Felix, I'm proposing that all investors be partners with unlimited liability. Investors would remain protected by limited liability, in as much as the funds invest in limited liability instruments. If the fund is not leveraged and purchased stock, then fund participants can lose no more than they invest.

But for funds that choose to invest borrowed money, my contention is that the net positive externalities of financial speculation are not sufficient to justify a state grant of limited liability. Indeed, investors in leveraged funds could, in a rout, lose more than they have invested.

Why should wealthy, "accredited investors" who invest on margin via hedge funds receive more protection than a retail investor who does the same without an LLP between herself and the bank? Why should a fund investor who indirectly takes positions in derivatives markets be better protected than say, me, when I write an option or take a futures position as an individual?

Felix -- That's a very good question, and implicitly an excellent point.

My original suggestion of organizing investment funds as ordinary partnerships implies joint and several liability, so that in your example, the pension fund would be on the hook for obligations that investors with shallower pockets do not meet.

Pro rata liability might be worth considering. Joint and several liability increases the risk of faced by fund investors relative to direct investors, thus discriminating in favor of retail investors rather than creating a "level playing field". But pro rata liability is also problematic. Despite a lot of historical and theoretical interest, no common legal form currently apportions liability in this way. From a practical standpoint, it's easy to see why. It would be very hard for lenders and counterparties to judge the creditworthiness of a fund with many investors responsible only for their small piece.

None of the alternatives are ideal. But given existing organization forms, I'd argue that joint and several liability is clearly superior to full limited-liability for investment funds. Investors can mitigate their own risks completely by choosing funds that restrict their investment to stakes in limited liability entities, and leveraging themselves individually as much or as little as they please. Investors who choose to join funds that take very risky bets ought to be responsible for those bets, and if that means policing the creditworthiness of their coinvestors, that seems like a good outcome to me. Investors like pension funds, which are deep-pocketed fiduciaries for risk intolerant beneficiaries, probably would have to steer clear of funds that are highly leveraged or that enter into risky derivatives contracts. Again, this seems to me a feature rather than a bug.

Douglas -- Good points all. "Limited liability socializes risk," is a shorthand, not entirely accurate for reasons you suggest, but not as inaccurate as you claim either. Limited liability entities are supposed to prominently advertise that fact (e.g. "Inc.", "LLP", "SRL", "Ltd."), the idea being that all counterparties know what they are getting into. So you can claim that anyone with exposure to a limited liability entity has explicitly contracted to take on their risk.

This analysis is theoretically correct, but fails a real world smell test:

1) It is perfectly possible for unlimited liability entities to arrange for nonrecourse credit arrangements backed only by business assets. In an idealized world of rational actors without transaction and information costs, the default arrangement wouldn't matter. In the real world, the popularity of LL entities argues that which arrangement "normally" prevails matters a great deal.

2) Banks are not the only creditors to LL entities. Most employees, customers, and suppliers, are direct creditors as well. When a company goes bankrupt abruptly, the costs can be spread quite widely, often among parties who could not have been expected to do a thorough analysis of the company's financial situation and business risk.

3) Even among diligent creditors, there are hard informational problems in evaluating firm solvency, meaning that creditors must assume a form of model risk in dealing with many LL entities. Think Barings -- creditworthy, not fraudulent (as an organizations), great books, broke in an instant thanks to one employee. In a world where the defaults were set up differently, lendors might seriously discriminate against LL entities. In the real world, that would mean discriminating against the vast majority of business customers of any scale.

4) Finally, as you note, the lending decisionmakers may have different interests than those of depositors, governments, and taxpayers, all of whom are implicitly guaranteeing many loans and pension funds. Any LL entity whose stakeholders will in practice be bailed out by a government clearly has its risks socialized. All banks, most pension funds, Freddie, Fannie, arguably LTCM and Chrysler, we're talking large numbers of large entities. And there is a perverse incentive here, since the larger the risks taken by an organization, the more painful the costs to other stakeholders, the more likely taxpayers will end up footing the bill even without an explicit guarantee. (See my agency costs piece for more on this.)

For all these reasons, I think that in practice it is more accurate to say that "limited liability socializes risk" than to assert that it does not. But the phrase is a bumper sticker answer to a complicated question.

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You write, "Your position seems to be that these businesses are not productive, so they should be treated as second-class businesses. I think they are productive, of liquidity, though I'm not entirely sure."

My position is that limited liability does matter, and that a default it should only be granted to organizations whose risks the citizenry wishes to encourage. All business and risks have costs and benefits. Indeed, hedge funds are major liquidity providers, and liquidity is important to financial markets. But they take very large risks, and are better able to shift the costs of those risks to other parties than other kinds of enterprises. It is a judgement call, but in my judgement the benefits of "hedge fund entrepreneurship" to the general public do not sufficiently outweigh the external risks their activities create to merit a grant of limited liability.

If I didn't think systemic risk and bank agency cost issues were serious, I'd probably come to a different judgement.

A very interesting idea.

To provide negative feedback for the use of large quantities of leverage, it may be sufficient to limit liability to the managerial partners of the fund, as opposed to extending it to the investors.

Yes, it would be nice to also de-incentivize "investing irresponsibly" in irresponsible hedge funds, but investors don't directly make decisions about how much risk and leverage to take on. Thus, it may not be necessary (or fair) to imperil them with over-unity levels of liability -- especially when they may be acting on falsified prospectus and reporting information.

And arguments about the depositors having deep pockets may not find a sympathetic ear with those that have noted institutional and pension fund participation.

Another idea for how to solve the "excess leverage"/insolvency problem through regulation, without really adding any more regulation, would be to simply bring back reserve requirements and not exempt broad money from their reach.

Aaron -- The problem with only putting managers at risk is that they'd be small players taking on the liability created by very large pools of money, very highly leveraged. The position of hedge fund creditors would not be substantially improved, as managers would be bankrupt instantaneously if their funds went down. The approach would severely disincentive established managers from taking risk. But we'd end up with a world where established, wealthy managers run conservative, long-only funds, while young-whippersnappers with nothing to lose but a leased Porsche would risk personal bankruptcy in order to let institutional investors risk other peoples' money.

I'm not sure that the money genie can be put back into the bottle, at least not until it dies a traumatic natural death. But it'd certainly be worth a shot.