Limited Liability

Limited Liability

A Legal and Economic Analysis

Stephen M. Bainbridge and M. Todd Henderson

The modern corporation has become central to our society. The key feature of the corporation that makes it such an attractive form of human collaboration is its limited liability. This book explores how, by allowing those who form the corporation to limit their downside risk and personal liability to only the amount they invest, there is the opportunity for more risks taken at a lower cost.

Chapter 1: Introduction

Stephen M. Bainbridge and M. Todd Henderson

Subjects: law - academic, corporate law and governance

Abstract

Limited liability is the most important feature of the modern corporation. In the introduction, we set the stage for our analysis of the scope limited liability by first offering an explanation for the doctrine. We start with the ideas of corporate separateness and corporate personhood—legal fictions that are based on state statutes deeming associations of various individuals called “corporations” to be treated as separate legal entities. We show that this simple fact enables corporations to engage in productive activity at massive scale that would not be possible in the absence of this legal trick. From here, we introduce the ideas of asset partitioning, of which limited liability is a flavor. Deeming a corporation to be a distinct entity permits individuals to isolate assets in the firm, thus shielding them from the creditors of the owners of the firm, as well as shielding the assets of the owners from the creditors of the firm. This isolation allows firms to borrow against and invest firm assets with more certainty and specialization, as well as allows risk-sharing at lower cost than otherwise possible. However, limited liability is not just a legislative diktat, it is, we argue, what the parties to any transaction would agree to behind the ex ante veil of ignorance. We consider four cases—contract creditors of public corporations, tort creditors of public corporations, contract creditors of close corporations, and tort creditors of close corporations—to show how the efficient default rule is one of limited liability. We then consider when exceptions are warranted from this default rule, grouping these all roughly under the umbrella of piercing the veil, or disregarding the legal separateness of the corporation in question. We admit our skepticism that the doctrine designed to optimize the exception to the rule of limited liability is effective at striking the right balance, and set out a plan of work to make that case.