Limited Liability and the Efficient Allocation of Resources: Twenty-Five Years Later

Limited Liability and the Efficient Allocation of Resources: Twenty-Five Years Later

The following piece is a part of NULR of Note’s “Bring Back The ‘90s” initiative, aimed at exploring the evolution of legal thinking over the past three decades. For more, click here.

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In Limited Liability and the Efficient Allocation of Resources, 89 Nw. U. L. Rev. 140 (1994), I responded to a chorus of scholars who suggested that limited liability for corporations had outlived its usefulness—a thesis that was based in large part on the mistaken assumption that limited liability was meant to subsidize entrepreneurship. I also responded to the critics of the critics who offered overly ornate justifications for limited liability, such as the need (in its absence) for investors to monitor management and other investors. (I tend to agree with William of Ockham that the simplest explanation is usually the best explanation. But I also agree with Einstein who more or less said that everything should be made as simple as possible, but no simpler.)

To be clear, I do not disagree that subsidies are usually a bad idea. Folks should bear their costs lest we encourage the formation of businesses that make no economic sense. My simple thesis was that limited liability does not in fact operate as a subsidy—as an incentive or reverse-tax designed to encouraging business activity by forgiving some of the costs foisted onto society. Rather, limited liability is best explained as a burden shifting device that requires creditors to seek a personal guarantee or other security, if they want it, instead of defaulting to a presumption of unlimited liability. My argument was (and is) that in a world without limited liability entities, entrepreneurs would be required to risk all of their wealth to be in business for profit.

Before free incorporation—when there was no alternative to a traditional partnership—businesspeople had no choice but to bet the farm on a business venture unless their creditors agreed up front to some limitation on recourse. But creditors had no incentive to bargain with entrepreneurs in the absence of limited liability. So, entrepreneurs could not decide how much they were willing to risk.

With limited liability, the burden is shifted to creditors to seek security, allowing entrepreneurs and creditors to negotiate up front and permitting entrepreneurs to decide how much of their wealth they want to risk. Thus, limited liability is no subsidy at all. Quite to the contrary, limited liability encourages business formation by eliminating a barrier to contracting. Creditors lose nothing in the bargain except possibly the prospect of windfall recovery they would voluntarily forgo in exchange for a higher rate of interest or more security.   

In the end, limited liability reduces uncertainty as to how much wealth an entrepreneur might lose in a business venture as well as informing possibly over-optimistic entrepreneurs as to the risk they assume by going into business. And all else equal, less uncertainty means more investment.

Limited liability also induces competition and ultimately more efficient operation among creditors. Some creditors may choose to forgo security and charge higher prices—interest rates in the case of lenders. Since creditors can diversify their portfolio of obligors, they can assume some of the risk of business failures more cheaply than can individual entrepreneurs. There is no a priori reason to think that one creditor strategy is better than another. So, the market can decide the matter. May the best creditors win.

Admittedly, the foregoing explanation does not address the cost of accidents or other wrongs in which the loss may fall on the victim if the tortfeasor business cannot pay. But the chances are that if a small business is the culprit, the owner will have been personally involved, or at the very least answerable for failure to supervise. And if the owner is insolvent, it makes no difference if the business is incorporated. You can’t get blood from a turnip. As a business and the number of employees grows, the managers will become more risk averse. And let’s face it, who wouldn’t rather sue a corporation with more insurance. Towanda!

The often-missed point is that limited liability protects investors only as investors. It does not protect those who participate in a wrong—tortfeasors or their negligent supervisors.

To be sure, the Sackler family—who withdrew billions from Purdue Pharma while the opioid crisis grew—may be the exception that proves the rule. But it remains to be seen if they can retain their fortune in the face of possible claims that distributions to them were illegal as a matter of corporation law or that the distributions constituted fraudulent transfers.

I make no claim that those who invented the idea of limited liability—when the first corporate charters were granted and later became freely available—understood how it would work two hundred or so years later. Indeed, I suspect that limited liability was seen as a practical necessity for amassing enough capital to permit the Industrial Revolution to continue with big ticket projects like railroads and other infrastructure.

Events since 1994 have confirmed my position. There has been a proliferation of limited liability entities including LLCs and LLPs, and limited liability has become even more readily available than it was in 1994. Admittedly, the former (LLCs) were motivated largely by tax doctrine that saw limited liability as indicative of corporateness. And the latter (LLPs) came out of the savings and loan crisis, as a result of overreaching by the government in seeking to hold professional firms and their members liable for abuses caused mostly by deregulation.

Limited liability may well have prevented the 2008 credit crisis from spreading further into the non-financial sector by forcing banks, as a practical matter, to resume lending at their own risk after the bailout. As Mr. Dawes, Sr., the managing director of the Dawes Tomes Mousely Grubbs Fidelity Fiduciary Bank in the movie Mary Poppins said: Think of the foreclosures! In other words, but for limited liability, the banks may have wanted even more than a pound of flesh to help business reflate.

Admittedly, the big banks benefited from limited liability even though the credit crisis may have resulted from their own underestimation of the risks inherent in the system. But by forcing the financial sector to assume and monitor the risk of business failure, we know where the buck stops, thus minimizing the need for heavy-handed regulation. The banks must worry for the rest of us. Sometimes they get it wrong.  But limited liability is better than debtor’s prison. Nevertheless, our system is eerily akin to the fundamental but contradictory tenets of the society in which Max Headroom resided: all citizens were entitled to unlimited consumer credit, but credit fraud was punishable by death.

According to Google Scholar, this is my fifth most cited piece of all time. It was cited several times—with almost embarrassing approval—by the late Richard Speidel (of the Northwestern faculty) at a talk he delivered to the annual meeting of the AALS Business Law Section in 1995. I am not sure the Article had even been published at the time. (So, I suspect that Speidel may have been involved in its acceptance for publication.) Additionally, it was cited just last year by Michael Simkovic. I note also that it was my penultimate major piece not posted contemporaneously on SSRN. In other words, the piece pre-dates the internet. Nevertheless, it remains a personal favorite. Indeed, my argument may be stronger today than it was in 1994.

Although limited liability remains controversial for some, it is ever less worrisome as a practical matter because investors have become ever more diversified through indexing—so much so that scholars have begun to worry that index funds may soon control an outright majority of the shares of public companies. But the point for present purposes is that much, if not most, of the loss from business failure is suffered by other business and thus echoes through the economy. In other words, index investors have effectively waived any claim to limited liability. Who needs it? Indeed, it has been suggested that investors might well object to litigation between public companies as an inherently wasteful exercise in moving money from one pocket to another. The dynamic is similar in many ways to that of the U.S. healthcare system. The expenses generated by the uninsured are ultimately borne by the insured in the form of higher prices that must be charged by providers.

Needless to say, the indexing argument applies only to investments in public companies since it is difficult to diversify with stocks for which there is no liquid market. But curiously, the argument for unlimiting stockholder liability has focused on public companies, which raises the question: What is the real worry about limited liability? To be sure, public companies account for about seventy percent of aggregate business equity. So, the campaign to unlimit liability may be more about traditional distrust of bigness or unprincipled deep-pocket litigation strategy. Still, I am inclined to think the critics are genuinely concerned about moral hazard and victim compensation. The worry may be that public companies may pursue riskier strategies than non-public companies precisely because investors have been immunized by diversification. In other words, although management becomes increasingly conservative as a business grows, it may be that public companies can be egged on by diversified investors to pursue short term profits even at the risk of eventual ruin. The problem with this argument is that diversified investors are uniquely able to wait for long-term gains, if the present value justifies it. So, I am skeptical of the short-termism critique.

Yet another trend offsetting the proliferation of limited liability entities has been an equally dramatic (though less widely noticed) expansion of successor liability doctrines under which buyers of assets are increasingly likely to be saddled with environmental and product liabilities incurred by predecessor sellers despite seemingly bullet-proof contractual provisions to the contrary. In effect, plaintiffs and courts have devised new ways to pierce the corporate veil horizontally—as between otherwise unrelated corporations—simply because the buyer bought the assets of a business that is later the target of legal action. It is as if one buys a house in good faith at fair market value and then must answer for a slip-and-fall caused by the seller’s failure to shovel snow from sidewalk two years prior. The end result is that business in the aggregate has become its own insurer. 

The bottom line is that limited liability is largely illusory. As I argued in 1994, limited liability has little to do with escaping responsibility. Quite to the contrary, it facilitates business planning primarily for start-ups. Thus, I remain a big fan.

Richard A. Booth is the Martin G. McGuinn Chair in Business Law at Villanova University, Charles Widger School of Law.

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