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Business Associations
University of Illinois School of Law
Aviram, Amitai

Fall 2011

Business Associations I


I. Three economic forms of firms

a. Public firm

i. Many members; centralized management

b. Private firm

i. Few members; decentralized management

c. Passive firm

i. Firm owns assets but doesn’t conduct active business

ii. Firm structure used to benefit from some legal features

(e.g., preferable tax treatment; limited liability, etc.)

II. Agency Problems

a. An externality is the characteristic that your actions affect someone else, negatively or positively

i. Positive externality: Maintaining an attractive front yard

ii. Negative externality: Keeping a lion in your front yard

b. A primary goal of law is to internalize externalities

i. Tort law forces an injuring party to internalize negative externalities it created to an injured party

1. E.g., the lion tamer example

ii. Contract law prevents opportunistic behavior that exploits a party that relied on a contract

iii. Corporate (organizational) law prevents a controlling stakeholder in a firm from misappropriating rights of other insider stakeholders

1. This type of externality is known as an agency problem

c. Agency problem (aka principal-agent problem): an externality that occurs when A owns an asset that is controlled by B

i. Separation of control & ownership

d. Terminology

i. Actor (A): person who is acting on behalf of another

1. E.g., agent (A) in agency law; director/officer in corporate law

ii. Beneficiary (B): person on whose behalf A is acting

1. E.g., principal (P) in agency law; the corporation in corporate law

e. Which stakeholder interests can be protected contractually?

i. Community

1. Protect local jobs & environment

2. Maintain services provided by firm

ii. Employees, suppliers & customers

1. Firm honors commitment to employ (emp.)/to buy (supp.)/to sell (cust.)

2. Pay money owed to employee/supplier

3. Maintain agreed upon product quality (cust.)

4. Maintain agreed upon working conditions (emp.)

iii. Creditors

1. Receive specified interest & principal at specified times

iv. Members

1. Receive firm’s remaining assets after all other obligations are met

f. Members vs. community

i. Solutions to the externality

1. Contracts? Usually won’t work (collective action problem)

a. Each firm wants government services, but would refuse to sign a contract to pay for them, hoping others would pay and it would benefit anyway

ii. Legislative mandate? Yes

1. Community protects against members’ opportunism via regulatory law (e.g., environmental law, zoning, antitrust, tax)

2. Members protect against community opportunism by lobbying (campaign finance laws are supposed to strike the appropriate balance between protecting community & protecting firms)

iii. Agency solutions? No (too intrusive)

1. Firm not required to care for community’s interests, only to abide by the law; government does not elect firms’ directors

g. Members vs. suppliers/customers

i. Solutions to the externality

1. Contracts? Yes

a. Both firm & suppliers/customers protect themselves from the other party’s opportunism via contract law

2. Legislative mandate? Generally no (too intrusive)

a. In some cases suppliers/customers receive protection via legislative mandate (e.g., consumer protection law, antitrust law)

ii. Agency solutions? No (contracts already address the externality & other stakeholders have greater need for agency solutions)

a. Firm not required to care for customers’ or suppliers’ interests; only to abide by the law & its contracts

h. Members vs. creditors

i. Both members & creditors want firm to make money. Where’s the externality?

1. If firm avoids risk (low upside & downside), there’s a low chance of insolvency, but profits are low whether things go well or poorly

a. Creditors like this, but members do not

2. If firm takes risks (high upside & downside), higher chance of insolvency if things go poorly, but profits are higher if things go well

a. Members like this (keep all profits of upside, share losses with creditors on downside), but creditors don’t (prefer low risk)

3. How can creditors contractually control firm’s risk-taking?

ii. Because contractual protection is effective for creditors, the solution to their externality problem is contractual (like customers/suppliers)

1. Exception: when the firm is bankrupt, creditors get agency solutions

i. Members vs. members

i. When members control the firm (decentralized management), the following governance dysfunctions may occur:

1. If m



i. Other examples of horiz. agency problem:

1. SHs employed by firm vs. other SHs

2. Short-term SH vs. long-term SHs

3. Renegade business partner


p. Agency problems vs. agency law

i. Agency law governs situations in which one person (A) acts on behalf of another (P), including interactions with third parties (T)

1. Example: P hires real-estate agent A to buy a house

ii. Legal issues

1. Contracts: Will P be liable for contracts A signed with T?

a. E.g., if A signs agreement to buy T’s house, and P doesn’t like it, must P pay?

2. Torts: Will P be liable for torts committed by A?

a. E.g., when A negotiates to buy T’s house, she loses her patience with T and punches him. Is P liable to T for damages?

3. A’s duties to P: How to deal with A’s shirking or stealing

a. E.g., A loves T’s house so much, she decides she’ll buy it for herself and find P another house. Can she do this?

q. The agency relationship – Definition

i. Restatement of Agency, §1.01: An agency relationship is created when A & P manifest assent that A shall act –

1. On P’s behalf

2. Subject to P’s control

ii. Restatement of Agency, §1.02: Parties’ labeling & popular usage do not control

r. Setting

i. The parties:

1. P – Principal: Person for whom action is to be taken

2. A – Agent: Person who is to act

3. T – Third Party: Person who deals with agent

ii. The relationships:

1. (1) – The agency relationship (between P & A)

2. (2) – A’s interaction with T

3. (3) – Legal liability of P to T (and of T to P)

s. Types of authority [Rest. § 2.01, 2.03]

i. Authority: the legal power of A to bind P

ii. Regarding a specific action of A:

1. A/T reasonably believes that A is authorized; and

2. This reasonable belief is traceable to manifestations by P