Corporations
Frank Partnoy
Fall 2011
Chapter 1: Economics of the firm – Pg. 3-24
a. Risk
i. Types of risk
1. Non-controllable risk: Risk that the parties to a business venture cannot control
a. E.g., Weather, demand, quality and quantity of supply from other suppliers, economic variables
b. Arguments to allocate this risk for both sides
2. Controllable risk: Risk that the parties to a business venture might be able to influence
a. E.g., How much you produce, Type of inputs to use, expenditures (R&D; physical plant; advertising and marketing; etc.)
b. Allocated to the people who control them
ii. Risk v. uncertainty
1. Risk can be quantified
a. If a business can quantify the risks associated with a particular decision, it can determine the expected return of that decision
i. (Probability of each event) * (return associated with each event) = expected return
2. Uncertainty cannot be quantified
a. Shareholder (SH) return based on uncertainty bearing
b. Big money is to be made in taking unspecified risk
iii. Risk tolerance
1. Risk aversion: Risk averse entities prefer a certain return to a higher uncertain return, even if the uncertain return has a higher expected return
a. Entities are more likely to be risk averse when large amounts of money are at stake
2. Risk neutrality: Risk neutral entities base their behavior entirely on expected return, don’t care about risk
3. Risk seeking: Risk seeking entities prefer a high uncertain return to a low certain return, even if the uncertain return has a lower expected return
a. Although entities generally are risk averse with respect to gains, they are typically risk seeking with respect to losses
b. Includes managers and shareholders
4. Expected return
a. Take the amount expected to gain or lose and multiply it by the probabilities for the expected return. Then add up the numbers to determine expected return
i. 1/3 *$6= $2
ii. 66% *$3= $2
iii. Expected return would be $4.
iv. Managing risk
1. Insurance: Offers private parties the ability to pool risk.
a. Can create a moral hazard: Insured entity more likely to take on more risk.
2. Diversification: Participation in numerous ventures involving different risks.
3. Allocation: Shifting risks among various entities to those entities most willing or best able to bear those risks.
a. Also allocation by sophisticated entities with superior information to entities less likely to understand risks
b. Can do this within a firm ie: to a manager
4. Externalization: Move the risk to people outside of the firm. (ex: pollution, banks bailout)
b. Allocating risk
i. Principal v. agent
1. Principal: Investor/owner
a. Principal will want to maximize return on investment and ensure that agent is using as much effort as possible to make venture a success
i. Principal will want agent to put principal's interests above agent's own interests
b. Principal will want/need to monitor agent to ensure that he does as expected (avoid shirking)
2. Agent: Manager/employee
a. Agent will want to maximize return on efforts, given alternative uses of time
b. Agent will want to expend as little effort as possible to make venture a success
ii. Time horizons for allocating risk
1. Ex ante (in advance)
a. Specify outcomes for contingencies in advance
b. Contracting for optimal structure in advance involves high transactions costs
2. Ex post
a. After-the-fact determination of whether the desired level of performance is occurring/has occurred
b. Ex post mechanisms have ex ante effects, because agent cannot be sure whether principal will enforce ex post mechanisms, creating an incentive for agent not to shirk
iii. Sources of rules
1. Contract
2. Common law
3. Statute
iv. Agency costs: Costs to the principal of monitoring the agent (or not monitoring the agent)
1. Optimal balance that best compromises between the conflicting perspectives of risk controlling and risk bearing
2. Tensions that rise b/w agents and principles, owners and managers, etc.
v. Allocating risk to the principal
1. If risk is the main concern, principal might be the better risk-bearer by virtue of ability to diversify and insure
a. Con: Principal must incur monitoring/disciplining costs to reduce costs of agent shirking
2. Principal will be more willing to bear the non-controllable risks
3. Principal can monitor agent by an employment contract
a. Because contracting involves transactions costs, might want to avoid contracting for all contingencies in advance by using, e.g., a best-efforts clause
i. Whether agent used best efforts decided ex post by an arbitrator
b. See Contract terms, BPP 8
vi. Allocating risk to the agent
1. If shirking is the main concern, agent might be the better risk bearer since entitlement to profits will incentivize agent to maximize venture's success (Invest Agent Into Company)
a. Con: Agent might not be willing or able to bear risks
2. Rental: Places the risk of shirking entirely on agent
3. Tie compensation to success: Creates incentive for agent and reduces need to monitor and discipline his performance
a. As agent's returns become increasingly dependent on success, agent will become more concerned about control
4. Long-term contract: Might more closely align agent's interests with long-term interests of principal, but might work against
vii. Risk should be allocated based on:
1. The one with the ability to bear the risk
2. incentives
c. The role of law in allocating risks
i. Fiduciary obligations
1. Legal system infers that when principal hires agent, principal expects agent to behave as principal would behave (as if agent were owner)
2. “Duty of loyalty”
3. Seek to protect those who delegate authority (capitalists) against the laziness, disloyalty, or worse of those who exercise this authority (managers)
ii. Mandatory v. default rules
1. Default rules
a. Impose duties where opportunities for strategic behavior exist
b. Like contract law: Default set of terms that law assumes parties have agreed to, absent evidence to the contrary
c. Important factors
i. Transactions costs: Default rules reduce cost of contracting
ii. Information asymmetry: Where information is asymmetrical, law might impose default rules to prevent injury to parties with less information access
d. Generally may contract around default rules
2. Types of default rules
a. Majoritarian default rule: Default term that most parties would agree to inserted in all contracts to reduce transactions costs
i. E.g., “Employee at will – An employment, having no specified term, may be terminated at the will of the employer”
1. N.B.: If underlying policy considerations apply, default rule might not be a default
b. Tailored default rule
e authorized by the AoI?
2. Issued: can only issue the amount authorized
3. Outstanding: shares sold and in the hands of SHs. B/c corps can buy back shares, not all issued are outstanding
iii. Debt:
i. Corporate Duties: duties owed to the corporation
i. Fiduciary duties:
1. Duty of care – directors must be attentive and prudent in making decisions
a. Focused on process, ex: how much time you spent, how careful/attentive you were
2. Duty of loyalty – requires managers to put the corporations interests ahead of their own
a. Focused on self interest, ex: paying self instead of the corporation
ii. Business judgment rule (BJR): Procedural presumption that directors acted in the best interests of the corporation; presumes that director decisions (1) are informed, (2) serve a rational business purpose, (3) are disinterested, and (4) are made independently; presumption rebutted by showing that one of the four presumed elements was not present – Provides broad discretion to board/officers.
iii. Derivative Suit vs. Class Actions
1. Derivative suit: Equitable action brought by SH on behalf of corporation; action brought against the corporation for failure to bring an action at law against a third party (usually a director); corporation is a nominal defendant, and plaintiff SH controls prosecution of the suit
a. Recovery goes back to the corporation
2. Class Action: A direct suit by a lawyer on behalf of SH suing the corporation and its insiders
a. Recovery goes to SH directly
j. Fiduciary duties
i. Director duties
1. Bayer v. Berand
a. C's president dominated the board and made decisions SHs did not like. C brought in a singer to do a radio show to market C's products. The singer was C's president's wife. SHs brought suit, and alleged that the fact that the singer was C's president's wife created a conflict of interest, thus rebutting the BJR presumption.
b. Court said that the character of advertising and the expenditures for advertising were matters of business judgment; case would have been disposed of on summary judgment if C's president's wife was not involved
c. “[W]here a close relative of the chief executive officer of a corporation, and one of its dominant directors, takes a position closely associated with a new and expensive field of activity, the motives of the directors are likely to be questioned. . . . [T]he entire transaction, if challenged in the courts, must be subjected to the most rigorous scrutiny to determine whether the action of the directors was intended ort calculated to 'subserve some outside purpose . . . .'”
d. Court held that the evidence failed to show a breach of fiduciary duty
i. Fact that C's president's wife's participation in the program may have enhanced her career does not warrant subjecting directors to liability where the advertising served a legitimate purpose and benefitted the corporation
1. Plaintiff SHs did not allege that the program was ineffective or inefficient; C's president's wife's compensation did not exceed that paid to other artists for comparable work
