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Business Associations/Corporations
University of San Diego School of Law
Lee, Mark R.

CORPORATIONS OUTLINE
Prof. Mark Lee
Spring 2011
 
Introduction to the Business World
 
Business association: a set of contracts among owners, creditors, executives, and workers; in economics, a “firm” or “nexus of contracts”
 
Firm: a contract for a hierarchical relationship in which certain people have control over resources contributed by others
 
Fixed obligation
 
Residual claimants: have a claim to what is left after paying creditors, employees and other fixed claimants
 
Nonrecourse loan: functionally equivalent to a loan with no recourse to a person with no significant assets other than those invested in the business
 
à Most issues concerning governance of business associations, relate to the allocation of power between the residual claimants and the managers
 
Economic Theory of Business Associations: why do parties choose a certain business association?  Parties to business transactions choose the form of contract that minimizes the total costs in the parties’ particular business
·         Transaction Costs (Coase Theorem): the costs of entering into multiple transactions help explain the decision to organize firms
o   Illustration: A buys bulbs and sells them to B, who affixes knobs and sells the enhanced products to C, who buys and affixes second knobs and sells the completed widgets to consumers OR A buys the bulbs and knobs, hires B and C as employees and has them affix the knobs to the bulbs, and then sells the completed widgets
o   But:
§  Parties could also avoid the costs of repeated contracts by negotiating a single long-term contract that provides in advance for prices and quantities
§  Coase theorem does not explain why parties may choose a hierarchical or firm-type arrangement instead of entering other types of contracts
·         Shirking: a problem in situations involving team production (two or more people combining their resources to produce more than they could by working separately); it is difficult to measure each party’s contribution from what they jointly produce, so some members may contribute less effort or lower-quality resources in the hope that others will pick up the slack
o   If the shirkers cannot be penalized, they will come out ahead but joint profit will decline
o   Possible solutions:
§  Monitoring: hire a monitor to observe the parties’ effort and mete out rewards and punishments
·         But the monitor could shirk à so give the monitor a share in the profit left after subtracting payments to the team members; so the more effort by the monitor to detect shirking, the higher his reward
·         In corporation, monitor = shareholders
§  Contracting: the members can bind themselves together by contract, specifying the way each worker is supposed to perform his job (but this is costly to write)
·         Bounded Rationality: when contracting is difficult due to the inability to foresee and plan for contingencies, provide a way to deal with contingencies as they arise by establishing a decision-making device such as voting by owners, allocating power to executive or board of directors, or let courts fill in the blanks
·         Agency Costs: the costs imposed on the principal when an agent with discretionary authority takes actions to help himself rather than the principal; ex: shirking
o   Possible solutions:
§  Monitoring
§  Bond: any kind of asset that can be lost if the one who posted the bond misbehaves, may include intangibles like reputation for honesty
o   Agency costs = monitoring costs, bonding costs, and residual losses
·         Opportunism: the propensity to seize on the opportunity for gain, permitted by the literal terms of the contract or by breach of the contract
o   Possible solutions:
§  Long-term contract with penalties for failure to perform – but the threat to not perform cannot adequately be solved by litigation
§  Buy the resources you need instead of contracting (newspaper buying its own press)
·         Risk Bearing Costs: people can reduce risk by holding diversified portfolios of assets
o   Finance theory assumes that people are risk averse; risk = the variance of possible outcomes from an investment or other endeavor
 
The Role of the Law in Business: to what extent should the law of business associations be left to private contract, and to what extent should the law regulate the terms on which the parties enter into business associations?
·         Contractarian View: a business association is viewed simply as a nexus of contracts
o   1) The law provides a mechanism for enforcing the parties’ arrangements; but courts are not the only mechanism of enforcement
o   2) The law provides a way of determining the parties’ contract terms = gap-fillers
§  When does a gap exist that needs to be filled?
§  How should a court go about filling the gap? 
·         Hypothetical bargain – court should formulate a hypothetical bargain that informed parties would have entered into if they had contracted every detail
·         Regulatory View: the law should dictate some of the terms of business associations; state-conferred privilege (the appearance of state creation)
o   1) Government regulation is believed to be necessary to protect public corporation shareholders from terms to which they have not actually consented, rescuing them from a position of weakness in the corporation
o   2) Shareholders’ contracts should not be enforced because of the need to protect the interests of non-shareholders who are affected by the firm
§  Corporate managers may ignore the costs incurred by non-contracting parties – pollution, consumers
§  This externalization of costs may cause a misallocation of resources (results in more pollution than is socially optimal)
o   3) Regulation of contracts has been based on the inherent incompleteness of all corporate contracts – parties cannot contract against every contingency
o   à General distrust of state corporation law à strong federal law of business associations
§  Require minimum federal standards for corporate charters, or
§  Federal securities laws
o   This view emphasizes the sophistication and variety of market and contract devices; efficient capital market hypothesis = relevant info is quickly and accurately reflected in the prices of capital assets; the costs of contracting are reflected in market prices = you get what you pay for
 
Bargain Elements and Constraints
·         Deal Points – the 4 fundamental bargain elements, subject to 3 constraints
o   Risk of Loss: the allocation among the participants of losses from the investment in or operation of the business
o   Return: salaries, interest, and other fixed claims, and shares of the residual (profit)
o   Control: who has the right to make the various decisions affecting the business; generally it goes with the residual claim but some aspects of control may be allocated to lenders, employees, or others
§  Most questions of governance relate to the allocation of power between the residual claimants and the managers
o   Duration: how long the relationships among participants will last
§  Termination
§  Transfer
§  Withdrawal
·         Constraints – 3 constraints on the 4 deal points
o   Conflict of Interest: arises from the fact that people tend to pursue their own self interest, so they may cheat, steal or shirk
o   Governmental Regulation: may limit the freedom of participants to adopt rules they might have chosen
o   Specificity: complete specificity of all outcomes in all possible situations is not possible, and even if it were possible, it would probably not be worth the cost
§  Rely on other devices such as sharing provisions to align their interests, vague general rules, good faith and honesty
 
Types of Business Associations
Sole proprietorship: there is only one owner (residual claimant), who has the exclusive claim to the profits of the business; personally liable for all business debts
 
General partnership: two or more residual claimants who share the monitoring role; personally liable for the debts of the business
·         Aggregate features:
o   Personal liability of partners for debts of the business
o   At least nominal ownership by individual partners of partnership property
o   Technical dissolution of the partnership upon any change in membership
o   Flow-through taxation, where partnership income is taxed directly to the individual partners not the partnership
·         Entity features:
o   Power to sue or be sued in the partnership’s name
o   The right to hold or convey title to property in the partnership’s name
o   The ability to provide for continuance of the partnership by contract even when the partnership technically dissolves because of a change in membership
 
Corporation: has many residual claimants who contract to allocate control and profits; owners are passive and delegate to the corporation’s managers the responsibility for day-to-day operations
·         Owners are fungible capital providers, so shares can be freely transferred
·         Limited liability – owners are not personally liable for the debts of the business; public filing that informs all creditors of incorporation
·         Separate legal entity:
o   Rights, powers, liabilities separate from the owners and managers
o   May own and hold title to property
o   Continued existence is unaffected by changes in its shareholders
o   Corporation is liable for the debts of the business
o   Subject to taxation separately from that of the shareholders – taxed twice
 
Close corporation: the membership is limited rather than open to all; partnership-type owner-management and corporate-type limited liability
 
Limited Liability Company: owners have the limited liability of limited partners and corporate shareholders, the flexibility to take on the management powers of general partners without jeopardizing their limited liability, and the flow-through taxation of general and limited partnerships
 
Limited liability partnership: essentially a general partnership whose owners, by filing a registration and complying with other formalities, obtain full or partial limited liability
 
Limited Partnership: some owners are general partners (active involvement in management and personal liability); others are limited partners (non-management monitoring status and limited liability)
·         Combines partnership-type taxation with corporate-type organization
·         Personal liability on the managers can reduce credit costs by ensuring creditors that the business will be managed in their interests
 
G

but the UPA governs elements of the relationship upon which the parties have not agreed, as well as the rights of third parties
 
UPA and RUPA: implied standard-form agreement of partnership
·         Standard form contracts to reduce the costs of entering into agreements
o   Ownership: essence of partnership is that the partners are co-owners; each has the power to control the business and to share in the residual claim/profits (UPA § 18(a) & (e); RUPA § 401(b) & (f))
o   Agency: each is a co-principal and an agent in a principal-agent relationship
§  Power to bind business to acts within the scope of agency (UPA §§ 9-14; RUPA §§ 301-305)
§  Personally liable for the acts of the agents (UPA § 15; RUPA § 306)
o   Voting: each may veto important acts (UPA § 18(h); RUPA § 401(j)); including admission of new partners (UPA § 18(g); RUPA § 401(i))
o   Transferability: NO free transferability (UPA §§ 31-38; RUPA §§ 601, 801)-
·         Drafting Around the Default Rules: many default rules can be modified by private agreement of the partner
o   Spoiling the deal: concern that efforts to draft partnership agreements may cause problems
 
Informal Partnerships: a partnership may exist even if it is not planned, or even if the relationship is explicitly planned not to be a partnership
·         Issue: did the parties enter into a partnership but opt out of a standard form term OR did they enter into a non-partnership relationship (ex: employer-employee, debtor-creditor)?
·         4 Elements of Partnership (UPA § 6; RUPA §§ 101(6), 202)
o   Membership: a partnership consists of two or more persons/corporations
§  “Silent partner” – typically a person who has invested in a business in return for a profit share and who reserves the right to participate in major decisions, but does not expect to participate in routine management decisions, may not participate in decisions at all, and may be unaware what is happening in the business
·         But the law does NOT distinguish between passive and active partners
o   Association: implies an intentional relationship; the partners must intend to enter into a relationship that includes the legal elements of partnership, but they do NOT have to know they are engaging in a partnership (RUPA § 202(a))
§  Intent – Minute Maid dissent
o   Form of Activity: the parties must carry on a business for profit
§  If just lender relationship with agreement that compensation for the loan is in the form of sharing profits (either in lieu of or in addition to normal interest), that would be enough to rebut the presumption of partnership that arises by profit sharing agreement (Minute Maid)
o   Type of Participation in the Activity: the parties must be co-owners = profit-sharing + control
§  Profit-sharing – relates only in the third party liability case? Note 4, at 35
§  Minute Maid v. United Foods: UF buys juice from M but doesn’t have enough credit to get the best deals; CS financially backed UF; UF bought juice from M but didn’t pay; is CS liable?
·         UPA § 7: profit-sharing is prima facie evidence of partnership unless the parties are engaged in a special relationship (lender-borrower, bailor-bailee, etc.); ex: non-recourse loan + share of the profit does not mean partnership
o   Profit – both parties would profit by increasing the purchases
o   Joint control – CS had a say in how much and what UF would buy and store; charged interest to go in special fund and any deficit would be shared equally; more than just normal creditor terms
·         Hypo bargain: M never would have made the deal with UF if it had known that UF had no money and that CS would not be liable
·         YES partnership
§  Martin v. Peyton: fat cats loaned money to KNK
·         Control – no cash withdrawals without permission, no speculation in foreign currency, fat cats could make the partners leave the firm, 40% of profit until debt repaid, option to join firm if desired, could veto any speculative business decision
o   Option to become partners clause – makes it seem like there is no partnership before that option
·         NO partnership
·         Third party and inter-party cases should not be distinguished except in the estoppel situation (note 4, at 35)