Business Organizations
Professor Palmiter
Fall 2010
RISK
“Quantifiable uncertainty”
Risk can be quantified, whereas uncertainty cannot
If a business can quantify the risks associated with a particular decision, it can determine the expected return, or average return of the decision
Types
Non-controllable – risks that the parties to a business venture cannot control
Controllable – risks that the parties might be able to influence
Approaches to risk
Risk averse – avoid betting unless guaranteed a greater return than what they currently have
Risk seekers – would bet even though they wouldn’t make as much on average as not betting
Risk neutral – a risk neutral person makes decisions based solely on expected returns and would be happy to take on risk anytime it will generate a benefit on average
Would rather have 50% chance at $2200 than $1000
Average gains – $1100 v. $1000
Would rather lose $1000 with certainty than take a 50% chance of losing $2200
Average losses – $1000 v. $1100
The success of a business depends on how well it manages risk
Successful firms exploit favorable developments and minimize the effects of unfavorable ones
How well a business manages risk depends on how the parties allocate different risks
Allocation of risks:
Insurance – upfront payment in exchange for the right to payment if a specified event occurs
Pro rata share of pool’s total loss where many people pay into a pool is easier to predict than the loss to any particular member
Diversification – participation in numerous ventures, each of which involves different risks
Performance of entire diversified portfolio more likely to be balanced between gains and losses
Allocation – parties to a business venture might allocate risks to the person who is most willing or best able to bear the risks
Perhaps because one party is in a better financial position to insure or diversify
Or one party with superior information might allocate risks to the person who is least likely to understand the risk
Principal-agent relationship – allocating risks
Where a principal and agent enter in a for-profit business, the tensions between them are inevitable (“Principal” = investor/owner, “agent” = manager/employer)
Principal will want:
To maximize the return on her investment
The agent to use as much effort as possible to make the venture a success
The bulk of the venture’s profits
The agent to put the principal’s interests about the interests of others, even above the agent’s own interests
To know that the agent is working for her and to have the means to impose her will, if necessary
Agent will want:
To maximize the return on his efforts
To be well compensated for his efforts even if the business doesn’t succeed
To expend as little effort as needed to make the venture a success
Discretion to accomplish the goals of the venture without interference from the principal or blame if the venture should fail
Given this divergence, the principal will want to monitor the agent to ensure he does as expected, and discipline if he does not – “agency costs” of working through principal-agent relationship
This helps in particular to reduce controllable risks – to align the agent’s incentives with the interests of the principal
Shirking – where a person does less than is optimal to control a risk
Commonly occurs by the party who does not bear the consequence of the risk, and therefore has no incentive to control the risk
But concern about reputation might discourage this
Might be most efficient to put the risk on that party to avoid costs of monitoring
BUT the person who is in the best position to control risks might not be the best person to bear them
CLEAR tension between risk controlling and risk bearing perspectives
May also be an issue of varying time horizons
If agent only wants the job for a year, focused on maximizing immediate return
If principal sees it as a longer term investment, what is done to maximize immediate return might not benefit her down the road
Business firms are built on the premise that participants must specialize and cooperate to accomplish their individual interests
What is required in terms of risk is an arrangement that will be the best compromise between the conflicting perspectives of risk controlling and risk bearing
Because of the uncertainty about the future, the agreement between parties must address:
Term of relationship
Allocation of financial rights and obligations including profits and losses
Discretion and responsibilities of agent
Supervisory powers of the principal including access to information
Ability of either participant to terminate relationship
Means by which they can change their relationship
The role of law in allocating risks
Types of rules
Mandatory – those that the parties cannot contract around
Default – those that are accepted but that parties can choose to contract around
Majoritarian default rule – one that most people in society would choose to comply with
Tailored default rule – attempt to capture what particular parties would have in mind – might vary depending on the particular relationship
These are made tailored by the use of specific words like “reasonable”
Penalty default rule – one that most people would NOT want – will penalize parties unless they contract around them
In the US, corporate law is decidedly governed by default rules
Key characteristics of the basic business corporation
Separate perpetual existence
Ownership interests tied to residual earnings and assets
Limited liability for all participants
Centralized management under a board structure
Transferability of ownership interests
Overarching legal question: How do law and contract enable each of the participants protect themselves?
Overarching policy question: For whose benefit should the corporation be run?
Specific questions when considering an investment:
How long does the investment last?
Who manages the investment?
What is the return on the investment?
How can investors get out?
What are the investors’ responsibilities to others?
Some basic terms and concepts
Corporate statutes: MBCA vs. Delaware
Corporate law is a product of the state
MBCA is not law – it is a draft that states may choose to revise, adopt, and make into law if they choose
MBCA governs in 35 states
Originally designed to clarify Delaware law
But now, DE law and MBCA have begun to diverge, particularly in the area of fiduciary duties
Judge-made corporate Law
Corporate law is significantly judge-made
Although there are many statutes that govern
ALI principles, stating what academics believe the law “should be” are not binding on the courts, and are not commonly used by judges
Corporate choice of law: the internal affairs doctrine
Choice of law rule = internal affairs doctrine – permits the parties through the incorporation process to fix the law that applies to their corporate relationship, wherever litigation is brought
Internal affairs – those that relate to the legal relationships between the traditionally regarded corporate participants – rights of shareholders, fiduciary duties of directors, and procedures for corporate action
ONE state will govern the operations of a corporation – the state of incorporation
Parties choose the terms of relationships by deciding which state to incorporate in
This is the parties’ choice of law
Simple rule with only very slight deviations
Constitutional requirement – any other state must recognize this
Provisions involved:
Due process requires that parties must know what they are in for
Commerce clause requires states not to interfere with competition/commerce from other states
Full faith and credit – requires that all states give effect to all laws of other states
McDermott – company’s actions in Panama would be illegal in US, but since they were not illegal in Panama, and the company was incorporated there, no US liability
Commonly Delaware
DE’s statutes designed to give management flexibility in structuring and running business
Pro-management??
DE courts and bar are experienced and sophisticated in corp law matters
Large body of case law to interpret DE statute – certainty for corporate planners
DE legislature leader in corporate law reform – amends DE corporations statute often as new needs and problems arise
Organic documents: Articles vs. Bylaws
Articles must only include a bare-bones statement – must include:
Corporation’s name
# of shares authorized
Registered agent, with address
Signature
Articles must be filed with the state and trump the bylaws
They provide the framework for the bylaws
Corporate statutes > Articles > Bylaws > Director resolutions
The corporate actors: shareholders / directors / officers
Separation of finance and management
Shareholders provide money capital
Managers (directors and officers) oversee the business and its employees
Corporate law is focused on the relationship between shareholders and managers – the “internal organization” of the corporation
The central premise is that neither of these parties can exist without the other
However, shareholders and managers often have different agendas
Corporate law allocates risks between shareholders and managers in an attempt to minimize conflicts and maximize the company’s success
“Outside” relationships with creditors, suppliers, customers, employees, and gov’t authorities are subject to legal norms that treat the corporation more as a person
Including: laws of contract, debtor-creditor, antitrust, labor, and tax
Corporate securities: common stock / preferred stock / debt
Equity financing
Corporation can issue shares of stock – equity financing
Shareholders pay the corporation for their shares, each of which represents an ownership interest in the corporation and gives the shareholder a bundle of rights and powers
SHs have financial rights to dividends when declared by the board and a pro rata share of corporate assets on dissolution
SHs have voting rights to elect directors and approve important corporate transactions and liquidity rights that enable them to sell their interests
Usually “one share one vote” but may be different
Voting rights can be limited to specified matters, such as voting for only two of a corporation’s five directors
Conversion rights – shareholders have the option to convert their shares into another security of the corporation
This option is granted by the corporation – can be made exercisable only on certain events and during certain periods
Redemption rights – give the shareholders an option to force the corporation to repurchase their shares
Can
water company
Conflict? Self-dealing?
Court doesn’t inquire as to whether it would have approved –
Shareholders consented to this – shareholders are free agents, may do as they choose
Shareholders typically do not owe fiduciary diuties to the corporation
Majority governs!
Only where extremely oppressive to the minority shareholders will the court step in – when intent to subserve some outside purpose or in a manner inconsistent with the corporation’s interest
E.g. oppression when one person owns majority of shares
Equitable limitations on corporate actions
Bove v. Community Hotel Corp. – common shareholders want new investors, preferred shareholders want dividends – dividends required under articles before new shares authorized
Board could amend articles to change rights of preferred shareholders
This would require UNANIMOUS decision of shareholders
Board merged company into a new company (needed only 2/3 vote for this) –
This is a way to get around the unanimous requirement of amending articles
Court held it was not important – “independent legal significance” – the validity of corporate action taken pursuant to one section is not necessarily dependent on it being valid under another
This gives a lot of flexibility – you can essentially choose which law to apply!
Schnell v. Chris-Craft – shareholders sought to replace the board, so the board moved up annual meeting date, moved it to a new place – to impede the shareholders from voting at the meeting
Leading case on corporate voting rights
Board did have the power to do this – can amend the bylaws to change meeting specifics
BUT – the board has a duty to act in the best interests of the corporation and not to act inequitably
Although this was legal, the board acted inequitably, court struck down the bylaw change
Board’s motive = self-interest
Shareholder voting is a fundamental right
It is their prerogative to vote in a new board of directors
Distinguished from Bove:
Bove – action of merger was motivated to benefit at least some of shareholders
Board was trying to bring cash into the company
Schnell – action of moving meeting date motivated only to benefit board
These cases show difference between powers and duties of the corporation
In both cases, the boards were taking actions that were within their power, but in Schnell, board violated duty (of loyalty) – conflict of self-interest brought judicial review
Choice of state of incorporation
Foreign corporation
One not incorporated in that state
States do not have to let foreign corporations do business in their state
But states typically do – good for economy
Internal affairs doctrine – choice of law
The law of the state of incorporation governs the internal affairs of the corporation
McDermott v. Lewis – corporation incorporated in Panama (which allows corporations great freedom); but lots of ties to U.S.; trying to take actions that would be illegal under U.S. law – letting management get free votes (stealing votes)
DE Supreme Court held that Panama law controlled
Issue of federal constitutional law
Don’t want confusion within or outside the United States – would violate commercial certainty and due process – parties must know which laws will apply
Due process clause
Commerce clause
Full faith and credit clause
Need to have only one state dictate the rules governing a corporation
Parties can choose the terms of their business relationship by incorporating in a particular state
This can be done anywhere – doesn’t require anything but filing of papers
DE most common – most expensive
Off-the-shelf set of rules
Rules won’t be changed easily
2/3 of legislature required for change (more than in other states)
To what extent can one state dictate what happens in another?
State anti-takeover statutes – a hostile takeover exposes management to shareholder control – when shareholders receive a bid for their shares, what role should management have in assessing the bid?
