Piercing the Corporate Veil, Financial Responsibility, and the Limits of Limited Liability
Washington and Lee University - School of Law
Washington & Lee Public Law Research Paper No. 03-13
This article takes a fresh look at veil-piercing jurisprudence, a notoriously incoherent area of the law. I argue that a sensible approach to veil-piercing requires careful attention to the appropriate policy basis for limited liability. Despite heroic efforts of some commentators, shareholder limited liability for contract as well as tort claims and for public as well as closely-held corporations cannot be defended on efficiency grounds alone. Instead, limited liability should be understood as an effort to subsidize business activity by redistributing wealth from corporate creditors to shareholders. The subsidy idea is more obvious as to tort claimants, but it may also be at work in the contract area too. Contract creditors have the opportunity to bargain for compensation for the increased of risk of nonpayment presented by limited liability. Nevertheless, recent research in behavioral economics suggests that the limited liability default rule may have distributional consequences in this setting as well. If limited liability amounts to a subsidy paid by contract and tort creditors to business investors, the policy question then is, how large should this subsidy be?
I argue that overly broad limited liability imposes too great a cost on corporate creditors. This is because limited liability can facilitate opportunistic efforts by shareholders to extract value from third parties without consent or compensation. They can do this by increasing the risk of corporate default beyond the level accepted by contracting parties or by engaging in risky activities that have the potential to cause harm that the corporate tortfeasor cannot redress. One consequence of the threat of opportunism is to raise the cost of credit for all corporate borrowers ("good" as well as "bad" types). If the purpose of limited liability is to encourage investment by shielding shareholders from the risk of corporate insolvency, the social costs of this benefit may therefore be too high. The scope of limited liability should instead be restricted to cases of corporate insolvency that occur in spite of shareholders' good faith efforts to manage their firm in a manner that respects creditor interests. This limitation would still provide investors with protection from what should be their real concern, the possibility of corporate insolvency arising from events or circumstances that cannot be foreseen or avoided.
I propose that courts limit limited liability to shareholders who have managed their corporation in a financially responsible manner. As to contract creditors, this means realistic evaluation of the corporation's ability to repay a debt at the time it is incurred and avoidance of actions that unreasonably increase the risk of default thereafter. As to potential tort victims, shareholders act responsibly if they purchase liability insurance against foreseeable risks. Financial responsibility thus has nothing necessarily to do with the amount of capital contributed to the business at its outset, a factor often emphasized in veil-piercing litigation. Once the appropriate limits of limited liability are understood, courts can pierce the corporate veil in order to hold shareholders personally liable for losses that result from their irresponsible behavior.
Number of Pages in PDF File: 93working papers series
Date posted: October 2, 2003
© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo2 in 0.844 seconds