Corporations McCarthy Spring 2016
1. Business, Risk & Agency Concepts
Controllable Risks: The kinds of risk that can be influenced
Example: vineyard owners face risks associated with: the type of grapes, amount spent on research and marketing, …
The party who bears the consequences of the risk will have greater incentive to control the risk but the other will not.
However, the party who is in the best position to control risks might not be the best person to bear them.
Non-Controllable Risks: The kinds of risk that the parties have no control over
Example: The weather or economic variables.
Diversification: participating in numerous ventures, each of which involves different risks. Ex: investing in 10 different vineyards with different expected rainfall.
It is impossible for EE who invests in human capital( you always forgo other opportunity.
Allocate the burden of risk to the person who is best able to bear it.
Risk v. uncertainty: Risk is quantifiable uncertainty. It will help a biz in assessing its risks if it can determine or estimate the probabilities of uncertain event and determine expected return.
Expected return: the weighted average return based on the probabilities of events.
Risk Averse: Characteristic for avoiding or otherwise reducing risk
Risk Seeking: Characteristic for taking on risks.
Risk Neutral: A person makes decision based solely on expected returns, and would be happy to take on risk anytime it will generate a benefit on average.
2. Allocating Risks to the Owner – employment
a. Reduced by monitoring (directly, through agent, employment K) and disciplining E to align incentives with O’s
b. If fixed salary, worried about shirking
3. Allocating Risks to the Employee – tenancy
O can allocate risk to E by basing compensation on success or failure of the business
Gives E more incentive to maximize success (less shirking)
4. Middle Ground Solution
a. Fixed salary with % of profits
Look to who is best able to control risk and who is willing to bear the risk
Tenancy vs. employment – look at risks, incentives, and monitoring costs
i. Risk averse E would prefer employment while risk averse O would prefer tenancy
Shirking Risks and Associated Costs:
There is not enough incentive to do more than what is required.
Information Costs: The parties may agree to a pre-specified yield beforehand but there are costs involved to obtain the information needed to set up baselines. Costs incurred from completing due diligence which involves the expenses related to the investigation of an investment or financial activity and is necessary to determine profitability.
Monitoring Costs: Costs involved with supervising the subordinates.
In this employment scenario, the monitoring costs would be high for Julia.
Disciplinary Costs: Can come in the form of reduction of pay, termination, litigation, etc.
Transaction Costs: The lawyer’s fees’ and other costs involved for securing professional services to effectuate a transaction
2. Introduction to Corporate Law 17-49
Firm – a legal entity used to assemble, organize and manage resources to carry on some economic activity. Structure of firm avoids costs of creating numerous separate, detailed contracts with independent contractors and allows for the creation of long term employment contracts
Principle reason firms exists is that they reduce the information, transaction, and agency costs that would exist in a theoretical free market
The reasons why Corp is existed?
Reduction of information, transaction, and agency cost
Increase ability to gain capital
Incentive for working efficiently
Separate Entity: corp is a legal entity, separate from Owners and Managers
Perpetual Existence: corp has unlimited life
Limited Liability: Shs’ liability is limited to the amount of money she paid for her shares. The Corp owns the asset and is liable for its debts.
3 Major Exceptions to Shareholder Limited Liability
Shareholders will be personally liable where the corporation is not properly formed
For unpaid capital contributions they have agreed to make
Where the veil of limited liability is pierced for equity reasons
Centralized management: Shs elect Corp’s directors, who have power to manage Corp’s biz. Directors owe a duty to act in the best interest of the Corp.
Transferability of ownership interests: SHs are free to transfer their stock without consent of other Shs.
Close Corporation is harder to exit bc no market for share
Formed for any purpose
Independent legal capacity
May issue stock to diversify risk
Protection from personal liability
Must comply with complex laws
Statutory filing requirements
Less favorable tax treatment
Possible double taxation
Costly & time consuming
Articles of Incorporation
Also known as a charter or certificate of organization
Must be filed with state officials and must contain certain provisions such as the company’s name, address. Amount of stock authorized, and names and addresses of incorporators MBCA §2.02
Control the corporation’s internal operations
2. Corporate Statutes
a. No federal law; basic governance through state law
b. MBCA – outline for states to use
c. DGCL – more than half of NYSE incorp in DE and DE courts have greater expertise
d. Always created under the laws of a particular state
icable on no other basis [than bad faith]”.
Because the expectation of good faith underlies all directors’ fiduciary duties, a court’s finding of bad faith on the part of corporate directors rarely stands alone; it typically involves a breach of either the duty of care or the duty of loyalty, as well. Therefore, let us proceed directly to consider those elements of the rule.
even these decisions, although lacking disinterestedness or independence, may be qualified for the protection of the business judgment rule if a majority of the disinterested, independent directors vote to approve it in the reasonable, good faith belief it is in the best interests of the corporation and its shareholders.
(2) Duty of Loyalty – must act with the corp’s interest above their own; in good faith
Penalties for violating fiduciary duty
Dirs liable for any losses they cause corp
SH can’t sue dir bc can’t act directly for the corp and don’t want to sue actual corp (ie themselves)
iii. Solution 1 – Derivative Suit
Action brought by SH in equity on behalf of the SHs
Corp is nominal defendant (w/ breaching dir)
Recovery belongs to the corporation
iv. Solution 2 – Class Action
Can sue in class action alleging breach of duty against corp and dirs.
However, most corps have agreed to indemnify or insure Ms against suit so they rarely have to pay
Bayer v. Beran – dir approves $1M in radio advertising; wife is hired; Ps sue dirs on behalf of the corp (derivative suit)
i. No breach of fiduciary duty (DOC or DOL) bc court didn’t want to violate BJR
Personal interest (promoting family in co) examined with scrutiny but not a per se violation of DOL
No violation of DOL bc was a prof singer, not paid more, others involved in hiring decision, K was std form, and no evidence another commercial would be better.
Schnell v. Chris-Craft Industries, Inc. (P.40): dir were worried that certain Shs would vote to replace them in the next Shs meeting, they decided to make it more difficult for SHs to make travel arrangement. By-law said that Dir could move up SHs meeting if they gave proper notice which they did.
Holding: attempted to utilize the corporate machinery and the Delaware Law for the purpose of perpetuating itself in office, and to that end, for the purpose of obstructing the legitimate efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest against management