Business Law 2.pdf

LESSON 2 LEGAL PERSONALITY AND LIMITED LIABILITY  Examples of conflicting interests in business activity 1. An entrepreneur wants to reduce its activities by selling part of the firm; the banks financing him are opposing this decision. 2. A majority partner wants to invest...

LESSON 2 LEGAL PERSONALITY AND LIMITED LIABILITY  Examples of conflicting interests in business activity 1. An entrepreneur wants to reduce its activities by selling part of the firm; the banks financing him are opposing this decision. 2. A majority partner wants to invest the annual gains in developing business activity; the other partners want them distributed. 3. The board of directors wants to develop a new risky business; the shareholders don’t want. 1 Corporation, 3 securities, 3 different interests 1/3 1 Corporation, 3 securities, 3 different interests 2/3 1 Corporation, 3 securities, 3 different interests 3/3 Corporations as a solution to manage diverging interests Large business create many different conflicting interests (Owners vs. Creditors; vs. Employees; vs. External Investors; vs. Managers; vs. Consumers; vs. Public Authorities, etc.). A corporation offers a possible solution to manage these conflicting interests. This is possible because corporations are characterized by 5 core attributes: 1. Legal Personality 2. Limited liability 3. Transferable shares 4. Delegated management (board of directors) 5. Investor ownership Corporations as a solution to manage diverging interests These characteristics are common to all corporations in different Countries (the model is a development of East Indian Companies). Corporations: ü Facilitate the coordination between participants of the business ü Contain the risks of opportunistic conducts ü Reduce the costs of organizing the business activities Some differences exist between national models (e.g. in Germany corporations are characterized by Mitbestimmung or mandatory co-partecipation of workers).  The contractual base of the interests Typical conflicts in a corporation could be: Majority Shareholders vs. Minority Shareholders; Shareholders vs. Creditors; vs. Employees; vs. Managers, etc. The conflicts aren’t only against “owners”: e.g. managers vs. employees. Many of these conflicting relations are based on a contract: e.g. the corporation charter (statute) that ties the shareholders; the contract between the corporation and its management; the contract between the corporation and its clients, etc.  A firm as a nexus of/for contracts A) Nexus «of» contracts: most of the relationships within a corporation are contractually-based (corporation as a bundle of contracts). B) Nexus «for» contracts: a corporation serves as a common counterpart in several contracts, coordinating the actions of multiple persons through exercise of its contractual rights à this is possible because corporations have a legal personality. Nexus for contracts means that the corporation can operate as a single contracting party: it is distinct from the various individuals who own or manage the corporation à It enhances the ability of these individuals to engage together in joint projects.  A corporation as a single contracting party A corporation, as a single contracting party/legal person, has its own patrimony (separated by those of the other parties involved in the corporation: shareholders, directors, etc.). Creating a separate patrimony is a choice of delimitating a pool of assets from the other assets owned singly or jointly by the shareholders (even if all the assets could be considered eventually as still being of property of the shareholders). For what reason? For reducing the conflicts of interests! … But how?  Separate patrimony 1/2 With a separate patrimony a corporation (legal person) can: – use the assets; – sell the assets; – make the assets available for attachment by its creditors. This means that the assets included in the patrimony of corporation aren’t available for attachment by the shareholders’ personal creditors. Assets belong to the corporation/legal person, rather than the shareholders or other persons interested in them (employees, managers, etc.).  Separate patrimony 2/2 An entity with own legal personality as a corporation, that has its separate patrimony, protects its assets from the creditors of the shareholders and from the risk of disrupting business activity (so called entity shielding). This means that the assets are protected by law in two different ways: – Priority for creditors of corporation rule; – Liquidation protection rule.  Priority for business creditors It is a priority rule that grants a right to claim corporation’s assets to its creditors before the claims of the creditors of the shareholders. It operates as a security for the creditors of corporation. Corporation’s assets are automatically made available for the enforcement of liabilities arising from running the business activity. Bonding the corporation’s assets, the rule makes these commitments credible for (actual or future) creditors of corporation.  Liquidation Protection This rule provides that creditors of a shareholder cannot freely claim his «portion» of corporation’s assets. At the same time, the shareholders cannot withdraw their «portions» of corporation’s assets at will (but they can disinvest by selling the shares). The liquidation protection rule serves to protect the going concern value of the corporation against patrimonial detriment conducted by individual shareholders or their (actual or potential) creditors.  The benefits tied to the rules 1/2 Creditor priority and liquidation protection rules reinforce one another where the assets in question comprise contractual agreements. Firm’s value creation comes from the interaction of the various contracts the firm has negotiated. The two rules assure firm’s counterparties for the value generated by that bundle of contracts and the associated assets, which are typically complementary (idea of nexus of contracts).  The benefits tied to the rules 2/2 A firm is a nexus of contracts and a bundle of assets. Considering a firm an autonomous entity facilitates to transfer these assets and contracts. It is far easier for the owner of a corporation or a company to transfer his shares than it would be for a sole proprietor to transfer his contracts/assets. Remember the Dutch East Indian Company, that, in 1612, created the first joint stock exchange to let its investors sell or buy its shares.  Legal Personality and Limited Liability 1/2 The maximum grade of limited liability for firms’ obligations is granted to owners’ firm when the last one has its own legal personality as in corporations. Legal personality is a legal fiction that attributes a firm (i.e. a nexus of contracts and assets) autonomous rights and duties as if it were a natural person As a natural person, an “incorporated” firm has its own name, patrimony, obligations, can sue or be sued, etc. Consequently, the owners of the “incorporated” firm are not liable for its debts.  Legal Personality and Limited Liability 2/2 According to the limited liability rule, in contracts between a firm and its creditors, the creditors are limited to making claims against assets that are held in the name of the firm itself. They have no right to claim against assets that the firm’s owners hold in their own names => in fact, they are different persons, as among natural persons. These two forms of asset shielding/partitioning involve that: – 1. Business assets are strictly pledged as security to business creditors. – 2. Personal assets of the business’s owners are reserved for the owners’ personal creditors.  Limited vs. Unlimited Liability With unlimited liability the business risk is totally borne by owners and it depends on the way the business is carried on (e.g. entrepreneur/partnerships). Therefore, owners (partners) will generally prefer to be actively involved in the running of the business, to keep the risk under control => This need to control makes investing in multiple businesses difficult. Limited liability, by contrast, it makes feasible for shareholders to diversify their holdings => It lowers the aggregate risk of shareholders’ portfolios and so the corporation’s cost of equity capital (by reducing the risk premium the shareholders will demand). Effect of risk diversification: investment funds