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Business Associations/Corporations
University of Georgia School of Law
Sawyer, Logan E.

Corporations Outline

Fall 2010 – Sawyer

ECONOMICS OF THE FIRM

Risk

Overview

Risk:quantifiable uncertainty

Controllable risks:business risks that one or more parties to the venture might be able to influence.

Ex: amount of money spent on research, advertising and marketing approach

Non-controllable risks:risks that the parties cannot control and those controllable risks that remain after all reasonable efforts to control them have been exercised.

Ex: Weather, demand for their product, interest rates

Expected Return:the weighted average return based on the probabilities of event.

Risk Preference

Three Levels of Risk Preference

Risk averse: prefers to make decisions that are less risky

Risk seeking: prefers to make decisions that are more risky

Risk neutral: makes decisions based solely on expected returns, and would be happy to take on risk anytime it will generate a benefit on average.

People are generally less risk averse with respect to gains, and are risk seekers with respect to losses.

SH are usu. more risk seeking bc they can diversify.

Non-Controllable Risks

Ways to avoid bearing risk

Insurance

Diversification: investing in ventures that have negatively correlated risks

Placing the burden of the risk on the person who is best able to bear it

Controllable Risks

Can be reduced by monitoring and disciplining devices that align the agent’s incentives with the interests of the principal.

Shirking:when a person does less than is optimal to control a risk.

Allocating Risk to the Owner

Steps to Monitor Employee

The owner must decide what constitutes optimal performance by the employee

The owner must determine whether the desired level of performance is occurring or has occurred.

Monitoring Devices

Direct supervision

Hiring supervisors

Employment contract between the employer and employee: specifies employee duties and sanctions if the employee failed to perform those duties

Allocating Risk to the Employee

Tenancy:renting the vineyard to the employee for fixed rent and allowing the employee to retain all the vineyard profits

Performance-based compensation:basing the employee’s compensation on the success or failure of the business

Annual salary of X, but if the annual net income of the business is less than Y, the annual salary will be reduced by Z%

Mixed salary and commission payment

Differing interests:short-term employee interests vs. long-term employer interests

Middle Ground Solution

Employer and employee agree to divide the profits of the business in a mutually agreeable proportion

Two problems

As the employee’s returns become increasingly dependent on the success of the business, the employee will become come concerned about control

Deciding the appropriate allocation of profits is difficult

Vineyard Problem

Ernest and Julia want to open a vineyard. E will be the employee. He has equipment and expertise. J is the owner of the vineyard and only knows that growing grapes is risky. Should they structure their relationship as a tenancy or as employment?

To determine which is better, we must consider who can best manage the risk.

Possible risks:

Weather – No one, non-controllable risk

Seeds – E, controllable risk

Market forces – No one, non-controllable risk

Farming – E

Employment

Considering from E’s perspective

E would like employment bc it is lower risk – he gets paid no matter what. But that means the return is also lower, and that means lower incentives.

Considering from J’s perspective

Her risks are higher, so her return and incentives are higher.

But she doesn’t have the expertise. So how would she deal with this?

Monitor E

Direct supervision

Hire a supervisor

Employment K

None of these monitoring options are free.

Tenancy

Considering from J’s perspective

Her risk is lower. Her return and incentives are lower.

J doesn’t have to monitor

Considering from E’s perspective

His risk would be higher. His return and incentive are higher. But he has the expertise.

His monitoring costs are lower than J’s.

Solution:Tenancy is the optimal option because it leads to higher net returns. But if E is risk averse, then he would still want employment.

TAKEAWAY:

Understand the conflicts between SH and those who run the corp.

SH are usu. less risk averse bc they can diversify. But they are concerned about low incentives for employees.

E is like someone running the corp.

INTRODUCTION TO CORPORATE LAW

Characteristics of a Corporation

Separate Entity:Every corp. is a legal entity that is separate from the investors who provide it with money and the people who manage its business.

Perpetual Existence:A corp. has an unlimited life.

Limited Liability:A SH’s liability is limited to the amount of money she paid for her shares. It is the corp., not the SH, that own assets of the business and is liable for its debts.

Centralized Management:SH elect a corp.’s directors, who have the power to manage and oversee the corp.’s business. Directors delegate responsibility for daily decisions to corp. officers. The separation between ownership and managerial control is one of the distinctive features of the modern corp.

Transferability of Ownership Interests:SH are free to transfer their stock without obtaining the consent of other SH.

Basic Terms and Concepts

Types of Corporations

Close corporation:usu. no market for the corp.’s securities and there is a substantial overlap of ownership and management.

Public corporation:there is an available market where the corp.’s securities can be bought and sold and there is a separation of ownership and control.

Corporate Actors

Shareholders:own stock in the corp. and elect the directors.

Directors:responsible for managing the corp.’s business and elect the officers.

Officers:responsible for running the corp.’s day-to-day business.

Stakeholders:creditors, employees, customers, and the community.

Corporate Securities

Debt is more secure for those purchasing it bc debt holders get paid first.

Equity provides higher returns for those purchasing it if the corp. does well.

Of course, the flip side is also true. If the corp. sells equity and then does really well, then the corp. will keep less.

Fiduciary Duties

Two Fiduciary Duties

Duty of Care

Requires the director to act in the corp.’s best interests and to exercise reasonable care in overseeing the corp.’s affairs and in making business decisions.

BJR applies to duty of care. It creates a presumption that in making a business decision, the directors of a corp. acted on an informed basis, in good faith, and in the honest belief that the action was taken in the best interest of the corp.

To rebut the presumption of the BJR,a P must show that a decision either:

was not informed;

did not have a rational business purpose (i.e. constituted a waste of corp. assets);

was made by a director or directors with a personal interest in the decision; or

was made by a director or directors who otherwise were not independent (i.e. were beholden to someone who had a personal interest in the decision)

If the P is able to rebut the presumption of the BJR, the burden shifts to the directors who must prove that th

ion gets the benefit of the BJR.

TAKEAWAY:If you give to a real charity a relatively small amount then it is almost always allowed.

THE CHOICE OF ORGANIZATIONAL FORM

Corp.

GP

LP

LLC

Formation

File

No file

File

File

Control

By shares

Equal

GP – Equal

LP – No control

Member – Equal

Manager – Equal

Management

BOD

All

GP – Equal

LP – No mgmt

Member – Memb.

Manager – Man.

Limited Liability

Yes

No

GP – No

LP – Yes

Yes

Payout

By shares

Equal

Equal by contribution

Equal

Tax

Corp. is taxed

Ind. are taxed

(Double Taxation)

Pass-through taxation

Pass-through taxation

Pass-through taxation

Transfer

Freely transferrable

Consent

Consent

Freely transferrable

Overview

A Few Thoughts

The rules we talked about are default rules. But tax and liability rules are not default rules.

It is always better to use the form that is closest to what your client needs bc the less changes you make the safer your document will be and the cheaper it will be for your client.

Under LLC virtually everything can be changed by contract [Uniform Limited Liability Co. Act § 103], but you have to draft a lot to make it look like a corp. and it’s not easy to know how a ct. would rule on it.

Corporation

Legal entity distinct from its owners

Governed by the laws of the state in which it was incorporated

Management is centralized in a BOD

Limited liability for SH, Directors, and Officers

Partnership

General Partnership (GP)

All partners have unlimited liability

All partners have an equal voice in management

All partners have the authority to act as agents for the partnership and incur obligations that will bind all partners

Limited Partnership (LP)

Combines elements of a GP and a corp.

Must have at least one general partner in addition to the limited partners

General partners have comparable liability to the liability they have in a general partnership, but a limited partner’s liability is limited to the capital she has contributed to the corp.

A limited partner has no voice in the active management of the partnership, which is conducted by the general partner

Limited Liability Co. (LLC)

A legal entity distinct from its owners (called members)

Like a corp., members have limited liability