Evolution ofCorporate Law & Finance
Business Associations Section 7b
Law: Development of thefirm’s legal traits
Prof. Amitai [email protected]
College of LawUniversity of Illinois
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LawOverview of Section 7b
1. Regulation of financial transactions Early views on lending & money Regulation of lending by the Catholic Church Regulation of lending in the common law & 20th century U.S.
2. History of the corporate entity3. History of corporate governance
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LawFirm’s legal traits
Independent legal personality Asset partitioning
Limited liability (SH not liable for C’s obligations) C not liable for SH’s liabilities
Investor ownership (C acts to maximize SH welfare) Centralized management
Managerial agency problem (holding managers accountable to SHs) Majoritarian agency problem (protecting minority SHs)
Exit-focused dispute resolution Restrictive dissolution / perpetual existence Transferable shares Capital lock-in
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LawDevelopment of firm’s legal traits
Independent legal personality Asset partitioning
Limited liability (SH not liable for C’s obligations) C not liable for SH’s liabilities
Investor ownership Whose welfare does C maximize? (SHs)
Centralized management Managerial agency problem (holding managers accountable to SHs) Majoritarian agency problem (protecting minority SHs)
Alienability of ownership (exit-focused dispute resolution) Restrictive dissolution / perpetual existence Transferable shares Capital lock-in
a4
b2
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b3
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c3
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LawCorporation’s legal traits
But before we discuss corporate law, let’s discuss the evolution & regulation of financial transactions Evolution & regulation of financing techniques
Bilateral lending (usury laws) Bills of exchange & other payment systems Bond financing
Evolution & regulation of financial intermediaries Banks Securities exchanges Insurance
LawOverview of Section 7b
1. Regulation of financial transactions2. History of the corporate entity
Demand for limited liability Early forms of limited liability Pre-modern attitudes towards limited liability Could limited liability have developed without corporations? The evolution of limited liability in corporations Asset partitioning and the development of business entity law
3. History of corporate governance
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Why (or when) islegal personality important?
We already discussed that in section (a)2(Biz entity vs. contract)
Use of a business entities (rather than Ks)benefits from economies of scale Contracts are easily tailored to specific needs
of parties But if there are many parties involved,
managing all the relationships is very complex
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Why (or when) islimited liability important?
“[I]f [limited liability] simply does not matter—then what are we to make of our inherited wisdom that it was key to the emergence of the modern business organization and thus to the development of modern commercial society?
[…] Clearly, limited liability meant something to someone. The question is what and to whom?”
- Amalia D. Kessler, Limited Liability in Context: Lessons from the French Origins of the American Limited Partnership, 32 J. Legal Stud. 511 (2003)
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Explaining the popularity of thesole proprietorship
Sole proprietorships are, by far, the most common business entity in the U.S. Account for 66.4% of California 2002 tax returns (excluding
individuals and exempt organizations)
How can we explain the popularityof a business entity that doesn’toffer limited liability?
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Explaining the popularity of thesole proprietorship
Explanation 1: People are irrational or poorly informed
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Explaining the popularity of thesole proprietorship
Explanation 2(a): Personal liability not unique to SPs Bob, a wealthy businessman, forms Bobco, Inc. He invests $100 in the corporation, which has no other
assets. Bobco applies for a $10,000 loan from a bank. You are the bank manager. Under what conditions will you
lend to Bobco?
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Explaining the popularity of thesole proprietorship
Explanation 2(b): Some personal liability is avoidable even in a SP Carol operates a SP that owns a small apartment building
and collects about $3,000 in rent each month The building needs renovations that cost $10,000. Carol has
considerable savings, but would rather borrow money for the renovation so that she can deduct interest payments.
But she doesn’t want to be personally liable on the loan Will the bank agree to limit her liability?
Non-recourse loan
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Demand for limited liability Explaining the SP’s popularity
But what about torts?
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Demand for limited liability Explaining the SP’s popularity
Dan opens a solo law firm, and chooses to incorporate as DanCo, Inc. Assume that law firms are allowed to incorporate in that state
Dan forgets to file a client’s brief on time, and the client’s suit is dismissed.
The client sues for malpractice and wins a judgment. However, DanCo has no assets. Does the client have a cause of action against Dan
personally?
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Demand for limited liability Explaining the SP’s popularity
Disliking the costs and formalities of operating a corporation and seeing that it doesn’t protect him from malpractice liability, Dan dissolves the corporation and continues operating the law firm as a sole proprietorship
Again he commits malpractice Any difference in the liability?
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Demand for limited liability Explaining the SP’s popularity
Despite his gross negligence, Dan’s law firm prospers. To handle additional business, he hires two more attorneys as associates (the law firm remains his sole proprietorship).
One of Dan’s attorneys now commits malpractice in the course of working for Dan’s law firm. Dan was not consulted in the negligent actions, nor was he negligent in supervising the employee. Is Dan liable for the malpractice? Would he be liable if the law firm were a corporation?
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Demand for limited liabilitySumming up
Liability in Contracts Counterparty can waive personal liability But will insist on personal liability if firm is poorly capitalized Cost of individual opt-outs w/ # of contracts firm makes
Liability in Torts Owner directly liable for:
Torts she personally commits Torts of employees she failed to supervise
But not for torts of employees whom she has no duty to supervise
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Demand for limited liabilitySumming up
Liability in Contracts LL makes little difference when firm has few contracts LL saves costs as # of contracts increases & # of people in
firm who enter contracts increases Liability in Torts
LL makes little difference in firm in which owner is either sole employee of directly supervises all employees
LL reduces owner’s risk when: Firm has employees that the owner does not have to supervise Owner doesn’t work at firm (passive investor)
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Demand for limited liabilitySumming up
What does this tell us about the development of business entities? Little pressure for limited liability business entities in firms
that have few employees, and in which owners are employees and supervise others
We would expect to see increased pressure for limited liability business entities as firm has: More employees More contracts with third parties Passive investors Employees with skills that owners are unable to supervise
LawOverview of Section 7b
1. Regulation of financial transactions2. History of the corporate entity3. History of corporate governance
Evolution of the board of directors Intervention solutions to the agency problem: ultra vires & the BJR Voice solutions to the agency problem: shareholder voting Exit solutions to the agency problem: dissolution & dissociation
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The agency problemManaging the “Sleepyville Snoozers”
Sleepyville, a town of 1K people, has a minor league baseball team called the Sleepyville Snoozers Team breaks even but doesn’t make a profit
Olivia, a resident, hears that the owner is moving to another state & plans to move the team with him She suggests buying the team to keep it in town
Owner will sell for $10M Requires each resident to pay $10K $10K/person is too much for most residents And not all residents care about the team
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The agency problemManaging the “Sleepyville Snoozers”
Olivia instead suggests raising the money via internet Plan: 100K people will invest $100 ea. in Snoozer Inc. Snoozer raises $10M, buys team Team’s games to be broadcasted
live on internet to the owners
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The agency problemManaging the “Sleepyville Snoozers” Olivia’s plan for managing the team:
Team hires a coach Coach makes proposals Owners hold online vote on each proposal
Efficiency problem: Coaches unwilling to work under these terms. Why?
Agency problem: Olivia suggests instead that the coach will make all decisions himself, without owner interference Any risk that the coach will abuse his power?
Another solution? Hint: Gevurtz article
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The agency problemManaging the “Sleepyville Snoozers”
This is the central tension in corporate law
Efficient operation of the business
Minimizing agency costs(agent shirking/stealing)
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Solutions to the agency problem
Three Arch-types of solutions to mitigate the agency problem of insiders (directors/officers/controllers)
LitigatorySubstance: authority constraints; fiduciary dutiesProcedure: derivative actions;SH inspection rights
StructuralVoting for directors
Tying compensation to profits
MarketMarket for corporate control
Frequent need to raise capital
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Solutions to the agency problem
Litigatory
BJR (Allen, Hovenkamp)
Ultra vires (Hovenkamp)
Structural Market
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Solutions to the agency problem
Litigatory
Structural
SH voting (Dunlavy)(Democratic/Oligarchic)
Market
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Solutions to the agency problem
Litigatory
Structural Market
Frequent need to raise capital“Capital lock-in”
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Centralized managementFunctions of Boards of Directors
1. Advisory board Directors add value through their prestige and contacts Discouraged by increased focus on fiduciary duties
2. Supervisory board Directors add value through their supervision of the officers May be discouraged by liability for unknown problems
(conscious disregard of duties)
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Centralized managementFunctions of Boards of Directors
3. Executive board Directors add value through managing the company Common in small firms; problem in large firms: who
supervises BoD?
4. Representative board Directors monitor company on behalf of stakeholders that
they represent E.g., particular SH, labor union, government
Directors add value by creating trust between corporation & stakeholder
Can be combined with other roles (often supervisory)