Importance of Limited Liability

I’d like to take a look into a fundamental tenant of business in our economic structure–limited liability.  My interest in this post was sparked by an editorial written by David Shindel and Monica Silwanowicz which ran in some of the newspapers here, here and here.  In this article they discuss how the State of Michigan does not respect the limited liability nature of a business owner’s investment in their company and then proceed to attach a company debt to the business owner personally.  When discussing this with a few people a question kept coming up, “Why shouldn’t a person have to pay their debts?  Isn’t this just allowing them to cut and run, sticking the State with the bill?”  The answer to this is yes, and no.  The answer shows why the concept of limited liability is important to our economy, but also causes problems to that same system.

There are many reasons for limiting the liability of an individual’s investment in a business, but perhaps the most significant is in the understanding of risk.  By allowing an individual to limit the ultimate extent of his or her risk you are allowing them to understand and quantify the risk of the potential investment.  Understanding the extent of “skin in the game” allows you to make an informed decision on whether to make the investment or not.  Unlimited exposure to the liabilities of company is a risk too great for the vast majority of individuals.  Very few of us have the financial means to be able to afford a risk like that.

The limited liability nature of companies helps to encourage investment.  Here’s a simple example:  say you had $100 that you were interested in investing.  You considered buying shares of Dr. Pepper Snapple Group Inc.  (NYSE: DPS).  Since your liability in this investment is only $100, you know what you are getting into and what will happen if the company ends up making unwise decisions and goes belly up (you lose $100). 

Now take away the limited liability and look at the same investment.  Now, by investing the $100, you have theoretically opened yourself up to unlimited liability exposure.  If the company fails, you may held personally liable for their debts.  Makes you think twice about that same investment! 

Multiply that scenario by the trillions of dollars that are invested throughout the world and you can see where limited liability becomes a useful tool for raising capital and promoting economic investment.

Is there a downside to this?  Absolutely.  There are a whole host of unintended consequences to this, more than I can discuss here.  A lot of these downsides revolve around an investor/owner taking advantage of the preferential status.  For example, a company could gather revenue from their business activities and distribute it to its owners without paying its creditors.  When the creditors come to collect, the company folds, investors move on with their money in hand, and the creditors get stuck holding the bag.  This seems like too basic an example, but I have seen it personally and find it happening all too often.  The legal system has put laws in effect to prevent this, but practically, this is very difficult to prove and expensive to litigate.  This should put all business owners on notice to watch the credit you extend your clients/customers and to do a little digging before doing business with them.

Another downside is the effect to an investor’s/business owner’s risk tolerance when conducting the company’s business affairs.  A business owner may be more reckless with their decisions because they know that if it doesn’t work out, someone else will take the brunt of the loss.  A great example is the current financial industry.  The banks were taking outlandish business risks with little thought to the downside.  Why?  Because they didn’t have any downside risk.  If things went bad, they just took off.  In actuality, it was even worse because we (the government) were the ones having to pay for these reckless mistakes.

What does this mean for you?  Well, this means a great deal.  First you need to understand that you, as a business owner, get to enjoy this privilege (assuming you own an entity that has this nature, which most do).  Second, that there are limitations to this (one example being what Shindel and Silwanowicz discussed). 

Thirdly, that your customers/clients have the same privilege.  This can expose you to complications when it is time for the customer to pay you.  The morale of this is to check out your customers/clients carefully before extending significant credit. 

This is a surprisingly controversial part of business law. And, as with most things, there is not a right or wrong answer to this debate (despite what some people may say).  It is important for people to understand why this is out there, and what it can mean for you and your company.

And, as always, if you have any questions or want to discuss how this affects your business in particular, please just contact us.  If you have any comments please let me know by posting below.