Law and Economics of Corporations

1)Corporations contrasted with other business forms

2)History of corporations3)Limited liability – a special privilege?

Nader: yes Hessen: no

4)Modern corporate democracy5)Non-profit corporations, mutual companies,

benefit corporations

How Businesses are Organized

Sole proprietorship An individual owns the business. The owner keeps profits, if any, and is fully liable

for any debts Owner pays taxes on his/her own tax return

Partnership Formed by two or more people who want to pool

their money for a business purpose Partners fully liable for debts No partnership income tax Partners pay tax on their share of partnership

profits irrespective of any distributions

How businesses are organized

Limited partnerships General partner

Fully liable for debts Usually manages the business Gets bonus payment

Limited partners Not liable for partnership debts Some limited partnership units traded on stock

exchanges No partnership income tax Partners pay tax on partnership net income

whether distributed or not

Problem with partnership tort liability

Each partner (generally) is fully liability for the partnership’s torts

As with all tort actions, recovery of damages limited by partners’ assets

Tort remedies generally fall on parties with deep pockets Wealthy people reluctant to enter partnerships,

more likely to incorporate, making tort victims less well off, not better

Corporations

Latin corpus, body A new corporation sells shares of stock to

investors. New corporations are usually closely held

Only qualified persons can buy shares Shares cannot be sold freely

An existing corporation may “go public” Sell shares to general public Raise additional funds for the business

Chartered by state governments (except banks)

Enjoy limited liability

Limited liability

Usually evidenced by a suffix such as AT&T, Inc. (Incorporated) Oracle Corporation Lucasfilm, Ltd. (Limited) BP, PLC (Public Limited Company)

Shareholders cannot be held personally responsible for corporate debts or employee torts. At worst, shares become worthless.

Contrast: when a partnership commits a tort, the partners’ entire wealth is at stake

History of corporate charters

East India Company, 1600-1874 Granted monopoly of trade with India Evolved into a colonial quasi-government

Early America Corporate charters created by an act of the

colonial assembly (later, by state legislatures) Usually came with a grant of monopoly power Endowed with perpetual existence and limited

liability for shareholders Resentment, especially against banks, fueled

Jacksonian revolution Second Bank of US, nominally private, abolished

1836

Rise of and reaction to large corporations, late 1800’s

Railroads greatly reduced transportation costs, enhanced opportunities for large, efficient corporations

Standard Oil achieved dominant market share Kept expenses minimal Got preferential shipping rates from railroads Bought out less efficient firms Consumers benefited from drastically falling

prices Sherman Anti-Trust Act, 1890 Subsequent anti-trust acts

Supreme Court on Corporations

A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law

Chief Justice John Marshall, 1819 The corporation is a creature of the state. It

is presumed to be incorporated for the benefit of the public. It receives certain privileges and franchises, and holds them subject to the laws of the state and the limitations of its charter

Hale vs. Henkel, 1906

Mitt Romney on Corporations

“Corporations are people!” Democrats: “No they’re not!” Romney meant corporations are groups of

people Democrats’ interpretation: a corporation is a

separate person

Delaware, a corporate haven?

A specialty for a state with few comparative advantages Low filing fees and taxes Annual meetings need not be held in Delaware Stock transfer records need not be kept in

Delaware “Absolute” limited liability for shareholders

State government heavily influenced by duPont family

Rules further liberalized in 1963 in response to competitive threats from other states

Competing views of corporations

Ralph Nader “Taming the Giant Corporation” (1976) and many

other publications and speeches General theme: corporations have far too much

power and must be reigned in by federal chartering and other means

Robert Hessen “In Defense of the Corporation” (1979), response

to Nader Corporations do not get special privileges from

government Corporate features are created by contract, not

by government. Could exist without government.

Nader complaints about corporations (1976)

Industrial pollution Toxic substances Racial discrimination Alienated white-

collar workers Political power

campaign contrib. friends in gov’t revolving door lobbyists

Corporate welfare sugar industry merchant shipping

Privacy invasions Dominance of local

communities Deceptive

advertising Unsafe products Unreliable

technology Market power Multinational corps. Concentrated wealth Corporate crime

Is a corporation a “person”in a legal sense?

“Incorporated” suggests a body (corpus) Can sue or be sued or convicted of a crime

BP was held criminally liable for Gulf oil spill BP also paid civil damages Apple recently won a patent lawsuit against

Samsung Can “live” indefinitely regardless of

management or stockholder turnover IBM incorporated in 1911 as Computing-

Tabulating-Recording Corporations subject to income tax Shareholders not liable for corporate debts

Is limited liability a special privilege?

Ralph Nader: yes Early 1800’s: justified by limited purposes and

limited lifetimes; attracted shareholder capital Robert Hessen

No, customers and suppliers are warned of the limited liability

Exception: one-man corporations are an abusive way to escape liability

Question If corporate shareholders can disavow liability

why can’t individuals? Answer(?) corporation has deep pockets and/or

insurance

The doctrine of vicarious liability

From common law: masters are responsible for torts committed by their servants (respondeat superior). Servant acts on behalf of the master Masters likely to have “deep pockets” for

compensation of tort victims Sends a signal to masters to be careful about

hiring and supervising Extended to general partners Hessen: should apply to shareholders who

are actively involved in management

Is a corporation a “person” in an economic sense?

Corporate actions are performed by management

No essential economic difference between corporations and other forms of business All raise capital to conduct business in hopes of

earning profits

Crony capitalism

A situation in which corporations and other business entities concentrate on seeking government favors rather than serving customers

An inevitable outcome of the increased power that has been assumed by governments, particularly Federal gov’t

All major corporations must engage in lobbying in order to survive Microsoft learned this lesson

Businesses increasingly beholden to bureaucrats, not consumers

Modern corporate structure

A small group of people start a business and incorporate. Individuals buy shares of stock Shareholders wishing to sell usually required to

offer shares back to the corporation Shares are not traded on an exchange. Share

value is hard to determine Shareholders may decide to “go public”: offer

shares for sale to the general public (IPO) Shares listed on a stock exchange (NYSE,

Nasdaq) where anyone can buy or sell

Modern corporate structure

Shareholders own the company Number of shares determines the fraction they

own (I own 250 of 150,000,000 shares) Shareholders not entitled to company assets Shareholders can get a share of profits, if any,

as dividends Shareholders elect a Board of Directors

Board of Directors Sets broad company policies Hires management (CEO, CFO, etc.)

Liability of corporate boards of directors

Directors’ duties Elected by shareholders (but in practice often

hand-picked by CEO) Act as agents for the shareholders Hire top management (CEO, CFO, etc.)

Director’s compensation Cash compensation, stock, options

Directors’ liability Open to shareholder lawsuits if they grossly

mismanage the company (Hewlett-Packard?) Corporation buys special liability insurance for

directors (“errors and omissions”)

Cypress Semiconductor

Typical corporation in some ways Shares traded on NASDAQ Quarterly dividends paid, about 4% Share repurchase $1.6 billion market capitalization $1 billion annual revenues Followed by about 16 Wall St. analysts $200M cash, no debt CEO salary $669,000 + $11.4M restricted stock

Atypical in other ways T. J. Rodgers, founder (1982) and CEO is a

dominant personality, outspoken libertarian T.J. owns almost 10% of the shares

Shareholder democracy

Annual meeting at which shareholders vote Nominees for board of directors Proposals submitted by management Proposals submitted by shareholders Very few shareholders attend meetings – voting

almost all online Reality: shareholder control is very tenuous

Nominations not contested Shareholder proposals almost always fail Shareholders subject to rational ignorance

Non-profit organizations

Definition: an organization that does not distribute profits

Non-profit organizations can and sometimes do make profits (revenue minus expense)

Profits (if any) are re-invested in the organization

Non-profit organizations generally seek tax exemption Organization exempt from paying most taxes Donors may deduct donations from their taxable

income

Non-profit organizations

Examples of non-profits CSAA (Auto Club) Sutter Health (hospital chain) Churches Family foundations (e.g. Gates) Private universities (Santa Clara U. owned by

the Society of Jesus – Jesuits) Some are organized as non-profit

corporations Executives of non-profits sometimes earn $1

million or more

“Public benefit” corporations

Special quasi-independent government agencies with little resemblance to profit-oriented corporations

Usually subsist on tax support Examples:

VTA Bus & light rail operations (very unprofitable) County highways

Port Authority of NY and NJ Toll bridges and tunnels (profitable) PATH commuter rail (unprofitable) World Trade Center

Mutual companies

Mutual insurance companies are hybrids Customers technically own the company but

exercise little control Excess income rebated to policyholders

Examples State Farm Insurance Vanguard Group (mutual funds & ETFs)

“Benefit Corporation” starts Jan. 1 in California

Board must must take into account the environment, community, employees and suppliers when they make decisions – maximizing “stakeholder” value

Requires filing a “Benefit Report” Does anyone remember Adam Smith?

By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.