A New Understanding of the History of Limited Liability: An Invitation for Theoretical Reframing

In this paper, I will investigate the historical development of limited liability—widely considered the cornerstone of the business corporation. I challenge the common, linear narratives about how limited liability evolved, and argue that corporations, the stock markets, and the corporate economy enjoyed a long and prosperous history well before limited liability in its modern sense became established. This radically different historical understanding calls for the economic theory of limited liability to be revisited. It also opens up a new set of conceptual, empirical, and theoretical research questions, and points to new possibilities for viable liability regimes in the future.

Limited liability is viewed by many eminent corporation law scholars as a defining attribute of the business corporation. Notable contemporary observers, including the Presidents of Columbia and Harvard, viewed limited liability corporation as the greatest single discovery of modern times, surpassing steam and electricity. Such statements about the historic importance of limited liability as a game-changing invention were theoretically substantiated with the emergence of economic analysts of corporation law in the 1960s and beyond.

I conceptualize this process as divided into three definable periods, linked by two critical transition phases, rather than just two periods, before and after the invention as held by the conventional wisdom. In Period I—the nascent corporate economy featuring the first joint-stock corporations in 1550–1600, until around 1800 – there was no notion of the attribute of limited liability and no actual manifestation of it as such. One should not read my argument as claiming the attribute of limited liability existed but was not yet conceptualized in this period: pre-1800 business corporations simply predated the relevance of limited liability. Corporations then were not unlimited but they were not limited either—hence, the question of limited vs. unlimited liability had not yet been formulated. What may have misled some scholars are the manifestations of the separate legal personality of the corporation. The implication of the legal personality attribute of the corporation was that the corporation was not a pass-through enterprise but a liability-bearing entity. But without debt finance, without a procedure for dissolving insolvent corporations, without the legal ability to determine whether shareholders would bear liability in insolvency, limited liability in the modern sense could not yet exist.

Next, in the first transition phase, there were small but significant technical steps toward forming the attribute of liability and distinguishing it from legal personhood. By Period II, from around 1800 until around 1930, the concept had been moulded, and diverse types and levels of limitation of liability experimented-with. I posit a continuum—which opened up in the 19^th century between unlimited liability and full limited liability in its modern sense. Liability regimes in this period included: double liability, triple liability, partly paid shares, pro-rata several liability and unlimited liability. The second transition phase, leading into to Period III (from around 1900 until the mid-20th century), was characterized by a gradual convergence into a single, universal model—the model I term in my paper limited liability in the modern sense. Amid the convergence process, public intellectuals celebrated the “invention of limited liability”, and in the post-convergence phase (Period III) legal-economic theoreticians laid out the theoretical arguments supporting the proclamation that, without limited liability, the entire corporate economy could not have developed.

The entire corpus of corporate finance that has developed since the 1950s is based on the assumption that publicly-traded corporations are limited liability corporations in the modern sense, whose shareholders bear no personal liability. The new historical understanding offered here narrows the conditions in which the theories of limited liability actually apply.

More empirical and historical studies—comparing jurisdictions with different liability regimes, sectors with different liability regimes, and the before-and-after of the introduction of a specific liability regime—can take us a long way toward better understanding the economic history of the 19th century and the economic theory of limited liability. I reject the assertion that convergence to full limited liability was the outcome of an evolutionary selection of the optimal liability regime (full limitation in the modern sense). That assertion mistakenly relegates Period II and the transition to Period III to the category of a mere hiatus, a footnote in the history of limited liability and the rise of the corporate economy. But if full limited liability was the outcome of an evolutionary process, why did it take more than a century to sort out the most efficient liability regime and why the initial process was one of divergence rather than convergence? How could the Industrial Revolution unfold before the recourse to limited liability? Does the convergence have anything to do with the political economy of financial regulation, with the Great Depression and the New Deal? Why did we end up with limitation of liability for all types of debt, including tort debts, while theory doesn’t favour this? Current theory of limited liability does not provide tools for addressing these historical puzzles. Studies dealing with these questions will be instructive for a variety of issues including the legal-economic history of the corporation and the role of law and organizations in economic development.

Aside from challenging the deeply-embedded historical narratives that surround the birth of limited liability, this study also renders an understanding that is pertinent to today’s corporate operations. It suggests that various liability regimes that were widely used in Period II—and were weeded-out by the historical convergence in the transition to Period III—can inspire the discussion of alternatives to our present-day modern limited liability regime. The various financial schemes and institutional environments of the 19^th century can be exploited to expand our imagination and consider alternative liability regimes for different sectors (particularly the financial sector) and different types of corporations in the 21^st century.

I urge scholars not to assume that the convergence to full limited liability was an evolutionary drive to efficiency. The outcome of the convergence—full limited liability in all sectors including the financial sector—is not necessarily “first best”. The burden is on the dominant theory of limited liability to check and reconcile its predictions, not only with the 19^th century economic growth and stock market expansion but also with the consequences of the 2007 crisis. The relatively new full liability regime of investment banks and their leverage ratios may have contributed to that crisis. I do not suggest that full joint and several liability of shareholders should be considered. But I believe other 19^th century regimes should be considered at least with respect to some sectors and some types of liability. The current theory can partly explain the advantages of limited liability in the modern sense, but it fails to assess sufficiently the viability of other liability regimes or the shortfalls and costs of full limited liability.

The complete paper is available here.