Corporate Personality, Limited Liability, Enterprise Groups and Piercing the
Veil: Critical
Limited Liability (LL) and the Corporation – Frank H Easterbrook and Daniel R Fischel
Introduction
Manne:
o Modern publicly held corporation with many small shareholders could not
exist without limited liability
o Without LL, to guard against risk, investors would reduce the number of
different firms he holds and monitor each more closely
LL does not eliminate the risk of business failure but rather shifts some of the risk to
creditors
Value of the firm might be maximised if creditors bear a substantial portion of the
risk of business failure
Posner:
o Creditors are appropriate risk bearers because they are less risk averse than
stockholders or have superior information
o Counter: creditors are generally more risk averse than stockholders; they
accept a lower rate of return on investment precisely because the
stockholders are wiped out first. Thus, stockholders take the most risk (their
returns being greater) and reap the gains if the firms do well
Risk averse = reluctance to take risk
Equity investors have the residual claim (they stand to gain or lose almost the whole
value), therefore they have incentives to invest in the amount of monitoring likely to
produce these gains (or avoid losses)
Debt investors are more likely to be ignorant since they have an ‘equity cushion’
o Equity cushion = exists if the value of the collateral (property of an entity that
is subject to security interests) exceeds the value of the creditor’s claim, thus,
the creditor is oversecured
Halpern, Trebilcock and Turnbull:
o LL is necessary for the existence of an organised securities market
o Otherwise, the value of shares would not be the same to every investor
o Different investors would attach different value to shares, depending on the
investor’s wealth, it would be impossible to conduct an organised liquid
market
Liquid market = many available buyers and sellers and comparatively
low transaction costs; easier to execute a trade quickly and at a
desirable price since there are numerus buyers and sellers and the
product being exchanges is standardised and in high demand
If LL was not provided by law, firms would attempt to create it by contract, but the
legal rule enables firms to obtain the benefits of LL at lower costs
The Rationale of Limited Liability
, The separation of investment and management requires firms to create devices by
which these participants monitor each other and guarantee their own performance
as neither group will be perfectly trustworthy
LL decreases the need to monitor:
o All investors risk losing wealth because of the actions of agents, thus, they
could monitor these agents more closely
o The more risk they bear, the more they will monitor
o However, diversified investors neither have the expertise nor the incentive to
monitor actions as only a small portion of their wealth will be invested in any
one firm
o LL makes diversification a more rational strategy, therefore, potentially
reduces the cost of operating the corporation
o Price shareholders pay reflect the risk they hold towards the managers’
actions
o Thus, managers find ways to offer assurances to investors without the need
of direct monitoring
o Overall, as investors’ potential losses are ‘limited’ to their investment as
opposed to their entire wealth, they spend less to protect their positions
LL reduces the costs of monitoring other shareholders:
o Greater the wealth of other investors, the lower the probability that any one
shareholder’s assets will be needed to pay a judgement
o Thus, existing shareholders would have incentives to engage in costly
monitoring of other shareholders to ensure that they do not transfer assets
to others with less wealth
o LL makes the identity of other shareholders irrelevant, avoiding these costs
LL makes it possible for market prices to impound additional information about the
value of firms:
o Without LL, shares would no longer have one market price
As, the value of shares would be a function of the present value of
future cash flows and of the wealth of shareholders; thus, not
fungible
Fungible = commodity whose individual units are essentially
interchangeable, and each of its parts is indistinguishable from
another part
o Investors would therefore be required to expend greater resources analysing
the prospects of the firm to check the price is “right”
o With LL, investors can accept the market price as given and purchase at a
“fair” price
LL allows more efficient diversification:
o Diversification enables investors to minimise their risks by owning a diverse
portfolio of assets
Diversification = mixing a wide variety of investment; a form of risk
management
o Without LL, diversification would increase risk as if any one firm went
bankrupt, an investor would lose his entire wealth
Veil: Critical
Limited Liability (LL) and the Corporation – Frank H Easterbrook and Daniel R Fischel
Introduction
Manne:
o Modern publicly held corporation with many small shareholders could not
exist without limited liability
o Without LL, to guard against risk, investors would reduce the number of
different firms he holds and monitor each more closely
LL does not eliminate the risk of business failure but rather shifts some of the risk to
creditors
Value of the firm might be maximised if creditors bear a substantial portion of the
risk of business failure
Posner:
o Creditors are appropriate risk bearers because they are less risk averse than
stockholders or have superior information
o Counter: creditors are generally more risk averse than stockholders; they
accept a lower rate of return on investment precisely because the
stockholders are wiped out first. Thus, stockholders take the most risk (their
returns being greater) and reap the gains if the firms do well
Risk averse = reluctance to take risk
Equity investors have the residual claim (they stand to gain or lose almost the whole
value), therefore they have incentives to invest in the amount of monitoring likely to
produce these gains (or avoid losses)
Debt investors are more likely to be ignorant since they have an ‘equity cushion’
o Equity cushion = exists if the value of the collateral (property of an entity that
is subject to security interests) exceeds the value of the creditor’s claim, thus,
the creditor is oversecured
Halpern, Trebilcock and Turnbull:
o LL is necessary for the existence of an organised securities market
o Otherwise, the value of shares would not be the same to every investor
o Different investors would attach different value to shares, depending on the
investor’s wealth, it would be impossible to conduct an organised liquid
market
Liquid market = many available buyers and sellers and comparatively
low transaction costs; easier to execute a trade quickly and at a
desirable price since there are numerus buyers and sellers and the
product being exchanges is standardised and in high demand
If LL was not provided by law, firms would attempt to create it by contract, but the
legal rule enables firms to obtain the benefits of LL at lower costs
The Rationale of Limited Liability
, The separation of investment and management requires firms to create devices by
which these participants monitor each other and guarantee their own performance
as neither group will be perfectly trustworthy
LL decreases the need to monitor:
o All investors risk losing wealth because of the actions of agents, thus, they
could monitor these agents more closely
o The more risk they bear, the more they will monitor
o However, diversified investors neither have the expertise nor the incentive to
monitor actions as only a small portion of their wealth will be invested in any
one firm
o LL makes diversification a more rational strategy, therefore, potentially
reduces the cost of operating the corporation
o Price shareholders pay reflect the risk they hold towards the managers’
actions
o Thus, managers find ways to offer assurances to investors without the need
of direct monitoring
o Overall, as investors’ potential losses are ‘limited’ to their investment as
opposed to their entire wealth, they spend less to protect their positions
LL reduces the costs of monitoring other shareholders:
o Greater the wealth of other investors, the lower the probability that any one
shareholder’s assets will be needed to pay a judgement
o Thus, existing shareholders would have incentives to engage in costly
monitoring of other shareholders to ensure that they do not transfer assets
to others with less wealth
o LL makes the identity of other shareholders irrelevant, avoiding these costs
LL makes it possible for market prices to impound additional information about the
value of firms:
o Without LL, shares would no longer have one market price
As, the value of shares would be a function of the present value of
future cash flows and of the wealth of shareholders; thus, not
fungible
Fungible = commodity whose individual units are essentially
interchangeable, and each of its parts is indistinguishable from
another part
o Investors would therefore be required to expend greater resources analysing
the prospects of the firm to check the price is “right”
o With LL, investors can accept the market price as given and purchase at a
“fair” price
LL allows more efficient diversification:
o Diversification enables investors to minimise their risks by owning a diverse
portfolio of assets
Diversification = mixing a wide variety of investment; a form of risk
management
o Without LL, diversification would increase risk as if any one firm went
bankrupt, an investor would lose his entire wealth
