Against Limited Liability

Limited liability is a firmly entrenched aspect of entity law. Prominent scholars have referred to it as “one of mankind’s greatest ideas.”[1] As applied to tort liability, however, it is one of mankind’s dumbest mistakes. Limited liability lets business owners escape liability for the damage their projects wrongly inflict on others, shifts business risks and costs to victims and government, and puts businesses that capitalize and insure to meet their obligations at a competitive disadvantage. Limited liability diverts investment away from the businesses whose operations would have maximized social wealth.

Professor Michael Simkovic has conservatively estimated the externalization of risk and loss from business owners to third parties at $4.3 trillion in 2017, about 20% of GDP.[2] The true figure is probably much higher.  Limited liability is an engine of destruction that hampers the American economy by steering a large portion of economic activity into socially wasteful, but artificially profitable, projects.

Entity owners, of course, like limited liability. It excuses them from liability for the damage their projects cause third parties. Increasingly, even the largest businesses have chosen to conduct dangerous operations through undercapitalized subsidiaries. If the risk manifests, the parent company invokes limited liability and walks away. Before the risk manifests, the parent takes the profits from the subsidiary as dividends. Whether or not the risk manifests, a subsidiary can take the same risk again—a one-way valve that facilitates the externalization of risk.

No generally applicable law requires that a business entity maintain any minimum level of capital or purchase liability insurance. Undercapitalization alone is an insufficient basis for piercing the entity veil. That leaves entity owners free to decide how much—or how little—money they will make available to those their entities wrongfully injure. The amount the owner chooses to contribute as capital is the limit of the owner’s liability. For entity owners, tort liability is optional.

New technologies capable of creating ever-larger disasters and the increased willingness of wealthy entity owners to deploy those technologies threaten to magnify the current level of destruction. They include artificial intelligence, cyber-warfare, virus laboratories, space littering, abandoned oil and gas wells, and climate manipulation. By design, the entities that undertake these activities will have neither the ability nor the intention to pay for the damage they wreak. They will have limited liability and nominal unencumbered assets.

Limited liability was not the product of reasoned debate. States adopted it to attract businesses or avoid losing them. The states did so prior to the rise of tort liability in the 1960s and 1970s. The arguments for limited liability make little sense in the tort liability context.

Professors Frank H. Easterbrook and Daniel R. Fischel initiated the limited liability debate with a 1985 article in the University of Chicago Law Review.[3]  They argued that limited liability attracted capital, but they did not address the counter-argument that it did so only to the extent that the recipients of that capital were externalizing their tort liability. They argued that limited liability was needed to keep large businesses that could pay their debts on a level playing field with small businesses could not—essentially an argument that neither should pay their debts. They argued that stock markets could not function in an unlimited liability regime, ignoring the fact that stock markets did function in the period before limited liability became ubiquitous. But they also argued persuasively that, under joint and several liability, (1) investors would lose the benefits of diversification and (2) some investors might have to monitor the wealth of other investors.

Those two problems were the principal remaining impediments to unlimited liability. Under joint and several liability, the investor of a few hundred dollars could be held liable for billions. Professors Henry Hansmann and Reinier Kraakman advanced the debate in a 1991 article in the Yale Law Journal in which they proposed that the unlimited liability be prorata.[4] That solved the diversification and monitoring problems, but created two others: (1) enforcement of prorata liability in the context of a large company might require hundreds of thousands of lawsuits, and (2) shares in high-risk U.S. companies might be held by foreign entities that had limited liability under foreign law.

Professor Nina Mendelson solved the first problem with a proposal that only controlling shareholders should have unlimited liability.[5] Non-controlling shareholders would have limited liability and could continue to reap the benefits of diversified stockholdings.

The second problem can be solved by (1) extending controller liability to all corporate beneficial owners, not just those who control through shareholdings, (2) requiring that controllers consent to the jurisdiction of the U.S. courts as a condition of doing business in the United States, (3) adjudicating unlimited liability in U.S. courts, (4) excluding controllers who rely on foreign law to evade controller liability from doing business in the United States, and (5) applying diplomatic sanctions to the countries shielding them.

The enactment of a federal statute converting the American economy from limited to controller liability could make the economy more efficient while reducing human suffering. The necessary evil of limited liability is no longer necessary. The Article is here.

1E.g., STEPHEN M. BAINBRIDGE & M. TODD HENDERSON, LIMITED LIABILITY: A LEGAL AND ECONOMIC ANALYSIS 302 (2016).(go back)

2Michael Simkovic, Limited Liability and the Known Unknown, 68 DUKE L.J. 275, 304 (2018) (go back)

3Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. CHI. L. REV. 89, 95 (1985).(go back)

4Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J. 1879 (1991) [hereinafter Hansmann & Kraakman, Toward Unlimited].(go back)

5Nina A. Mendelson, A Control-Based Approach to Shareholder Liability for Corporate Torts, 102 COLUM. L. REV. 1203 (2002).(go back)