Limited Liability: Large Company Theory and Small Firms
| DOI | http://doi.org/10.1111/1468-2230.00267 |
| Published date | 01 May 2000 |
| Author | Judith Freedman |
| Date | 01 May 2000 |
THE
MODERN LAW REVIEW
Volume 63 No 3May 2000
Limited Liability: Large Company Theory and Small
Firms
Judith Freedman*
Current enthusiasm for the `enterprise culture’ results in strong support for easy
access to limited liability forms of business organisation. This has manifested
itself in the creation of new limited liability vehicles such as the LLC and the LLP.
The UK Company Law Review is examining ways of enhancing the attractiveness
of the limited liability company to small business owners. This article examines
the claims made for the `efficiency’ of limited liability and the applicability of
these claims to small firms. It raises the importance of taking into account public
policy issues beyond economic efficiency when considering the degree of risk
taking and shifting to be encouraged. The article concludes that, although it is
difficult to find rational methods of restricting access to limited liability, it does
not follow that limited liability should be positively encouraged for all small firms.
It is important to signal the limitations of limited liability.
Introduction
New limited liability forms of business organisation are in vogue. Limited liability
is widely regarded as a mechanism that encourages entrepreneurship and makes a
major contribution to the law of business organisations.1Popular and political
sentiment proclaim: ‘the more limited liability the better’.2In the USA, the Limited
Liability Partnership (LLP) and the Limited Liability Company (LLC) have
emerged over recent years as frequently used and strongly supported new legal
forms of organisation. The UK is following suit, with its own LLP, originally
intended for the regulated professions only, but now to be available to all types of
user.3The Company Law Review Steering Group in the UK is working on the
ßThe Modern Law Review Limited 2000 (MLR 63:3, May). Published by Blackwell Publishers,
108 Cowley Road, Oxford OX4 1JF and 350 Main Street, Malden, MA 02148, USA. 317
*Law Department, London School of Economics. I am grateful to R. Baldwin, P. L. Davies, V. Finch,
C. Norberg, J. K. McNulty and the two anonymous referees for their helpful comments.
1 For some examples of this contention see J. Freedman and M. Godwin, ‘Incorporating the Micro
Business’ in A. Hughes and D.J. Storey (eds), Finance and the Small Firm (London: Routledge, 1994)
(hereafter Freedman and Godwin (1994)); A. Hicks, ‘Corporate Form: Questioning the Unsung Hero’
[1997] JBL 306.
2 For recent pronouncements and comments to this effect, see ns 17, 38, 132 and text to n 66 below.
3 The Limited Liability Partnerships (LLP) Bill was introduced into the House of Lords in November
1999. See also Department of Trade and Industry (DTI), Limited Liability Partnerships Draft
Regulations: A Consultation Document URN 99/1025 (London: DTI, 1999); Trade and Industry
Committee, Fourth Report Draft Limited Liability Partnership Bill HC 59 (1999) para 38; J.
Freedman and V. Finch, ‘Limited Liability Partnerships: Have Accountants Sewn up the ‘‘Deep
Pockets’’ Debate?’ 422 [1997] JBL 387; A. Griffiths, ‘Professional Firms and Limited Liability: An
premise that access to limited liability should be unrestricted and attractive to small
business owners.4
The objective of this article is to question the notion that easy availability of
limited liability for small firms is necessarily a desirable feature of a system of
business organisations. The purpose here is purely to examine the theoretical
arguments on limited liability and their application to small, owner managed firms.
The empirical evidence, as well as other aspects of the legal needs of small firms,
are reviewed elsewhere.5This article does not consider whether internal
governance needs might justify the introduction of specialist limited liability legal
forms for small firms. This is an important question, but the preliminary issue,
dealt with here, is to consider the importance of making limited liability widely
available to small, closely held firms.6
The first part of this article poses some broad questions about the tests to be
applied in assessing the value of limited liability for small firms and suggests that
economic efficiency must be weighed in the balance with other factors. The second
part discusses the trend towards extension of limited liability through new legal
vehicles or deregulation of existing legal forms. It introduces the USA debate on
LLCs in order to provide context for the later theoretical discussion, which is based
in part on literature arising from the surge of interest in the applicability of limited
liability to small firms in the USA inspired by the LLC. The current UK position
on limited liability for small firms is also outlined. The third part of the article
discusses the debate on limited liability for firms in general. It shows that the
economic advantages of limited liability are now being questioned in some
contexts and are, in any event, unconvincing when applied to small, closely held
companies. This part goes on to describe the difficulties encountered in restricting
access to limited liability to those firms for which such a regime does appear to be
suitable.
The fourth part of this article considers the application of economic efficiency
tests to LLCs. It questions whether the legislative popularity of the LLC in the
USA can be attributed to the characteristic of limited liability rather than other
factors. It argues that the development and rapid uptake of the LLC in the USA is
not in itself an indication that limited liability is efficient for small firms, either for
the owners or the community more generally. In part five it is concluded that
limited liability is not desirable in all circumstances, whether judged by economic
or non-economic tests. It is difficult to find a rational method of restricting access
to limited liability forms of business organisation, but it does not follow that
Analysis of the Proposed Limited Liability Partnership’ [1998] CfiLR 157; A. Griffiths, ‘Structuring
the Law of Private Limited Companies Through the Next Millennium’ in D. Milman (ed), Regulating
Enterprise (Oxford: Hart Publishing, 1999).
4 The Company Law Review Steering Group, Modern Company Law for a Competitive Economy: The
Strategic Framework, (London: DTI, 1999) (hereafter The Strategic Framework) para 5.2.10 and
question 10 and see text to n 66 below.
5 DTI Company Law Review: The Law Applicable to Private Companies URN 94/529 (London: DTI,
1994); J. Freedman ‘Small Business and the Corporate Form: Burden or Privilege?’ (1994) 57 MLR
555 (hereafter Freedman (1994)); Freedman and Godwin (1994), n 1 above; Andrew Hicks, Robert
Drury and Jeff Smallcombe, Alternative Company Structures for the Small Business (London:
Chartered Association of Certified Accountants, 1995) (hereafter ACCA Report) and contributions
from a number of authors in Barry A. K. Rider and Mads Andenas (eds.), Developments in European
Company Law,Vol 2/1997: The Quest for an Ideal Legal Form for Small Businesses (London: Kluwer
Law International, 1999); The Strategic Framework,ibid.
6 The term ‘closely held firms’ is used here to mean firms which are owner managed with few or no
outside investors. Further work is under way on the internal governance issues as part of the Company
Law Review – see The Strategic Framework,ibid.
The Modern Law Review [Vol. 63
318 ßThe Modern Law Review Limited 2000
limited liability should be positively encouraged for all types of firm. The creation
of new limited liability vehicles, or attempts to further increase use of existing
limited liability forms by small firms, may encourage firms which were previously
run as sole traderships and general partnerships to take on the mantle of limited
liability. Such developments could mislead business owners about the value of
limited liability for themselves as well as sending out unfortunate signals that both
undermine the importance of personal responsibility for business actions and result
in transfers of risk to those least able to bear them.
Limited liability: economic analysis and alternative tests
Much of the literature discussed below evaluates limited liability on the basis of
economic analysis. This approach measures limited liability in terms of economic
efficiency,7posing three central questions. First, does limited liability allocate risk
to those most capable of bearing it? Secondly, does it result in optimal levels of
risk taking, ensuring that ventures with a net positive value to society, but not
others, are undertaken? Thirdly, does it reduce transaction and monitoring costs? In
this literature, these measures of ‘efficiency’ operate within an overall framework
of profit maximisation. All forms of satisfaction can be incorporated into this
concept, but they must be given a value in monetary terms. This may lead to many
interests and values being hidden or cancelled out simply in order to produce a
workable model.8Economic analysis assumes that a society with greater wealth,
measured in terms of profit maximisation, is necessarily better off than a society
with less.9Self-interest remains the guiding force in this world: all is explained
through this medium.10 In broad terms the test of efficiency used by these analysts
(the Kaldor-Hicks test) is whether the aggregate benefits of the system exceed the
costs to such an extent that the winners could compensate the losers.11
As will be seen below, even accepting the measures and approach of economic
analysis, there are strong arguments in support of the view that limited liability is
not efficient for the smallest firms. In addition, it is argued here that efficiency is
not the only test to be applied. Other values must also be weighed in the balance.12
These other values should be seen as moderating the efficiency test, not simply
contributing to it, although they are sometimes explained away in terms of
efficiency by the economic analysts.13 These underlying considerations, reflecting
society’s values, need to be exposed and discussed in order to ensure that legal
policy does properly reflect moral and political criteria. The danger is that they will
be lost under an all subsuming cloak of ‘efficiency’. There may come a point at
7 For the different types of efficiency and generally an excellent discussion of the relevance of
economic analysis to company law see S. Deakin and A. Hughes, ‘Economics and company law
reform: a fruitful partnership?’ (1999) 20 Company Lawyer 212 (hereafter Deakin and Hughes). See
also S. Deakin and A. Hughes, ‘Economic Efficiency and the Procedularisation of Company Law’
[1999] CfiLR 169; C.W.Maughan and S.F.Copp, ‘Company law reform and economic methodology
revisited’ (2000) 21 Company Lawyer 14.
8 G Lawson, ‘Efficiency and Individualism’ (1992) Duke Law Journal 42:1 53.
9 R. Dworkin A Matter of Principle (Oxford: Clarendon Press, 1986) 237.
10 R. Posner, Economic Analysis of Law (New York: Aspen Law and Business, 5th ed, 1998) 3.
11 Note that there does not need to be actual compensation. Kaldor-Hicks efficiency is easier to achieve
than Pareto efficiency, which would require someone to be better off and no-one to be worse off: see
Jules L Coleman, Markets, Morals and the Law, (Cambridge: CUP, 1988) chapter 2; Brian R.
Cheffins, Company Law: Theory, Structure, and Operation (Oxford: Clarendon Press, 1997) 14–16.
12 Deakin and Hughes, n 7 above, 217.
13 Deakin and Hughes in CfiLR, n 7 above, 171.
May 2000] Limited Liability and Small Firms
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