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

I.) The Corp’n Overview-The Big Box
A.) The corp’n is an investment vehicle for the pooling of money and labor
1.) Suppliers of capital join w/ labor to make possible the advantages of bus. specialization
a.) As industrial and manufacturing concerns grew w/ industrialization and specialized, needed a way to finance corporations without all of the liability
B.) Five Basic Attributes
1.) Separate entity w/ perpetual existence
a.) The corp’n is entirely a creature of the law-a legal artifice
b.) Is a legal entity that can enter into contracts, own property and be a party to a lawsuit
c.) Corp existence and attributes arise completely from state statutes
d.) The corp’n is distinct from those who contribute capital and those who manage the bus.
i.) The corp. owns the assets of the bus. and is liable for any bus. debts
2.) Limited Liability
a.) The corp’n is liable for its own obligations
b.) Corp insiders (directors, management etc.) are not personally liable to outsiders for corp obligations
c.) Outsiders bear the risk of corp insolvency
d.) Investors and managers risk only their own personal investment
3.) Centralized Management
a.) Board of Directors (BOD) is the locus of corp power responsible for managing and supervising the bus.
i.) Shareholders (SH) elect the board but otherwise have a limited role in managing the corp’n
a.) SH have no power to bind the corp or act on behalf of it either
b.) Can vote on fundamental changes only
b.) The BOD delegates to management officers who then can act on behalf of the corp’n and bind it
4.) Transferability of Ownership Rights
a.) SH ownership interests are freely transferable
i.) SH can sell their financial rights and realize the value of their investment
5.) Ownership Interests Tied to Residual Earnings and Assets
a.) Corp’n establishes a hierarchy for the stream of earnings generated by bus.
b.) Creditors are at the top and receive a return based on their contracts
c.) SH are last and receive dividends declared at the discretion of the board
d.) Upon dissolution of the corp., creditors have top priority
C.) Corp Law Generally
1.) Corp. law generally focuses on the often conflicting relationship between SH and managers/directors
a.) They comprise the “internal” organization of the company
b.) Agency costs
i.) The fallout associated w/ the division between ownership and control
ii.) Where ownership delegates power of management and control there are bound to be conflicts of interest and exploitation of opportunism
2.) Separation between the SH and the managers creates opportunity for exploitation and personal gain
a.) SH and corp. insiders should want to maximize profit but each will likely have its own separate agenda
i.) Managers may shirk duties after SH investment, take exorbitant perquisites, may be reluctant to undertake risky ventures in effort to maintain job security
3.) Corp law allocates the risks between SH and managers to minimize conflicts
a.) Many think that the corp form provides great impetus for managers to exploit SH and other constituents
b.) To them, corp law is a means to regulate manager opportunism
c.) Corp law is a mix of mandatory and default rules
4.) Those injured by the bus. have direct claims on the corp. through legal norms and governmental regulations
a.) Though corp. are creatures of state law, they are still subject to federal regulations such as anti-trust law, banking regulations, securities laws, environmental, health, workplace safety etc.
b.) Federal Securities Act of 1933
i.) Governs disclosure for capital raised in public markets
c.) Securities and Exchange Act of 1934
i.) Publicly traded corps. are subject to periodic reporting requirements and proxy disclosure and voting rules
d.) Sarbanes-Oxley Act of 2002
i.) Federalizes aspects of corp law
5.) “Outside” relationships w/ creditors, suppliers, customers, employees, and other government authorities are usually subject to legal norms that treat the corp’n as a person
II.) Principal and Agent Problems or Agency Costs
A.) Generally
1.) At the core of most corp law issues is the fundamental conflict between the shareholder owners and the managers who possess the delegated powers of control
a.) Delegating the power of control and management to non-owners creates agency costs
2.) The corp structure creates an inherent divergence of interests between the two parties
3.) In order for the venture to be successful, the principal must effectively:
a.) structure the allocation of risk such that the agent has little/no/reduced incentive to shirk and
b.) monitor the conduct of the agent
4.) Must align the interests to avoid shirking and the fallout from exploitation of the corp form
B.) Principal
1.) The principal is the investor, owner, shareholder of the corp bus.
2.) The owner/investor (hereinafter the principal) wants:
a.) To maximize the return on her investment, given other investment choices
i.) This means that the principal would like to charge as much as the market will allow (maximize income) and pay as little as possible (minimum wage/outflow)
ii.) In other words, maximize profits and minimize labor and agency costs
b.) Venture to be a success
c.) To see the bulk of the venture’s profits
i.) Principal will generally bear the risk of loss
ii.) In exchange for shouldering the risk, the principal will get the returns
d.) Management/employees to put the interests of the investor above all else, inc. own interests
e.) The means to impose his will if necessary
C.) Agent
1.) The agent is the manager, employee etc. of the firm and the invested capital
2.) The manager/employee (hereinafter the agent) wants:
a.) Munificent compensation, regardless of the firm’s performance
b.) To make the firm successfu

on is important in the creation of incentives
a.) Stock options
i.) W/ shorter time frame, agent has incentive to increase the stock value in the short term at expense of long term value in order to capitalize on his gains
b.) the allocation of financial rights and obligations
i.) Principal often bears the risk
ii.) In exchange for shouldering the risk however, the principal gets the reward of return
c.) the discretion and responsibilities of the agent
i.) Control
d.) the supervisory powers of the principal
i.) Monitoring constraints
e.) ability of either party to terminate their relationship
f.) the means by which they can change their relationship
2.) General Strategies
a.) Pooling the risk
i.) By pooling the risks between the principal and agent, each member bears a pro rata share of the total loss, which is easier to predict each individual loss
ii.) This is the insurance scheme
iii.) Upside
a.) Reduces the incentive for agent to shirk
b.) Lowers need for monitoring by principal b/c of increased incentive
iv.) Problems
a.) Principal may have over-sacrificed returns to reduce agency costs
b.) Agent may be unable to bear this risk
b.) Diversification
i.) Participation in multiple ventures, each w/ different risks
ii.) Balances the overall risk between the investments
c.) Allocation to the person most willing to bear it
i.) Whoever is in a better position to bear the risk or to diversify
3.) Allocating risks to the Principal (Non-controllable risks)
a.) The party w/ the greater wealth is in a better position to bear the uncontrollable risks
i.) Almost always the principal
ii.) He is in a better position to diversify (hedge), pay to have risks calculated, control exposure etc.
iii.) Investor is likely risk averse and will not want to bear the risk
b.) Problems
i.) If agent doesn’t bear these risks, then chance that he will shirk and bring about controllable risks
ii.) Agent lacks the incentive to internalize the costs of shirking
iii.) Monitoring/discipline costs
c) Remedy
i.) Ex ante, principal must decide the desired level of performance
ii.) “Best efforts” clause as ex post consideration in employment K
a.) Enforce performance w/ amorphous language that allows for adjustment to arising contingencies
b.) Gives agent some incentive to avoid shirking