Bus. Orgs. Ryan Fall 2012
Outline – Book
I. Economics of the Firm
i. Non-Controllable – risks that parties to a business venture cannot control, they cannot be completely eliminated
ii. Controllable – Might be able to be influenced, such as what product is best to use or sell
1. Risk Aversion (usually depends on amount of money at stake); Risk Seeking (you bet on coin flips); and Risk Neutrality (making decisions based solely on expected returns, and happy to take on a risk anytime it will generate a benefit on average) – People’s attitudes towards risk change as the amount of money at stake increases.
iii. Managing risk – The success of a business depends on how well it manages risk. Ways to manage risk:
1. Insurance: In purchasing insurance, a person or business pays a fee upfront, sometimes called an insurance premium, in exchange for the right to payment if a specified event occurs.
a. Insurance Pools: Your payment is drawn from the pool of insurance premiums. Each member of the pool bears a pro rata share of the pool’s total loss, which is easier to predict than the loss to any particular member
2. Diversifiaction – By participating in numerous ventures, each of which involves different risks. Diversification can take many forms from investing in different plots of land to stocks & Bonds – usually you want the risks to be different and independent from each other.
3. Allocation – Allocate risks to person who is most willing or best able to bear those risks, perhaps b/c she is in a better position ot insure or diversify
B. Allocating Risk
i. Principal & Agent – “Principal” refers to the role of investor/owner and “Agent” refers to the role of manager/employee. They have diverging interests
ii. Structuring the Business relationship
1. Contract & Law govern the relationship
2. “Shirking” – when a person does less than is optimal to control a risk.
C. Agency – “Agency Cost” – Costs that are inherent in the principle agent relationship and typically of three kinds:
i. Monitoring costs: Cost born by principle to ensure agenst are doing what they are supposed to be doing
1. Hire supervisors etc. to monitor employees
ii. Bonding Costs: you put up some money assets that would be held if you weren’t honest as you appear to be basically put up insurance policy that can be drawn against you engage in embezzlement and theft
iii. Residual Loss:
1. If Julia does everything on her own she gets 100%
2. Ernest however is an employee, his incentives – get paid the most for least work.
II. Some Basic Terms & Concepts
A. Types of Corporations
i. “Public” – Those whose shares are publicly traded on stock exchanges
1. Shareholders can sell their shares fairly easily & shareholders do not play a managerial role
ii. “Close” – Those without publicly traded stock
1. There is typically no ready market for the corporation’s securities and there is a substantial governance overlap among some or all of the participants.
iii. Subchapter C – Corporation and its shareholders are different taxpayers, and divdents are simply addt’l taxable income to shareholders. (double taxation)
iv. S Corporations – Most Public or Close Corporations are formed as “S Corporations” based on the provision of the Internal Revenue Code or Limited Liability Companies aka LLCs
1. Limited Liability Company –
a. Limited liability for all the owners,
b. The pass-through tax treatment and capital structure of a partnership, and
c. Almost complete internal flexibility in terms of management and control.
2. Limited Liability Partnership – Differs from general partnership only b/c certain partners by statute are relieved of personal responsibility for certain liabilities.
B. Coprorate Statutes
i. Coproate law in the US is largely a matter of State law
ii. In the absence of corporate statutes:
1. Little certainty and security in what law would apply
2. Federal govt might move in to expand its interest in corporate law (Commerce Clause)
3. Individuals would do business in much same way as they do now but with higher contract costs
C. Articles of Incorporation: All corporations have AoI aka Corporate Charter. They are the constitutional document of any corporation.
D. By-Laws: Rules/Procedures of how the corporation will be run. Usually held at corporate headquarters
E. Corporate Actors
i. Stockholders (Shareholders) – are said to actually ‘own’ the corporation they actually own the corporation’s stock
1. Elect the Board of Directors
2. Must give their approval before fundamental changes are made in the corporation (i.e., mergers or amendments to Articles of Incorporation)
ii. Board of Directors – act for the corporation w/ legal responsibility for managing or supervising the corps. Business
iii. Officers – President or VP
iv. Note: Public v. Close Corporation disctinction MUST be made first
1. Public – role of parties is often cleanly split, w/ shareholders playing a limited role
2. Close – shareholders are typically more active and wear several hats
v. Stakeholders – Creditors, employees, customers, community (top p.26)
F. Corporate Securities
i. Three basic types: Common Stock, Preferred Stock, Debt
1. Debt – Least risky w/ lowest return. Holder of debt receives fixed payments of interest over time. (aka Bonds or Notes)
2. Common Stock – takes greatest risk but has greatest return. Once corp. pays everyone, the common stock is entitled to whatever is left. Payment is made through dividends (Cash payments which corp makes at discretion of directors)
3. Preferred Stock – b/w common stock and debt (lower return than CS but higher return than debt). Also, holders may have priority to dividends before common stock holders.
G. Corporate Choice of Law Rule: The law of the state of incorporation, with rare exceptions, governs the “internal affairs” of the corporation. This means the relationships b/w owners (shareholders) and managers (directors/officers) are governed by the corporate statutes and case law of the stat where the corporation is incorporated.
III. Fiduciary Duties
A. Director Duties – Arise b/c of tensions b/w shareholders, who own the business, and managers, who control it. This responsibility derives from Fiduciary principles drawn originally from the law of Trusts
i. The basic fiduciary duties are of responsibility (care) and loyalty
1. Care/Responsibility – requires managers to be attentive and prudent in making decisions
2. Loyalty – requires managers to put the corporation’s interests ahead of their own
performance, supervision of the agent, the principal bears this cost
b. Usually the gains from monitoring exceed the costs
2. Bonding costs
a. The cost of obtaining a security bond to secure employment, (protects the agent in case agent shirks) the agent usually bears this cost
i. Shirking- when a person does less than is optimal to control a risk
3. Residual Costs
a. The reduction in welfare experienced by the principal that diverge from the agent’s actions
C. Allocation of Risks
i. Volatility risks
1. Ex. high 200, low 100, average 150
ii. Three types of people
1. Risk Neutral
2. Risk Averse
3. Risk Seekers
iii. People are generally risk averse with respect to gains, and typically are risk seekers with respect to losses
iv. Types of Risk
a. Ex. types of grapes
b. risks peculiar to a business
c. Can create incentives, monitoring devices, and sanctions to control risks
a. Ex. weather
b. Usually the principal is better able to deal with this risk by diversifying or insuring business
V. Corporate Federalism – CHAPTER 3
A. Enabling statute with default provisions greatly reduces contract costs – Enabling model which lawyers and legislators in DE create an optimal relationship b/w sources of capital b/w shareholders & managers – mostly grants management maximum “flexibility.”
B. In the absence of corporate statutes:
i. Little certainty and security in what law would apply
ii. Federal govt might move in to expand its interest in corporate law (Commerce Clause)
iii. Individuals would do business in much same way as they do now but with higher contract costs
C. For a merger- need an agreement of merger, need approval of board of directors and stockholders of both companies, and must be adopted by both
i. 8 Del. §251
ii. Example from Class Current Events: In news now: Kraft merges w/ Cadbury and this was ‘hostile’ not ‘freiendly’
1. Friendly: Welcome/solicited by the targeting company
2. Hostile: Unsolicited and frequently unwanted by the targeted company
a. Kraft proposed an acquisition proposal, usually done through a letter (‘Bear Hug Letter’).
b. What was the prob. w/ the initial offer Kraft to Cad? Too much stock & not enough cash (Kraft was offering Cadbury holders stock in merger but they wanted cash). Kraft then sweetened the offer w/ more cash and the agreement was formed.
3. It was “Bear Hug” b/c there was also a threat “if you do not enter into negotiation w/ us for merger by xyz date we will take our offer directly to the shareholders” – Back to corporate law