Corporate Law Research Paper

An understanding of corporate law must begin by examining the general problems of the theory of the firm, which defines the financing, managing, and/organizing needs of business enterprises generally. With this background, it is possible in the second part to examine some basic features of corporate law— including the limited liability of shareholders and the contractual nature of corporate enterprises—and to consider the regulatory competition among corporate law policy makers. In the third section, internal organizations problems will be discussed, in particular the separation of ownership and control and the consequent issues of corporate governance. Finally, the fourth and final section will address the regulation of the financial structure of the corporation, specifically the problems raised by bonds issuance and the role of financial markets such as the market for corporate control.

1. The Theory Of The Firm And Corporation

The reason why business ventures in modern economies are carried on by organized firms, instead of by individuals, is best understood through the theory of transaction costs (Coase 1937). The basic insight of this theory is that through the firm, it is possible to transform part of the transaction costs of running a business into what might be called control costs or agency costs. A useful example is the employer– employee relationship. Imagine that an entrepreneur has two possible choices to accomplish a particular task. Either the entrepreneur can buy the required service from an independent provider (contracting on the market), or he can hire an employee (creating an organization) to perform the same service. Under the first option, the entrepreneur must draft a detailed contract that specifies the relationship between the parties. Creating a separate contract involves significant expenditures of time and money to draft, monitor and possibly enforce the agreement. In economic parlance, these expenses are called ‘trans-action costs.’ These transaction costs will be further increased every time the entrepreneur must negotiate a new agreement for a different service from a different provider.

Under the second option, if the entrepreneur hires an employee to perform the necessary services, his transaction costs will go down. An employment contract is an ‘open’ contract, in which the details of the performance do not need to be delineated with great particularity. Instead, an employer can simply direct the work of the employee according to specific and perhaps changing needs. Although this approach reduces transaction costs, it generates a new form of costs. These costs arise because, in contrast to an external provider who likely has an incentive to perform efficiently, an employee has less incentive to be efficient. As a consequence, the employer will need to monitor the employee’s performance, thereby ex-pending both the cost of sanctions for deviations and the cost of incentives for proper performance. The increased costs that a principal incurs in monitoring to ensure that an agent adequately performs are called ‘control costs’ or ‘agency costs.’

In addition to monitoring expenditures by the principal, agency costs also include what might be termed ‘bonding expenditures’ by the agent. (Jensen and Meckling 1976). Bonding expenditures are costs incurred by the agent to expand resources that guarantee the agent will not take certain actions, like quitting. The classic example of bonding expenditures is training or professional education in the field, which creates a high level of specialization and can make it more costly for the agent to change jobs.

Generally, a firm will prefer to internalize production whenever the agency costs will be lower than the transaction costs of an external relationship. Given the incentives and means for reducing transaction costs, the expected result is an increase in agency relationships for business enterprises, meaning an increasing preference for the firm structure over an integrated network of independent entrepreneurs. The firm can thus be understood as a method of organizing production (Posner 1998).

In addition to organizing production, another fundamental need that firms have is to raise capital with which to operate or expand. Again examining the economics of available choices, the nature and purpose of the corporate structure will be revealed. If an entrepreneur lacks financial resources or does not want to risk his own money in the business, he can borrow capital. Economic analysis demonstrates, how- ever, that if the entrepreneur finances his business only through borrowed capital, the interest rate will rise to an uneconomic level because of the high risks of an unbalanced financial structure (Posner 1998).

There are two potential solutions to this problem. Either the entrepreneur can draft a very detailed loan agreement, which will lower the level of risk faced by the lender, or he can admit partners to the enterprise, who will provide (and risk) the necessary capital, but will also share the profits of the business. This second option can be economically preferable in several respects. First, it lowers the entrepreneur’s contracting costs because he no longer has to negotiate the details of a loan agreement, and because it is not necessary to bargain around the interest rate since the partners’ return on their investment will be determined by the business’s success. In addition, the presence of credit- worthy partners can improve the credit rating of the firm, thus lowering the cost of satisfying future capital needs.

If the need for capital increases significantly, how- ever, this option becomes less desirable and the partnership structure shows its limits. The first problem is that partners in a firm have unlimited liability, which means significant agency or control costs. Because they are personally and unlimitedly liable for the conduct of the business, they will seek to intrude in the management of the firm to protect themselves and their investment. Moreover, because the financial strength of the partnership depends on the personal assets of the different partners, before investing every-one of them will want to investigate the other partners’ wealth. Additional limitations are inherent in the nature of partnership, which is strictly dependent on the identity of the individual partners and can, for example, be dissolved on the death of one of the partners: the impermanence of the partnership agreement may thus affect the ability of the firm to raise capital from financial institutions.

For all these reasons, it becomes clear that the partnership structure is not suitable for larger, capital-intensive enterprises. Instead, the corporation is the form designed to facilitate further capital-raising activities. The two defining features of the corporate structure that allow it to do this are the limited liability of its owners and the division of ownership into ‘shares,’ meaning securities that represent a stake in the corporation but can easily be bought and sold. Corporate law is the set of mandatory and default rules that creates these features and regulates the consequences of them.

2. Basic Features Of The Corporation And Corporate Law

2.1 Limited Liability

Notwithstanding attempts to trace back the modern corporation to ancient forms of organization of business enterprises, ‘limited liability,’ as the term is understood today, was an invention of the seventeenth century, granted to legal entities established for the purpose of raising funds to finance colonial expansions. The increasing need for new capital, which could neither be found in the treasuries of western monarchies nor raised through taxes, made resort to private saving an imperative resource. In order to collect such a considerable amount of money it became necessary to involve also small and medium bourgeoisie classes. Because these groups were risk-averse with their money, it was necessary to ensure legally that if they invested, only the amount of the investment would have been at risk. Limited liability was considered a royal privilege, an exemption from the general principle of unlimited liability, and as a consequence, it was subject to the discretion of the sovereign. It was only later that the ‘power’ to grant limited liability to corporations became a nondiscretionary power and was entrusted, in continental Europe, to the judiciary.

Borne out of historic necessity, limited liability has remained critical to the development of the modern corporation, and consequently to the development of western capitalism. The predominant economic ex-planation for the modern importance of the corporate structure is that it reduces the costs generated by the separation and specialization of ownership and management functions (Easterbrook and Fischel 1985, Woodward 1985). A more detailed account of this economic effect involves several distinct but complementary considerations.

The first major consideration is that limited liability reduces the investor’s need to incur monitoring costs. True to its name, ‘limited liability’ defines and restricts to the original investment the total amount of money an investor can lose. With the fear of unlimited liability gone, the investor no longer has a great incentive to interfere with the management of the corporation or to monitor the financial wellbeing of fellow share-holders.

Another important consequence of limited liability is that it makes freely transferable shares possible. In a setting with unlimited liability, shares would not be readily transferable because it would be highly relevant who is selling the shares and who composes the shareholders’ group (they are not, in other words, ‘commodities’). Meanwhile, when shares are readily transferable, the investor’s incentives to monitor management are further reduced because his shares can be sold if he is dissatisfied with the corporation’s performance, which can be easy if there is an active market for the shares. Another consequence of the reduction in the need to monitor and the availability of ownership through shares is that they permit the investor to diversify his investments into several companies, which further attenuates the consequences of poor management or adverse external events in one particular company.

The free transferability of shares, in turn, makes it possible to create a market for corporate control, which can be a powerful mean of external governance of the corporation. In fact, if shareholders are dis-satisfied with the management of the corporation, they can sell their shares, thus causing a decline in the price of the shares. The corporation can thus be exposed to hostile takeovers by newcomers that believe to be able to make a profit buying the shares at a low price, manage it efficiently and thus enjoy a capital gain in the value of the shares. Thus, the presence of a market for corporate control represents an incentive for managers and controlling shareholders to act efficiently and not oppress minorities because, as long as shares have a voting right attached, poorly managed companies are exposed to the risk that shareholders will sell their shares and cause a change in control.

Corporate law not only creates limited liability to promote these aims, it also regulates some potentially harmful side-effects of limited liability. One consequence of limited liability and ownership through shares is that ownership can become more and more separate from management: the typical shareholder is not knowledgeable about the firm and, because there are reduced incentives to monitor management, does not expect to participate in its management. This separation between management and control—as will be discussed below—brings with it some potential for problems.

While the basic economic feature of firms and the need to raise capital justify the legal concept of limited liability as a general matter, there are also scenarios experienced by all systems that counsel in favor of exceptions to limited liability. For example, if the corporate structure is used to mislead creditors or perpetrate fraud, or provides inappropriate incentives to corporate actors, the protection of limited liability is no longer justified and it is instead better policy to permit the creditors of the corporation to reach shareholders’ personal assets. In light of these potential consequences, all European and North American legal systems provide a mechanism ‘to pierce the corporate veil’ or to eschew a corporation’s limited liability.

In civil law systems, the circumstances in which this mechanism is available are usually strictly defined by law. For instance, under Italian law, article 2362 of the Civil Code permits the corporate veil to be pierced in the case of corporate insolvency if there is a single shareholder. In common law systems, by contrast, there is greater flexibility in determining when the corporate scheme can be disregarded. A general overview of US and British cases on this issue suggests that the most important situation in which courts pierce the veil is when separate incorporation misled creditors. There are also a range of other exceptions, such as when the debtor corporation acted as a mere alter ego of the shareholders, when the corporation is not adequately capitalized or when shareholders have deceived creditors on the financial solidity of the corporation. In addition, US courts have demonstrated a willingness to disregard corporate limited liability in tort cases reasoning that without the possibility of such liability, corporations have less incentive to avoid disastrous harm to victims who they will never be required to compensate beyond the limited value of the corporation. In that situation, instead of simply attracting capital, limited liability creates the potential for a ‘moral hazard’ (Hansmann and Kraakman 1991).

2.2 The Corporation As A Standard Contract

Corporate law provides for limited liability, regulates its consequences and provides for exceptions to it through a set of rules that provide for what can be understood as a standardized contract. Corporate statutes enacted by the different legislators can be seen as a set of default rules that apply once the company is incorporated in a particular state. These comprehensive rules reduce the costs of contracting that parties would face if they had to individually negotiate all of the terms that are provided in the corporate law. The fundamental problem in this respect concerns mandatory versus enabling rules. Should corporate law provide for some mandatory fundamental rules concerning shareholders’ rights, minorities protection, corporate governance, and so on that parties can not opt out? Or, should corporate law only propose some enabling rules, that apply only if parties do not agree to the contrary? Finding the appropriate balance between mandatory and enabling rules is one of the fundamental problems of corporate law.

On one side, providing for mandatory rules ensures a higher level of protection of minorities in systems in which there is no active market for corporate control. When shareholder minorities are not organized and are thus unable to play an active role in controlling managers and shareholder majorities, mandatory legislative protection becomes a necessary incentive for investment. On the other hand, the lack of flexibility that characterizes mandatory rules can be inefficient if those rules differ from the ones that the parties would prefer. For instance, the presence of a mandatory rule concerning corporate disclosure can interfere with the willingness of a risk-averse investor to finance an enterprise that would prefer to opt for a lower level of disclosure. In such situations, default rules that are modifiable by the parties might produce a more efficient result. Enabling rules promote efficient regulation, however, only when investors are able to make their decisions based on accurate assessments of the regulation chosen by managers and controlling share-holders. This prerequisite suggests that default rules will only be efficient when there are organized minorities (usually institutional investors), who do not face information asymmetries and problems of collective actions in ‘contracting’ around default rules.

Against this basic economic background, it is clear why in common law countries, and the US in particular, the presence of more developed financial markets and of stronger ‘organized’ minorities (through institutional investors such as mutual funds) made possible corporate statutes that contain primarily default rules, in contrast to the more rigid mandatory systems that prevail in continental Europe. Things are changing at a rapid pace in Europe, and with the development of financial markets and the increasing intervention of foreign investors, even more traditional civil law countries are moving toward a more flexible corporate law that relies more on default rules (Easterbrook and Fischel 1989, Coffee 1989).

2.3 Regulatory Competition In Corporate Law

An important consequence of the fact that different legislators provide for different corporate law statutes, which strike different balances between mandatory and enabling rules, is that a ‘regulatory competition’ has developed to attract corporate charters (Cary 1974, Winter 1977, Romano 1987). Regulators may desire to have business enterprises incorporating within their boundaries for different reasons, such as incorporation fees, taxes, or indirect effects on the economic system. To achieve their goal, regulators have incentives to enact a body of corporate law that fits the needs of those who will choose the state of incorporation. One risk in this situation, however, is that those who have the power to choose (the controlling shareholder, the directors or the managers) have different incentives than the minority share-holders. Consequently, they may be tempted to choose a jurisdiction that maximizes their utility, but not that of the minority investors. The result is that regulatory competition can lead either to a race to the top (where rules maximize the wealth of all the subjects involved) or a race to the bottom (where rules attract corporations at the expense of minority investors). Between these two possibilities, the final result will depend on the ability of investors to ‘penalize’ corporations that choose a regime that is bad in terms of minority protection.

In the US, regulatory competition has been possible because corporations are free to incorporate and reincorporate in the different states. This freedom of regulatory competition has produced the so-called ‘Delaware effect,’ meaning that a majority of corporations, regardless of their physical location, have chosen to incorporate in Delaware (Macey and Miller 1987). The effects of this competition on shareholders’ wealth are still discussed by scholars, but it is clear that corporations demonstrate a preference for statutes that provide more default rules.

In Europe regulatory competition has not been possible so far because of a more ‘protectionist’ approach, based on the so-called siege reel principle, which requires that corporation be governed by the law of the state where they have their principal place of business. Some recent decisions of the European Court of Justice seem to suggest a more opened approach that would promote regulatory competition. Most particularly, the so-called Centros Case, decided by the European Court of Justice on March 9th 1999, affirmed the possibility for a business to incorporate in England even though it operated only in Denmark and did not have contacts with England. This case suggests that changing world economic pressures will encourage wider acceptance of enabling rules and regulatory competition in corporate law in Europe.

3. Separation Of Ownership And Control And The Reduction Of Agency Costs

The separation of ownership and control (Berle and Menas 1932) raises problems of agency costs, analogous to, perhaps even more extreme than, the agency costs discussed above when an employer monitors an employee. Investors are principals who entrust their savings to majority shareholders, directors or managers (depending on the level of the analysis). Internal governance structures, such as corporate governance rules, and external governance structures, such as the market for corporate control, can be seen as devices designed by corporate law to reduce these costs, allowing principals to oversee, directly or indirectly, the activity of their agents.

3.1 Internal Governance Structures: Corporate Governance And Internal Organization

Corporate governance, strictly speaking, is the set of rules that governs the relationships between and the balances the interests among shareholders, directors, managers and employees. In a more general sense, corporate governance also includes social controls on firms regarding such issues as antitrust, consumer protection, and pollution control. For the purposes of this discussion of corporate law, analysis will be limited to the three major areas that affect the internal organization of corporations: shareholder voting, the board of directors, and control and auditing.

3.2 Shareholders Voting

Shareholder voting regulations address issues such as who should vote, what issues should they vote on, and which procedures they should follow. From an economic standpoint, scholars contend that voting power is granted to the group that has the appropriate incentives (collectivity problems to one side) to make a discretionary decision that maximizes the corporate wealth (Easterbrook and Fischel 1983). For this reason, in most but not all systems, the shareholders’ meeting usually has the power to deliberate major changes in the financial and legal structure of the corporation. In common law countries, which are characterized by efficient and strong capital markets, directors are granted expansive discretionary powers in relation to shareholders. By contrast, in the civil law systems of continental Europe, the shareholders’ meeting is still seen as the ‘central’ organ in corporate law. The shareholders’ meeting is entrusted exclusive powers concerning the juridical and financial structure of the corporation (such as to amend the corporate charter, and to deliberate over the issuing of new shares).

One of the fundamental problems concerning share-holders’ voting is the issue of collective action and individual opportunism. Either when there is a control-ling shareholder or widely dispersed ownership, the marginal shareholder will have no incentives to collect costly information in order to vote intelligently. Instead, the marginal shareholder is likely to rely on the possibility that other shareholders will incur those costs and follow their lead in voting. In economic terms, this situation is referred to as the ‘free-rider problem.’ While rational at the individual level, the choice at the aggregate level can preclude minority shareholders from ever using their voice to oversee the management of the corporation. Instead, they will sell the shares or ‘exit’ if they are dissatisfied with the way the corporation is run.

Meanwhile, for several reasons, institutional investors who hold a minority but non-trivial share can exercise active control on management through voting and it is often rational for them to do so. First, institutional investors encounter significantly lower information costs than individual investors and the availability of a non-trivial number of votes may make it possible to actually influence the management of the corporation. The other traditional alternative for minority shareholders, selling shares, can be difficult without having a bearish effect on the market. The presence of institutional investors, a development of the 1960s and in the 1970s in the US and more recently in Europe, is an important development that affects the effectiveness of corporate governance tools. In fact, without qualified minorities capable of activating them, instruments permitting direct control by minorities, such as derivative suits and proxies, would be absolutely useless (Black 1992).

Proxies and proxy fights are considered one of the most important tools through which minorities can participate in the life of a corporation, even if available data suggests that they are used less frequently than tender offers to transfer corporate control (Pound 1988). A proxy fight occurs when management and dissidents seek to obtain authority to act as designated voting representatives of voting shareholders at share-holder meetings. Virtually all the legal systems provide rules to regulate proxy fights. The regulation of proxy fights aims both to permit the solicitor of proxies an opportunity to reach all shareholders, which can be difficult with public companies if shares are recorded in ‘street’ names or the name of the nominee that administers the transfer of shares for clients (i.e., brokerage or bank). Corporate law also seeks to ensure that shareholders are provided with fair in-formation and granted the possibility of an unbiased vote.

Another important feature of corporate voting is the potential for categories of shares with different rights attached. Almost all the legal systems statutorily prohibit cumulative voting and provide that every share should have no more than one vote. Nonetheless it is permitted, and indeed common, that corporations issue more than one class of stock, granting different rights for each class (for example, one class of voting shares and one class of non-voting shares with stronger economic rights). Typically, a class of shares granted with limited voting rights is issued for public share-holders, and another class with full voting rights is issued to majority shareholders interested in the actual control of the company (Gordon 1988). Notably, however, not all stock exchanges are willing to list limited voting shares. The New York Stock Exchange, for instance, until recently had very strict rules concerning limited voting shares.

In comparing regulation of proxies and the presence of non-voting or limited voting shares, there are two possible approaches to protecting minorities. On one hand, it is possible to acknowledge minority share-holders’ lack of interest and ability in managing or controlling the corporation, and to protect them by reducing their administrative powers but enhancing their economic privileges, such as dividends and residual claims in case of dissolution. On the other hand, it is possible to allow minorities to play an active role in controlling majority shareholders’ and managers by providing for specific tools such as proxy fights. The latter option generally requires the presence of institutional investors and/organized minorities capable of actually using these tools in an informed and competent way. These different approaches are not mutually exclusive and in fact are often both present in corporate law statutes.

3.3 Boards Of Directors

Directors are elected by the shareholders’ meeting on a one-share-one-vote basis. They are entrusted with the power to manage the corporation and to represent it to third parties. Usually, directors are organized in a board and, as discussed above, different legal systems allocate competence between the shareholders’ meeting and the board differently. Continental European systems usually provide for more extensive competence for the shareholders, while the US and other common law systems permit the board of directors to make the key decisions for a corporation without deferring to the shareholders’ meeting.

The internal organization of a board of directors also differs among national systems. In the US, for instance, the flexibility of corporate regulation allows for the possibility of establishing one or more committees within the board of directors, which are designated specific tasks such as compensation or auditing. Another peculiar model is the board of the German corporation, which is characterized by a so-called dualistic system. The Vorstand has managing and representation powers, but its members are elected and controlled by the Aufsichtsrat, a controlling board directly appointed by the shareholders that can remove them for cause (wenn ein wichtiger Grund orliegt, according to the § 84.3 AktG). German workers are also granted representation by law in the Aufsichtsrat, demonstrating a commitment to co-management between the providers of capital and labor (Mitbestimmung). In France the dualistic German-like model can be chosen, but is rarely used in practice. Instead, the board of directors is often dominated by the President Directeur General, who is both the chairman of the board and the chief executive officer of the corporation. This role was introduced during the German occupation for ideological reasons, but it has nonetheless proven to be efficient (for comparative references Weigmann 1997).

Normally, directors have two major duties, the duty to act with reasonable care in the managing of the corporation’s businesses, and the duty to act loyally, which includes to avoid in conflict of interests. Breach of either of these duties can result in civil liabilities either to the company or its shareholders. While the duty of loyalty is strictly enforced, the duty of care is often blurred. Most systems provide for a ‘business judgment rule,’ which acts as a safe-harbor that prevents judges from second-guessing the merits of the directors’ choices.

3.4 Auditors

Finally, most legal systems (but not all) provide for a separate board of auditors entrusted with the task of controlling the activity of the directors, especially with reference to accounting practices. The board of auditors is elected by the same majority that appoints directors, which can lead to problems since the elected auditors by the majority do not necessarily have any incentive to act in the interest of minority share-holders. For this reason, some legislation provides a mandatory rule, at least for public companies, under which the board of auditors must include a member appointed by minority shareholders. An example of this approach is the new Italian law on financial markets and listed corporations (the d. lgs. n. 58 of 1998, art. 148).

4. External Governance Structures: The Market For Corporate Control

Until this point, discussion has been limited to those internal governance structures that reduce the cost of control faced by corporate investors. These costs are also reduced by external forces, most significantly the market for corporate control. The inability of managers or controlling shareholders to create wealth for all shareholders can be reflected in the market price of the shares. As noted above, if shareholders are dissatisfied with the way their agents act, they can exit the investment. The sale of their investment will lead to a drop in the price of the shares, which might allow a shareholder who believes to be better able to manage the corporation to buy control and change management. The threat to managers and present controlling shareholders of loosing control should provide an incentive to align their preferences with those of minority shareholders (Manne 1965, Jensen 1988, Jarrel et al. 1988).

Given this possibility, making transfers of control easy could be seen as the best way to reduce agency costs, although this solution has its own problems. When a new shareholder takes control, he usually pays a premium for control. If the market is not very efficient, liquid, or quick in adjusting shares prices to the new control, it is possible that control can be acquired directly from the controlling shareholder. In that situation, the premium for control will be paid directly to the controlling shareholder and minority shareholders will not enjoy any of the premium. For this reason, some legal systems have a mandatory tender offer rule, which seeks to distribute the control premium among all the shareholders. Typically in Europe, where there are less efficient markets, corporate legislation requires a public offer to buy shares to acquire control. In the US, by contrast, where the market is considered more efficient and able to minimize exploitation of minority shareholders, there are no—or less stringent—rules requiring specific compulsory offers in case of acquisition of control.

5. Financing The Corporation: The Issuing Of Bonds

To complete a discussion of corporate law, it is necessary to note briefly an alternative financing option for corporations that is permitted by the corporate law of all legal systems: the issuance of bonds, which is essential to provide a mixed financial structure, thus leveraging financial risk.

Bond-holders can be seen as economic actors who are willing to lend money to the corporation but, different from the shareholders who accept a variable rate of return depending on the profits of the corporation, prefer to receive a fixed interest rate. In economic terms, the reason for this preference could be that they do not want to undergo the controlling expenditures faced by shareholders and prefer instead to contract in advance for a fixed rate of return. Bond contracts are thus written with the explicit purpose of avoiding the bondholder-stockholder conflict (Smith and Warner 1979). The US system provides an interesting illustration of the different interests of shareholders and bond–holders: while Delaware corporate law is usually chosen because its default rules allow greater flexibility, New York law is usually chosen to govern bond issuing because it is considered particularly protective of creditors and its mandatory rules preclude the need for very detailed contracts.

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