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Business Associations/Corporations
University of San Diego School of Law
Partnoy, Frank

A little history and perspective
§         English Practice
o        No default rules
§         Early U.S. Practice
o        Through 1900, the vast majority of companies in the US were Railroads
§         Railroads
§         The race to Delaware
o        Race is among all the states
§         Race to the top: More shareholder protections over managers???
§         Race to the bottom: More managerial protections over shareholders.
o        Delaware had the best and most efficient default rules – Maybe
§         They have the best rules as far as the managers are concerned
§         Federal v. State
o        The trend most recently is to Federalize corporate law
o        Most default rules are state
§         Technocratic Period (WWII – 1980’s)
§         Proprietary Period (1980’s – Now)
o        The big difference between these two periods is that people are now going to jail for financial fraud
o        Takeovers are now easier
o        Stock options exist now where they didn’t before
o        In Techno, the managers and CEO’s were trusted
Advantages of Incorporating
§         Reduces Personal Liability
§         Adds Credibility
§         Tax Advantages – Benefits deductible for you and your employees
§         Easier Access to Capital Funding
§         An Enduring Structure
§         Easier Transfer of Ownership
§         Anonymity
§         Centralized Management
Four Basic Attributes of a Corporation
§         Separate entity with perpetual existence
§         Limited Liability
§         Centralized management
§         Transferability of ownership interests
Principal v. agents (vs. debt)
§         Principal is the employer, an agent is an employee.
§         Incentives of principal (owner, shareholder)
o        TO MAXIMIZE RETURN OF THE BUSINESS; maximize profit and pay a fixed claim to the employee.
o        Moral hazard: Taking on add’l risk b/c of insurance, etc.
§         Incentives of agent (manager, CEO, employee)
o        TO SHIRK: When the employee steals (anything you can) f/the employer.
§         Moral hazard: Taking on add’l risks in the presence of insurance.
·         Eg. Driving like a maniac b/c you have insurance.
o        Wants to get paid, get a portion of the company, to stay employed.
§         Maintenance of Control (p.14)
o        Principle will monitor/discipline the agent to ensure he does as expected.
§         These efforts constitute agency costs.
o        They should distribute the business risks to minimize conflicts and maximize the value of their participation in the venture.
o        Their agreement must address:
§         the term of their relationship
§         the allocation of financial rights and obligations (profits and losses)
§         the discretion and responsibilities of the agent
§         the supervisory powers (including access to info) the principal
§         the ability of either participant to terminate their relationship
§         the means by which they can change their relationship
§         Deal points
o        Risk of loss: The principal bears the risk of loss.
o        Return: Thus, the principal would have the opportunities for return.
o        CONTROL: Thus, the principal expect to have control.
§         Default rules often set these rules
o        Duration of the contract: As specified by the parties.
§         Constraints:
o        Law
o        Ethical
o        Governmental
o        (Inevitable) Conflicts of interests
Business risk
§         Types of risk
o        Frank Knight: “risk” vs. “u

“expected return” is the sum of each possible return multiplied by the probability of that return.
§         The magnitude of the risk is irrelevant in their decision-making.
§         Risk seeking
o        You want the risk
o        Usually so w/respect to loss.
o        Takes the magnitude of risk (and expected return) into account when making a decision.
§         Risk averse
o        You do not want the risk
o        Usually so w/respect to gains.
o        Takes the magnitude of risk (and expected return) into account when making a decision.
§         How people/managers feel about risk matters a lot in corporations.
o        If risk preferences are expressed differently, then you would have a conflict.
§         The vast majority of people are risk averse w/respect to gains
o        One customary economic measure of risk aversion is the risk premium.”
§         The vast majority of people are risk seeking w/respect to losses
§         Endowment effect (study)
o        $30 vs. coin flip for $21 or $39
o        Assume you won $30, then coin flip for $9
§         Both these scenarios have the same expected value and volatility.
§         More people did the latter, and wanted the flip after they received $30.
·         Thus human beings are important: Risk preferences might change if perspectives are changed, although the outcomes are the same.
People are not always economically rational.