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Business Associations
University of Illinois School of Law
Aviram, Amitai

Amitai Aviram
Business Association
Fall 2017
 
The shielding problem
Preventing B from exploiting T by dealing through A
(balanced against B’s interest to limit liability from A’s reckless behavior)
E.g. (contracts), A agrees to buy T’s building for twice the market price. Must B pay?
E.g. (torts), when A negotiates to buy T’s building, she loses her patience with T and punches him. Is B liable to T for damages?
Law & practices dealing with the shielding problem are called corporate compliance (or external governance); will be covered in Chapter 2
The agency problem (“vertical agency problem”)
Preventing A from shirking / stealing from B
E.g., Tony (T) offers A $1M if he causes B to buy T’s building. Can A accept this payment?
The principal problem (“horizontal agency problem”)
Preventing some Bs from exploiting other Bs
 
The second goal of corporate law is to facilitate business activity that is conducted jointly by multiple people: acting jointly through others
A business association (“firm”) is a legal concept designed to let multiple beneficiaries conduct business jointly
Doing business jointly creates a problem of collective control: making all EHs speak with one voice
Difficult if there is:
High cost to act collectively
Unequal access to info/expertise
Differing business interests
Two dysfunctions (note analogy to the agency problem):
Beneficiary apathy: some EHs lack ability/incentive to monitor As efficiently
Beneficiary rivalry: EHs have different incentives regarding firm’s behavior, so controllers can exploit minority beneficiaries
Example: Bank of America has thousands of SHs; how can they collectively control the bank’s agents (employees) and direct the bank’s behavior?
 
Acting jointly through others adds a third problem
The shielding problem: Preventing B from exploiting T by dealing through A (balanced against B’s interest to limit liability from A’s reckless behavior)
The (vertical) agency problem: Preventing A from shirking or stealing
The principal problem (“horizontal agency problem”): Making EHs speak with one voice (preventing some EHs from exploiting other EHs)
When beneficiaries can’t speak with one voice (because of apathy or rivalry), we need delegated control: appoint an uncontrolled actor (autonomous fiduciary – e.g., the board of directors) to control firm on EHs’ behalf
This reduces the principal problem, but increases the agency problem (keeping the autonomous fiduciary accountable to the beneficiaries)
The principal problem also complicates the shielding problem: Each EH is concerned about her personal assets seized because of firm’s obligations (& firm is concerned about each EH’s obligations). Do we distinguish between firm’s assets/liabilities & EH’s? Asset partitioning  (e.g., limited liability) reduces principal problem by doing so, but this increases the shielding problem
E.g.: EH forecloses on shares of a gas station & owns them in lieu of a defaulted $2M loan. When gas station makes profits, it pays them to EH as dividends. Gas station has a spill that causes $10M in environmental damage. When gas station is sued for the damage, it doesn’t have money to pay. Must EH pay the damages?
 
Many Bs Acting jointly through others
Can all Bs speak with one voice?
Low cost to interact with each other?
Equal access to info/expertise?
Similar business interests?
Dysfunctions
Beneficiary apathy (makes agency problem worse)
Beneficiary rivalry (controlling Bs exploit minority Bs)
The principal problem (“horizontal agency problem”)
Preventing some Bs from exploiting other Bs
 
Delegated control mitigates the principal problem, but exacerbates the:
agency problem: keeping board accountable to SHs
shielding problem: SHs hide behind firm’s limited liability
 
Outline
Chapter 1: Acting through others
a. Introduction to BA
b. Firms
c. Actors
Chapter 2: Corporate compliance (external governance)
a. B’s liability for A’s contracts
b. B’s liability for A’s torts
c. Reaching better defendants
Chapter 3: Corporate governance (internal governance)
a. Fiduciary duties
-Duty
-Standard of review
-Application
 
 
Firms (1/4): Types of firms
Types of firms
Two taxonomies of firms
Economist’s perspective
How do you decide which type a given firm is?
Characteristics of the firm (especially ownership structure) that tend to create governance problems (agency/principal problems)
How are firm types different?
Policy used to mitigate the expected governance problems
Lawyer’s perspective
How do you decide which type a given firm is?
Conforming with a legal test for creating the firm (usually, incorporator’s choice + following certain formalities)
How are firm types different?
Different sets of mandatory & default rules
Economic types of firms
Private firm (low cost for Bs to speak in one voice; e.g., few Bs)
Direct control by Bs
Liberal termination/dissociation (firm often must accommodate dissenting B’s exit)
Restricted alienability (difficult to sell B’s interest to third parties)
Contractual flexibility (parties can opt out of most rules)
                    Shielding Problem            Agency problem (-)     Principal problem (+)
Public firm (high cost for Bs to speak in one voice; e.g., many Bs)
Delegated control (firm controlled by a board that is elected by Bs)
Restrictive termination/dissociation (firm rarely needs to accommodate dissenting B’s exit)
Liberal alienability (easy to sell B’s interest to third parties)
Contractual rigidity (most rules are mandatory)
Shielding Problem            Agency problem (+)    Principal problem (-)
Proprietorship (a single B)
Operates a business but does not have multiple owners
                    Shielding Problem            Agency problem (-)     Principal problem (X)
Passive firm (single B or multiple Bs)
Firm owns assets but doesn’t operate a business; firm structure used to benefit from some legal features (e.g., preferable tax treatment; limited liability, etc.)
Shielding Problem            Agency problem (X)    Principal problem (X)
 
Legal types of firms
Corporation
Public corporation
Close corporation
Benefit corporation
Partnership
General partnership (“GP” or “partnership”)
Limited liability partnership (“LLP”)
Limited partnership (“LP”)
Limited liability limited partnership (“LLLP”)
[Joint venture] [Joint stock company] ———————–
Limited liability company (“LLC”)
Two defaults for governance: member-managed (similar to partnership) or manager-managed (similar to corporation)
Extreme contractual flexibility
Proprietorship (aka Sole Proprietorship)
An individual operating a business directly (without using an artificial entity); sometimes uses a business name (“doing business as” or dba)
Business trust (based on the common law concept of a trust)
Cooperative associations (ownership based on employment/consumption, not capital)
Nonprofit associations/corporations
 
Types of firms
The corporation
By default, the corporation is optimized to be a public firm
Delegated control
Liberal alienability/restricted termination & dissociation
Contractual rigidity
Applicable law
Corporations are governed by state statutory law
Less uniformity between states than in agency or partnership law
Public corporations are also subject to

a lot of issues that come up in corporate governance
We will do this bit by bit, starting with the next class on ConDocs
But why waste time talking about creating general partnerships?
 
Creating a GP: Martin v. Peyton [NY 1925] Knauth, Nachod & Kuhne (KNK) was a well-known banking and brokerage partnership (founded in 1839)
KNK’s expertise was in German securities…
But World War 1 causes this market to collapse…
KNK moves into petroleum securities…
When the oil company bubble bursts, KNK is in deep financial difficulties…
John Hall, a KNK partner, asks friends at investment bank Payton, Perkins & Freeman (PPF) for help. They strike a deal to lend KNK $2.5M:
Do KNK & PPF have the same incentives re managing KNK?
PPF lends KNK $2.5M in marketable securities
What’s the most PPF can expect to lose?
PPF receives:
Downside protections:
Collateral: KNK’s speculative securities
Dividends on the securities PPF lent to KNK
Upside potential:
40% of KNK’s profits for duration of loan, with minimum & maximum caps
Option to join the firm
Control protections:
Inspection & veto rights; duty on KNK to consult with PPF
Hall manages KNK; all other partners must give KNK option to be bought out
PPF should not have trusted John Hall
KNK speculates in foreign currency, loses money & becomes insolvent
KNK’s creditors sue PPF, claiming KNK’s failed business was in fact a partnership between PPF and KNK
If that’s true, PPF has unlimited liability for all of KNK’s obligations
That’s a lot more than the $2.5M they thought was the most they could lose
But how could this be a partnership?
First let’s take a step back and compare ways to create firms
 
Three methods (used by different types of firms)
1. Creation by filing (corporation, LLC, LP, LLLP)
Firm is created when Secretary of State confirms that an entrepreneur (EH or someone who will recruit EHs) filed certain documents
Creating a corporation
Incorporator chooses the state of incorporation
Incorporator drafts charter
Incorporator files charter with the relevant state’s Secretary of State
The person filing the charter is the incorporator (DGCL §107); an incorporator is an autonomous fiduciary (owes a fiduciary duty to the corporation)
Once state certifies the filing, corporation has been created (DGCL §106)
——-firm exists
Organizational meeting of incorporator/initial board (adopt bylaws/name directors)
Adopts bylaws; names directors if initial board was not named in charter
Board issues shares to SHs
Board appoints officers & other agents
Defective corporations
De facto corporation
Corporation by estoppel
Corporation is created only when Secretary of State acknowledges that the charter was filed
Exception – “defective corporation”: sometimes courts recognize a corporation even without Secretary of State’s certification of the charter being filed
De facto corporation
Corporation by estoppel