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Business Associations/Corporations
University of Iowa School of Law
Sale, Hillary A.

Chapter One:
Economic and Legal Aspects of the Firm

A.        Some Basic Concepts and Terminology

ú         R.H. Coase defines the firm as the antithesis of the market. In the idealized market, each producer and consumer separately calculates her own self-interest and chooses what to make and what to buy based on price signals received in the market. As a result, resources are allocated to their highest and best use. But in the firm, resources are allocated pursuant to conscious orders or directions from the employer to her employees. Thus, the “firm” is what we call 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 arise when an entrepreneur allocates resources via contract with outsiders.
ú         On the other hand, principle-agent theorists, and many law and economics scholars, describe the firm as a nexus of contracts between the various claimants to a share of the gross profits generated by the business.

B.        Organizing the Firm: Selecting a Value-Maximizing Governance Structure

ú         The expected return of an investment is the mean of possible outcomes.
ú         “Risk” means the degree to which the various possible outcomes will differ from the expected return.
ú         Investors are generally characterized as “risk averse,” “risk neutral,” or “risk preferring.” An investor’s risk preference will likely differ according to the circumstances.
ú         Risk-averse investors often minimize risk by diversifying their portfolios. An investor is able to achieve a less risky portfolio by diversifying her holdings so that the range of possible outcomes varies less from the expected return–or mean of possible outcomes–than before. The more diversified the portfolio becomes, the less will be the possible disparity between actual and expected total returns.
ú         Three concepts that are useful for understanding transaction costs include:
o        Bounded Rationality. While individuals intend to act rationally, there are cognitive limits, or bounds, on their ability to do so.
o        Opportunism.Opportunism is self-interest seeking with guile: Individuals who act opportunistically seek to further their own ends by taking advantage of the information deficits of those with whom they deal. An opportunistic actor seeks to extract an advantage that would be denied him if the party with whom she deals had full information.
o        Team-Specific Investment. When a person or asset has a higher value in its current team use than its value in its next best use, the person or asset is said to have team-specific value.
ú         One response to the problem of opportunism is to execute a contract that specifies the rights and duties of the parties, thereby creating an explicit team.
ú         Contracting, whether discrete or relational, involves significant transaction costs. Organizing as a firm can reduce such costs because the firm can adapt quickly to changed circumstances through unilateral management decisions.
ú         Most rules provided by the state may be modified by private ordering. Such rules are called “default” rules. Other rules, however, cannot be modified by private ordering, and are therefore called “immutable.”
ú         There are three types of default rules:
o        Tailored Rules are designed to give contracting parties the exact rule they would themselves choose if they were able to bargain without cost over the matter in dispute.
o        Majoritarian Rules are designed to provide investors with the result that most similarly situated parties would prefer.
o

employer and should withhold no information which would be useful to the employer in the protection and promotion of his interests.
o        It is irrelevant that performance on a contract is to occur after the employment relationship is terminated, if the contract calling for such performance was negotiated prior to termination of employment.
o        However, absent a non-competition agreement, a former employee, after termination of his employment, may compete with his former employer. However, he cannot use his former employer’s confidential information or trade secrets.

ú         Hamburger v. Hamburger (Mass. 1995, 19):
o        An employee is free to make logistical arrangements, such as arranging financing and leasing space, while still an employee.
o        Absent a non-competition agreement, a former employee, after termination of his employment, may compete with his former employer, using the general knowledge, experience, memory, including “remembered information,” and skill the former employee acquired while employed. However, he cannot use his former employer’s confidential information or trade secrets. Customer lists are not “trade secrets” if they are readily available from published sources, such as business directories.
o        A non-competition agreement is enforceable if it is reasonable given its duration and geographic coverage, and the nature of the employer’s risk from such competition. Rule from notes following case.