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Business Associations/Corporations
South Texas College of Law Houston
Leahy, Joseph K.

CHAPTER 1: Introduction to the Law of Enterprise Organization

1) Who Corporations Law Focuses On
a) Owners/Shareholders
b) Managers
c) Directors – fiduciary for the corporation
d) Sometimes creditors
2) Internal vs. External Perspective
a) External Perspective
i) The law should be “x”.
ii) Many scholars say “Shareholder Wealth Maximization” is the dominant perspective. Efficiency is how you gain it ($).
b) Internal Perspective
i) The law is this because this case tells you to do this.
ii) What is the most efficient approach to governing the relationship between the three groups?
3) Types of Efficiency
a) Kaldor-Hicks
i) Is there any way to make A better off in a way that A can compensate B for his loss and still have a gain
ii) Primary type of efficiency
iii) There only has to be a “NET GAIN”
iv) IF at least one party would gain from it after all those who suffered a loss as a result of the transaction of policy were fully compensated.
b) Pareto
i) Is there a way we can make A better off without making B worse off?
ii) All parties to a transaction have positive gains or no gains at all –NOBODY LOSES
iii) Almost all public policies and many private arrangements fail the Pareto efficiency because no matter how much good they do on balance, they make at least one person worse off.
4) Relationships Between the Three Groups
a) Managers v. Owners
i) Agency Costs – any cost associated with the exercise of discretion over the principal’s property by an agent. Basically the cost of having employees. Keeping the agency costs low is key (external).
(1) Monitoring – costs that owners expend to ensure agency loyalty (anti stealing cost)
(2) Bonding – costs that agents expend to ensure owners of their reliability (getting the most out of their labor; incentive packages, bonuses) (anti shirking cost)
(3) Residual – costs that arise from differences of interest that remain after monitoring and bonding costs are incurred.
b) Owners v. Owners
c) Shareholders v. Creditors

CHAPTER 2: Acting Through Others: The Law of Agency

1) Agency – P and A agree that the A will act on the P’s behalf and subject to the P’s control. Critical because the A can bind the P.
a) Managers are agents of the corporation
2) Types of Agents
a) Scope
i) Special agents – limited to a single act or transaction
ii) General agents – series of acts or transactions
b) Disclosure to Third Party
i) P disclosed
ii) P undisclosed
iii) P partially disclosed
c) Right to Control
i) Employee/Servant
ii) Independent contractor
3) Governance of Agency
a) By Contract
b) By Exit Rights – if it’s not in the contract you can quit
c) Fiduciary Duties (main focus) – duty of A to put his interest after the interest of the P and to advance the goals of the P first.
i) Duty of Loyalty
ii) Duty of Care
iii) Duty of OBedience
4) Liability in Contract
a) Actual Authority – that which a reasonable person in A’s position would infer from P’s conduct
b) Apparent Authority – authority that a reasonable third party would infer from the actions or statements of P.
c) Agency by Estoppel – occurs when the third party is justifiably induced to detrimentally change her position because the transaction is believed to be on P’s account, if
i) P intentionally or carelessly caused third party’s belief, or
ii) Having notice of such belief and that it might induce others to change their positions, the P did not take reasonable steps to dispel the belief.
5) Tarnowski v. Resop
a) Summary: Resop (Agent) takes $2k “secret commission” from T on coin operated music machine deal on behalf of Tarnowski (Principal).
b) Plaintiff’s remedy from sellers:
i) Deal is void; $9500 out of $11,000 down payment returned
c) Plaintiff’s remedy from agent:
i) Secret Commission
ii) All costs of collecting from sellers as damages
iii) Total of $5,200 recovered from Resop

CH 3: The Problem of Joint Ownership: The Law of Partnership

1) Partnership
a) Is the simplest form of jointly owned and managed business
b) Mutual agency because all partners are both principals and agents of each other
c) Don’t have to file anything
d) Two people in business for profit together as co-owners
e) All partners have unlimited liability for the debts of business
2) Why have Joint Ownership?
a) Traditional argument is to raise more capital
i) But you could simply just borrow money
ii) When the cost of borrowing costs so much it is cheaper to bring in new owners
3) Meinhard v. Salmon
a) SUMMARY: Meinhard and Salmon are joint venturers. They take a 20-year lease from Mrs. Gerry to operate a hotel. Salmon holds the lease in his name and runs the hotel; Meinhard supplies half the capital but is a passive investor. Salmon gets 60% of profits for first five years, then 50-50 for the remaining fifteen. Losses are split equally throughout the venture. When the first lease is about to run out Mrs. Gerry’s son presents Salmon with a new opportunity: lease the whole block for 80 years. Salmon accepts for his corporation (Midpoint), without consulting Meinhard. Meinhard now wants a piece of the action. In the end the court gave Salmon one more share of power than Meinhard.
b) Breached Fiduciary Duty – You must bring the opportunity to the other person; you can’t take an opportunity that belongs to the partnership/corporation
c) Puntillio – precise observance of formalities
d) Internal Perspective/Law – joint venturers, like copartners, owe to one another, while the enterprise continues the duty of the finest loyalty
e) If a case cites Meinhard, the Agent/Fiduciary is going to lose (especially if it quotes the “punctilio” paragraph of Cordozo)

CH 4: The Corporate Form

1) Characteristics of the Corporate Form
a) Legal personality with indefinite life
i) The corporation is seen as a legal person and its own entity.
ii) A corporation does not dissolve or change as easily as partnerships
b) Limited liability for investors
i) Good for creditors because they can look at the corporation’s assets and know what they can get
ii) Limited Liability -In partnership you can go after a partner’s house but in corporations there is no “personal” liability but unlimited liability for the corporation for its debts
iii) Shareholders risk losing the amount of their investment
c) Free transferability of share interests
i) Shares can be freely sold and it’s not restricted
ii) It allows people to get out of their stock easily – makes shares more valuable if they are liquid
d) Centralized management
i) Not as many people in a position of management
ii) Run by Board of Directors
iii) Shareholders don’t have a position of management unless written into the charter
e) Appointed by equity investors – Separation of Ownership and Control
i) Equity votes for management
2) Types
a) Control
i) Controlled – one or more shareholders has the ability to appoint the board
ii) “In the Market” – control is in the market and no shareholder or group exercises control
(1) As long as control is in the market, practical control resides with the existing management of the firm.
b) Number of Shareholders
i) Close Corporation – small corporation with regard to the number of shareholders
ii) Public Corporation – Big corporation with a large number of shareholders
3) Choice of Law
a) Internal Affairs Doctrine – the law of the state of incorporation governs the internal affairs of a corporation, including such matters as who votes, on what, and how often.
i) Can be headquartered anywhere
ii) About 50% of big corporations are incorporated in Delaware
4) The Process of Incorporating
a) Formation
i) Incorporator drafts and signs a document (charter)
ii) File with secretary of state and pay fee
(1) §106 Now the corporation comes into existence
iii) Hold an organizational Meeting

b) De Facto Corporation Doctrine
i) If both sides though they were dealing with a corporation and then they find out they aren’t really a corporation then the debtors can’t later say they don’t owe it money because they didn’t know they were dealing with a corporation.
c) Articles of Incorporation/Charter
i) §102(a)(1) – (6) What must go into the Charter?
(1) Name of the corporation
(2) Address and registered agent
(3) Purpose – default “any lawful purpose”
(4) Shares
(a) Amount of stock authorized to issue
(b) its par value per share (stock with a stated face value – the lowest amount you can sell it for or you can state that there is no par value)
(c) Must be at least one class of voting stock
(5) Name and mailing address of the incorporator
ii) §102(b)(1) – (7)What “MAY” go in the charter?
(1) Size of the board
(2) Procedures for removing directors from office
(3) May contain any provision that is not in contravention of law
(4) Put whether or not the board is staggered
(a) Staggered offers more stability and can help prevent hostile takeovers
(5) Blank check preferred stock – directors can issue preferred stock where they set the criteria
(a) Poison Pill
iii) Directors may not change the charter.
iv) Amendments to Charter must be proposed by the Board of Directors
(1) Can’t be proposed via proxy
5) §109 §2.06 The Corporate Bylaws – rules governing the corporations internal affairs
a) Can be amended more easily than the charter
i) Generally doesn’t require both a board resolution and shareholder vote
b) Must conform to the charter (charter trumps bylaws)
c) Can put a more specific purpose and although it doesn’t trump the charter it can further define the purpose
d) Can the directors change the bylaws?
i) Default – NO
ii) DGCL §109(a) – Directors can be given the power to change bylaws only in the Charter
iii) Default – shareholders can amend the bylaws and this power CANNOT be taken away.
6) Centralized Management
a) §141 The Board
i) Directors are elected by shareholders. Management runs the ballot and chooses who they shareholders may vote for.
ii) Collective Action Problem – management can pick the directors it wants and the shareholders go along with it
iii) The board does not have to be shareholders or employees of the corporation
iv) If there is a director who is an employee they are an “inside director” and one that is not is an “outside director”
(1) Inside – they have an interest in the company and have a hand in running the company
(2) Outside/Inde

s the net present value of borrowing $10,000 at an 8.5% interest rate, and repaying it in a year, given the 7% discount rate?
(a) $10,000 – $10,140 = -140
(b) Don’t do it. You’re borrowing at 8.5% to make 7%. Not a good idea.

1. Future Value (r = interest rate)
FV = PV (1 + r)n

2. Present Value (r = discount rate)
PV = FV / (1+r)n

3. Rate
r = (FV/PV)1/n – 1

4. Net Present Value (calculates what you could have gotten but doesn’t take into account intangibles, i.e. happiness)

d) Risk and Return (left out of present value)
i) Expected Value – the weighted average of all your predicted outcomes multiplied by their predicted probabilities
(1) Not a real return
(2) It is the sum of what the returns would be if an investment succeeded, multiplied by the probability of success, plus what the returns would be if the investment failed, multiplied by the probability of failure.
(3) Ex. Flipping a coin and if it lands on Heads then you get $1000
(a) ($1000 x .5) + ($0 x .5) = $500
(i) But at no time are you going to get paid $500, it is either $1000 or $0.
(ii) The question is how much will you pay for the expected outcome.
ii) Risk Neutral – all an investor is concerned about is the expected return of an investment
(1) Will pay about up to an expected value
(2) They are not afraid of or bothered by risk – not afraid of the swing from the high to the low
(3) Look more at the average payout
iii) Risk Averse – volatile payouts are worth less
(1) They are worried about what the outcome will be and that they might get the lower return
(a) Risk Premium – the additional amount that risk averse investors demand for accepting higher risk investments in the capital market (Certainty equivalent)

“Risk Adjusted Rates”
1. Expected Value
EV = value x % chance

2. Certainty Equivalent
CE = EV – RP

3. Risk Neutral Investor
PV = EV/(1+r)n

4. Risk Averse Investor
PV = CE/(1+r)n

iv) Problems
(1) National Hotel Corporation wants to borrow $10million from First City Bank for one year. NHC offers to pay to FCB $11.3 million, as principal and interest, at the end of the one-year term. FCB believes that, if it extends the loan, it has a 95% chance of being repaid in full at the year’s end and a 5% chance of receiving nothing because NHC will be bankrupt and worth nothing at all. The risk-free discount rate is 6.5% percent. But the risk-averse managers of FCB require a 2% risk premium to extend a loan to a borrower with the characteristics of NHC.
(a) What is the nominal interest rate that NHC offers to pay for the loan?
(i) r = (FV/PV)1/n – 1
(ii) FV = 11.3m PV = 10.0m n=1
1. R = (11.3m/10m)1/1 – 1
2. R = 1.13 -1 = .13
3. R = 13%
(b) Assuming NHC obtains a loan at the rate it demands, what is FCB’s expected return on the $10m that it would lend?
(i) EV = (% chance x value + % chance x value . . .)
(ii) EV = (11.3m x .95) + (0 x .05) = 10.735m
1. 10.735m – 10m = 735,000
(c) What is the net present value of the loan extended on NHC’s terms if investors are generally risk neutral? What discount rate would these investors use?
(i) NPV = (PV$received) – (PV$paid) and PV$received = FV/(1+r)n
1. EV$received = $10.735M = FV (need to discount this to PV)
2. r = .065 (risk neutral)
3. PV$paid = $10M (assume loan is made now)
(ii) NPV = (PV of $10.735M) – ($10M)
1. NPV = (10.735M/(1+.065)1) – $10M
2. NPV = 10,079,812 – 10M = $79, 812
(d) What is the NPV of the loan if FCB’s managers correctly assess the risk premium that most investors in the market would charge for the NHC loan? What discount rate does FCB use in this case? Should it extend the loan on NHC’s terms?
(i) Same equations as (c)
1. EV$receive = 10.735M = FV
2. r = .065 + .02 =.085
3. PV$paid = $10M
(ii) NPV = (PV of 10.735M) – (10M)
1. NPV = (10.735M/(1+.085)1) – (10M)
2. NPV = 9,894,009 – 10M = -$105,991
(iii) Don’t make the loan!
(e) Same as (d) but instead “what is NPV if Bank requires a RP of $197,880? Should bank make the loan?
(i) EV$received = 10735M = FV r = .065 n = 1
1. CE = EV – RP
2. CE = 10.735M – 197,880 = $10,537,120