Evolution of Corporate Law & Finance Business Associations Section 7b Law: Development of the...

Evolution ofCorporate Law & Finance

Business Associations Section 7b

Law: Development of thefirm’s legal traits

Prof. Amitai [email protected]

College of LawUniversity of Illinois

Copyright © Amitai Aviram. All Rights ReservedS12D

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

© Amitai Aviram. All rights reserved.2

Copyright © Amitai Aviram. All Rights Reserved3

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


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

b2

b3

a3

c3

b3


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


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



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


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)


Why is ltd. liability important?


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?



Explanation 1: People are irrational or poorly informed



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?



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


Demand for limited liability Explaining the SP’s popularity

But what about torts?



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?



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?



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?


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



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)



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


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



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



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


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



This is the central tension in corporate law

Efficient operation of the business

Minimizing agency costs(agent shirking/stealing)


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



Litigatory

BJR (Allen, Hovenkamp)

Ultra vires (Hovenkamp)

Structural Market



Litigatory

Structural

SH voting (Dunlavy)(Democratic/Oligarchic)

Market



Litigatory

Structural Market

Frequent need to raise capital“Capital lock-in”


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)


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)

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