Why Is Shareholder Liability Limited?

[Dover]

Why Is Shareholder Liability Limited?

Will Pate asks an interesting question:

What is the best reasoning behind why shareholders have limited liability for a corporation's environmental and social costs? Not on a case by case basis, but why it is the blueprint for the most powerful pillar of society?

and challenges sundry VCs to respond. The nature of the answer actually makes those of us in the trade well qualified, so here goes:

Before getting to a specific answer, I'm going to set background by turning back the clock to the origin of the corporation. (You can find a broader outlook on the corporate concept in the wikipedia.)

The embryonic form of the modern corporation emerged in Northern Europe in the late 16th and early 17th century. The Dutch and English were the most notable successful practitioners of the form. It is English common law that formed the basis for American law, so I'm going to focus there.

This key institution of capitalism was birthed by monarchy. It was the time of Elizabeth I. The European exploration and colonization of the world were underway, and England wanted its piece of the action. But the privy purse was in bad shape after a war with Spain and several rounds of internal struggle occasioned by the Protestant Reformation. The institution of the corporation was formed to mobilize private capital in pursuit of development goals that the government could not itself afford. (And it might have been noticeable, even then, that private initiative worked out better than government projects.)

To encourage men and families to put their wealth at risk, several notions were tied together:

The corporate form itself, from corpus, a body. To fit the new institution into common law, the fiction was created that the organization was itself a person, with many of the same rights. With two differences. First, it was immortal. This had the effect of encouraging investments and planning over longer terms than a natural life span, something that to then had been the province of the church and great noble houses - on their good days. Secondly, the corporation was controlled by owners who would receive the benefits of the business, and could pass on their share of ownership to others (the world's first "exit event.") ...cont'd

http://www.pacificavc.com/blog/2004/09/02.html#a675

[Frodo]

1. Because it's largely impossible for them to have complete knowledge.

You would have the shareholders of Enron not only lose their entire investment but also cough up penalties when the true financial picture was hidden from them?

I could see piercing the corporate shell for "corporations" that are just liability shields for illegal activity (largely the case already), but shareholders of publicly traded firms liable for the firm's behavior?

Do you hold a similar opinion of personal liability in bankruptcy cases?

[happyslug]

2. Some bad history

Or more accurately oversimplifications to make a point. For example while "Joint Stock" Companies existed during the early colonial period, they tended to FAIL and were taken over by the Royal Government (In fact it was the ROYAL i.e. GOVERNMENTAL FOUNDED Colonies AND those founded by INDIVIDUALS that were the most successful, NOT the colonies founded under the "Joint Stock" Companies of the Colonial Period).

Another error was while Corporations and stocks were traded in the 1600s and 1700s, Corporations were the rare creature and most "stock" were bonds issued by governments. In fact in 1720 the British Parliament passed "The South Sea Bubble Act" which restricted the creation of Corporations. This was the law in Britain till 1825 (and in America from 1741 till the time of the Revolution). Do to these laws and the general hostility to private Corporations, Corporations were rare except in banking, fire and marine insurance, Canal and water businesses (And this was endorsed in the late 1700s by both Sir William Blackstone AND Adam Smith in their respective books regarding Law and Economics).

On the other hand incorporation enabling acts were easy to obtain for "Charities". Now the Charities could be Colleges, Schools, Hospitals old folk homes, etc. and other agencies that provided for the public good. These Corporations often had perpetuity charters (or if limited durations rarely if ever not renewed). These Charities were by far the larger number of corporations till the 1840s but the key was they did work for the public good (a key to their success).

Note, except for Charities, most Corporations had a limited life span often measured in years not decades. At the end of the period set forth in the Charter it had to dissolve OR be re-chartered. For example When President Jackson "Fought" the Bank of the United States, it was over the bank's charter being renewed. The bank had only a 25 years Corporate Charter and was about to expire and the Bank asked Congress to re-newed its charter. Jackson opposed the renewal and fought the Bank and defeated the bank causing the Bank of the United States to closed down do to lack of a Charter(The bank actually survived for a few years on a Pennsylvania Charter but died do to the loss of Business do to the loss of its Federal Charter).

Prior to US Civil War it was rare to have a private corporation that had a charter over ten years in duration as opposed to the perpetuity modern Corporations have. This changed with the coming of the Railroads. Railroads required a lot of capital but once completed were very profitable. Thus you had a lot of people willing to invest in a Railroad in the 1840s onward. It was do to this expansion of the Railroads that created the modern Corporations NOT what happened prior to 1840. The growing Steel Industry was next, but even these were rare (J&L Steel was still a partnership as late as 1937). Thus perpetuity is a post 1860 change in Corporate life.

Surprising, the Early Corporations (i.e. pre-1800) did NOT have limited liability, in fact such early corporations could demand more money from ALL of their stockholders. Under the concept of subrogation Creditors to the Corporation could do the same. Stock Holders to protect themselves would only buy stock that prohibited such demand for additional money. This, at first, failed, but as the cost to get each stockholder to pay up, Creditors used the concept less and less. By the 1800 the trial Courts were upholding Stock's with such demand limits and in most cases getting the stock holder to pay up was NOT worth filing an appeal. Thus by 1800 most corporations had "gained" limited legal liability do more to the difficulty of suing each stockholder than any enactment of law or Judaical determination.

Thus the report is a over simplification of the history of Corporate Law which tends to ignore the fact that the Modern Corporation are an invention of the late 1800s based on concepts borrowed from Charitable Corporation but applied to private enrichment. Corporations have been (and are) used to shift risk from the investors to others (Generally the people at large). The people rarely get the benefit of this shift .

[rapier]

3. notes

Any discussion on the nature of corporations is good.

The modern bussiness corporation has only a casual realtionship to early joint stock companies.

The 'need' for limited liabiliy would probably be given, by the majority who have no questions about the nature of the modern bussiness corporation, as it is a necessity in order to encoruage taking risk. A large part of the bussiness cannon is that it is risk taking which makes the economy grow.

Now how limiting risk spurs risk taking is a tricky thing. Mostly it means taking risk with other peoples money. With a pubic corporation it is always other peoples money. Well to the extent that managers and majority holders don't strive to make as much other peoples money their own through high salaries, option grants and various perks like no pay back loans, etc. etc.

[Frodo]

4. Not all "risk" is a good thing.

If I invest $1,000 in a company's stock I obviously assume some risk. Up to and including (as has happened to me twice) the company going under and the stock value going to zero. That's the "risk" I accept.

But if shareholders are not protected from liability for actions of the corporation then the "risk" becomes, not my $1,000 investment, but my entire net worth.

People don't take those kinds of risks. The markets would be in big trouble.

Now, maybe some liability for any stockholder who actual had managerial control over the company. So I can't form a "corporation" soley to protect myself from actions I cause the comapany to take.

[amazona]

5. because if not we could never invest

Most of us have a very few stocks representing a miniscule fraction of a percent of a share in the company in question. We have no control over company operations and little knowledge of how the company is operated. We are just trying to invest a little money and build a responsible future so that we won't live in a cardboard box when we're too old and sick to work. If I faced liability for, say, my investment in Ford (hey, they made Pintos) or Wyeth (They made Fen Phen) or any number of less-than-happy products, I could not invest, because the risk of losing more than I had invested would be a risk that a person of my low means could not tolerate.

You would be punishing people for trying to be responsible and plan for their own futures instead of being a burden on society.

CEOs and decision makers should be on the line when laws are broken and costs are shifted to the public sector. Not some shareholder with a couple hundred shares of common stock.

[Name removed]

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