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Business Associations
University of Illinois School of Law
Aviram, Amitai

business association
UIUC Aviram
Part 1:  Agency
                1.   Agency problem (as known as principal-agent problem): an externality that occurs when A controls an asset that is owned by B
ʘ Separation of control & ownership
·  Externality: is the characteristic that your actions affect someone else, negatively or positively
o    Positive externality: Maintaining an attractive front yard
o    Negative externality: Keeping a lion in your front yard
–      Actor (A): person who is acting on behalf of another (can cause externality)
•       E.g., agent (A) in agency law; director/officer in corporate law
–      Beneficiary (B): person on whose behalf A is acting (can suffer from externality)
•       E.g., principal (P) in agency law; the corporation in corporate law
–      Agency costs: the magnitude of a given agency problem
•       Probability A’s externality would harm B times harm from the externality
•       Difference between value created by firm when A is working for B, and value that would have been created by firm if A was working for herself (owned the firm)
•       To minimize agency cost
Align a party’s welfare with the group’s collective welfare
Performance-based compensation
Joint ownership
Have government enforce appropriate behavior by whomever acts for the group
Private ordering
Public paternalism
Private paternalism
Allow a party unilaterally to express dissent in a manner that may affect the group’s behavior
Allow a party unilaterally to end her association with the group without losing her share of the value produced by the group
Termination (dissolution)
          2.         Governance solutions
(1)     intervention
a.       Private ordering
·   Private ordering coordinates stakeholders by enforcing voluntary agreements the stakeholders reached (includes supplying default terms & interpreting the agreements)
Ø  Advantages
–                                                                                Least effort to enforce (agreements reflect balance of power between stakeholders)
–                                                                                Usually easy to morally justify
–                                                                                Stakeholders likely know best what terms are most suitable for them
Ø  Disadvantages
–                                                       When stakeholder can’t exclude others from their contribution, others have no need to bargain with that stakeholder
–                                                       Societies discourage some voluntary agreements; e.g., when:
· Bargaining power varies widely;
·       Society is more sympathetic to one party than the other;
·       Society wants to avoid commodification of sacred values, such as life/liberty
–                                                       When it is difficult to anticipate future contingencies or to describe in objective terms all desirable/undesirable behavior
b.      Public paternalism
·                                                                        Public paternalism coordinates stakeholders by enforcing behavior that government believes is in the stakeholders’ interest
–                                                       The political process determines what government’s beliefs are, so stakeholders & the firm use the political process to protect their interests
Ø  Advantages
–                                                       Protects social values (that the stakeholders are not concerned with)
–                                                       Protects stakeholders with weak bargaining power but significant political power (e.g., those who can’t exclude others from their contribution)
Ø  Disadvantages
–          Polity that elects government’s officers is not identical to the group of stakeholders in a firm – so outcome of political process represents balance of political power (votes & lobbying power), which might be so unfavorable to some stakeholders that they would not participate
–          One size fits all: government can’t create special terms for each firm, so the balance that is struck is a compromise that isn’t optimal for some firms
c.       Private paternalism
·                                                                        Private paternalism coordinates stakeholders by requiring those who act for the firm to pursue the interests of protected stakeholders
             Requires determining a protected class of stakeholders (beneficiaries)
             Actor must then act in the interest of the beneficiaries
–                                                       Determine a group of beneficiaries (protected stakeholders)
–          Impose a fiduciary duty (“FD”) on the firm (and on stakeholders who control the firm) to pursue the beneficiaries’ interests
–          Give actor discretion to act in the interest of the beneficiary, even if the act is against the wishes of the beneficiary (this element exists in “hard” private paternalism; “soft” private paternalism, without this element, is closer to private ordering)
Ø  Advantages
            Good for stakeholders not well protected by private ordering & public paternalism
Ø  Disadvantages
–          Works poorly when beneficiaries’ interests are diverse (no single “interest of the beneficiary”, so firm is either paralyzed or firm’s controllers can do whatever they want and claim they are pursuing beneficiaries’ interests)
–          Prioritizes beneficiaries over other stakeholders, so non-beneficiaries only get what private ordering (contracts) & public paternalism (regulation) give them
(2)       Branches of business law
mainly rely on one of the intervention solutions to coordinate stakeholders
–                                                       Regulatory law (public paternalism) E.g., tax, antitrust, environmental regulation
–                                                       Commercial law (private ordering) Firm’s business transactions (buying, selling, lending, etc.)
–                                                       Corporate law/organizational law (private paternalism) Firm’s internal governance (relationship between firm & its “owners”)
Branch of bus. Law
Private ordering
Government enforces voluntary agreements
Commercial law
Public patern

                               Firm may fire employee or renege on payments due
–                                                             Firm may degrade working conditions
·                                                                     Do intervention-solutions address externalities?
–                                                             Private ordering? Yes, mostly
·  Collecting payments & job protections can be negotiated; working conditions ar- e harder to specify objectively in contracts
–                                                             Public paternalism? Yes, somewhat
· Because working conditions are difficult to protect contractually, and because the public is sympathetic with employees’ interests, public paternalism has some role in the firm-employee relationship
·  Labor law includes some support for private ordering, but also mandates some worker conditions (minimum wage, workplace safety, etc.)
–                                                             Private paternalism? No (firm not required to care for employees’ interests, only to abide by duties imposed by law/contracts)
·       Employees have relatively heterogeneous interests
·          SHs are more vulnerable
·                                                                     Counter-externalities
–                                                             When firm hires employees to manage it (delegated control), a managerial (vertical) agency problem results (managers vs. SHs)
·      Shirk: manager may put less than optimal effort into her work
·      Steal: manager may enrich herself at SHs’ expense (or preserve her job when she should lose it)
–                                                             Same problem with other employees (e.g., construction worker shirking at work; cashier embezzles)
·                                                                     Do intervention solutions address counter-externalities?
–                                                             Private ordering? No
·     Firm’s interests vs. employees difficult to anticipate & specify in a contract
–                                                             Public paternalism? No
·     Voters unlikely to support firm’s interests against employees
–                                                             Private paternalism? Yes, soft private paternalism (employees must pursue firm’s interests, but must also follow the firm’s instructions)
·     Firm’s interests are homogenous (profitability); firm’s organs (board of directors) are able to supervise employees
Relationship: firm v. creditors