Appropriate legality

My alternative to limited liability is to rely more on partnerships; or, to be more precise, limited partnerships.

Small is Beautiful, EF Schumacher’s book on “economics as if people mattered” is no longer as trendy as it once was but the lessons it teaches remain as valid today as they were 30 years ago.

The essence of Small is Beautiful is the contention that bigger is not always better, that what is more important is to have something that works rather than something that is the newest and most modern. In particular, Schumacher argued for what he called “appropriate technology” as a middle path between primitive and the state of the art.

My argument today is that just like technology needs to be “appropriate”, so, too, does “legality”. To the extent that law-making is ever consciously done in Pakistan, it consists all too often of outside consultants stuffing their chosen vessels with as many pet theories and ideas as possible. This is not necessarily the best way to proceed.

Take, for example, the law of companies. I have recently met a number of people all working either to develop small businesses or to help small entrepreneurs. These include Umar Saif at the Punjab Software Board and Kalsoom Lakhani of  “Invest 2 Innovate”. In each case, one of the standard problems they report is the lack of a proper exit option for investors.

Before I offer my proposed solution, let me first explain how investing works in the US. The standard process there is that someone with a good idea first patents his concept, then sets up a private company using money borrowed from his parents. Assuming the concept is good, he (or she) will then go looking for investors. If the investors think the idea is good, they will buy into the company and receive shares in return. But the real big pay-off normally comes when the company goes public and the shares of the company are available for trading.

In Pakistan, the problem is not in terms of setting up a company. If anything, the Securities and Exchange Commission of Pakistan (SECP) has done an admirable job of making it both easy and quick to set up a company. The problem is that setting up a company doesn’t get you anywhere while also burdening the fledgling entrepreneur with significant regulatory costs.

Let me first explain why setting up a company doesn’t “get you anywhere”.

The basic idea behind a limited liability company is that it allows people with money and people with brains to get together in such a way that nobody gets to lose more than the specific amount of money they have invested in the company. In Pakistan, however, the concept of limited liability is meaningless. This is first because our banks normally don’t lend money without a personal guarantee to back it up. Second, the NAB law provides that if a company defaults on a loan — for any reason whatsoever — the directors and shareholders can all be held personally liable. The net result is that even if you set up a company, you personally are still on the hook and people are still afraid to get involved because they could wind up going to jail for the defaults of the company. Yes, I know, it’s medieval. But, so far as I can tell, nobody with any actual power in this country actually gives a damn.

The further problem with companies in Pakistan is that running a company carries significant regulatory costs. Each company needs to file reports every year with the SECP, specialised people are needed to keep track of shares and corporate formalities like having board meetings and there is a whole world of laws out there applicable to corporations which the average entrepreneur knows nothing about. Finally, the biggest problem with companies is that the exit ramp to riches through an initial public offering (IPO) is not generally feasible.

An IPO leads to riches in the US because the US has an established process whereby people are willing to put their money in completely unknown companies in the hopes of making it big. There is no equivalent investor community in Pakistan nor is there an equivalent established procedure.

My argument, therefore, is that we need to think outside the box and look for other collaborative models. Yes, the limited liability company may be the way things are done in the West. But that doesn’t mean it’s the best way for Pakistan.

My alternative proposal is to rely more on partnerships; or, to be more precise, limited partnerships.

The simple definition of a partnership is that it is the relationship between two or more persons who have agreed to share the profits of a business. Under Pakistani law, every partner must be a general partner — i.e. someone who is completely liable for all the debts of the firm. English law, however, since 1930, has recognised the concept of a limited partnership in which there are two classes of partners — general partners and limited partners. Unlike general partners, limited partners are not liable for the debts of the partnership beyond the size of their stake in the partnership.

In my view, small entrepreneurs in Pakistan would be far better served by limited partnerships than by the corporate model. Limited partnerships require one simple contract to set up and one-time registration. Furthermore, partnerships are tax efficient and avoid the double tax on income which is a problem with corporate dividends. Finally, limited partnerships allow investors the same degree of liability protection as companies.

The only problem with my analysis is that Pakistan does not have limited partnerships. But that is purely due to legislative laziness, not for any other reason. India has been offering limited partnerships since 1996 and Pakistani professional associations have been asking for limited partnerships for decades. Nor is the law itself very complicated. I have already drafted a model limited partnership act and it takes up all of three pages.

Allowing limited partnerships in Pakistan is not going to solve the problems faced by local entrepreneurs. But it would certainly be a good first step. And it would, for once, show that someone in government actually cares.

Published in The Express Tribune, December 18^th, 2012.