Evolution of Corporate Law Finance Business Associations Section

Evolution of Corporate Law & Finance Business Associations Section 7 b Law: Development of the firm’s legal traits Prof. Amitai Aviram@illinois. edu College of Law University of Illinois Copyright © Amitai Aviram. All Rights Reserved S 12

Law Overview of Section 7 b Regulation of financial transactions 1. Early views on lending & money Regulation of lending by the Catholic Church Regulation of lending in the common law & 20 th century U. S. l l l 2. 3. History of the corporate entity History of corporate governance 2 © Amitai Aviram. All rights reserved.

Law Firm’s legal traits l Independent legal personality l Asset partitioning l l Investor ownership (C acts to maximize SH welfare) Centralized management l l l Limited liability (SH not liable for C’s obligations) C not liable for SH’s liabilities Managerial agency problem (holding managers accountable to SHs) Majoritarian agency problem (protecting minority SHs) Exit-focused dispute resolution l l l 3 Restrictive dissolution / perpetual existence Transferable shares Capital lock-in Copyright © Amitai Aviram. All Rights Reserved

Law Development of firm’s legal traits l l Independent legal personality Asset partitioning l l l b 3 c 3 Whose welfare does C maximize? (SHs) Centralized management l b 2 Limited liability (SH not liable for C’s obligations) C not liable for SH’s liabilities Investor ownership l a 4 b 2 b 3 Managerial agency problem (holding managers accountable to SHs) Majoritarian agency problem (protecting minority SHs) Alienability of ownership (exit-focused dispute resolution) l l l 4 Restrictive dissolution / perpetual existence a 3 Transferable shares Capital lock-in Copyright © Amitai Aviram. All Rights Reserved

Law Corporation’s legal traits l But before we discuss corporate law, let’s discuss the evolution & regulation of financial transactions l Evolution & regulation of financing techniques l l Evolution & regulation of financial intermediaries l l l 5 Bilateral lending (usury laws) Bills of exchange & other payment systems Bond financing Banks Securities exchanges Insurance Copyright © Amitai Aviram. All Rights Reserved

Law Overview of Section 7 b Regulation of financial transactions History of the corporate entity 1. 2. Demand for limited liability Early forms of limited liability Pre-modern attitudes towards limited liability Could limited liability have developed without corporations? The evolution of limited liability in corporations Asset partitioning and the development of business entity law l l l 3. History of corporate governance 6 © Amitai Aviram. All rights reserved.

Why (or when) is legal personality important? l l We already discussed that in section (a)2 (Biz entity vs. contract) Use of a business entities (rather than Ks) benefits from economies of scale l l 7 Contracts are easily tailored to specific needs of parties But if there are many parties involved, managing all the relationships is very complex Copyright © Amitai Aviram. All Rights Reserved

Why (or when) is limited liability important? l “[I]f [limited liability] simply does not matter—then what are we to make of our inherited wisdom that it was key to the emergence of the modern business organization and thus to the development of modern commercial society? […] Clearly, limited liability meant something to someone. The question is what and to whom? ” - Amalia D. Kessler, Limited Liability in Context: Lessons from the French Origins of the American Limited Partnership, 32 J. Legal Stud. 511 (2003) 8 Copyright © Amitai Aviram. All Rights Reserved

Why is ltd. liability important? 9 Copyright © Amitai Aviram. All Rights Reserved

Explaining the popularity of the sole proprietorship l Sole proprietorships are, by far, the most common business entity in the U. S. l l Account for 66. 4% of California 2002 tax returns (excluding individuals and exempt organizations) How can we explain the popularity of a business entity that doesn’t offer limited liability? 10 Copyright © Amitai Aviram. All Rights Reserved

Explaining the popularity of the sole proprietorship Explanation 1: People are irrational or poorly

Explaining the popularity of the sole proprietorship Explanation 2(a): Personal liability not unique to SPs l l l 12 Bob, a wealthy businessman, forms Bobco, Inc. He invests $100 in the corporation, which has no other assets. Bobco applies for a $10, 000 loan from a bank. You are the bank manager. Under what conditions will you lend to Bobco? Copyright © Amitai Aviram. All Rights Reserved

Explaining the popularity of the sole proprietorship Explanation 2(b): Some personal liability is avoidable even in a SP l l Carol operates a SP that owns a small apartment building and collects about $3, 000 in rent each month The building needs renovations that cost $10, 000. Carol has considerable savings, but would rather borrow money for the renovation so that she can deduct interest payments. But she doesn’t want to be personally liable on the loan Will the bank agree to limit her liability? l 13 Non-recourse loan Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Explaining the SP’s popularity But what about torts? 14 Copyright

Demand for limited liability Explaining the SP’s popularity l Dan opens a solo law firm, and chooses to incorporate as Dan. Co, Inc. l l l Assume that law firms are allowed to incorporate in that state Dan forgets to file a client’s brief on time, and the client’s suit is dismissed. The client sues for malpractice and wins a judgment. However, Dan. Co has no assets. l 15 Does the client have a cause of action against Dan personally? Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Explaining the SP’s popularity l l Disliking the costs and formalities of operating a corporation and seeing that it doesn’t protect him from malpractice liability, Dan dissolves the corporation and continues operating the law firm as a sole proprietorship Again he commits malpractice l 16 Any difference in the liability? Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Explaining the SP’s popularity l l Despite his gross negligence, Dan’s law firm prospers. To handle additional business, he hires two more attorneys as associates (the law firm remains his sole proprietorship). One of Dan’s attorneys now commits malpractice in the course of working for Dan’s law firm. Dan was not consulted in the negligent actions, nor was he negligent in supervising the employee. l l 17 Is Dan liable for the malpractice? Would he be liable if the law firm were a corporation? Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Summing up l Liability in Contracts l l Counterparty can waive personal liability But will insist on personal liability if firm is poorly capitalized Cost of individual opt-outs w/ # of contracts firm makes Liability in Torts l Owner directly liable for: l l l 18 Torts she personally commits Torts of employees she failed to supervise But not for torts of employees whom she has no duty to supervise Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Summing up l Liability in Contracts l l l LL makes little difference when firm has few contracts LL saves costs as # of contracts increases & # of people in firm who enter contracts increases Liability in Torts l l LL makes little difference in firm in which owner is either sole employee of directly supervises all employees LL reduces owner’s risk when: l l 19 Firm has employees that the owner does not have to supervise Owner doesn’t work at firm (passive investor) Copyright © Amitai Aviram. All Rights Reserved

Demand for limited liability Summing up l What does this tell us about the development of business entities? l l Little pressure for limited liability business entities in firms that have few employees, and in which owners are employees and supervise others We would expect to see increased pressure for limited liability business entities as firm has: l l 20 More employees More contracts with third parties Passive investors Employees with skills that owners are unable to supervise Copyright © Amitai Aviram. All Rights Reserved

Law Overview of Section 7 b Regulation of financial transactions History of the corporate entity History of corporate governance 1. 2. 3. l l 21 Evolution of the board of directors Intervention solutions to the agency problem: ultra vires & the BJR Voice solutions to the agency problem: shareholder voting Exit solutions to the agency problem: dissolution & dissociation © Amitai Aviram. All rights reserved.

The agency problem Managing the “Sleepyville Snoozers” l Sleepyville, a town of 1 K people, has a minor league baseball team called the Sleepyville Snoozers l l Olivia, a resident, hears that the owner is moving to another state & plans to move the team with him l l Team breaks even but doesn’t make a profit She suggests buying the team to keep it in town Owner will sell for $10 M l l l 22 Requires each resident to pay $10 K/person is too much for most residents And not all residents care about the team Copyright © Amitai Aviram. All Rights Reserved

The agency problem Managing the “Sleepyville Snoozers” l Olivia instead suggests raising the money via internet l l l 23 Plan: 100 K people will invest $100 ea. in Snoozer Inc. Snoozer raises $10 M, buys team Team’s games to be broadcasted live on internet to the owners Copyright © Amitai Aviram. All Rights Reserved

The agency problem Managing the “Sleepyville Snoozers” l Olivia’s plan for managing the team: l Team hires a coach l Coach makes proposals l Owners hold online vote on each proposal l Efficiency problem: Coaches unwilling to work under these terms. Why? l Agency problem: Olivia suggests instead that the coach will make all decisions himself, without owner interference l Any risk that the coach will abuse his power? l Another solution? l 24 Hint: Gevurtz article Copyright © Amitai Aviram. All Rights Reserved

The agency problem Managing the “Sleepyville Snoozers” l This is the central tension in corporate law Efficient operation of the business 25 Minimizing agency costs (agent shirking/stealing) Copyright © Amitai Aviram. All Rights Reserved

Solutions to the agency problem l Three Arch-types of solutions to mitigate the agency problem of insiders (directors/officers/controllers) Litigatory Substance: authority constraints; fiduciary duties Procedure: derivative actions; SH inspection rights Structural Market Voting for directors Market for corporate control Tying compensation to profits Frequent need to raise capital 26 Copyright © Amitai Aviram. All Rights Reserved

Solutions to the agency problem Litigatory BJR (Allen, Hovenkamp) Ultra vires (Hovenkamp) Structural 27

Solutions to the agency problem Litigatory Structural Market SH voting (Dunlavy) (Democratic/Oligarchic) 28 Copyright

Solutions to the agency problem Litigatory Structural Market Frequent need to raise capital “Capital

Centralized management Functions of Boards of Directors Advisory board 1. Directors add value through their prestige and contacts Discouraged by increased focus on fiduciary duties l l Supervisory board 2. l l 30 Directors add value through their supervision of the officers May be discouraged by liability for unknown problems (conscious disregard of duties) Copyright © Amitai Aviram. All Rights Reserved

Centralized management Functions of Boards of Directors Executive board 3. Directors add value through managing the company Common in small firms; problem in large firms: who supervises Bo. D? l l Representative board 4. l Directors monitor company on behalf of stakeholders that they represent l l l 31 E. g. , particular SH, labor union, government Directors add value by creating trust between corporation & stakeholder Can be combined with other roles (often supervisory) Copyright © Amitai Aviram. All Rights Reserved