ETH Zurich, Spring 2015

Law & Business TransactionsIncorporation and Limited Liability

Gérard Hertig

G. Hertig 2

I. Operating as an Entrepreneur

• Name and branding issues• Operating directly or using a vehicle• Segregating personal/business assets &

liabilities– Litigation and collection considerations– Tax, family and inheritance implications

• Joining forces with associates– The partnership way– The incorporation way

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 3

Setting-up a Firm• Operating as a single individual with a firm name• Using contracts or entities provided by law– Ownership and decision-making (‘governance’)– Legal personality

• Role of – Type of business activities– Geographical scope– Incentives and reputation

• Focusing on business corporations

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 4

II. Business Corporations• Law provides separate legal personality• Not full set of rights compared to humans• Marriage• Voting and holding of public office

•What about human rights ?• Equal treatment • Taxation and search warrants

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 5

Examples 1 - 51. Firm A is forbidden to advertise its food

products while firm B is allowed to do it2. Firm C can operate without having to pay taxes

whereas firm D is subject to import and sales taxes

3. The police suspects that armed gangsters have entered a grocery store and want to storm it

4. A church is forbidden to have services on Tuesdays

5. Firm E is told it cannot have foreign owners04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 6

Separate Legal Personality• Nexus of contracts or Nexus for contracts?

• Law allows firm to:

– Serve as a single contracting party

– Distinct from owners or managers

• Facilitates undertaking of joint projects by owners, managers and third parties (why?)

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 7

Examples 6 - 106. A is rich, B is an inventor and C is a astute business men.

They want to cooperate to develop and distribute a new product. How should they proceed?

7. In addition, A consults you on how he could secure a bigger share of the resulting profits.

8. B also wants your advice on to remain the owner of the patent at the core of the new product.

9. C is concerned about getting a salary before any profits are distributed to his associates.

10. Finally, D —who will distribute the products via his retail shops—would like to know if and how he could get a share of the profits generated in this enterprise.

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 8

Implication 1 : Separate Patrimony

• Corporate assets– ≠ owners’ assets– ≠ managers’ assets– ≠ employees’ assets

• Firm can do what it wants with its assets– Put them to use– Sell or pledge them– Destroy them?

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 9

Implication 2 : Firm’s Assets are Shielded

• Priority rule: Firm’s creditors come first• Makes the firm’s commitments credible• But this is:– A ‘default’ rule: Firm can pledge its assets– A weak form of protection for firm’s creditors:

they only have priority

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 10

Examples 11 - 15

11. Manager C delivers gold used by the Corp. to manufacture its product to Bank E so as to get a loan. Can investor A or inventor B require the bank to return the gold a) To the Corp. (of which they are shareholders) or b) to themselves)?

12. The Corp. is doing badly and must be liquidated. Will its creditors get something?

13. Will the Corp.’s shareholder get something?14. Will the manager have to return the salary he got in

previous years?15. Will already paid suppliers have to return all or part

of what they have received?04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 11

Implication 3 : Liquidation Protection

• Owners cannot withdraw their share of firm assets at will

• Personal creditors of owners managers, employees cannot seize firm’s assets

• Stronger form of entity protection than priority rule

• Protects going concern value of the firm

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 12

Examples 16 - 20

16. New Corp. (which continued Corp.’s business) is also doing badly. Investor A wants the firm to exchange some of its assets against the share he owns.

17. Inventor B has lost a large sum playing poker. One of his fellow players asks New Corp. to pay B’s debt, claiming that B owns the patent used by New Corp.

18. Manager C has also lost a large sum playing poker. The same winning player asks New Corp. to pay C’s debt, claiming that B works better after having played poker.

19. Distributor D has not paid his employees. The latter want New Corp. to pay their wages, claiming that it owns money to D

20. In addition, the employees justify their claim by alleging that D is a shareholder of New Corp.

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 13

Implementation 1Authority to speak for the firm

• Third parties must know who within the firm has authority to – Buy and sell assets in the name of the firm– Enter into contracts that are bonded by those assets.

• Firms are free to specify the delegation of authority by contract

• Corporate law provides additional rules– If no delegation by contract or if reliance on ‘apparent’

authority– Board of directors or managers prototypically – Not shareholders

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 14

Implementation 2Suing the Firm

• Third parties must know the procedures by which they can sue the firm regarding– Contracts entered into in the name of the firm. – Damages caused by representatives of the firm

• Procedural rules make it generally easy to bring a suit – No need to name individual owners– No need to serve notice on individual owners

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 15

III. Limited Liability• Limited liability → owner shielding• Shareholders are generally not liable for the firm’s

debt– Not always the case historically– May become liable if get involved in firm management

• Facilitates shareholder diversification– Reduces need to monitoring of firms activities as loss

limited to investment made– Makes it easier to invest in multiple firms

• Reduces the cost of capital04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 16

Partitioning Assets to Get Credit

• Allocating assets to distinct lines of business– Specialized owners and specialized creditors– Facilitates monitoring– Reduces cost of capital and debt

• Importance of non-recourse across lines of business– Keeps specialization relevant– Creditors do not need to increase monitoring– Assets less likely to get diluted or reallocated

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 17

Examples 21 – 22

21) Firm X resells French wines. It also owns 100% of the shares of Firm Y (which produces Italian wines) and of Firm Z (which operates French cuisine restaurants).

You are an important creditor of Firm X and just learned that Firms Y and Z were in financial trouble. Should you worry about this?

22) Creditors of Firm Y believe that Firm X could easily fix the problems faced by Firm Y. Can they sue Firm X for damages if it does nothing, which results in Firm Y being unable to pay ist creditors

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 18

IV. Transferable Shares

• ID of owners can change without impact on continuation of the firm’s business– No immediate concern for the firm’s counterparties– Facilitates shareholder diversification

• Avoids member withdrawal issues prototypical of partnerships

• Shares are not necessarily freely transferable

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 19

23. T. is very wealthy and, among others, owns 80% of Firm G’s shares. He decides to sell his holding to buy a new yacht. The purchaser is a start-up that has borrowed heavily to finance the deal.You are a creditor of Firm G.Should you worry about the new situation? And, if so, what can you do?

24. Various shareholders enter into an agreement not to sell their shares without the prior approval of the others. Is this a violation of the share transferability rule? And is such an agreement potentially a good idea?

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

Examples 23 - 24

G. Hertig 20

V. Delegated Management

• Decision-making generally delegated to managers– Board of directors– Executives

• Owners make most important decisions– Putting an end to firm existence– Major transactions– Distribution of profits– Electing the board

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management

G. Hertig 21

Examples 25 - 26

25) A firm is doing very badly. The CEO decides to file for insolvency without consulting the board.How do you judge his behavior?

26) A mid-level managers decides to re-allocate duties among the members of her group. She does not consult the chairman of the board before doping so.How do you judge her behavior?

04.03.2015

Entrepreneurs / Business Corporations / Limited Liability / Transferable Shares / Delegated Management