Limited liability can be broadly defined as the legal protection that limits the maximum amount a shareholder or company participating in a business can lose or be charged in case there are claims against the company or its bankruptcy. Liabilities may be personal or corporate and can result from damages caused to third parties or from debts.
The liabilities that need to be limited in a capitalist system are those of firms in relation to their creditors. This type of protection may vary depending on the nature of the legal form used by the company. For instance, a limited partner can only lose his/her investment, but a general partner may be responsible for all the debts of the partnership. Or, parties to a contract may limit the amount each might owe the other, but cannot contract away the rights of a third party to make a claim.
Why is limited liability so important under capitalism? Because it allows the combination of the entrepreneurship indispensable under a capitalist system with the prudence necessary to protect the savings of investors and the development of joint private ownership. Moreover, it facilitates smoother and faster bankruptcies. So, why it took so long to be legally accepted?
The concept of limited liability can be traced back to the Romans, but it was rarely used. In the beginning there were many who considered the idea of limited liability a bad idea, because it was traditionally seen as a sign of weakness and lack of commitment among the part owners.
So, the first modern limited liability law was only enacted by the state of New York in 1811. In England, under the Joint Stock Companies Act of 1844 investors still carried unlimited liability but it was later abolished by the Limited Liability Act of 1855. Nevertheless, the extension of limited liability protection to partnerships only took place in the 1990s. Today, in the rest of the world, there are still many countries where the concept is either ignored or misunderstood.
Within the common law legal systems there were also some who did not oppose limited liability per se but condemned the fact that such privilege was granted by the government. For them, if limited liability was really needed a market for credit insurance and guarantees should be left to develop instead of a legal protection. Such markets did in fact developed but mostly only for international issues and trade where enforcing collections would be more difficult.
Indeed, under the principle of the freedom of contract the parties should be able to choose whether to ask for personal guarantees or to buy protection against the risk of default rather than be forced by law to accept limited liability. However, this would undermine the objective of fostering prudent entrepreneurship and the pooling of capital through joint stock companies which are fundamental under capitalism. This rationale applies only to joint responsibility under the various forms of incorporation, but not necessarily to personal or professional liabilities.
Professionals like lawyers, doctors, accountants and others are prevented by law and ethics from limiting their liability. The argument is that the accreditation of such professionals is not enough to assess the liability risk of their acts and therefore they must be personally responsible for their decisions so that they always make the decisions carefully. In such cases they may opt instead for buying an insurance policy.
Unfortunately, in some countries the definition of professional liability has been abused to make the protection afforded to firms by limited liability void. For instance, Portugal, in a clear violation of the principles of the rule of law, has introduced legislation allowing the tax authorities to seize the personal assets of corporate directors to offset unpaid corporate taxes.
Limited liability provides a strong discipline for both creditors and debtors. Since credits are secured only by the limited assets of the company, lenders must be more scrupulous when assessing the creditworthiness of the borrowers. In turn, this greater scrutiny forces borrowers to be more careful in the assessment and selection of investment projects. The reverse side of this process is that by not relying on personal collateral the volume of debt financing is lower which in turn may limit investment and capital accumulation. Moreover, as long as lenders rely on the future rather than the past value of collateral, the amount of leverage used may be counter-cyclical as they facilitate lending when prices are high and restrict it when they are low.
Yet, overall, these offsetting effects are not enough to reverse the tremendous rise in the role of equity and credit necessary to finance the level of sustainable capital accumulation experienced under capitalism with a rise in small and big firms alike. For instance, between 1860 and 1914, the share of British government bonds of the total market capitalisation of securities in London declined from 50 to 5%, thanks mainly to the rise of equities
Although active markets for risk sharing through derivatives and guarantees have been a positive development in modern capitalism they cannot be a substitute for the limited liability protection. Likewise, the bankers’ desire to protect secured lending by asking for additional personal guarantees should be resisted not only by borrowers but also by regulators to keep the benefits of limited liability.
In conclusion, while liability insurance markets can ease the risk of unlimited liability, the financing of private enterprise and the rise of shareholding ownership is not possible without limited liability. Therefore, limited liability constitutes the sixth pillar of capitalism. And, not surprisingly, some have argued that its unnamed inventor should rank as high as the other inventors credited with the industrial revolution.