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Social Science
SOSC 4043
Sonya Scott

SOSC 4043 – FALL TERM BOOK NOTES Readings for October 9 , 2013 The Neglected Benefits of the Corporate Form: Entity Status and the Separation of Asset Ownership from Control - Current idea of corporate law has neglected one of the most important functions of corporate law: the creation of a legal and institutional basis for accumulating enterprise-specific physical capital, as well as specialized organizational and other intangible capital, and for ‘locking in’ that capital by discouraging premature asset withdrawal by managers, investors, or their heirs - Corporate law helps accomplish these things because a corporate charter creates a separate legal entity - The separate entity status of corporations transforms the relationships among corporate participants in ways that cannot be replicated through a collection of contracts - Shareholders as a class are better-off because they have, in the corporate form, a mechanism for committing capital to an enterprise and yielding control rights to directors almost irrevocably - I show that business organizers began seeking out corporate status to organize their businesses because the separate entity status of corporations, and the resulting separation of the roles of managing the enterprise from that of contributing capital to the enterprise, helped solve certain contracting problems that arise in enterprises that are especially complex, long-lived, or large in scale - the Industrial Revolution and rapid expansion of transportation and communications capabilities in the late eighteenth and early nineteenth centuries opened up opportunities for business people to begin operating large-scale enterprises - Two legal forms were used with growing frequency during this period: the unincorporated joint- stock company and the corporation - the unincorporated joint-stock company evolved out of partnership law and, because - courts treated these firms as partnerships, their organizers could not prevent them from being broken up by individual members or their heirs - Corporate law in the US, however, appears to have evolved out of the body of law that applied to religious, eleemosynary, and civic institutions with recognized public purposes o the courts were willing to recognize business corporations as separate legal entities with potentially unlimited life, giving them the potential ability to protect the assets of the enterprise from being broken up to satisfy the demands of individual resource contributors or their heirs - as business people began undertaking larger, more complex, and more long-lived business ventures, innovating to take advantage of expanding markets and new mass production technologies, they began experimenting with new organizational forms that had what we can now see as corporate-like features o They also began seeking corporate charters from state legislatures - From 1800 to 1860, however, the US underwent a massive transformation in technology, transportation, and communications that greatly increased productive capabilities in agriculture, mining, and manufacturing, and massively expanded access to markets - This industrial revolution brought new opportunities to business people to undertake productive ventures, such as building and operating roads, bridges, railroads, or factories, that had the potential to continue in operation for decades - In the early 1800s, a group of business people who wanted to undertake a long-term joint business venture, such as building a canal or a factory for manufacturing textiles, had three choices about how they could organize their enterprise o They could form a general partnership in which the participants would jointly own and manage the assets of the business and share responsibility for the liabilities of the business; they could form an unincorporated joint stock company, which was a special type of partnership that used trust law to separate the assets of the enterprise from the personal assets of the partners (or ‘members’ as they were sometimes called), which made it easier to raise capital from passive partners; or they could attempt to form a chartered corporation o To form a corporation, however, business people had to go to their state legislatures and ask them to pass a special act granting the business organizers a charter to create a separate legal entity to hold the assets to be used in the enterprise. - Team production’, as the phrase is used by economists, refers to production that requires various inputs of differing types from two or more individuals and for which the output is not easily separable into pieces or portions that are attributable to the various inputs individually - When inputs are complex and difficult to specify in advance, and when outputs are ‘nonseparable’ and risky, it is virtually impossible to draft complete contracts that can help govern the relationships among the participants in the joint production process over an extended period of time - any contract that failed to specify the division of the output would likely lead to costly ‘rent- seeking’ behavior among the participants over time as the joint surplus was realized. - Each partner in a business venture organized as a partnership hence had tremendous power over the other partners. Individual partners could enter into contracts that bound the other partners, could incur debts that the other partners could be held liable for, and could threaten to pull out, forcing dissolution of the business, if they did not get what they wanted out of the partnership. And each time a partner pulled out, or died, or had to exit the partnership for some other reason, the partnership had to be reorganized to keep the business going - This complicated the relationships not only among the partners but between the partnership and suppliers and customers who surely knew and understood that the partnership was highly vulnerable to being broken up. o Thus, while partnerships provided a potential solution to the ‘team production’ problem, they could be difficult to manage over an extended period of time - Participants in a large network of business relationships in which mutual success depends on numerous individuals making team-specific investments over a sustained period of time require more assurance of continuity and financial stability - by the late eighteenth century, entrepreneurs pursuing business ventures that did not require any special monopoly or franchise from the state were increasingly using unchartered joint stock companies for such businesses as land speculation and settlement - Legally, unchartered joint stock companies were partnerships in which partners agreed to place the assets used in the business into a trust controlled by a group of trustees, in exchange for transferable claims on distributions from that trust o The promoters were able to achieve some degree of commitment of resources to the business venture o This, to some extent, separated the role of control from the role of investment in the business and made it possible to raise capital from a larger number of investors o Although the organizers of a joint stock company could agree among themselves to commit funds to the partnership trust indefinitely, these agreements apparently were not binding on the heirs of the members o So if a joint stock company member were to die, the heirs could compel dissolution just as partners in an ordinary general partnership could compel dissolution. o Moreover, a joint stock company did not completely separate the role of investing from the role of controlling the company o members were regarded as still legally in control of the enterprise, and could for this reason be held personally liable for debts of the business, just as individual partners could be held personally liable for debts of an ordinary general partnership. How Corporations Succeeded in Locking the Capital, and Separating Investment from Control - the primary reason why the state would provide a charter incorporating the entity was to provide a mechanism for holding property for some public, charitable, educational, or religious use, so that such property would not be owned by the individuals who at any point in time might be managing the organization or charged with making decisions about the use of the property - Since the property held by an incorporated entity was not owned by individual human persons, it could not be passed to the heirs of such persons but would continue to be the property of the institution, even as its ‘managers’ (mayors or bishops or presidents, for example) might come and go - It is with respect to this type of corporation that the law developed the concept of a separate legal ‘person’ or ‘entity’ - . Because of - the special public purpose nature of the businesses that were granted corporate status, it was important that the business property be held separately from the personal property of the individual business promoters, and that it not be subject to being subdivided or otherwise broken up o Incorporating a business, he added ‘helped protect the collective ownership of real property *and+ facilitated the mobilization of capital’ - courts eventually took the position that they might ‘pierce the veil’ of the separate entity in order to reach through to the individual persons associated together in the entity only if ‘the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud, or defend crime’ - It is legal separateness that I regard as the singular accomplishment of corporate law, the characteristic that provided the benefit business organizers so eagerly sought - Delegation of control rights helps ensure that none of the participants in the enterprise can exercise too much control over factors that affect the outcome for the other participants o This makes it easier for all of the participants in the enterprise to make credible commitments to cooperate with each other - a corporation is a separate legal entity with potentially perpetual life, and is the legal owner of the assets used in the business - from the time of the earliest corporations, financial investors who wanted to participate in a business organized as a corporation had to make substantial financial commitments, and these commitments were considered part of the corporation's permanent capital o Charters did provide that investors could receive dividends out of operating profits but not out of the permanent capital of the corporation o early case law emphasized that the resources that had been invested in corporations no longer belonged to the shareholders but, rather, remained the property of the corporation unless and until paid out in the form of dividends - The modern trust fund doctrine holds that, in an insolvent corporation, the directors have fiduciary duties running to creditors because corporate assets are held in trust to satisfy creditors first - the corporate form made it possible for investors in shares as well as creditors, employees, and suppliers to enter into long-term relationships with a firm with a greater assurance that the pool of assets would remain in the business to keep the business going forward Why I.M. Singer & Co. Had to Incorporate - provides an example in which the corporate form was used not to raise financial capital or to achieve the benefits of limited liability, but to lock in existing capital, provide a mechanism for settling any subsequent disputes among the leading participants in the firm, and ultimately support the development of a massive marketing organization - if the firm were still organized as a partnership at the point when Singer died, the valuable business which the two of them had built over the previous years would be destroyed in the legal battles over claims to Singer's estate o Singer's heirs, however many of them there might be, would all have some legal claim to some share of the business, and it would probably require years of court battles to establish who was to get what o without liquidating much of the firm, he would not be able to come up with enough cash to prevent catastrophe by buying out Singer's share from the heirs o Solution was to incorporate the business - Once incorporated, the business assets would no longer be the joint property of Clark and Singer but would belong to the corporation o Equity shares would be issued to Clark and Singer, each of whom would provide a pro- rata claim on any distributions from the business o But any such distribution would be at the discretion of the board of directors of the company, and could not be compelled by either former partner or by the executor of the estate, nor would it likely be compelled by any court of law handling the proceedings - The only function that incorporation served was to make sure that the substantial organizational capital that had been accumulated by the firm could not be torn apart, or its reputation easily destroyed, as a result of the messy personal affairs of one of the partners Under-appreciated Lessons (and a Proposed Application) - the corporate form of organization was a brilliant mechanism for raising capital because it permits passive investment by separating the role of contributing capital from the role of managing or controlling the business - Contemporary scholarship on corporations places a huge emphasis on the so-called agency costs that result from this separation o however great and troubling these agency costs are, they must be relatively trivial compared with the benefits arising from this separation o These benefits, I argue, have to do with the improved ability business people had to create long-term wealth-generating organizations once these roles were separated - A primary benefit of the corporate form, this chapter has argued, arises from the fact that passive investors yield ownership rights over the assets they contribute to the legal entity created by corporate law o In yielding ownership rights, they give up the right to withdraw the financial capital or other contribution they have made, and agree to accept in return only the distributions from the business that are ordered by the board of directors which has been given legal authority to make decisions for the corporate entity o This has the effect of reassuring and encouraging investment by all of the participants in the enterprise, including other financial investors as well as managers and specialized technicians, suppliers who make specialized investments to meet the needs of this particular corporation, and customers who buy the corporation's products on the promise that the products will live up to certain minimum performance or quality standards, or will be replaced or repaired by the corporation - where there is no active financial market that makes it easy for an investor to sell his or her claim on an enterprise at anywhere near its full value, passive investors in a firm who are neither deeply rooted in the community where a business operates nor deeply committed to the long- term success of the business are likely to try to pull their capital out at the first sign of trouble Systemic Perspectives on Corporate Governance Systems - an economy’s corporate governance system has a significant impact on the profitability and growth of corporations, their access to capital and the cost of their capital o it can influence the decisions undertaken by the firms and ultimately has an impact on the wealth created in a country - investors’ perceptions of the managerial decision-making process can influence their confidence in the corporation, the price at which capital is provided to the firm and, thereby, the cost of capital o a higher cost of capital will reduce economic growth - two major corporate governance systems: o 1) market-based o 2) bank-based - Suggested that market-based systems are most effective in monitoring and disciplining management o Provide flexibility to companies to use new structures and financing forms and will encourage the growth of companies based on knowledge as opposed to hard assets - The problems associated with concentrated holdings are found in both governance systems - Markets and monitoring appear to be ineffective and solutions rely on corporate law, product markets both internationally and domestically, and improvements in international capital flows - Although there are changes designed to improve capital markets in bank-based countries, other organizational structures and share ownership patterns will impede any significant convergence - The market-based system with its reliance on widely held shares and deep, effective capital markets is not a viable alternative in the short or medium term Corporate Governance Systems - Observed in the exercise of power in the management of resources, and involves the nature and extent of authority and the control and incentives provided to utilize human and other resources for the wellbeing of the general public - From the corporate perspective, a governance system is a framework of laws, regulatory institutions and reporting requirements that conditions the way the corporate sector is managed o Also incorporates the financial system since the latter has a role to play in conditioning behaviour of the corporate sector o The financial system is the structure of financial contracts that governs the distribution of claims on all cash flows generated from productive assets in the economy - The governance system defines the relationship of the owners to their firm and the mechanisms through which the owners affect the institution’s behaviour - Thus, governance system is concerned with the creation of wealth through the maximization of economic efficiency of the firm, and with shareholders as the residual claimants they have the greatest incentive to create wealth - The governance issue, therefore, is to ensure that management’s interests are aligned with those of the shareholders - Another characteristic of this system is the presence of widely held companies and the relative minor role played by banks in the governance function - Non-controlling equity holders are not able to exert much control Characteristics of the Governance Systems - Monitoring is very important - The monitor represents its own interests with the objective of maximizing its own expected utility, so this may cause issues Market-based (market-centred) systems - Market-centered systems also have other monitoring arrangements, incentives, and disciplinary techniques assigned to achieve strong managerial performance - Widely held nature of securities and the lack of significant intercorporate, individual/family and bank holdings - On the incentive side, there is the presence of senior management compensation that is tied to variables designed to align the interests of management and shareholders - By using compensation tied to share price, management is expected to make decisions that lead to higher share price - Share price performance can be used as an indication of management success and fire management - The board of directors must be vigilant in over-seeing management actions with the ultimate goal of shareholder wealth maximization o Must also adopt a corporate strategy, appoint and monitor senior management, communication with shareholders and stakeholders, and ensure internal control systems are in place and function effectively - It is the shareholder’s responsibility to monitor management and the board of directors - Transactions in equity claims issued by corporations are undertaken in the securities market - The capital market monitors the firm in the sense that the security price provides a signal of management success o When company issues new securities, the share price will react to reflect the expectations of the impact of new capital on the firm’s performance - The market for corporate control is a very important means to solve the principal-agent problem - The market for managers is effective if management, in order to maintain its marketability, operates the firm to achieve strong returns German System - Two-tiered board system: the supervisory board and the management and executive committee o Codetermination act of 1976 o Board has specific control duties and powers such as appointing, dismissing
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