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Stopping to think about limited liability

1st January 2014 By David Bell in Business advice

© Si Barber 07739 472 922.Staff and members at Foundation East 06092011. ..Limited liability companies are such a fact of life, both in the UK and around the world, that one does not often stop to think about why that is, and whether it is unarguably a good thing. This may sound slightly heretical but recently I have been doing just that. For me it has been rather like my approach to the concept of free markets: people of my generation have grown up being taught of free markets as a more or less unalloyed force for good, or at least as the ideal to be aimed for, and it is only in more recent years that I have started to see that this may not actually be true. When the instances of market failure seem to outnumber those of market ‘success’ and when the markets which we are presented with as being most ‘free’ (e.g. the financial markets) are actually riddled with structural biases and imbalances, one does start to wonder. But that is a subject for another post …

Limited liability does not in fact have as long a history as one might think – the concept emerged in England earlier but was rare until the 19th century, from when it caught on in a big way so that by the end of that century it was common practice throughout the western world. It is often said to have been a (or even the) key enabling factor in the shift towards large-scale industrialisation (a proposition that obviously can never be tested).

The most oft-quoted, and most readily understandable benefit of limited liability to society at large is that it encourages entrepreneurship – in fact this is not obviously and always a good thing per se – if it allows the entrepreneur to take bad risks at the expense of his creditors then the net benefit to society may be negative. This is one of the areas which first prompted me to think about this subject – successful entrepreneurs (especially before the internet age) typically have many failed ventures behind them; in addition, for each successful enterprise in a given field there will be numerous failed ones; all of these failures will have resulted in losses for bank, trade and tax creditors and sometimes employees too – might the aggregate losses in fact outweigh the gains of the one success? The direct effect of limited liability really is only to transfer risk and cost from investors to creditors and a further problem with this is that not all creditors are dealing as equals. Trade and bank creditors tend to make sure they are well protected, whether by charges or personal guarantees - whereas the largest unsecured creditor in a bankruptcy is very commonly the public purse. And there is another type of potential creditor who does not even have the opportunity to negotiate terms – a third party who is harmed by the corporation’s actions, whether a single person when something falls on them in the street or all of us when serious environmental damage occurs.

The more closely thought through argument in favour of limited liability concerns capital efficiency, where there are a number of factors at work:(i) limited liability facilitates aggregation of the capital of many small investors who wouldn’t want to be on the hook for a large enterprise’s potential losses, (ii) it allows the small investor to diversify his own portfolio and therefore accept a lower return on his capital, (iii) it removes the costs to the investor of having to monitor management and fellow shareholders behaviour and actions, and (iv) it enormously improves transferability of shares, as without it the company’s creditors would want to assess each new shareholder based upon their private resources. All these together undoubtedly result in more efficient allocation of capital, although you may notice they apply really only to large scale public corporations – they are largely irrelevant to closely-held companies which are of course, by number, far the most typical case of limited liability corporation.

I think that the lesson from my musings here is that all of us who benefit from the limited liability regime, from the window-cleaner all the way to the hedge-fund manager, should learn to think of it much more as a privilege than a right, and therefore seek to conduct ourselves with the utmost probity in all of our business dealings.

In researching this blog post I have relied very heavily on David Millon’s 2007 article in the Emory Law Journal, which you can read in full here.

  • About the Author
    David Bell

    David Bell

    Director