Putting Skin Back into the Game

How institutional innovation can revamp capitalism

For most of human economic activity, entrepreneurs such as captains of maritime trade expeditions were fully liable with all their assets. They had skin in the game. Then, in the 19th century, a legal innovation arrived— and changed the course of history.
This is one of two related articles inspired by the history of limited liability companies. Read the other here.

Something is wrong with the way we do business. Google was just fined €1.5 billion for violating the EU’s anti-trust laws. Last month, UBS received a €3.7-billion penalty for tax fraud in France. BP’s bill for the 2010 Deepwater Horizon oil spill has recently surpassed the $65-billion mark. The root causes of these fines were recklessness, negligence, or fraudulent behavior of managers. However, none of the managers involved will have to chip in with their own money. Does it need to be this way?

Anyone concerned with the prosperity of humanity must feel bewildered by how the world conducts business today — and puzzled by the absence of a public debate about the fundamental features of economic life. As corporations continue to chip away at the world’s social capital and natural resources, it has become urgent to question the constructs that characterize modern commercial enterprise. One such construct is the driver of recklessness and negligence in business: limited liability companies.

For the bulk of economic history, people were fully liable for their business activities. All their personal assets were at risk, sometimes even those of their relatives. Failure in commerce — such as a failed maritime expedition — could destroy livelihoods and bring down entire families.

This all changed in the 19th century when most countries in Europe and North America adopted laws to democratize two economic concepts. The first was the right of incorporation, which allowed entrepreneurs to establish organizations with their own identity in the eye of the law. The second was a cap on the risk of company owners, set at the amount of their investments.

Mainstreaming limited liability companies was a legal innovation with enormous consequences. It has encouraged risk-taking and investment and led to unprecedented wealth and prosperity over the past 150 years. The Economist called it the “key to the modern world”. Today, the vast majority of commercial activity occurs through legal entities with some form of liability cap.

Yet dissociating risk from reward creates its own set of problems. The most important is what economists call the phenomenon of moral hazard— the notion that negligence, mismanagement, and fraudulent behavior become more likely when decision-makers aren’t liable for their actions.

Moral hazard — explained by Robert Prentice, McCombs School of Business (1:21)

Company managers, for instance, are tempted to take gambles because they reap the rewards of success (through bonus checks) but can pass the harms of failure to shareholders (through stock prices). Prominent victims of moral hazard include shareholders of Lehman Brothers and Bear Sterns, two investment banks that faltered in 2008 as a result of their managers’ excessive risk-taking. Indeed, researchers pinpoint moral hazard as the root cause of the Global Financial Crisis.

Moral hazard also applies to company owners, who can externalize outsize losses from risky bets to the public — to employees who lose their paychecks, suppliers who don’t get paid, or taxpayers who must fund the remediation of environmental and social damage. The 1984 gas leak at Union Carbide’s Bophal plant and the 2001 bankruptcy of Enron are two traumatic examples of reckless companies inflicting great harm on society.

Today, the perils of moral hazard are as relevant as ever. Would Facebook pursue such predatory data acquisition strategies if its managers were personally liable for violations of privacy laws? Would Volkswagen have sold 11 million diesel cars with devices designed to cheat emissions tests, had their managers faced personal accountability? Would oil and gas companies continue to sell fossil fuel products if the government could appropriate the personal assets of their decision-makers to compensate future generations for the consequences of global warming?

Between 2009 and 2015, Volkswagen sold 11 million diesel cars designed to cheat air pollution tests. When the company admitted to the fraud, the price of its stock declined by 23%.

As long as there is an asymmetry between upside potential and downside risk, managers will prioritize short-term profits over long-term sustainability. In the book Skin in the Game, Nassim Nicholas Taleb argues that such asymmetry can be mitigated best if decision-makers participate symmetrically in both risk and reward:

“Forcing skin in the game corrects the problems of asymmetry better than a thousand laws and regulations.”

So how do we put managerial skin back into the game?

The blueprint for an alternative to the limited liability company has existed for a thousand years — the commenda. First introduced in the port cities of 11th-century Italy, the commenda is a hybrid legal form in which managers are personally liable for all debt and losses, but investors are only exposed to the extent of their investment. The hallmark of the commenda is that it corrects incentive asymmetries by linking decision-making with risk exposure.

Today, the commenda continues to exist in many western countries, where it is sometimes called limited partnership or Kommanditgesellschaft. Yet commenda-type organizations play an insignificant role in modern economic life. In the case of Switzerland, whose laws provide for one of the purest forms of a commenda, such organizations only account for 0.2% of all registered commercial entities.

Despite the perils of limited liability, there’s no need to revert to century-old economic practices. The world has changed in profound ways since countries in the western hemisphere have drawn the defining contours of commercial law. Specifically, globalization and digitization have made it increasingly difficult to understand and appraise risk. Extreme forms of personal liability would thus stifle entrepreneurship and innovation.

However, it would be unreasonable to argue that completely limiting business liability is still a legitimate economic paradigm. 19th-century Europe grappled with poverty, health, and social inequality. Lawmakers saw economic growth as the golden path to prosperity. Today, the most pressing and tangible problems are climate change, education, health and nutrition, environmental pollution, mass migration, and data privacy and security. Unchecked economic growth will not resolve these issues. If anything, an economy that ignores the non-negotiability of planetary boundaries and the importance of social cohesion will make matters worse.

The first step toward a better liability distribution is to develop a differentiated understanding of risk. Deconstructing the entity of risk into different sub-types enables us to create distinct liability bundles. These can be allocated across economic agents — managers and shareholders, and also society — more deliberately and purposefully.

Such selectively limited liability companies (S-LLCs) would have two main benefits. First, they would enfranchise society at large — governments and citizens — within the governance frameworks of liability. At the moment, these frameworks are almost exclusively designed with managers and shareholders in mind, and societal actors only play a passive role as suckers of last resort. Second, they would encourage managers and company owners to take those risks that are adequate for the challenges and aspirations of the 21st century.

For instance, managers of multinational food companies should be incentivized to sell nutritious and affordable products by being shielded from inherent and reasonable risks involved in the sourcing, production, and distribution of food. They should, however, be held accountable for the harm they inflict upon others if their products cause obesity, biodiversity loss, food insecurity, or the displacement of indigenous communities. Similarly, energy companies should remain protected by limited liability for a myriad of execution risks inherent in bringing energy to the masses — in pricing, trading, contracting, engineering and construction, maintenance, and so forth — but not for any societal damage caused by greenhouse gas emissions.

Sugary soft drinks such as Coca-Cola are linked to a range of health problems. Soft drink producers thus impose costs (negative externalities) to society. Because these companies are not held accountable for such costs, their managers don’t have an incentive to produce healthier alternatives.

Developing new legal forms requires institutional entrepreneurship, a movement that challenges entrenched social constructs and explores alternatives. Such a movement doesn’t need to be radical. It can build on what’s already there, evolving existing concepts within the boundaries of existing laws. In many countries, it’s already possible to refine default liability rules through contractual arrangements. Venture capitalists, for example, typically execute separate shareholder agreements with the entrepreneurs they back to hold them liable for a range of aspects the law usually doesn’t provide for.

So we don’t need a revolution in our legal statutes. What we need is a new conception of the social contract, a pact between business and citizens rooted in a shared set of values and aspirations that are appropriate for the 21st century. This conception can only evolve if we have a conversation about the long-term goals of our economic system. We no longer rely on risk-taking and recklessness in commercial enterprise to push our societies forward. We need prudence and circumspection, and mechanisms that promote environmental sustainability and social equity. We need entrepreneurs who accept individual responsibility and act as reasonable stewards of our natural and human capital.

Three groups in society are particularly well suited to become pioneers of institutional entrepreneurship. Academics can lead on deconstructing the entity of risk and suggesting future-proof liability bundles. Governments can then leverage their spending power by mandating a more appropriate risk distribution through procurement rules and public-private-partnerships. Similarly, investors can use contractual arrangements to change the spread of liability in the companies they invest in.

Longer-term, structural changes such as new taxes on externalities, mandatory insurance for outsize risk (e.g. for nuclear power plants), or reforms of company laws can help institutionalize a new liability regime and catalyze a shift in business culture.

There is nothing inherently natural in the concept of the limited liability company. Designed by our ancestors as a result of a — partially accidental — political process, it is as fragile and contingent as any other social construct. As we bump against the natural boundaries of our planet and the breaking points of our society, we need to start a conversation about what we want from our economy, and about the vehicles that promise to get us there.

All facts about the history of limited liability and the commenda are sourced from Marie-Laure Salles-Djelic’s 2013 article When Limited Liability Was (Still) An Issue: Mobilization and Politics of Signification in 19th-century England