No Easy Fixes for Limited Liability

US senator and presidential hopeful Elizabeth Warren (who also happens to be one of America’s most eminent bankruptcy scholars) has a proposal to make private equity firms liable for the debts of their portfolio companies by ending the limited liability protection that they currently enjoy. Another well known professor of bankruptcy law and financial regulation, Adam Levitin, has weighed in with an attack on the concept of limited liability itself.

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.

These extreme claims might have some basis in the Modigliani-Miller theory of corporate leverage, but Levitin does not substantiate them with serious evidence. In fact, the claims appear to be rhetorical in nature because Levitin goes on to say:

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.

…

…, 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.

The problem is that this limited excision of limited liability does not work in the presence of derivative markets because limited liability equity can be replicated by a call option. Owning the shares of a company with substantial debt is equivalent to holding a call option on the assets of the company with a strike price equal to the face value of the debt. This is essentially the Merton model of corporate debt (Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, 29(2), pp.449-470.)

The converse is also true: it is impossible to ban derivatives without banning debt as I argued in a blog post a decade ago. Many proposals for fixing modern finance ignore the ability to replicate one instrument with another set of instruments.

Posted at 9:14 pm IST on Fri, 30 Aug 2019         permanent link

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