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Shipping companies use a number of dirty practices to evade responsibility, study shows

The shipping industry handles 80-90 per cent of global trade in goods and has been the backbone of the ‘third wave’ of globalisation that started in 1980s.

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Recent years have been marked by growing concerns about doing business “responsibly,” for example, by taking environmental damages into account. Which corporate structure or legal system helps to better achieve this goal is a key question. I studied the relation between the ability to use limited liability when structuring corporate groups and corporate responsibility by looking into the maritime shipping industry. I define “responsibility” as decision-taking motivated by (i) preventive decisions in day-to-day operations to avoid “disasters,” (ii) compliance with regulatory standards and (iii) consideration for long-term impact, potentially at the cost of short-term profit.

Limited liability of equity holders is one of the main features of modern corporate law. While its costs and benefits are theoretically well understood, two issues remain under-explored. First, regarding costs, existing research has mostly focused on “risk-shifting” towards contractual creditors, such as lenders, and neglected tort creditors, such as victims of environmental damages. As opposed to lenders, tort creditors are not part of any contract with firms, and so cannot protect themselves via contractual clauses.

Second, the theoretical benefits of limited liability — for example, allowing investors to hold diversified portfolios — apply primarily, if not only, to individual investors. However, parent companies also benefit from limited liability vis-à-vis subsidiaries. Together, the use of subsidiaries and the possibility to externalise tort liabilities open the possibility of massive corporate irresponsibility: socially costly activities can be located in small subsidiaries, possibly in jurisdictions with low regulation. Corporate irresponsibility is then organised by paying out any income to parent companies and liquidating subsidiaries in case of large liabilities.

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Why the shipping industry

I studied the evasion of corporate responsibilities within the maritime shipping industry for several reasons. The shipping industry is economically relevant, as it handles 80-90 per cent of global trade in goods (UNCTAD, 2019). As such, it is the backbone of globalisation. Moreover, the three components of responsibility identified above are relevant: (i) “disasters” can arise from day-to-day operations, such as from oil or chemical spills, (ii) regulation exists but can be evaded via flags of convenience, and (iii) “long-run” risks are important, due to the recycling of large and dirty tankers or containerships.

Finally, the activity of subsidiaries is arguably more observable in the shipping industry than in other industries where responsibility evasion via small and offshore subsidiaries may also be taking place (banking, chemicals, etc.). For my tests, I collected detailed data on the ownership and operations history of all large merchant vessels that ended life over the 2000-2019 period.

I use these data to make two contributions. The first one is to document dramatic changes in the shipping industry over the past four decades, in order to systematically evade responsibilities. All three dimensions of corporate responsibility discussed above are concerned. At a broad level, the trends coincide with both the “third globalisation wave” (starting in the 1980s) and with the recent rise in tort liabilities, itself associated with growing environmental concerns.

As a second contribution, I explored the microeconomic determinants of these trends more precisely. Empirically, causality is hard to establish, because long-term trends necessarily correlate with a number of other “time effects.” For identification, I used a variety of theoretically motivated strategies, exploiting either fixed effect specifications, cross-sectional variation or plausibly exogenous sources of variation at high frequencies. These tests support the view that responsibility evasion is a major determinant of the stylised facts.

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Disassociating ownership

The first main fact is the increasing dissociation of ownership, which takes several forms. Most importantly, ships, which used to be owned by groups, are increasingly held by subsidiaries. In other terms, the legal and the ultimate ownership of ships are now separated. Furthermore, the amount of assets in each subsidiary is minimised, as shipping companies typically create one distinct subsidiary for each ship. In 2020, almost 90 per cent of all registered owners of ships globally are one-ship subsidiaries.

This structure allows shipping companies to insulate the parent’s assets, and ships in other subsidiaries, in case a ship causes costly damage. Consistent with the view that the dissociation of ownership is driven by liability evasion, I found that dissociation is more likely when beneficial owners hold more ships, and when damages potentially arising from these ships are either more costly or more likely: for larger ships, for older ships and for single-hull ships.

For identification, I also used quasi-random variation arising from ship detentions by port authorities. Such events arguably lead companies to update their view about the liabilities that may arise from a ship. In the three months following ship detentions, I found that ships are significantly more likely to be moved to new subsidiaries.

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Evading regulation

The second fact I document relates to the evasion of regulatory standards. This is achieved by registering ships with flags of convenience, that is, countries that sell the right to use their own flag, but do not always verify the compliance of ships with international standards. Theoretically, the issue of flags of convenience is closely related to limited liability: the possibility to dissociate a corporate group into many subsidiaries also allows choosing where subsidiaries are located, and so the regulatory framework to which they are subjected.

The use of flags of convenience has been booming over the past four decades. For example, for containerships, they represent 82.3 per cent of the global tonnage in 2019, as opposed to only 19.6 per cent in 1980. This growth of flags of convenience is not driven by selection of ships or shipping companies over time, but by active reflagging decisions.

The widespread use of flags of convenience implies that the world fleet is composed of older and riskier ships, which are more likely to be lost at sea. In terms of the mechanism, if regulatory evasion is a dominant force behind the adoption of flags of convenience, then it should be more likely when the need for shipping companies to cut costs is felt more strongly. Consistent with this idea, I found that the adoption of flags of convenience is more likely when freight rates are low.

For further identification, I relied on events in which a company loses a ship at sea. These events are plausibly random, and suddenly tighten the financial constraints of shipping firms. I found that, in the following three months, these firms became more likely to reflag other ships, including to flags of convenience. Therefore, flags of convenience are a way to reduce costs amidst global competition.

Consistent with the idea that flags of convenience are used to evade regulations, I also found that older ships fly lower-quality flags (such as, flags of countries that have ratified fewer international conventions) and move to world areas where they are less likely to face tight inspections by port authorities.

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Evading long-term responsibility

My final results relate to the third dimension of corporate responsibility, that is, the ability to take long-term outcomes into account. Long-term responsibility is key in the shipping industry, since old ships are large and often dangerous waste.

I explored two decisions related to end-of-life ships, both of which show how companies evade long-term responsibility by way of third parties. First, almost all ships globally are dismantled in poor environmental conditions after being “beached” on the shores of Bangladesh, India or Pakistan. Second, a fast-growing number of shipping companies use “last-voyage flags,” most likely in an attempt to hide such dirty practices: ships are sold to a third party just for the last voyage to a beaching yard. In doing so, shipping companies get paid for the value of a ship’s raw materials, but do not assume any of the responsibilities associated with toxic wastes or oil residuals (which end up at sea).

While last-voyage flags were close to non-existent in the early 2000s, they represented 55.2 per cent of all end-of-life ships globally in 2019.

The six most-popular last-voyage flags are primarily flags that did not exist in the early 2000. The most striking example is the one of Palau, an island with a population below 20,000 inhabitants and a capital city below 300 inhabitants. Its ship registry represents less than 0.001 per cent of the world fleet, but 59.5 per cent of last-voyage flags in 2019. In other terms, it is likely that this registry has been created specifically with the purpose of allowing shipping companies to evade end-of-life responsibilities.

This practice of last-voyage flags is again related to limited liability: in this case, shipping companies evade responsibilities by outsourcing dirty decisions to small limited liability third parties. In cross-sectional tests, I found that last-voyage flags are significantly more common for companies in common law jurisdictions: this is consistent with the view that judges in common law countries are more likely to take contracts seriously, and not to consider them as mere veils to hurt public interests.

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This paper shows that the maritime shipping industry, which constitutes the infrastructure of the last globalisation wave, has evolved over the past four decades to systematically evade responsibilities. The shipping industry came to rely almost exclusively on dissociated legal and ultimate owners, on one ship subsidiaries, on flags of convenience, and on last-voyage flags. A number of tests confirm that liability and regulatory evasion, in a context of global competition and growing environmental concerns, are dominant forces behind these patterns. An open question is whether similar forces are at play in other industries where the activity of offshore subsidiaries may be less observable.

These findings have a variety of implications. First, they highlight a downside of globalisation: the drop in transportation costs was partly achieved via the evasion of shipowners’ responsibilities, including environmental liabilities. In the terminology by economist Dani Rodrik, globalisation may have gone “too far”.

Second, my results raise questions about the use of limited liability in parent-subsidiary relationships, particularly for tort liabilities. Indeed, limited liability enables group owners to externalise damages to society. The associated costs are more severe than those generated by standard risk-shifting, since tort creditors are not contractual creditors. Based on a similar reasoning, some legal scholars have challenged the use of limited liability for torts or for fully-owned subsidiaries. Raising the issue of extended liability is especially important given that ex post liability and ex ante regulation are not perfect substitutes.

Finally, the facts that I document call for more careful definitions and measures of corporate social responsibility (CSR). The debates on CSR cannot abstract from concrete liabilities and regulations that may be evaded or masked through networks of (potentially offshore) subsidiaries.

Guillaume Vuillemey is associate professor of finance at HEC Paris. 

This is an edited excerpt from the author’s paper, first published in the journal Social Science Research Network (SSRN). Read the full paper here.

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