In 1776, Adam Smith warned of the dangers of limited liability. Company directors were “the managers of other people’s money”. They could not be expected to watch over it with the “anxious vigilance” that partners would apply to their own cash. “Negligence and profusion,” Smith concluded, “must always prevail.”
The South Sea bubble and other scandals of the early 18th century provided the background to Smith’s observation. For the next 150 years, corporate organisation was viewed with deep suspicion. But the huge capital requirements of rail transport paved the way for the extension of the limited liability model, which capped shareholders’ losses when their companies could not pay their debts.
Still, partnership (which offers no such protection) remained the norm in finance. The failure in 1866 of Overend Gurney, the iconic British banking collapse of the 19th century, happened just a year after its incorporation. When the House of Baring faced collapse in 1890, the Bank of England co-ordinated a rescue, but the partners were ruined.
Louis Brandeis, a progressive lawyer who became a distinguished Supreme Court Justice, borrowed Smith’s “other people’s money” as the title of his excoriation of American finance sector at the beginning of the 20th century. Brandeis’s concern was the intermingling of industry and finance that was characteristic of America’s “gilded age”. It had allowed JP Morgan and Andrew Carnegie, Henry Clay Frick and John D Rockefeller to create a self-reinforcing cycle of economic and political power. That power, Brandeis stressed, was acquired with the savings of the American public.
The progressive backlash led by Brandeis and hostile journalists — the “muckrakers”, such as Ida Tarbell and Upton Sinclair — enjoyed some success in exposing the excesses of capitalism. The great industrialists of the interwar era, such as Alfred Sloan and Henry Ford, treated finance with disdain.
Smith was not alone in warning that those who staked other people’s money would not treat it as carefully as their own: “When I speak of high finance as a harmful factor in recent years, I am speaking about a minority which includes the type of individual who speculates with other people’s money.”
This was President Franklin Roosevelt in 1936. The Wall Street crash and the introduction of securities regulation imposed new discipline on finance and its relationship to business. That worked for 50 years. But when Barings failed again in 1995, the organisation had become a limited company. The wealth of managers who supervised “rogue trader” Nick Leeson survived the crash; their business did not.
Barings had converted to a public company as part of the rush to incorporation that characterised the financial sector in the 1980s and 1990s. Partnerships had been the norm in stockbroking, market making and investment banking; mutuals had been common in lending for house purchase and in insurance. Most now chose limited liability and a stock market listing. Lehman was one of the first to become a public company — and its first near-death experience, in 1984, soon followed.
The ostensible reason for conversion in most cases was the need for wider access to capital; the effect was that the goodwill of these businesses could be monetised for the benefit of those fortunate enough to be around at the time. A less widely appreciated consequence was that people in lower tiers of these organisations, deprived of the rewards of partnership, received as bonuses the profit shares once paid to partners.
A new gilded age began. The mantra of “shareholder value” restored the nexus between finance and business that Smith had feared and Brandeis denounced, and again elided the difficult but critical distinction between other people’s money and one’s own. And the stage was set for negligence and profusion to prevail once again.
This article was first published the Financial Times on September 9th, 2015.