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MindMap Gallery Business organizations and corporate finance law

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

F. Vieveen

Recent works View more works>>

Business organizations and corporate finance law

F. Vieveen

Recent works View more works>>

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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