Back to the nineteenth century


 

IIn June 1892 Aron Salomon, a boot-maker from East London, set up a company called Salomon & Co Ltd. He had 20,001 shares in it. His wife, daughter and four sons, also shareholders, had one share each and were, according to judge Vaughan Williams, ‘mere dummies’. In a way the company was Mr Salomon himself, but in somewhat different form.

Aron Salomon sold his business to Salomon & Co Ltd and the price he and his other self agreed upon was such that he not only drained cash from the company but became its creditor. He secured the loan by the company’s assets and when, very soon, the company folded creditors got nothing. They tried to sue and reach his personal assets but in vain.

The story, known as Salomon v Salomon, is the cornerstone case of modern corporate law. It extended limited liability to the smallest, one-man companies. Though the decision has remained controversial the idea that everybody should be allowed to shield personal assets from debts created by his or her own business is so entrenched in our minds that few have dared challenge it.

This week the Supreme Commercial (Arbitrazh) Court published on its website the new version of the Civil Code proposed by the President’s Council for Codification and Improvement of Civil Legislation. The proposed changes have been around for months and, judging by the imposing panel of developers and the political support they receive, the amendments will become law in the near future. When this happens the minimal capital requirement for a company in Russia will increase 50 times over, from 10,000 roubles or $320 to 500,000 roubles or more than $16,000.

In effect, limited liability protection will become too expensive for small businesses. For many the reform will mean a return to the nineteenth century when an entrepreneur was held liable along with all his property. If the business failed he and all his business partners lost everything: land, money, house.

The corporate veil was not created by economic demand but political will
 

Limited liability – in fact, no liability at all – is the sacred cow of our company law, its Alpha and Omega. We tend to believe that it is inherent in the nature of business as an inevitable product of the evolution created by the economic necessities of the industrial revolution and that it is universal, undisputed and indispensable. We take it for granted, therefore, that corporate law everywhere must provide for the easy creation of incorporated, limited liability companies.

Yet the corporate veil was created not by economic demand but by political will. The industrial revolutions in Europe and in Russia had little to do with corporations – they were carried out by partnerships where every member was liable to the last rouble or shilling. Nor do we really know why a separate legal personality must be easily available to everyone, including the smallest businesses.

Entrepreneurs in Victorian Britain and merchants in late nineteenth century Russia were generally opposed to the idea of limited liability. Rewarding success and punishing failure was considered natural and fair. ‘There is no shifting or narrowing of responsibilities’, wrote Professor John McCulloch from University College London, ‘every man … [should be] personally answerable to the utmost extent for all his actions’. For Adam Smith the apparent disparity in the risks and rewards taken by shareholders in companies with limited liability – they benefit from a cap on their down-side risks, whereas the chance of up-side gain is unlimited – paved the way to ‘negligence and profusion’.

Nowadays we cannot imagine our economy without corporations but the rationale for separating a one-man company from its owner remains blurred. There is little economic sense in such a structure unless it is heavily capitalized: banks, like most prudent creditors, would only lend if they can reach the personal assets of those behind the corporate veil. They refuse to deal with small companies as separate entities and tend to treat them as good old partnerships.

Yet the ultimate target of the reform is the fly-by-night companies which don’t conduct genuine commerce but effect an entrance to the economic netherworld. If the reform works out as planned, there will be fewer companies to control, and the army of taxmen - one of the biggest in Europe – will be able to collect whatever is needed. It will be the end of relatively low taxation in Russia.

The World Bank, which believes that capital requirements should be as low as possible — or even better, abolished entirely — will probably drop Russia from the 123rd place - the ranking of ease of doing business - further down its list. For the first time after years of copy-pasting Western legislation, Russia doesn’t seem to care and, believes RussianLawOnline, rightly so.

 

picture: NatalyArt - Fotolia.com

This article in abridged version also appeared in The Moscow Times

 

 

Do small businesses need limited liability?
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