Limited liability has been known in Europe since at least the twelfth century,and developed later in England and throughout the developed world. Limitedliability can be achieved by private contractual arrangements, by the use oflimited liability forms of enterprise, by other statutory limits on liability, andby bankruptcy. The principal advantage of limited liability is in encouraginginvestment by passive investors in risky enterprises, particularly where theseinvestors are poor monitors of managers. Joint and several liability is aparticular deterrent to investment by wealthy investors, who are likely to bearall of the costs of judgment. Pro rata liability shifts collection costs fromwealth investors who must seek contribution from other investors tojudgment creditors, who must collect from all investors if they are to recoverthe entire judgment. It is generally agreed that in the context of contractualliability, the costs of limited liability on contract creditors will be fullyinternalized, as the cost of credit rises to reflect increased risk of firmbankruptcy shifted to these creditors. Determining the efficient rule in thecontext of tort liability is much more complex. While it is generally true thatlimited liability allows firms to become judgment proof and frustrate tortcreditor recovery, this is only the beginning of the inquiry. First, tort creditorsmay benefit from efforts of contract creditors to minimize firm risk. Second, itis not clear that unlimited liability would deter risky firm activities if widelydispersed shareholders are poor monitors of risky firm activities, or if manytort liabilities are uncertain in their incidence and extent of harm. Third, it isnot clear that shareholders are necessarily the superior risk-bearers wheremass torts involve class actions where each claim is relatively small, if someshareholders would bear a large amount of liability.

JEL classification: K22

Keywords: Limited Liability, Piercing the Veil, Bankruptcy, ShareholderLiability

1. Introduction

This paper reviews the literature on limited liability. This literature began inthe eighteenth and nineteenth centuries with a concern for agency costsrather than for the liability system. After a long hiatus, when it reemerged inthe 1960s and '70s it was concerned primarily with contract liability and withthe role of limited liability in facilitating capital markets. It was only after thetheoretical literature on limited liability on these topics was relatively welldeveloped that attention turned to tort liability. This literature developed intandem with the growth of tort actions in the United States for catastrophicliability - generally involving class actions on behalf of large classes ofplaintiffs. It became clear with the development of such actions that actorshad developed liability-limiting strategies that had the ultimate effect offrustrating the liability system. (Dent, 1991; LoPucki, 1997; Roe, 1986; Ringleb& Wiggins, 1990) Because liability systems within societies tend to beunitary, empirical work has generally been difficult to undertake. There are afew examples of parallel systems of limited and unlimited liability, but theevidence on the effects of limited liability remains extremely limited.

2. The History of the Law of Limited Liability

2.1. Ancient Rome

In ancient Rome many corporate entities were de facto rather than de jure, andliability remained unlimited. (Gillman & Eade, 1995) This is attributed at leastin part to the fact that most firms were not highly specialized, becausepressure toward limited liability occurs with a separation of ownership andcontrol. (Gillman & Eade, 1995) While vicarious liability existed in Rome, itwas strictly interpreted by limiting the agents' authority, thus creating somede facto limited liability. (Johnston, 1995) Further, the pater familias, the headof the principal economic unit in Rome, was liable for the debts of a slave orson only to the extent of the extent of the peculium, or sum entrusted to him.(Johnson, 1995; Perrott, 1982) While Rome had well developed notions ofboth corporate personality and limited liability, they were not related to eachother. (Perrott, 1982)

2.2. Medieval Italian and Continental Versions of Limited Liability

Joint and several unlimited liability became the rule in Italian city-states asearly as the 12th and 13th centuries. (Medici, 1982) As commerce expandedoutside capital was required and outside investors who participated, either forinterest or a share of profits, were liable only to the extent of their investment.(Medici, 1982; Holdsworth, 1925) This form was widely adopted throughoutthe Mediterranean as the commenda for the maritime trade, and soon crossedover to inland undertakings. (Medici, 1982; Perrott, 1982) The en commanditepartnership was legalized in France in 1671, in Ireland in 1782, elsewhere onthe Continent and in a few states in the U.S.A. in the early 19th century(Shannon, 1931), and in England in 1907. (Holdsworth, 1925) Limited liabilityalso developed for limited liability companies, which in most instances lacktransferable shares but have other corporate characteristics. (Carney, 1995)Limited liability did not make its appearance in chartered companies until the1780s when clauses were inserted in charters limiting the liability ofshareholders to the amount represented by their shares. Previouslyshareholders' liability had been unlimited, though the directors of the FrenchEast India Company appear to have had limited liability. (Minchinton, 1982) In1807 France provided limited liability for joint stock companies known associétés anonymes. Napoleonic conquests spread this form to a number ofGerman provinces, Prussia, Italy, the Low Countries and Switzerland. Limitedliability survived the fall of Napoleon with the adoption by various Germanstates of local statutes modeled after the Code de Commerce; the FrenchCode also constituted the basis of the provincial Italian legislation during thefirst half of the nineteenth century and of the Spanish Code of 1829.(Blumberg, 1986; Macharzina, 1982)

2.3. English Limited Liability: Seventeenth and Eighteenth Centuries

Those forms of corporation that required no royal grant from the EnglishCrown were treated as having limited liability for their members without anexpress grant. (Anderson et. al. 1983) The limited partnership or commendaform never took hold in England. (Perrott, 1982; Gillman & Eade, 1995) WhileCoke made claims for the crown that corporate status could only come from aroyal grant, the facts were otherwise, and Chancellor Coke was forced toargue that corporations created without royal permission must have had a"lost grant." Charters could be obtained by common law or Parliamentary Actas well as from the Crown. (Minchinton, 1982) At one point, the default rulefor chartered companies seemed to be limited liability.(Holdsworth, 1925)Indeed, if members of these corporations were to be held personally liable, itrequired an act of Parliament. (Anderson, et. al., 1983; Blumberg, 1986;Holdsworth, 1925) On the other hand, shareholders were liable to pay anyassessments levied against them by the corporation, and some creditors wereable to obtain court orders requiring the corporation to make suchassessments. (Holdsworth, 1925) Some corporations solved this problem bycontracts that prohibited such assessments.(Holdsworth, 1925) Some of theinitial companies grew from guilds where members began to do business asjoint stock companies, with charters in the 16th century that recognized this,sometimes with limited liability. ( Perrott, 1982; Shannon, 1931; Holdsworth,1925) There is a statist tradition that treats limited liability as a privilegegranted by government to encourage certain forms of economic activity.(Bainbridge, 1993) In one version, government wished to encourage privateundertaking of projects that were too large for individuals. (Sundown, 1982)Much of the focus of English legal history on this subject takes this view,and assumes that the basic rule is (should be?) unlimited shareholder liability.Much of this attitude probably stems from the Bubble Act's 1720 prohibitionof trading in shares of unincorporated joint stock companies. But this did notend the use of unincorporated joint-stock associations; half of the companiesformed in the 18th century after 1720 were unincorporated, and achieved defacto limited liability through the use of trusts and contract terms limitingcreditors to corporate assets. (Anderson & Tollison, 1983) Their charters alsoprohibited assessments in excess of the nominal value of the stock.(Blumberg, 1986) Not only is the "privilege" argument rejected by thehistorical evidence, but also by the economic evidence. The value thatshareholders attach to limited liability will be a function of the probability offirm insolvency, which in the case of torts, will be a partial function of firmsize. Thus, all other things being equal, limited liability with respect to tortswill be of less value to shareholders of large firms than small firms. (Horvath& Woywode, 1996) Since the likelihood that a firm will elect corporate statusis positively related to its size, it appears that limited liability with respect totort liability is an incomplete explanation for the use of the limited liabilitycorporation. (Forbes, 1986)

2.4. Nineteenth Century English Reforms

The origins of a law and economics discussion of limited liability lie inEngland, but they center not on discussions of the efficiency of externalizingthe costs of firm activities, but rather on the increasing agency costs of firmswith passive investors and management separated from ownership. AdamSmith believed that the separation of ownership and control found in limitedliability companies would only lead to managerial shirking, and that in generallimited liability companies could only survive where they were grantedmonopolies, while noting their potential usefulness in businesses with largescale economies requiring large capital (an issue related less to limited liabilitythan to transaction costs).(Smith, 1776) This debate continued among Britisheconomists throughout the late 18th and 19th centuries. Some writers wereconcerned that limited liability would reduce shareholder monitoring and leadto riskier choices by managers. (Amsler, et al., 1981) John Stuart Millexpressed concern for the protection of small investors from fraud, whileencouraging their investment of their savings in enterprise. (Amsler, et al.,1981) Others report that the debate included discussions of the effects ofexternalizing the cost of failure on creditors, which would reduce capitalavailable to business. (Halpern et al., 1980)

Repeal of the Bubble Act in 1825 and adoption of a general incorporationlaw in 1844 were not responses to the need to limit liability, but to the growthin the number of unincorporated joint stock companies, suggesting thatgeneral incorporation laws occurred in England not primarily because of a feltneed to limit liability, but to respond to the development of large companiesthat operated under the disabilities of not being recognized as entities in thecourts. (Anderson & Tollison, 1983) The 1844 Act emphasized unlimitedliability by requiring registered companies to publicize their members.(Shannon, 1931) In the years following 1844, the debate about limited liabilitywas carried on almost entirely in terms of partnership, rather than companylaw (Saville, 1956); those who opposed limited liability did so on the groundsthat it would create excessive speculation, create difficulties in securingcredit, and promote fraudulent investment schemes. (Shannon, 1931) In theearly 1850s pressure for limited liability came in part from philanthropistsseeking a safe investment for the savings of working people. (Saville, 1956)The main argument for adopting limited liability was that the 1844 Act had notsucceeded in attracting investors to new businesses. (Diamond, 1982) Inparticular, wealthy investors were discouraged from participation. (Perrott,1982) Yet some joint stock companies had thousands of investors. (Blumberg,1986; Hansmann & Kraakman, 1991) It was not until 1855 and 1856 thatParliament granted limited liability to members of registered joint stockcompanies. This led to an increase in the number of companies seekingregistration. (Shannon, 1931; Blumberg, 1986; Gillman & Eade, 1995) The 1855legislation attempted to protect creditors with both publicity (filings andinclusion of "Ltd." in the company name) and minimum capital. (Diamond,1982) This pattern was followed throughout Europe. After the 1855 Act it wascommon for industrial companies to create shares with large amounts ofuncalled capital in the event of liquidation until the 1890s, and this trendcontinued in some cases in British banking until the 1960s. (Evans & Quigley,1995) While England was more highly industrialized than the United States inthe early 19th century, it lagged the United States in the development oflimited liability. In 1885, 30 years after introducing limited liability, only 10% ofthe number of "important" firms were incorporated in England. Forbessuggests English entrepreneurs found limited liability less useful thanAmericans, although he offers no explanation for why this should be so.(Forbes, 1986) Another explanation for the late arrival of limited liability inEngland compared to the United States is the lack of jurisdictionalcompetition of the kind that existed in the United States. (Forbes, 1986) Butby 1855 English firms were registering under both French and American laws,giving credence to the competition among jurisdictions explanation. (Saville,1956)

2.5. American Limited Liability

The American colonies inherited the Bubble Act early in their history, but theColonial legislatures were more willing to issue charters than Parliament, sothe corporation, rather than the joint stock company, became the dominantAmerican form of business entity. (Blumberg, 1986) The earliest treatisestated that the fundamental rule of corporate law was limited liability.(Hovenkamp, 1991) The New England states provided for unlimited liabilityuntil increased demand for corporate charters for manufacturing, coupled withcompetitive pressure from other states, caused them to adopt limited liabilitybetween 1816 (New Hampshire) and 1847 (Rhode Island). WhileMassachusetts, the dominant industrial state, had granted 18th centurycharters providing for both limited and unlimited liability, in 1808 its firstgeneral statute provided for unlimited liability, which was not repealed until1830. (Blumberg, 1986; Dodd, 1948; Forbes, 1986; Hovenkamp, 1991;Livermore, 1935) Massachusetts courts were hostile to this law, construing itnarrowly as in derogation of the common law. (Livermore, 1935)Massachusetts continued to grant limited liability only by special charteruntil 1839, when competitive pressures from other states forced the adoptionof a general corporation law with limited liability. (Livermore, 1935) Whilelimited liability was the general rule in the United States after 1830, and inmost cases before that date, there were a few exceptions. California'sconstitutions of 1849 and 1879 imposed pro rata shareholder liability until1931, and at one time six states imposed shareholder liability for unpaidwages, a law that survives in New York (Blumberg, 1986; Manne, 1967) and inWisconsin. (Wis. Stat. §180.0622(2)(b)) Both federal and state law imposeddouble liability for shareholders of banks from 1865 to 1932. (Blumberg, 1986;Macey & Miller, 1992) The rapid adoption of limited liability in the U.S. forlaw and accounting firms when catastrophic liabilities appeared after thecollapse of thrift institutions suggests that limited liability may be moredirectly caused by the prospect of catastrophic tort or regulatory liability thancontract liability. On the other hand, limited liability for banking shareholderswas introduced after the collapse of the U.S. banking industry in the early1930s, although it was replaced with Federal deposit insurance andcomprehensive monitoring of bank solvency by regulators.

2.6. Other Nations

Virtually all nations seem to have developed the notion of limited liability forshareholders in stock corporations. This doctrine has extended to Asiannations that have adopted western legal forms. For example, Korea is a civilcode country that provides for limited liability of shareholders. (Kim, 1995)

2.7. Managers and Creditors

Generally the subject of limited liability is addressed only in the context ofshareholders, but it is important to recall that both managers and creditors ofcompanies also benefit from limited liability. Generally managers will not bepersonally liable for the acts of their subordinates unless they activelyparticipate in them, or sign corporate obligations in their personal capacity.

(Kraakman, 1984; Thompson, 1994) More recently, however, variousregulatory statutes in the U.S. have provided liability for managers for failureto supervise. (Thompson, 1994) Creditors are generally not held liable for theobligations of their debtors. (Easterbrook & Fischel, 1985) Some exceptionshave developed where creditors hold pledged shares as collateral, (Evans &Quigley, 1995) foreclose on pledged property that is the source of liability,(Dent, 1991) exercise such control over the debtor that the relationship can bemore properly characterized as one of principal and agent, or of co-partners,or where it can be said that third parties have been deceived into believingone of these relationships existed. (Lawrence, 1989)

3. The Role of Liability Rules

Liability is generally viewed as a device for minimizing the social cost ofprivate activities, and for forcing actors to internalize the full cost of theiractions. An efficient liability system causes actors to consider the full cost oftheir actions. Limiting liability can thus be seen as subsidizing risky behaviorand allowing some actors to externalize part of the costs of their actions.While corporations generate positive as well as negative externalities,(Leebron, 1991) there is no way to measure the balance of these externalitiesunder a regime of limited liability. Posner argues that the social losses ofemployees from injuries are too small to warrant inclusion in a calculation,and makes only a passing reference to other tort liabilities. (Posner, 1992)While others have discussed the issue of other tort liabilities (see part 15,infra), only one author has discussed the efficiency issues connected tomass tort liabilities, which have raised the question of the efficacy of limitedliability in the tort context. That article suggests that in many cases mass tortliability, which commonly occurs in the context of unforeseeable harms, isinefficient, because such actions cannot be deterred by liability rules (exceptperhaps at the expense of over deterrence). (Schwartz, 1985) If this is correct,then discussions of unlimited shareholder liability in the context of large,well-capitalized publicly-held corporations are moot, and the discussionshould focus on closely-held firms, where the justifications for limitedliability, in terms of capital markets, are much less persuasive.

4. Means of Achieving Limited Liability

While most discussion of limited liability centers around use of the corporateform to produce limited liability for shareholders, other means are available.Lending rather than investing in equity in a firm also provides limited liability.(Easterbrook & Fischel, 1985) Indeed, part of the English debate over limitedliability centered on whether creditors could accept variable interest underusury laws and retain limited liability. (Gillman & Eade, 1995) Creditors can,however, be held liable for firm debts under circumstances discussed in part2, supra.

4.1. Express Contracts

The oldest liability-limiting device is an express contract by which a creditoragrees to look only to the assets of a business firm. This was well known atcommon law in the joint stock association. (Anderson & Tollison, 1983;Hessen, 1979)

4.2. Becoming Judgment Proof

Securing assets with a friendly creditor can immunize them from seizure byother creditors. Debtors can sell assets to unrelated entities, which financethe purchase with issuance of their own securities, thus financing thedebtor's enterprise. Individuals can hold property in tenancies by the entiretythat immunize them from seizure by creditors of individual owners, and somejurisdictions offer large exemptions from seizure by creditors.(LoPucki, 1997)Owners can remove either themselves or their assets to foreign jurisdictionswhere enforcement is costly or impossible. (Alexander. 1992; LoPucki, 1996;Grundfest, 1992) If shareholders were subject to unlimited liability, sharesmight only be owned by risk-preferrers (high rollers - Hansmann & Kraakman,1992) or by foreign investors not readily subject to enforcement by localcreditors. (Grundfest, 1992)

Recent developments in capital markets have permitted the securitizing ofassets - that is, the separation of productive assets from an integrated firminto a separate entity that cannot be attacked as part of the bankruptcy of therisk-taking firm. This has the effect of making firms engaged in high-riskactivities virtually judgment proof (LoPucki, 1996) It is, of course, just a newvariation on the use of corporate subsidiaries to achieve insulation of someassets from the risky activities of an integrated firm. (Blumberg, 1986; Dent,1991; Hansmann & Kraakman, 1991; Landers, 1975; Leebron, 1991; LoPucki,1996; Presser, 1992; Ringleb & Wiggins, 1990; Roe, 1986)

4.3. Incorporation and the Use of Other Limited Liability Entities

While limited liability for passive investors in partnerships (societas),recognized in Europe at an early date, (Medici, 1982; Perrott, 1982; Shannon,1931) was not generally recognized in common-law jurisdictions, New Yorkadopted a limited partnership act in 1822. (Livermore, 1935) Most other U.S.states did not follow this pattern until the promulgation of the UniformLimited Partnership Act in the 20th century. More recently, all Americanstates have adopted limited liability company legislation [as Europeannations had done much earlier (Carney, 1995)], and most have provided forlimited liability for electing general partnerships ("limited liabilitypartnerships"). Some of these states have conditioned such limited liabilityon maintenance of liability insurance in specified minimum amounts. Withthese developments the partnership default rule of unlimited liability willoccupy a very small niche in the United States. (Ribstein, 1992) The mixedform - the limited partnership, with investors having both unlimited personaland limited liability, may be explained by the ability of management toentrench itself from control changes, coupled with the greater flexibility andreduced bankruptcy costs that result from making fixed payment promises tolimited partners rather than to outside creditors. (Ribstein, 1988)

4.4. Subsidiaries and Enterprise Liability

Incorporation has long been the predominant means of limiting liability.While this was not controversial for a long time, use of corporate subsidiarieshas generated considerable commentary. While incorporation to protect thepersonal estates of passive individual investors has been accepted by manycommentators as efficient, when a corporation subdivides its own activitiesinto separate subsidiaries for the purpose of insulating corporate assets fromthe risk of particular activities, some commentators have argued that this isinefficient, because it allows corporations (not just individual investors) toexternalize the costs of some risks. (Blumberg, 1986; Dent, 1991; Leebron,1991; LoPucki, 1997; Roe, 1986) As catastrophic liabilities for environmentaldisasters, product liabilities and other mass torts have increased, largecorporations have resorted increasingly to the strategy of disaggregationthrough subsidiaries, which may not be an efficient arrangement of the firm,since integration through a firm rather than by contract previously appearedto be more efficient. (Dent, 1991; Hansmann & Kraakman, 1991; Roe, 1986; )On the other hand, if all corporate shareholders were to be subject tounlimited liability, corporations might spin off thinly capitalized high-risksubsidiaries to their individual shareholders as an evasion. (Hansmann &Kraakman, 1991) Leebron argues that this spin-off process would depend inpart on the operational costs of separating integrated operations amongentities, and the relative cost of insurance. (Leebron, 1991) One author hasargued that limited liability was not designed to protect corporateshareholders; in the United States, at least, corporate power to own shares inother corporations followed limited liability. (Landers, 1975) FollowingModigliani & Miller, Leebron argues that there is no economic justificationfor letting pure conglomerates separate risky activities to furtherdiversification, because individual shareholders can make their owndiversification. (Leebron, 1991) Thompson argues that while credit marketswill discipline many corporations that choose excessively risky activities, thisis less obvious for subsidiaries, where parents are the suppliers of credit.(Thompson, 1994) Regardless of the arguments against honoring thecorporate veil with parent-subsidiary corporations, changing basic liabilityrules in any society would require such radical changes as to make themhighly unlikely.(LoPucki, 1997) One article argues for a higher tax on profitsthat would be used to finance a subsidy to creditors to reduce managers'preference for risky activities under limited liability. (Banerjee & Besley, 1990)

5. Exceptions to Limited Liability: Lifting or Piercing the Veil

Numerous countries have provided exceptions from limited liability whereactions inconsistent with the separate personality of entity and owners havebeen taken. (Presser, 1991) Germany has developed the doctrine of "lifting" or"piercing" the corporate veil to hold shareholders liable where there ismisrepresentation to third parties or commingling of assets. (Alting, 1995;Schiessl, 1986; Thümmel, 1978; Weber-Ray, 1995) Veil-piercing is far morelikely in the closely-held corporation (including subsidiaries), where thejustifications for limited liability are weaker, because of shareholder ability tomonitor and participate in management. (Easterbrook & Fischel, 1985; Klein &Zolt, 1995; Leebron, 1991) Indeed, veil-piercing is virtually non-existent in thelarge publicly-held corporation. (Easterbrook & Fischel, 1985) On the otherhand, the relative ability of close corporation shareholders to bear risk ismuch weaker. (Leebron, 1991) Further, where a corporation dominates themanagement of another without a formal contract, the dominant shareholdermay be liable for liabilities of the servient firm. (Alting, 1995) Veil-piercing inthe United States is often triggered by activities that can generally becharacterized as fraudulent conveyances under English traditions (Clark,1977; Clark, 1986; Presser, 1991) or by actions of a shareholder that createconfusion in third parties about whether they are dealing with theshareholder or a corporation. (Presser, 1991). In some jurisdictionsundercapitalization alone may be sufficient to trigger unlimited shareholderliability.

France provides for liability of managers to the corporation, itsshareholders and creditors if managers act in violation of the company'sconstitution or law. (Perrott, 1982) Similar rules exist in the U.S. ( Krendl &Krendl, 1978; Presser, 1991) and in Korea (Kim, 1995) Many countries haveprovided for shareholder liability where a legally required minimum number ofshareholders is not maintained, although this rule is disappearing in Europepursuant to European Community directives. Where some defects in theincorporation process are accompanied by an active role on the part ofshareholders and plaintiffs' belief that they were dealing with a corporation,American courts will also hold shareholders personally liable. (McChesney,1993) In European jurisdictions inadequate capitalization alone may besufficient to trigger shareholder liability (Presser, 1991; Alting, 1995), while inothers some evidence of fraud, such as commingling of assets may berequired. (Alting, 1995; Dobson, 1986; Presser, 1991), while in others mereclose relationships between parent and subsidiary corporations may lead toparent liability. (Pardinas, 1991) Anglo-American jurisdictions also use thedoctrine to impose liability on shareholders where third parties are confusedabout whether they are dealing with shareholders or an entity. (Halpern, et al.,1980; Presser, 1991) Doctrines of piercing the corporate veil are lessdeveloped outside of common law countries, where notions of equity andagency are either non-existent or less well developed, and courts frequentlyhave relied on notions of fraud or abuse of the purpose of the corporateform.(Presser, 1991)

6. Statutory Limits on Liability

Certain industries might not exist without special provision for limitedliability. The U.S. nuclear power industry, for example, needed thePrice-Anderson Act, which limited liability in case of a nuclear accident, inorder to raise capital. Other statutory compensation schemes, such asworkers' compensation statutes, and certain treaties, such as the Warsawconvention, which limits damages for airline passengers, also permit damagelimitations. (Coffey, 1994) In the case of new industries where potentialliabilities, while huge, are uncertain, such limits may prove to be efficient,although it is difficult to know how such judgments could be made ex antewhere individual losses are likely to be catastrophic, if they occur.

7. Bankruptcy

Bankruptcy provides a means for limitation of liability. (Easterbrook &Fischel, 1985; LoPucki, 1997) Limited liability for a firm, which limits investorrisk to assets dedicated to the firm, is similar to a discharge in bankruptcy,which limits a debtor's liability to current assets, thus protecting futureassets. (Posner, 1976) In bankruptcies involving corporations withsubsidiaries, American courts may use the device of consolidating the assetsand creditors' claims of all the related corporations as a means of disregardingthe separateness of corporate entities, and thus piercing corporate veils.(Frost, 1993)

8. Limited Liability and the Supply of Capital

The principal argument in favor of limited liability stems from the common lawrule of liability for partners - joint and several liability - in which any onepartner may be held liable for the entire amount of the firm's debt. (Livermore,1935) This appears to be the general European rule as well. (Medici, 1982)Under these conditions there are three economic arguments in favor of limitedliability: (1) it fosters economic growth by encouraging investors to takerisks; (2) it facilitates the efficient spreading of risks among corporations andtheir voluntary creditors; and (3) it avoids the enormous litigation costs thatwould be required for creditors to seek recovery from shareholders. (Menell,1990) The first justification is treated in parts 9 and 10; the second, in part 14(limited liability in contract); and the third in part 12.

9. Encouraging Risky Investments

It has long been argued that joint and several unlimited liability woulddiscourage wealthy investors from investing in risky enterprises, particularlywhen they intended to play a passive role where they could not monitor andsupervise the firm's risky activities. (Blumberg, 1986; Diamond, 1982;Easterbrook & Fischel, 1985; Grossman, 1995; Halpern, et al., 1980; Hansmann& Kraakman, 1991; Leebron, 1991; Manne, 1967; Woodward, 1985) This issupported by one study that suggests that the choice of limited liability ispositively correlated with the wealth of owners. (Horvath & Woywode, 1996)

9.1. Encouraging Diversification by Wealthy Investors

Limited liability permits the diversification which is necessary to riskminimization in a specialized firm, where passive investors specialize inrisk-bearing, and not monitoring of management. (Easterbrook & Fischel,1985; Hovenkamp, 1991; Mitchell, 1989; ) Under joint and several liability,wealthy investors would be the first targets of firm creditors upon failure, andthus would be forced to forego the benefits of diversification in order toconcentrate their investments to allow them to monitor effectively.(Grossman, 1995; Hansmann & Kraakman, 1991; Hicks, 1982; Kraakman, 1984;Leebron, 1991; Manne, 1967) Indeed, diversification would increase theexpected risk of wealthy shareholders; the maximum possible loss is invariantwith diversification, but its probability increases with diversification.(Leebron, 1991 Ribstein, 1991)

One result of unlimited liability might be larger firms engaged in morediversified activities, to protect shareholders from personal losses. (Presser,1992; Roe, 1986) This diversification would, of course, be limited by theincreasing agency costs associated with management of conglomerates, andthe costs of using internal capital markets, with their limited monitoringability, rather than external markets. Because such diversification and increasein size would convey more benefits on wealthy investors under a joint andseveral liability regime, the benefits of this strategy would not besymmetrically distributed across investors, which could lead to constituencyeffects, in which wealthy investors would specialize in owning largediversified firms. Such diversification at the firm level is generally inefficientbecause investors can home-make their own diversification, absent unlimitedliability rules.

9.2. Reducing Shareholder Monitoring of Co-Owners

A joint and several liability rule would force shareholders to monitor not onlyfirm activities, but also the wealth of their fellow shareholders, which leads toexcessive monitoring costs. (Carr & Mathewson, 1988; Easterbrook & Fischel,1985; Halpern et al., 1980; Hansmann & Kraakman, 1991; Leebron, 1991;Woodward, 1985; ) The result would be higher costs and lower returns toequity, which would limit the supply of equity for industry. (Carr &Mathewson, 1988) One article rejects this, arguing that shareholders wouldnot need to increase monitoring of either firms or fellow shareholders, sinceshare prices in efficient markets provide them with all required information.(Meiners, et al., 1979) But other authors respond that joint and several liabilityof shareholders would destroy efficient capital markets, because the value ofshares would be a function of the expected cash flows of the business andthe wealth of each individual buyer, and of expected fellow shareholders.(Easterbrook & Fischel, 1985 and 1991; Halpern et al., 1980)

10. Evidence on the Effects of Unlimited Shareholder Liability on Investment

There is some evidence that unlimited liability, at least on a joint and severalbasis, would reduce the number of shareholders and thus the amount ofcapital contributed to firms. Both limited liability and unlimited liability banksco-existed in 18th and early 19th century Scotland. From the beginning of the19th century the average size of the limited liability banks was ten times thatof the unlimited liability banks, and when the unlimited liability banks werelater given the choice of forms, all chose limited liability. (Carr & Mathewson,1988) Unlimited liability banks had lower levels of capital than limited liabilitybanks in relation to total assets, and shareholders in unlimited liability banksearned higher returns (risk premiums) on their investments. (Evans & Quigley,1995) Depositors in 18th and 19th century Scottish unlimited liability bankswere provided no information about the bank's assets, but rather received alist of shareholders. (Evans & Quigley, 1995) A study of German enterprisesshowed that limited liability firms tend to be larger than unlimited liabilityfirms among start-ups. (Horvath & Woywode, 1996)

There is some evidence to the contrary. Evans & Quigley's study showedthat the majority of banking assets in Scotland were held by unlimited liabilitybanks, which they explain as a function of depositor preference for unlimitedliability banking and the higher shareholder returns available. (Evans &Quigley, 1995) Outside banking, some English joint stock companies hadthousands of stockholders; whether they would have had more as limitedliability corporations is not testable. (Blumberg, 1986; Hansmann &Kraakman, 1991) Gilson reports that law firm size in the United States isinvariant with the choice of liability rule, once tax considerations areeliminated. (Gilson, 1991) This result may have changed with the introductionof new limited liability forms more readily available to U.S. law firms in the1990s, which resulted from the catastrophic liability of some U.S. lawyers inthe wake of the failures of client financial institutions in the late 1980s.(Hamilton, 1995) One modern anomaly occurred in the era of efficient capitalmarkets: American Express Company remained a joint stock company withunlimited shareholder liability until 1965. From its creation in 1850 untilconversion to a limited liability corporation it had as many as 25,000shareholders, with only one ten percent shareholder. There was neitherilliquidity nor perverse stock pricing. (Grossman, 1995) This limited evidence,based on a company with pro rata shareholder liability, rejects the theoriesthat an efficient capital market with diversified shareholders could not existwithout limited liability, although it does not reject the theory that joint andseveral liability would preclude such markets. (Grossman, 1995) Theunanswered question is whether American Express faced serious expectedrisk of large contract liability (much less catastrophic tort liability) prior to itsconversion. It seems unlikely that American Express had a high risk of tortliability; it provided financial services of a limited sort - at the time, primarilytravelers' checks and credit cards - so it produced no products capable ofproducing either strict product liability or mass tort liability. There was somerisk of massive forgery of travelers' checks that could have deterredinvestors. While it was sued for more than twice its net assets in 1963 inconnection with its certification of soybean oil inventories, it is not clear thatcreditors or stockholders would have understood this risk in advance, nor isit clear how much had to do with its 1965 conversion to the limited liabilityform of corporation. (Grossman, 1995)

11. The Effects of Pro Rata Liability on Investment

Subsequent to the development of theories about the impact of joint andseveral liability the literature began to examine the effects of pro ratashareholder liability. While this rule does not appear to play a significant roletoday, there are companies limited by guarantee, which is a form of pro ratamultiple liability. Subsequent to reform of English company law in themid-19th century, many registered limited liability companies voluntarilyprovided multiple liability through assessable shares, and Scottish banksshifted to this form after 1879. (Evans & Quigley, 1995) Further, to the extentshareholders were personally liable in the early 19th century in the U.S., andin California until 1931 by statute (Blumberg, 1986) , it was pro rata. (Presser,1992; Blumberg, 1986; Livermore, 1935; Macey & Miller, 1992) Similarly, U.S.bank stockholders were subject to pro rata double liability from 1865 to 1932.(Blumberg, 1986; Macey & Miller, 1992)

11.1. Effects of Pro Rata Liability on Wealthy Investors and SecuritiesMarkets

Pro rata liability solves the problem of imposing disproportionate liability onwealthy investors. This reduces the need of wealthy investors to concentratetheir investments so they can monitor them more closely. (Grossman, 1995;Halpern, 1980; Leebron, 1991; ) Pro rata liability also eliminates the cost ofmonitoring other shareholders' wealth. (Leebron, 1991) It also solves theproblem of differential pricing of securities based on the expected losses ofbuyers with different wealth levels. (Grossman, 1995; Hansmann & Kraakman,1991; Leebron, 1991; Presser, 1992) By doing so, it solves the diversificationproblem for investors, because the probability of a wealth-erasing assessmentwould not increase with each single stock purchased. The differencesbetween joint and several liability rules and pro rata rules may be exaggeratedif a joint and several rule is coupled with a rule of contribution. Under thesecircumstances, a joint & several rule shifts the transaction costs of collectionfrom corporate creditors to shareholders. (Leebron, 1991)

11.2. Effects of Pro Rata Liability on the Market for Corporate Control

A pro rata rule would discourage wealthy investors from investing in largeblocks of risky companies and thus would reduce shareholder monitoring ofmanagement activities. (Hansmann & Kraakman, 1991; Leebron, 1991;Ribstein, 1992) Under limited liability concentrated block ownership occurswhere the payoffs from monitoring are greatest. (Demsetz & Lehn, 1985)

Modern arguments for pro rata liability in tort argue that diversificationwould remain at efficient levels with such a rule. (Halpern et al., 1980;Leebron, 1991) Hansmann & Kraakman argue that most liability would beborne either by wealthy investors or institutions. What they ignore is thatsuch a rule could have the effect of discouraging the formation of investmentpools from which judgments are easily collectible; the cost to investors ofholding through mutual funds and collective pension plans could rise to thepoint where individual diversification through mutual funds becomesuneconomic. (Leebron, 1991; Coffey, 1994; Thompson, 1994) Grundfestbelieves mutual funds would be able to avoid this problem by establishingthemselves off-shore and using various hedging strategies involvingderivatives. (Grundfest, 1992)

12. Costs of Collection

The costs of collecting judgments under a joint and several liability rulewould be high, as firm creditors collected from wealthy shareholders, who inturn would need to seek (probably incomplete) contribution from less wealthyshareholders. (Woodward, 1985) While a pro rata liability rule would be lessdisruptive of capital markets, it would also be less effective in collectingdamage awards for judgment creditors because of the presence of largenumbers of small investors, where collection costs would be high. It wouldhave the effect of transferring collection costs from shareholders to creditors.(Leebron, 1991) This would weaken both the deterrent effect andcompensation value of unlimited liability. Anglo-American courts of equitydeveloped a relatively effective collection device, the creditors' bill, whichallowed all creditors to seek a determination of both corporate andshareholder pro rata liability, which was res judicata, even for nonresidents,as to all issues other than defenses personal to each shareholder, such as thenumber of shares held or one's actual identity as a shareholder. (Blumberg,1986)

Posey argues that the effects of limited liability on the ability of tortvictims to recover is less obvious. With unlimited liability, a firm'sexpenditures on prevention increase, thus reducing net assets (andincreasing collection costs from shareholders). In the alternative, unlimitedliability might reduce firm activity levels, and with it the stock of capital (andthe ease of collection). (Posey, 1993)

Hansmann & Kraakman assert that for publicly held firms the increasedtransaction costs of unlimited liability under a pro rata rule are less than theincreased costs of externalized liability under limited liability, but they offerno evidence to support this statement. (Hansmann & Kraakman, 1991) Further, this conclusion assumes that companies should be strictly liable forunforeseeable accident costs - that such a rule is efficient - even where thecosts to individual plaintiffs are small but the damages to a firm arecatastrophic (although these authors do not discuss this issue). Leebronnotes that the difference between joint and several liability with a right ofcontribution and pro rata liability is a question of who will bear thetransaction costs of collection - individual wealthy shareholders or plaintiffs.Leebron also argues that because of this, which rule is better depends not oncollection costs, but on which rule creates more shareholder monitoring, andbelieves that joint & several liability is superior in this respect. This analysisassumes that transaction costs of collection are ultimately not significant. Atthe same time, he concedes that for public corporations with many smallshareholders, unlimited pro rata liability to tort victims may be pointlessbecause of high collection costs, and that because of transaction costs, it isunclear what is the best rule. (Leebron, 1991) Other authors argue that noneof the policy arguments in favor of limited liability have any real applicationto closely held firms where owners are also managers and thus can controltheir risks. (Klein & Zolt, 1995)

13. Evidence About Joint and Several Versus Pro Rata Liability

American law provided experience with both pro rata and joint and severalliability: Both New York and California law provided for pro rata liability.(Blumberg, 1986; Livermore, 1935) American banks from 1865-1932 providedfor double pro rata shareholder liability. While American courts wereinnovative in enforcing this liability, the collection rate on shareholderassessments was only 50.8%. Macey and Miller regard this as a success,because it is probable that many shareholders were insolvent. (Macey &Miller, 1992) Grundfest has argued that capital markets would respond to prorata liability by generating a large number of investors who areattachment-proof to specialize in holding equity of risky companies. Thesewill include foreign investors and individuals of modest means holding smallamounts of equity, where collection costs will exceed the amount collected.(Grundfest, 1992) They will also include separation of substantial assets fromrisky enterprises through leasing and thin capitalization. (Lopucki, 1997;Note, 1994) Recent evidence from Germany, however, supports thehypothesis that for investors in large firms risk aversion (and the liability rule)does not influence the choice of firm. (Horvath & Woywode, 1996)

14. Limited Liability in Contract

Early literature concentrated on limited liability for contract obligations. Itmay be that these writers thought tort liability was trivial. It was only laterthat writers, recognizing that liabilities for mass torts that could bankrupteven large firms, turned to analysis of the impact of limited liability on tortrisks.

14.1. The Theory of Limited Liability in Contract

In a perfect capital market with zero transaction costs the value of the firm andits optimal investment policy would not be affected by the liability rulechosen. Unlimited liability would reduce creditors' risks and the interest ratesand other contractual protections demanded, and increase returns toshareholders to compensate for this risk. (Halpern, et. al., 1980) Firms thatchoose a limited liability regime will face higher borrowing costs (Anderson &Tollison, 1983; Posner, 1976), although it is argued that trade creditorstypically fail to incur the transaction costs to investigate credit risk. (Landers,1967) In the case of one-shareholder corporations with little capital, creditorswill either charge higher interest rates for risky loans or insist on personalguarantees, so that credit terms are invariant to the liability rule. (Ekelund &Tollison, 1980; Meiners, et al., 1979) If we introduce transaction costs, wherelenders are uncertain about the extent of shirking and risky behavior byowners with limited liability they may increase interest costs to the pointwhere owners prefer to finance without borrowings at the firm level. (Eswaran& Kotwal, 1989) This analysis has been extended to stock insurancecompanies: if shareholder liability is limited, policyholders will presumablyrecognize the risk they bear and pay less for policies. Insurers can bondagainst risky investments by writing participation rights into insurancepolicies. (Garven & Pottier, 1995) They can also submit to regulation thatassures minimum capital and constrains risky investments.

Under an unlimited liability regime, Leebron argues that shareholderswould probably prefer to borrow using their interest in the firm as collateral,because they would each only be liable for their own borrowing (pro rata),while if the firm borrows, each would be liable for everyone's borrowings(joint & several). (Leebron, 1991) Corporate borrowing with limited liability isequivalent to nonrecourse borrowing by shareholders who pledge theirshares as collateral, but the transaction costs of such borrowing would behigher, because so many lenders would have to investigate the firm inmarkets with large numbers of potential lenders. (Leebron, 1991) Limitedliability creates a state of the world where the worst possible state of theworld is known to all investors, both creditors and shareholders, whileunlimited liability does not allow shareholders the same certainty. (Leebron,1991)

The evidence from 18th and 19th century Scottish banking is consistentwith this model. Shareholders in unlimited liability banks earned higherreturns than shareholders in limited liability banks. (Evans & Quigley, 1995)But despite such differences in returns, in small firms risk aversion leads to apreference for limited liability, especially as firm projects grow riskier,according to a study of German firms. (Horvath & Woywode, 1996)

14.2. The Cost of Limited Liability in Contract

There are at least three costs borne by firm owners for achieving limitedliability, at least two of which apply to both contract and tort liability. First,under limited liability, voluntary creditors will impose higher costs on firms(see above). Second, in many legal regimes, tax costs will be higher for limitedliability, because the entity may be treated as separate, although this is not anecessary condition for limited liability. In the United States the developmentof the Limited Liability Company and Limited Liability Partnership haveeliminated the tax cost for closely held enterprises in recent years. Third, inmost legal systems except the United States, forming a limited liability entitywill subject the firm to extensive public disclosures. (Horvath & Woywode,1996) This apparently is designed to provide potential creditors withinformation about the firm's capital where unlimited liability is not available.While Posner argues that creditors are the most efficient risk-bearers (Posner,1992), Easterbrook & Fischel reject this, arguing that the evidence isotherwise: creditors accept lower returns because they prefer less risk,presumably because they are not the least cost monitors of firms.(Easterbrook & Fischel, 1991) Johnsen argues that creditors accept lowerreturns because they monitor only the value of debtors' assets in alternativeand less specialized uses, rather than in the present use, which is left toshareholders. (Johnsen, 1995) Recent literature on domination of largecorporations by big banks in Germany and Japan has raised the question ofwhether at least some creditors are superior monitors of firms, but fails tobring any evidence to bear on the subject.(Roe, 1994)

Some authors treat small trade creditors as if they were involuntarycreditors, because they face high transaction costs in assessing the riskinessof their credit extensions. (Landers, 1967; Easterbrook & Fischel, 1985 and1991) These arguments ignore both the ability of trade creditors to monitorcurrent payments on a monthly or more frequent basis and their ability to freeride on the negative covenants imposed by larger creditors with scaleeconomies in negotiating credit contracts. Further, they ignore the ability ofmany trade creditors to bear risk by diversifying their customer base.(Carney,1990)

The costs of limited liability imposed on creditors depend on capitalstructure; thus, secured creditors monitor assets, not firms, so theirmonitoring costs are not increased by limited liability. (Ribstein, 1991;Johnson 1995) To the extent that limited liability imposes unmonitored risk oncreditors, it has been suggested that increasing the tax on firm profits andpaying subsidies to creditors can solve the risky behavior problem. Thecreditor subsidy will reduce interest costs to the firm, while raising managerialefforts, thus leaving managers better off, because managers exert less effortwhen liability is limited. (Banerjee & Besley, 1990) A similar suggestion hasbeen made with respect to the level of taxation of profits on U.S. financialinstitutions, to reduce incentives to take risks. (John et al., 1991) Thedifficulty with these proposals is that profits taxes do not distinguish returnsto risk from returns to superior management.

14.3. The Benefits of Limited Liability in Contract

Many of the benefits of limited liability in contract are related to capitalmarkets. With limited liability, investors have the ability to diversify theirinvestments in shares of corporations. This is true in part because withoutlimited liability, for a wealthy investor, each investment would increase therisk of being held personally liable for the debts of a failed firm. (Blumberg,1981; Carr & Mathewson, 1988; Diamond, 1982; Easterbrook & Fischel, 1985 and 1991; Grossman, 1995; Halpern et al., 1980; Leebron, 1991; Woodward,1985) It is also true because it reduces the need for any shareholder tomonitor management for risky choices. (Blumberg, 1986; Easterbrook &Fischel, 1985 and 1991) It also seems likely that given modern techniques forreporting financial results of firms, that monitoring shareholder wealth is morecostly than monitoring firm wealth. Evans and Quigley argued that unlimitedliability was observed in Scottish banking at a time when it was cheaper tomonitor shareholder wealth than bank solvency. (Evans & Quigley, 1995)Finally, limited liability reduces the transaction costs of collection.

15. Limited Liability in Tort

Limited liability's externalization creates three problems: (1) firms makeexcessively risky decisions because they do not consider externalized costs;(2) corporations fail to insure fully; and (3) product costs do not reflect fullsocial costs. (Dent, 1991; Leebron, 1991) Many authors apparently believedthat the problem of tort liability under a limited liability system was not aserious one, either because they felt that other parts of the legal system haddealt with the principal forms of business accidents, through workers'compensation, unemployment insurance, and mandatory automobileinsurance (Manne, 1967), or because they focused on the large publicly heldcorporation, where the risk that individual tort liability would bankrupt a firmseemed trivial. For this reason, much of the early literature focused oncontract liability. (Easterbrook & Fischel, 1985; Halpern, et al., 1980; Meinerset al., 1979; Posner, 1976) The development of the mass tort, stemming eitherfrom industrial accidents or strict products liability, has changed the analysis.(Hansmann & Kraakman, 1992; Leebron, 1991; Roe, 1986; Schwartz, 1985)

15.1. Externalizing the Costs of Torts

The general wisdom states that with limited liability managers loyal toshareholders will select unduly risky projects, because the owners of the firmcan externalize some of the social costs of their choices. (Blumberg, 1986;Brander & Lewis, 1986; Hansmann & Kraakman, 1991; Leebron, 1991) Thismay be borne out by a study showing that limited liability firms have a higherincidence of bankruptcy than unlimited liability firms. At the same time, theyappear to have higher growth rates - the reward for undertaking riskierprojects. (Horvath & Woywode, 1996) In oligopoly, the effect of limitedliability may provide a signaling effect for firms that take on more debt - thatthey intend to pursue output strategies that raise returns in good states andlower returns in bad states. (Brander & Lewis, 1986) The extent of anyreductions in precautions may be a function of the profitability and wealth ofthe firm, however; the more profitable the firm, the more the owners have atrisk, and the greater their precautionary expenses. But where firms aremarginally profitable, owner-managers may choose a lower level ofprecautions under limited liability. (Craig & Theil, 1990) Generally the risk ofbankruptcy is treated as a last-period problem; but if it is seen as an expectedcost of a firm with positive cash flows, the incentive to take excessive riskmay be less than static models would suggest. (Suen, 1995)

15.2. The Impact of Agency Costs on Firm Risk-Taking Decisions

Agency costs will also influence the amount of firm risk assumed. While firmsmay increase their risk where there is a unity of ownership and control, as inclosely held owner-managed corporations, it is less obvious that this holdswith public corporations. Managers of public corporations often hold largeundiversified investments in firm-specific human capital, and often in thestock of the firm as well. They are also holders of large fixed claims on the firmin the form of salaries. (Jensen & Meckling, 1976) As a result, they may beunduly careful in making choices for the firm, and may retain excess equity inthe firm. (LoPucki, 1997) Further, their primary concern will be with failure ofthe firm, because that will cost them their jobs. Easterbrook & Fischel arguethat with unlimited liability managers will reject some positive net presentvalue projects as too risky, but will accept all such projects under limitedliability. (Easterbrook & Fischel, 1985 and 1991) Presser argues that suchmanagers would seek to diversify (and perhaps expand) firm activities toreduce the risk of total loss. (Presser, 1992) To alleviate the managerial riskaversion problem, many compensation plans give managers some claim onthe upper tail of expected outcomes. To the extent that managers assumeunlimited liability as shareholders, the value of incentive compensation tiedto stock is reduced, and managers may be excessively cautious. (Hansmann& Kraakman, 1991) One benefit of limited liability thus is to neutralize somepart of a manager's risk aversion. Easterbrook & Fischel (1985) further arguethat the moral hazard of engaging in overly risky activities under limitedliability can also be dealt with through (1) minimum capital requirements; (2)mandatory insurance; (3) managerial liability; and (4) regulation of inputs.Minimum capital requirements are widely employed throughout Europe.(Carney, 1997) They represent a relatively crude form of protection, since theyare not related to either the riskiness of firm activities nor its capital structure.All states in the United States have moved away from such requirements,providing evidence that in a competitive market for corporate law, theserequirements do not survive as efficient. (Carney, 1995) Mandatory insuranceand managerial liability are discussed at sections 17 and 18, infra. Directregulation of inputs, such as regulation of nuclear plants, presents problems,in that regulators have weak incentives to balance costs and benefits.(Easterbrook & Fischel, 1985)

15.3. The Effectiveness of Shareholders as Monitors of Risky Activities

There is little discussion of the relative efficiency of shareholders, managersand creditors as monitors. While Posner argues that creditors are the mostefficient risk-bearers (Posner, 1992), Easterbrook & Fischel reject this, arguingthat the evidence is otherwise: creditors accept lower returns because theyprefer less risk, presumably because they are not the least cost monitors offirms. (Easterbrook & Fischel, 1991) Manager liability suggests the functionof tort law is deterrence, while shareholder liability suggests the function isloss-spreading. (Thompson, 1994) In public corporations, at least, passiveshareholders are entirely dependent on management for a flow of informationabout risk management, as well as all other details of operations. (Arlen &Carney, 1992) Most writers believe that limited liability will reduce shareholdermonitoring of managers. Easterbrook and Fischel believe that suchmonitoring will be replaced by creditor monitoring. (Easterbrook & Fischel,1985) Even with limited liability, firms subject to high agency costs (whichpresumably includes excessively risky behavior) generate large block ownersbetter able to monitor.(Demsetz & Lehn, 1985) With constant returns tomonitoring managers, the incentive of shareholders is not affected directly bythe liability regime, but if managerial effort were to vary with the liabilityregime, then different levels of shareholder monitoring would be efficient.(Carr & Mathewson, 1988) While Hansmann & Kraakman concede thatpassive shareholders in large corporations are unlikely monitors of risk, theybelieve markets will perform this function, and that share prices will reflectmanagerial risk-taking. Ironically, they also argue that managers will not beexcessively cautious under an unlimited liability regime because many largeuninsured tortious activities create a risk of catastrophic loss only manyyears later and thus will be heavily discounted by today's management.(Hansmann & Kraakman, 1991) If this is true, it is not clear how markets willbe able to provide effective monitoring.

15.4. Catastrophic Tort Liability

Only one author has addressed the effect of unlimited liability on deterrenceof catastrophic torts. Schwartz argues that to the extent many mass torts arenot foreseeable, strict liability coupled with unlimited liability has no deterrentvalue. (Schwartz, 1985) If this is so, the arguments in favor of unlimitedliability in tort are thrown back on risk-spreading ability, where the evidenceis thus far inconclusive. Where class action claims involve relatively smallamounts per claimant and joint and several liability runs the risk of imposingmost of the liability on a few wealthy shareholders, it may well be that leavingliability with the injured class places it with the group best able to bear it.

16. Limiting the Cost of Limited Liability in Tort

The social costs of externalizing the costs of accidents through limitedliability have been discussed in part 15, supra. This section examines thefactors that may limit the size of the externalized costs. Managers of largefirms facing catastrophic mass tort liability typically do not seek liquidation,which might be in shareholders' interest, because it ends the firm and with ittheir employment. Indeed, managers engaging in activities likely to result incatastrophic liability should probably maximize current distributions toshareholders in order to reduce the pool of assests subject to creditor claims.Rather, managers facing such a last period problem may have imposedagency costs on shareholders when they have kept resources within firmsand then acquiesced in reorganizations that give mass tort claimantssignificant ownership in the firm. (Roe, 1986) While this creates an agencycost for shareholders, it ameliorates the effects of externalization of the costof accidents for these firms.

Ribstein argues that owners of limited liability enterprises internalize mostcosts of tort by virtue of the fact that voluntary creditors will either imposehigher credit costs or force additional firm monitoring, or both. Becauseunsecured contract creditors are at risk of some loss (or loss sharing with tortcreditors) in the case of tort liability, he argues that tort risk is sufficientlyinternalized that the benefits of limited liability outweigh its costs toinvoluntary creditors. (Ribstein, 1991) Obviously this arrangement does notinternalize the expected cost of accidents in excess of a firm's unsecuredassets. But to the extent that voluntary creditors insist that debtors carry tortinsurance, at least some of these costs may also be internalized. (Ribstein,1991) Further, in close corporations, shareholders have significant personalinvestments to protect, and have incentives to insure to protect them.(Ribstein, 1992)

17. The Benefits of Limited Liability in Tort

17.1. Shareholders as Inefficient Monitors of Risky Activities Ex Ante

The capital market benefits discussed earlier apply equally to limited liabilityin tort. The exposure of railroads to heavy tort liability, in connection withlarge scale operations that could not be readily monitored by shareholders,was one of the original justifications for English limited liability rules in the19th century. (Blumberg, 1986) Shareholders in public corporations are oftenpoor monitors of much tort liability, which depends on a constant and candidflow of information about agents' behavior.(Arlen & Carney, 1992) Asspecialists in providing capital, these passive investors lack the skills to beeffective monitors, so their monitoring activities would be inefficient.(Easterbrook & Fischel, 1995) With unlimited liability in tort, the relevantdomain for monitoring by stockholders expands and agency costs increase.(Orhnial, 1982) Imposing default liability on the monitor is consistent with thetheory of imposing liability on the party who can avoid it most cheaply.(Ribstein, 1991) In large corporations, this will almost never be dispersedpublic shareholders. Limited liability eliminates the disincentive for wealthyinvestors to take large (perhaps controlling) ownership positions in riskyfirms, which increases shareholder monitoring where it is efficient. (Hansmann& Kraakman, 1991)

17.2. Reducing Collection Costs of Judgments

Limited liability also reduces the transaction costs of collecting judgments,by shifting some risk to plaintiffs. A system of pro rata liability wouldincrease collection costs, but it would lead to incomplete collections becauseof the difficulties of obtaining jurisdiction over many individual shareholderdefendants. (Alexander, 1992; Grundfest, 1992; but see Hansmann &Kraakman, 1992a; Patterson, 1995). Grundfest argues that a class ofattachment-proof investors would develop that would specialize in holdingrisky common stocks, which would arbitrage away any price differencesbetween risky and less risky businesses that should send managers signalsabout behavior. (Grundfest, 1992) But Grundfest's argument ignoresmanagers' personal incentives to avoid risk, in order to protect theirfirm-specific human capital. Bainbridge argues that limited liabilityencourages investors to more fully capitalize firms, so that tort claimants arebetter off collecting from firm assets than bearing the transaction costs ofcollection from shareholders. (Bainbridge, 1993) Bainbridge's argument isstronger under a pro rata liability rule than a joint and several liability regime.

17.3. Incomplete Insurance Markets

Easterbrook & Fischel suggest that limited liability was more important in19th century because insurance markets were less developed, but this ignoresthe more recent development of mass tort liability, where insurance marketsare probably as incomplete as were 19th century markets. (Easterbrook &Fischel, 1985; Schwartz, 1985) One solution proposed for the problem of highcollection costs under unlimited liability is to provide for personal liability ofshareholders only when a corporation is uninsured against the risk, whichwould increase incentives to insure. (Alexander, 1992; Dent, 1991; Leebron,1991; Schwartz, 1985) The difficulty is that insurance markets are incomplete.(Blumberg, 1986; Dent, 1991) The existence of insurance markets will dependon (i) information costs; (ii) moral hazard, (iii) adverse selection and (iv)ability to bear risk. (Halpern, et al., 1980) Because many firms will fail becauseof systematic risk, insurers will be unable to diversify this risk.(Easterbrook &Fischel, 1985; Halpern, et al. 1980; Leebron, 1991) Further, the potential formass torts, which are uncertain in both their incidence and extent of liability,may make some activities uninsurable. (Hansmann & Kraakman, 1991;Ribstein, 1991) Finally, because lower-risk firms will self-insure rather thanpurchase costly insurance, the insurance market will be dominated byhigher-risk purchasers, raising insurance costs and causing even more firmsto self-insure. (Ribstein, 1992) Finally, firms cannot be expected to insureagainst remote risks to their full extent, in part because of boundedrationality. (Schwartz, 1985) Mandatory insurance may create new moralhazard problems, encouraging managers to take risks, if insurers are notefficient monitors. (Easterbrook & Fischel, 1985) Some manufacturingactivities may create potential liabilities decades in the future, wheremanagers will heavily discount the risk. (Hansmann & Kraakman, 1991)Further, the high loading costs of insurance (as much as 25%) reduce itsefficiency. (Hansmann & Kraakman, 1991) If liability insurance weremandatory, it would create a new barrier to entry of small firms. (LoPucki,1997)

18. Substitutes for Shareholder Liability

18.1. Tort Creditor Superpriority

One substitute for unlimited liability for shareholders is to provide tortcreditors with greater priority in a bankruptcy system. Under U.S. law,secured creditors have priority over tort creditors. Providing tort creditorswith a priority over all voluntary creditors would shift risk from involuntarycreditors to voluntary creditors. (Buckley 1986; Presser, 1992) While thiswould increase monitoring by creditors, their comparative advantage inmonitoring for this kind of risk over shareholders is not always clear. Oneauthor suggests that contract creditors specialize in valuing firm assets inalternative uses, while shareholders capture the quasi-rents from the currentfirm-specific use. (Johnsen, 1995) Whether credit terms would be set to reflectaccurately the new risks that the firm's owners (including creditors) could notescape is an empirical question, but the increasing use of public markets forborrowings in the U.S. suggests that these markets might become efficient, soprices would accurately reflect risks. At the same time, securitization offinancial assets enhances their availability to the same passive investorslikely to hold stocks, which probably reduces any comparative advantages inmonitoring formerly held by creditors. Leebron argues that tort victims mightconsent to the priority of secured creditors if the loan made additional assetsavailable to satisfy their claim or provided increased creditor monitoring. Ifnew funds are provided to operate the business by the loan, tort creditors willsuffer if firm assets subsequently shrink. (Leebron, 1991)

18.2. Lender Liability

Another substitute for unlimited shareholder liability is to treat contractcreditors as owners of the firm, and subject them to unlimited liability.Leebron argues that in many public corporations creditors can exercise morecontrol than public shareholders, and are better able to diversify risk than tortvictims. Further, private contract lenders (as opposed to bondholders) aresuperior monitors when compared to tort victims. (Leebron, 1991) Indeed,some creditors may well be superior monitors to public shareholders as well.(Easterbrook & Fischel, 1985) At the very least, large creditors are in aposition to monitor firms for adequate capitalization, and to adjust interestrates to create incentives to capitalize the firm. (Ribstein, 1992) On the otherhand, unlimited liability for creditors would exacerbate thestockholder-bondholder conflict, and because of liability for catastrophictorts, lenders' negative covenants would be of less value. (Leebron, 1991)

18.3. Managerial Liability

To the extent that neither shareholders nor creditors are effective monitors ofmanagers' risky choices, one solution might be to make managers personallyliable for corporate obligations. But managers, while perhaps best able tomonitor themselves, are inefficient risk-bearers, so that imposing liability onthem will lead to even more risk aversion in firm decisions than managers maynow choose. (Thompson, 1994) Further, their investments in firm-specifichuman capital are uninsurable. (Easterbrook & Fischel, 1985) Apparentlybecause of the large risk premiums that would be required to persuademanagers to bear liabilities personally, Kraakman has argued that managerialliability does not provide enough additional deterrence over enterpriseliability to offset the greater costs involved. (Kraakman, 1984) In the contextof deliberate torts such as securities fraud, it is precisely managerial liability -both civil and criminal - that is required to deter these actions, given the lastperiod problems facing managers tempted to commit securities fraud. (Arlen& Carney, 1992) Indeed, Kraakman also states that enterprise (limited) liabilityfails when costs are shifted to third parties through firm wrongdoing, andfirms lack sufficient assets to respond in damages. But he also argues thatimposing liability on managers while permitting indemnification providesmanagerial incentives to keep firms solvent and able to respond tojudgments. Dual liability of firms and managers lessens the risk that penaltieswere set too low for either, because now two levels of decision-makers mustcalculate costs and benefits. (Kraakman, 1984)

If French managers violate the company's constitution or law, they can bemade personally liable to the company, its shareholders and creditors. Franceis thus in the forefront of the movement to extend the liability of management,and not simply of the membership. (Perrott, 1982)

19. Risk Bearing Ability and the Role of Insurance

There is general consensus that diversified shareholders are superiorrisk-bearers to tort victims. (Leebron, 1991; Menell, 1990; Murphy, 1995;Thompson, 1994) But some authors have argued that the risk-bearingsuperiority of shareholders is not obvious. Tort victims may be superiorrisk-bearers if they can obtain insurance more cheaply (Leebron, 1991) or ifindividual harms are small while corporate (and shareholder) liability is large,relative to wealth. The principal argument in favor of limited liability withrespect to risk-bearing is that insurance markets are incomplete, and wouldnot allow investors to insure against personal liability for corporate failures.The occurrence of corporate bankruptcies will be positively correlated withthe business cycle, and with systematic risk of shares. Because of this,insurers will find they cannot easily diversify such risk, and will decline towrite such insurance. (Halpern et al., 1980) Further, there may be an adverseselection problem: shareholders will choose to insure only their risk attachedto ownership of high beta companies. Because managers are undiversified,they have incentives to have firms insure against liability to protect the life ofthe firm. (Thompson, 1994) Additional insurance caused by unlimited liabilityonly serves to reduce the cost of accidents if insurance companies areefficient monitors, and can adjust premiums to reflect experience. (Ribstein,1992) The ability and incentives of insurers to monitor for risky activities maybe limited in several ways. First, insurers will retain some ability to contestclaims if contract conditions are violated. Second, experience-based rates areset ex post, so that rates will lag observation of risky behavior. Third, wherean insured believes it is in the last period of insurance coverage, incentives toavoid higher premiums are eliminated. (Price, 1995)

While involuntary tort claimants cannot diversify their risk in the sameway tortfeasors can because their entire future wealth and earning power maybe at stake, they can insure against their loss. (Leebron, 1991; Meiners, et al.,1979) Because potential victims can decide how much insurance they desire,forcing either corporations or shareholders to carry additional insurance maycause overinsurance, except for the fact that most individuals do not insureagainst pain and suffering (Hansmann & Kraakman, 1991), perhaps becausethis is a risk they are willing to bear. (Leebron, 1991) Indeed, it is not clearsuch insurance is available to individuals, perhaps because no market for ithas been demonstrated. Where tortfeasors are in risky industries or in cyclicalindustries, they may be more efficient risk-bearers than the tortfeasors or theirshareholders because of their superior ability to purchase all-risk insurance.(Ribstein, 1992) Analysis may also change when the corporation is closelyheld, so that tort victims may be better able to diversify and insure thanshareholders. Similarly, where unlimited liability discourages diversificationand forces investors to hold fewer stocks to improve monitoring, risk-bearingability of shareholders declines. (Thompson, 1994) Further, analysis maychange if mass tort liability involves relatively small injuries to large numbersof victims, and the possibility of catastrophic shareholder liability. The natureof mass tort liabilities has been explored with respect to this issue by onlyone writer. (Schwartz, 1985)

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