Corporate Veil

0 Analysis

It’s very important to understand why companies are granted ‘limited liability’. Based on the concept of economic efficiency, five reasons can be provided for the cause of granting limited liabilities to the companies.

Firstly and most importantly, limited liability decreases shareholder’s responsibility towards monitoring manager’s duties. This is primarily due to the fact that a shareholder’s financial consequences are limited if he chooses to invest in a certain company. Generally speaking, a shareholder does not have the expertise to monitor the duties of managers. Limited liability makes a shareholder investment strategy more diverse and rational.

Secondly, the principle of limited liability provides incentives to the managers of the company to act in the best interests of the shareholders by encouraging the free transfers of shares. There is a direct relation between promoting free transfers of shares and limited liability because under the principle of limited liability the wealth of other shareholders is not relevant. Motivation towards efficient management of company by managers is derived from the fact that managers always have the risk of replacement of incumbent management or takeover if they manage company inefficiently, given that shareholders can sell their shares at a discount if they are not satisfied with company’s efficiency.

Thirdly, limited liability also promotes efficient and viable operation of security markets. This is due to the reason that trading price of shares is independent of the wealth of individual shareholders (Fischel, 1991).

Fourthly, limited liabilities allows a company to borrow or raise capitols from its shareholders at a lower cost and also allows shareholders efficient diversification. Think of the case when a shareholder has unlimited liabilities, he could lose all his wealth in case of a failure of one company. In that scenario,