Extended Liability of Shareholders? EXTENDED LIABILITY OF SHAREHOLDERS

Extended Liability of Shareholders?

EXTENDED LIABILITY OF SHAREHOLDERS?

TIMO H KAISANLAHTI*

This article re-examines the dogma of limited liability of shareholders in the stock market.

Shareholders are efficient risk-bearers due to the diversification of investments. It is therefore

tempting to conclude that they are better suited to bear the costs of accident than tort victims.

Within this framework, some prominent scholars have proposed that each shareholder of a

listed company should have a secondary liability to bear the tort judgments against the company

on a pro rata basis without an upper cap. I, however, draw attention to the crucial condition for

risk bearing based on diversifying the stock portfolio: the maximum liability in each company

must be known ex ante.

A. INTRODUCTION

1. Background

Limited liability prevails today as the hallmark of a modern joint stock company:the almost universal principle in company legislation in market economies is that,of their total wealth, owners risk only the amount that they have invested in theshares of a particular company. The creditors of a firm cannot collect from thepersonal assets of shareholders if their claims are not fulfilled. The company isresponsible for paying damages and other debts only with the assets it has; it isnot possible to go after the owners for more than they have invested in thecompany.

In financial parlance, owners bear only part of the negative impact on wealthof the activities of an enterprise. By setting an upper cap on potential loss,limited liability is generally seen as a vehicle for promoting investments. Withoutthis privilege, investors would be unwilling to turn over funds to companiesabout which they have only limited information and control.1 Investors, at leastprivate individuals, are risk-averse actors who prefer a secure prospect to a riskyone, even though the latter represents the same monetary value as the secure

April Journal of Corporate Law Studies 139

1 See, eg B Greenwald and JE Stiglitz, “Information, Finance, and Markets—The Architecture ofAllocative Mechanisms” (1992) 1 Industrial and Corporate Change 37, 49.

* LLD (Helsinki); Docent, University of Joensuu; Head of Legal Affairs, Varma Mutual PensionInsurance Company (email: [email protected]). I acknowledge the very valuablecomments of the anonymous referee of this Journal.

alternative.2 If the creditors and other claimants of a company were allowed tobreak through the corporation veil, it would most likely deter individuals fromparticipating in enterprises as minority owners.

The virtues of limited liability have, however, been challenged. TwoAmerican law scholars, Henry Hansmann and Reinier Kraakman, stood up 15years ago and argued that shareholder liability is a question of tort law ratherthan a matter of company legislation. They proposed that each shareholder of alisted company should have a secondary liability to bear the tort judgmentsagainst the company on a pro rata basis. Under such a regime he is liable for thesame portion of a company’s excess of tort liabilities over assets that his sharesbear to the total number of shares outstanding. Hansmann and Kraakmanfurther suggested that, due to the proportionality, there is no need to set anupper cap on potential loss of an investor. In this respect the proposal differsfundamentally from historical experiments with multiple liability regimes wherea shareholder was liable pro rata for the exact same amount—or somepredetermined multiple of it—that he had invested in the company originally.3

2. Aim and Structure of the Article

This article discusses the concept of limited liability and explores its rationaleand restrictions from the viewpoint of a portfolio investor who does not play an“active” role in the management of the company. Thus, the question of liabilityof a parent company or other controlling shareholder remains outside my scope.4

I will concentrate on a company’s non-contractual tort and other extra-contractual liability. With a strict focus on torts and other extra-contractualliabilities, I avoid the question of which creditors are involuntary and which arenot.5 In other words, I do not get involved in the debate on whether a borrower

140 Extended Liability of Shareholders? JCLS VOL. PART

2 “Risk aversion is a corollary of diminishing marginal utility for wealth: someone with diminishingmarginal utility for wealth will get more ‘pain’ from a pound lost than ‘pleasure’ from a poundgained”: JF Weston and TE Copeland, Managerial Finance (Orlando, The Dryden Press, 9th edn,1992), 359. In a similar manner WA Klein and JC Coffee, Business Organization and Finance (NewYork, Foundation Press, 8th edn, 2002), 236: “A critical axiom of modern investment analysis isthat in their major investment decisions the overwhelming majority of people are risk averse. Onecorollary is that investors will accepts volatility risk only if they are paid to do so”.

3 H Hansmann and R Kraakman, “Toward Unlimited Shareholder Liability for Corporate Torts”(1991) 100 Yale Law Journal 1879. For earlier proposals see P Halpern, M Trebilcock and STurnbull, “An Economic Analysis of Limited Liability in Corporation Law” (1980) 30 University ofToronto Law Journal 117, 137; and CD Stone, “The Place of Enterprise Liability in the Control ofCorporate Conduct” (1980) 90 Yale Law Journal 1, 70; these authors, however, extended liability tocontractual debts as well to torts.

4 See, eg L Bergkamp and WQ Pak, “Piercing the Corporate Veil: Shareholder Liability forCorporate Torts” (2001) 8 Maastricht Journal of European and Comparative Law 167; NA Mendelson,“A Control-based Approach to Shareholder Liability for Corporate Torts” (2002) 102 ColumbiaLaw Review 1203; and DK Millon, Piercing the Corporate Veil, Financial Responsibility, and the Limits ofLimited Liability, Washington & Lee Public Law Research Paper No 03-13 (Virginia, 2003).

5 Hansmann and Kraakman, supra n 3, 1920–21.

or some other stakeholder in a contractual relationship with a company iscapable of taking limited liability into account when they are negotiating theprice and other conditions for the transaction. Secondly, I am not questioning thefairness of limited liability per se in a current environment where large andaggressive tort claims exist. Instead, I simply consider the possible impact thatextended liability—in various forms—might have on the behaviour ofshareholders.

Limitation of liability is by no means a feature familiar only within companylaw. The insurance crisis due to excessive tort claims has had its impact onenvironmental regulation as well.6 Assurance requirements cap liability at astatutory limit. The ultimate example, nuclear liability, is also limited. From apublic policy standpoint the limitation of shareholders’ liability serves the verysame function as statutory caps of environmental laws. The choice of the limitreflects a trade-off between the benefit of reduced uncertainty on the one handand the risk that accident costs above the limit will be uncompensated on theother hand.7

Section B provides a sketch of the arguments used in the current legal andeconomic debate about the desirability of limited liability.8 However, after thisgeneral description of the playing field, I do not purport to offer a completereview of jurisprudential literature on this matter as several up-to-date surveysare already available.9 Instead, my aim is to study some of the most fundamentalassumptions in pro rata liability.

The exposure in section C is based on ideas developed in financial economicsyears ago. So far I have not encountered a similar one, at least not in any of thelegal journals or other jurisprudential literature I am familiar with. Mycontribution is in applying these concepts to the very basic question of whetherlimited liability—in its pro rata or absolute form—is an indispensable conditionfor diversification. For this reason, the argumentation is based on the assumptionthat shares are quoted on a stock market or are otherwise widely held.10 I


6 See generally M Faure and T Hartlief, “Remedies for Expanding Liability” (1998) 18 OxfordJournal of Legal Studies 681.

7 JW Boyd, Financial Responsibility for Environmental Obligations: Are Bonding and Assurance Rules FulfillingTheir Promise?, Resources for the Future, Working Paper No 01-42 (Washington, 2001), 46–47.

8 For an account of the moral arguments (which is outside the scope of this article), see, eg J Kilpi,The Ethics of Bankruptcy (London, Routledge, 1998), 177–1196; or LE Mitchell, Corporate Irrespon-sibility (New Haven & London, Yale University Press, 2001), 59.

9 See WJ Carney, “Limited Liability”, in B Bouckaert and G De Geest (eds), Encyclopedia of Law andEconomics, Volume III: The Regulation of Contracts (Cheltenham, Edward Elgar, 2000); P Halpern,“Limited and Extended Liability Regimes”, in P Newman (ed), The New Palgrave Dictionary ofEconomics and the Law, Volume 2: E–O (London, Macmillan Reference, 1998); and R Kraakman,“Unlimited Shareholder Liability”, in P Newman (ed), The New Palgrave Dictionary of Economics andthe Law, Volume 3: P–Z (London, Macmillan Reference, 1998).

10 The pros and cons of limited liability within non-listed and other small companies are analysed inJ Freeman, “Limited Liability: Large Company Theory and Small Firms” (2000) 63 Modern LawReview 317; and A Hicks, “Corporate Form: Questioning the Unsung Hero” (2000) Journal ofBusiness Law 306.

consider the regime of unlimited pro rata liability advocated by Hansmann andKraakman, and argue that it does not allow diversifying the stock portfoliobecause investors need to know their maximum liability in each company ex ante.

Liability of shareholders, however, is not the only option for a legislator toassess. The most standard off-the-rack proposal (de lege ferenda) for satisfying theclaims of tort victims is to require companies to carry insurance for that purpose.This alternative is examined in section D vis-à-vis the proposal of Hansmannand Kraakman, and I argue that if companies were required to have insurancecoverage to an unlimited amount, it would be extremely difficult, if notimpossible, for them to find it.

In section E I review and comment on studies of historical company lawexperiments with extended liability. The available evidence suggests that thedouble or other multiple liability system with an upper cap could function oncurrent stock markets despite the collection costs and other procedural hurdlesthat tort plaintiffs would have to overcome to hold shareholders accountable.Finally, section F concludes with a short summary of the arguments presented inthis article.

B. CONVENTIONAL WISDOM CONCERNING LIMITED LIABILITY

1. Common Rationales for Excluding Liability

Two leading proponents of the economic analysis of company law, FrankEasterbrook and Daniel Fischel, identify several rationales for limited liability.The central one is derived from the aversion of investors to risk.11 Typicalinvestors would reduce the number of firms in their portfolio to minimise the riskof losing their whole wealth due to a claim against one of the companies. Bydiminishing the monitoring costs, limited liability thus allows for more efficientdiversification. As portfolio diversification reduces the risk to investors, it allowsthem to bid more for a company’s shares, which means that to obtain a certainamount of financing an enterprise needs to issues fewer shares than underunlimited liability. So the cost of capital to an enterprise is reduced as aby-product of diversification.

Secondly, looked at from a slightly different angle, an accompanying benefitof limited liability is that it assists management in making optimal decisionsabout real investment. When the risk of losses to owners is limited to the amountthey have paid for their shares, managers can invest in any project with positivenet present value, whatever the risk. In other words, the management of a


11 The following is based on FH Easterbrook and DR Fischel, The Economic Structure of Corporate Law(Cambridge, MA, Harvard University Press, 1991), 41–44. A more detailed review is provided byKraakman, supra n 9.

company with limited liability is free to take up riskier ventures—aiming forgreater returns—than would be allowed by the owners under an unlimitedliability environment.

Moreover, unlimited liability would intensify the monitoring of managers.The greater the risk that investors have to bear, the more closely they will watchover the actions of managers. By extending the risk to investors, more resourceswill have to be expended on control functions. However, the costs of this activitywould not arise just from watching over the managers. If liability is unlimited,the wealthiest shareholders are most likely to be the targets for claims.Consequently, under a regime of unlimited liability investors will be interested inthe financial status of their fellow owners, to evaluate the extent of their ownliability in the case of a claim. The preferred situation is where all the investorshave about the same wealth. To achieve this, the current owners must havecontrol over who is accepted as a new owner; investors with less means than theexisting shareholders would not be accepted. This means that without limitedliability investors are likely to demand restrictions on the transferability of shares.

In other words, unlimited liability hinders efficient trading on stock marketsceteris paribus. With limited liability the bundle of ownership rights and duties in acompany are transformed into a homogeneous commodity—the share—whosefair price can be established in continuous trading by stock market participantsthrough demand and supply. Therefore, by allowing the free transfer of shares, alimitation on liability supports the informational efficiency of the markets. Themore efficient the pricing process, the lower the cost of capital for companies. Atthe same time, limited liability provides a powerful incentive for managers to actmore effectively. If individual owners have the option of disposing of their shareson a stock market for a fair price, the incumbent management is under the threatthat the new investors will replace them with another, more effectivemanagement team. This threat induces the managers to work hard in order tokeep the share price up, which in turn raises the costs of a possible takeover andthus diminishes its probability.

2. The Challenge of Pro Rata Liability

A company may be operated in such a way that renders it “judgment-proof ”:having only nominal assets available to pay the claims of tort victims.12 Anothergenerally non-disputed fact is that limitations on shareholder liability—as withany other restriction of liability—are likely to encourage accident-prone,high-risk operations, most notably by lowering the threshold for a company toengage in a hazardous industry. While shareholders have to face the costs ofpossible accidents only up to the value of their shares, the limitation of liability


12 See S Shavell, “The Judgement Proof Problem” (1986) 6 International Review of Law and Economics45.

externalises the costs of such accidents from their investment calculations. Sinceexternalisation is permitted by law, a company involved in hazardous activitiesmay have a positive net value considered from the shareholders’ viewpoint. Sosuch a company may be an attractive investment. This does not, however,necessarily mean that its operations are in general desirable. The net benefit tosociety as a whole may be negative due to externalisation, meaning that profits toshareholders from these activities are less than the loss of welfare due to potentialaccident costs.13 From these observations Hansmann and Kraakman derive theclaim that limited liability is a socially dubious arrangement: “if a promoter canneither purchase insurance nor recruit investors without it, the proposed venturemay very well not be socially efficient in the first instance”.14

The proposal to abolish limited liability relies heavily on the efficiency of themarkets for insurance and for equity investments and other securities. Becausecurrently even enterprises whose owners are protected by limited liability havepurchased liability insurance,15 Hansmann and Kraakman argue that firmswould most likely decide to have more insurance under unlimited liability inorder to cover tort losses that are foreseeable.16 They also presume that moderndevelopments in risk assessment as well as the globalisation of insurance marketshave made liabilities much easier to insure.17 Secondly, even if companies were


13 LoPucki in particular has carried this argument further: see LM LoPucki, “The Death ofLiability” (1996) 106 Yale Law Journal 1. According to LoPucki, American companies arebecoming more and more judgment proof because they can take advantage of secured credit,asset securitisation and foreign havens for secreting assets, in addition to the traditional vehiclesfor avoiding legal liability—such as scattering assets among subsidiaries. See also Mendelson supra4, 1236, who proposes even that

“[a]s among excessively risky projects, corporations will be more inclined to select those with arelatively delayed realisation of excessive costs. Projects where the risky activity leads to a latentinjury—one not immediately detectable, such as pollution or cancer—will be preferred.”

On the other hand, these kinds of arguments have been countered by White, who claims thatmajor companies face significant barriers to judgment proofing; contract and other voluntarycreditors, according to White, force major companies to maintain a substantial amount of equitycapital on which tort creditors are able to free-ride, see JJ White, “Corporate Judgment Proofing:A Response to Lynn LoPucki’s The Death of Liability” (1998) 107 Yale Law Journal 1363,1394–1412. Critical comments against the judgment proof argument à la LoPucki are alsoprovided by SL Schwarcz, “The Inherent Irrationality of Judgment Proofing” (1999) 52 StanfordLaw Review 1; and SL Schwarcz, “Judgment Proofing: A Rejoinder” (1999) 52 Stanford Law Review77. See also CW Mooney, “Judgment Proofing, Bankruptcy Policy, and the Dark Side of TortLiability” (1999) 52 Stanford Law Review 73. Evaluation of this debate, however, is outside ourscope. For the purposes of this article it is enough to note that Hansmann and Kraakman basetheir argumentation on the risk of possible judgment proofing of shareholders.

14 Hansmann and Kraakman, supra n 3, 1892.15 For an evaluation of whether insurance might undermine the deterrent effect of liability and thus

be socially undesirable, see S Shavell, On the Social Function and the Regulation of Liability Insurance,Law and Economics Discussion Paper No 278 (Cambridge, MA, Harvard Law School, 2000).

16 Hansmann and Kraakman, supra n 3,1888–89.17 On the general availability of insurance, see JE Stiglitz, Whither Socialism (Cambridge, MA, The

MIT Press, 1994), 287–88.

not able to purchase total shelter against tort judgments, this would not establishan obstacle for the unlimited liability rule; according to Hansmann andKraakman, modern securities markets would provide the means for an investorto diversify their risk if the unlimited liability were pro rata.18

In order to understand this proposition, it is important to realise thatunlimited liability may be arranged in at least two different ways. First, the rulemay be “joint and several liability”, meaning that each shareholder is potentiallyliable for the full amount of a tort judgment to the extent that it exceeds thevalue of a firm’s assets.19 Thus shareholders would also be liable for the share ofthe compensation for damages of their fellow stockowners if these lack financialassets or are otherwise judgment-proof.

The alternative to joint and several liability is the pro rata rule, under whicheach stockowner is personally liable for a judgment that exceeds the company’sassets, but only for the percentage that their ownership represents of all theshares issued.20 For example, someone who owns 0.1% of the shares may beassessed for the same proportion of the excess liability. If a company that hasissued 1,000,000 shares is unable to meet a judgment of £1,000,000,000, eachshare would be assessed as liable for £1,000.21

An equally important feature of the pro rata rule is that it applies to theoriginal amount of excess liability, meaning that the absolute maximum value ofliability per share is derived from the total shortfall. If, in the previous example,all other stockholders were judgment-proof, an owner of a single share wouldhave to bear only £1,000. If one stockholder is unable to fulfil their proportionof the excess liability, the other members of the company are not obliged to stepin their place. In other words, each owner is liable only for their share of thejudgment.22

A pro rata rule is not equivalent to joint and several liability coupled with acontribution rule. Under the latter arrangement, the maximum responsibility of


18 Hansmann and Kraakman, supra n 3, 1903–4. For a general but critical review of the effects onthe stock market see W Cortenraad, The Corporate Paradox—Economic Realities of the Corporate Form ofOrganization (Dortrecht, Kluwer Academic Publishers, 2002), 287.

19 See generally LA Kornhauser and RL Revesz, “Joint and Several Liability”, in P Newman (ed),The New Palgrave Dictionary of Economics and the Law, Volume 2: E–O (London, Macmillan Reference,1998) for a comparison of joint and several liability with non-joint liability.

20 This is not a novelty. As early as the 1980s, Gower proposed a new form for private companieswhere members would be obliged to meet the outstanding liabilities of the company, but with aceiling limit placed upon the contribution: see J Hill, “Close Corporations in Australia—TheClose Corporations Bill 1988” (1989) 15 Canadian Business Law Journal 43, 57. DW Leebron,“Limited Liability, Tort Victims, and Creditors” (1991) 91 Columbia Law Review 1565, 1581,remarks that the prevailing rule of limited liability is also actually a pro rata arrangement: lossesup to the amount of the investment—with a zero amount of excess liability—must be allocatedamong the owners according to their proportions of share capital.

21 This example is modified from the one provided by Leebron, supra n 20, 1578.22 A similar arrangement is employed at the insurance market of Lloyd’s in London: see N Arshadi

and GV Karels, Modern Financial Intermediaries and Markets (Upper Saddle River, NJ, Prentice-Hall,1997), 172.

individual owners depends on the wealth of fellow stockowners, because they areliable for the amount of the judgment that cannot be collected from others.Ultimately, under a rule of joint liability, even when the contribution rule isapplied, an owner might be held liable for the £1,000,000,000 judgment in theearlier example. The value of a share would therefore depend on the owner’swealth: the wealthier the owner is, the more they are risking de facto by investingin the shares of a enterprise under a rule of joint and several liability. If thefellow stockholders have moderate means compared to them, it is likely that theywill have to pay some of the damages levied against those who turn out later tobe judgment-proof.

This risk of also being liable for the share of other stockowners of thejudgment is precisely why Hansmann and Kraakman clearly favour the pro ratarule against the rule of joint and several liability: “Under a pro rata rule, shareswould have the same expected value for all shareholders.”23 In effect, they arguethat a pro rata rule would make shareholders internalise the costs of torts in ahomogeneous way, which should also be reflected in the share price on the stockexchange.

On today’s stock markets, transactions in shares can be very rapid. This formsthe very basis of the liquidity that the markets can offer investors. In a regimewith an extended pro rata rule, however, this feature would induce existingshareholders to sell their shares opportunistically, in order to avoid liability, assoon as they hear of a tort liability that is about to materialise. To determinewhich stockholders should bear the extended liability, therefore, a timing rulewould have to be chosen. Hansmann and Kraakman propose a rule under whichliability would primarily belong to those who were shareholders at the momentthe company’s management became quite certain that a claim of mass tortwould be filed. This information-based rule would prevent shareholders fromevading responsibility for tort damages. If the moment cannot be determined ina particular case, then the hour when the claim was actually filed would bedecisive. In such a case that the company is dissolved before filing, those whowere the last shareholders would bear the liability.24

Hansmann and Kraakman also claim that the costs of collection would notbe prohibitive under a pro rata rule. They refer to current bankruptcymechanics: accounts receivable are already collected routinely from dozens oreven hundreds of debtors by bankruptcy trustees.25


23 Hansmann and Kraakman, supra n 3, 1904.24 Ibid, 1897.25 Ibid, 1900.

C. RISK OF JOINT FAILURE DUE TO EXTENDED LIABILITY26

One of the cornerstones of modern financial theory is that diversification—“notputting all your eggs in one basket”—reduces risk.27 By purchasing a smallnumber of shares in a large number of companies, investors can dramaticallyreduce their overall risk because they insulate themselves against theconsequences of any one company failing; they are vulnerable only to downturnsin the market as a whole.28 This benefit of diversification in risk pooling is thefunctional justification for the stock market.29 Diversification, however, neverchanges the real risk in the economy, it only reallocates it. So the advantage ofdiversification is simply in eliminating the most extreme outcomes.30

In the light of the virtues of diversification, the proposition of Hansmannand Kraakman seems to be a reasonable one. If an investor holds a portfolio ofdifferent stocks issued by several companies, the pro rata liability does not appearto place too heavy a burden on them prima facie. There is, however, acounteractive force: pooling intensifies the risk of joint failure. This effect can becaptured by examining a group structure for firms in which the parent companycan transfer funds and other resources between its subsidiaries. With such anarrangement the probability of the joint failure of companies belonging to thesame group is greater than if the companies were operated individually.

Hansmann and Kraakman do indeed acknowledge that the pro rata rulecould add to the risk. However, their interpretation is that it would only have aminor effect on diversification; it could be diluted with more intense diversi-fication:31

“It seems unlikely that even a catastrophic liability judgment would impose costsexceeding a publicly-traded firm’s value by more than, say, a multiple of five. Thus, anunlucky small shareholder who had placed 5% of a $100,000 portfolio in the stock ofsuch a firm would stand to lose $25,000, or 25% of their portfolio’s value, in the worstcase scenario. A large institution with 0.2% of its assets invested in the same stock


26 As already noted in A.2, the following analysis, in a manner similar to one of Hansmann andKraakman, is based on an assumption that the shares are quoted on a stock market.

27 The classical analysis of this feature is provided by HM Markowitz, “Portfolio Selection” (1952) 7Journal of Finance 77, 78: “Diversification is both observed and sensible; a rule of behavior whichdoes not imply the superiority of diversification must be rejected both as hypothesis and as amaxim.” The prices of listed shares reflect the effect of diversification. If the diversification optionwas not allowed or otherwise unavailable, meaning that each investor could place their funds inonly one particular company, the price of that company’s share would be higher ceteris paribusbecause it includes also the compensation for specific risk: see A Damodaran, Corporate Finance:Theory and Practice (New York, John Wiley & Sons, 2nd edn, 2001), 163.

28 DA Moss, When All Else Fails: Government as the Ultimate Risk Manager (Cambridge, MA, HarvardUniversity Press, 2002), 78.

29 See KJ Arrow, Aspects of The Theory of Risk Bearing (Helsinki, Yrjö Jahnssonin säätiö, 1965), 45.30 SP Mason, “The Allocation of Risk”, in The Global Financial System: A Functional Perspective (Boston,

MA, Harvard Business School Press, 1995), 169.31 Hansmann and Kraakman, supra n 3, 1900.

would lose 1% of its asset value. Although such losses would be serious, they wouldhardly be beyond the pale of ordinary market fluctuations.”

Here Hansmann and Kraakman are sketching what they think to be the worstcase. As we have seen, however, diversification is by no means a deus ex machina

that can make the risk of extended liability for a shareholder disappear.Hansmann and Kraakman disregard the effect of possible joint failure. Theirscenario is one where it is possible that one, but only one, of the portfolio firmsends up in insolvency.

Secondly, they are not willing to spell out the highest multiple of liability: themultiple of five is provided only as an example. More recently one of theauthors, Kraakman, has come out with an even higher figure: “in the worstcase . . . the resulting liabilities would be unlikely to exceed the company’s assetsby a factor of more than a ten”.32 As Mendelson remarks, however, the basis forthese multiples remains unclear.33 The guidance for a risk-averse investor issparse: the reservation “unlikely” does not ease the uncertainty.

To demonstrate the limitations of the view of Hansmann and Kraakman, Iwill play it safe and set the factor of extended liability at a still higher level, say25: so an investment of £100 would mean risking an extra £2,400 at maximumif this extended liability materialises.

Choosing a multiple of 25 can be justified by the well-established principlethat diversifying an investor’s portfolio in 20 or 30 different companiesneutralises the variance in a portfolio’s return that is due to unique,company-specific risk.34 This risk derives from the perils to which an individualcompany is exposed and which are peculiar to that particular company and itsline of business. But, even with this kind of diversification, investors cannot avoidall risk; they have to bear the market risk regardless of the number of companiesin their stock portfolio. There is no means of eliminating the risk that is inheritin the stock market, which derives simply from the choice of being present inthe market as an investor. Market risk arises because there are always economy-wide perils that threaten companies in all lines of business. That is why theshare prices of companies on the stock market tend to move together; in general,when the market is going up or down, only a few exceptions are moving in theopposite direction. So each investor in the stock market is always exposed tomarket risk, whatever the number of companies in which they hold shares intheir portfolio.35


32 Kraakman, supra n 9, 651.33 Mendelson, supra n 4, 1287 fn 342.34 RJ Gilson and BS Black, The Law and Finance of Corporate Acquisitions (Westbury, NY, The

Foundation Press, 2nd edn, 1995), 92: “Holding 20 properly chosen stocks reduces unsystematicvariance [unique risk] by roughly 95% and thus achieves most of the value of diversification.”

35 RA Brealey and SC Myers, Principles of Corporate Finance (Boston, MA, McGraw-Hill, 6th edn,2000), 167.

We are now ready to proceed with our example: a prudent risk-averse investorwants to put together a portfolio of shares in a way that does not expose herpersonal property to extended liability beyond the funds invested in thisportfolio. She are willing to risk a certain fixed amount placed in the portfolio,£100,000, but not a penny more. How should she build her portfolio?

To answer this question, let us suppose further that every company in theportfolio faces a loss of a fixed amount, £1,000, with a probability of occurrenceof 1%.36 Each company in the portfolio contributes 4 pence per pound ofcoverage to the portfolio, or four times the expected loss. So, for example, toprovide coverage for the maximum acceptable liability, £100,000, the amountinvested in each company would be £4,000; the anticipated loss in eachcompany is £1,000, as already stated.

An additional investment object, a new company, contributes to therisk-bearing capacity of the portfolio—as Hansmann and Kraakman tellus—but at the same time adds to the probability of the portfolio making a loss.The data in Table 1 distinguish the risk-bearing effects from the risk-producingeffects.37

When an investment of £4,000, which equals four times the expected loss(£1,000), is added to the portfolio, the risk-bearing capacity of the portfoliomight be expected to strengthen quickly. The table illustrates, however, that therisk-bearing capacity does not begin to strengthen until the portfolio includes100 investment objects.38

Adding investments does not strengthen the risk-bearing capacity because thefunds accumulated from 24 or fewer investments cannot cover even a single loss.Since a loss is more likely to occur as additional investments are entered in the


36 As noted by the anonymous referee for this journal, the assumption that each company in theportfolio has an equal probability of being assessed can be criticised as unrealistic. Naturally, someindustries in real life may face fewer and smaller tort claims due to the nature of their business. Iuse this assumption, however, initially for descriptive purposes as it simplifies the calculationspresented in Table 1, but the general outcome is by no means dependent on the assumption.Moreover, even if one would expect smaller and fewer claims against for example financialservices than chemical industry, this cannot be known for sure ex ante, bearing in mind that “WallStreet” has been attacked aggressively with tort claims due to the recent corporate scandals in theUS. So the assumption of equal probability can be defended as being reasonable in the currentenvironment.

37 The table is slightly modified from ML Smith and SA Kane, “The Law of Large Numbers andthe Strength of Insurance”, in SG Gustavson and SE Harrington (eds), Insurance, Risk Management,and Public Policy: Essays in Memory of Robert I. Mehr (Boston, MA, Kluwer Academic, 1994), 9–10;our presentation also follows quite closely their argumentation.

38 The transaction costs of providing diversification with shares in some 100 companies may beprohibitive for investors with modest means. However, such investors could use mutual funds ortracking funds as an alternative, as the Journal’s anonymous referee remarked. I certainlyacknowledge the existence of this option, but my concern is that the withdrawal of individualinvestors from the stock market can hardly be considered advantageous for the economy as therewill be fewer parties trading and assessing the true value of listed shares. For a similar concern seeSB Presser, “Thwarting the Killing of the Corporation: Limited Liability, Democracy, andEconomics” (1992) 87 Northwestern University Law Review 148, 170.


Table 1: Probability that Portfolio Will Fail Due to Extended Liability of 25Times Invested Capital per Company

Number of Companies inPortfolio

Number of failures that can beabsorbed with Portfolio funds

Probability (%) that Portfoliowill fail*

1 0 1.00

2 0 1.99

3 0 2.97

4 0 3.94

23 0 20.64

24 0 21.43

25 1 2.58

26 1 2.78

27 1 2.97

48 1 8.34

49 1 8.64

50 2 1.38

51 2 1.45

52 2 1.54

73 2 3.71

74 2 3.84

75 3 0.69

76 3 0.72

77 3 0.76

98 3 1.72

99 3 1.78

100 4 0.34

101 4 0.36

102 4 0.37

123 4 0.82

124 4 0.84

125 5 0.17

126 5 0.18

127 5 0.18

*The probability of failure can be obtained following the Addition Theorem of Probability. See, egSM Ross, An Elementary Introduction to Mathematical Finance—Options and Other Topics (CambridgeUniversity Press, 2nd edn, 2003), 4. In a case of two companies (A and B), this means adding up theindividual probabilities of failure of both companies and distracting from this sum the multiple ofthese probabilities: Prob(A) + Prob(B) – (Prob(A) × Prob(B)) = 0.01 + 0.01 – (0.01 × 0.01) = 1.99%.For three companies the probability of failure can derived from the following: Prob(A) + Prob(B) +Prob(C) – [Prob(A) × Prob(B)] – [Prob(A) × Prob(C)] – [Prob(B) × Prob(C)] + [Prob(A) × Prob(B) ×Prob(C)]. The formula gets more complicated as the number of companies is increased, but theprinciple remains the same.

portfolio, the probability of failure increases. It is not until the portfolio consistsof 25 investments of equal size that the probability decreases.

The argument above is understood by Hansmann and Kraakman. However,they miss the fact that the probability of failure with several (in our example 25)investments is still larger than with only a single investment. It is not until thenumber of investments exceeds 99 that the probability of (joint) failurediminishes below the 1% that is the failure rate of a single investment in ourexample.

If more new investments beyond 100 are added, the probability of failurecontinues to follow the pattern described above. The probability increases,except at points of discontinuity where the assets in the portfolio reach the levelwhere they can absorb another loss. For every 25 investments, the capacity toabsorb a loss increases by one unit; and the probability of failure reaches a newlow at the same point.

The marginal effect of adding an extra investment is to weaken the portfolio,except where the resources contributed by the extra investment allow theportfolio to absorb an additional loss. In other words, the local and ultimateeffects of adding additional investments to a portfolio can be in oppositedirections. However, the additional capacity gradually overcomes any tendencyof extra investments to weaken the portfolio. With 1,000 investments, forinstance, the probability of (joint) failure is not detectable at the sixth decimalplace.

To summarise, the funds required to maintain the probability of failure at agiven level depend on the probability of loss and the number of investments. Anincrease in the number allows a smaller per-investment contribution torisk-bearing capacity, but the absolute level of risk-bearing capacity still increaseswith the number of investments. Although risk-bearing resources are employedmore efficiently in a large portfolio, a higher absolute level of these resources isrequired as the number of investments increases.

However, it is vitally important to note that the assessment made in theexample above was made possible in the first place because the maximum(potential) liability was known ex ante by setting the numerator at 25. As hasalready been said, Hansmann and Kraakman have offered multiples of 5 and 10only as examples that are “likely” to be enough to cover even the highestmonetary value of any tort judgment. With this indeterminacy, however,investors are denied any certainty about their possible maximum liability. Inother words, to provide risk-spreading opportunities, an explicit upper cap forpotential liability is essential for the stock markets.39 Under limited or multiple


39 B Greenwald and JE Stiglitz, “Information, Finance and Markets: The Architecture of AllocativeMechanism” (1992) 1 Industrial and Corporate Change 37, 49.

liability, investors know for sure the maximum liability that they face in thefuture.40

In fact, there is no reason why current shareholders should be the ones toprovide cover against tort liabilities. The company could alternatively issue putoptions for investors, who would for a premium commit themselves to subscribein the future for new shares at a preset price—perhaps the current share price orsome multiple of it when the puts are issued—in a situation where tort claimsexceed the value of the company’s current assets. Murphy has demonstrated thatthis type of equity put options is far cheaper than alternative methods forreducing the chance of bankruptcy.41 Actually, these “loss equity puts” arealready used in practice.42 For our purposes, however, the most important thingto note is that when issuing put options, it is also necessary to set ex ante the pricefor the potential liability sold to investors. A premium for puts cannot be setwithout knowing the price of the share that may be subscribed against the put atthe discretion of the company. Such a put could not be sold to investors onmodern markets.43

D. INSURANCE AS AN ALTERNATIVE

Proponents of unlimited pro rata liability could counter the arguments presentedabove by stating that they are only of secondary importance: the coverage of tortvictims should be the main concern, not the possible effects on shareholders. Toovercome this line of argumentation it is necessary to provide alternatives thatare capable of satisfying tort victims at least as well as the proposed unlimited prorata liability of shareholders. After all, even proponents of pro rata liabilitycannot immediately exclude the possibility that an alternative legal vehicle couldbe more effective in providing coverage for tort victims.


40 Similarly B Pettet, “Limited Liability: A Principle for the 21st Century?” in MDA Freeman and RHalson (eds), Current Legal Problems 1995 Volume 48, Part 2: Collected Papers (Oxford University Press,1995), 142 and fn 91: “The investor knows that the most he can lose is what he has put in to thecompany . . . Or whatever he has agreed to contribute, if for instance the shares are only partlypaid up.” See also JL Carr, S Glied and GF Mathewson, “Unlimited Liability and Free Bankingin Scotland: A Note” (1989) 49 Journal of Economic History 974, 975.

41 See A Murphy, “Buying Put Options to Insure Against Bankruptcy” (1997) 6 Journal of FinancialEngineering 307. For a more comprehensive review see NA Doherty, Integrated Risk Management:Techniques and Strategies for Managing Corporate Risk (New York, McGraw-Hill, 2000), 433–48.

42 See CR Culp, The Art of Risk Management: Alternative Risk Transfer, Capital Structure, and the Convergenceof Insurance and Capital Markets (New York, John Wiley & Sons, 2002), 443; and Doherty, supra n 40,438–39.

43 Cf Cortenraad, supra n 18, 121, who hypotheses that there would be individuals willing to writeput options with unlimited risk. The price of such options, however, would be prohibitive forshareholders (ibid): “Since [shareholders] must pay the option supplier for bearing the liability riskand since the latter cannot reduce the extra risk through diversification, the combined price of theoption and the share will in all likelihood exceed the price of a limited liability share.”

The most standard off-the-rack proposal (de lege ferenda) for satisfying theclaims of tort victims is to require companies to carry insurance for thatpurpose.44 An example is provided by Pettet:

“A company hit by huge mass tort claims will probably be insolvent whether it wasadequately capitalised or not . . . What is needed is a law requiring companies topurchase liability insurance against tort claims to the extent that the claims overtoptheir assets . . . only if the assets were exhausted and the claim remained partiallyunsatisfied would the overtop insurance cut in and provide funds.”45

This statement is based on an implicit assumption of insurance being available;if this option exists, it would mean that the insurance company provided effectivemonitoring. However, this is not true: the insurance market does not offernon-limited cover when that is not imposed by law. If it were required, themandatory insurance would in essence substitute the judgment by the insurancemarket about the acceptable level of risk for that of the legislator or regulator. Alegally imposed duty to provide such insurance does not make unlimited risksmore insurable than they are in the current situation where no such duty exists.Insurers simply do not offer types of coverage that they cannot provide on acost-effective basis; if required, they tend to offer the minimum coverage with themaximum exclusions and exceptions permitted by law.46

Insurers are just as capable as investors in diversifying risks.47 Because of theefficiency arising from specialisation, however, the insurance market is the bestavailable institution for monitoring and quantifying tort risks; the business ofinsurers is precisely that of monitoring and assessing tort risks. This applies if,and only if, insurers are able to link the premiums, their fee and other conditionsof an insurance policy to precautions relating to a particular insured company. Ifinsurers are unable to assess a company’s level of care and then derive terms foran insurance policy for it, the classical dilemma of “moral hazard”48 arises andinsured enterprises are likely to take less care than if they did not have to buycoverage.49


44 See, eg Shavell, supra n 12, 54.45 B Pettet, supra n 40, 157. For a similar proposal see Note, “Should Shareholders Be Personally

Liable for the Torts of their Corporations?” (1967) 76 Yale Law Journal 1190, 1201–1204.46 LoPucki, supra n 13, 81.47 Arrow, supra n 29, 47: “there are no other major institutions in which the shifting of risks through

the market appears in such an explicit form as in insurance and common stocks”. G Franke,“Shareholders as Insurers of the Firm” (1996) 152 Journal of Institutional and Theoretical Economics113, 117: “We regard the shareholders as financiers and insurers of exogenous and endogenousrisks of corporations. They diversify their portfolios and so get rid of unsystematic risks . . .”

48 Eg Culp, supra n 42, 316, provides a general description of the moral hazard problem: “When thepurchaser of insurance can take actions that impact either the probability of incurring aninsurable loss or the size of the loss and asymmetric information prevents the insurer fromperfectly observing those actions of the insured, the problem of moral hazard may arise.”

49 See, eg Shavell, supra n 12, 54, where it is observed that if insurers cannot determine the quality ofa utility’s employee training programme for a nuclear facility, the utility’s incentives to adequatelytrain the worker will be dulled by a liability insurance.

In the environment proposed by Pettet the moral hazard problem escalates,because a company would be required to take the policy on behalf not of itselfor shareholders but of possible tort victims. The moral hazard problem cancertainly be overcome by adjusting the insurance premium to reflect the increasein the expected loss resulting from the insured firm’s taking less care. Theproblem with this option, however, is that the premium requirement in anunlimited liability environment would probably be set at such a high level that itwould not be feasible for firms at all.

I am not claiming that, under the prevailing regime of limited liability,companies are monitored perfectly by insurers. The point is that there arealternatives in practice to monitoring the behaviour of the insured person andadjusting the premium accordingly. These take the form of partial insurancecoverage, such as deductible insurance or coinsurance. In both cases, theresulting coverage is not complete; it leaves a risk-averse person with some riskand does not completely solve the moral hazard problem.

If companies were required to have insurance coverage to an unlimitedamount, it would be extremely difficult for them to find it;50 it would be beyondthe limits of what is insurable. Insurers cannot control the actions of a companythat does not have a true interest in limiting accidents, because the ultimatebeneficiaries of the insurance contract would not be the company itself or itsinvestors but outsiders, the tort creditors.

Legislators have certainly laboured to create numerous requirements forcitizens to purchase liability insurance. The most notable example is thecompulsory automobile insurance that is common in most developed economies.But this type of insurance is based on actuarial data of accident frequencies fordifferent driver categories and of the amount of coverage actually paid;established insurers have collected this data over several decades. It is impossible,however, to have similar information about unforeseeable accidents that com-panies might cause in the future; experience-based premiums can be determinedex post and so they will lag behind the observations of risky behaviour.51 Soinsurers simply would not offer unlimited insurance against such accidents.

To counter the argument above, it is possible to refer to the example ofLloyds of London, world-famous for providing insurance even for the mostextraordinary and bizarre eventualities.52 The sample size of similar events may


50 Eg Faure and Hartlief supra n 6, 696. WK Viscusi, “The Performance of Liability Insurance inStates with Different Products-liability Statutes” (1990) 19 Journal of Legal Studies 809, found in hisstatistical study of insurance markets in different US jurisdictions that the availability of insurancevaries under different statutory regimes: the more the provisions rendered the liability risk lessvolatile by capping liability, the more insurance coverage was being available.

51 Carney, supra n 9, 686.52 Lloyd’s is an insurance provider sui generis: it is not a company but a brokered market in which

underwriting syndicates both compete and cooperate. The extraordinary policies issued byLloyd’s include a concert pianist’s hands and the legs of a racehorse. Arshadi and Karels, supra n22, 171. See also http://www.lloydsoflondon.com.

be very small or even non-existent. So there is also no actuarial data for suchaccidents on which to base the premium required, meaning that the riskexposure from providing insurance may be considerable.53

Nevertheless, such contracts do exist and premiums for them are set inpractice. It could well be argued that this kind of insurance offered without anactuarial basis is really the equivalent of a lottery. Wouldn’t Lloyds or similarorganisations also be prepared to offer insurance to cover the higher unlimitedliability that Pettet refers to? The answer is no. Even the society of Lloyds is noplace to find unlimited coverage: members have to name the maximum liabilitythey can carry per year.54 This in turn means that contracts written always namethe maximum amount to be paid. Since it contradicts the basic principles ofactuarial practice, the proposal of Pettet is in fact not feasible in the real world ofinsurance.

Hansmann and Kraakman are by no means in favour of the mandatoryinsurance requirement described above.55 However, in essence, they propose asimilar system; but they approach the matter from a different angle than Pettet.In order to ease the worried mind of a small risk-averse investor facing theprospect of unlimited liability, they introduce a new concept, “portfolioinsurance”, which would cover the investor’s portfolio in a case of a tort claim.Hansmann and Kraakman, in their words, “see no reason why unlimitedcoverage ought not to be available to small shareholders at a price that is notprohibitive”.56 What distinguishes this kind of insurance, however, from themore common liability contracts written today is precisely the open-endednature of the possible loss that has to be covered. This type of instrument doesnot exist on current insurance markets. And precisely because of the feature oflimitless liability, it is also unlikely that insurers would ever be willing to writesuch policies in the future. Hansmann and Kraakman do not seem to recognisethe importance of this difference, even though they state that the proposedconcept of portfolio insurance is “unconventional”. On the contrary, theyare ready to consider portfolio insurance the equivalent of more typicalpolicies such as life insurance: “insurers . . . might be willing to supply suchcoverage because, like the life insurance sold to airline passengers, it would beprofitable”.57


53 V Allsopp, Understanding Economics (London, Routledge, 1995), 354.54 R Gastel, “The Lloyd’s of London Marketplace”, in R Gastel (ed), Reinsurance: Fundamentals and

New Challenges (US, Insurance Information Institute Press, 1995), 57: “Once elected into theSociety, members select a membership category, based on their wealth. This dictates themaximum amount of risk they can underwrite for that year.”

55 Hansmann and Kraakman, supra n 3, 1927.56 Ibid, 1901.57 Hansmann and Kraakman, ibid, 1901, fn 62, also refer to the British experience with mandatory

vehicle liability insurance that does not carry an upper cap, at least for personal injuries. However,maximum potential liability can be estimated quite accurately even regarding the British vehicleinsurance. Section 145(4) of the Road Traffic Act provides that the minimum insurance cover

To repeat briefly the argument presented above, there is clearly no actuarialdata available about corporate mass torts as there is for motoring accidents.Therefore, it is highly unlikely that insurers could assess the risks for setting apremium for portfolio insurance. Insurance companies are not accustomed toproviding unlimited coverage.58 Secondly, as Leebron remarks, providinginvestors with coverage against excess liability would involve insuring against notonly tort liability but also the commercial risk of failure that is correlated withthe economy; because such a risk is non-diversifiable, insurers would beunwilling to provide insurance against it.59

This is also demonstrated in telephone interviews carried out by Hansmannand Kraakman where “writers of liability insurance for business claim to beable to control moral hazard by inspecting those insured and employingexperience ratings”.60 This is certainly so, but these interviewed insurers havemost likely considered in their comments only coverage of well-known risks andlimited, not unlimited coverage.61 Moreover, theoretical studies of insurancehave concluded that upper limits on coverage are optimal. Beyond a certainpoint the expected benefit from additional coverage is smaller than its costs,given that the price of coverage must reflect the cost of paying losses thatotherwise would fall on the counterparty of the insurance contract.62 Tosummarise, the theory of unlimited pro rata liability asks for more than theinsurance market can ever bear.63


against property damage must be at least £250,000. Moreover, a person is exempted from therequirement to have an automobile insurance—against liability for death and injury to any personas well damage to property—altogether if they deposit with a certain authority the sum of£500,000. See A Evans, Liability, Risk and the Law (London, Witherby & Co, 2000), 326–27. Thisamount, covering all liability, represents a reliable estimate of the maximum insurance coverage tobe upheld by court.

58 JC Alexander, “Unlimited Shareholder Liability Through a Procedural Lens” (1992) 102 HarvardLaw Review 387, 428.

59 Leebron, supra n 20, 1604. See also Easterbrook and Fischel, supra n 11, 48–49; and RBThompson, ”Unpacking Limited Liability: Direct and Vicarious Liability for CorporateParticipants for Torts of the Enterprise” (1994) 47 Vanderbilt Law Review 1, 22.

60 Hansmann and Kraakman, supra n 3, 1890.61 Halpern, supra n 9, 590. See also Cortenraad, supra n 18, 31; Culp, supra n 42, 319; MG Faure,

“The Limits to Insurability from a Law and Economics Perspective” (1995) 20 Geneva Papers onRisk and Insurance 454, 459; and V Finch, Corporate Insolvency Law: Perspectives and Principles(Cambridge University Press, 2002), 97. For similar comments made by a representative of theinsurance industry see M Aickin, “Legal and Cover Restrictions” (1986) 11 Geneva Papers on Riskand Insurance 157, 157: “No risk is insurable without cover limitations to define the risk which istransferred.”

62 For a review see SE Harrington and PM Danzon, “The Economics of Liability Insurance”, in GDionne (ed), Handbook of Insurance (Boston, MA, Kluwer Academic, 2000), 287–88. G Huberman,D Mayers and CW Smith, “Optimal Insurance Policy Indemnity Schedules” (1983) 14 Bell Journalof Economics 415, provide a mathematical exposure of this.

63 WW Bratton and JA McCahery, “An Inquiry into the Efficiency of the Limited LiabilityCompany: Of Theory of the Firm and Regulatory Competition” (1997) 54 Washington and Lee LawReview 629, 655.

At least in theory, insurance does not have to be bought from a third party;there is the possibility of “home-made” insurance. As early as the 1970s Posnerproposed an in-house alternative to a mandatory insurance. According to him, acompany involved in a dangerous activity should “post a bond equal to thehighest reasonable estimate of the probable extent of its tort liability”.64 Therequirement to post this bond would reserve funds to meet any tort liabilities ofthe company. However, this proposal is not easily implemented in practice. Forone thing, the “reasonable estimate” of maximum liability is hard to assess, evenif agreement can be reached on who is to make such an estimate—Posner doesnot provide guidance on this matter. The difficulties in assessing the amount areat least as great as with the alternative of mandatory insurance. Secondly, bondrequirements create implementation costs of their own. A major difficulty withPosner’s proposal is the opportunity cost of holding such a bond.65 In otherwords, Posner requires a certain amount of assets to be put aside and separatedfrom alternative use in production. The soundness of the bond has to bemonitored as well.66

On the other hand, as Boyd and Ingberman have remarked, bonding has theadvantage that it shifts the burden of recovery from tort victims to the companythat generated the risk: with multiple or pro rata unlimited liability, victims haveto pursue compensation, maybe for years to come, from shareholders who arereluctant to honour such claims.67 In contrast, bonding leaves the shareholders asthe residual claimants to the bonding funds, and they have an effective incentivefor controlling any hazardous activities of the company. 68

D. EXTENDED LIABILITY IN ECONOMIC HISTORY

1. American Banks under Double Liability

Some jurisdictions have experience of multiple liability. Such a system existed inthe American banking sector prior to the Great Depression. The NationalBanking Act of 1863 stated that each shareholder was liable to the amount ofthe par value of the shares held by him in addition to the amount invested insuch shares. So bank shareholders were liable for assessment to the benefit ofcreditors if the bank failed; the liability was, however, limited to the par value of


64 RA Posner, “The Rights of Creditors of Affiliated Corporations” (1976) 43 The University of ChicagoLaw Review 499, 520.

65 I thank the anonymous referee for drawing my attention to this feature.66 Cortenraad supra n 18, s 311; and J Boyd and DE Ingberman, “Fly by Night or Face the Music?:

Premature Dissolution and the Desirability of Extended Liability” (2003) 5 American Law andEconomics Review 189, 226.

67 This is reviewed from a historical point of view in the following section.68 Boyd and Ingberman, supra n 66, 226.

the shareholder’s stock. The system lasted over 70 years until it was repealed in amulti-step process in the early 1930s.69

The system of extended liability was valuable for banking companiesparticularly because depositors enjoy in principle the benefit of withdrawingtheir financing overnight. In this respect banking differs from other industries.Thus, the double liability served as a ‘guarantee’ for depositors against the riskof bank panics.70 Moreover, compared to industrial firms, banks invest generallysmaller portion of their assets in physical plant, inventories and other assetswhose existence is readily to be assessed by outside investors. Because in thosedays the wealth of current bank owners was more easily monitored than thebank assets, shareholders were ready to the extended liability regime asdepositors required lower rate of return in such banks. In other words, theregime lowered the funding costs of banks.71 Industrial firms could have taken upthe very same regime voluntarily in order to appeal investors. However, this didnot take place which suggests that firms could get funding on favourable termseven without the ‘guarantee’ that multiple liability provided.

There is some empirical evidence that the double liability regime reduced risktaking among banks in the late nineteenth and twentieth century.72 From atheoretical point of view, however, the efficiency of multiple liability has beenquestioned due to the collection costs.73 Macey and Miller have researched theeffects of double liability until the 1930s. They found that the system existed notonly on paper; in fact, it was effectively enforced through the court system:thousands of cases were argued before the lower courts, and even the SupremeCourt of the United States made over 100 decisions on this topic. Secondly,about half the amount assessed as owing by shareholders was actually collectedfrom them, even in the recession during the early 1930s. Macey and Miller findthis to be a good recovery rate, given that double liability had a drastic effect on


69 A general economic analysis of the system is provided by BC Esty, “The Impact of ContingentLiability on Commercial Bank Risk Taking” (1998) 47 Journal of Financial Economics 189; BKWilson and EJ Kane, The Demise of Double Liability as an Optimal Contract for Large-Bank Shareholders,National Bureau of Economic Research (NBER) Working Paper 5848 (Cambridge, MA, NBER,1996); A Saunders and BK Wilson, Contingent Liability in Banking: Useful Policy for DevelopingCountries?, World Bank Policy Research Working Paper No 1538 (New York, 1995), 2; and Y Yan,“Double Liability, Moral Hazard and Deposit Insurance Schemes”, in Three Essays on FinancialIntermediation (Montreal & Quebec, McGill University, 1998).

70 See generally EJ Kane, Designing Financial Safety Nets to Fit Country Circumstances, World BankWorking Paper No 2453 (New York, 2000), 25–27.

71 See LT Evans and NC Quickley, “Shareholder Liability Regimes, Principal–Agent Relationships,and Banking Industry Performance” (1995) 38 Journal of Law and Economics 497.

72 See RS Grosmann, “Double Liability and Bank Risk Taking” (2001) 33 Journal of Money, Credit andBanking 143.

73 F Allen and D Gale, “Capital Adequacy Regulation: In Search of a Rationale”, in R Arnott, BGreenwald, R Kanbur and B Nalebuff (eds), Economics for an Imperfect World: Essays in Honor of JosephE. Stiglitz (Cambridge, MA, The MIT Press, 2003) “If the shareholders’ liability extends to theassets they own, it may be very costly for the receiver to pursue the shareholders and enforce theirliability.”

bank shareholders: many of them were insolvent when their banks failed.74

However, given the current environment, where ownership of listed companieschanges constantly, other commentators have doubted the viability of theextended liability regimes.75

It has been argued that multiple liability would barely affect the stock price ofa well-managed adequately capitalised bank.76 I am not aware, however, of anyeconomic studies regarding the possible effects of double liability on the liquidityof American bank shares. Nevertheless, from the historic records it is evidentthat, during this period, US bank stocks were thinly traded—due, at least partly,to the fact that the prices were very high (hundreds or thousands of dollars pershare). And bid–ask spreads were large, ranging from 10 to 30%, meaning thatowners could sell their shares at a heavy discount relative to buyers.77

2. Pro Rata Liability in the State of California and the Case ofAmerican Express

Before 1931, Californian law imposed pro rata unlimited liability in section 322of its Civil Code, which stated that “[e]ach stockholder of a corporation isindividually and personally liable for such proportion of debts and liabilities asthe amount of such stock or shares owned by him bears to the whole of thesubscribed capital”. This section was repealed in 1930 and limited liability wasprovided for California companies from the beginning of the following year.Until then, the California law had provided a real world experience of the laterHansmann and Kraakman proposal for pro rata liability—the only differencebeing that the paragraph covered not only torts but also voluntary debts.

Weinstein has considered the effects of the legislative change in California.He found no evidence that adopting limited liability in 1931 had any significantimpact on share prices. Weinstein is, however, very cautious in drawing anyinference from this regarding limited liability in general. First, the sample size isstatistically quite small: only seven companies were listed in New York StockExchange and 47 listed elsewhere. Besides any shortcomings in the statistics,Weinstein points out that no creditor tried to go after the small shareholders of


74 See JR Macey and GP Miller, “Double Liability of Bank Shareholders: History and Implications”(1992) 27 Wake Forest Law Review 31; and JR Macey and GP Miller, “Double Liability of BankShareholders: A Look at New Data” (1993) 28 Wake Forest Law Review 933. Cf HE Jackson, “Lossesfrom National Bank Failures During the Great Depression: A Response to Professors Macey andMiller” (1993) 28 Wake Forest Law Review 919.

75 Eg Mendelson, supra n 4, 1284–85, argues that the excessive costs of looking for numerous smallshareholders would preclude tort victims from receiving full compensation. Alexander, supra n 58,398–99, reviews other procedural hurdles that tort plaintiffs would have to overcome to holdshareholders accountable.

76 Kane, supra n 70, 25.77 Saunders and Wilson, supra n 69, 11.

any listed California firm,78 and that large class-action tort liability suits had notbecome part of American law in the 1920s and 1930s.79 Also in a later study,Weinstein concludes from these facts that we can say nothing about whether amove to pro rata unlimited liability today would either impact shareholderwealth or force firms to arrange their ownership structures so thatjudgment-proof entities actually owned the equity.80

Besides the Californian referred experiment, one particular US company,American Express Corporation, offers a real world case study of unlimited prorata liability. When this company was founded in 1850, paragraph 5 of itscharter gave the board of directors the right to assess for loss and damages on apro rata basis. This paragraph was, however, abolished in 1965, when AmericanExpress became a limited liability company.81

Grossman has examined with statistical means the liquidity of shares issuedby American Express in the 1950s. In his article published in 1995, Grossmanfinds that a regular market existed for American Express shares that wereactively traded. The number of shareholders was also high, averaging about25,000.82 The wealth of shareholders did not appear to have been a factor in theshare price at any time. Moreover, the spread between bid and asked prices wascomparable to other shares in the same price range.83 On this evidence,Grossman concludes that the case of American Express gives support to thenotion that limited liability is not a necessary condition for the liquidity of sharesissued by a company.84

Grossman, however, misses a fundamental point. The pro rata liability did notexist de facto. The paragraph referred to above states that:

“[the] Trustees are hereby further authorised and empowered in the extraordinary lossor damage . . . to assess the whole or any portion of the amount of such loss or damageon each and every of the members . . . of [the] Company in proportion to the numberof shares . . . owned and held by each.”85

This is clearly to be read that the pro rata liability was not unconditional. Itdepended on the Trustees, which in turn consisted of major shareholders andtheir representatives. So it is highly unlikely that they would have taken the


78 However, in principle the argument that seeking costs would preclude full compensation for tortvictims applies to pro rata liability as well as to multiple liability (see D.1 above).

79 See MI Weinstein, “Share Price Changes and the Arrival of Limited Liability in California”(2003) 32 Journal of Legal Studies 1, 3 and 19–24.

80 MI Weinstein, Limited Liability in California: 1928–1931, University of Southern California LawSchool Olin Research Paper No 00-17 (Los Angeles, CA, 2001), 55.

81 PZ Grossman, “The Market for Shares of Companies with Unlimited Liability: The Case ofAmerican Express” (1995) 24 Journal of Legal Studies 63, 75.

82 One particular shareholder, however, controlled a position of 10% at that time: Grossman, supra n81, 77.

83 Ibid, 76.84 Ibid, 84.85 Ibid, 73 fn 34.

decision to activate the liability because of a tort judgment for an amountexceeding the company’s assets. And no tort victim or any other person couldactivate the pro rata liability against the board’s will.86

3. Joint and Several Liability vis-à-vis Limited Liability in Irish andScottish Banks

In addition to this experience with multiple and pro rata liability, the generalswitch from joint and several liability to limited liability has been examinedeconometrically. Hickson and Turner studied trading in the shares of an Irishbank, The Ulster Banking Company, in the period January 1868 to December1879. Pursuant to section 18 of the Irish Banking Copartnership Regulation Actof 1825, the shareholders were jointly liable for debts of the bank up to threeyears after they had ceased to be shareholders.

Shares could only be sold to those with certain levels of wealth on approval ofthe shareholders’ committee. As the members of the committee were amongstthe wealthiest shareholders, they had effective incentives to ensure thatlow-wealth individuals did not enter the bank.87 This approval mechanism servedas an alternative to limited liability. In other words, unlimited liability neces-sitates restrictions on share trading ceteris paribus.88 Hickson and Turnerdemonstrate that this arrangement did not have a meaningful effect on theliquidity of the bank’s shares. However, it should be born in mind that in thosedays an “active” market meant on average one or two trades per working day.89

It is evident that such an approval mechanism could not bear the current volumeof market trading with sophisticated electronic means.90

Scotland imposed a regime of unlimited liability in joint and several form onbank shareholders for even longer than Ireland. Not until 1962 were banks


86 Neither does Weinstein note this in a later study: see MI Weinstein, Don’t Leave Home Without It:Limited Liability and American Express, University of Southern California Legal Studies ResearchPaper No 05-2 (Los Angeles, CA, 2005). Thus, Weinstein’s conclusion is similar to Grossman’s(ibid, 28): he is unable to find any effect on shareholder wealth of moving from unlimited to limitedliability. Weinstein suggests that this may be due to the fact that American Express was “acompany without significant risk of tort liability”.

87 CR Hickson and JD Turner, “The Trading of Unlimited Liability Shares in Nineteenth-centuryIreland: The Bagehot Hypothesis” (2003) 63 Journal of Economic History 931, 956. For theoreticalproofs of this incentive see A Winton, “Limitation of Liability and the Ownership Structure of theFirm” (1993) 58 Journal of Finance 487, 498; and JL Carr and GF Mathewson, “Unlimited Liabilityas a Barrier to Entry” (1988) 96 Journal of Political Economy 766, 772.

88 See B.1 above.89 CR Hickson, JD Turner and C McCann, “Much Ado about Nothing: The Limitation of Liability

and the Market for Nineteenth-century Irish Bank Stock” (2005) 42 Explorations in Economic History459.

90 This is also implicit in current listing requirements, which customarily do not allow companies toinclude in their articles of association any restrictions on the free transferability of listed shares.See, eg E Werlauff, EU Company Law: Common Business Law of 28 States (Copenhagen, DJOF, 2ndedn, 2003), 309.

allowed to switch to limited liability. According to Saunders and Wilson, theunlimited liability provision effectively minimised the losses suffered by banknoteholders and other creditors.91 Scottish noteholders had little cause for panicbecause of the effective coverage provided by unlimited liability. The protectioncould be assessed by adding up the wealth of stockholders because theiridentities were public. On the other hand, there was a primitive “approvalmechanism” in place: the transfer of bank stocks required that ownership first bedissolved before a new bank could be formed. This feature—like theshareholders’ committee in Irish banks—minimised the problems that mightarise should ownership be transferred to people with less personal wealth.92

In the final analysis, economic history gives no definitive answers regardingthe viability of unlimited pro rata or multiple liability. The economic studiesreviewed above cover only one particular country or company at a certain pointof time. Therefore institutional factors may have a major impact on the results.For example, the financial reporting requirements were undeveloped in thosedays.93 However, the available evidence is suggestive that the multiple liabilitycould function even on current stock markets despite the collection costs andother procedural hurdles that tort plaintiffs would have to overcome to holdshareholders accountable. On the other hand, the evidence in favour ofunlimited pro rata liability is more limited. One therefore has to be cautious indrawing conclusions from it as the viability of unlimited pro rata regime isdubious from a theoretical economics point of view illustrated above in sectionsB and C.

E. CONCLUSION

Investors may easily divide their holdings between several listed companies.Diversifying portfolio funds eliminates most of the specific risk deriving fromeach company in the portfolio; however, the market risk always has to be borne if


91 Saunders and Wilson, supra n 69, 11. Not all researchers share the enthusiasm of Saunders andWilson. Kroszner remarks that notes issued by both limited and unlimited liability banks inScotland successfully competed against each other. Thus, according to him, the experience isinconclusive (RS Kroszner, “Free Banking: The Scottish Experience as a Model for EmergingEconomies”, in G Caprio and D Vittas (eds), Reforming Financial Systems: Historical Implications forPolicy (New York, Cambridge University Press, 1997), 56): “some form of extended liability . . .might give depositors and noteholders some assurance that a bank could withstand a negativeshock”. Moreover, Carr and Mathewson, supra n 87, 766, have shown that with unlimited liabilitybanks tended to be smaller than under the rule of limited liability.

92 For an economic analysis regarding the legal regime of Scottish banking see also Carr andMathewson, supra n 87, 775–78; Carr, Glied and Mathewson, supra n 39, 974; and Evans andQuickley supra n 71, 497.

93 Evans and Quickley, supra n 71, 497, suggest that extended liability of Scottish banks served as acontractual response to informational asymmetries between shareholders and creditors, as thewealth of shareholders was more easily monitored than the assets of banks.

an investor participates in the stock market. But this is a burden that an investoris aware of and takes on ex ante.

Tort victims do not enjoy the same luxury of choice regarding risk-control asinvestors. They cannot decide on the maximum loss they are prepared to carry ex

ante, before an accident occurs. Of course, potential victims can take outinsurance. But they cannot know with certainty that the insurance will cover theparticular accident that they later encounter; the policy may well exclude thatparticular type of accident, as force majeure for example. Moreover, insurancepolicies have an upper cap in almost every case: a provision sets the maximumthat can be paid out to the victim; liability in excess of this threshold is notcovered by the insurance.

Shareholders are efficient risk-bearers, so it is tempting to conclude that theyare better suited to bear the costs of accident than tort victims. Within thisframework, Hansmann and Kraakman proposed in the early 1990s that eachshareholder of a listed company should have a secondary liability to bear the tortjudgments of the company on a pro rata basis.

In this article, however, I have drawn attention to the crucial condition forrisk bearing based on diversifying the stock portfolio: the maximum liability ineach company must be known ex ante. The authorities must therefore state thatmaximum explicitly. The current system, in which the excess liability is set atzero, is also a choice made by the legislator. Whatever the actual choice, a systemwhere each and every shareholder takes on a pro rata liability for assessmentwhen they purchase their shares can be viable, as long as the maximum liabilityis specified ex ante.


Extended Liability of Shareholders? EXTENDED LIABILITY OF SHAREHOLDERS

Documents

Transcript of Extended Liability of Shareholders? EXTENDED LIABILITY OF SHAREHOLDERS