Limited Liability

Quick Summary of Limited Liability

A phrase used to indicate that those having liability in respect of some amount due may be able to invoke some agreed limit on that liability.

Limited liability is a concept whereby a person’s financial liability is limited to a fixed sum, most commonly the value of a person’s investment in a company or partnership with limited liability. A shareholder in a limited liability company is not personally liable for any of the debts of the company, other than for the value of his investment in that company. The same is true for the members of a limited liability partnership and the limited partners in a limited partnership. By contrast, sole proprietors and partners in general partnerships are each liable for all the debts of the business (unlimited liability).

Although a shareholder’s liability for the company’s actions is limited, the shareholder may still be liable for its own acts. For example, the directors of small companies (who are frequently also shareholders) are frequently required to give personal guarantees of the company’s debts to those lending to the company. They will then be liable for those debts in the event that the company cannot pay, though the other shareholders will not be so liable.

History

In the UK, it became more straightforward to incorporate a joint-stock company following the Joint Stock Companies Act 1844, though investors in such companies carried unlimited liability until the Limited Liability Act 1855. There was a degree of public and legislative distaste for a limitation of liability, with fears that it would cause a drop in standards of probity. The 1855 Act allowed limited liability to companies of more than 25 members (shareholders). Insurance companies were excluded from the Act, though it was standard practice for insurance contracts to exclude action against individual members. Limited liability for insurance companies was allowed by the Companies Act 1862. The minimum number of members necessary for registration as a limited company was reduced to 7 by the Companies Act 1856. Limited companies in England and Wales now require only one member.

Similar statutory regimes were in place in France and in the majority of the U.S. states by 1860. By the final quarter of the nineteenth century, most European countries had adopted the principle of limited liability.

In the UK there was initially a widespread belief that a corporation needed to demonstrate its creditworthiness by having its shares only partly paid, as where shares are partly paid, the investor would be liable for the remainder of the nominal value in the event that the company could not pay its debts. Shares with nominal values of up to £1,000 were therefore subscribed to with only a small payment, leaving even a limited liability investor with a potentially crushing liability and restricting investment to the very wealthy. During the Overend Gurney crisis (1866-1867) and the Long Depression (1873-1896), many companies fell into insolvency and the unpaid portion of the shares fell due. Further, the extent to which small and medium investors were excluded from the market was admitted and, from the 1880s onwards, shares were more commonly fully-paid.

Though it was admitted that those who were mere investors ought not to be liable for debts arising from the management of a corporation, throughout the late nineteenth century there were still many arguments for unlimited liability for managers and directors on the model of the French société en commandite. Though such liability for directors is still permitted for directors of English companies, its abolition is planned as of 2006. Further, it became increasingly common from the end of the nineteenth century for shareholders to be directors, protecting themselves from liability.

In 1989, the European Union enacted its Twelfth Council Company Law Directive, requiring that member states make available legal structures for individuals to trade with limited liability. This was implemented in England by Statutory Instrument SI 1992/1699 which allowed single-member limited-liability companies

Economic and social justification and criticism

Limited liability is supposed to encourage enterprise but it has also been argued, from a libertarian perspective, that it distorts the free market by allowing the entrepreneur to externalise some risk and impose it on society at large. Moreover, there has been some concern that present structures favour large creditors who are in the position to negotiate secured terms, whereas small creditors’ debts are left unsecured. There have been calls to restrict limited liability to only non-managing investors but, as of 2006, these have been resisted in the UK^[14]. The general legal response to such concerns has been to make directors liable for any dishonesty.

There is evidence that shares in public companies would be at a disadvantage if liability were unlimited and the experience of partly-paid shares in the nineteenth century (supra) seems to confirm this. A single counterpoint, limited to a narrow span of time and a single company in a growth economy, existed in the 1950s where there was a healthy market in unlimited liability American Express shares.

The anarcho-capitalist libertarian and Austrian economist Murray N. Rothbard, in his Power and Market (1970), defended limited-liability, stating,

Finally, the question may be raised: Are corporations themselves mere grants of monopoly privilege? Some advocates of the free market were persuaded to accept this view by Walter Lippmann’s The Good Society. It should be clear from previous discussion, however, that corporations are not at all monopolistic privileges; they are free associations of individuals pooling their capital. On the purely free market, such men would simply announce to their creditors that their liability is limited to the capital specifically invested in the corporation, and that beyond this their personal funds are not liable for debts, as they would be under a partnership arrangement. It then rests with the sellers and lenders to this corporation to decide whether or not they will transact business with it. If they do, then they proceed at their own risk. Thus, the government does not grant corporations a privilege of limited liability; anything announced and freely contracted for in advance is a right of a free individual, not a special privilege. It is not necessary that governments grant charters to corporations.

In the U.S. lawyers have suggested that, while limited liability towards creditors is socially beneficial in facilitating investment, the privilege ought not to extend to liability in tort for environmental disasters or personal injury.

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