ATP 108 Commercial
Transactions - 2019
LECTURE 1 – INTRODUCTION TO COMPANY LAW –
FOUNDATIONAL CONCEPTS
Course Instructor – Stephen Mallowah LLB, LLM, MSc
Is there a common structure of law business corporations?
Are there similarities of legal characteristics of companies/ corporations
in all jurisdictions?
There are five characteristics that it is possible to observe in every business
company:
1) Legal personality;
2) Limited liability;
3) Transferable shares;
4) Delegated management;
5) Investor ownership.
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The five core structural characteristics of a Company
¤In all economically important jurisdiction there is a basic statute that provides
for the formation of firms with all of the abovementioned characteristics.
¤These characteristics respond to the economic exigencies of the large modern
business enterprise.
¤Even if there are other forms of business enterprise that lack one or more of
these characteristics, in market economies, almost all companies adopt a
legal form that possess all of them.
¤These characteristics make the company attractive for organizing
productive activity, but also generate tensions and trade-offs that lead to the
the agency problems that corporate law must deal with.
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1) Legal Personality (I)
▪ Firm as a “nexus of contracts”: this description is often used to
emphasize the fact that most of the important relationships within a
firm are essentially based on consent, rather than involving some
form of extra-contractual command-and-control authority. This
definition fails to distinguish the firm from other contractual
relationships.
▪ It is more accurate to describe the firm as a “nexus of contracts” in
the sense that a firm serves as the common counterparty in
numerous contracts with suppliers, employees an customers.
▪ The first and most important contribution of corporate law is to
permit a firm to serve as a single contracting party that is
distinct from the various individuals that own or manage the
firm - “separate patrimony”.
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1) Legal Personality (II)
▪ The separate patrimony involves the creation of a pool of assets that are
distinct from other assets owned by the shareholders, and of which the
firm in itself, acting through its managers, is viewed in law as being the owner.
▪ Consequently the corporation’s assets are unavailable for attachment by
the personal creditor of the shareholders. “entity shielding” or
“corporate veil”.
▪ Entity shielding involves two distinct rules of law:
1) Priority rule: grants to firm’s creditors a claim on the firm’s assets that is
prior to the claims of the personal creditors of the shareholders. This rule is
common to all modern legal forms of enterprise organization;
2) Rule of liquidation protection: provides that the owners of the company
are prevented from withdrawing their shares of firm assets at will. This
rules serves to protect the going concern value of the firm and it is not
found in some other legal form for enterprise organization, such as
partnerships. 5
1) Legal Personality (III)
▪ For a firm to serve effectively as a contracting party, two other
types of rules are also needed:
1)Rules specifying to third parties the individuals who have
authority to enter into contracts that are bonded by the
company’s assets. These rules of authority are discussed later
as a separate characteristic, “delegated managers”.
2)Rules specifying the procedures by which both the firm and
its counterparties can bring lawsuits on the contracts
entered into in the name of the firm.
▪ The concept of “separate legal personality” of the company
involves each of the three abovementioned foundational rule types:
entity shielding, rules of authority and rules of procedure.
▪ According to the concept of legal personality, in the eyes of the law,
the company is itself a person. 6
2) Limited Liability (I)
▪ According to the limited liability rule, the creditors of the company are
limited to making claims against assets that are owned by the company
itself and have no claims against assets that the firm’s shareholders
hold in their own names.
▪ Historically, this rule has not always characterized the corporate form, since
important jurisdictions made unlimited shareholders liability for corporate
debts the governing rule. Today the limited liability has become a nearly
universal feature of the corporate form.
▪ Limited liability is effectively the converse of entity shielding: entity
shielding protects the assets of the firm from the creditors of the firm’s
owner, while limited liability protects the assets of the firm’s owners from
the claims of the firm’s creditors.
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2) Limited Liability (II)
▪ Limited liability and entity shielding, together, set up a regime of asset
partitioning whereby business assets are meant to be a security to
business creditors, while the personal assets of the company’s owners
are reserved for the owner’s personal creditors.
▪ A related aspect of asset partitioning is that it permits firms to isolate
different lines of business for the purpose of obtaining credit. By
separately incorporating, as subsidiaries, distinct ventures or lines of
business, the assets associated with each venture can be pledged as
security just to creditors that are involved in that venture.
▪ The use of corporate form – by virtue of asset partitioning, entity
shielding and limited liability – can assist the company in reaching
different goals:
§raising debt finance;
§sharing the risk of transactions with the firm’s creditors;
§monitoring the conduct of the firm’s managers, by shifting downside
business risk from shareholders to creditors.
▪ When we refer to limited liability, we mean specifically limited liability in
contract, which do not extend to limited liability in torts. 8
3) Transferable shares (I)
▪ Transferability is functional to the corporation’s going concern,
because it allows the continuity of the business notwithstanding the
changes of the identities of its owners.
▪ Transferability enhances the the liquidity of shareholders’
interests and makes it easier for shareholders to construct and
maintain diversified investment portfolios.
▪ Fully transferable ≠ freely tradable : even if shares are
transferable, they may not be tradable without restriction in public
markets, but rather just transferable among limited groups of
individuals or with the approval of the current shareholders or of
the company.
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3) Transferable shares (II)
▪ Free tradability maximizes the liquidity of shareholdings and the
ability of shareholders to diversify their investments. It also gives
the firm maximal flexibility in raising capital.
▪ On the other hand, free tradability makes it more difficult to
maintain negotiated arrangements for sharing control. Therefore all
jurisdictions provide instruments for restricting transferability.
▪ Generally, we refer to corporations with freely tradable shares as
“open” or “public” companies, and to corporations that present
restrictions on the tradability of their shares as “closed” or
“private” companies.
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3) Transferable shares (III)
▪ Two other important distinctions:
§Listed / Unlisted corporations: we refer to a listed company
when its shares are listed for trading on an organized securities
exchange;
§Closely held / widely held corporations: we refer to a closely
held company when its shares are held by a small number of
individuals whose interpersonal relationships are important to the
management of the firm.
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4) Delegated management with a board structure (I)
▪ Standard legal forms for business organizations differ in their
allocation of control rights, including:
§The authority to bind the firms to contracts;
§The authority to exercise the powers granted to the firm by
its contracts;
§The authority to direct the uses made of assets of the firm.
▪ Standard legal corporate form delegates principal authority over
corporate affairs to a board of directors (or to a similar
committee organ) that is periodically elected by firm’s
shareholders.
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4) Delegated management with a board structure (II)
▪ The board of directors typically has four basic features:
1.The board is separate from the operational managers of the
company;
2.The board is elected, at least in substantial part, by the firm’s
shareholders;
3.Thought largely or entirely chosen by the firm’s shareholders, the
board is formally distinct from them;
4.The board ordinarily has multiple members.
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4) Delegated management with a board structure (III)
1. The board is separate from the operational managers
▪ The nature of this separation varies according to whether the
board has one or two tiers.
§ Two-tier boards: top corporate officers occupy the board’s
second (managing) tier, but are generally absent from the first
(supervisory) tier;
§ Single-tier boards: hired officers may be members of, and
even dominate, the board itself.
▪ The legal distinction between directors and officers divides all
corporate decisions (that do not require shareholders approval)
into those requiring approval by the board of directors and those
that can be made by the firm’s officers on their own authority.
▪ Initiation and execution of business decisions are reserved to the
officers, while monitoring and ratification of decisions are 14
reserved to the directors.
4) Delegated management with a board structure (IV)
2. The board is elected by the firm’s shareholders
▪ Election of the board assure that the board remains
responsive to the interest of the firm’s owners, who bear the
costs and benefits of the firm’s decisions.
▪ Election of the board distinguishes the corporate form from
other legal forms, such as non-profit corporations or
business trusts, that permit or require a board structure, but do
not require election by the firm’s owners.
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4) Delegated management with a board structure (V)
3. Thought largely or entirely chosen by the firm’s shareholders, the
board is formally distinct from them
▪ This separation economizes on the costs of decision-making
by avoiding the need to inform the firm’s ultimate owners and
obtain their consent for all the decisions regarding the firm.
▪ It also permits the board to serve as a mechanism for
protecting the interests of minority shareholders and other
corporate constituencies.
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4) Delegated management with a board structure (VI)
4. The board ordinarily has multiple members
▪ It facilitates mutual monitoring and checks idiosyncratic
decision-making.
▪ Some company statues, however, permit to waive the collective
board in favour of a single general director or a one-person
board. This frequently happens in small corporations where
most of the board’s legal functions can be discharged effectively
by a single elected director who also serves as the firm’s principal
manager.
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5) Investor ownership (I)
▪ There are two key elements connected to the ownership of a
firm:
1. The right to control the firm, which generally involves voting
in the election of directors and voting to approve major
transactions;
2. The right to receive the firm’s net earnings.
▪ In business corporations both elements are tied to a specific kind of
input, which is represented by capital. Consequently, in an
investor-owned company, both the right to participate in control and
the right to receive the firm’s residual earnings, as a default rule,
are proportional to the amount of capital invested in the firm.
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5) Investor ownership (II)
▪ An investor-owned company reflects several efficiency advantages:
§ Among the various participants in the firm, investors are often
the most difficult to protect simply by contractual means;
§ Investors of capital have homogeneous interests among
themselves, hence reducing the potential for costly conflict
among those who share governance of the firm.
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5) Investor ownership (III)
▪ Investor-ownership is another aspect in which the law of business
corporations differs from the law of partnerships:
§the partnership form typically does not presume that
ownership is tied to contribution of capital. Ownership is also
assigned against contributions of labour or of other factors of
production.
▪ A business company is less flexible than a partnership in terms of
assigning ownership. However, deviating from the default rule, at
certain conditions, ownership shares in a business company
can be granted also to contributors of labour or of other
factors of production. Example: share options. 20
Sources of Corporate Law
▪ A core statute: almost all jurisdictions with well-developed market
economies have at least one core statute that establishes a basic
corporate form with the five characteristics abovementioned.
▪ Other sources: corporate law generally extends beyond the
bounds of this core statute:
§Special and partial corporate forms;
§Other bodies of law. - Common Law
§Precedent
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Other bodies of law
¤There are other bodies of law that, even if separate from core
company statutes, are to be considered functionally as part of
corporate law, since they have important effects on corporate
structure and conduct.
§Law of groups: Partnership, societies, cooperatives etc.
§Securities laws: they have strong effects on corporate
governance through rules demanding disclosures and regulating
sale and resale of corporate securities, mergers and acquisitions,
and corporate elections.
§Bankruptcy laws (or insolvency laws): they affects both the
extent to which creditors may need generalized protections in 22
corporate laws and the internal governance of company.
Law versus Contract in corporate affairs (I)
▪ The relationships among the participants in a company are, to an
important degree, contractual.
▪ The principal contract is represented by the “corporation’s
charter” (or “articles of association” or “constitution”).
§The charter sets out the basic terms of the relationship among
the firm’s shareholders and between the shareholders and the
firm’s directors and managers. It can also affect the contents of
the contracts between the firm and its employees or creditors.
§Some or all of a firm’s shareholders may, in addition, be bound by
one or more shareholders’ agreements, which regulate the
internal relationships among the firm’s owners. 23
Law versus Contract in corporate affairs (II)
▪ Since corporations are subject to a large body of laws and since
the defining elements of the corporate form (with the exception of
legal personality) could in theory be established simply by contract,
the question is “What role do these laws play?”
▪ If these rules of law did not exist, the relationships they establish
could still be determined by means of contract, just by placing
similar provisions in the organization’s charter. So, why do we
have, in every advanced jurisdiction, elaborate statutes
providing numerous detailed rules for the internal governance
of corporations?
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Mandatory laws versus default provisions
▪ Default rules / mandatory rules: in order to answer to the
previous questions, it is important to distinguish between legal
provisions that are merely default rules, in the sense that they
apply only if the parties do not provide for something different
and laws that are mandatory, in the sense that they can’t be
waived by parties, leaving them no option but to conform.
▪ A significant part of corporate law consists of default
provisions: it means that corporate law simply offers a
standard form that the parties can adopt, at their discretion, in
whole or in part.
§Advantages of a legally provided standard form:
§It simplifies contracting among the parties involved, requiring
that they specify only those elements that deviates from the 25
standard terms.
Default provisions
▪ Default provisions can be supplied in a variety of ways:
§A common form of default rule is a statutory provision that will
apply unless the parties explicitly provide an alternative.
Example: the common US corporate statute requires that a
merger is approved by a vote of 50% of all
outstanding shares. That rule can be displaced by a charter
provision that requires approval by 60% or 70%, or some other
number, of the shareholders.
§Sometimes corporate law itself specifies the rule that will govern if
the default provision is not chosen (so called “either-or
provisions”). The law in this case gives the company a choice
between two statutory provisions, one of which is the default
and the other is the “secondary” provision.
Example: the French corporate law allows companies’ charters
to opt for a two-tier board structure as an alternative to the 26
default single-tier one.
Mandatory provisions
▪ The main reason that justifies the presence of mandatory
provisions is usually based on some form of “contracting failures”.
▪ Mandatory provisions may also serve a useful standardizing
function, in circumstances where the benefits of compliance
increase if everyone adheres to the same rules.
▪ When used in conjunction with a choice of corporate forms,
mandatory provisions can facilitate the freedom of contract by
helping corporate actors to signal the terms they offer. The law
enables this by creating corporate forms that are to some degree
inflexible, but then permitting a choice among different corporate
forms. 27
Legal Rules versus Contract (I)
▪ Default rules serve another important function that cannot be
reached by contract: they provide a means of accommodating,
over time, developments that cannot easily be foreseen.
▪ A contract that must govern complex relationships over a long
period of time is necessarily incomplete, either because
situations that were not foreseeable at the time the contract was
drafted may arise or because the situations, thought foreseeable,
seemed too unlikely to justify the costs connected to the creation of
specific provisions.
▪ In this contest, company law plays a strategic role, since it serves a
“gap-filling” function : it provides for such situations as they arise
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either by adding new rules or by interpreting existing rules.
Legal Rules versus Contract (II)
▪ The problem of contractual incompleteness goes beyond mere
gap-filling. Since corporations usually have a long-term life, it is
likely that some of the charter’s terms will become obsolete
with the passage of time. Default rules, instead, are altered
over time to adapt them to the changes in the economic end
legal environment.
▪ However, the quality and speed by which default rules are
supplied, interpreted and updated will depend on a range of
variables, such as the legislative system, the civil procedure and
the judicial expertise.
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What is the Goal of Corporate Law?
▪ Corporate law serves multiple functions:
§defines a corporate form;
§contains and regulates conflicts among firm’s participants;
§pursues the aggregate welfare of all who are affected by a
firm’s activity, including firm’s shareholders, employees, suppliers,
customers, as well as third parties.
▪ With reference to the last assumption (corporate law pursues the
aggregate welfare), some scholars and economists assert that the
appropriate role of corporate law is simply to assure that the
company serves the best interests of its shareholders. 30
CBG OUMA & E ARUWA 2014 2/26/19 31
