if they are making investments which involve enough risk to upset the stakeholders.
• assets with exposure to differing types of risk and different vulnera- bilities to failure of the enterprise.
Such differences require structuring of a project in a way which gives an acceptable distribution of risk. That distribution reflects the bargain- ing ability of the different stakeholders, which is exercised in imperfect markets. Stakeholders negotiate trade-offs which are acceptable to all and are compensated through distribution of the value created by an investment project for the risk to which they are exposed.
enterprise are restricted. If they are not, and if rights to the value created are freely alienable, the type of organisation is an open cor- poration with common stock. Unrestricted residual rights and the free alienability or marketability of such rights are two significant charac- teristics of such an organisational form. This requires both an appro- priate body of enterprise law to validate the organisational form and an efficient capital market to ensure full marketability of shares. If there are restrictions on the enterprise, then it is a closed corporation.
Two issues are at the heart of risk control in the modern business enterprise – limited liability and bankruptcy.1 The ultimate risk for most stakeholder groups is a failure of the enterprise. A failed invest- ment can reduce the value of equity to nothing; greatly reduce the value of the debt held by creditors; lose both managers and workers their jobs; and deprive a local community of employment opportuni- ties, government of tax revenue, suppliers of demand. Contracts will not be honoured. In theory, the shareholders are the first to suffer, losing any value to their ownership shares. Although in the event of a liquidation existing claims on the enterprise may be honoured, employees lose their jobs and suppliers future orders. There is a priori- tisation of the obligations which the enterprise owes to particular cred- itor groups which is used as a base for distributing any remaining value, thereby distributing the impact of risk. In the event of bank- ruptcy, there are both rules about the degree of liability of the owners of the failed enterprise and rules for what must happen in order to resolve the bankruptcy.
Thus, an attempt to control risk is at the very core of the modern business enterprise. Limited liability is the result of an attempt to reduce the risk to which the owners of an enterprise are exposed, at the expense of other stakeholder groups, notably creditors. Just as in normal times different stakeholders bargain in the sharing of costs or returns so they also bargain in the distribution of risk for the bad times. Institutional structures help determine how that risk is distrib- uted, by establishing the framework, both legal and conventional, in which bargaining occurs.
Various forms of liability have been tried. Before the modern era the basic reference liability was an unlimited one, in which the share- holder was potentially liable for the whole of any debt incurred by the enterprise. At the present, it is limited liability. There are other poss- ibilities, such as an unlimited proportional liability, that is, if a share- holder owns 5% of the shares he/she is liable for 5% of any debt of the insolvent company. Another alternative would be the negotiation of
contracts between shareholders and creditors which limit liability on an individual basis. In a situation of limited liability, the act of asking for contractual limited liability would be interpreted as a anticipation of serious trouble for the enterprise (Moss 2002: 82–83).
Under limited liability, owners of shares are only liable for the amount they have invested in the purchase of these shares and liable only for the period of time they own those shares. Limited liability is a legal device whose function is ‘to shield the owners of corporations from personal liability in the event of corporate default’ (Moss 2002:
53). It is possible to opt out of limited liability indirectly by the share- holder pledging personal security for any loan(s) received by the enter- prise which he/she partially owns. Why is it so desirable to shift risk management from the owners to other creditors and not allow these various stakeholder groups to negotiate the transfer of risks them- selves? The initial aim of limited liability, when first introduced during the nineteenth century, was to mobilise capital and induce additional investment, notably in areas of high risk where failure was common (Moss 2002: 57–58). Whether it did is difficult to answer because there is no real evidence showing a link between limited liability and eco- nomic performance (Moss 2002: 69), although the presumption is that it did.
The impact on investment depends on two opposing influences, one encouraging investment, the other discouraging it. Limited liability was designed to encourage a new inflow of equity funds from passive investors, who were now much less at risk of ruin. At the same time, limited liability raised the default risk for creditors who could no longer seize the personal assets of shareholders when an enterprise failed to honour its debts. As a consequence, a rational creditor would ask for a risk premium to be included in the rate of interest received, raising the cost of capital, which would tend to reduce the level of investment. In the words of Moss, ‘The shareholder’s maximum possible loss is capped at a much reduced level, while the creditor’s probability of loss is simultaneously increased’ (Moss 2002: 74).
The conventional argument that risk diminishes the supply of capital to investment is based on a tendency for investors to be risk averse. The distinctive combination of limited downside and unlimited upside which characterises stock market investment with limited liabil- ity, just as lotteries, explains its attractiveness. Moss (2002: 83) has argued that limited liability mimics an insurance policy in shifting a portion of default risk from shareholders to creditors. Typical of financial theorists, Doherty talks of the default put option created by The Investment Process and Decision Making: the Organisational Perspective 111
this historical development, the ability of shareholders to pass the enterprise on to its creditors. Today, involuntary creditors, such as injured consumers or polluted communities, have such large potential claims on companies that the meaning of limited liability has been transformed.
From the perspective of an individual investment project, the impli- cations of limited liability differ according to the size of the project rel- ative to the size of the enterprise, how the project is to be financed, and the existing debt leverage of the enterprise. The weighted cost of capital is likely to rise, and sometimes dramatically, as enterprises have no choice but to use debt or additional equity to finance such a project, particularly where the project is large and the enterprise already highly geared.
Insolvency in conditions of unlimited liability means that an owner might lose all his/her assets, including earning capacity for the rest of his/her life or for a period necessary to pay off the debt. In order to avoid this situation it is possible to separate out activities with a partic- ularly high risk into stand-alone companies, sometimes with a large part of any existing debt. Sometimes these are called special purpose vehicles. An individual can limit the impact of any particular failure to the relevant company. A rational risk control strategy might be to make this a consistent policy. There is therefore a tendency for enter- prises operating in an environment of high risk and limited liability to be small. This limits the exposure or value at risk to a liability suit for professional or product damage. Some studies have shown widespread attempts in the USA to avoid liability for hazards and disease by shield- ing assets through divestiture of the relevant activities (Ringleb and Wiggins 1990).
Nevertheless, insolvency still represents a threat to both creditor and debtor, who can each initiate a bankruptcy. In order to ensure that an individual continues to make a contribution to economic life there needs to be a restriction on how bankruptcy affects an individual. The same applies to a company. It is illegal in most countries to operate a company which you know to be insolvent. The danger of insolvency, which might reflect a problem of scarce liquidity, could easily be com- pounded by a prisoner’s dilemma situation in which there was a rush by creditors to secure their loans, and to refuse further credit critical to the continued operation of an enterprise. Herd or contagion effects are linked to such a loss of confidence. An otherwise viable enterprise might be brought down. It was partly to stop such a run that bank- ruptcy laws were enacted in the first place. In the words of Moss (2002:
135), ‘Even apart from the discharge provision…., bankruptcy law rep- resented an important risk management mechanism, dramatically reducing the risk of runs on cash-poor debtors as well as the risk to creditors of receiving less than their fair share from a failed enterprise.’
A second aim was therefore to increase the recovery rate for creditors and diminish what banks call the loss given default (LGD).
Discharge is the important mechanism for debtors which shields them from considerable downside risk by forcible shifting it onto cred- itors. The original purpose of the promise of discharge from debt was to rectify an information asymmetry by persuading debtors to reveal their assets. Over time, this motive receded in importance. Bankruptcy laws are often passed in the aftermath of an economic crisis. Through limited liability and bankruptcy laws the aim is to encourage risk- averse savers to invest in risky ventures by providing them with an insurance against extreme loss (Moss 2002: 124) and by giving them a mechanism for release from bankruptcy. The first step in the latter mechanism was to free the debtor from the threat of imprisonment.
Discharge from debts on the realisation of certain basic requirements, such as the loss of all current assets, serves the purpose of restoring the individual to business life. The bankrupt does not have to hazard his entire lifetime earning capacity on a particular venture. Risk is trans- ferred from debtors to creditors. There is an ex ante benefit – the encouragement of individuals to undertake activities more hazardous than they would otherwise (moral hazard), and an ex post benefit – the avoidance of financial catastrophe in the event of bankruptcy. This might help the resurrection of failed entrepreneurs. The same argu- ment can apply to the corporation itself, which under chapter 11 rules in the USA can remain in business while adjustments are made to restore its operations to solvency.
Bankruptcy costs are significant, consisting largely of legal and administrative costs. They impose a cost on any enterprise which goes into liquidation. The risk of insolvency partly comprises the risk of incurring these costs. They are regarded by financial theorists as a fric- tion in the efficient operation of markets strong enough to justify risk management.
There is a connection between the two elements, limited liability and bankruptcy. It is often claimed that limited liability and bankruptcy laws allow inefficient investment decisions to be made. This is because the interests of two key stakeholder groups, creditors and owners, diverge. In the words of one commentator (White 1989: 138): ‘Inefficient bank- ruptcy decisions and inefficient investment incentives appear to be the The Investment Process and Decision Making: the Organisational Perspective 113
price society pays for limiting the liability of equity holders. From the standpoint of economic efficiency, no simple bankruptcy priority rule works as well as unlimited liability by the firm’s owners.’