Money: Corporations

The limited liability canard

One of the standard arguments made by corporate critics to show that corporations are creatures of the State, rather than purely contractual creations of the market, involves what is called "limited liability." Only the State, they claim, can limit liability, and they go on to suggest that this is some sort of special dispensation designed to defraud creditors and allow corporations to mangle workers and lay waste to the commonwealth from behind some magic wall of legal immunity.

Now there is so much bunk in all these charges and innuendos that one grows weary at contemplating them. To begin with a very simple point, what is called limited liability did not, as an historical matter, depend on any State action. It has been, and still can be, created solely by private contract. It is, furthermore, no anomaly in need of specially justification, but rather a natural and logical result of our traditional notions of moral and legal responsibility.

Limited liability, in this context, means that an individual is not personally liable for the debts of a corporation simply because he happens to own some of its shares. It is nothing more ominous than that.

Some critics, who purport to detect a grave injustice in this rule insist that corporate shareholders should, in a just world, be personally liable for all corporate debts, just as are partners in a partnership. Now, why they should want to treat shareholders as if they were partners (which they aren't), and not as if they were trust beneficiaries, or mortgagees, or elephants, is unclear. The only explanation would seem to be that if they were partners they would be personally liable but if they were something else they wouldn't be (Q.E.D.). All very unprincipled.

What is called limited liability (which is really an unfortunate expression because taken out of context it suggests that a pre-existing liability were somehow limited) is an expression which arose from the practice of firms using such terms as "Limited" or "Ltd." in their names to alert the public that they were not partnerships and that persons dealing with the firm must look to the assets of the firm, and not the credit of the owners, for their security. It put them on notice that an employee of the firm was not an agent of the shareholders.

On the face of it, it is hard to see why this rule, which is simply an application of the principle that a person is responsible only for his own acts, should stir the bowels of reformers. The cause of some of their confusion may lie in the historical circumstance that gave rise to the rule.

When capital was scarce and firms were small (and, perhaps, accounting imperfectly developed) the prevailing form of business was the partnership, wherein several proprietors combined to operate a joint enterprise, each being active in the management and each capable of contracting for the whole. Because each proprietor was fully liable for the debts of his enterprise, and each partner was an agent of the enterprise, it logically followed that each partner could, by his acts, make not only himself fully liable for debts of the enterprise, but also make each and every other partner similarly personally liable.

This meant that partners had to be chosen with care and that investors must take an active part in the management of the firm, for they were personally liable for every act of each of the other partners in the pursuit of the firm's affairs. It also meant that persons who didn't have the time, talent, or opportunity to take an active part in closely overseeing a firm's affairs would be very hesitant to invest in any sort of business, and that venture capital would come not from the public at large, as it did in 19th and early 20th century America, but from persons of great wealth and business involvement. There would be no "people's capitalism" and the world would look very different than it does now. There would very likely be less wealth and it would be concentrated in the hands of the Rockefellers, du Ponts, Rothschilds, and other great capitalists who could afford the costs and risks of being a partner in far-flung business undertakings.

This didn't happen because of the rise of the modem business corporation. The corporation which developed in the 19th century is a private contractual relationship which evolved to meet the need to bring together large pools of capital under professional and centralized management. The thousands of persons who supplied capital to these undertakings did so in exchange for various contractual rights, such as the right to participate in the profits of the enterprise, if there were any, and to remove the directors if they became dissatisfied with their management. They were purchasing an investment, not being hired to advise the directors in the management of the company. By this contract, they never had the right to run the company, to make operating decisions, to hire or supervise employees or agents, to make contracts on behalf of the firm, or to do any of the things which partners have a right to do and on which we base the partner's personal liability for the obligations of the firm.

To hold such a shareholder personally liable for a contract or tort of an employee of the firm would be contrary to all principles of justice, for the shareholder never had any of the rights of control or supervision over that employee to justify making him responsible for the employee's actions. In fact, if the shareholder were made liable it would be a great anomaly—he would be the only passive investor who was personally liable for the debts of the firm in which he invested. It would be as if a bank depositor were held liable for the bank's debts or you held liable for those of your brother-in-law who is always borrowing money from you.

So we wind up, after a lot of words, seeing that there is simply nothing to the claim that the so-called limited liability of a corporate shareholder is somehow wrong or unjust or in any way dependent on a special grant of State favor. It is simply a natural result of our traditional concepts of an individual's moral and legal responsibility.

©1977 by Davis E. Keeler