Two recent posts looked at private equity (PE) as an aberrant form of business model dependent first on very artificial tax preferences and second on the ability to empty the cash from “cash cow” businesses. In this final part of my critique of PE, I will look at the liberal use of bankruptcy protection as a “feature, not a bug” of this business model.
The Great Recession of 2008 exposed a well-buried characteristic of the modern business corporate form of ownership that is, unfortunately, still poorly understood and largely ignored by the business and general press. Because the real nature of the corporation is not usually discussed, most of the arguments from either side, either in defense of the benefits, or in opposition to the drawbacks of this form of business governance, miss the boat.
The corporate charter is, first and foremost, a socialized insurance policy backstopping the probabilistic risks of business failure. It guarantees owners that, no matter how badly they screw up, and no matter how badly they screw over creditors, customers and employees, the government will protect the owners and their agent managers from aggrieved victims bearing torches, pitchforks and lawyers.
Classically, this protection is called limited liability, and it is normally just portrayed as limiting the financial losses of the owners to the amount of their investments. This is “backstop insurance.” While this was long ago in U.S. history a difficult protection to get, this designation has been expanded in recent years by U. S. state governments to be now given out as freely as candy.
We have been living for over 100 years with the unforeseen consequences of devolving corporate law to the individual states. New Jersey, and then more famously Delaware, passed very corporation-friendly laws in the late 19th century in order to draw the headquarters operations of large businesses, but most of the other states have also since liberalized their corporate laws considerably in order to keep pace.
Most recently the rise of limited liability companies, which further blur lines between individuals and corporations (full disclosure: I have formed a couple myself, but they have been profitable), plus online state corporate filing systems, have granted more and more corporate rights for a cost approaching zero. But the question rarely asked is, “Where do these expanded rights come from, and at what cost?”
When practiced to its original intent, limited liability is a very good thing. Most businesses and their investors have no intention to go out of business, and this “business failure insurance” is as prudent as fire insurance on the corporation’s buildings. With corporate protection, the business can grow to finance large investments in capital and jobs for its community, and this is usually in the interest of the community, the workers, and the creditors as well as the investors.
The moral hazard of limited liability
But all insurance invites a moral hazard potential as well. Moral hazard occurs when people or businesses take excessive risks because they are insured against all or part of the potential loss. Most people and businesses would not think of acting in this manner, but some do. If I were allowed to take out a very lucrative life insurance policy on you, for instance, without any great justification or relationship, I might find your untimely demise to be in my best interest. That is classic moral hazard, but surely we can be more clever and less obvious than that if we try hard.
Corporations can get massively large, but more importantly, intricately firewall-segmented. Complex layers of corporate charters with overlapping owners can be created in order to take huge financial risks with part of a business, say casinos in Atlantic City, without jeopardizing another piece of the business, say, real estate investments in New York City. For the “bad actors” in this play, limited liability can be a license for reckless growth, excessive borrowing, partnerships with “shady characters,” and predatory business practices, all without fear of consequences.
So, when the casinos go bust in this example, the core corporate ownership interests are mostly sheltered, and the greater costs of the business failure are pushed off onto the other “stakeholders” – terminated employees, the bondholders, the suppliers and banks who extended credit, and the local governments (and their citizens) who provided the tax breaks and infrastructure improvements now routinely demanded in order to bring the business to their community.
Ironically, corporate owners are usually associated with conservative politics touting “free market” principles, but their ability to take inordinate risks is enabled by a very socialistic “failure protection” philosophy, which has been called “privatizing profits while socializing losses.” Theoretically, there could be a private market in “failure insurance” that, with enough reputation and financial backing, would provide much of the same protections that corporation law provides. Instead, even the most die-hard capitalist is happy to let local, state and federal governments, as well as the rest of their constituent communities, eat the corporation’s losses in bankruptcy, and yet still protect the financial, and sometimes physical, well-being of the excessive risk-taking owners.
The rise of private equity financing has exacerbated this issue. In a lot of private equity deals, a very small capital stake is leveraged many times over by high-interest debt financing. Thus, the normal downside for the “owners” is minimized because the “worst case” of bankruptcy is really only the loss of five-to-ten percent of the asset value of the firm. And in many cases, the cash of the business has long since been extracted by this time through management fees.
All business ventures, even the best-run, are probabilistically subject to failure. But letting some of these guys continue to gain corporate protection to run ever-riskier businesses is like continuing to sell fire insurance to known arsonists. While many business owners were consumed by the “fires” created by the Great Recession of 2008, thousands of others were effectively “firewalled” while their businesses burned around them. They “collected” well on their business failure insurance.
Key to corporation law is the concept of the corporation as a “person” in the eyes of the law. Someone once remarked that this can never really be true until the state of Texas executes one. One of the most egregious cases of business malpractice in recent years happened when the credit bureau Equifax let its stored personal financial data on 143 million people get stolen by hackers. Instead of putting this company out of business for that crime, which is arguably merited, the recently-compromised Consumer Financial Protection Bureau, with the anti-consumer-protection Mick Mulvaney now at the helm, is apparently ending their probe into the company’s malfeasance. 
I am most probably spitting into the wind here. Will taxpayers ever get back the power to demand sanctions on the less-responsible businesses taking advantage of their communities? I doubt it. It is a nice fantasy, though. Your vote does matter.