When Charles Dickens, the famous British novelist, was a young boy, his father was a pay clerk for the Royal Navy, but was not able to manage his money well and accrued more and more debts. Eventually he was put into debtors’ prison, whereupon young Dickens had to work in a factory to make ends meet.
In another interesting financial case, the father of Henrik Ibsen, the famous Norwegian playwright, was a well-to-do merchant, but encountered hard economic times in the 1800s and the family had to sell their main house to pay losses due to a business downturn.
This is said to have made it impossible to send Henrik Ibsen to university, whereupon he was forced to leave school at 15 and become a pharmacist apprentice. Later on both writers used their experiences to create amazing stories and plays. Such personal tragedies, though, should not always lead to family destitution and ruin. We have laws now that protect personal assets from business losses and debt. And this is where the idea of limited liability comes in.
When beginning a business, one must create an entity—a business structure or limited liability company to separate your personal finances, from your business finances. As recently as two centuries ago, everyone’s business was essentially farming, so when your business did poorly, you had to pay creditors from your personal finances. Your personal finances and your business were considered indistinguishable.
After the Industrial Revolution, though, there was more business in the city away from the farm, and so it made sense to separate the business part of one’s life from the personal part. The idea of limited liability was born and limited liability companies of different types came into being, such as the corporation. It would be the entity, which would conduct business, hire workers, and lure investors and owners; however, all of these actors would have lives and personal assets separate from the corporation.
Everything that the corporation owns or has is the corporation’s and if something ever went wrong with that corporation’s business then creditors would take everything that the corporation had as payment for the debt. If anything still remained, it would go to the owners; however, if the corporation still owed money to the creditors, the creditors could not go after the owner’s personal finances or workers’ finances to get their money, as that is separate.
What this does is allow business to take more appropriate risks. In turn, this helps induce more business activity and a better economy. For example, imagine if you had been an investor in the H.W. Johns manufacturing company. Such a company in the mid-1800s would seem to be a sound investment. They created new products that could fireproof roofs. The material? Asbestos in the era before it was found to contain cancer-causing properties. For investors this was a sound investment: how could a venture providing fireproofing fail? And if it did, you the investor would not have to worry that the creditors for the company will come after your personal finances.
Granted, the company later merged with Manville Coverings and the Johns Manville Corp. hid evidence about adverse health effects, but that is a different aspect from the early stages of the saga where the entity was least was trying to research and find a new helpful product.
Note to be fair, the company created materials good for fireproofing and because of the research, better insulation materials are now available. However, the original goal was valuable: to save lives from fires in a day where many people would die in building fires, and where those fires could have been reduced in their severity by such fire-resistant insulation as asbestos.
Nevertheless, when a business makes a mistake, that does not mean that all the owners like Ibsen’s and Dickens’ fathers will have to lose their life savings.
Interestingly enough, the Johns Manville Company eventually emerged from its bankruptcy and its litigation and in 2001, Berkshire Hathaway, run by Warren Buffett, purchased the company. Therefore, clearly a company can have many good ideas and good products that benefit society even if one of their lines of business does cause trouble.
Of course, as a business, when a problem emerges, you want to solve the problem or come to a resolution with all parties involved, but that does not mean everything you do is wrong. And that is probably a wonderful story for another column in this page.
Douglas B. Reynolds Ph.D. is a professor of economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at DBReynolds@Alaska.Edu. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.