By Xinyu Hou, CERF Research Associate, Cambridge Judge Business School, University of Cambridge
For decades, Manville Corporation (formerly Johns-Manville) concealed the adverse health effects of the asbestos in its products. By 1982, the company was facing over 16,500 lawsuits and filed for Chapter 11 bankruptcy reorganisation to resolve the cases. Like other mass tort litigations involving public corporations, none of Manville’s shareholders were held personally liable for the damages caused by the company. Although the corporation established a pool of funds exceeding $2 billion to compensate claimants, the mounting claims soon dried out the pool, resulting in only a 5.1% payout rate for successful claimants as of 2019.
Limited liability and accountability
Without limited liability, shareholders would have been more cautious before investing in a toxic industry and would have had stronger incentives to monitor the firm. This could have potentially prevented corporations from engaging in practices that harm public health and the environment in a large scale. To clarify, limited liability refers to the legal concept of restricting the amount of liability to the assets of the company, shielding investors from personal liability. The question remains, why should shareholders of entities responsible for damages be absolved of any responsibility?
As we enter an age of innovation where AI, robotics, medical implants, and new materials are transforming our lives, this question becomes increasingly crucial. We should acknowledge that limited liability serves as a crucial safeguard to mitigate the risks of investing in a volatile market, enabling investors to take on risky projects and start new ventures. However, we must also recognise the potential damages that corporations can cause and the need to hold them accountable for their actions. Thus, it is important to strike a balance between limiting liability and holding corporations accountable for the harm.
The Coase theorem suggests that if there are no costs associated with contracting, such as fees for lawyers and accountants and information gathering, it would be optimal to allow voluntary creditors and shareholders to negotiate liability rules. However, since contracting is costly, the default legal rule should be the most likely contract that they would agree on, which is the limited liability rule. If the parties desire to switch to an unlimited liability rule, they could do so. However, if the creditors are tort claimants who are involuntarily involved in cases like Manville’s, it is hard to negotiate liability rules ex ante. In this situation, the legal system and policies should consider the interests of both parties, as well as the other stakeholders that might potentially benefit from the firms’ productivities.
Analysing the issue of limited liability
In my paper “Limited liability and scale,” I developed a simple theoretical model to analyse the issue of limited liability. While the paper has a law flavour, it is worth mentioning two notions of fairness that are often considered in the law literature on injuries. The first notion of fairness suggests that injurers should be held accountable for the harm they have caused, even if their actions were not wrongful, a form of “an eye for an eye, and a tooth for a tooth.” The second notion concerns compensation that makes the victims whole, which aligns with the Common law tort doctrine. While it would be interesting to discuss the philosophy of these two notions, my paper primarily focuses on the economic efficiency aspect, given that we want firms to conduct proper care while still encouraging innovation and scale.
The model considers a firm’s preferences for care and scale, and it shows that the optimal liability rule is determined by the tradeoff between damages to the tort claimants and benefits to the outside stakeholders, such as consumers, workers, beneficiaries of public services, or members of the community who benefit from job creation and reduced crime rates. We suggest that increasing liability induces better care but also raises marginal costs, which leads to less-than-efficient scale and even the holdup of a valuable project. Limited liability improves scale but reduces care, and it tends to be more efficient if the benefit from scale is large enough, i.e., when the outside stakeholders have a larger potential value.
This implies that a one-size-fits-all approach to liability is not appropriate. For firms with advanced technology and natural monopoly power, the choice of scale does not capture all the benefits and can be too small. In such cases, limited liability can help balance externalities and increase scale. Conversely, for firms operating in highly competitive markets (where products are easily replicable), full liability may be necessary to achieve social efficiency. This finding can also extend to the labor market where firms have varying levels of monopsony power.
This logic can be used to interpret policies. For instance, one reason for corporate income tax is that it can be seen as a safety net for tort claimants. If the only way that the firm is profitable is to generate tort claims, then imposing an income tax that takes away 40% of the upside may improve overall efficiency. The literature has studied policies such as requiring insurance and capital to improve limited liability, which in effect increase actual shareholder liability coverage. The model can be used to analyse the combined impact of these policies and limited liability as well.
Considerations in allocating liability
In practice, there is still another question to ask: how to allocate liability for firms with multiple shareholders if an extra liability is ideal? One possible solution could be to adopt the “joint and several” unlimited liability rule, which is commonly used in partnerships, where the creditors can go after the deep-pocket investors. This rule works better for closely held corporations but may not be practical for public corporations as it requires significant information gathering and verification. Additionally, the deep pockets could hide their assets strategically (such as through as trust fund) or find someone without assets to delegate their investments. Alternatively, a ‘pro rata’ liability rule, which assigns liability proportional to shareholding, could largely solve the information problem. This could be implemented by requiring partial liability coverage on top of the limited liability rule. However, the question of how to allocate liability becomes more complex when considering shareholders whose interests do not align, as well as bondholders who may also be responsible. These issues are not addressed in the current paper and is left for future studies.