THE COSTS AND

BENEFITS OF LIMITED
LIABILITY
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The costs and benefits of limited liability

Benefits:

Encourages investment as the liability of the members is limited to

the value of the shares they hold.

Encourages risk taking as the members feel sure that if things go

wrong they will not loose everything.
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Not only does limited liability protect a company’s shareholders from
creditors, it also puts business assets of an individual out of the reach
of that individual’s personal creditors. In Prest v Petrodel Resources
Ltd we saw that by placing the assets in the company, they were
essentially removed from the marriage (although they still went to
Mrs. Prest as the court found a resulting trust). So if a shareholder is
insolvent, the personal creditors can take the shares, but not the
assets of the company.
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Although limited liability seems to do a disservice to
creditors, it has in a way benefited them too as they
have been forced to protect themselves against the
risk in various ways: secured lending (fixed and
floating charges), risk premiums in the interest
charged, board representation so they can monitor
the company’s direction
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Disadvantages

Risk is moved to the creditors, not all of which, can protect

themselves against that risk by charging higher interest premiums or
being represented in the company’s board e.g. small trade creditors
stand to loose heavily in the case of an insolvent liquidation.

Powerful secured creditors also get priority over the weaker, most
vulnerable creditors in the event of a company’s insolvency.
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Employees also stand to loose heavily in the case of a company’s
insolvency as they are given no priority over the powerful secured
creditors who have fixed charges over the most valuable assets.

The most distirbing use of limited liability can be seen in group

structures, where creating one gives a double limitation of liability not
only for themselves but also for the parent company. Limitation of
liability can be achieved through the creation of subsidiaries.
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An example of the aforementioned principle:

• Fred, Nancy, Dougal and Mat are shareholders in M Ltd, the parent
company.

• M Ltd has wholly owned subsidiaires N Ltd, Y Ltd and X Ltd and has
assigned them various duties.

• All the profits of the subsidiaries flow back to M Ltd.

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• Y Ltd goes into liquidation

• Would M Ltd, the parent company be liable for Y’s debts? Due to the Salomon
principle, probably not.

• And again due to the Salomon principle, there is also no question of Fred,
Nancy, Dougal and Mat being personally liable for the debts of Y Ltd or M Ltd
at all.

• So with the above example, we can see how limited liability can especially
benefit group structures.