Tuesday, September 15, 2009

Limited Liability: One of Man's Greatest Inventions?

Limited liability:
Type of investment in which a partner or investor cannot lose more than the amount invested. Thus, the investor or partner is not personally responsible for the debts and obligations of the company in the event that these are not fulfilled.
Limited liability may not be at the top of your list for one of mankind's greatest inventions, but maybe it should be:
“The economic historian of the future may assign to the nameless inventor of the principle of limited liability, as applied to trading corporations, a place of honour with Watt and Stephenson, and other pioneers of the Industrial Revolution. The genius of these men produced the means by which man’s command of natural resources has multiplied many times over; the limited liability company the means by which huge aggregations of capital required to give effect to their discoveries were collected, organized and efficiently administered.” – The Economist, Dec. 18, 1926
Some of the benefits of limited liability include:
  1. Reducing the need to monitor the management of firms,
  2. Reducing the need to monitor other shareholders. (You are not liable for more than you invest and therefore aren't on the hook for corporate debts if other shareholders have fewer financial resources than you do.)
  3. Because all investors share equal risk, shares of common stock are fungible.
  4. Facilitates diversification (without limited liability, investors would likely minimize their financial exposure by only investing in one company.)
  5. Enlists creditors to help monitor managers of firms (because creditors bear some of the downside financial risk of a company's performance).
Without this innovation in organization of financial capital, modern forms of business organization are unlikely to have ever developed. Without this, industries would be limited in size and scope, technological innovation and economic development would be far behind what it is today, large-scale projects would have been difficult at best to organize in the private sector, and advanced market economies would likely not exist as we know them today.

Timur Kuran argues that the lack of development of laws, which allow the formation of corporations and the accumulation of large sums of capital that outlive the life of one individual, plays a large role in the under-development of much of the Islamic world. Without implementation of ideas such as limited liability, the Western world would likely be in a similar boat today.


jeremy h. said...

Okay, so the benefits seem straightforward. Any costs?

Brian Hollar said...

One of the costs is to creditors. Under more traditional common law, investors' personal assets were not shielded and were personally liable for any financial loss for any financial loss of any enterprise they invested in. However, this is something that can be contracted around and is basically a risk-allocation problem that is voluntarily entered into by the creditors and can be accounted for by adjusting interest rates. (They know ex ante what they are getting themselves into.)

One of the potentially bigger costs is that it shields the assets of investors against any tort (civil harm) a company might get caught up in. Since tortfeasors (those harmed) are did not engage in a voluntary agreement to limit this liability, they are potentially left without adequate remedy for extreme harm a limited liability company might have caused them.

jeremy h. said...

So how do we know if benefits exceed costs?

Nathanael D Snow said...

Took a course with Charles Knoebber at NCSU. Did lotsa Henry Manne, Woodward, Alchain, Demsetz type look at llc.
Absolutely wonderful institution.
Teaching Alchian/ Demsetz paper tonight, actually.
Was wondering if those who dislike corporatism ever thought why firms exist in first place. (you mean its not to make some people rich at the expense of others???)
Actually it might have been intended that way early on, but the returns were such that the pie grew - in spite of itself.
Is this how good institutions REALLY emerge??? Someone tries to cheat, and it makes everyone better off??
Reading new Doug North and mind is blown.
rant rant rant
anyway, need a pickle sometime Bob.