Tagged: limited liability

Are limited liability arrangements unjustified economic interventions?

Are limited liability arrangements unjustified economic interventions?

The familiar Western legal concept is a creation of the state, originally crafted for trade expeditions. The first trade expeditions were highly risky, capital-intensive ventures, so to mitigate risk for such trading companies, European governments limited the liabilities of such trading companies by designating them joint-stock enterprises.

The earliest joint-stock enterprise was London’s Muscovy Company, established to trade with Russia in 1555. Limited liability was also granted to the famous British East India Company and Dutch East India Company, in the 17th Century. America’s first limited liability law was passed in 1811.

What’s the point of a joint-stock enterprise? The transaction cost of borrowing capital is decreased by allowing small shareholders to invest directly in a company without needing to interface directly with its proprietors. A joint-stock enterprise protects shareholders’ personal assets from any of the enterprise’s creditors. The benefit of limiting liability is that companies are able to raise capital from the long tail of the population, not just wealthy elites. The cost is manifested through increased moral hazard.

Would it really be such a bad thing if investors actually paid closer attention to what they are investing in? Without limited liability arrangements, prudent investors would need to hash out deals with proprietors, regularly conduct fundamental analysis, and determine a rate of interest. If bankruptcy laws didn’t exist, investors and proprietors would need to set their own terms for failed ventures.

Limiting liability through shareholder arrangements aggravates the principal-agent problem. Though corporations vaguely attempt to “maximize shareholder value,” rationally ignorant small shareholders don’t hold management of any one company accountable, since the amounts of money at stake are relatively small. Small shareholders with diversified portfolios of large mutual funds and index funds suffer from the local knowledge problem, just like socialist governments. They can’t possess enough meaningful knowledge of all the different individual agents to direct resources so as to maximize societal value.