Does Limited Liability Matter: An Analysis of California Firms, 1920-1940

Abstract

In 1931, California became the last U.S. state to adopt limited liability for stockholders. Prior to that, from its inception as a state in 1849, stockholders of California corporations faced pro rata unlimited liability. California’s unique liability rule during 1849-1931 provides a natural experiment for testing whether stockholders’ liability rules “matter.” Using a small sample of publicly traded California firms and a corresponding sample of benchmark companies, we find that California firms realized annual excess returns that were approximately nine percentage points higher than other companies during the 1920s, which is consistent with the view that unlimited liability increases the expected returns on equity. We also find that excess returns for California firms were approximately -12% in October 1929, which suggests that the 1929 stock market crash put the personal assets of stockholders of California firms at risk We find that share turnover was significantly lower for California firms than other firms during the period California had unlimited liability, but not so after California adopted limited liability. Finally, we find weaker evidence that California firms had more leverage, lower asset risk, and less growth as compared with other firms during the period it had unlimited liability. Overall, the results suggest that rules regarding stockholders’ liability matter for the pricing of securities, share turnover, and various corporate policies.