What does ‘Limited Liability’ mean?
Limited liability (LL) presupposes that the debts of the company are separate from the debts of its investors and has been dubbed an ‘ingenious device’ by legal experts. This is because the company is a distinct legal personality, separate from its shareholders.
The ingenuity of Limited Liability
The most compelling arguments for LL as a unique and ingenious device are based on principles of economic efficiency. Foremost, LL encourages economic activity by protecting investors from loss that exceeds their equity capital. In this way, LL facilitates people to take commercial risks in their trade without the anxiety that they will be personally liable for any fiscal damages – encouraging investment and economic growth. Indeed, investors facing a potential of unlimited liability would be concerned about the risk of losing their entire wealth through failure of a company they’ve invested in. Furthermore, shareholders would demand greater return from their investment because of the associated risks. Additionally, LL results in decreased monitoring of the company’s behaviour by shareholders because their risk is confined to the loss of the equity which they invested. Moreover, LL permits equity diversification by reason that investors can reduce their individual risk through acquiring shares in a variety of companies. LL directly promotes market efficiency, as the prices at which shares trades does not depend on the wealth of shareholders.
Despite its myriad of benefits, LL has disadvantages. First, it is important to note that the usual arguments for LL are less clear in the case of closely held companies and subsidiary companies. For example, it is usual for a controlling company to monitor its subsidiary company and by extension, this reduces the need to diversify shareholdings. More broadly, LL creates a problem of moral hazard. That is, the transfer of the burden of liability from shareholders to creditors facilitates increased risky behaviour by the company. It may incentivise behaving opportunistically by allocating resources to risky economic activities, for the purpose of generating greater profits. By this, LL allows for corporate recklessness as the company lacks any reputational incentives, given that the shareholders will not bear all the expected costs of the risky activity. The uncompensated transfer of risk means that creditors will not be compensated. Furthermore, in the case of insolvency, tort victims may be left unpaid when the company is unable to meet liabilities, bearing the burden of business failure. This is unjust, and leaves tort victims unprotected and uncompensated.
To ensure that creditors and tort victims are partially paid off in the case of insolvency, a potential reform is to increase shareholder liability. This could be done by adopting a control-based approach, whereby liability is based on how much control the shareholders exercise over the company. By this, substantial shareholders may be personally liable for corporate torts inflicted by companies in which they hold shares. However, it is noted that this may increase the risk of shareholder bankruptcy. Alternatively, it is recommended that the senior executives, or whoever pursued the corporate violation, should be personally prosecuted. This would disincentives risky behaviour and ensure all appropriate precautions have been taken by the company before any decisions are made.