LIMITED LIABILITY CORPORATIONS

Limited Liability Corporations

Limited Liability Corporations

Introduction

Why are publicly mandated rules leaving owners' liability unlimited imposed on selected industries? Although the literature contains many recent examinations of the nature of the firm under different liability regimes, little of policy relevance emerges from the discus- sion. The most efficient policy would be to allow freedom of choice on liability-to permit the market to choose the most efficient rule. Currently, in many jurisdictions, most firms have the freedom to choose liability rules. This freedom, however, is not universal; some firms have no choice. For example, in service professions such as accounting, law, and medicine, owners of firms typically are forced to accept unlimited liability. There is another example. In Scotland until the middle of the nineteenth century, any bank could issue notes. Only three banks (located in Edinburgh) had limited liability in their charters; all others until 1879 faced de facto unlimited liability for note issue imposed by Parliament. Why should any jurisdiction man- date a liability rule? What are the effects of these rules? These are the unanswered questions that we address.

An understanding of the relative efficiency of alternative liability rules sheds no light on these questions. One potential explanation lies in an externalities argument: a public-interest approach. Suppose that consumers of a product are inadequately informed about its potential risks. The market failure argument maintains that unlimited liability provides protection to the uninformed consumer: An increase in potential liability to the supplier reduces the expected return from fraud by increasing the penalty if fraud is detected and therefore deters chiseling on product quality. The net result, according to this argument, is a reduction in the risk to the consumer from misleadingly low quality products or services. Similar arguments maintain that unlimited liability provides needed protection to the uninformed creditors of firms: Knowledgeable managers or owners cannot exploit for their personal advantage uninformed suppliers of financial capital (debt) or other inputs.

Growth Of LLCs

LLCs are created pursuant to state statutes and provide businesses with a relatively new set of organizational options. Most state statutes became effective during the 1990s, and as of July 1, 1996, all fifty states and the District of Columbia had enacted LLC statutes.3 The data we use in this study indicate that the number of LLCs increased from a negligible amount in 1990 to about 2 percent of businesses in the mid-1990s and to more than 5 percent of all businesses in 2000. The large growth in LLCs occurred primarily because the entity combines the attractive features of both partnerships and corporations. LLC members (i.e., owners) receive limited liability that was once only afforded to corporate shareholders or for nonmanager limited partners. Members may also gain the flexibility and tax advantages of a partnership (e.g., lack of a double tax on distributed earnings and pass through of losses) by making the election to be taxed as a conduit entity. The LLC is generally superior to an S Corporation because it is more flexible and there are no limits on ...