Wonnell, Spring 2012
Corporations, Law and Policy, Materials and Problems, 7th (American Casebooks)
1. ECONOMICS OF THE FIRM
A lawyer performs best in a business setting when the lawyer understands the economic stakes for each of the participants.
o Grapes and winemaking (the capital investor and the party that does the work)
§ Controllable risks: business risks that one or more parties to the venture might be able to influence.
· e.g., amount of work on vineyard, research, advertising, marketing.
§ Non-controllable risks: parties cannot control and controllable risks that remain after all reasonable efforts to control them have been exercised.
· e.g., weather.
§ Uncertainty: something that cannot be quantified; risks can be quantified.
§ Expected return: the weighted average return based on the probabilities of events.
§ Risk can be beneficial to a firm.
§ Risk averse: not even willing to take a rational risk for the sake of complete certainty.
§ Risk neutral: makes decisions based solely on expected returned, would be willing to risk anytime it will generate a benefit on average.
§ Risk seekers: love to bet even if on average they will not benefit more by doing so.
§ If something can be quantified it is more likely to affect decisions; however, uncertainty can also affect behavior.
§ Success of a business depends on how well it manages risk.
§ Ways to manage risk:
· Insurance (pooled risk)
· Note: Some people act as individual insurer in commodity exchange markets where they bet on non-controllable risks and can claim the premium if they are right.
· Diversification (exposure to independent risks in different domains)
· Note: Capitalist in the best position to diversify. Worker can diversity to a limited extent because of the ultimate limit of being at one place at one time.
§ Principals and agents can affect controllable risks by acting or not acting.
§ Controllable risks can be reduced by monitoring and disciplining devices.
§ Shirking (moral hazard): when a person does less than is optimal to control risk.
§ Best position to control risk does not necessarily = best position to bear risk.
B. Allocating Risks to the Owner
· Owner must set standard for optimal performance ex ante and monitor the performance ex post.
§ Supervise (expensive)
§ Contractually (still expensive)
· Optimal to define not by effort but results.
· e.g., “best effort,” ex post, can use yearly comparisons or comparison to other salespeople to determine if met. Last step, go to arbitrator to decide.
· Costs of drafting, negotiating and cost of enforcing is high.
Allocating Risks to the Employee
· Risk entirely on employee.
§ e.g., lease to employee and allow him to get his own profits; but, employee might not have sufficient capital.
· Less drastic, base salary on success or failure or business.
§ Monitoring may still be necessary if the owner and employee have different investment horizons.
§ Self-effectuating monitoring device; however, it can lose meaning when demand is high.
The Middle Ground Solution
· Monitoring still required even if profits are shared.
· Other problems:
§ As the employee’s returns increasingly depend on the success of the business; employee will become more interested in operating the vineyard as he sees it fit.
· Other issues:
§ Specialization of skill manager develops over time which may help him demand more or limit him to a particular company.
What Else Is There?
1. Law and Human Relationships
§ The legal duty of loyalty and fiduciary obligation is an ideal that in reality is probably never attained.
§ The ideal of the owner-managed firm is unattainable where the work is done by an employee.
2. Beyond Agency Costs
§ More complex questions arise when we have publicly-traded companies.
· Who is the owner?
· Do the shareholders tell the executives what to do?
· Do executives have duty to make company as profitable as possible?
· What about other stakeholders?
· Relationships with government or community; are they relevant?
· Is the political process and contractual negotiation sufficient to give outside stakeholders what they want?
· Should corporate law go beyond agency cost and profit maximization?
5. THE CHOICE OF ORGANIZATIONAL FORM
· Corporation: governed by law of the state in which it is incorporated; centralized board of directors; limited liability.
· General partnership: all partners have unlimited liability and equal voice in management and can incur obligations and bind all partners.
· Limited partnership: at least one general partner and other limited partners. General partner has complete liability. Limited partners have no voice in active management.
· Uniform Rules as to Partnerships: Virtually everywhere UPA AND RUPA govern general partnerships; while, ULPA and RULPA govern limited partnerships.
· LLC: hybrid, 1990s on proliferated; owners called “members” who have limited liability. Management can be centralized or decentralized per operating agreement. LLC can elect to be taxed as a partnership. Statues vary by state.
Unless specified otherwise by agreement where available as an option for that particular business form.
§ Corp: formal action with the state; articles of incorporation must be filed, certain information required.
§ GP: no filing required; formed consensually when two or more enter into a contract; may also be created by operation of law.
§ LP: requires filing with the state; certificate must set forth rights and duties of partners and identifying the general partners.
§ LLC: requires filing articles of organization; some states require an operating agreement.
2. Limited Liability
§ Corp: limited to original investment
· Exceptions: not properly formed; unpaid capital contributions agreed to make; limited liability pierced for equitable reasons.
§ GP: partners, as individuals, can be held jointly and severally liable.
§ LP: general partner has unlimited; limited partners limited to amount invested as long as they don’t participate in management.
· If GP is a corp., then issue of unlimited liability can be tackled that way.
§ LLC: like corporation.
3. Management and Control
§ Corp: centralized in board of directors elected by the shareholders; day-to-day operations delegated to officers appointed by board.
§ GP: each partner has equal voice regardless of contribution.
§ LP: GPs has responsibility for most management decisions; LPs can vote on major decisions.
§ LLC: member-managed or manager-managed.
4. Continuity of Existence
§ Corp: Exists in perpetuity.
§ GP: at will, dissolved on the death, bankruptcy or withdrawal of any partner; if through withdrawal, withdrawing the partner can demand liquidation of business; when partner dies, surviving partners can elect to pay off estate and continue operating.
§ LP: Dissolved only when GP withdraws.
§ LLC: exists in perpetuity unless otherwise provided for by agreement.
5. Transferability of Interests
§ Corp: free to transfer shares without consent.
§ GP: All current partners must consent to transfer of partnership interest or admission of new partner; however, economic interest can be transferred.
§ LP: can transfer financial interests, but assignee can exercise governance rights of a LP with consent of all other partners, no risk of personal liability created by transfer of limited partner interest.
§ LLC: Since 1996, many statutes allow free transferability of member rights.
6. Fiduciary Duties
§ Duty of care: requires directors to as in best interest of corporation.
§ Duty of loyalty: requires directors to place the best interest of corp. above their own.
§ Partnerships and LLCs are contractual so fiduciary duties do not necessarily apply; however, some states preclude complete elimination of fiduciary duties.
C. Planning Considerations
§ Current assets (cash or converted to cash within 1 year).
· Cash: petty and in deposit at bank.
· Marketable securities: purchased with cash not needed for current operations.
· e.g., commercial paper or treasury bonds.
· NOTE: GAAP allows reporting these at fair market value rather than cost; known as “mark to market.”
· Accounts Receivable: amounts not yet collected from customers to whom goods have been shipped or services delivered.
· Deducted by an allowance for “bad debt,” usually based on historical information. Historical information may not be useful if significant change in customers.
· Notes or loans receivable: like accounts receivable but usually represent a large portion of the assets of a firm in a financing business. Therefore, changes in the percentage of bad debts can have huge impact in these firms.
· Inventory: goods held for use in production or for sale to customers.
· GAAP require to be valued at lesser of cost or market.
· Cost of goods sold: expense of the items sold for inventory; usually largest single expense for a firm.
· Methods of tracking:
· Each piece of inventory.
· By counting before period and afterward and recording difference.
· LIFO (last purchases by firm sold first).
· FIFO (older purchases by firm sold first).
· Average Cost method (not sequential).
· Methods of valuing closing inventory (LIFO/FIFO) can affect the net income assuming increasing costs of inventory which in turn can affect taxes and lower increases in assets.)
· Obsolete inventory must be removed from assets and recorded and charged against earnings in a period when deemed obsolete.
· Value judgment, manager reluctant to deem obsolete.
· Prepaid expenses: payments a firm has made in advance for services it will receiving in the coming year.
· Deferred charges: reflect payments made in the current period for goods or services that will generate income in subsequent periods, such as advertising to introduce a new product.
· Can be abused; watch for large deferred charge figures.
§ Fixed Assets (aka property, plant and equipment)
· Assets a firm uses to conduct its operations.
· GAAP require keeping the value on the balance sheet at historic cost.
· GAAP recognize that the value of fixed assets might decline over time; to record reduction a depreciation expense is recorded.
· Where book value of fixed asset exceeds market value because of obsolescence it must also be written down as an expense against earnings.
§ Intangible assets
· No physical existence but substantial value.
· e.g., patent or trademark
· GAAP, carried at cost less an allowance for amortization (equivalent of depreciation for tangibles) but ONLY if purchased. If developed, not recorded.
· Good will: If one firm acquires another for a price that exceeds the fair market value of the acquired firm’s identifiable assets, GAAP require recording difference as “goodwill.”
· Current: must be paid within one year of date on balance sheet.
· Long Term: debts due more than one year form the date of the balance sheet date.
· GAAP, generally, require footnotes for “off balance sheet financing”
· GAAP are complex as to contingent liabilities, e.g., plaintiff’s claim in a pending civil suit.