MindMap Gallery Business organizations and corporate finance law
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Business organizations and corporate finance law
Business organizations and corporate finance law refer to the legal framework and regulations that govern the formation, operation, and financial activities of businesses. Here are some key aspects of business organizations and corporate finance law
Edited at 2023-10-25 11:22:52
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Business Organizations & Corporate Finance Law
The organization as a nexus of contracts
Jensens and Meckling 1976
Organizations are legal fictions which serve as a nexus for contracting relationships among individuals
Contractual relations are the essence of the firm
Agency
A contract under which one or more persons engage another person to perform some service on their behalf, which involves delegating some decision-making authority to the agent
Costs:
Monitoring costs
Bonding costs
Residual loss
Both parties have incentives to solve the agency problem, so that the principal and the agent will structure their relationship so as to minimize the sum of these costs
The role of the law is to provide a set of default arrangements that most contracts will adopt
Outside financing
Equity
Leading to suboptimal rewsults because there is a discount for agency costs
Both parties still have an incentive to reduce agency costs, independently of any legal obligation
Debt
Lender will have different incentives than the borrower, resulting in agency costs
The theory of the firm
Coase 1937
Using the market entails positive transaction costs
Using the organization entails positive organization costs
These costs define the boundary of the firm
As the firm gets larger, the marginal costs of using the organization increase, explaining the number of products produced within the firm
Alchian and Demsetz 1972
A firm is based on fiat or authority
As such a firm is a way to organizate team production and the right to the residual claim of this production:
Several individuals contribute to joint output
It is difficult to assess how much each individual contributed by looking at the outputs (metering problem)
Rewards are therefore weakly correlated with effort
There is an incentive to reduce effort
The firm is a policing device created to solve the metering problem. This is done by the monitor, who should receive the residual control rights because the better the monitor, the better the output
The firm can own or rent assets; the guideline is that the firm will own assets for which the monitoring problem is serious.
Gross-Hart-Moore 1989
Contracts are inherently incomplete
In long-term contracts, it is impossible to specify all contingencies: some clauses may either be unenforcable, or it may be difficult to predict and plan for all future events
The main problem here is what to do when a non-contractible contingency materializes
Incomplete contracts
Ownership is to have the residual control right on assets
If a non-contractible contingency amaterializes, the owner can freely decide what to do with the asset.
As such, ownership gives the power to complete incomplete contracts
A firm is a bundle of physical assets
Because the firm is identified with its assets, ownership of the firm implies ownership of the assets
The firm's owner is the one who decides what to do with the firm assets if the contract does not specifify a course of action
Bargaining power
The GHM theory is based on property rights in the limited sense of residual control rights.
Property as
Residual Control Rights
Solving the problem of Incomplete Contracts
Hold-up problem
Strategic incentives to underinvest in firm-specific innovation when a transaction is non-contractible ex ante
Legal entities
The legal form
Dari-Mattiacci, Abatino, Perotti 2011
In history, substitutes arose where there was no legal form, e.g. the slave-run business in the time of the Roman Empire.
Hansmann, Kraakmand & Squire 2006
Legal personality
Legal status granting the entity the possibility to own property, be part of contracts & enter into bankruptcy.
Representation
The company was not a party to the contract, by agency law it was made to be.
Limited liability
Equity holders are shielded from company debts, irrespective of the will of the creditor
Entity shielding
Creditors are shielded from claims of personal creditors to the equity holders
Weak: firm creditors have priority over personal creditors
Strong: personal creditors cannot ask for the liquidation of the firm
Complete: personal creditors have no claim on firm assets
Entity shielding is more important than limited liability.
In history, entity shielding developed earlier
In practice, companies can more easily do without limited liability than with entity shielding
In theory, limited liability is easier to construct by contract
Hansmann Kraakman 2000
Entity shielding offers company's creditors priority and liquidation protection. this is only feasible through mandatory law because it defines the property rights (the pool of assets) over which participants can contract.
Entity shielding reduce monitoring costs and protect the going-concern value of a firm, but its costs are found in bankruptcy probability because there is a smaller pool of assets.
Limited liability can be achieved through contracts because in the contracts with firm creditors, there could be a provision where the creditor waives their right to proceed against owner's personal assets.
Organization law has two main functions
1. Enabling: the set of rules that allow the decrease of transaction costs and the control of agency costs, and enables parties to allocate residual control rights
2. Essential: entity shielding can be established through propritary entitlements, defining the property rights over which firm's particpants can contract.
Capital Lock-In
Protecting company assets from equity holders: the owner has no direct claim on it's share vis-a-vis the company
This is the core of the corporate form (Blaire 2003)
Development of capital lock-in (Dari-Mattiacci et al 2017)
The corporation emerged out of the need to lock in capaital for the long-term.
Lock-in subjects investors to a risk of expropriation
The corporation only emerged where thiss risk was low.
Lock-in creates a risk of expropriation which can be limited by constitutional reform.
Shareholders want to be renumerated for their (permanent) loss of capital , via dividend payments
However, capital-lock in causes an organizational to be costly to dissolute and to incentivize capital intensive investments.
A partnership does not do it, which is the reason why still many enterprises are organized as a partnership.
Cihan and Guinnane 2019
Transferable shares
Preserving liquidity of equity holders with transferability of shares
providing an exit possibility for owners
buyers of shares are bound by the contractual arrangements with the previous owners
Kuran 2005
The middle east failed to introduce the needed instituional innovation to allow for the corporate form
The Waqf was an alternative to the corporation
However:
the Waqf was a vehicle for financing Islam as a society
the Waqf could only be founded by an individual
the foundational deed was irrevocable and unmodifiable
The Waqf could exist for an indefinite time, and a matawalli (manager) could be appointed
Buttler 1985
During the 17th century, the corporate charter was a law ad personam.
Today, the corporation is a freely available organizational form
This development happened in the 19th century, when trade in privilege corporate status caused a competitive market for corporate charters.
Entities in contracts and bankruptcy
Posner 1976
Firms are organized in different entitiews if different creditors have different monitoring advanrtages
Merging the firms increases the monitoring costs
Entity partitioning allows for effective asset partitioning, in contrast to a contract
Due to creditor incentives, entities are structured in a specific manner
Ayotte and Hansmann 2013
Firms are organized in entities when it is advantageous to bundle together different contracts
This is the case, when
Contracts may be a firm's main asset
The bundle of contracts may habve more value together than their sum
Ex ante there is a problem with incentives to invest (if investments are non-contractible)
the investment problem
an entrepreneur will only invest if the full benefits of the investments are captured
the possibility of selling individual contracts is then beneficial for liquidity purposes
Ex post there is a problem with opportunistic assignments (if contract characteristics are non-contractible).
the opportunism problem
an entrepreneur can make a profit by assigning the contract to a lower-quality party
the possibility of selling individual contracts then causes the counterparty to bear a loss or deter underinvestment
Bundled assignability
In an entity, because:
i) constraining assignment by contract is difficult due to the definition of the bunde
ii a legal entity is the nexus of all contracts; realizing bundled assignability can be done effectively through the organization
iii) assignability by sale of the company can be constrained by change of control clauses
To assign menas to sell both rights and liabilities to a third party, fully replacing the orginal contract
Baird and Casey 2013
A firm can be split into entities when it iss easier to monitor a portion of the firm
Bankruptcy tailoring is focused on the key point that entity partitioning comes together with withdrawal rights
this cannot be done by contract because, in bankruptcy, a contract is overruled.
Bankruptcy applies to firms
Reining in the corporate form
Pargendler 2021
Veil peeking
Mitigates regulatory partitioning by enabling the imputation of shareholder rights or duties to the corporation
Bi-directional peeking
All shareholders are affected
Goal is to avoid frustration of regulatory purpose
Regulatory partitioning
Public law
All sorts of rights and duties
Many types of tailoring
Veil piercing
Tempers asset partitioning by imposing shareholder liability for contracts, torts, or regulatory claims
Uni-directional piercing
Only controlling shareholders
Goal lis to avoid fraud and migling with assets
Asset paratitioning
Private law
Uniform definition and application
Financial rights and duties
Hansmann and Pargendler 2014
Shareholder voting
Limitations in the way sharheolders could vote
Protect minority shareholders
Protect consumers
Shareholders want to maximize profit
Monopoly pricing
Consumers want to maximize consumper surplus
Competitive pricing
The problem is not that some consumers overpya, but rather that some consumers do not buy products that cost less that they are willing to pay
Restrictions on shareholder voting are not present in competitive industries
The seperation between ownership and consumption
Hart and Zingales 2022
Move from shareholder value to shareholder welfare in the case of monopoly power
Extending the logic from Hansmann and Pargendler
Capital-structure tailoring
Iacobucci and Triantis 2007
Firms are organized in different legal entities when it is advantageous to use different capital structure arrangements for different pools of assets.
Capital structure tailoring
This cannot be done by contract, due to two difficulties:
i) non-recurse secure debt
ii) tracking shares
The boundaries of legal entities are therefore:
1. Capital-structure tailoring
2. Creditor monitoring
3. Bundled assignability
Hansmann Kraakman 2002
A general theory of proprietary rights in respect to third parties
What is property?
1. Erga omnes
Property can be enforced against the world
2. In rem
Property is a right on assets
The right follows the asset
What is the problem with contracts?
A contract also affects third parties, who were not a party to the original contract (privity principle)
Property laws solve problems arising from potentially incompatible contracts
There is only a limited list of proprietary rights (numerus clauses)
In contrast to the freedom of contract