Does Limited Liability Matter?

In 1911, Nicholas Murray Butler (president of Columbia University and winner of the Nobel Peace Prize) wrote that the limited liability corporation is the greatest single discovery of modern times. It has since become one of the most common organizational structures, providing that, if a firm incurs losses and goes bankrupt, its shareholders can only lose the money they have invested in the firm. This sounds significant, but is limited liability really that important for firms? In a new paper, we address this question by using a unique Canadian setup. We use the enactment of limited liability legislation across Canadian provinces to examine the effect of the change in liability status on firm outcomes for a group of Canadian public firms known as income trusts. An income trust was structured so that a corporation’s business income was paid to the trust, mainly in the form of deductible interest payments. The cash was then distributed to the trust’s unit-holders, reducing the underlying corporation’s taxes to zero and maximizing investor payouts[1]. We show that the switch from unlimited to limited liability for income trusts that occurred in the early 2000s led to an increase in firms’ net external financing, investments, profitability, payout activities, and equity volatility. We document stronger results among capital-intensive firms. Our conclusion is that limited liability matters a great deal.

Enactment of the Liability Acts for Canadian Income Trusts

There are several reasons why there is a dearth of academic research on limited liability.  First, the change in legal status from unlimited to limited liability is rarely observed. Second, current empirical tests face identification problems: The liability status is chosen by the firm. The prospect of this choice can have serious consequences on the estimates from empirical tests, leading the researcher to potentially draw incorrect conclusions.

In our paper, we use a quasi-natural experiment to study the effects of limited liability on firm outcomes, alleviating the previous empirical challenges. Our setup, in which the switch from unlimited to limited liability is imposed by changes in law, is unique. Our sample consists of 70 income trusts from a wide range of businesses, such as restaurants, consumer products, transportation, industrials, and oil and gas.

The Impact of Limited Liability

Our results indicate that the limited liability structure is indeed important. First, we examine the change in market value around the switch from unlimited to limited liability. We conduct an event study around the enactment of the liability acts. Our event study results show positive and highly statistically significant cumulative abnormal returns (CAR) around the announcement dates of limited liability legislation.

We next investigate how accounting outcomes for income trusts change around the switch to limited liability. We find that the switch has a different effect on capital-intensive trusts (those trusts operating in the energy sector) and other business trusts. After the change in the liability status, energy trusts increase their net external financing by 18.1 percent. We also find an increase in debt financing for both energy and business trusts. The results are consistent with the notion that unit-holders (the equity investors in income trusts) are more willing to raise external financing after the switch in liability status, since they are no longer bearing the risk of personal liability beyond their initial investments.

We further document an increase in assets for both energy and business trusts, and an increase in capital expenditures by 17 percent for energy trusts, following the switch in liability status. The evidence also suggests that these investments are productive, as we find that profits and payouts increase for energy trusts. In addition, for business trusts, we find an increase in the selling, general, and administrative (SG&A) expenses, which indicates that business trusts increase their investments in intangible assets, such as brand equity.

Additionally, we find an increase in equity volatility for both energy trusts and business trusts, which supports the idea that after the liability acts, unit-holders are willing to take on more risk. However, we do not find any evidence that unit-holders take advantage of debt-holders through risk shifting. The likely explanation is that our trusts have relatively low leverage, and the risk-shifting phenomenon should mainly be present among highly levered firms.

Overall, we contribute to the discussion on the effects of limited liability on firms. Our results support the notion that limited liability provides firms with greater access to capital. That in turn increases firms’ investment activities, profitability, and payouts, resulting in higher shareholder value. Our results on the increases in external financing and investments following the liability acts are the first to document the real effects from the change in a firm’s liability status. As the liability risk of income trusts in Canada was perceived to be remote before the liability acts, we believe the statistically and economically significant results we present provide a lower bound on the importance of limited liability on firms.


[1] However, the preferential tax treatment for income trusts ended when the government enacted the Fairness Tax Plan (FTP) on October 31st, 2006.

This post comes to us from Yrjö Koskinen, Nga Nguyen, and J. Ari Pandes at the University of Calgary’s Haskayne School of Business. It is based on their recent article, “Does Limited Liability Matter? Evidence from a Quasi-Natural Experiment,” available here.