Limited Liability and Other Limits on Corporate Liability

(A draft discussion paper)

by Charlie Cray, Center for Corporate Policy
(send feedback to [email protected])


Although most legal and business scholars conclude that the significance of limited liability is often overrated, in fact limited liability is a key feature of the corporation that many believe is key to its historical success as a business form. Limited liability has been so deeply embedded in business culture and the law that it is often assumed to be an automatic feature of corporations.

But that has not always been the case: before laws of general incorporation were passed in the nineteenth century, contentious public policy debates centered around granting limited liability to joint-stock corporations.

Debates over limited liability in the past resemble current debates over external regulation of liability and related policies (e.g. tort reform and indeminification for directors and officers, i.e. "acting minds") which define how much the corporation and its shareholders should be protected from financial liability beyond the extent of their investment. Those who tout limits on liability, usually described as a key feature to market-centered economic growth, rarely admit the negative consequences: such as the encouragement of risky behavior that others have to pay for. By failing to debate these questions, we disregard the corporation as a legal institution, allowing it to silently acquire, with the help of corporate accountants and lawyers, certain rights and powers that immunize it from any sense of accountability to society.

The question of limited liability is by no means merely academic. It has come up in a number of instances in recent years:

John Castellani, president of the Business Roundtable (whose members are CEOs of some of the biggest U.S. public companies) and the U.S. Chamber of Commerce both support a limit on auditors' liability, and have reportedly asked Congress to address the issue.

Meanwhile, a survey of companies which own nuclear power plants found that the relatively small number of very large companies that own nuclear power plants “have adopted business structures that create separate limited liability subsidiaries for each nuclear power plant, and in a number of instances, separate operating and ownership entities that provide additional liability buffers between the nuclear power plant and its ultimate owners.”

These and other examples suggest that current concerns about corporate accountability could benefit from a review of the history of limited liability both as a matter of corporate design (and industry-specific regulation) and the alternatives proposed by those who opposed it.

Defining Limited Liability

Simply stated, “limited liability” means that shareholders are not liable for debts incurred in the operation of a firm. Thus, shareholder losses are limited to the amounts invested by them – that is, to the amounts originally invested in the firm at the time of the stock purchase.

Limited liability as we use it here does not mean that corporations cannot be sued, or that stockholders don’t have any exposure for corporate abuses. There are other laws that provide external shields against corporate and individual liability for harms done, but that is not our concern here. Rather, here our focus is on the inherent liability imbued in the business form itself.

Although shareholders did not enjoy limited liability in the early history of corporate law in the U.S. (Klein and Coffee, 141), they do now. There are both common law and statutory exemptions. For example, New York's corporate law makes a New York corporation's ten largest shareholders personally liable for unpaid employee wages. (N.Y. Bus. Corp. Law § 630). (From 1994 until 1997, the New York Senate approved a bill to repeal this liability every year, but it repeatedly died in the Assembly, largely due to the efforts of Labor). In other cases, when individuals misuse the corporate form for personal gain, courts often “pierce the corporate veil.”

In today’s world, even if there is no politically feasible way to directly change limited liability, it’s still worth remembering that it is not a “natural” or inherent part of business design and that, even if we continue to automatically grant this important privilege through the process of incorporation, why not ask for something in return?

The provision of limited liability ended the legal incentive for corporate shareholders to monitor the behavior of the businesses in which they invested. As one author suggests, the use of the phrase “LLC” (limited liability company) – was required by the British Parliament until 1855 in recognition of the inherent “irresponsibility” that the doctrine provided for its members.(Nace, 78)

Indeed, placing obligations on the corporation in exchange for this privilege is the logical consequence of recognizing that corporations are public institutions, not merely private associations with no greater obligation than making money. As a society, there is no reason we should automatically grant corporations a feature (limited liability) that results in what economists call significant “externalities,” i.e. costs that are regularly borne by the rest of society.

As one corporate historian puts it, “the point is to shake the notion of limited liability loose of its doctrinal moorings, to view it as a historically developing legal principal that was only one of many possible definitions of organizational responsibility and accountability, not an inevitable development.” (Roy, 162)

Limited Liability Defined

The notion of limited liability goes back at least as far as 2000 BC, when merchants used it to finance seagoing vessels. According to Robert Monks and Nell Minow, limited liability was key to regarding corporations as independent entities that exist apart from the governments that created them and their owners (shareholders): “The English courts first spelled it out during the 15th century. It means that the corporation is separate from its owners and employees; what is owed to the corporation is not owed to the individuals in the group that make up the corporation; and what the group owes is not owed by the individuals that make it up. Hence, if a corporation goes bankrupt and is sued by its creditors for recovery of debts, the individual members of the corporation are not individually liable.” (Monks and Minow, 2001, p. 9)

As Lawrence Mitchell suggests in Corporate Irresponsibility, “defining limited liability is simple. … no matter how much pain it causes, the corporation is responsible for paying damages (if at all) only in the amount of assets it has. … You can’t go after the stockholders for any more than they’ve invested. You can’t go after the managers or employees except in limited and largely irrelevant cases. No matter what kinds of harms the corporation causes, and no matter what kinds of judgments a court may levy against it, it must pay only what it has.” (Mitchell, 53).

Thus, “limited liability” refers to the fact that outside “investors” (versus active participants) can pool their capital in new ventures without worrying that they might lose their entire worth. It allows those with significant wealth to make capital available for research, innovation and technical progress, without having to oversee the management of their investment on a daily basis. Thus, the limited liability corporation has been considered a key feature of economic progress.

Because limited liability is not available to small business owners, however, it is hardly the aid to business growth (which mainly comes from smaller companies) that it is touted to be. While limited liability is theoretically available for all companies, it actually only helps public companies, which means bigger ones because smaller, single-owner businesses and partnerships (e.g. restaurants) can be held personally liable for unpaid debts owed to creditors and employees, for any injuries to a patron who sues, or for the misconduct of fellow partners -- even for which they had no knowledge or control.

Investors in a corporation that operates the same kind of business undertake no such risk. Thus limited liability can lower the cost of business for big businesses, thereby raising the barriers of entry for smaller companies, who are often required to put up other property (e.g. homes) as collateral for loans.

Harvard’s president, Chares W. Eliot, called limited liability “the corporation’s most precious characteristic,” and “by far the most effective legal invention made in the nineteenth century.” (Roy, 158) Nicholas Murray Butler, the onetime president of Columbia University, was even more effusive, describing limited liability as a more significant invention than the steam engine. (Mitchell, 53)

Today, the arguments in favor of limited liability are well known and broadly accepted. For instance, limited liability has allowing stockholders to diversify their investments without fear of losing all of their money from one failed corporation. It has not only facilitated the formation of mutual funds and other forms of fiduciary investment, it arguably has also encouraged market liquidity.

The law and economics movement advances another justification for considering the privilege of limited liability as wholly natural, contending that, even if the law did not bestow it, limited liability would exist because the investing class would be able to exact the benefit as a contractual term when bargaining with the corporation about whether to invest or not. (Easterbrook and Fischel, 89).

A counter-argument suggests that if limited liability did not exist in the law the market would replace it with an insurance solution. Companies that cause the greatest damage would, in such a system -- be required to pay the highest premiums to get the same types of coverage. By enabling limited liability we distort markets by either passing various costs involuntarily onto the public at large or eliminating the possibility of another market activity – that of selling insurance to cover a particular kind of risk.

Just because an individual owner’s liability is limited doesn’t mean that the risks associated with their investments disappear. Corporate law created limited liability for shareholders because it provides them with an inducement to invest precisely because they can, for all practical purposes, disregard the way in which others might be harmed by the corporation’s activities. The treatment of corporations as “a nexus of contracts” conveniently ignores this fundamental problem.

In fact, the argument can be made that by enabling limited liability we have destroyed the capacity of markets to weigh the different risks that different industrial sectors pose on the broader society. If the risks were forced into an insurance market, the rates for such insurance would vary by corporate sector, depending on the type of enterprise and the size of externalities associated with it. Polluters, for example, would have to pay higher premiums.

As Harry Glasbeek suggests, limited liability not only blocks our ability to distinguish among companies that cause greater harm, but feeds into skepticism about all corporations: “The many unredressed harms inflicted by corporate actors for which notable individuals are not held responsible, as well as the fact that very often these harms are inflicted by corporations that do not offer any of the economic welfare benefits that supposedly warrant the grant of limited liability … continue to draw attention to the question of the legitimacy of the corporation.” (Glasbeek, 290)

The impact of business failures, as we’ve seen at Enron and other companies, can impact many people besides investors – including employees, consumers, and the broader community of taxpayers and citizens. Thus, limited liability is a misnomer in the broader sense: it may limit the liabilities for investors and corporate insiders, but arguably increases “externalities” – i.e. can increase costs to society. E.g. after Enron’s collapse, the workers at Enron’s headquarters received a pittance – an average of $13,500 – as severance, and even that was triple of what they would have received had the AFL-CIO and Rev. Jesse Jackson not stepped in to help. Many of those ex-employees would soon rely upon taxpayer-funded programs.

Because it shields the owners and managers from personal liability, limited liabiity creates what economists call a moral hazard, an increase in the risk of bad behavior because the costs of that behavior are shifted onto someone else. “Liability limitations artificially distance individuals from the real life effects of the enterprise in which they invest, thus decreasing their acknowledged personal responsibility,” corporate scholar Theresa Gabaldon has suggested (Mitchell, 60).

“Limited liability means never having to say you’re sorry – or at least feel the pain of sorrow,” Mitchell suggests. “It means the corporation can, in effect, draw in its wagons and pay attention only to those people to whom corporate law says it’s responsible, namely, stockholders. And the responsibility it has to stockholders is to maximize their stock prices.” (Mitchell, 59)

As Mitchell points out, “limited liability for the corporation is not the least natural – it is constructed from the beginning. And, unlike a person, a corporation has no sense of responsibility on which we can rely. This combination makes the corporation potentially very dangerous.” (Mitchell, 55)

Another important consequence of limited liability is that it is a central feature leading to the separation of ownership from control, which scholars (most famously Berle and Means) have identified as a key structural flaw in modern corporate design. Shareholders give up their right to control the use of the corporation’s property, a right that in theory is delegated to professional managers who have the expertise and time to manage that money effectively, while they may not. Too often, however, this separation of ownership and control leaves managers effectively unaccountable to others in the company.

Others point out that limited liability also has consequences that reach far beyond arcane debates over corporate law and corporate governance. It also has an important impact upon the culture – by shaping social values. “The particular harm it creates is passivity and irresponsibility, the sense that you needn’t care and won’t suffer any of the consequences if you don’t.” (Mitchell, 60)

In the context of today’s debates over “values,” it’s worth noting that from the time it was introduced, many objected to limited liability because they felt that abrogating liability was immoral. One should be responsible for one’s actions, critics argued. Limited liability was therefore seen as a means of undermining community values. It reduced the incentives of investors to take responsibility for the risks of their investment.

Harry Glasbeek describes the role that limited liability plays in driving a culture of irresponsibility in his book, Wealth by Stealth: “[W]hen people say a corporation has limited liability, they mean the opposite. The corporation’s liability, like yours and mine, is only limited by its physical ability (that is, by the extent of its assets) to honor that liability. Its legal obligation, like yours and mine, is not limited. It is the investor/shareholder whose liability is limited. What is carefully hidden by saying that a corporation has limited liability – that is, hidden by the perverse use of language – is that it is people who, if they were not shaded from legal view by the veil of corporate personality, have limited liability. … It is, of course, the same “Hidden behind the veil” corporate captains of industry, finance retail, and everything else, and their mouthpieces, who continuously urge the rest of us, unincorporated human beings to stand on our own two feet, to take responsibility for our own actions. We are told that we should not rely on artificial protections and, especially, that we should not accept handouts from governments just to shield us from the operation of the market.” (Glasbeek, 9)

Glasbeek’s point is that limited liability obstructs our view of the unwritten public-private balance sheet. Individuals to use the corporate form to extract value from the public while paying a limited price in the event of failure. If we grant businesses and individual investors the privileges of limited liability, what do we – as a society of sovereign people who grant this privilege – get in return? The answer is usually nothing.

In fact, the question is rarely asked. Those who ask it are treated as naďve. The assertion is made that there is no alternative to limited liability, that it is essentially a natural outcome of evolution, and anyone who doesn’t accept that fact doesn’t believe in free market capitalism.

Yet this was not always the case. It was once broadly understood that limited liability for investors was a special privilege for corporations that set them apart from others in a free market capitalistic economy, and made the corporation a danger to society. It was important to prevent corporations from posing a broader hazard to society by, for instance, confining them to certain types of business. If the incorporators sought to use the vehicle for another purpose, its contracts would become unenforceable. They were beyond the legal boundaries of the corporation’s purpose. In legal terms, these actions were ultra vires.

How the Adoption of Limited Liability Grew In Europe

Between the 15th and 18th centuries, the biggest European fortunes were accumulated not by those who made commercial goods, but by those who traded them.

Yet for the global traders, there were great risks of piracy, other problems like lost ships and bad market intelligence. Motivated by the competition to dominate global trade, the great European powers sought ways to shield merchant shipowners from being destroyed by these risks. Just as there is a kind of “race to the bottom” today concerning certain aspects of corporate globalization, there was a kind of race among imperial powers to find ways to support their own merchants’ ventures.

One institution used to solve the problem was the commenda. Under the commenda, the organizers of a voyage would collect funds from a number of investors. The liability of those investors would be limited to the funds they invested. That way the wealthy could back shipowners without worrying that they might lose their entire fortune.

Risk spreading through limited liability for investors was not the only appeal of the commenda. It was also a way around the laws of usury for investors with spare cash who did not want to run a business themselves. Instead of illegally lending money for interest, a rich individual could reap a legal capital gain through a commenda.

For these reasons, limited liability status for shareholders was established primarily for the larger foreign trading companies, including the East India Company in 1662. This protection was restricted to these particular enterprises and did not become a universal condition in corporate finance in the U.S. until the 19th century. (Baskin 86).

In fact, until the mid-19th century, limited liability for corporate shareholders was granted in Britain only through acts of Parliament, which was restricted in this regard to entities involved in undertaking large-scale public improvements such as canal or railroad building.

Although limited liability strengthened the ability of railway companies to concentrate equity capital, the transitional financing required during the period of incorporation could present barriers to business formation. The problem involved parliamentary rules requiring substantial subscriptions to share capital before the process of charter ratification could be completed. In these cases wealthy individuals were often reluctant to subscribe because the purchase of scrip made them partners in the promotional venture, with full liability for losses if it failed. (Baskin, 139).

So-called commandite, or limited partnerships, where directors had unlimited liability and investors limited liability, slowly replaced family firms throughout Europe, though not in England: commandite organizations were the dominant style of firm in France in the 19th Century until it acquired a modern law for the free incorporation of limited liability companies in 1867.

As two Economist reporters put it: “As for limited liability, that was viewed to the extent that it was considered at all, as a weakness, rather than a strength, because it would lower the commitment of the partner-owners. “It is impossible for a mill at any distance to be managed unless it is under the direction of a partner or superintendent who has an interest in the success of the business,” argued Sir Robert Peel, Britain’s richest industrialist in the 1820s.” (Micklethwaite and Woodldridge, 42)

British law provided remarkably little protection for shareholders until the late 1800s. It was not until the case of Salomon v. Salomon & Co. Ltd (1893), when the House of Lords ruled in favor of an unsavory leather merchant who had transferred his assets into a limited liability company, that the separate legal identity of the company, and the “corporate veil” of protection that it offered to its directors, was firmly established in the law. And many companies used partly paid shares – shareholders, for instance, paid in only 10 shillings for each pound share; that meant that if the firm got into difficulties, the other 10 shillings would be called for. (Micklethwait).

Criticism of limited liability was fueled by certain mid-century scandals, including the spectacular collapse of Overend, Gurney, a revered financial house.

“With its luring but deceptive flag, ‘limited,’ it has been a snare and a delusion,” argued one old opponent, “like the candle and the moth, or gunpowder in the hands of a child.” (Micklethwaite)

Nevertheless, the pressure to compete on equal terms was relentless. In May 1863, France passed a law allowing businesspeople to establish joint stock companies with full limited liability, provided that the capital involved did not exceed 20 million francs. Four years later, that limit was removed. (Micklethwaite, 52)

The British Companies Act of 1856 similarly provided for limiting liability in the event of a bankruptcy for those who purchased equity shares of incorporated businesses. (Baskin, 130).

Limited Liability in the United States

Limited liability was routinely granted to corporations as far back as the early 18th century. Davis (1917) notes that only one company, the Hamilton Manufacturing Society, chartered in New York in 1797, was refused this privilege.

Others argue, however, that it wasn’t widespread until the 1800s. Because limited liability had the effect of shifting risks from owners to the creditors (lenders, suppliers, construction companies and laborers), it’s at least clear that it wasn’t accepted without debate.

In Massachusetts, limited liability was the exception rather than the rule. In 1808 the legislature passed a law specifically establishing -- not limiting – liability of manufacturing corporations. Investors could be levied to pay the debits of the company until the law was repealed in 1829. Berle reported that, in 1822, Massachusetts laws stated that any member of any manufacturing company was to remain liable in his individual capacity for all debts contracted during his membership of the corporation. (Roy 158)

Although grants of limited liability had been made to commercial enterprises as early as 1786, legal opinions on this practice remained sharply divided in many states well into the 1820s. Some had shared the misgivings of British officials … about the potential of limited liability to promote dishonesty and fraud by lessening creditors’ rights of redress. Others, who were influenced by the ideas of Thomas Jefferson, remained opposed because they believed that limited liability primarily benefited wealthy entrepreneurs and did little to improve the lot of yeoman farmers, who were considered to be the social backbone of the new American state. (Baskin, 141)

Proponents of Jacksonian democracy favored limited liability, however, believing that it was a mechanism for placing the interests of impecunious businesses on a par with those of the wealthy. (Baskin 141)

New York State’s general incorporation statute of 1848, which served as a model for many other states, sought not to limited liability, but to protect creditors by requiring that companies provide information in the form of annual reports indicating the amount of paid-in capital and the total debt outstanding.

Many state legislatures ratified limits on liability through statutes, but others continued to uphold investors’ liability. In Maine, “the law changed back and forth nine times between 1823 and 1857 – between no liability and full liability, depending on whether the whigs or the Democrats had a majority of the legislature.” (Nace 78)

As late as the General Act of 1853, Pennsylvania established individual liability in manufacturing and mining and (to a lesser extent) banking. For small corporations, lenders often required shareholders to cosign notes of indebtedness for the corporation. Some state constitutions and legislatures imposed additional liability on stockholders for the benefit of creditors, which is called statutory liability. (Roy 157)

Before the Civil War, “judges began to develop a doctrine that conferred limited liability on shareholders in the absence of any charter provision to the contrary. Usually, however, charters were not silent. Some required that shareholders be exposed to unlimited liability for debts or legal settlements against a corporation; others required “double liability,” which meant that shareholders’ exposure was limited to twice the amount of their investment.” (Nace 78) Double liability was actually a compromise between limited liability and full liability. It protects shareholders by limiting their exposure to twice their investment, as opposed to unlimited liability.

By the end of the 19th Century, historians were already beginning to recognize that the broader societal benefits attributable to limited liability were beginning to look like an anachronism, and its continued adoption an institutionalized advantage that undermined societal values:

“There is nothing in the corporate form itself to justify the exaggerated application of limited liability,” William Cook wrote in The Corporation Problem. “The pernicious movement has decreased the personal responsibility on which the integrity of democratic institutions depends, and has introduced into both investments and social services a dangerous level of insecurity. Its prevalence in this [19th] century has been due to an overestimation of the importance of national internal development [T]he element of personal responsibility is gradually pushing its way back into the management of corporations so far that limited liability, instead of being an advantage, is often regarded by promoters and investors as a positive detriment.” (Cook, as quoted in Roy, 161)

But the opinions of historians was less important than that of businessmen and legislators. By the end of the 19th Century, it was commonly understood that the balance of tort liability was best defined not in the corporate charter, but in external laws and by the courts.

The Role of the Courts

Despite early controversies over its economic or moral wisdom, limited liability increasingly became seen as an inherent right as a result of judicial rulings that validated it as a part of common law. (Roy 159)

In Salomon V. Salomon & Co. Ltd., a case that helped the English House of Lords lay down the doctrine of separate legal personality and limited liability for so-called closely-held or one-man corporations, it was noted that when one judge had stated that it would be lamentable if corporate law permitted the avoidance of personal responsibility by using the expedience of incorporation, a higher court shrugged off this revulsion. It actually was the very “policy of the Companies Act to enable this [avoidance of responsibility] to be done.”

The decision in another, recent well known New York taxicab case -- Walkovszky v. Carlton -- is extremely well-known and is taught in every corporate law class in the common-law world because, as Glasbeek suggests, “the result was so unpalatable and yet so much in line with precedent. It was a very strong statement to the effect that the logic of corporate law is to be protected, even if that protection leads to outcomes that are contrary to the people’s expectations and to legally endorsed goals.” (Glasbeek, 42)

One of the judges who wrote the majority opinion in that case noted that the “law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability.” It was also recognized that “the privilege is not without its limits. Broadly speaking, the courts will disregard the corporate form, or, to use accepted terminology to “pierce the corporate veil”, whenever necessary “to prevent fraud or to achieve equity.” Yet the court held that the corporate veil may not pierced simply because the defendant corporation is part of a larger enterprise. Instead, proof that multiple corporations are simply part of a single corporate group may give rise to enterprise liability, and may not necessarily be used to reach the stockholder.)

According Klein and Coffee (142), the law regarding the ability of the courts to “pierce the corporate veil” and hold shareholders liable for the debts of a corporation is “exceedingly murky and varies somewhat from state to state. Roughly speaking, shareholders are in danger of personal liability for the debts of a corporation if they use the corporation for fraudulent purposes or if they, themselves, disregard the separate character of the corporate entity (for example, by mingling corporate and personal funds).” It becomes more difficult to “pierce the corporate veil” in cases where creditors claim that shareholders knowingly “undercapitalized” the corporation at its formation so that it could not pay its foreseeable debts and, as discussed above, when a single business is spread among different corporate entities.

Klein and Coffee report that at least until 1985 no case has ever held individual shareholders of a public corporation (as opposed to a closely held corporation) to be personally liable, and that “the courts have shown no greater inclination to pierce the corporate veil for the benefit of tort victims than for the benefit of other creditors. Nor have the courts shown a greater tendency to pierce where the shareholder is another corporation (that is, the parent corporation in a parent/subsidiary relationship) than when the shareholder is an individual.” (Klein and Coffee, 143)

Contemporary Issues Related to Limited Liability

According to Monks and Minow, during the 1980s another form of limited liability became popular as a result of revisions in bankruptcy law. As a result, it became expedient even for companies with substantial assets to declare bankruptcy because of the protections – and the extra time – it gave them. E.g. Texaco was able to negotiate down the damages assessed against it arising out of the Pennzoil acquisition. Ultimately, many of these companies emerged from bankruptcy with their liabilities better organized and the shareholders – whose downside liability was always limited – were given a second chance to profit. (Monks and Minow, 9).

According to experts on global regulation, in response to the reality of globalized insurance and reinsurance of the risks of 20th Century seagoing, the 1976 London Convention on Limitation of Liability for Maritime Claims globalized liability limitations that created incentives for marine insurance without making insurance compulsory. (Braithwaite and Drahos, 423) “The earlier concept of limitation held that a shipowner should be able to free himself from liabilities which exceed his total interest in a venture subject to marine perils. The more modern view is that the shipowner should be able to free himself from liabilities which exceed amounts coverable by insurance at reasonable costs.” (Mankabady, in Braithwaite and Drahos). It’s not clear if attempts have been made to universalize this construct the way that limited liability was spread from oceangoing merchants to other joint-stock companies.

Another development in the spread of limited liability in to additional corporate forms was reported by the Wall Street Journal in 1993: the adoption of limited liability by corporate partnerships. The relatively new variation on the corporate structure suggests that debates over the question remain relevant (albeit obscure) today.

As the Journal described it, the limited liability company (LLC), is “arguably the hottest thing in business start-ups today.” LLCs are a hybrid that offers owners “the liability protections of a traditional corporation and the tax advantage of a partnership.” Their acceptability grew from only 8 states in 1991 to 35 states in 1993 (virtually all states allow them today). A 1988 IRS ruling permitted LLCs to be treated as partnerships, so that each owner’s profits are taxed only on his or her personal returns, and not double taxed, as with corporations, giving LLCs the advantages of partnership, while limited liability provides the advantages normally attributed to corporations. (WSJ, 11/8/93).

Although not limited liability in the strictest sense, the liability of insiders is not only limited by the corporate form, but also by external protections. E.g. state (TX, FL) homestead laws allow top executives to shield certain forms of property from disgorgement proceedings. Similarly, the tax deductibility of certain penalties for financial and securities fraud assessed without any admission of guilt are tax deductible, which in effect shifts them from shareholders to the taxpaying public.

These policies, external to the corporate form itself, could and should be directly addressed through state or federal laws. In fact, proposals to do so have been made.

One of the many criticisms levied against the $1.4 billion settlement with the 10 Wall Street banks was that a sizeable chunk of the settlement could be tax-deductible, essentially pinning a good portion of the fine on taxpayers.

In response, Senators Charles Grassley (R-Iowa) and Max Baucus (D-Mont) introduced the Government Settlement Transparency Act of 2003, which promises to make sure that nothing is tax deductible in any settlement with any level of government that involves payment for potential wrongdoing. Although saddled with other provisions that ruined investor interest in the bill, a proposal in the House would have preempted state homestead laws.

Addressing Limited Liability

a) Limited Liability for Large Companies

As suggested in example of nuclear power plants above, the ability of holding companies to establish limited liability for their subsidiaries should clearly be challenged. There are a number of possible approaches.

For example, Jane Anne Morris suggests that we consider "[p]rohibit[ing] corporations from owning stock in other corporations. Owning stock in other corporations enables corporations to control huge markets and shift responsibility, liability, resources, assets and taxes back and forth among parent corporations, subsidiaries and other members of their unholy families. By defining corporations in such a way to prohibit such ownership, much of the anti-trust regulatory law becomes unnecessary and superfluous.

Clearly the problem of corporate "shape-shifting" is not limited to the question of liability. Multinational tax avoidance, for example, is a huge problem exacerbated by the ability of corporations to shift income around among subsidiaries through "transfer pricing" and other tax strategies.

Apart from the question of antitrust regulation, Morris' proposal suggests that we place direct limits on corporations through their charters and corporate law.

Yet stopping corporations from owning other corporations is a large proposal, not just politically, but legally. For example, doing so through the charters without influencing the home state of incorporation (e.g. Delaware) would require that we either establish a system of federal chartering or overturn the "Internal Affairs Doctrine" -- which the courts have used to assert that states do not have the law to regulate the internal affairs of a company that is incorporated elsewhere.

The problem becomes even more complicated when we consider the fact that most large corporations operate on a global scale. Corporate entities are divided into countless subsidiaries to further limit liability and confound attempts at establishing a chain of accountability. (Blumberg)

Another approach might be to attach a liability burden to a corporation through the rule that requires a company to report when it reaches a 5 percent threshold in another corporation.

b) Limited Liability as a Shield for Shareholders, Directors and Managers

Halpern, Trebilcock, and Turnbull argue that limited liability should not be available to small, undercapitalized corporations and in circumstances in which the potential victims of corporate harm-doing are not in a realistic position to bargain with the corporation about the impact of its activities.

In a similar vein, Hansmann and Kraakman suggest that, where the impact of corporate conduct amounts to a tort – that is, a wrongfully inflicted harm on someone who was not contractually connected to the corporation – the principle of limited liability should not hold sway. (Hansmann).

Glasbeek suggests that “these are acknowledgements of the anachronistic nature of limited liability in a market capitalist economy; they are also vainglorious attempts to repair the damage done by the principle. The suggestions have not been acted upon, mainly because to implement them would be to question the logic of modern corporate law and, thereby, threaten to bring the edifice down. It is in this context that the movement to impose more responsibility on directors and management must be understood. It is a way of imposing obligations on people without directly attacking the grant of full, human-like personality to corporations or the doctrine of limited liability to investing property owners.” (Glasbeek, 290)

Over 100 years ago, Cook proposed that stockholders of banks should be liable for double their investment so that depositors could be compensated if a bank failed. He reasoned that the stockholders enjoyed the profits from using the deposits so they, not the depositor, should suffer from insolvency.

Another approach has been taken by the courts, which have “pierced the corporate veil” in specific cases. However, in general the ability to do so has been met with fierce resistance. Only when courts are persuaded that the corporate vehicle was used fraudulently will they do so. (Glasbeek, 42)

The standards by which veil piercing is effected are vague, leaving judges great discretion, and as Glasbeek suggests, “ While these occasions remain exceptions to the rule, the very fact that the judiciary, the bastion of conservatism, feels itself pushed in these directions indicates a pervasive awareness of how anti-social behavior on the part of small business, when swathed in corporate clothing, can menace the hold of market capitalism on our collective mind.”

Another approach might be to once again require certain types of companies to be commandite, or limited partnerships, where directors had unlimited liability and investors limited liability. Greider explains the logic behind this proposal:

Reducing ‘limited liability’ protection for the designated insiders increasing their exposure to personal loss – would instill a measure of personal responsibility at the commanding heights. The point is to force those who benefit to take some responsibility for the costs of their adventures. This new measure of discipline (if one can imagine its adoption) also would provide the leverage for encouraging structural reforms by corporations themselves. Companies, for instance, might be permitted to retain the full scope of their “limited liability” protection if they restructured internally to disperse power and ownership so that other contributors became authentic insiders themselves, starting with the employees. "Management thus would have to accept greater internal accountability, including legal obligations for disclosure and deliberations with other contributing elements, including the supporting communities, in exchange for retaining their own ‘limited liability’ protection. If they choose not to reform, insiders would face greater financial risk for the consequences of their actions.” (Greider, 219)

Christopher Stone (1975) also recommends that changes be made in the standards for directors’ liability. Corporate bylaws and court doctrines generally protect directors in the event of significant liability if they relied “in good faith” on reports, such as audits, provided by management. Settlements and legal fees are usually picked up by “the corporation” (i.e. shareholders or taxpayers), because directors are usually indemnified or covered by liability insurance, the premiums for which are usually paid for by the corporation. Thus, in addition to being liable to the corporation for losses owing to “gross negligence,” Stone suggests that we ought to attach liability, by statute, to failures to perform those of the mandated directors’ functions that are deemed most vital, and narrowly defined.

We should also be skeptical to the notion of "innocence" when it comes to non-insider (i.e. arms-length) shareholders. Here the caveat emptor principle ("buyer beware") might apply. Hiding behind a shield of ignorance about the company one invests in should not be considered an acceptable standard, regardless of the context.

Even the above proposals regarding insiders will seem fairly impractical in a political sence, except that it is interesting to note how they overlap with the position of fairly established corporate interests in recent debates over corporate governance reform, where the question is asked how to make directors of corporations exercise better oversight on behalf of shareholders.

The National Association of Corporate Directors – an influential professional organization closely aligned with corporate interests – issued a report on director compensation and professionalism which examined how best to correct certain agency chains involving corporate board directors, so that the directors represent the shareholders interest. The NACD’s suggestions included director independence, expertise in the industrial sectors that the company competes in, limiting the number of boards an individual director can sit on (so that they put in enough time on those they serve), and competencies (e.g. finance, accounting, industry knowledge) required for professionalism and oversight.

One of the NACD’s recommendations was that each director should have a significant personal, long-term equity stake in the firm. This can be accomplished in part by ensuring that most or all of a director’s compensation be in the form of equity, as well as requirements (in the director’s contract) that they own a substantial amount of stock in the company, in order to concentrate the director’s attention on creating shareholder value. In cases like WorldCom (where an outside trustee is tasked with making certain proposals to reform the company), it is worth considering a requirement that stock granted to insiders carry double liability (double liability might also be attached to special classes of stock designed to provide insiders with extra proxy voting power). These “deep pocket” shares might create an incentive to pay closer attention to potential sources of “externalities” that could potentially bankrupt the company.

In New Jersey, two bills were introduced in 2002 -- A3823 and A3824 -- which incorporate a section intended to address the problems created by limited liability. The provisions would create four types of obligations for corporate principals (debts including monies owed to the government, personal injury and workers compensation verdicts or settlements, civil liability to anyone arising out of environmental crimes or harms to the environment, and any benefit or pension claims). The principals liable for such debts include the ten largest shareholders, the ten most highly compensated employees, the inside members of the corporation's highest governing board, and any employees or agents of a corporation whose negligence or other wrongful acts proximately caused the liability in questions.


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"The Spread of Limited Liability Companies" by the Corporate Research Project