2 - What should be the Limits to Limited Liability?

Summary

What's the issue?

Limited liability has become a shield employed to protect value extraction and to justify behaviour that undermines the ability of UK companies to absorb financial risk, and this now presents a major moral hazard for society.

How should limited liability be reformed, to prevent abuse?

Analysis

The mid-19th-century reform of limited liability and company law conferred privileges on shareholder-investors that encouraged them to invest in projects that were financially high risk but socially beneficial. Shareholder liability was limited to their unpaid share capital, in return for which shareholders forfeited claims to outright company ownership. Each company was granted a separate legal identity with an overriding obligation to itself, including all of its other stakeholders.

But things have moved on a great deal during the century and a half since. Instead of investing in railways and other public infrastructure, the rise of financial engineering by investment banks, private equity and hedge funds has generated not only lucrative transaction fees, but also increased capital gains for shareholders. Companies now move funds around a complex network of tiered wholly owned subsidiaries to financially engineer returns on capital for shareholders.

In terms of regulatory governance, the UK government has delegated oversight of financial reporting and standard setting to the International Accounting Standards Board (IASB), whose remit is no longer confined to public limited companies, but is spilling over into other spheres of the economy, including small and medium-sized enterprises (SMEs) and the public sector (both central and local government enterprise accounts). The IASB's agenda has been framed by two central concepts: (1) that general purpose financial statements should present a ‘reporting entity’s’ financials; and (2) that the information disclosed by reporting entities should be ‘decision useful’ to investor-shareholders.

The economist's notion of the firm as a ‘unit of account’ has thus long since been abandoned by accountants who now use the IASB's concept of a ‘reporting entity’ – a company that can consolidate the financial activity of many firms. A parent company can also benefit, in its own right, from limited liability, as well as insulating itself from financial risks in wholly or partially owned subsidiaries.