H2O

This is the old version of the H2O platform and is now read-only. This means you can view content but cannot create content. You can access the new platform at https://opencasebook.org. Thank you.

Introduction

Original Creator: Holger Spamann Current Version: Holger Spamann Show/Hide

What is a corporation?

Formally speaking, a corporation is nothing but an abstraction to which we assign rights and duties. It exists independently of humans in the sense that it has indefinite life, and its assets and obligations are legally separate from those of any humans involved in its founding or administration.

The corporate abstraction is an extraordinarily useful and widely used device for organizing relationships between various people and different assets. Most importantly, a group of people can pool their assets by transferring them to a corporation that will act as a single contracting interface with third parties (and with the owners among themselves, for that matter). Or a single person can set up multiple corporations to hold different assets and to enter into contracts relating to those assets. You can and should, therefore, also think of the corporation as a contracting technology. It facilitates contracting by partitioning and pooling assets.

Of course, being an abstraction rather than a real person, the corporation cannot exercise its rights, discharge its duties, or consume its profits by itself. Human beings must act on its behalf and ultimately consume its profits, if any. Humans can be involved directly, or through a chain of corporations (e.g., corporation A’s sole shareholder is corporation B, whose shareholders are human beings). The basic default governanceis simple: (common) shareholders elect the board (cf. DGCL 211(b)), which formally manages the corporation (cf. DGCL 141(b)), mostly by appointing the chief executive officer and other top management, who in turn act on behalf of the corporation in day-to-day matters. As to consuming the profits, the board may decide to distribute available funds to shareholders—or not (cf. DGCL 170(a)). By default, each share confers one vote and the right to equal distributions per share (cf. DGCL 212(a) – the more shares you own, the more votes you have and the more of any distribution you get. Corporate law fills in the details: what if the board is unfaithful to shareholder interest? What if shareholders have divergent interests? Are there any other interests to be taken into account?

Technically, the corporation is not the only abstraction available for asset pooling and partitioning. There are variants such as the limited liability company (LLC) that have all or most of the features discussed here, and are subject to very similar rules. From the perspective of this introductory course, the differences are minor, and hence not covered.

What the corporation is not

The corporation is not a person like a human being. To be sure, we sometimes refer to corporations as “legal persons.” But you should realize that this is just legalistic shorthand to emphasize the fact that a corporation can be the object and subject of legal claims. It does not mean that a corporation is a person in the sense that it has the same rights and obligations as human beings. Or have you ever heard of a corporation being drafted into military service? Or invoking a human right not to be tortured?

The corporation is also not the same as a business. A corporation may “own” a business, but they are not the same thing. A business is a collection of assets and a set of real world activities. A corporation is an abstract legal reference point to which we assign those assets. (Another formal note: In most jurisdictions, one technically cannot own a “business.” Rather, one owns the assets that form the business, which include not only chattel and real property but also contracts, intellectual property, etc.)

Example 1: Mike’s Pizza

To make this more concrete, think of your local pizza store. Perhaps it is called “Mike’s Pizza,” and Mike indeed runs the place. You might think that Mike is the “owner” of the store. In all likelihood, however, the formal “owner” of the pizza place — or rather the contracting party on the relevant contracts — is actually a corporation. The corporation might be called “Mike’s Pizza Place Inc.,” or “XYZ Corp.” for that matter. XYZCorp. might be (a) the lessee under any lease contract for the store building or other leased items, (b) the employer of any employees, © the owner of any real estate or chattel such as the pizza oven or the store sign, and (d) the contracting party with the payment system operator (so your payment for the pizza might show up under “XYZ Corp.” on your credit card statement).

Of course, Mike might be XYZ Corp.’s sole shareholder, director, and chief executive officer (CEO). As shareholder, Mike would elect the board (here a single director), which in turn appoints the CEO. As CEO and director, Mike would then have plenary power to administer the business. And as shareholder, he might receive any profits as dividend. For many practical purposes, it is thus irrelevant if Mike owns the store outright or through a corporation. So what’s the point of incorporating?

One benefit of incorporating can be convenience in contracting in certain transactions. If Mike ever wanted to sell the pizza place after incorporating, he would just sell the corporation — a single asset (or to be more precise, all his shares in the corporation, still just one collection of a uniform asset). By contrast, as a single owner, he would have to transfer all the assets individually.

Another convenience is that incorporating changes the default rule from unlimited liability to limited liability. The default rule for corporations is that shareholders, directors, and corporate officers are not liable for corporate debts (but they do stand to lose any assets they invested in the corporation as shareholders: hence the expression “limited liability” rather than “no liability”). By contrast, the default rule for single owners is the same as that for any other individual debt: full liability except for protection under the bankruptcy code. It is extremely important that you realize these are only default rules. Contracts can and often do transform limited liability into unlimited liability and vice versa. For example, a no-recourse mortgage contractually limits the borrower’s liability to the value of the underlying real estate. Most importantly for present purposes, controlling shareholders such as Mike often contractually guarantee particular corporate debts such as bank loans (i.e., they contractually promise to pay the corporate debt if the corporation does not). In contractual relationships, the legal concept of “limited liability” is thus neither necessary nor sufficient to provide actual limited liability for shareholders; it merely facilitates it. The situation is different (and controversial) for most tort liability, as most tort creditors never consented, even implicitly, to the limited liability arrangement.

(Question: Did you, as a customer of Mike’s Pizza, consent to Mike’s limited liability? Does it matter, legally or as a policy matter? What if Mike himself negligently dropped a piece of glass onto your pizza — is he still protected by limited liability? Should he be?)

Another benefit is entity shielding. Entity shielding refers to a liability barrier in the opposite direction: Mike’s personal creditors cannot demand payment or seize any assets from XYZ Corp. The personal creditors can only seize Mike’s shares in XYZ Corp. Entity shielding is extremely useful because it allows those interacting with XYZ Corp. to focus their attention on the pizza store’s assets and financial prospects, and not worry about Mike’s other businesses. Imagine for example that Mike also runs a construction business in a different city. Without entity shielding, creditors from the construction business might seize assets of the pizza store, and vice versa. As a consequence, the two businesses’ financial health could not be assessed independently of each other. By contrast, with entity shielding, a bank making a loan to develop the pizza store need only assess the financial prospects of the pizza store, i.e., XYZ Corp. And if the construction business does fail, XYZ Corp. can nevertheless continue business as usual. Entity shielding is more than a mere convenience in that it cannot be accomplished by contracting in the technical sense of the term (i.e., as opposed to the broader set of voluntary arrangements discussed below, which include corporate charters). That being said, the law also provides entity shielding to other entities such as partnerships.

One can neatly summarize limited liability and entity shielding with the simple legal construction of the corporation as a separate “legal person.” “Naturally,” one might say, separate persons are not liable for each other’s debts. Importantly, however, the legal construction is only a convenient summary of policy choices that must be grounded elsewhere. For there is nothing natural about declaring the corporation a separate legal person in the first place (nor, for that matter, would there be anything natural about the opposite arrangement, in particular holding investors liable for all debts of the business). It is a convenient fiction, and the law does not adhere to it strictly. We will encounter exceptions in corporate law (notably “piercing the veil”), and there are many more in tax, antitrust, etc. See generally Felix Cohen, Transcendental Nonsense and the Functional Approach, 35 Colum. L. Rev. 809 (1935).

Example 2: Apple Inc.

I have just argued that the corporation can be useful for small, single-owner-manager businesses such as Mike’s Pizza. But the corporation’s full advantages only come into play in larger businesses with multiple shareholder-investors, many or most of whom have no direct involvement in management. Almost all large firms are organized as corporations. And the majority of economic activity is bundled in large firms.

Think of Apple Inc. When its legendary co-founder and CEO Steve Jobs died, from a legal perspective all that happened was that the board of Apple Inc. had to appoint a new CEO. By contrast, if Steve Jobs had been the single owner of Apple, the entire business would have been part of his estate, presumably with deleterious consequences. Similarly, if the board of Apple Inc. decides to replace the CEO, it does so by simple resolution — it does not need to expropriate the old CEO.

Even more important than independence from its managers, Apple is independent from its shareholders, and the shareholders are excluded from management. Think of Apple Inc.’s millions of shareholders. Imagine the mayhem if any one of them could demand participation in Apple’s management, or liquidation and distribution of Apple’s assets. Or if the creditors of any one shareholder could demand payment from Apple, even just for a limited amount, and seize Apple’s assets to the extent the payment is not forthcoming. And of course it would be impossible for Apple to enter into a contract or file a suit if this required the signatures of all its shareholders, just as no plaintiff could sue “Apple” if it required naming every single shareholder as a defendant. In other words, Apple Inc. as we know it could not exist without the convenience of a single fictitious “legal person,” restricting shareholder involvement in management, and entity shielding.

Many think that Apple Inc. and other large corporations also could not exist without limited liability. The argument is that shareholder liability would deter wealthy investors (who are the ones most likely to be sued), would make the corporation’s credit-worthiness dependent on its fluctuating shareholder base, and would interfere with diversification (the strategy to invest in many different assets so as to not put all eggs into one basket). There is reason to doubt this common wisdom, however. Limited liability distorts shareholders’ incentives because they (fully) benefit from the upside but do not (fully) bear the downside of risky investments. And the problems of unlimited shareholder liability may be minor if liability is proportional to the number of shares held. Empirically, California provided for proportional shareholder liability until 1931, and American Express was organized with unlimited shareholder liability until 1965. It appears that shareholders largely viewed the shift to limited liability with indifference both in California and in American Express.

Back to indefinite life, and the inability of individual shareholders to demand liquidation. If an Apple shareholder wants to cash out, he or she can simply sell the shares. The default rule is that shares are freely transferable. This default rule complements indefinite life. It reconciles the corporation’s need for continuity with individual shareholders’ need for liquidity, i.e., the ability to convert their investment to cash. In smaller corporations, particularly family firms, however, the charter or shareholder agreements sometimes restrict transferability of shares. And even if sale is not restricted, there is often no market for a small corporation’s shares at a price that fully reflects the corporation’s value. In these cases, liquidity can be a major source of disagreement between shareholders.

In general, multi-member organizations also have governance problems that Mike’s Pizza does not have. (I write “organizations” because the problems are not specific to corporations.) When the only shareholder (Mike) is also the only director, the only manager, and the only employee, there are no conflicts to resolve. But when there are millions of shareholders or more generally investors, a multi-member board, dozens of managers, and thousands of employees, conflicts abound. Millions are not necessary for conflicts to arise, however. The conflicts can be even more acrimonious when there are only two shareholders. Mitigating these conflicts is the main preoccupation of corporate law and of this course.

The broader picture

Before embarking on our study of conflict mitigation, here are a couple more basic facts to round out the corporate picture.

Holdings and subsidiaries

Large businesses are usually not one but many corporations. Usually, a so-called “holding company” sits at the top of a pyramid of several layers of fully-owned subsidiary corporations. That is, the holding company owns 100% of the shares of several direct subsidiaries. These direct subsidiaries in turn own 100% of the shares of some other, indirect subsidiaries. And so on. This is a further illustration of the point that a corporation and a business are not the same thing.

Some advantages of the subsidiary structure are similar to the advantages of incorporating Mike’s Pizza. Others include tax considerations and regulatory requirements. For example, Apple Inc. has become infamous for its use of Irish subsidiaries to “manage” its corporate tax liability. And yet, the relevant part of its corporate structure (see here and here [p. 20]) appears simple compared to the full network of subsidiaries of, e.g., JP Morgan, which comprises hundreds of subsidiaries.

In this course, we usually focus on the top level holding company because that is where the governance problems arise.

Partnerships and other entity types

You may wonder what would happen if a multi-person firm did not incorporate. The answer is that “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership,” unless the association was specifically formed under a separate statute such as the DGCL (which will generally require at least a registration). See section 202 of the Uniform Partnership Act of 1997.

This is a very dangerous default rule. Absent agreement to the contrary, (1) all partners have unlimited liability for partnership debt, (2) all partners have equal rights to participate in management, (3) any partner may be able to demand dissolution at any time, and (4) partnership interests are not transferable. It is a recipe for disaster.

You might now wonder how businesses could even operate before incorporation became generally available in the 19th century. There are three answers: First, some were lucky enough to procure a special corporate charter from the king or legislature. Second, some businesses may indeed not have commenced or grown beyond a certain point because the corporate form was not available. Third, and most importantly, the partnership rules described above are merely the default rules. They can and usually are heavily tailored in the partnership agreement, provided that the partners are aware that they are forming a partnership.

For example, the partnership agreements of contemporary law firm partnerships reserve management to a committee, and provide for a regulated cash-out without dissolution if a partner wants to exit the partnership. The one thing that the partnership agreement cannot exclude in a traditional partnership is unlimited liability. To limit liability in a practical way, the law firm must choose a different entity type, as most large firms have done by now. (Some have not, and intentionally so. Can you guess why?)

Contractual freedom

There is a more general theme here. Almost everything in corporate law can be modified by contract, at least if we understand contract in a broader sense to include charters and bylaws. For example, the charter can create separate classes of stock with different voting and distribution rights (DGCL 151(a), 212(a)). Even if a rule is mandatory on its face, like unlimited liability for partners in general partnerships, one can usually circumvent it by choosing an economically equivalent but legally different transaction or entity type, such as the limited liability partnership (LLP). See generally Bernard Black, Is Corporate Law Trivial?, 84 Nw. U. L. Rev. 542 (1990).

We will discuss the normative sense or nonsense of this state of affairs towards the end of the course. Until then, it is important to keep in mind that any judicial or legislative decision we read is contingent on the particular contractual arrangements chosen by the individuals involved. More to the point, as a budding corporate lawyer, you should always be thinking: what clause or arrangement could have avoided this problem?

EDIT PLAYLIST INFORMATION DELETE PLAYLIST

Edit playlist item notes below to have a mix of public & private notes, or:

MAKE ALL NOTES PUBLIC (3/3 playlist item notes are public) MAKE ALL NOTES PRIVATE (0/3 playlist item notes are private)
  1. 1 Show/Hide More The Pizza Shop Problem: Litigator's perspective
    Here is a little problem to warm up and introduce some basics of agency and partnership. Before attempting the problem, please read (!): Uniform Partnership Act (1914) §§ 6(1), 7(4), 9(1), 13, 15, 21(1), 29, 31(1)(b), 37, 38(1); Restatement of the Law (Third) Agency §§ 1.01, 1.04(7), 2.01, 2.03, 2.05, 3.01, 3.03, 4.01(1), 4.02(1), 6.01, 7.03, 8.01-03.
  2. 2 Show/Hide More The Pizza Shop Problem: The Transactional View
    We just looked at Louis and Kathy’s pizza shop from a litigator’s perspective. Most of the work of corporate lawyers, however, is to avoid disputes arising in the first place, in particular to design procedures that will resolve conflicts without litigation. So let’s travel back in time six years.
Close

Playlist Information

December 07, 2017

Author Stats

Holger Spamann

Other Playlists by Holger Spamann

Find Items

Search below to find items, then drag and drop items onto playlists you own. To add items to nested playlists, you must first expand those playlists.

SEARCH
Leitura Garamond Futura Verdana Proxima Nova Dagny Web
small medium large extra-large