Reforming Limited Liability Law
Everyone in America seems to agree on the importance of personal responsibility. We should be accountable for what we do. If we hurt someone or breach a contract, we should pay.
True economic recovery will require creative solutions to deeply rooted problems. Our first great task is to change the way we talk about what's possible.
Yet at the core of American business law is a doctrine that makes corporations more likely to behave badly, makes the harms that occur more severe and passes the costs on to others. If we really care about personal—and corporate—responsibility, we should drastically restrict the doctrine of “limited liability.”
Limited liability is the notion that investors in a corporation should not be personally liable for bad things the business does. The investor may lose what’s been invested, but there won’t be personal liability if the company produces SUVs that roll over or if it defaults on its pension obligations.
Historically, limited liability was the most important legal innovation leading to the creation of the modern corporation and stock markets. It allowed entrepreneurs to finance businesses with small investments from a multitude of shareholders rather than a few deep-pocketed partners. With partnerships, each partner was liable if something went wrong. With limited liability, people could buy stock without fearing they would lose more than their investment. Trillions of dollars in investment capital became available, spurring the economy into hyperdrive.
Another rationale for limited liability was fairness: the iconic shareholders (widows, orphans, retirees) don’t have any real control over a corporation’s decisions and should not be required to pay when something goes wrong.
But notice something. These rationales do not apply or make any sense when corporations are themselves the shareholders: for example, when a parent company owns 100 percent of the shares of a subsidiary. Parents are not financing subsidiaries through the stock market, so the promise of limited liability is immaterial in incentivizing small investors to contribute. And in most cases, the parent controls the subsidiary, so it’s hardly unfair to hold the parent accountable. Nevertheless, the rule of limited liability holds.
What are the impacts of this doctrine, now expanded far beyond its original rationales? When someone doesn’t have to pay for bad behavior, it increases the likelihood and severity of bad behavior. Corporate subsidiaries drilling for oil in the Arctic, making shoes in Vietnam or harvesting hardwood in the Amazon will be more likely to spill oil, exploit child labor and destroy virgin jungle.
And who bears the costs of corporate bad behavior? Whoever is unlucky enough to be victimized by the shoddy products, the environmental degradation or the breached contracts brought about by the subsidiaries. Sure, they can sue the subsidiary. But lawyers know how to protect the subsidiary’s assets by funneling them to the parent. And as long as the lawyers and the accountants do their job well, the parent is protected. Lawyers can easily create subsidiaries through which to operate the riskiest of their endeavors, allowing parents to enjoy the upside while hedging against the downside.
Mention the possibility of ending limited liability for parent companies and witness the gnashing of teeth in corporate counsel’s offices. Large multinational corporations would have to care about the behavior of their subsidiaries around the globe, and parents would have to pay for the sins of their corporate children.
The volume and intensity of corporations’ complaints would be a dead giveaway of how much they benefit from limited liability. It would also indicate how much others are being hurt, since the corporate “benefit” is not that injuries don’t occur but simply that corporate parents don’t have to pay.
It’s time to recognize limited liability for what it is: a subsidy for corporations, paid not out of government coffers but from the pockets of those hurt by corporate malfeasance. It’s an avoidance of responsibility.
To redress the worst of these ills, we would not have to do away with limited liability completely. We’d fix most of the abuses merely by refusing to award corporations the protection of limited liability when they are owners or controllers of other corporations. The benefits of limited liability—and they do exist—are supposed to flow to shareholders who are actual people, not corporations manipulating the doctrine to impose costs on the rest of us.
Read the next proposal in the “Reimagining Capitalism” series, “No Free Parking for Monopoly Players: Time to Revive Anti-Trust Law,” by Barry C. Lynn.