Corporations Lee Fall 2015
1. Introduction
a. Legal And Economic Views Of Business Associations
i. What is a firm or business association as an economic matter?
1. A business firm is a command economy where there is an owner who controls the actions of the employees and also takes all of the risks regarding profits and losses. Employees do the bidding of the owner and provide labor.
b. Economic Theory And Business Associations
i. Why do we have business firms?
1. Business firms enable people to minimize the costs of a truly market model.
ii. Market Model Costs:
1. Transaction Costs – includes time involved in contracting, negotiating and pricing issues.
2. Shirking – One person provides inferior products to another person because of difficult detection of inferiority.
3. Bounded Rationality – The costs necessary to cover contingencies that can’t be known by individuals.
4. Agency Costs–generally refer to the costs imposed on the principal when an agent with discretionary authority takes actions to help himself rather than the principal (ex. shirking by agents is an agency costs)
5. Opportunism – Taking advantage of someone or something. If there is sequential production then the parties later in production can hold the parties earlier in the production hostage because of no market for the early production.
6. Risk Bearing Costs – one person may not have all the necessary capital or may not want to risk all their capital.
iii. Business organizations minimizing these costs:
1. Transaction costs – fewer contracts because it is a command economy.
2. Shirking – Owner has interest in monitoring employees so can minimize shirking.
3. Owner can make decisions regarding uncertainty that occurs, therefore not as many costs in preparing for the contingencies.
4. Eliminate opportunism because employees have no incentive to engage in opportunism and could get fired.
5. Can aggregate more capital through more people (owners) or have one owner take all of the risk.
iv. However, there are costs associated with firms:
1. Agency problems – employees do not work as hard as owners because they do not have as much incentive.
a. Solve this by hiring employees with integrity
b. Requiring the posting of a bond.
c. Motivate employees
v. The major question in determining whether to form a business organization is whether the market model or the association minimizes the most costs.
1. If association minimizes costs, make an association.
2. If market model minimizes costs, then make a market model.
2. Types of Business Associations
a. Sole Proprietorship
i. One owner
ii. Personally liable for all business costs (including torts by employees)
iii. Problems
1. Size – cannot grow larger than one owner can manage.
2. Key Employee – a key employee can hold the owner hostage
b. General Partnership
i. Governance
1. No formation rules – you can back into a partnership if you act like one.
2. UPA and RUPA cover governance in most states.
ii. Default features:
1. Multiple owners
2. partners share equally in profits/losses
3. personal liability for firm debts
4. partners share equally in management decisions
iii. Benefits:
1. Flow-through taxation (only taxed once, on partner income)
2. Spreads large capital needs by pooling
3. Spreads cost of risk bearing
4. Reduces opportunism by making key employees partners
iv. Limitations:
1. Difficulty raising capital
2. Problems making decisions w/ multiple owners
3. Compensation issues (how do you split the profit?)
4. Business may outgrow the partnership form
5. personally liability for partners
c. Corporations
i. How formed / governed:
1. Formation rules and governance controlled by state and other statutes (such as Delaware General Corporation laws / Model Business Corporation Act)
2. Must file Articles of Incorporation, disclose certain info to public so creditors know of limited liability, etc.
ii. Default features:
1. shareholders are owners (principals)
2. Separation of ownership and management where owners are passive and management is professional and active.
3. owners not personally liable for business debts (Limited Liability)
4. Board of Directors are elected by shareholders and develop business strategy (agents)
5. Officers are appointed by Board of Directors and implement the business strategy
iii. Benefits:
1. Designed to aggregate lots of capital from small investors.
2. Limited liability of owners
3. Centralized management
4. Free transfer of shares
5. Separation of ownership from control
6. low cost of risk bearing (loss limited to investment + sell shares if you’re not happy)
7. ability to raise lots of capital
iv. Limitations:
1. Increased agency costs especially because of professional management.
2. Increased credit costs (creditors will charge more to make up for limited liability)
ed liability for all
iii. Default features:
1. Limited liability for all partners
2. Flexibility to be active without losing limited liability
3. Partnership (flow-through) taxation
g. Limited Liability Partnership (LLP) – Two Types:
i. General partnership with full or partial limited liability
1. How formed / governed
a. Formation rules and governance controlled by state and other statutes
b. Usually used by lawyers/accountants/ and other professionals
2. Default features:
a. Partnership (flow-through) taxation
b. Full or partial limited liability (depending on statute)
3. Benefits:
a. Protected from the negligent acts of your partners (Liability cannot be imputed to you.)
ii. Limited Liability Partnership (LLP) limited liability partnership with a general partner limited liability election
3. The Role of Law
a. One role is to provide standard contract forms that people can easily opt into. The role of law is to facilitate the creation of business.
i. The potential problem is that standard forms do not work for everyone and as the parties start to deviate form the standard the more customization, and more costs occur.
b. Another role is to regulate the businesses
i. This is more controversial
1. Smaller businesses are more generally assumed to be equal in bargaining power and sophistication.
2. Corporations get more regulation because it is assumed that the owners are either unsophisticated or don’t own enough to care so professional management can impose terms on owners.
c. Contractarian View
i. a business association is viewed simply as a nexus of contracts
1. the law provides a mechanism for enforcing the parties’ arrangements
a. courts are not the only enforcement
2. provides a way of determining contract terms
a. usually these contracts are vague and incomplete
i. the law can minimize these costs by providing standard terms “gap fillers” that parties can opt into or that apply unless the parties opt out
