business associations section 2a: firms – general concepts prof. amitai aviram [email protected]...

Business associationsSection 2a:

Firms – general conceptsProf. Amitai [email protected]

University of Illinois College of LawCopyright © Amitai Aviram. All Rights Reserved

F14D

1. Types of firms– Concepts common to different types of firms– The corporation– The partnership

2. Customizing the firm (private ordering)3. Firms: external relationships

Firms: general conceptsOverview of Section 2a

© Amitai Aviram. All rights reserved.2

• Business associations (BAs or “firms”) are legal concepts designed to allow multiple beneficiaries to conduct business jointly– In contrast, agency law is optimized for a single beneficiary (principal)

conducting business through one or more actors (agents)– Agency law can govern co-principals (Rest. 3.16), but the legal issues that arise

from having multiple beneficiaries are underdeveloped• External relationships: with multiple Bs, no single person is “the business”

– So Bs need to create an artificial being with an (independent) legal personality– Asset partitioning: separation of firm’s & Bs’ assets/liabilities (e.g., limited liability)

• Internal relationships: as artificial beings, firms must have human beings act on their behalf– So firms face an agency problem from whomever acts on their behalf: agents,

organs (those who control the agents for the firm; i.e., the BoD), controllers (the Bs who control the organs)

– Having multiple Bs requires changes to the agency solutions because of rational apathy: some/all Bs will lack ability/incentive to monitor actors efficiently

Types of firmsComparing firms to agency


Types of firmsHow firms are created

• Spontaneous creation (general partnerships & some business trusts)– Firm is created when SHs act in certain ways, even if they formally don’t act to

(or even want to) create a firm– Similar to agency (which is created when P&A satisfy Rest. §1.01 test)

• Creation by filing (corporations, limited partnerships, LLLPs, LLCs)– Firm is created when Secretary of State confirms that an entrepreneur (a SH or

someone who will recruit SHs) filed certain documents• Creation by conversion (firm of one type become another type)

– Conversion through election (firm converts by filing some document)• General partnership can convert into limited liability partnership or limited

partnership; limited partnership can convert into general partnership– Conversion through merger (firm converts by merging into another firm of a

different legal type)• Requires statutory authorization (typically, conversion between

corporation/limited partnership/LLLP/LLC authorized & conversion between general partnership/limited partnership are authorized)


Types of firmsFinancial terminology

• To finance operations, firms receive money from investors in return for claims on its assets & future profits

• Capital can mean either side of this transaction– Firm’s money (& other resources, stated in terms of money value)– Investors’ claims on firm’s assets & future profits

• Capital is categorized as debt or equity, depending on nature of claim– Debt: Claim to a predetermined stream of money, unrelated to the

firm’s performance (e.g., bonds, loans). Owner of claim is a creditor.– Equity: Claim to the remainder of the firm’s assets after paying all other

claims. Owner of claim is a SH.• Units of equity capital are called: shares (in MBCA) or stock (in DGCL) in a

corporation ; “(partner’s) interest” in GP/LLP; “distributional interest” in LLC; “units” in some firms

– Some types of capital are hybrids with characteristics of both debt & equity (e.g., convertible bonds)


Types of firmsConstitutional documents

• A firm’s constitutional documents regulate the firm’s legal internal relationships (between the firm, SHs & management)– Required: firm-specific info (e.g., name of firm, address, # of shares)– Optional: opting out & replacing default rules

• Two common models– A single document

• Private document: partnership agreement (in general partnerships)• Public document: memorandum of association (some non-US corporations)

– Two documents; one public (usually more difficult to change & less detailed), the other private (easier to change & more detailed)

• In US corporations– Charter – Articles of Incorporation (MBCA) / Certificate of Incorporation

(DGCL) – public; must contain certain info, may contain more– Bylaws – private; easier to amend; can’t contradict charter

• In LLCs: articles of organization / operating agreement• In LLPs: statement of qualification / partnership agreement


Country• Laws of physics• Constitution• Laws/regulations• Presidential directive• Decisions of gov’t employees

Types of firmsHierarchy of legal sources in a corporation


Corporation• Applicable federal/state laws• Charter• Bylaws• BoD’s resolutions• Decisions of officers

Country• Laws of physics• Constitution• Laws/regulations• Presidential directive• Decisions of gov’t employees

Types of firmsHierarchy of legal sources in a corporation


• Private firm (few SHs)– Direct control by SHs– Liberal dissolution (easy for dissenting SH to dissolve firm)– Restricted alienability (difficult to sell interest to 3rd parties)– Contractual flexibility (parties can opt out of most rules)

• Public firm (many SHs)– Delegated control (firm controlled by a BoD that is elected by SHs)– Restrictive dissolution (difficult for dissenting SHs to dissolve the firm)– Liberal alienability (easy to sell shares to 3rd parties)– Contractual rigidity (most rules are mandatory)

• Passive firm (often a single SH)– Firm owns assets but doesn’t conduct active business– Firm structure used to benefit from some legal features (e.g., preferable

tax treatment; limited liability, etc.)

Types of firmsEconomic types of firms


• Partnership– General partnership (“GP” or “partnership”)– Limited liability partnership (“LLP”)– Limited partnership (“LP”)– Limited liability limited partnership (“LLLP”)

• Corporation (“corp”)– Public corporation– Close corporation

• Limited liability company (“LLC”)– Two defaults for governance: member-managed

(similar to partnership) or manager-managed (similar to corporation)• Business trust (“BT”)

– Based on the common law concept of a trust

Types of firmsLegal types of firms


Types of firmsThe corporation

• By default, the corporation is optimized to be a public firm– Delegated control– Liberal alienability/restricted dissolution– Contractual rigidity

• Some corporate laws have special rules for close corporations, which are optimized to be a private firm

• Public corporation (or publicly-traded corporation): corp that issued shares to the public, optimized to be a public firm– This is usually defined by Federal securities laws, not state corporate law

• Applicable law– Corporations are governed by state statutory law

• Less uniformity between states than in agency or partnership law• Public corporations also subject to federal securities laws

– ABA created a Model Business Corporation Act (“MBCA”)• Serves as uniform law on which some states base their corporate law

– Majority of publicly-traded companies incorporated in Delaware• Delaware General Corporation Law (“DGCL”) is dominant for public corps


The corporationClose corporations (DGCL)

• DGCL §342 allows corp to elect close corporation status, if:– Charter provides that it is a close corporation– Charter provides that it may have no more than 30 SH– Corporation didn’t issue stock in a public offering– Stock is subject to one/more transfer restrictions specified in §202

• DGCL rules unique to close corporations– Direct control/contractual flexibility

• DGCL §351: charter may have corp managed by SHs rather than directors• DGCL §350: SH agreement between SHs who hold a majority of the outstanding

voting stock may bind the parties even if it interferes with the BoD’s discretion or power

– Within this scope, directors are relieved from FD, which are imposed instead on the SHs party to the agreement

– DGCL §354: Shields SH agreements from being voided because they operate corp as if it were a partnership

– Liberal dissolution• DGCL §355: Charter may give SHs a right to dissolve the corporation (at will or

at the occurrence of a certain event)


The corporationClose corporations

• MBCA– No formal election to be a close corp, but some rules apply when corp’s shares

are not publicly traded– Liberal dissolution

• Judicial dissolution allowed in cases of deadlock/oppression, if corp is not listed on stock exchange, has <300 SHs & <$20M value [MBCA §14.30(b)]

• When judicial dissolution is allowed, SH may elect a buy-out in lieu of dissolution [MBCA §14.34]

– Contractual flexibility• Permits SH agreements (if all SHs are parties to it) [MBCA §7.32]

• Common-law close corporations– Case law in some states (e.g., Mass.) applies different rules when corp is

closely-held; close corp still follows identical formalities to a public corp– Direct control

• FD analysis is more sensitive to risk of oppression of minority SHs– Liberal dissolution

• Courts are less reluctant to order judicial dissolution when relationship between SHs is dysfunctional


The corporationCreating a corporation

• Choose the state of incorporation• Draft Charter• File Charter with the relevant state’s Secretary of State

– The person filing the charter is the incorporator (DGCL §107/MBCA §2.01)– State will process & certify the filing – Corporation has been created! (DGCL

§106/MBCA §2.03)• Draft bylaws (DGCL §109/MBCA §2.06)• Organizational meeting (DGCL §108/MBCA §2.05)

– Name directors– Adopt bylaws

• Directors convene & appoint officers• Issue shares


• Corporation is created only when Secretary of State acknowledges that the charter was filed

• Exception – “defective corporation”: sometimes courts recognize a corporation even without Secretary of State’s certification of the charter being filed– De facto corporation– Corporation by estoppel

The corporationDefective corporations


• An incorporator is an agent of the corporation– Owes the corporation FD– Until corporation is formed, incorporator is liable to T as an agent

to a non-existent principal• Hypo: Incorporator Inga signs contract with third party Tom,

on behalf of C Corp., a corporation not yet created. Later, Inga creates C.

• How can C become party to the contract?• Can C ratify the contract? (recall Rest. §4.04(1)(a))• Adoption (as opposed to ratification):

– Does not relate back to time of contract’s formation– Does not release A from liability

The corporationLiability for pre-incorporation acts


Types of firmsThe partnership

• By default, GP is optimized to be a private firm– Governed in most states by the Uniform partnership act (1997) (“RUPA”)– A few states still use the Uniform partnership act (1914) (“UPA”)

• Other variations of partnerships– Limited liability partnership (“LLP”): same as GP except partners have limited

liability (governed by RUPA)– Limited partnership (“LP”)

• Two classes of partners: general & limited• General partners have control rights & unlimited liability• Limited partners have limited liability & very limited control rights• Governed by Uniform Limited Partnership Act (“ULPA”)

– Limited liability limited partnership (“LLLP”): same as LP except that all partners have limited liability (governed by ULPA)


The partnershipCreating a GP

• Definition of a GP– RUPA §§101(6), 202(a): “an association of two or more persons to carry on as

co-owners a business for profit”– ‘Co-owners’ means:

• Shared control of the business; and• Shared profits of the business.

– No formal creation requirements. Doing business as co-owners results in creation of partnership by operation of law.

• Fenwick [NJ 1945]– Fenwick owns a beauty shop; Chesire works as a receptionist– Chesire demands raise; Fenwick counters with offer to make her a partner, with

a right to 20% of the profits (in addition to her salary). They sign an agreement.– Unemployment Compensation Commission disputes existence of a partnership.

Why?• What does Fenwick claim? What’s his best argument?• What’s the Commission’s argument?


• Fenwick court’s analysis– Intention of parties: No change in business’ operation– Right to share in profits: Chesire gets 20%– Obligation to share in losses: Chesire not obligated– Ownership and control of property and business: Fenwick retains– Community of power in administration: Chesire not involved– Conduct of the parties toward 3rd parties: Filed partnership tax returns, but

didn’t hold themselves out as partners to suppliers & Fenwick licensed their trade name personally

– Rights of parties on dissolution: Chesire’s dissolution is similar to quitting a job• How much shared control is enough?

– According to Day v. Sidley & Austin (1975), Sidley & Austin was managed in the following way:

• Executive Committee decides on all matters, except for participation, admission & severance of partners

• The latter require the approval of partners holding a majority of partnership interests (not majority of partners)

– This minimal shared control was seen as sufficient; S&A is a partnership

The partnershipCreating a GP


The partnershipCreating a GP: exercise

• Key reason for Fenwick court’s ruling was that the agreement gave Chesire no management rights. Structure an agreement that would give her formal management rights but allow Fenwick to ‘run the show’

• Fenwick court noted Chesire didn’t share in losses. Mitigate this factor while being sensitive to increasing Chesire’s risk

• Suppose Fenwick decides to hire Chesire as a non-employee agent instead of making her partner. MakeChesire a non-employee agent withoutchanging the substance of the relationship


1. Types of firms2. Customizing the firm (private ordering)

– Customizing via SH agreements– Customizing via constitutional documents

3. Firms: external relationships



Customizing the firmCustomizing in public & private firms

• Rules governing a firm can be derived from the law or from contracts created by the stakeholders

• Public firms derive more rules from laws and fewer from contracts compared to private firms

– More mandatory laws (that contracts cannot modify)– Opting out of defaults is done by manipulating the firm’s

institutions (e.g., rights attached to shares, or to firm offices) rather than manipulating individual SHs’ rights

• Example: X wants double the voting rights of other SHs• Private firm (e.g., partnership): partnership agreement provides that X

has double voting rights• Public firm: charter creates Class B shares with double voting rights as

Class A shares; X receives Class B shares


Customizing via SH agreementsWhy is agreement enforcement a major issue?

• SHs in a close corporation sign a SH agreement obligating them to vote in favor of a specified slate of directors– Directors favor expanding into the widget market

• Some SHs renege on the agreement; vote for directors who refuse to expand into widgets– As a result, Acme does not expand into widgets

• Other SHs sue for breach of the agreement– What are the damages? How easy is it to prove them?– How can you make the agreement easier to enforce?


Customizing via SH agreements1. Voting trust

• Title of shares transferred to a trust• Agreement forming the trust gives trustee power to vote the shares• Disadvantages?• Statutory restrictions

– Publicity: some states require the voting trust to be made public (e.g., DGCL §218), or to submit to the firm information on participating SHs (e.g., MBCA §7.30), which makes this info accessible to MSHs through SH inspection rights

– Duration: some states limit the duration of voting trusts (MBCA used to have a 10-year limit, but no longer does)


Customizing via SH agreements2. Contractual enforcement

a) Specific performance– DGCL §218(c) allows voting agreements, implicitly allows a remedy of specific

performance– MBCA §7.31(b) states that voting agreements are specifically enforceable– Court may refuse to enforce due to oppression / violation of other SHs’ rights

b) Irrevocable Proxies– Proxies usually revocable; can be made irrevocable if attached to an interest

[MBCA §7.22(d)]– Being a party to a voting agreement is considered an interest [MBCA §7.22(d)(5)]– So, the proxy tends to be an enforcement mechanism that is ancillary to a

voting agreementc) Is the SH agreement valid?

– If it constrains discretion that isn’t subject to FDs (e.g., appointing directors)

• Voting agreements generally permissible [DGCL §218(c); MBCA §7.31]– If it constrains discretion that is subject to FDs (e.g., appointing officers)

• Does it impermissibly constrain BoD’s discretion? [McQuade/Clark]


Customizing via SH agreementsMcQuade v. Stoneham [NY 1934]

• Stoneham owned a majority of the stock of the NY Giants• McGraw (the Giants’ manager) & McQuade (a city magistrate) bought

a small amount of stock from Stoneham• The three signed a SH agreement

– Agreed to do their best to elect each other as directors& appoint each other officers at specified salaries

• McQuade lost Stoneham’s favor & was fired– McQuade sues for specific performance

• Court:– BoD must exercise independent business judgment on behalf of all SHs– If directors agree in advance to constrain BoD’s judgment, SH will not receive

the benefits of their independence– Therefore, agreement is void as against public policy

• Protection in the SH agreement didn’t save McQuade– How can he protect himself from being fired?


Customizing via SH agreementsMcQuade v. Stoneham

• McQuade seems to offer a bright line rule

Valid Void

• But the rule is not so bright

ConstrainSH judgment

Constraindirector/officer

judgment


Customizing via SH agreementsClark v. Dodge [NY 1936]

• Clark knows a valuable secret formula. Dodge contributes money. They form two drug companies.

• Clark and Dodge sign an agreement:– Clark agrees to disclose his secret formula– Dodge agrees to invest the required money– Clark receives 25% of profits (salary & dividends)– Dodge would vote, both as SH & director, to assure that Clark

would be a director & General Manager as long as his performance was faithful, efficient and competent

– Why does Clark need the agreement? Why does Dodge?• Clark discloses secret formula. Dodge eventually fires Clark.

– Clark sues. Dodge claims SH agreement is void.– Apply the reasoning in McQuade to this case


Customizing via SH agreementsClark v. Dodge

• Clark court: MSHs aren’t harmed by a commitment to keep someone as an officer “as long as he is faithful, efficient and competent”– I.e., SH agreements are valid if SH merely agree to do as directors what they

could do validly anyway• This contradicts the holding in McQuade

– Also, SHs may be harmed by an obligation not to fire without cause (e.g., downsizing; better/cheaper candidate)

• Clark court: McQuade was designed to protect MSHs who were not parties to the agreement– In Clark, all SHs are parties to the SH agreement

• Clark creates an exception to McQuade when all SHs are parties to the SH agreement

• How can Dodge avoid the SH agreement (reach McQuade outcome)?


Customizing via SH agreements“Homemade McQuade”

The homemade McQuadeTurning Clark…

… into McQuade


Customizing via SH agreements“Homemade McQuade”

• Preempting the “Homemade McQuade”– The company can prevent a “Homemade McQuade” by creating constructive

knowledge of the agreement – including the agreement in the charter or printing a reference to the agreement on all stock certificates

• Another obstacle for Homemade McQuades – Galler v. Galler– In Galler, the court held that a SH agreement is valid even if not all SHs are

parties to it, if:• The corporation is closely-held• The terms are reasonable (i.e., MSH should not object)• The MSH does not object


Customizing via SH agreementsCaselaw summary

• McQuade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors

• Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement

• Galler: SHs can constrain their judgment as directors even when some SHs aren’t parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs don’t complain)


Customizing via constitutional docsConstitutional documents: contents

• Charter: mandatory terms [DGCL §102(a)]– Firm’s name– Address of firm’s registered office and name of its registered agent– Nature of the business to be conducted (“any lawful act or activity”)– Name/address of incorporators and initial directors– Specify if firm is not a stock corporation (in which case, conditions of

membership must either be specified, or refer to bylaws)– “A statement of the designations and the powers, preferences and rights, and

the qualifications, limitations or restrictions [on firm’s stock]”– Number of authorized shares & share par value

• Both authorized shares & par value will be explained in a few slides



• Charter: optional terms [DGCL §102(b)]– “Any provision for the management of the business and for the conduct of the

affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders […]”

– “Any provision which is required or permitted […] to be stated in the bylaws may instead be stated in the certificate of incorporation […]”

– SH preemptive rights– Supermajority requirements for SH or BoD votes– Opting out of limited liability or perpetual existence– Limits on directors’ fiduciary duty

• Bylaws [DGCL §109(b)]– “The bylaws may contain any provision, not inconsistent with law or with the

[charter], relating to the business of the corporation, the conduct of its affairs, and its rights and powers or the rights and powers of its stockholders, directors, officers or employees.”



• Creation of constitutional documents– Charter [DGCL §101(a)]: incorporator– Bylaws [DGCL §109]

• Until stock is issued – BoD• After stock is issued – SHs, but charter may also authorize BoD to amend bylaws

• Amendment of constitutional documents– Charter [DGCL §242(b)]

• First, BoD must adopt the proposed amendment• Then, SHs approve the proposed amendment (in some circumstances, SHs vote

in separate groups [DGCL §242(b)(2)])– Bylaws [DGCL §109]

• SHs always allowed to amend• BoD not allowed to amend by default, but charter may authorize BoD to amend

bylaws


Customizing via constitutional docsConstitutional documents: assumptions for exam• On the exam, assume that the corporations mentioned in the fact

pattern have the following terms in their constitutional documents, unless the fact pattern states otherwise

• Charter– Corp. is a stock corporation, has limited liability & perpetual existence– Corp. may conduct any lawful act or activity– Director FD is limited to the maximum degree allowed under §102(b)(7)– BoD may amend bylaws

• Bylaws– Chairperson of BoD is authorized to call a BoD meeting– BoD is authorized to call both annual & special SH meetings


Customizing via constitutional docsConstitutional documents: limits on bylaws

• Boilermakers Local 154 Retirement Fund v. Chevron Corp. [Del.Ch. 2013]– Chevron & FedEx BoDs amend bylaws to add a “forum selection bylaw”, which

requires that derivative suits, fiduciary duty suits, DGCL suits and internal affairs suits involving the company will be adjudicated in Delaware courts.

– The bylaw addresses venue (which court) not applicable law. What law would apply to fiduciary duty suits, internal affairs suits, etc. & why?

• Plaintiff SHs sue to invalidate the bylaws, claiming:– Bylaw does not have valid subject matter– Bylaw is not binding on SHs because BoD, not SHs, amended the bylaw– Bylaw should be invalidated because there are many circumstances in which it

can be abused



• Valid subject matter– DGCL 109(a): bylaws may address any subject “not inconsistent with law or

with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.”

1. Bylaws are subordinate to the law & charter• So, anything that the law says should be in the charter (e.g., number of authorized shares,

rights of shares) is not valid bylaw subject matter2. Valid subject matter includes

• Business/affairs of firm• Rights/powers of firm, SHs, directors, officers & employees

3. Bylaws dictate process, not substantive decisions• Court: “[B]ylaws typically do not contain substantive mandates, but direct how the

corporation, the board, and its stockholders may take certain actions.”



• Effect of BoD-adopted bylaws– By law, SHs have the right to amend bylaws; BoD may amend bylaws only if the

firm’s charter allows it– The charters of Chevron and FedEx allowed the BoD to amend bylaws– Court: Delaware law does not follow the “vested rights doctrine”, which

prohibits a BoD from modifying bylaws in a way that diminishes SH rights without SH consent

– Any SH who bought shares in the company knew of the authority BoD had to amend bylaws, had consented to being governed by the bylaws as may be amended by the BoD

– SHs can always repeal a BoD-amended bylaw they don’t like• Potential for abuse

– In an earlier case (CA, Inc. v. AFSCME Emps. Pension Plan [Del.2008]), the court said a bylaw is not valid because there are many potential situations in which it would mandate actions that would violate directors’ FD

– Chevron court clarifies that CA was a unique case & doesn’t represent Del. law– Bylaw is not invalidated because it can be abused; if a particular act abuses the

bylaw, that act can be challenged© Amitai Aviram. All rights reserved.39

Customizing via constitutional docsStock specifications

• Delaware– DGCL §102(a)(4) allows corporations not to issue any stock (charter needs to

state this & either specify conditions of membership or that these conditions are in the bylaws)

– DGCL §151(a): “Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any and all of which classes… may have such voting powers, full or limited, or no voting powers, and such [economic rights]… as shall be stated… in the certificate of incorporation… or in [a BoD resolution] pursuant to authority expressly vested in it by its [charter].”

– DGCL §151(b) allows the issuance of redeemable shares as long as after redemption there are still shares with full voting powers

– DGCL §151(e) allows the issuance of convertible shares• MBCA

– MBCA §6.01(b) – “Minimum requirements”:• At least one class of shares with unlimited voting rights• At least one class of shares with a residual claim (i.e., the right to receive the

net assets of the corporation upon dissolution) – doesn’t have to be the class with unlimited voting rights

– MBCA §6.01(c) – Authorizes non-voting stock, convertible stock, and other characteristics of stock


Customizing via constitutional docsStock specifications

• Authorized shares: Maximum # of shares corporation can have– BoD has authority to issue shares, up to the authorized number (DGCL §161)– What purpose do authorized shares serve? (Note: number of authorized shares

must be specified in charter; changes to charter require both BoD & SH vote)• Outstanding shares: # of shares corp issued (& not repurchased)• Authorized but unissued shares: Shares that are authorized but have

not been issued by the firm (or were issued & repurchased)– Example: Acme’s charter says it has 1,000 authorized shares. Acme’s BoD issues

200 shares to investors. Acme now has 1,000 authorized shares, 200 outstanding shares, 800 authorized but unissued shares

• Treasury shares (DGCL): shares that have been issued in the past, but later repurchased by the issuing corporation– Example: Acme Corp. now repurchases 50 of its 200 outstanding shares. After

purchase, it has 1,000 authorized shares, 150 outstanding shares, 50 treasury shares, 800 authorized but unissued shares

– MBCA classifies treasury shares as authorized but unissued shares (MBCA §6.31(a))• I.e., Acme has 1,000 authorized shares, 150 outstanding shares, 850 authorized

but unissued shares © Amitai Aviram. All rights reserved.41

Customizing via constitutional docsPolicy on customizing control rights

• Hypo 1: Acme Corp. has only one class of stock. SHs are entitled to dividends (if BoD authorizes dividend distribution) & to Acme’s net assets upon dissolution, but not entitled to vote– Is this permitted by MBCA §6.01?– Are there any risks to this capital structure?

• Hypo 2: Acme has instead two classes of stock– Class A shares are the same as in the above hypo (entitled to dividends & net

assets upon dissolution, but not entitled to vote)– Class B shareholders have the same rights as Class A, except that each Class B

share also has one vote– Is this permitted by MBCA §6.01?– Are there any risks to this capital structure?



• Can the market protect itself?– Abe is offered Acme non-voting shares; economic value of 1 Acme share is $10– Abe thinks Acme’s directors are a bunch of thieves

• Abe estimates that they will “steal” $10M ($1/share)• Abe agrees to buy a share for $9 ($10-$1 stolen)

– If SH can assess the decrease in share value caused by the inability to keep BoD accountable, then there’s no harm from non-voting shares

• SH pay a price proportionate to their (limited) rights• Companies who want to raise capital more cheaply can give voting rights to SH

& receive a higher price per share– Can SH assess the harm from an unaccountable BoD?

• Does FD suffice?– Suppose that there is no way to assess the discount for lacking the ability to

keep the BoD accountable. Nonetheless, a BoD action that is not in SHs’ interest violates directors’ FD.

– Isn’t it enough to give SHs right to sue BoD for breach of FD?© Amitai Aviram. All rights reserved.43


• If we can’t trust the market to protect itself & we can’t trust FD to protect nonvoting SHs, why not prohibit nonvoting shares?– Can still bypass with “supervoting” shares

• E.g., 1 class A share has 1 vote; 1 class B share has 1M votes– So why not require each share to have equal voting power (“1 share, 1 vote”)?

• Equal voting power: SEC’s attempt– In 1988, the SEC adopted Rule 19c-4, prohibiting any stock exchange or mutual

securities association from listing any stock of a corporation that takes any action to the effect of nullifying, restricting or disparately reducing the per share voting rights of existing common SH.

– The Business Roundtable v. SEC (D.C. Cir., 1990): Court vacates the rule on the ground that it exceeds SEC’s authority

• SEC instead informally pressures stock exchanges to adopt similar requirements in their listing rules

• But does an equal voting power rule solve the problem?



• Hypo based on Stroh v. Blackhawk Holding Corp. [Ill. 1971]: Chris forms Blackhawk Corp., with two classes of shares:– Class A – “Normal shares”

• Chris buys 50,000 shares for $2/share (firm receives $100K)– Class B – Voting rights, but no econ rights (no rights to dividends or assets in dissolution)

• Chris buys 500K such shares for 0.1¢/share (firm receives $500)• Blackhawk sells to public 500K Class A shares at $4/share (firm receives $2M)

• Do Blackhawk’s shares offer equal voting power? Yes (was required by the Illinois constitution at the time)

• Does this prevent a split between control & economic rights? No


Buyer Shares Acquired Cost Votes Economic Rights

Chris 50K Class A $100K (~4.8%) 50K (~4.8%) 50K (~9%)

Chris 500K Class B $500 (~0%) 500K (~47.6%) 0 (0%)

Public 500K Class A $2M (~95.2%) 500K (~47.6%) 500K (~91%)

Total $2,100,500 1,050,000 550,000

Customizing via constitutional docsAddressing SH right misappropriation

• Problem of “watered stocks”: Acme worth $100, has 10 shares outstanding– How much is each share of Acme worth?– Acme’s BoD issues 10 new shares to Jill for $2/share ($20 total)– What is Acme worth now?– How many shares does Acme have now?– How much is one Acme share worth now?– Value of Jill’s shares? Value of other SHs shares?

• Legal solutions to the misappropriation1. Limit the number of shares that BoD is allowed to issue without

authorization from the existing shareholders• Authorized shares: maximum number of shares that the firm can have• Charter must specify the number of shares the corporation is authorized to

issue (their number can only be changed by changing the charter)• Both MBCA [§1.40(2)] & DGCL [§161] use this concept

2. Set a minimum price for the shares• Par value is the minimum price for which a share can be issued (doesn’t affect

the price share is sold by the SH to a new SH)• E.g., Acme has 1M common shares, with a par value of $1. If Acme issues a

new share to Sarah, it must receive consideration of no less than $1. Sarah, however, is free to sell the share at any price (or give it as a gift).

• DGCL uses this concept [DGCL §153(a)]; MBCA does not© Amitai Aviram. All rights reserved.46

Customizing via constitutional docsAddressing creditor right misappropriation

• Problem of siphoning assets to SHs: Acme has 10 shares outstanding, $100 in assets, no debt– Acme issues $50 of one-year bonds, bearing 10% interest

• Acme’s net assets are now $150; it will need to pay $55 in 1 year• A year later, Acme lost $70; it has $80 in assets ($150-70)• How much are the bondholders entitled to?

– Before bonds mature, Acme declares $8/share dividend• SHs receive 100% of Acme’s assets ($80); bondholders receive nothing

– Instead of dividend, Acme repurchases 8 of its shares at $10 each• 80% of SHs receive 100% of Acme’s assets; bondholders & 20% of SHs receive nothing

• Legal solutions to the misappropriation1. Contractual approach: bond agreement can create limits on

dividends/repurchases or state that if certain financial ratios indicate firm approaches insolvency, firm must pay debt immediately

2. DGCL approach: specify a minimum amount of assets that dividends cannot compromise (“legal capital”)

3. MBCA approach: prohibit a dividend that causes insolvency© Amitai Aviram. All rights reserved.47

Customizing the firmReview

• Controller Cass is creating a firm, and wants to own 60% of the control rights & 20% of the economic rights

• Methods 1-2 are suitable for private firms– Customizing via arrangements between SHs– Assume only other SH is minority SH Mary

• Methods 3-5 are suitable for public firms– Customizing via constitutional documents (share specifications)– Assume other SHs constantly change (“the public”)


Customizing the firmReview: Method 1 (voting trust)

• 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80• Mary forms a trust with Cass as the trustee, and transfers to the trust

legal title to 40 shares– Mary is the beneficial owner of the fruits of this trust (e.g., dividends), but Cass

(as trustee) gets to vote them at his discretionMary – 40Trust – 40Cass – 20

Control: 60% (20+40)

Dividends: 80% (40+40)


Customizing the firmReview: Method 2 (voting agreement)

• 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80• Cass & Mary sign a voting agreement (AKA vote pooling agreement)

in which Mary promises to vote 40 of her shares as Cass instructs– Some voting agreements have a designated arbitrator would decide how to

vote if parties disagree– To ensure that the agreement is specifically enforceable, Mary may give Cass an

irrevocable proxy to vote a 40 of Mary’s shares• Why does Cass need an irrevocable proxy?

• MBCA §7.22: Proxies are ordinarily revocable at the will of the SH, but a SH can give an irrevocable proxy. Usually, the proxy must be coupled with an interest. Acceptable interests include:– Proxy holder is a pledgee– Proxy holder has purchased/agreed to purchase the shares– Proxy holder is a creditor of the corporation who required the irrevocable proxy

in order to extend it credit– Proxy holder is an employee of the corporation who required the irrevocable

proxy in his employment contract– Proxy holder is a party to a voting agreement

• Proxy irrevocable only as long as proxy holder has an interest in firm© Amitai Aviram. All rights reserved.50

Customizing the firmReview: Method 3 (dual-class; 1 share, 1 vote)

• As in Stroh– Class A shares have one vote per share, full economic rights– Class B shares have one vote per share, no economic rights

• Assuming firm plans to issue 2M A-shares to raise money– C buys, for a symbolic price (0.1¢) 2M B-shares– C also buys 20% of A-shares (400K shares)– Public buys remaining 80% of A-shares (1.6M shares)– Result: C has 60% of control rights (2.4M out of 4M votes) & 20%

of economic rights (400K out of 2M A shares)


Customizing the firmReview: Method 4 (dual-class; voting/non-voting)

• If non-voting common shares are permissible:– Class A shares are non-voting, full economic rights– Class B are voting, no economic rights

• C buys 20% of A-shares– Remaining A-shares sold to the public– Result: C has 20% of the economic rights

• C buys 60% of B-shares– Remaining B-shares sold to other investors who want to buy control

rights and who are acceptable to the controller (typically, such investor would also buy A-shares to get economic rights, and will insist on sharing control rights via SH agreement with C)

– Result: C has 60% of control rights


Customizing the firmReview: Method 5 (class-specific rights)

• Design share classes as follows:– Class A shareholders (as a group) appoint 2 of the 5 directors &

receive 80% of the economic rights– Class B shareholders appoint 3 directors & receive 20% of the

economic rights• Controller buys only Class B shares & issues to the public

only Class A shares– Results: Controller has 60% of control rights (appoints 3 of the 5

directors), and receives 20% of the economic rights• Example: “Golden shares”


1. Types of firms2. Customizing the firm (private ordering)3. Firms: external relationships

– Asset partitioning (limited liability)• Benefits & costs of asset partitioning• Legal analysis of PCV• Problem with reverse piercing• Asset partitioning in a GP

– Legal personality– External claims & liabilities



Asset partitioningWhat is asset partitioning?

• Asset partitioning means that the property, rights & obligations of the firm are separate from those of the firm’s SHs

• Example: Abe owns 100% of the shares of AbeCo. AbeCo borrows money from a bank, but when the loan is due, AbeCo is insolvent– Abe does not need to pay the loan; AbeCo’s obligation is not his

obligation


Why didn’t you say ‘limited liability’?• Limited liability is one side of asset partitioning – the

concept that a SH is not liable for the firm’s obligations– A related concept is that a SH does not have ownership rights in

the assets of the firm

• The other side of asset partitioning is that an entity is not liable for the obligations of its SHs– E.g., John & Jane each own 50% of the shares of a corp running a

small grocery store. John declares bankruptcy. The debtors cannot seize the store’s inventory. What can they seize that relates to the grocery?




Exceptions to asset partitioning• Asset partitioning is so ubiquitous

that it’s easier to study theexceptions than the rule– For limited liability (the rule that SHs

are not liable for C’s obligations), theexception is called piercing the[corporate] veil (“PCV”)

– For the rule that C is not liable forSH’s obligations, the exception iscalled reverse piercing


Asset partitioningWhat is asset partitioning?Exceptions to asset partitioning

• MBCA §6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct.”

• Distinguish between:– Direct liability: SH’s acts create a legal cause of action against the

SH, not just against corp• Example: Ann, a shift manager at a restaurant owned by Pancake Corp.,

gets into an argument with Teresa, a customer who didn’t like the food & wants her money back. Ann punches Teresa. Teresa sues Ann & Pancake Corp., but does not request to PCV (nor provides any evidence justifying PCV). Both Ann & Pancake corp. move to dismiss the suit against them. Is Pancake liable to Teresa? Is Ann liable to Teresa if there’s no PCV?

– PCV: SH’s acts cause court to ignore limited liability, so SH becomes liable for the corporation’s obligations


Asset partitioningBenefits

• Why have limited liability? Diversification– Diversification reduces risk because by dividing investment between many

firms, exceptionally good & bad investments offset each other– Why is reducing risk (getting an average return on the investment instead of

a chance of either great or terrible return) a good thing?• But with unlimited liability, diversification actually increases risk

– Example: Iris has $1,000 available for investment– Barbara offers Iris to buy shares in Barbara’s restaurant business– Assuming unlimited liability, what is the largest loss Iris is exposed to if the

business fails?– With unlimited liability, risk increases the more firms you invest in

• Limited liability facilitates smaller, more risk-averse, and minority (i.e., non-controlling) equity investments


Asset partitioningCosts

Do creditors unfairly carry the burden of limited liability?

• Voluntary creditors

• Involuntary creditors


Asset partitioningCosts: voluntary creditors

• Laura wants to invest $1,000 in a debt investment; Betty offers that Laura will lend to BettyCo (Betty’s corporation)– Assume Laura has $500K, diversified into 500 investments of $1K ea.– Laura checks BettyCo’s solvency & anticipates a high probability that BettyCo

would repay the loan & interest, but some probability BettyCo would default– Current risk-free investment yield (e.g., FDIC-insured bank savings account): 5%– Will Laura agree to lend money to Betty’s corporation at 5%?– Can Betty offer Laura terms that would make Laura lend to BettyCo?– Why does it matter that Laura is diversified?

• Can Laura contractually protect herself from default if:– Betty “cooked the books” of the firm (intentionally defrauded Laura)?– BettyCo’s accounts contain many unintentional inaccuracies (e.g., forgetting to

reduce BettyCo’s available cash after BettyCo paid dividends to Betty, co-mingling Betty’s assets with BettyCo’s assets) because Betty is absent-minded?


Asset partitioningCosts: involuntary creditors

How LL threatens tort liability• Recall our discussion of externalities in sub-section 1a1

– A may impose negative externalities on B, which is inefficient because A does not consider cost imposed on B

– Tort law internalizes this cost by forcing A to compensate B– But limited liability acts as an “exemption” from tort law


Asset partitioningCosts: involuntary creditors

• Hypo: A owns Acme, a taxicab company– A regularly draws all profits out of Acme, so Acme has no assets other

than the (used) cabs– Tort: A’s cab runs over B– B sues Acme, but Acme has no assets

• Tort law internalizes cost of accidents byforcing drivers to compensate accident victims– Causes drivers to drive carefully and maintain their cars

• But limited liability means SHs get the upside of business profits, while they can avoid costs that bankrupt the business– Activities that cause torts will be moved into poorly capitalized

corporations that are undeterred & unable to compensate victim– Veil piercing is needed to address this loophole


Asset partitioningLegal analysis of PCV

SH

Corp. Sister Corp.

Debtor Defendant

PCV Corp. SH

Enterprise liability Corp. Sister Corp.

Reverse piercing SH Corp.

Legal test for all three:1. Such unity of interest between [Debtor] and [Defendant] that

their separate personalities no longer exist; and2. Adherence to fiction of separate corporate existence would

sanction fraud or promote injustice


Asset partitioningLegal analysis: unity of interest

• Can’t distinguish debtor’s assets/liabilities from defendant’s– Due to debtor’s failure to comply with corporate formalities (e.g.,

sloppy corporate records misrepresent debtor’s assets/liabilities)– Due to commingling of debtor’s & defendant’s assets

• Siphoning assets from debtor to defendant (“tunneling”)– Debtor’s assets gifted or sold below fair value to defendant

(including through dividends)– Failure to respect debtor’s separate entity (e.g., defendant uses

debtor’s assets as its own)


Asset partitioningLegal analysis: unity of interest

Example (enterprise liability)• In one case, court considered whether the corporations had:

– Common employees– Common record keeping– Centralized accounting– Same officers– Same shareholders– Same telephone number– A common business name– Services rendered by employees of one corporation on behalf of another– Payment of wages by one corp. to another corp.’s employees– Unclear allocation of profits & losses between the corporations– Undocumented transfers between corporations


Asset partitioningLegal analysis: injustice

• “[C]ircumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.”

– Sea-Land court: prospect of unsatisfied judgment does not satisfy this prong of the test

– Court suggests that 2nd prong will be satisfied if:• SH used corp. to avoid responsibilities to creditors; or• Corporation will be “unjustly enriched”


Asset partitioningLegal analysis: criteria for injustice

• Contract (voluntary) creditors– To mitigate the risk of corporation defaulting, a contractual

creditor can investigate corporation’s credit-worthiness and:• Decline to lend• Require higher interest to compensate for higher risk• Require personal guarantees

– Can contract creditor protect herself frombeing harmed by undercapitalization?

– By failure to abide by formalities?– By moving assets between the firm &

other firms/SH? By fraud?



• Tort (involuntary) creditors– Does a tort creditor care about SH’s respect for corporate

formalities?– Does a tort creditor care about corporation’s undercapitalization?



• PCV for a contract creditor: if unity of interest (failure to observe formalities or siphoning of assets) prevents creditor from acquiring contractual protection

• PCV for a tort creditor: if debtor was undercapitalized


Asset partitioningAsset partitioning in a GP

• Firm’s liability for SH debts– Hypo: April, Bev & Chris are partners in ABC law firm. Dave has a judgment

against Bev & wants to collect from ABC.– RUPA §501: “A partner is not a co-owner of partnership property and has no

interest in partnership property which can be transferred…”– RUPA §502: A partner’s share of the profits & losses & partner’s right to receive

distributions from the partnership (together, the partner’s “transferable interest”) is personal property, so creditor can seize Bev’s transferable interest in ABC

– RUPA §504: Allows a creditor to petition court to issue a charging order (a lien) against a partner’s transferable interest. Court may then order foreclosure (sale of the transferable interest to a third party, with proceeds used to pay debt to creditor)


Asset partitioningAsset partitioning in a GP

• SH’s liability for firm’s debts (unlimited liability)– Example: April, Bev & Chris are partners in ABC law firm. Dave has a judgment

against ABC & wants to collect from Chris.– RUPA §306: All partners are liable jointly & severally for all obligations of the

partnership unless:• Otherwise agreed by the claimant• Otherwise provided by law• Partner admitted into partnership after obligation was incurred• Obligation incurred while partnership is an LLP

– RUPA §307(d): Creditor must first attempt & fail to collect the debt from the partnership (exhaust partnership assets), unless:

• Partnership is a debtor in bankruptcy• Partner agreed that creditor need not exhaust partnership assets• Court permitted collecting from partner because partnership assets are clearly

insufficient to satisfy judgment or exhaustion of partnership assets is excessively burdensome

• Partner is directly liable for debt© Amitai Aviram. All rights reserved.72

1. Basic concepts about firms2. Types of firms3. Firms: external relationships

– Asset partitioning (limited liability)– Legal personality– External claims & liabilities



• A corporation is a legal entity independent of the people creating it, acting on its behalf or owning rights in it– But does that make any sense?

• Hypo: A car hits a pedestrian & kills him– The investigation reveals that the driver took

proper care in her driving, but the car brakesmalfunctioned

– It’s the car’s fault: the car is imprisoned forthree years for negligent homicide

• It seems silly to make a non-living object a legal entity (capable of being punished), yet we give legal entity status to firms (which are not only non-living, but lack physical form)

• Why do we give firms an independent legal personality?

Legal personalityThe logic of nonliving legal entities


• Legal personality makes asset partitioning easier– Without legal personality, the firm can’t own assets, so we can’t say that a

particular asset belongs to the firm (and therefore can’t be seized by creditors of a SH)

– Without legal personality, the firm can’t have legal obligations and therefore can’t borrow; SHs must borrow for it

• But asset partitioning can be done contractually, without the firm having an independent personality– Non-recourse loans: SHs take a loan in which creditor agrees it can only collect

interest & principal from specific assets & income related to the business of the firm (not from SH’s other assets) – effect like limited liability

– UPA created a special right in partnership property (tenancy in partnership), that was not alienable unless all partners agreed to sell it (so creditors of a SH can’t seize that property)

• So there must be another reason for firms’ legal personality…




• Example 1: Small bakery requires two employees &one person to finance business– If organized as set of contracts: 2 relationships (2x1)

• 2 employment contracts w/financier; or• 2 lending agreements w/employees

– If organized as separate entity: 3 relationships (2+1)



• Example 2: Mid-size supermarket requires 6 employees,2 people to finance business– If organized as set of contracts: 12 relationships (6x2)




• Example 3: Large steel plant requires 600 employees, 200 people to finance– If organized as set of contracts: 120,000 relationships (600x200)




• The tradeoff– Contracts allow modifications to address specific preferences of parties;

separate entity uses standardized terms– The larger the number of legal relationships involved in an activity, the more

difficult it is to manage the activity• Businesses with a few stakeholders are likely to opt for the flexibility

of contracts• Businesses with a many stakeholders are likely to opt for the

simplicity of the firm– Avoid dealing with 120,000 separate relationships


Legal personalityLegal personality by firm type

• Corporations– Always had a legal personality

• Partnerships– When UPA was created, a partnership was not considered to have a legal

personality (a partnership was a contractual relationship between people, not a legal entity)

• Forced UPA to come up with some odd rules (e.g., ownership of partnership assets, issues with continuing partnership when one partner leaves or dies)

• Later case law moved towards recognizing legal personality– RUPA explicitly acknowledges independent legal personality

• RUPA §201(a): “A partnership is an entity distinct from its partners.”• RUPA §203: “Property acquired by the partnership is property of the

partnership and not of the partners individually.”


1. Basic concepts about firms2. Types of firms3. Firms: external relationships

– Asset partitioning (limited liability)– Legal personality– External claims & liabilities



External claims & liabilitiesOutsiders as plaintiffs

• Authority– Acts of firm’s agents: governed by agency law (Section 1b)– Acts of firm’s organs:

• If act is not authorized by law, firm is not bound by it– But DGCL §141 gives BoD plenary authority, so BoD is authorized by law to do

any act on behalf of firm, unless case law/statutory law limits BoD authority• If act is authorized by law, firm is bound by it

– If act is ultra vires (authorized by law but prohibited by the charter): firm is bound unless SH or the AG sue to enjoin it, in which case T is compensated but doesn’t get anticipated profits of contract [DGCL 124(1)]

• FD: outsiders can’t sue for FD breach; not owed FD by firm’s actors– Exception: public benefit corporation laws in some states allow “benefit

enforcement proceedings” against directors & officers (the equivalent of SH challenges to corporate actions) to be brought by SHs, directors, 10%+ SHs in the parent firm of the benefit company, and any other persons specified in the PBC’s charter or bylaws


External claims & liabilitiesOutsiders as defendants

• Outsiders can be sued by the firm based on contract law, torts, etc.• Outsiders as such don’t owe FD to firm or its SHs, but they may

nonetheless be liable to the firm for aiding & abetting a breach of FD by the firm’s organs or agents

• Elements required (Morgan v. Cash):1. Existence of a fiduciary relationship;2. Breach of the fiduciary's duty;3. Knowing participation in that breach by T; and4. Damages proximately caused by the breach

• We know how to analyze FD (and approval, if relevant); here we will discuss the third element: knowing participation


External claims & liabilitiesMorgan v. Cash [Del. Ch. 2010]

• Corp can have multiple classes of stock w/different rights– E.g.: Acme has 1,000 common shares & 1,000 preferred shares that each have

a $1,000 liquidation preference and participate in any remaining liquidation value). Acme dissolves.

– How much will each SH get if Acme’s assets are worth: $500K? $5M?• Voyence has common & preferred shares

– Voyence agrees to be acquired by EMC for an amount that is below the liquidation preference (i.e., common SHs get nothing)

– 4 of 5 directors represent preferred SHs; 5th director (CEO Nash) is married to a partner in a preferred SH

• SH (and employee) Mary Morgan sues –– BoD for accepting this offer (claiming BoD should have held out for a better

offer that gave common SHs some consideration)– EMC for aiding & abetting BoD’s breach

• EMC moves to dismiss for failure to state a claim


External claims & liabilitiesMorgan v. Cash

• Knowing participation: Malpiede v. Townson [Del. 2001]– T's acquisition of favorable terms through arm's-length negotiations is not

knowing participation– T knowingly participates if T attempts to create or exploit conflicts of interest in

A, or where T and A conspire in or agree to the FD breach– Conflicting authorities as to whether T can knowingly participate in a breach of

DoC (i.e., when A doesn’t intentionally breach FD)• Morgan’s arguments:

1. EMC's offer of employment to Nash & Fortenberryinduced them to support EMC's lowered offer price• EMC has legitimate incentive to retain Voyence’s

management to maintain Voyence’s value• Offers were similar to what N&F were already receiving• No evidence N&F influenced BoD decision to

accept offer (BoD asked N&F to leave roomduring their deliberations)

Susan Nash (CEO)

Donald Fortenberry (CFO)


External claims & liabilitiesMorgan v. Cash

• Morgan’s arguments:2. EMC knew Voyence directors were designees of preferred SHs &

exploited CoI between directors & common SHs• Court: To knowingly participate, third party needs to either –

– Buy off BoD in a side deal (no evidence EMC conspired w/BoD)– Actively exploit BoD conflicts to detriment of SHs (no conflict here, since

pref SHs would have wanted higher offer)» Safe harbor: tough negotiating in arm’s length bargaining isn’t aiding &

abetting (not relevant here, since there’s no conflict)

H. Berry Cash (director)Dennis Gorman (BoD chairman) Skip Glass (director) Terry Rock (director) Susan Nash (director)


business associations section 2a: firms – general concepts prof. amitai aviram [email protected]...

Documents

firms performance

firms general concepts

different types of firms

external relationships

transaction firms money

conversion firm

private firm

agency amitai aviram