The Economics of Limited Liability: An Empirical Study of New York Law Firms

Abstract

Since the rapid rise in organizational forms for business associations, academics and practitioners have sought to explain the choice of form rationale. Each form contains its own set of default rules that inevitably get factored into this decision, including the extent to which each individual firm owner will be held personally liable for the collective debts and obligations of the firm.

The significance of the differences in these default rules continues to be debated. Many commentators have advanced theories, most notably those based on unlimited liability, profit-sharing, and illiquidity, asserting that the partnership form provides efficiency benefits that outweigh any costs. In this article, the authors test these theories empirically by examining the choice of organizational form by New York law firms. Although the evidence indicates a strong shift from the general partnership form to the limited liability partnership form, a significant number of New York law firms remain general partnerships.

The authors conclude that the prevailing theories based on unlimited liability, profit-sharing, and illiquidity are insufficient and posit that, in contrast to the beliefs of many commentators, the choice of form decision is quite complex. It is dependent on a variety of factors, including the behavior of other similarly situated firms that the decision-makers consider competitors for prestige and clients. Nonetheless, it is apparent that unlimited liability is generally considered burdensome, and it is the authors' prediction that, at some point in time, nearly all the firms in their sample will choose to file as limited liability partnerships. The general partnership form, with its unlimited liability, will operate only as a penalty default that punishes parties who fail to sufficiently define their organization, forcing firm members to reveal relevant information to courts and interested third parties.

Keywords: partnerships, law firms, limited liability, empirical

JEL Classification: K22, L84