CORPORATIONS OUTLINE—SACHS FALL 2013
ECONOMIC & LEGAL ASPECTS OF THE FIRM
A. KEY
a. SH= Shareholders (i.e. the owners of corporations)
b. BD =Board of directors/ officers (i.e. run the corporation)
c. FIRM = the set of relations that arise when resources are allocated by the entrepreneur via commands to her employees rather than the set of relations that arises when an entrepreneur allocates resources via contract with outsiders.
State Provided Governance Structures:
Default rules: state-provided standard form rules that govern the relationship if the parties do not provide otherwise. Parties may specifically change or modify these rules.
3 types of default rules:
i. Tailored rules: designed to give the contracting parties the exact rule they would have chosen
ii. Majoritarian rules: designed to provide investors with the result that most similarly situated parties would have preferred
iii. Penalty default rules: designed to motivate one or more contracting parties to contract around the default. May be set to penalize some or all of the parties as a means of forcing them to negotiate a rule that they prefer.
Immutable rules: rules provided by law that cannot be changed or modified.
The Firm and the Law of Agency
Agency law:
i. Agency: fiduciary relationship that arises when one person
1. (the principal) manifests assent to another person
2. (the agent) that the agent shall act on behalf and subject to the principal’s control, AND
3. The agent manifests consent to act.
ii. Principals & agents contract w/ each other to determine how much control the principal will retain and how much will be ceded to the agent.
iii. Basic Issues that arise out of an agency relationship:
1. The agent has certain duties and obligations to the principal
2. The principal has certain duties and obligations to the agent
3. The principal is responsible for tortious acts committed by the agent that fall within the scope of the agency
4. The agent has the ability to enter into binding agreements on the principal’s behalf, as long as the agreement may be traced to the principal’s authority
5. The agent’s knowledge (in the subject matter of the agency) is imputed to the principle.
Approaches to keeping the BD and officers operating in the SH’s best interest:
i. The regulatory approach (Interventionist): In order to protect the shareholders, substantial legal intervention is necessary.
1. Methods of Intervention
a. Give SHs a voice in the management of the business.
b. Give the shareholders procedural protections including voting rights
c. Disclose information to SHs
d. Impose fiduciary obligations on managers, the violation of which give rise to legal liability.
2. Problems: Managers have enormous power to manipulate these protections.
ii. The law & economics approach (Non-interventionist): Accountability is not really an issue. Managers want what the SHs want; company success.
1. Market is the Regulator: When managers do bad things, the market will correct itself. SHs will sell their stock, and others will refuse to buy, causing the value to plummet and forcing the directors and management out of jobs.
2. Variety of Markets:
a. Product market: firms compete against each other in production and sale of goods.
b. Capital market: where firms compete for funding.
c. National securities market: where firms compete for investors, and provide liquidity to investors, encouraging investment and trade.
d. Labor market: where individuals compete with other employees for work or for favored status. The status of the firm reflects on their future employment opportunities.
3. Fall back approach: Since bad management can still happen, the SH should diversify his interests in order to minimize his risk.
4. Counterargument: There are benefits to NOT diversifying interests:
a. SH will have a more active interest if they are involved w/ ONE co.
b. Promotion of SH loyalty
c. SH will more carefully manage one co.
5. Note: The role of law in this approach is MINIMAL
iii. Types of Legal Protections
1. Fiduciary Duty
2. Efficient Market Hypothesis
3. SH participation
4. SH voting
iv. State law: Most corporation law is state law. Majority of states (30 including Georgia) follow the MBCA. Most corporations, however, are incorporated in Delaware. Most of the regulations are similar or the same between Delaware and the other states. State law is characterized by the non-interventionist school of thought.
v. Federal Law: More recently, federal law has entered the picture. After Enron, etc., Congress forced better SEC oversight of corporate accounting and pushed through the Sarbanes-Oxley Act in 2002. Federal law in this area is dominated by the interventionist school of thought
Fiduciary Duty (Most CENTRAL feature of Corporate Law)
i. CSS v. Reilly ( Ct. of Appeals 4th Circuit; 1963): D was a sales rep who started his own fundraising business while still at his old firm. Former employer sues for breach of fiduciary duty. NOT a SH/manager case but raises basic questions involving fiduciary duty
1. Rule: During the course of employment, you must prefer your employer’s interest to your own. The duty of loyalty is implied in an employment K.
ii. Determination of Fiduciary Duty
1. The principle announced in the CCS case comes from an ad hoc notion of fairness (regulatory/traditional).
2. Law and economics people determine fiduciary duty by assuming that it is whatever the parties would have bargained for
a. Problem: This makes many assumptions, including the party’s knowledge, the state of the business world, etc.
b. Favoring Business: It would be impractical for businesses to anticipate every possible problem; courts are generally on their side.
iii. Waiver of Fiduciary Duty
1. Some duties are mandatory rules which cannot be waived. Most rules are default rules which can be changed by K.
Agency Law and Relations with Creditors
i. Traditional common law rules are designed to protect a principal’s property interests; 3rd party who deals with an agent does so at his peril.
ii. The agent’s actions will bind the principal only if the principal has manifested his asset to such actions. 2 forms:
1. Actual authority (expressed or implied from conduct) occurs when the principal manifests his consent directly to the agent.
2. Apparent auth
and since directors will not initiate an amendment curbing their own power, §8.01 effectively is an immutable rules provision for corporations that do not opt out in the initial charter.
vii. Note: Most states, allow SHs to initiate a change to the corporation’s bylaws.
viii. Note: Some important things SH get to vote on:
1. §7.28—they vote for directors
2. §11.04—they vote on mergers,
3. §14.02—dissolution
4. §12.02—sale of all assets
5. §10.03—amendments of the charter
The Board of Directors:
i. MBCA §8.01 requires each corporation (except as provided in §7.32) to have a BD. All corporate powers, business, and affairs of the corporation shall be exercised by or under the authority of the BD of the corporation. Responsibilities include:
1. Business performance and plans;
2. Major risks to which the corporation may be exposed;
3. The performance and compensation of senior officers;
4. Policies and practices to foster the corporation’s compliance with law and ethical conduct;
5. Preparation of the corporation’s financial statements;
6. The effectiveness of the corporation’s internal controls;
7. Arrangements for providing adequate and timely information to directors; and
8. The composition of the board and its committees, taking into account the important role of independent directors
ii. The BDs powers must be limited in the charter before incorporation.
iii. Collectively, directors determine:
1. the basic corporate policies,
2. appoint and monitor the corporate officers,
3. and determine when and if dividends are to be paid to the SHs.
iv. The BD generally:
1. choose the officers,
2. decide salary,
3. oversee the accounting and financial recording, disclosure, and auditing that the company must give to the SH and the SEC;
4. formulates corporate strategy;
5. Acts as a decision maker in a time of crises
v. Inside director: a director who also has his or her full time job in the company.
vi. Outside director: someone whose full time job is somewhere else- it could be a lawyer, musician, or CEO of other companies.
vii. Note (§ 8.01b): the BD oversees unless the charter provides otherwise. In principle, the charter can be amended. However, although charter amendments must be voted on by shareholders, charter amendments must be initiated by the Directors. The shareholders may suggest a change but the board does not have to listen.
