BUS ORGS ROSEN SPRING 2011
BUSINESS ORGANIZATIONS
Business Entities
I. Introduction
A. Issues that course will address
1. Scandal and Reform
2. Agency
3. Unincorporated Forms of Business
4. Corporations
5. Closely held corporations
a) Many family businesses fall into this category
6. Special Issues
B. Course Themes
1. Business Concerns
a) Regulatory obligations associated with various forms of business
2. Ownership vs. control
a) Owner may not be the same person as who controls day-to-day operations
3. Fiduciary Obligations
II. The Firm
A. Theories of the Firm
1. Coase – differentiating the market and the firm
a) Defines the firm as “the antithesis of the market” – “private hand”
i) In a firm, resources are allocated pursuant to conscious orders or directions from the employer to his employees as opposed to the market’s invisible hand through separate, self-interested choices of all producers and consumers
b) The “firm” is the set of relations that arises when resources are allocated by the entrepreneur via commands to his employees
i) As opposed to the set of relations that arise when an entrepreneur allocates resources via contract with outsiders
2. Nexus of Contracts
a) The firm is a nexus of contracts between various claimants to a share of the gross profits generated by the business
b) Example with Mary and her bakery
i) The firm not only includes the contractual relations between Mary and her employees but also her contractual relationships with customers, suppliers, lenders, etc.
3. Why do these theories matter?
a) Helps us understand how the law has developed in area of corporations
B. Sole Proprietorship vs. Business Association
1. Sole Proprietorship
a) One person performs three ownership and management functions
i) Residual claimant and ultimate risk-bearer
ii) Oversees the business and affairs of the firm, developing policy and directing implementation
iii) Manages the firm day-to-day
b) Able to make quick changes to adapt to shifts in the market without having to consult or get the approval of others
i) How can the sole proprietor adapt?
(a) Fire the employees that were working as agents
(b) Change the business’s purpose
(c) Decide to cease operations
c) Liability
i) Contributes all initial funds and is also the only residual claimant (gets everything on dissolution)
ii) Total liability for the entire operation
iii) This is personal liability
iv) Reports gains and losses directly on his personal income tax filings
2. Business Association
a) Shared ownership and control
b) More people involved to play particular roles
c) Common types
i) Partnership
ii) Corporation
iii) LLC
C. Organizing the Firm
1. The Role of the Corporate Lawyer – a planner
a) First and foremost a transaction-cost engineer
b) Because human beings are opportunistic—
i) The planner must understand when opportunism is likely; and
ii) Suggest an organizational structure that will minimize the expected costs of future opportunistic behavior
c) Remember: owners and managers of firms have a strong, usually rational, preference for private ordering over court ordering
i) This is usually more efficient and cost-effective as well
d) Thus, the corporate lawyer must understand how to select and modify governance structures so as to optimally minimize the use of litigation as a governance tool, while preserving the availability of litigation to deal w/ circumstances that cannot be appropriately governed solely by private ordering
2. The Goal of Informed Rational Choice between Competing Investment Options
a) Comparative search for the best investment
i) Requires both a comparative and an ex ante approach
(a) Comparative because a determination of the best decision involves a weighing of possible alternatives
(b) Ex ante because the goal is to predict which investment strategy will yield the optimal result
b) Risk and Return
i) Expected Return
(a) Determined by multiplying each possible return by its probability and then by summing these products
ii) Risk – the degree to which the various possible outcomes differ from the expected return
(a) When the range of possible returns is zero, the investment is risk-free
(b) An investor’s risk preference is likely to be affected by the magnitude of a particular risk in relation to his wealth
(c) Diversification – minimize risk by diversifying one’s portfolio
(i) The more diversified the portfolio becomes, the less will be the possible disparity b/t actual and expected returns
3. Transaction Costs and Choice of Organizational Form
a) Transaction cost factors
i) Bounded rationality
(a) There are cognitive limits or bounds on one’s ability to act rationally, despite one’s intention to act rationally
ii) Opportunism
(a) Opportunism is self-seeking with guile—individuals who act opportunistically seek to further their own ends by taking advantage of the information deficits of those with whom they deal
(b) Different from simple, open self-seeking, in which economic actors prefer their own interests to those of others, but do so while being honest and aboveboard in their dealings
iii) Team-specific investment
(a) When a person or asset has a higher value in its current team use than its value in its next best use, the person or asset is said to have team-specific value
b) Discrete and Rational Contracting
i) Discrete contracting
(a) The contract anticipates and provides a rule governing all contingencies—nothing is left to be worked out in the future
(b) Most likely to be successful when the team’s duration is short and the number of exchanges b/t the team members will be few
(c) As duration and frequency of exchanges increase, bounded rationality makes it more likely that the parties will specify an inappropriate rule for a particular contingency
ii) Rational contracting
(a) The parties do not attempt to provide an answer to all contingencies at the time the relation commences
(b) They attempt to build a governance structure that will allow them to solve problems when and if they arise
(c) The goal is to reinforce the relation itself
c) Deciding to Organize as a Firm
i) Advantages
(a) Allows the firm to adapt quickly to changes b/c of owner’s power to unilaterally make all management decisions
ii) Disadvantages
(a) Employees surrender autonomous control over their business and become subject to the employer’s opportunism
(i) Thus, a key factor for all firms is how to minimize the risk to which the employer is so exposed
4. State-provided Governance Structures (Public Ordering)
a) Entity and employment law as standard form contracts
i) By structuring the relationship as that b/t employer and employee, or as a corporation, partnership, or LLC, the parties receive the benefit of state-provided rules and dispute-resolution processes
ii) Thus, these are often described as state-provided standard form contracts
b) Default vs. immutable rules
i) Most rules are enabling
(a) Means that they provide parties with default rules that govern the relationship if the parties do not provide otherwise
(b) But they can modify or change them
ii) Some rules, however, are immutable
(a) Cannot be changed by contract or private ordering
(b) This is done b/c rule makers fear the effect on third parties if the rules were changed; and
(c) To protect the parties themselves from mistakes
c) Types of rules
i) Tailored
(a) Designed to give contracting parties the exact rule that they would themselves choose if they were able to bargain costlessly
(b) Provided through ex post judgment
(c) But problematic because of bounded rationality (don’t know what the parties really would have chosen)
ii) Majoritarian
(a) Designed to provide investors with the result that most similarly situated parties would prefer
(b) Similar to tailored in that the goal is to provide rules the parties would choose
(c) But distinguished in that tailored rules are literally designed to help the exact party, whereas majoritarian designed to help similar parties
iii) Penalty default
(a) Designed to motivate one or more contracting parties to contract around the default
(b) Why?
(i) To force the parties to share information with each other about their true intentions, rather than allow the parties to adopt a set of standard rules without revealing their true intentions
(ii) Also to avoid the social cost of providing rules to parties via ex post judging
5. Private Ordering
a) Governance role of Markets
i) Markets play an important role in the governance of firms
(a) Ensure that team members perform their services diligently and loyally
(b) Protect reasonable expectations of investors
(c) Make it less necessary for lawmakers to intercede
ii) Types of markets
(a) Prod
e still has this obligation of loyalty while he continues as an agent of the entity – termination is key
(c) It was irrelevant that the work was slated to begin after employment with the D – relevant inquiry is when business was solicited
(d) Until the employment relationship is severed, the employee must prefer the interests of his employer to his own.
(i) During such a time, he cannot solicit for himself future business which his employment requires him to solicit for his employer.
(e) Above all, the agent should be candid with his employer and should withhold no information which would be useful to the employer in the protection and promotion of its interests
v) Black Letter:
(a) Employee cannot compete until after termination of employment, and competing includes solicitation of business
(b) Employer should protect through non-compete agreement
b) Hamburger v. Hamburger (MA, 1995)
i) Facts: D worked for his father and uncle in a family business (Ace Wire) and the relationship soured. D decided to start his own business that competes with Ace after uncle essentially forces him out. Uncle (P) claims that the start of this company is breach of fiduciary duty.
ii) Holding: NO – D did not violate fiduciary duty
iii) Reasoning:
(a) Met with a potential investor before leaving employment at Ace Wire, but did not solicit customers – this is making logistical arrangements for new line of work
(b) Customer lists taken were not violation because these were generally available through published sources and thus are not trade secrets
(i) Rosen: note that courts could go the other way here
(c) At-will relationship that was not governed very strictly – equities fell with the D here as he was doing all the work of the company
iv) Black Letter:
(a) Courts are willing to allow employee to make logistical arrangements for new work while in current employment.
(b) Employees can also use general knowledge, experience, memory, and skill in establishing a new company (including “remembered information”)
(c) Facts will matter in these cases
(i) This case different from CCS because there was no evidence of solicitation prior to leaving
E. Limits on Firm’s Right to Discharge Employees at Will
1. Generally
a) Presumption of at-will employment – employer does not need just cause to fire employee unless there is an express or implied agreement to the contrary
i) BUT, this has deteriorated and presumption may be overcome by contrary evidence
(a) Violation of public policy
(b) Violation of employee handbooks which constitute unilateral contract
(c) Violation of covenant of good faith and fair dealing
b) Non-legal, natural limits on the ability to terminate in bad faith
i) Reputational impact – other employees of the entity or potential employees
ii) Not everything is governed by legal rules
c) Legal limits on termination in bad faith
i) Not limited to the law of agency
(a) Contract law, labor laws, etc.
ii) Can play an important role in addition to business community norms
2. Foley v. Interactive Data Corp. (CA 1988)
a) Facts: P let go by the company because he blows the whistle within the company about possible wrongdoing. Not necessarily for-cause firing in the legal sense. Prior to firing, had been promoted repeatedly and essentially promised job security
b) Issue: Was firing for “performance reasons” after whistleblowing breach of duty to employee?
c) Holding: YES – P pleaded implied-in-fact contract and its breach
i) No violation of public policy for whistleblowing firing, though.
ii) Also dismisses good faith and fair dealing tort claim
