Limited liability

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i) Moral hazard        

I. Introduction

The institution of limited liability for companies has typically been regarded as one of the most important innovations of the late industrial revolution period. This view was appropriately expressed by one early commentator, who stated: “The limited liability corporation is the greatest single discovery of modern times… Even steam and electricity are less important than the limited liability company”. Commentators generally consider that limited liability has been proved a vital instrument in the attainment of economic growth. However, recent analysis of the limited liability principle have questioned its potential advantages and have argued for adoption of a more restrictive approach by the regulation.

It is the aim of this paper to analyze the importance of the existence of limited liability companies in the 21st century, as a means of fostering entrepreneurial spirit, and to argue that while the above aim is regarded as essential in the market economy, there is invariably a need for a clear and precise framework through which the principle should apply. The potential abuse of the limited liability principle requires a careful consideration when deciding about the appropriate level of regulation.

The guiding principle of competitiveness of UK companies and the emphasis on the construction of a legal system that has an advantageous framework of company law and will allure businesses to it, as evidenced in the Company Law Review: Final Report, needs to be balanced with the guarantee that sensible prophylactic measures are taken by the legislator to avoid misuse of the principle. The need to attract more businesses does not justify an extremely lax application of the limited liability principle.

Due to the wide ambit of the subject matter, this paper will address primarily the major areas of concern in the field of companies limited by shares. The application of the principle will be discussed in relation to small businesses, groups of companies, tort creditors and provisions related to share capital and liabilities of directors will be analysed. Before this analysis, however, it is important to consider the concept of limited liability and the positive attributes of it.

II. The concept of limited liability

Eleven years after the Joint Stock Companies Act 1844, which introduced the incorporation by registration, the privilege of limited liability became available with the Limited Liability Act 1855. Initially, it was assumed that the limited liability principle would apply to public corporations, i.e. companies that have the ability to invite the public to subscribe for shares, since the grant of this right was considered vital to the raise of great amounts of capital for enterprises involved in public utilities. However, the “calamitous” decision in the Salomon case had the effect of allowing also members of closely held businesses to have the right to enjoy limited liability, provided that these kinds of companies are willing to submit to the formalities of the Companies Act..

The meaning of limited liability is that, in case of insolvency, shareholders are under no obligation to the company or its creditors beyond their obligations on the par value of their shares or under the guarantee they have agreed in the case of a company limited by guarantee. The limited company, thus, involves two separate concepts, first it has a separate legal personality altogether from the members and has its own assets and liabilities and secondly, its members can invest with limited liability.

It has been argued that if limited liability were not provided by the law, firms would attempt to create it by contract. Indeed, as it can be seen by the various devices used by unincorporated partnerships to give those owning stock limited liability, that was the case before the statutory grant of the limited liability. The formal introduction of the twin principles of incorporation and limited liability led to the establishment of companies as the major instrument in economic development and contributed to the evolution of commerce and arguably to world prosperity.

III. Why limited liability?

The major contribution of limited liability is that it supports the investor to invest its capital into dynamic business without worrying that he will incur further liability. The economic theory of the firm, which explains the company as a nexus of contracts joining inputs to produce outputs, has provided a solid base for the appraisal of limited liability. As regards mainly publicly held companies, where the distinctive feature is that of separation between management and investment, limited liability reduces the need to monitor the agents of the company, since the investor will not be held liable for the company’s debts created by the managers` decisions. The investor knows that the most he can lose is the amount he has put in the company. Besides, it reduces the costs of monitoring other shareholders, as it makes the identity of the other shareholder and specifically their wealth irrelevant.

Moreover, it promotes the free transfer of shares, which in turn, through the market price of those shares, induces the managers to act efficiently. The threat of a take-over may have a potential beneficial result on the decisions of the managers and if it increases the probability of maximization of the firm’s assets, shareholders and creditors will be better off.

Diversification of portfolios as well, will be easier within a limited liability regime. Manne argues that investors will be able to minimize risks and managers will enter into more risky businesses without putting in jeopardy the whole wealth of the shareholders. Consequently, the investor will charge less for the supply of his capital. Halpern et al. point out that under an unlimited liability regime, securities markets might even cease to exist or concentration of the shares would be in the hands of the wealthier shareholders, since the latter would lack the incentive to buy small amounts of shares, knowing that they may incur unlimited liability.

As regards contractual claims, the matter is which situation produces lower transaction costs and is more efficient overall. Limited liability reduces transaction costs, since there is no need for the parties to make individual contracts regulating their relationship. It is seen as the appropriate regime with regard to informed creditors with bargaining power. Voluntary creditors are better positioned to deal with the consequences of the failure of a company than shareholders, since they can take precautionary measures such as screening and higher interest rates when negotiating with the company. Posner regards limited liability as a means of risk shifting while Easterbrook and Fischel argue that when a company fails the loss is “swallowed” rather than shifted, since equity investors lose their investments before the debts holders. There is no externality of risk, since the creditors will be ex ante compensated and shareholders have the possibility to waive limited liability when they judge that this is more efficient. Furthermore, since the shareholders are well diversified, each debt contract will have an insignificant impact on their financial position.

Overall, the positive attributes of limited liability, as revealed above, provide a firm ground for its appraisal as a principle needed to promote trade and industry prosperity.

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IV. Areas of concern

The principle of limited liability, although now established almost universally, has never stopped to provoke various doubts as regards its possible deficiencies. We will now try to analyze and assess some of these problems.

i) Moral hazard

The most frequent argument against the conferring of limited liability is the moral hazard, which it may create through the shift of the risk of failure from shareholders to creditors. Under a limited liability regime, shareholders have the opportunity to effect uncompensated transfer of risks to creditors and thus it creates ...

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