At first blush, limited liability for corporate shareholders appears to be an anomaly. The trend over the last few decades has been to hold businesses liable for an ever increasing array of harms, ranging from defective products, to pollution, to gender and race discrimination, and sexual harassment. In the argot of economists, an enterprise should internalize its externalities. If a business can avoid paying some of the costs it generates, it will be able to sell its product too cheaply, the business will be more profitable than it should be, and more of the resources of society (capital) will flow to the business than would do so if the product reflected its true cost including its social cost. Limited liability for the shareholders of corporations seems totally at odds with the idea of enterprise liability. It allows shareholders -- the owners of a corporation -- to walk away from a losing business leaving various creditors holding the proverbial bag.
On the other hand, limited liability has become even more readily available since the late 1980s with the advent of new entities such as the limited liability company (LLC) and the limited liability partnership (LLP) among others. Businesses that were traditionally required to operate as partnerships, including law firms and accounting firms, with partners exposed to unlimited personal liability for the wrongs of fellow partners, can now enjoy the benefits of limited liability. So how do we square this with enterprise liability?
The traditional argument for limited liability is that it is necessary to encourage investment. In other words, by protecting entrepreneurs and investors from excess losses, limited liability reduces risk and encourages investment. But there is something wrong with this argument. If we really mean it when we say that a business should bear its costs (assuming we know what they are), then each investment should be considered on its merits. Limited liability would seem to be a subsidy of sorts -- albeit a universal subsidy available to anyone who wants it in connection with starting a business.
The answer to this seeming paradox is that limited liability is not about reducing risk. It is all about deciding how much risk to take. There is a big difference.
Consider the plight of an entrepreneur (call him Ace) who wants to go into the trucking business. He has heard that with a corporation he can get limited liability. So he forms Ace Trucking Corporation. Ace (the individual) enters into an employment contract with ATC. When he tries to buy a truck in the name of the corporation, the dealer insists on a personal guaranty for the loan. Same for the lease on a garage and even to get a telephone installed. Then on his very first delivery, he falls asleep at the wheel and plows into a fruit stand. Ace is protected from liability in his capacity as a stockholder. But so what? He was driving the truck. Ace the individual is liable.
Despite this initial setback, ATC has prospered and grown. Ace now spends most of his time behind a desk, hiring and firing new drivers and supervising the office and maintenance staff. Ace might be tempted to hire the cheapest rookie drivers and staff he can find in order to maximize profits. But his entire personal fortune is tied up in the business, and one serious accident could wipe him out. He is not likely to get reckless in his middle age. Indeed, Ace knows that he cannot expect any employee to care as much about the business as he does. So Ace will think long and hard about whether the benefit from adding each new truck and driver to the fleet will outweigh the cost of inevitable accidents. Moreover, although Ace takes some personal comfort from limited liability, he knows he may still find himself exposed individually for negligent hiring or supervision.
Time passes. ATC thrives and eventually goes public. Perhaps this explains limited liability. Without it, no one would buy stock, because the prospect of loss suffering a loss without some practical ability to control risk would be unacceptable. Wrong. That may once have been so. But today, most investors are well diversified. They can easily absorb losses from one portfolio company, because there will always be others that do better than expected. If we did away with limited liability for publicly traded companies it would not likely affect the market at all. As it is, the bankruptcy of one big company ripples through the market reducing the value of other companies such as banks, insurers, suppliers, and customers that must foot the bill. Practically speaking, diversified investors have waived limited liability. (Ironically, some commentators have stressed an argument that limited liability permits investors to diversify by investing in many stocks. The truth is investors would be even quicker to diversify if they could be held liable for the excess debts of the corporations in which they invest.)
The point is that limited liability adds no new risk to the system. Rather it permits an entrepreneur to decide how much risk to take. Without limited liability, Ace would need to risk it all in order to go into business. With limited liability, it is up to Ace's potential creditors to seek protection. Some may choose to raise prices, while others may seek a personal guaranty. As for the victims of accidents, they are in no different position than if Ace were an unincorporated sole proprietor. Forgive us our debts. Maybe. Forgive us our trespasses. No way. In the absence of limited liability, creditors would not likely negotiate with entrepreneurs about limiting their liability. And they would probably jack up prices as well. In short, limited liability addresses a potentially serious market failure.
This is not to say that limited liability cannot be abused. But it is less likely to be abused in a very small one-person corporation than it is in a somewhat more established corporation. To mix a barnyard metaphor, the owners of a more established business may be tempted to milk it dry before contingent claims come home to roost. Or they may sell the assets without the liabilities. Such tactics are not likely to work in a start-up business that has no one to cheat. As for the established company that engages in such shenanigans, the law has many ways to right such wrongs.
For a fuller exposition, see Limited Liability and the Efficient Allocation of Resources, 89 Nw. L. Rev. 140 (1994).