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Sunday, October 1, 2017

Limited Liability Does Not Mean What You Think It Means

Stop saying that!

In the much-beloved movie, The Princess Bride, Inigo Montoya has spent his life seeking revenge against Count Rugen, the man who murdered his father. When he finally confronts Count Rugen, he keeps repeating, “Hello. My name is Inigo Montoya. You killed my father. Prepare to die.” Finally, in utter frustration, Count Rugen yells, “Stop saying that!”

I know just how Count Rugen felt.

Everywhere I go, people begin arguments for a wide variety of normative conclusions with the premise, “Corporations have the special privilege of limited liability.” Thus:

  • “Corporations have the special privilege of limited liability; therefore, they have social responsibilities that individuals and other businesses do not.”

  • “Corporations have the special privilege of limited liability; therefore, government regulation is required to level the competitive playing field.”

  • “Corporations have the special privilege of limited liability; therefore, they are obligated to manage their company in the interest of all their stakeholders.”

I encounter this statement in so many contexts, both inside and outside the academy, that, like Count Rugen, I want to yell. “Stop saying that!”

However, in my case, it is not because I fear death, but because the statement is so patently false.

Corporations Do Not Have Limited Liability

It is the corporation’s share-holders who have limited liability.

Shareholders have limited liability. If a corporation contracts a debt that it does not pay or is found liable for a tort, one hundred percent of its assets are available to satisfy the debt or judgment. If it does not have enough cash on hand to pay what it owes, its creditors may force the firm to liquidate and sell off its physical assets to discharge its debt. The corporation is fully liable for all the debts it incurs and all the torts it commits.

It is the corporation’s shareholders who have limited liability. They are liable to lose one hundred percent of their investment in the firm, but no more. The firm’s creditors may not collect the corporation’s debt or judgment out of the shareholders’ personal wealth. Thus, the shareholders’ liability for the debts of the firm is limited to the size of their investment in the firm.

Everyone Has Limited Liability

If your brother decides that he wants to buy an SUV to go into business as an Uber driver and you lend him $10,000 to help him do so, you are not liable to pay his judgement if he drives carelessly and injures a passenger. You may lose the $10K you lent to him if he goes bankrupt and cannot pay you back, but that is the limit of your liability.

Our system of contract law does not hold one person liable for the debts of another. Even if rather than loan him the money, you make a $10K investment in his business in return for two percent of the profits, you are still not liable for any unpaid debts or tort judgments he incurs. The most that you can lose is your $10K investment.

Our system of contract law does not hold one person liable for the debts of another unless he or she has voluntarily agreed to take on that responsibility. And our system of tort law does not hold one person liable for the wrongful acts of another. We all have limited liability.

The only exception to this is the rule of respondeat superior, which makes an employer liable for the debts contracted and torts committed by his, her, or its employees when they are acting within the scope of their employment. With this exception, our liberal legal system eschews vicarious liability. Unless we have control over someone else’s conduct, as an employer controls his, her, or its employees, we are not liable for that person’s debts or torts.

Separation of Ownership and Control

The shareholders — the owners — of the corporation exercise no control over the action of the firm’s employees. They are not employers. Their role is analogous to that of the person who gives his brother $10K for his business. Shareholders’ limited liability, therefore, is merely a reflection of the ordinary rules of contract and tort law at work in the context of the corporation.

We all have limited liability. Just for a moment, try to imagine what the world would be like if there were no limited liability for shareholders. How many people would invest in corporations if they knew that should a corporate employee screw up, they could lose everything they own?

We all have limited liability. We don’t lose it merely because we invest in a corporation, and for the health of our economy, it’s a good thing that we don’t.

So the next time someone starts explaining to you how government regulation is needed because corporations have the special privilege of limited liability, please channel Count Rugen, and tell them to stop saying that.

Reprinted from Learn Liberty

  • John Hasnas is a professor of business at Georgetown's McDonough School of Business and a professor of law (by courtesy) at Georgetown University Law Center in Washington, DC, where he teaches courses in ethics and law.