Advantages Of Limited Liability Rule

Broadly put, the economic benefits of limited liability rule arise from asset partitioning which includes risk allocation, economies of monitoring, economies of share transferability (capital market facilitation) and stimulates investment. This section discusses these benefits and under what condition will they be maintained.

The primary benefit of limited liability rule that is affirmed by scholars is risk allocation. Limited liability rule allows investors to diversify their investment by partitioning their asset to minimize the risk of losing all of their investment at once (don’t put your egg in one basket strategy). This particularly benefits “absentee investors” as written by Blumberg. In a sense, the rule has the advantage of letting

The monitoring capacity of shareholders as well as creditors (both voluntary and involuntary) is conditional on their access to information. Put differently, the cost of acquiring, processing and using information determines the monitoring capacity and cost. The economies of monitoring that arise from limited liability rule are two-fold. First, recall the discussion under the risk-allocation benefit of limited liability rule, which allows investors to diversify their portfolio. By doing so, they minimize the risk of losing their investment all at once and shift the risk to creditors. In the absence of limited liability rule shareholders would have faced high information and monitoring cost of both the operation of each firm/business they invested in and the financial viability of fellow shareholders (mutual monitoring). The reason is straight forward, because, a potential risk that arises both from maloperation of the firm as a whole and financial condition of fellow shareholders affects the shareholder’s exposure to liability and

This benefit of limited liability rule is a cumulative effect of all other benefits discussed above. The allocation of risk, free transferability of share and low monitoring cost certainly encourage investors to invest. Nevertheless, it is worth keeping in mind most of this benefits work efficiently when applied to protect ultimate individual shareholders than institutional investors, with the exception of free transferability of shares. Blumberg argues, the contribution of limited liability rule in the creation of the development of large enterprise, even though valid, it is somehow overrated. His justification for this claim is that most of capital investments flow from financial institutions rather than individual investors. As discussed earlier these institutions for most are in a better position in terms of information, monitoring and controlling and influencing the capital market. Hence, using limited liability rule to encourage investment by institutional investors makes less sense compared to ultimate individual