Eli5: why the shareholders in a company are not liable to pay debts owed by the company?
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They are, but only up to the limit of what’s in the company assets.
When a company has financial issues, there’s an order on who gets paid first.
It’s broadly:
* The banks : loans are cheap vs. others forms of financing, but they get paid first.
* Tax Agencies / Employee wages
* Other Creditors
* If there’s any money left, then it goes to shareholders.
Shareholders in a company are not liable to pay debts owed by the company due to the concept of limited liability. Historically, business enterprises were organized as partnerships or sole proprietorships, where owners’ personal assets were fully exposed to the business’s debts and liabilities. This meant that if the business incurred significant debts or faced legal claims, the personal assets of the owners, including their homes and savings, were at risk.
The origins of limited liability can be traced back to Europe in the 19th century (with some earlier antecedents):
Joint Stock Companies and Early Limited Liability:
The concept of limited liability became closely associated with the emergence of joint stock companies during the 17th century. Joint stock companies were business entities that allowed multiple individuals to pool their capital by purchasing shares in the company. These early joint stock companies were often created for specific trading ventures, exploration expeditions, or colonial ventures. One significant example of an early joint stock company was the British East India Company, founded in 1600. The company allowed investors to buy shares and participate in the lucrative trade with the East Indies while limiting their liability to the amount invested in the company. This system of joint stock ownership provided a level of financial protection to investors and laid the groundwork for the development of limited liability.
The South Sea Bubble (1720) and the Limited Liability Lesson:
The South Sea Bubble was a speculative financial bubble that occurred in Britain during the early 18th century. In 1711, the British government established the South Sea Company to consolidate and reduce the national debt. The company was granted a monopoly on trade with South America, particularly with Spanish colonies, which were promising but highly uncertain markets. The South Sea Company’s shares experienced a rapid surge in value, drawing in numerous investors hoping to profit from the perceived lucrative opportunities. However, the company’s speculative bubble burst in 1720, resulting in a catastrophic financial collapse. Many investors lost significant amounts of money, and the episode revealed the dangers of excessive speculation and unbridled enthusiasm in financial markets.
The South Sea Bubble served as a cautionary tale, highlighting the need for responsible corporate governance and the importance of limiting investors’ liability. In the aftermath of the bubble, there was a growing realization that providing limited liability to shareholders could prevent excessive risk-taking and protect investors from total financial ruin.
France – Early Concepts (19th Century):
The concept of limited liability is often attributed to the French legal scholar and politician, Guillaume-Henri Dufour. In the early 19th century, Dufour proposed the idea of separating the legal personality of a company from its shareholders. He argued that the company should be treated as a distinct legal entity, responsible for its own debts and obligations. This separation would protect the personal assets of shareholders from the company’s liabilities.
United States – Early Adoption (19th Century):
The concept of limited liability was introduced to the United States through state-level legislation. In 1811, the state of New York passed a law granting limited liability to certain business entities, specifically manufacturing corporations. Under this law, shareholders were liable only for the amount they had invested in the company. Other states gradually followed suit and enacted similar laws, recognizing the benefits of attracting investment and promoting economic growth through limited liability.
United Kingdom – The Joint Stock Companies Act 1856:
One of the most significant milestones in the history of limited liability came with the Joint Stock Companies Act 1856 in the United Kingdom. Prior to this act, forming a joint-stock company required a special act of Parliament, which was a cumbersome and costly process. The 1856 act simplified the incorporation process and allowed companies to be formed with limited liability without needing a separate act of Parliament for each case.
Under this act, shareholders in joint-stock companies were only liable for the value of their unpaid shares in the event of the company’s insolvency. This change dramatically increased the popularity of the corporate form, paving the way for the growth of larger enterprises and capital-intensive industries during the Industrial Revolution.
Germany – The Limited Liability Act 1892:
Germany embraced the concept of limited liability with the passage of the Limited Liability Act in 1892. The act enabled the formation of limited liability companies (Gesellschaft mit beschränkter Haftung or GmbH). Shareholders of GmbHs were not personally responsible for the company’s debts beyond their capital contributions, fostering investment and entrepreneurial activities.
Development in Other European Countries:
Following the examples set by France, the UK, and Germany, other European countries began adopting the concept of limited liability into their corporate laws during the late 19th and early 20th centuries. This development contributed to the establishment of a more standardized legal framework for business entities across the continent.
Imagine a relative or close friend comes to you and says he needs $1,000 for his business. He’s gotten 99 people to give him $10 each and you’d be the 100th to get him $1,000. Your only risk is losing your $10. But on the upside, if the business is successful, you would get a share of that success which could be better than parking your money in a bank.
Now imagine if you did give him the money, you were also on the hook for 1 percent (your portion of shares) of any liabilities. That may not be really worth the risk and you may find it better to park your money in a savings account rather than risk near unlimited liability, potentially risking your home, future income, and assets. In this case, the risk isn’t worth it, and you don’t invest.
As you can see, limiting the risk to one’s investment makes it easier to convince people to invest.
In the 1500s people started organizing ships to travel to India and Indonesia to buy spices (which were cheap in those places where they were produced and super expensive in Europe). Spices were seriously expensive, pepper sold for twice its weight in gold!
One of the innovations that came from this burst of economic activity was the concept that a voyage was a separate entity from its financial backers. If the ship sank or was lost, the people who financed the voyage wouldn’t need to make the other investors whole. That meant that rich people could finance smaller parts of many voyages (since their wealth wasn’t being put at risk by each one) which also meant there was a lot more money to build ships and hire crews to go buy spices which also meant that more spices came to Europe, too.
This was a generally good thing (more people got more spices they wanted at lower prices and more crews and shipbuilders were employed than previously) so the concept expanded to other parts of the economy.
If a company goes under, the shareholders are last in line to get what’s left (if there is anything left) after the debts are paid
The reason shareholders are not liable for the debts is the same reason you’re not liable for your friend’s debts if you lend him the money to pay his credit card bill this month. His debts are his debts. The money you give him doesn’t change that.
Because the lender of the money agreed to condidions before lending the money.
Nobody held a gun to the bank’s head and said “you must lend to their corporation.”
Banks have a responsibility to do their own due diligence and ensure who they are lending to will pay them back.
I run a business and give credit to other businesses. If there is a credit dispute, my lawyer will go after the company, not individual employees or owners.
If I don’t get my money, that’s my problem, I should not have given that company credit.
I am employed by a corporation and it’s my job to review/approve credit arrangements and make sure my shareholders get paid.
If I fuck up, I might lose my bonus or get fired.
Because they already have. If the company goes majorly into debt to the point their stock price decreases or they go bankrupt altogether the shareholders have essentially paid for some of that debt as they would get less money back than they put in.
If you invested $5 in a company and then the company got insanely deep in debt it would be ridiculous for them to come and say “well you invested $5 and we took that but you’re involved so now we’re taking more money from you.” It would also be a potential avenue for fraud – start a company, get minor investors, pay an exorbitant amount of money for something from a business partner, don’t ever do any work to make money, extract even more money from the people who had only invested a little bit in the first place by going belly up and forcing those investors to pay the debt.
Why can’t a cat bark like a dog?
I saw a situation where someone was simply a passive shareholder and they were sued for back dividends.
Crazy case.
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