Limited Liability Law, Corporations, and Moral Hazard

David Moss in When All Else Fails: Government as the Ultimate Risk Manager points out (pp. 67-8) that opponents of a Massachusetts limited liability law explicitly made the moral hazard argument:

Another common counterargument was the traditional one: that limitations on liability would encourage reckless behavior. This represented an early articualtion of the moral hazard principle, though the term itself was not used. "Men who are restrained only by the limits of their capital stock," Representative Sturgis maintained, "do not and cannot feel under the apprehension of those who are restrained, each one by his own personal jeopardy,to the amount of all his means: to the extent of his very livelihood.... Your best security always is in the apprehension of your debtor."

Nonetheless, when it came to removing all obstacles to passive investment in corporations, the fear of the moral hazard of irresponsible corporate managers did not carry the day. In 1830 Massachussetts passed a limited liability law.

Moss indirectly also points up a moral hazard of allowing corporations with unlimited liability. When the creditors of corporations could count on all investors to be responsible for the corporation's debt they were thereby encouraged to provide easy credit (p. 66):

the effect was to make credit abundantly available to corporate managers, allowing (and even encouraging) them to borrow recklessly and engage in wild speculation. This is precisely the opposite of what had been argued in 1809, when lawmakers figured that unlimited liability would help to rein in reckless investing.

In 1809 legislators were counting upon corporate investors with unlimited liability to rein in recklessness of borrowing by corporate managers. However, I suspect that Moss' point (p. 64) that "passive investors were largely at the mercy of the corporate directors who managed their companies" was probably most accurate even in ca. 1800. Corporate managers had much control and if creditors--because of unlimited liability--were enticing them with easy borrowing, this was a moral hazard created by the nature of the corporation itself. This situation could have been an argument against corporations.

However, the proponents of a limited liability law used the recklessness of borrowing under unlimited liability as an argument for corporations with limited liability. But corporations with limited liability also were subject to the moral hazard of irresponsible managers. Limited liability might have made creditors more cautious but corporate managers primarily responsible to passive investors still had incentives to be reckless with other people's money. In fact, if limited liability applied to corporate manager-investors it is conceivable there was more manager moral hazard with limited liability than unlimited. With unlimited liability creditors would have an incentive to tempt corporate managers, but managers themselves, with unlimited liability, would also have an incentive to resist temptation.