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Corporate law and governance
Limited liability can be seen as being a distinguishing aspect of corporate law. It is the concept where shareholders financial liabilities are limited to the amount they invested into the company and they are not liable for any debts that are incurred by the company and it has become ‘one of the most important legal foundations of a free market economy'. Limited liability helps to protect shareholders and directors personal assets from creditors and third parties so that only company assets will be taken into account. A shareholder of a limited liability company will only be liable for the money they have paid or have agreed to pay the company for their shares, so they will only lose the money they have invested in the company but no more.
Limited liability can be traced back to the 17th century where individual members of companies could not be sued but the company itself was found to be fully liable for any debts it incurred. There are exceptions to the rule where a shareholder may be liable for money that is unpaid and the courts can ‘pierce' the corporate veil to make directors personally liable. The courts will only consider ‘piercing the corporate veil, on occasions, for example where a company has committed fraud or is a facade.
The concept of limited liability has lead to many discussions and different rationales. One of the main rationales that has been put forward suggests that limited liability is a way of facilitating investments by members of the public who are not professional investors. Bouverie thought that the government had a duty to encourage investments and without limited liability protecting their personal assets members of the public may not invest if they are personally responsible for company debts.
Henry Manne thought that without limited liability “wealthy individuals would never make small investments in a corporation” as it was a way of allowing individuals to participate in risky ventures “without risking disastrous loss”. However others considered limited liability companies as unsuitable for working class investors as they would be “totally ignorant” on how to nurture the companies or use lawyers to get through.
Another rationale that has been put forward is the operation of the public security market. Halpern, Trebilcock and Turnbill all believe that limited liability relives the investor of the need to be concerned about the public wealth of fellow investors and this facilitates the operation of the public securities markets. Some argue that eliminating limited liability would make shareholders become more involved in the company and the decisions made if they were personally responsible for company debts. This would give shareholders greater incentives to monitor corporate conduct. Monitoring the company may cost the shareholder money and so they may either invest less money to make up for the cost of monitoring, or not invest at all. Gabaldon thinks that shareholders should be more involved in the company and believes that corporate monitoring will be advantageous rather that inefficient.
It has been argued that limited liability facilitates diversification as investors can invest in more than one company at a time. Unlimited liability would risk shareholders personal assets if they were to invest in many companies at once, therefore without limited liability a shareholder is also less likely to invest in a number of companies as they would want to monitor closely the companies they are invested in and to be more involved in the decisions made. A moral argument that has been put forward is that if someone engages in a commercial activity they should be prepared to support that activity with all of their resources, so people should take personal responsibility for their debts.
It has also been discussed that limited liability might give shareholders an incentive to take higher risks and avoid tort liabilities as they will take all the benefit but do not suffer the risk of high failure. However, taking excessive risks may be seen as reckless or fraudulent trading.
It has been argued that limited liability encourages undue risk at the creditor's expense and therefore fails to adequately protect creditors. However an advantage of limited liability from a creditor's point of view is that now there is no difficulty of knowing who to sue when a claim has to be made against a large partnership with variable membership. In the early 19th Century it was difficult to know who the members were at one time so the creditor never knew who to sue. The creditor could potentially sue every individual shareholder but it was hard to discover who they were. The creditor normally looked to the richest individual who was a shareholder on a specific day that was important and it didn't matter whether they were a minority or majority shareholder.
Another argument for limited liability is that a right to limited liability will avoid long delays as Laing considered that the delay in getting a charter was an even greater obstacle than cost. Before the right to limited liability government had discretion whether to grant limited liability, without this discretion there is less chance for influence.
By incorporation the company is said to be have a separate legal personality, so the shareholders and the company are legally separate. This means that a creditor of a company cannot sue shareholders to be repaid, and a creditor of a shareholder cannot look at company assets to be repaid. There are some exceptions to this as the doctrine of limited liability could be easily abused so the courts will, on certain occasions, hold the directors or shareholders personally liable and they will do this by ‘piercing the corporate veil'. The courts have recognised that “there is one well-recognised exception to the rule prohibiting the piercing of the ‘corporate veil'”, the exception is allowing the disregard of the company when the corporate structure is a “mere facade concealing the true facts”.
A company is a separate legal entity from its shareholders this was decided in the case of Solomon. This case decided that company's assets are not the property of the shareholder; a shareholder cannot even insure company property from damage in their name. The same is for the company's debts, they are not the shareholders debts. Shareholders are also not personally liable for torts committed by the company.
The court will look at the people behind the company ignoring the principle from Solomon; this is usually done “when corporate personality is being blatantly used as a cloak for fraud or improper conduct” or if the director acts solely for their own personal benefit. An occasion where the courts are likely to ignore the company's separate corporate existence and the policy set out in statute would be if a shareholder is abusing limited liability and using the company as an ‘alter ego' thereby ‘piercing the corportae veil'.
The courts will sometimes allow creditors to reach the assets of the shareholders. By doing this it could be said that the courts are trying to balance the benefits of limited liability against its cost. There have been four reasons suggested for ‘piercing the corporate veil' which are peeping behind the veil, penetrating the veil, extending the veil and then completely ignoring the veil. The court has discretion over whether or not they will ‘pierce the corporate veil' and to what extend it is used. The corporate veil metaphor is widely used throughout the United Kingdom as well as Canada and the United States.
Peeping behind the veil is when the veil is lifted only to get information involving the person who controls the company. This is normally regarded as an act of curiosity; the veil is lifted to get some information about the shareholders. The aim of penetrating the veil is to impose responsibility on the shareholders for the company's acts, it recognises that the veil was there but tries to establish a shareholders direct interest in the company's assets. Extending the veil is when the veil is lifted from one component only to be replaced covering a large number of components. Ignoring the veil is the most extreme and is hardly ever used; it is applied if the courts think the company is not genuine, committed fraud or is a sham.
It can be said that “there can be no satisfactory explanation of a system whereby a person is not made fully accountable for his mistakes.” A persuasive rationale is that limited liability facilities the investment by members of the public, people who would otherwise not be willing to invest. They would not invest in companies if they had to risk their personal wealth and assets. Although the ‘privilege' of limited liability can be abused the courts are willing to step in and make shareholders and directors accountable if they believe the company is a sham or commits fraud, this shows that a person can be made fully accountable for their mistakes.
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