Scholar suggests that states be held liable for corporations’ unpaid debts to protect tort victims.
Under the corporate-law doctrine of limited liability, shareholders who invest in corporations are not liable for those corporations’ debts. Limited liability encourages economic growth by attracting investors, but it can also prevent monetary recovery for victims of corporate misconduct, creating a longstanding “dilemma” at the heart of American corporate law.
In a recent article, Andrew Verstein, a law professor at the University of California, Los Angeles, offers a solution to the dilemma of limited liability. Verstein proposes a new corporate law doctrine called “incorporation responsibility,” which would require the state that incorporates a business to repay that business’s unpaid debts. Verstein argues that incorporation responsibility would provide both recovery for tort victims harmed by a corporation’s misconduct and financial security for investors.
Verstein outlines that, until the late 19th century, some states held investors liable for a corporation’s debts, with some corporations voluntarily continuing the practice into the 20th century. Today, however, all jurisdictions recognize limited liability for shareholders in some form. Limited liability can be overcome, Verstein explains, but only when certain “exacting conditions” are met and victims of corporate wrongdoing are permitted to “pierce the corporate veil”—or recover damages from shareholders or directors of a corporation.
Limited liability is a highly litigated and controversial corporate law doctrine, Verstein argues, because it “prioritizes the beneficiaries of a harmful business at the expense of its victims.” If a company were to “harm millions of people and then file for bankruptcy,” victims would be left without adequate compensation while shareholders keep their profits, Verstein claims.
Proponents of limited liability insist that it is necessary to finance businesses—and, by extension, to “create jobs, develop new technologies, and generate wealth”—because investors are averse to risks and would not invest without the protection of limited liability, Verstein asserts. This view, Verstein argues, fails to account for the possibility of large liability insurance policies that corporations can buy to mitigate risks to shareholders.
Limited liability, Verstein contends, also prevents companies from efficiently internalizing the costs of the risks they take. The threat of tort lawsuits should, in theory, encourage shareholders to finance only “socially efficient projects” with benefits to shareholders and others that outweigh any costs imposed on tort victims, Verstein explains, but limited liability undermines this correlation.
Verstein claims that incorporation responsibility, his suggested approach, can “protect both investors and victims.” Incorporation responsibility would allow tort victims to receive full compensation, with states covering the difference where corporations cannot pay up, Verstein argues.
Verstein contends that incorporation responsibility would allow tort victims to look to one state for recovery rather than a multitude of individual shareholders, eliminating administrative hurdles to recovery. In addition to providing compensation for more tort victims, Verstein argues, incorporation responsibility would maintain current protections for investors.
Each state could respond to the adoption of incorporation responsibility by revising its own entity formation rules, Verstein notes. States could abolish veil piercing or revise incorporation requirements to expand shareholder liability, requiring shareholders to cover the state’s portion of a company’s unpaid debts.
Verstein also offers a number of potential innovations states might make if incorporation responsibility were adopted to attract corporations and maximize franchise fees, while also minimizing corporate liability to avoid having to pay corporations’ unpaid debts.
First, states could raise franchise fees, charging different companies different rates that reflect higher expected costs for businesses more likely to generate unpaid debts to tort victims.
Second, states could encourage risk control. Verstein notes that states can require companies to buy insurance or to keep “a buffer of capital on hand” to repay creditors, institute a corporate duty to take account of risks to third parties, or mandate board diversity to encourage corporations to take fewer risks.
Third, each state could better prioritize tort victims in the bankruptcy rules that determine which creditors get repaid when a company within the state’s jurisdiction is unable to fully pay its debts.
Fourth, states could expand shareholder liability by “stipulating a wide variety of cases in which shareholders must offset a state’s losses” when a corporation cannot pay its debts. Shareholder liability could be conditioned, Verstein explains, on shareholders’ unjust enrichment or their culpability in causing harm or on the state’s ability to pay. Alternatively, Verstein suggests that states could expand non-shareholder contributions, requiring parties such as “bondholders, officers and directors, or long-term suppliers” to pay some portion of unpaid debts.
Finally, states can use information as a way to reduce their incorporation liabilities. If states “know more about their corporations and shareholders,” they will be more likely to demand additional information from corporations, which could produce public benefits related to preventing money laundering and enforcing “the rule of law generally,” Verstein contends.
Verstein acknowledges that “sending the bill to incorporation states is not a free lunch” because state taxpayers would ultimately pay some corporations’ unpaid debts. He contends, however, that incorporation responsibility is nevertheless fair. This is so, Verstein argues, because “states reap billions in incorporation fees,” including by designing laws that entice businesses by limiting recovery for tort victims.
Incorporation responsibility is also efficient, Verstein contends, because it encourages states to innovate and compete to maximize positive outcomes for both corporations and tort victims. Verstein explains that states would have “a financial stake in finding a good answer” and are in the best position to consider the specific policies that would make incorporation responsibility work most effectively.
Verstein concludes that incorporation responsibility would create a “race to the top” situation by aligning states’ financial incentives with policies that both facilitate investment and protect tort victims. By passing liability to states, Verstein suggests, corporate law can move beyond the dilemma of limited liability without sacrificing economic growth.
