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Business Organizations
Rutgers University, Camden School of Law
Beckerman, John S.

Profile
School: Rutgers-Camden School of Law
Class: Business Organizations
Professor: John Beckerman
Textbook: Corporations Law and Policy [Hardcover] by Bauman, 7th Edition (2010), ISBN 978-0-314-19138-0
Semester: Spring 2011
 
I) Corporations Basics
A)  Economics of the Firm
1)      Introductory Material
(a)    Basics of Business Law
(i)     Provides a set of default rules for different constituencies
·         Corp statutes help lower transaction costs by imposing a set of default rules
Þ     Without the defaults, parties would negotiate an agreement that resembles the default agreement
Þ     The defaults allow those in business to have a starting point to negotiate from
Þ     Enabling model – Model which allows lawyers and businesses to run businesses the way they see fit
(ii)   First source of business law is the governing state statute in the corp’s place of incorp.
(iii) Next you looks at the common law to fill the gaps
(iv) Default rules of statute may be altered w/ K
(b)   Restricted Stock Options and Options in General
(i)     From the perspective of a start-up, you want to attract execs that will work, hard, stay a while, and be motivated throughout their career – one way this is done is w/ restricted stock options
·         Stock options which cannot be exercised until certain conditions are met
·         Thought of as good bc they align the interests of the shareholders and managers
(ii)   Option – the right to buy or sell something at a specified price
·         Option price is the strike price (or issue price or exercise price)
Þ     Option compensation plans cannot set a strike price at less than FMV at the time the option is granted
·         Buy Option (“call option”)- more common in executive compensation then sell option. If stock price increases, called “in the money”
Þ     The options at question in Tyson Foods
Þ     Incentive for stock price to rise
¨       In the old days, boards would re-price options if they were underwater (stock price falls below option price) – No longer done
¨       Re-pricing when the options are underwater is perceived as rewarding failure and poor performance (not allowed in DE)
*        Backdating – dating the option to a more favorable strike price when the option price is under water (compensation options must be granted in accordance w/ plans approved by the shareholders) 2 types of harm (Ryan case)
*        Dishonesty, betraying fiduciary duties to the shareholders. The problem is secrecy, not disclosed to shareholders.
*        Cost to company- company receiving less than it should for the shares
*        Spring-loading – Using Insider info (nonpublic corp info) to benefit stock option recipients by choosing a moment in time when they know the stock price will rise bc of a corporate disclosure
·         Sell Option (“put option”)
Þ     K can be set up to allow shareholders in small corp to put their shares
2)      Risk
(a)    Some risks are controllable
(i)     How hard ppl will work – Design compensation structure that max effort
(b)   Other non-controllable risks can be managed in other ways (success in business depends on how well people manage risk)
(i)     Insurance can be purchased
(ii)   Investments can be diversified
(iii) Allocate risk
·         Parties to a bus venture may allocate the risk to the person who is most willing or best able to handle the risk
(c)    Risk is essentially quantifiable uncertainty
(i)     Expected return is the weighted average return based on the probabilities of events
(ii)   People in business think about risk in different ways (risk seeker, risk neutral, risk averse)
3)      Allocating Risk
(a)    Costs inherent in the principal/agency relationship
(i)     monitoring costs incurred by principal
(ii)   bonding costs – ppl who deal with large sums of money have to have an insurance policy in case they are less than honest
(iii) Residual loss – decision by the agent that results in a reduction of the principals wealth
(b)   Parties in a venture allocate risk by selecting a business structure
(i)     In deciding business structures the parties must determine:
·         The risks each party is willing to take;
·         Acceptable level of agency costs – how much it will cost for the owners to hire employees
Þ     Wages and Shirking
(ii)   Critical decisions that are a part of forming a business venture/allocating risk
·         The terms of the relationship must be decided;
·         The allocation of the gains and losses of the venture must be decided;
·         The decision0making authority and discretion of each participant; and
·         The circumstances in which they can exit from their relationship
(c)    Allocating Risk to the Principal
(i)     The principal will be more willing to take on the non-controllable risks of the business’ success or failure (agents are risk averse)
(ii)   Employment Model – allocates risk to the Principal
·         Fixed payments to employees
·         Most incentive to shirk
·         Principal could monitor, hire a sup, or have a  K w/ incentives to perform
(d)   Allocating Risk to the Agent
·         Tenancy Model
Þ     Fixed payments to principal
Þ     Greatest incentive to work harder – receive residual
·         Intermediate Model
Þ     Contain a salary/employment relationship with incentives
¨       Bonus compensation for good results
¨       “Best effort” and “reasonable and custom” clauses
*        Shorthand for what the parties would like to negotiate to if they went through the trouble
*        Provides the employee incentive to work so he won’t get sued, decreases incentive to shirk
(e)    Ideal payment structure
(i)     Managers – Incentive based compensation
(ii)   Shareholders – Voting rights / residual profits / appreciated value
(iii) Creditors – Fixed Payments
4)      The Role of Law in Allocating Risk
(a)    Law and Human Relationships
(i)     The law imposes fiduciary duties as a way to mediate the relationship/manage the risk between owners and managers
(b)   Mandatory and Default Rules
(i)     Corp. law is a mic of mandatory and default rules
·         Mandatory rules – so basic that they cannot be altered by the parties
·         Default rules (most rules in bus law) – define the parties relationship unless the parties provide otherwise
(c)    Beyond Agency Costs
(i)     Agency Costs are the primary issue that corporate law tries to address
(ii)   Although, in some contexts, it may be appropriate for corp. law to address other stakeholders
B)   An Introduction to Corporate Law
1)      Overview
(a)    Key Corporate Characteristics/Types of Corps.
(i)     The Different types of Business organizations
·         Corporation –artificial person or legal entity created under law of a state or federal law, risk of loss generally limited to shares (2 types- public and private)
Þ     Corp organization for tax purposes
¨       Class S Corp. – similar tax treatment to p’ship but limited liability
*        Profits and losses flow through to the owners
*        These orgs have to file informational returns with the IRS
¨       Class C Corp. – corp. is taxed as an individual and then the dividends are taxed
*        disadvantage tax wise bc it is taxed as an entity
*        Legal owners are the brokerage houses who hold the shares, and the small guy who invests w/ the brokerage house is the beneficial owner
*        Trusts can conceal legal owners bc the affairs are carried out by trustee
Þ     Corp organization for financing purposes (public v. private corporations)
¨       Publicly traded on a stock exchange to raise equity
¨       Closed/closely held stock and equity is only raised privately
Þ     Characteristics of a Corp.
¨       Separate entity – Every corp. is a legal entity separate from investors
¨       Perpetual Existence – Corps. Can live forever
¨       Limited Liability – Shareholders cannot lose more than they invested
¨       Centralized Management- shareholders have limited management rights, can only vote for Board and big issues
¨       Transferability of ownership of interest – Publics can trade on markets
·         Limited Liability Company (LLC) – (Not a Corporation, do not say Limited Liability “Corporation” on the exam, it will be a presumptive C grade on exam)
Þ     Liability similar to a corp and taxed like a p’ship
Þ     Must be registered with the State so creditors know if it is limited or unlimited liability business
Þ     Default rule is they endure in perpetuity unless specifically limited
·         Partnership
Þ     Limited Partnership (LP): liability limited to amount of investment, limited partners are passive investors
Þ     LLP (newer than LP) – Some general partners and limited partners
¨       The risk for the passive limited partners is the amt they put in
¨       Law partners in this type are liable only for their own malpractice, not the malpractice of other partners in the firm
Þ     LLLP – Limited liability limited p’ship – statutes that limit the liability of the GP (creating a LP that has the essential characteristics of a manager-managed LLC)
Þ     GP –General P’ship – Every partner can be personally liable for p’ship as a whole; either debt or tort liability
·         Sole proprietorship – 1 owner, no limited liability, creditor can pursue owner's personal assets- no distinction between personal and business assets, owner and business identical, taxed as income of proprietor
Þ     Sole proprietorships and GPs have low start up fees
¨       In order to be limit liability the org has to file something with the state secretary of state / treasurer
¨       Most of the time limited liability filings can be done online
¨       Corps need to file so creditors know what kind of liability they are dealing with
(ii)   Why allow Limited Liability?
·         Encourage risk and investment
Þ     If protection was not in place then ppl would be much more reluctant in investing in corps
·         Limit personal risk
·         Allow businesses to accumulate sufficient capital to produce larger projects, without limited liability making people willing to invest in companies (because wronged persons can't go after investors personally), companies would not be able to raise as much capital- investors wouldn't want to risk personal liability
·         Downside- Negative Externalities (harm caused by company)- persons who suffer a tort from the limited liability company may not be able to recover all of their damages from the limited assets of the

less than 90 days to 9 months
(iv) Securities Laws
·         Securities Act of 1933 – Regs initial issuance of stock and debt instruments to the public
Þ     Creates SEC and culture of full disclosure of info to the public
·         Securities and Exchange Act of 1934 – Regulates periodic reporting of public co
Þ     Regulates buying and selling of securities on secondary markets
·         Info on value of financial instruments
Þ     Rating Co (S&P, Moody’s, Finch)
Þ     High yield bonds are riskier investments (junk bonds)
¨       When corp debt reaches maturity the co can pay it off or refinance – – when co can’t refinance then the co. goes into bankruptcy
*        Assets need to be sold when it can’t raise funds through debt or equity offerings
*        A co can agree to be acquired by another co that has a lot of cash
Þ     Insider trading illegal because it would make the cost of raising capital much more expensive, because investors less likely to invest in a rigged system
¨       People would also demand higher returns because they have less info than corporate directors and officers- raises cost of raising capital
(e)    Judge-Made Corporate Law
(i)     Judges occasionally have to fill in theoretical gaps
·         Corporate fiduciary duties are largely judge made/defined
(ii)   Courts from other jurisdictions often look to DE bc they have the most comprehensive bus case law
(f)    Corporate Choice of Law
(i)     By selecting a particular business structure the parties pick an off the rack distribution of rights
(ii)   Internal Affairs Doctrine – W/ respect to the internal affairs of a corp., you look at the law of the state of incorp.
·         Corp. planners can be confident about what rules apply
Þ     If the rule didn’t exist then there would be less certainty in bus law\
·         States can compete for corps. By creating an attractive Code
·         Managers largely can pick where they want to be incorp. or reincorporated
(g)    Corporate Planning
(i)     Corporate statutes leave the parties to arrange their affairs as they would like
(ii)   Clients don’t want to be involved in litigation
(iii) Creative lawyers can come up w/ lawful ways for their clients to achieve their goals
3)      Fiduciary Duties (Duty of Loyalty and Duty of Care)
(a)    Director Duties
(i)     Fiduciary Duties Come from Trust law
(ii)   Directors owe fiduciary duties to shareholders, but they do not owe any fiduciary duty to creditors bc creditors can K w/ corp
·         This duty is imposed bc the shareholder is at the mercy of the director and in order to mediate differences btw the interests
(iii) Directors and Managers (Agency law) need discretion and power to enrich everyone
·         Fiduciary duties are designed to prevent abuse
·         This is a common prob with the separation btw ownership and control
Þ     Ways fiduciary duties deal w/ the issue of separation of ownership and control
¨       Duty of Care –Managers must behave prudently and attentively in decision-making. Directors must know about the industry in which the business operates and inform themselves adequately before making a decision
¨       Duty of Loyalty – Make sure that managers do not put their interests before the shareholders of the corp.
*        (ie when the Lamberts issued themselves stock at preferential prices in Chesapeake II – see “follow the money” in notes for exp why)
¨       Duty of Good Faith: DE common law DE courts have imposed, directors must not intentionally harm the business [subset of loyalty] ¨       Duty of Disclosure: Directors must disclose matters to shareholders that shareholders are voting on, if it might affect how they vote
(iv) Business Judgment Rule (BJR)
·         Unless evidence of self-dealing is shown, Courts will assume that the action of the director is in the best interest of the Corp.
·         The BJR will presume that director decisions are:
Þ     Informed
Þ     Serve a rational purpose
Þ     Disinterested, and
Þ     Made independently
·         In order to shift the burden onto the directors, the plaintiff must prove the action in question was:
Þ     Not informed, or
Þ     Did not have a rational business purpose (waste) or