Corporate Law
Week 1:
Chapter 1 what is corporate law
5 characteristics of business corporation
● Legal personality
● Limited liability
● Transferable shares
● Delegated management under a board structure
● Investor ownership
Principal function of corporate law is to provide business enterprises with a legal form that
possesses these 5 core attributes
Corporate law decreases costs of businesses:
- by facilitating coordination between participants
- incorporate enterprise
- reducing scope for value-reducing forms of opportunism among different constituencies
Three principal sources of opportunism endemic to organization (principal-agent problems)
● Conflicts between managers and shareholders
● Conflicts between controlling and non-controlling shareholders
● Conflicts between shareholders and corporation’s other contractual
counterparties
1. Legal personality
- Firm is a nexus for contracts: firm serves as party in contracts with suppliers, employees,
customers, coordinating actions through contractual rights.
- Corporate law insures that the firm can serve as coordinating role by operating as a single
contracting party distinct from who owns the firm and the managers
- -> enhances ability of these individuals to engage together in joint projects
Core element of firms as nexus for contracts:
- Separate patrimony: involves demarcation of a pool of assets that are distinct from
other assets owned, singly or jointly, by the firm’s owners (shareholders) and the firm is
seen as owner.
- Includes the right to sell and use the assets, making them available for attachment by its
creditors.
- These assets belong to the firm and not to the owners of firm-> unavailable for
attachment by owners’ personal creditors; entity shielding
1
,Entity shielding 2 laws:
● Priority rule: grants creditors of firm a security on firms’ debts, a claim on firms’
assets that has priority over claims from firms owners’ personal creditors
(bankruptcy)
● Liquidation protection: individual owners of corporation (shareholders) cannot
withdraw their share of firms assets at will, nor can personal creditors of individual
owner
● Liquidation rule protects value of firm against individual shareholders
● Liquidation rule not found in other legal forms such as partnership (harder to
separate)
● Strong form entity shielding for corporations
● Weak form entity shielding for partnerships: only priority rule no liquidation rule
2 other types of rules needed for firm to serve as contracting party:
● Authority rule: rule specifying to third parties the individuals who have authority to
buy and sell assets and enter into contract that are bonded by those assets
● Delegated management is a rule of authority that provides corporate managers (board
of directors) as opposed to individuals owners, the power to bind the company into
contract
● Procedure rule: specifies the procedures by which both the firm and counterparties
can bring lawsuits on the contracts entered in name of firm
- Separate legal personality comes from these 3 rules: (entity shielding, authority,
procedure)
Separate legal personality means firm:
- can be sued and sue
- can enter into contract
- delegate authority
2. Limited liability / Owner Shielding
- Corporate form provides a default term in contracts between a firm and its creditors
whereby the creditors are limited to making claims against assets that are held in the
name of the firm itself and have no claim against assets that the firm’s shareholders hold
in their name
- Limited liability shield firms owners/shareholders from creditors’ claims-> this facilitates
diversification
- Limited liability refers to limited liability in contract: limited liability to creditors who
have contractual claims on the corporation
- No limited liability on third parties who have been injured as consequence of
corporations actions → pierce corporate veil
2
, - With unlimited liability, shareholders want to manage the risk more (risk-averse)
Advantages of limited liability:
- Limited liability diversifies shareholders holdings because there is a cap on losses
- Limited liability reduces risk so lowers risk premium which lowers firm’s cost of equity
capital (risk-loving)
- Limited liability allows for easy separation between an individual and a company
allowing them to part with the company easier. This is not the case in a partnership as the
partners are tied to the corporation.
Drawbacks of limited liability:
- Complexity; set up costs
- Public disclosure
3. Transferable shares
- Transferability permits firm to conduct business uninterrupted as identity of its owners
changes-> no complications of member withdrawal like in partnerships -> enhances
liquidity of shareholders’ interest
- Fully transferable does not mean freely tradable but rather just transferable among
limited groups of individuals or with approval of current shareholders
- Free tradability maximizes liquidity of shareholdings and ability to diversify, but make it
difficult to maintain negotiated arrangements for sharing control and participating in
management
- Value of shares would be difficult to judge without transferability -> ensuring single
price of share permits security markets to aggregate info about firms expected
performance
- Strong-legal form personality, limited liability and transferable shares go together
- Closely held against widely held: closely held if shares held by small number of
individuals with relationships
Delegated management with a board structure
- Four features of board of directors:
1. Board is separate from operational managers;
● divides all corporate decisions that do not require shareholder approval (only
decisions by hired officers) into those requiring approval by the board on their
own authority
● Board monitors decisions made by officers and the board also hires these officers
2. Board is elected by firms shareholders:
● Helps assure that board remains responsive to interests of firms owners
3. Board is distinct from firms shareholders
● Avoids need to inform the firms ultimate owners and obtain their consent for all
but most fundamental decisions
● Also permits board to serve as mechanism for protecting the interests of minority
shareholders and other corporate constituencies
3
, 4. Board has multiple members
● Facilitates multiple monitoring and checks individual
decision making
● For a small corporation there can be one director of
the board
4. Investor ownership
- 2 elements in ownership in firm:
1. Right to control firm
2. Right to receive firm’s net earnings
- In an investor-owned firm, voting rights and rights to profits are typically proportional
to the amount of capital contributed to the firm; default rule
- Cooperative form (another type): describes all four features of corporate firm except
transferable shares; allocates voting power and shares in profits proportionally to acts
of patronage (how much you put in); inputs supplied to firm (producer cooperative) or
firms products purchased (consumer cooperative)
Advantages of investor ownership
● Investors are most difficult to protect by contractual means and investor ownership
leads to efficiency
● Investors of capital have homogenous (same) interests among themselves -> reduces
potential for costly conflict among those who govern the firm
In non-profit firm, no person may simultaneously participate in both right to control and right to
residual earnings; firms have no owners
Sources of corporate law
Special corporate forms:jurisdictions have a distinct statutory for formation of closed
corporations/limited liability companies; shares are transferable but not freely in public market
● These forms departure from delegated management by permitting elimination of the
board in favor of direct management by shareholders
Quasi-corporate form: all 5 characteristics, but some have to be added by contract
- Example: added limited liability to partnership
Other bodies of law
● German Konzernrecht: limited liability and limits the discretion of boards of
directors in corporations that are closely related through common ownership;
protects creditors and minority shareholders of corporation with controlling
shareholders
● Security laws on mandating disclosure, mergers and acquisitions, stock exchange
rules
4
Week 1:
Chapter 1 what is corporate law
5 characteristics of business corporation
● Legal personality
● Limited liability
● Transferable shares
● Delegated management under a board structure
● Investor ownership
Principal function of corporate law is to provide business enterprises with a legal form that
possesses these 5 core attributes
Corporate law decreases costs of businesses:
- by facilitating coordination between participants
- incorporate enterprise
- reducing scope for value-reducing forms of opportunism among different constituencies
Three principal sources of opportunism endemic to organization (principal-agent problems)
● Conflicts between managers and shareholders
● Conflicts between controlling and non-controlling shareholders
● Conflicts between shareholders and corporation’s other contractual
counterparties
1. Legal personality
- Firm is a nexus for contracts: firm serves as party in contracts with suppliers, employees,
customers, coordinating actions through contractual rights.
- Corporate law insures that the firm can serve as coordinating role by operating as a single
contracting party distinct from who owns the firm and the managers
- -> enhances ability of these individuals to engage together in joint projects
Core element of firms as nexus for contracts:
- Separate patrimony: involves demarcation of a pool of assets that are distinct from
other assets owned, singly or jointly, by the firm’s owners (shareholders) and the firm is
seen as owner.
- Includes the right to sell and use the assets, making them available for attachment by its
creditors.
- These assets belong to the firm and not to the owners of firm-> unavailable for
attachment by owners’ personal creditors; entity shielding
1
,Entity shielding 2 laws:
● Priority rule: grants creditors of firm a security on firms’ debts, a claim on firms’
assets that has priority over claims from firms owners’ personal creditors
(bankruptcy)
● Liquidation protection: individual owners of corporation (shareholders) cannot
withdraw their share of firms assets at will, nor can personal creditors of individual
owner
● Liquidation rule protects value of firm against individual shareholders
● Liquidation rule not found in other legal forms such as partnership (harder to
separate)
● Strong form entity shielding for corporations
● Weak form entity shielding for partnerships: only priority rule no liquidation rule
2 other types of rules needed for firm to serve as contracting party:
● Authority rule: rule specifying to third parties the individuals who have authority to
buy and sell assets and enter into contract that are bonded by those assets
● Delegated management is a rule of authority that provides corporate managers (board
of directors) as opposed to individuals owners, the power to bind the company into
contract
● Procedure rule: specifies the procedures by which both the firm and counterparties
can bring lawsuits on the contracts entered in name of firm
- Separate legal personality comes from these 3 rules: (entity shielding, authority,
procedure)
Separate legal personality means firm:
- can be sued and sue
- can enter into contract
- delegate authority
2. Limited liability / Owner Shielding
- Corporate form provides a default term in contracts between a firm and its creditors
whereby the creditors are limited to making claims against assets that are held in the
name of the firm itself and have no claim against assets that the firm’s shareholders hold
in their name
- Limited liability shield firms owners/shareholders from creditors’ claims-> this facilitates
diversification
- Limited liability refers to limited liability in contract: limited liability to creditors who
have contractual claims on the corporation
- No limited liability on third parties who have been injured as consequence of
corporations actions → pierce corporate veil
2
, - With unlimited liability, shareholders want to manage the risk more (risk-averse)
Advantages of limited liability:
- Limited liability diversifies shareholders holdings because there is a cap on losses
- Limited liability reduces risk so lowers risk premium which lowers firm’s cost of equity
capital (risk-loving)
- Limited liability allows for easy separation between an individual and a company
allowing them to part with the company easier. This is not the case in a partnership as the
partners are tied to the corporation.
Drawbacks of limited liability:
- Complexity; set up costs
- Public disclosure
3. Transferable shares
- Transferability permits firm to conduct business uninterrupted as identity of its owners
changes-> no complications of member withdrawal like in partnerships -> enhances
liquidity of shareholders’ interest
- Fully transferable does not mean freely tradable but rather just transferable among
limited groups of individuals or with approval of current shareholders
- Free tradability maximizes liquidity of shareholdings and ability to diversify, but make it
difficult to maintain negotiated arrangements for sharing control and participating in
management
- Value of shares would be difficult to judge without transferability -> ensuring single
price of share permits security markets to aggregate info about firms expected
performance
- Strong-legal form personality, limited liability and transferable shares go together
- Closely held against widely held: closely held if shares held by small number of
individuals with relationships
Delegated management with a board structure
- Four features of board of directors:
1. Board is separate from operational managers;
● divides all corporate decisions that do not require shareholder approval (only
decisions by hired officers) into those requiring approval by the board on their
own authority
● Board monitors decisions made by officers and the board also hires these officers
2. Board is elected by firms shareholders:
● Helps assure that board remains responsive to interests of firms owners
3. Board is distinct from firms shareholders
● Avoids need to inform the firms ultimate owners and obtain their consent for all
but most fundamental decisions
● Also permits board to serve as mechanism for protecting the interests of minority
shareholders and other corporate constituencies
3
, 4. Board has multiple members
● Facilitates multiple monitoring and checks individual
decision making
● For a small corporation there can be one director of
the board
4. Investor ownership
- 2 elements in ownership in firm:
1. Right to control firm
2. Right to receive firm’s net earnings
- In an investor-owned firm, voting rights and rights to profits are typically proportional
to the amount of capital contributed to the firm; default rule
- Cooperative form (another type): describes all four features of corporate firm except
transferable shares; allocates voting power and shares in profits proportionally to acts
of patronage (how much you put in); inputs supplied to firm (producer cooperative) or
firms products purchased (consumer cooperative)
Advantages of investor ownership
● Investors are most difficult to protect by contractual means and investor ownership
leads to efficiency
● Investors of capital have homogenous (same) interests among themselves -> reduces
potential for costly conflict among those who govern the firm
In non-profit firm, no person may simultaneously participate in both right to control and right to
residual earnings; firms have no owners
Sources of corporate law
Special corporate forms:jurisdictions have a distinct statutory for formation of closed
corporations/limited liability companies; shares are transferable but not freely in public market
● These forms departure from delegated management by permitting elimination of the
board in favor of direct management by shareholders
Quasi-corporate form: all 5 characteristics, but some have to be added by contract
- Example: added limited liability to partnership
Other bodies of law
● German Konzernrecht: limited liability and limits the discretion of boards of
directors in corporations that are closely related through common ownership;
protects creditors and minority shareholders of corporation with controlling
shareholders
● Security laws on mandating disclosure, mergers and acquisitions, stock exchange
rules
4
