Eli5: why the shareholders in a company are not liable to pay debts owed by the company?
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Because thats the law, which is made so that people arent afraid to start companies, which is good for the economy.
Shareholders don’t have any of the actual money, or assets of the company, they just own shares.
And unless they own a controlling share, or a significant amount of shares they have no power to make decisions about what the company does.
Basically, under normal circumstances a shareholder is just someone who buys a share of a company, and in reward, either receives a small portion of profits, or just has the ability to sell the share for a profit if it becomes more valuable.
Asking shareholders to pay debts would be sort of like asking employees to pay debts.
Now the real question is why are shareholders and banks paid out when a company goes bankrupt before customers are? Customers who haven’t received a product they purchased are far more deserving of getting their investment back than banks or shareholders who invested knowing there was risk.
The short answer: because legally we decided that was the case. If a shareholder is liable for the debts of the company, it’s either a sole proprietorship (one owner) or partnership (multiple owners). Everything else, essentially, gets that special treatment (corporation, LLC, LLP, etc).
Why is it that way? I’m sure another commenter will have a better historical answer. But generally, the legal protections encourage risk, which does on net create more benefit than harm. We could not have built the society we have on sole props and partnerships, just like we can’t feed the society we have on artisanal local farms.
Answer: This is only partially the case. Debts get paid as a legally higher priority than shareholders. Companies always pay debt obligations before dividends (to shareholders).
If a corporation’s debts default, go to collection, or otherwise get liquidated, all debts get paid before a single shareholder gets a penny. If the company has a negative net value in default, shareholders get nothing. Not a penny, even after every chair and pencil gets sold.
Hypothetical – let’s say a stock is worth $100 in the market and owes $100 on a bond, but runs out of money and gets liquidated for a total of $101 after everything is sold. In that case, bond holders get $100 (fully paid) and shareholders get $1 (and a 99% loss on their taxes). So to be clear, in a failed company, shareholders get meaningfully more screwed than debtors. If liquidation yielded $99, it all goes to bond holders, but shareholders don’t owe the rest (more on that below).
There is anther legal point that applies to shareholders – they’re passive (not involved in operations of the company). As such, they do not have liability beyond the capital they provide (by legal structures). So their losses cannot exceed their investment. So if you invest money passively in a new car company that fails, you lose every penny of your investment, but not your private house and your car itself. This essentially prevents those operating a company (poorly) from treating their shareholders as ATMs.
That’s not to say that there’s never any funny business, but that’s how it’s supposed to work. The timing of debt payments, bankruptcy, and nested legal structures can complicate the base case. I’m not suggesting that outcomes are reliably fair.
The idea behind this system is that you should only be able to lose as much as you put in to begin with. So if your shares are worth 1 million, you can’t lose more than 1 million, which of course you would pay by simply liquidating those same shares when the company goes bankrupt.
Of course, this draws the expected criticism that you can lose no more than you put in, but you can gain far more than that…
In UK law, they are, but only up to the level they have invested.
Compare to a sole trader, whose house / car / granny can be seized to satisfy creditors.
To be personally liable for a business debt, you have to personally guarantee it. A good example of this are SBA Loans in the US. Your typically sign as a personal guarantor and use your house as collateral. If I own a share of stock in Apple, I am not personally liable for their debt.
The trade off for not being liable to pay the debts of a company is that you can’t use the assets of the company for personal gain. So The Walton family can’t just go to Walmart and start grabbing things off the shelf or take money out of the register. They can only extract company assets if they are paid a dividend that comes with tax implications and rules. The creation of corporations makes the company a completely separate legal entity then the owners.
It’s the rules (law) and it is intended to encourage businesses to form.
The first principle of a fair rule, is that it should be known ahead of time. Anyone lending or contracting with a company knows ahead of time who is liable. So at the top level it is fair to allow a company structure to limit liability to only what has been put in.
But also for many small companies, the shareholders are actually liable for their debts, when they’ve agreed to it. For instance, banks sometimes make small business loans that require the principal to separately guarantee the loan. This is known and agreed upon beforehand, and makes it possible to access bigger loans than the bank would otherwise be comfortable with.
It’s generally not a good idea to have people be liable for the poor decisions of other people. When you buy stock, you are buying a piece of a company, but other than voting once a year, you don’t have a say in how the company is run. A lot of pension funds and retirement accounts are funded with stocks. It makes it real hard to plan for retirement if one can be subjected to unlimited losses.
Because the shareholders are not liable for any debts, they are also the last to get paid if the company goes bankrupt. Secured creditors get paid first, basically any debts backed by real property such as land, buildings or equipment, these get sold off to pay those debts. Secondly, preferred creditors get paid. These are paychecks for the employees currently working and legal fees for the lawyers who are winding down your company and also includes bills due like keeping the lights on and paying for goods purchased on credit. Next, comes unsecured creditors, basically people who the company borrowed money from. If there are any subordinated debts, these get paid next. A company will sometimes offer a subordinate debt at a higher rate and people will take it knowing there’s a greater chance they won’t get paid. Afterwards, preferred stockholders are made whole. These are stocks that the company is obligated to pay a dividend to, but give up their voting rights. Finally, common stockholders are paid what is left, usually pennies on the dollar or nothing.
There used to be a type of stock called assessable stock. With this the company could ask for more money from the shareholders and if they didn’t pay up, the company could resell the stock. There was also capital assessable stock which was liable to pay debts in the case of bankruptcy. These went out of fashion in the 1930s. They weren’t a cause of the depression or anything, but they certainly didn’t help things.
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