certainly without intracompany limited liability, which is really what’s at issue in the Warren legislation—the shareholders in a publicly traded private equity firm do not face liability under the bill. In other words, intracompany limited liability just isn’t so critical to business activity as casual observers assume.
Limited Liability is a Vestige of Undeveloped Financial Markets
What we should see from the history of limited liability is that it is a historically contingent development. Consider when limited liability developed (again, the first modern limited liability law was 1811). It developed at a time when there were only primitive financial markets. Investors could not protect themselves adequately through insurance and derivatives. Yes, one could buy insurance, but the solvency of 19th century insurers was always a dodgy thing. Would we come up with limited liability from scratch today? I’m not so sure. It’s a legacy that might well have outlived its usefulness.
Major Firms Have Operated Without Limited Liability
The ultimate proof that limited liability is not necessary for modern business activity is the leading US financial firm from the late 19th and early 20th centuries—JP Morgan & Company. JP Morgan & Co. was a plain old handshake partnership (with Mr. J. Pierpont Morgan Sr. as the head partner), without limited liability of any sort. That did not stand in the way of it underwriting the largest loan ever made at the time (Anglo-French loan in WWI) or financing the Panama Canal or the US railway system. For most of Lloyd’s of London’s history, its Names were personally liable for the hazards they insured. California corporations had unlimited pro rata liability for shareholders until 1929. American Express had unlimited pro rata liability for shares into the 1950s. Indeed, even today, Wachtell, Lipton, Rosen and Katz, the US law firm with the highest profits per partner, is a general partnership—no limited liability. So too were many other Big Law firms into the 21st century. (There's an interesting argument that freely transferrable shares requires limited liability, but the empirical evidence suggests otherwise.)
A Physical Manifestation of the Lopsidedness of Limited Liability
If you've read this far, indulge me in an aside: Worldwide Plaza on 8th Ave. in New York was the longtime location of the leading law firm of Cravath, Swaine & Moore (which is now moving). When Cravath moved into the building in 1988 or so, it had the firm’s name carved above the doors—nice and centered. When Cravath converted to being an LP around 2003, it had to etch the in the additional letters, such that the name was longer centered: a physical manifestation of the lopsidedness of limited liability.
Private Equity Firms Are Able to Adjust Their Pricing to Account for a Lack of Limited Liability
Indeed, the idea that limited liability is necessary to attract investment is suspect as a matter of economic theory. Shouldn’t limited liability just be part of a trade-off relative to rates of return? That is, if private equity GPs were to lose the protection of limited liability, why wouldn’t they just demand a larger share of the pie—effectively a greater return on their investment? On a diversified portfolio of investments, they should come out just fine, especially given that the GP has substantial control over the liabilities incurred.
Bankruptcy Law Still Exists as a Type of Limited Liability
Moreover, even without state law limited liability, there is another form of limited liability that the Stop Wall Street Looting Act does not eliminate: bankruptcy. Bankruptcy is, in effect, a form of liability insurance. The natural person control persons of the GPs always have bankruptcy as a type of liability insurance. If Eddie Lampert, for example, finds himself liable for, say, $20 billion (a sum that exceeds his assets), he can file for bankruptcy, keep whatever property he has that is exempt, pay the rest to his creditors, and the remaining balance will be discharged. Thus, if Eddie is worth only, say, $5 billion, he will keep his Florida homestead, some tools of the trade, etc. and will get out of $20 billion in debt for just $5 billion. Personal bankruptcy is a form of limited liability. (Take note, Bloomberg editorial board...) It won’t protect all of one’s wealth, but will keep one from starving based on being a bad businessman or simply because of bad luck.
Limited Liability Is a Massive, Regressive Cross-Subsidy of Capital
Finally, let’s not lose sight of the distributional picture. Limited liability is a zero sum game, meaning that limited liability is a giant, legalized risk externalization from shareholders to non-adjusting creditors (tort victims, tax authorities, some trade creditors). In other words, limited liability is not Pareto optimal. There’s no obvious social welfare benefit from limited liability. Instead, there is simply a redistribution from the vulnerable to the wealthy.
It’s hard to see why such a policy is sacred, other than that it creates substantial implicit leverage and thus gooses returns in all equity investments. This might be a policy that makes sense in cases where private investment is not forthcoming because of the enormous and unpriceable risks involved in an enterprise and where there is huge social value, such as the system of liability channeling for vaccines. But that’s the exceptional situation. Why the iron works and the dry cleaner, much less the private equity baron need limited liability (as opposed to paying for insurance) is not clear.
Good Private Equity Doesn’t Require Limited Liability, Only the Posers Do
Limited liability has been a backdrop term to American capitalism only about a century. Its expansion can be seen as a remnant of the Gilded Age, and it remains a subsidization of capital at the expense of tort victims, tax authorities, and small businesses that cannot adjust their pricing for lack of market power. The “free market” is in fact deeply subsidized by the legal system. What’s clear is that limited liability is absolutely not necessary for most business activity. It’s just a regressive cross-subsidy of capital, plain and simple.
The Stop Wall Street Looting Act doesn’t pick a fight with limited liability generally, however. Thus, it doesn't really matter if you agree with me generally about limited liability. It only takes issue with a very narrow application of it, in a context where it has been systematically abused and where the abuses have created palpable harm for American workers and communities.
If private equity firms really have managerial expertise as they claim, however, their business model should not depend on limited liability. Smaller PE shops that have deep industry expertise are likely to do just fine, for example. The Stop Wall Street Looting Act’s curtailment of limited liability will merely separate the wheat from the chaff in private equity. Those firms that have real expertise will thrive and prosper, and work real managerial magic, and the firms that are only able to profit because of a rigged heads-I-win-tails-you-lose gamble will be out of business, as they should.
The Stop Wall Street Looting Act restores honest American capitalism, in which reward is commensurate with risk, so that private equity will profit from its talent, not from a lopsided financial gamble facilitated by a regressive legal cross-subsidy.
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