limited liability

limited liability

"Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct."
MBCA § 6.22(b)

The law permits the incorporation of a business for the very purpose of avoiding personal liability. Walkovszky v Carlton. Likewise, it is proper to break a business into multiple corporations so as to limit the liability of any one particular part of the enterprise. But see enterprise liability. Thus, equity [shareholders] of a firm risk no more than they put in. Note that debt creditors also enjoy "limited liability" in this sense, since they are not going to lose more than the amount they lend. Human capital liability is also "limited" in this way. Shareholders can also minimize their risk by shifting their assets into lower-risk investments such as Treasury bills.

Note also that corporations could create limited liability by contract if it didn't exist (for example, "nonrecourse" lending where a lender promises not to sue a debtor in exchange for higher interest). The limited liability rule thus lowers transaction costs.

Limited liability encourages the accumulation of capital, so that shareholders can invest their money at lower risk. Shareholders can thus enjoy lower agency costs, which would otherwise be high if a large number of diffuse shareholders had to monitor their directors.

Theory

Limited liability lowers the agency costs of shareholders, who can spend less time monitoring directors and other shareholders because their total risk is less. For the same reason, limited liability encourages the fungibility and diversification of share trading: would-be shareholders have to gather less information and can hold a greater variety of shares, thus reducing risk, while a system of unlimited liability would mean that any one holding in an investor's porfolio could bankrupt him, so that investors would hold fewer sorts of shares. Fungibility further reduces agency cost, as it increases the possibility that badly performing directors will attract outsiders to purchase the firm's shares and replace the board so as to increase their own profit. And diversification allows directors to take more risks, since the loss of one project will not ruin most shareholders.

Limited liability also helps the market efficiently price securities: their value is simply the discounted value of future income, which would have to be further discounted by (expensive-to-acquire) information about the individual risk that a particular corporation may pose.

Note that limited liability effectively shifts risk onto creditors, who face the possibility that the firm's debts will go unpaid. Under unlimited liability, in comparison, almost all the risk of loss would be faced by shareholders. But shareholders gain the benefits of the extra risk-taking that limited liability encourages, while creditors gain nothing. While this may create moral hazard, it is unclear whether the risk is offset by the gain made by the extra investment that the risk-taking will produce. Furthermore, voluntary creditors will not invest in a firm where the expected risk outweighs the expected return, or where they do not have enough information to monitor, regardless of whether liability is limited or unlimited. Cf. Coase Theorem.

See piercing the corporate veil, purpose of corporations

transaction costs of ex ante bargaining about limited liability:

Public corp Low impossible

Private corp High impossible

With contract creditors of a publicly held corporation, contract creditors would prefer unlimited liability, while shareholders would prefer limited liability, since they stand to gain residual profits. However, contract creditors can more cheaply monitor corporations' actions (through contract terms, etc.). Limited liability thus places the burden on the least cost avoider; creditors thus accept the greater costs and risks of monitoring for misbehavior in return for a more secure claim on the corporation's assets.

Bankruptcy

Note that equityholders (that is, shareholders) take in bankruptcy after the "secured" debt creditors; the shareholders effectively contract to get the residual value of the firm, rather than a fixed amount taken by debtors. Equityholders' increased risk increases their incentive to monitor directors; furthermore, shareholders can to an extent free-ride on the information possessed by creditors, who are most likely repeat players (institutional creditors such as banks issuing debt to the firm) and may have specialized information about the firm.

Insurance

Corporations can also purchase insurance to offset the risk of actors who cannot diversify their invested capital, such as employees who have invested firm-specific human capital. Insurance also creates an extra contract creditor (the insurer) who can charge a premium for extra risk imposed by the firm's actors.

Cases

Walkovszky v Carlton (refusing to hold a shareholder of many taxicab corporations, each with only one or two cabs, personally liable because he had moved funds out of each corporation so as to avoid negligence liability beyond the statutorily required minimum)
Costello v Fazio (subordinating the claims of promoters in a bankruptcy proceeding to that of general unsecured creditors where promoters had withdrawn nearly all of a money-losing partnership's capital before incorporation so as to protect themselves)

See also corporation law, corporation form