Organizational law empowers firms to hold assets and enter contracts as entities that are legally distinct from their owners and managers. Legal scholars and economists have commented extensively on one form of this partitioning between firms and owners: namely, the rule of limited liability that insulates firm owners from business debts. But a less-noticed form of legal partitioning, which we call "entity shielding," is both economically and historically more significant than limited liability. While limited liability shields owners' personal assets from a firm's creditors, entity shielding protects firm assets from the owners' personal creditors (and from creditors of other business ventures), thus reserving those assets for the firm's creditors. Entity shielding creates important economic benefits, including a lower cost of credit for firm owners, reduced bankruptcy administration costs, enhanced stability, and the possibility of a market in shares. But entity shielding also imposes costs by requiring specialized legal and business institutions and inviting opportunism vis-d-vis both personal and business creditors. The changing balance of these benefits and costs illuminates the evolution of legal entities across time and societies. To both illustrate and test this proposition, we describe the development of entity shielding in four historical epochs: ancient Rome, the Italian Middle Ages, England of the seventeenth to nineteenth centuries, and the United States from the nineteenth century to the present.
Date of Authorship for this Version
Hansmann, Henry; Kraakman, Reinier; and Squire, Richard, "Law and the Rise of the Firm" (2006). Faculty Scholarship Series. 5058.