1. WHAT IS CORPORATE LAW?

INTODUCTION
 Business corporations have similar set of legal characteristics and face similar set of legal
problems in all jurisdictions.
 5 legal characteristics of the business corporation: legal personality, limited liability,
transferable shares, delegated management, investor ownership.
 The principal function of corporate law is to provide business enterprises with a legal form
that possesses all these 5 characteristics.
 Corporate law enables business participants to transact easily through the medium of the
corporate entity, which lowers the cost of conducting business.
 Corporate law facilitates coordination between participants in corporate enterprise, and by
reducing the scope for value-reducing forms of opportunism.
 3 sources of opportunism: conflicts between managers and shareholders, conflicts
between controlling and non-controlling shareholders, conflicts between shareholders and
the corporation’s other counterparties (creditors, employees).
 Characteristics of corporation make it effective at minimizing coordination costs and
agency problems.

1.2 What is a corporation?

 5 legal characteristics of the business corporation: legal personality, limited liability,

transferable shares, centralized management under a board structure, investor ownership.
 These characteristics make the corporation especially attractive for organizing productive
activity.
 But also generate tradeoffs and tensions.

1.2.1 Legal personality

 Firm – “a nexus of contracts”; it emphasizes that the relationships within a firm are
contractual in character.
 Firm – “a nexus for contracts”; a firm serves as the common counterparty in contracts with
suppliers, employees, and customers, coordinating the actions of these multiple persons
through exercise of its contractual rights.
 Corporate law permits a firm to serve coordinating role by operating as a single contracting
party that is distinct from the owners and managers.
 The core element of a firm as a “nexus for contracts” is “separate patrimony” –
demarcation of a pool of assets that are distinct from other assets owned by the firm’s
owners.
 The firm’s entitlements of ownership over its designated assets include the rights to use
the assets, to sell them, and make them available for attachment by its creditors.
 These assets belong to the firm, not to the firm’s owners, so they are unavailable for
attachment by the owners’ personal creditors.
 “Entity shielding,” - it involves shielding the assets of the corporation from the creditors of
the entity’s owners. It is needed to create common expectations about the effect that a
contract between a firm and a creditor will have on the security available to the firm’s
other creditors. Entity shielding involves two rules:
1. A priority rule - grants to creditors of the firm, a claim on the firm’s assets that is prior
to the claims of the personal creditors of the firm’s owners.

2. A “liquidation protection” rule— provides that the shareholders cannot withdraw their
share of firm assets at will, nor can the personal creditors of an individual owner
foreclose on the owner’s share of firm assets. (It would lead to liquidation of the firm.)

 “Strong-form”- both rules are present: priority for business creditors and liquidation
protection. They make the contract negotiation easier and facilitate liquidity on the part of
shareholders. (Corporations)
 “Weak-form”- only the priority rule is present. (Partnerships)
 Also, two other rules are important:
1. “Delegated management” - Rules specifying the individuals who have authority to buy
and sell assets in the name of the firm. A subset of managers has power to bind the
company in contract. It establishes common expectations as to who has authority to

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 transfer rights relating to corporate assets prior to entering into a contract for their
transfer.

2. “Procedure rules” - 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.

 “Separate legal personality” – a company is capable of entering into contracts and owning
its own property; capable of delegating authority to agents; and capable of suing and being
sued in its own name.

1.2.2 Limited liability

 Limited liability rule - creditors are limited to making claims against assets that are held in
the name of the firm itself and have no claim against assets that the firm’s shareholders
hold in their own names.
 It facilitates diversification.
 The need to be “hands-on” occurs -shareholders prefer to be actively involved in the
running of the business, to keep risk under control.
 The “owner shielding” provided by limited liability is the converse of the “entity shielding”
- Entity shielding protects the assets of the firm from the creditors of the firm’s owners.

- Limited liability protects the assets of the firm’s owners from the claims of the firm’s
creditors.

 These forms of asset partitioning ensure that business assets are pledged to business
creditors and personal assets are reserved for personal creditors. It can reduce the overall
cost of capital to the firm and its owners.

1.2.3 Transferable shares

 Another characteristic of the business corporation: fully transferable shares in ownership.

 Transferability permits the firm to conduct business uninterruptedly as the identity of its
owners’ changes.

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 Fully transferable shares do not necessarily mean freely tradable shares. (they may have
restriction in public market).
 Advantages of free tradability:
1. Maximizing the liquidity of shareholders.
2. Maximizing shareholders’ ability to diversify their investments.
3. Giving a firm flexibility in raising capital.
 Disadvantages of free tradability
1. It makes it difficult to maintain negotiated arrangements for sharing control and
participating in management.
1.2.4 Delegated management with a board structure

Features of a board of directors:

1. Separation from the operational managers.
2. Board of directors is elected by the firm’s shareholders.
3. Distinction from shareholders.
4. Multiple members of the board – mutual monitoring and checking decisions made.

1.2.5 Investor ownership

Elements of ownership:

1. The the right to control the firm

2. The right to receive the firm’s net earnings.

Investor-owned firms - firms in which both elements of ownership are tied to investment of
equity capital in the firm. The power of an owner is typically proportional to the amount of
capital contributed to the firm.

Power can be distributed also in a different way: ownership of shares in a business corporation
can be granted to contributors of labor or other factors of production, or in proportion to
consumption of the firm’s services.

1.3 Sources of Corporate Law

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Major jurisdictions usually have at least one distinct statutory form specialized for the
formation of closed corporations or limited liability companies. They differ from country to
country.

Examples: the American limited liability company, and the UK private company.

1.3.2 Other bodies of law

Bodies of law contained in statutes or case law that are separate from the core corporation
statutes, but are nonetheless instrumental to the functioning of the five core characteristics of
the corporate form

Germany - Konzernrecht, an integral part of German corporate law. Protects the creditors and
minority shareholders of corporations.

US - Securities law has strong effect on corporate governance through rules mandating
disclosure.

Stock exchange rules regulate numerous aspects of the internal affairs of exchangelisted firms,
also serve as an additional source of corporate law.

UK’s City Code on Takeovers and Mergers- an additional source of corporate law.

1.4 Law vs Contract in corporate affairs

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 other managers.

At the same time, corporations are the subject of a large body of statutory law.

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 1.4.1 Mandatory law vs default provisions

Legal provision – default rules, which appply only if parties do not specify otherwise.

Mandatory laws – must be followed without any option for deviation.

Understanding the difference between them is crucial in navigating contractual agreements.

- A part of corporate law consists of default provisions. Corporate law offers a standard
form contract that parties can adopt. ADVANTAGE – saving costs by simplifying
contracting.
- Corporate law’s provision can be seen as “public good”.
- A common form of corporate law default is a statutory provision that will govern unless
the parties explicitly provide an alternative. Example: one share = one vote.
- Alternatively, corporate law itself sometimes specifies the rule that will govern if the
default provision is not chosen—an “either-or” provision. Example: French corporate
law.

1.4.2 The benefits of legal rules

1. Providing convenient standard forms.

2. Encouraging revelation of information.
3. Facilitating choice of the most efficient among several alternative rules.
4. Providing means of accommodating unforseen developments over time.
5. Gap filling role – filling gaps in contractual relationships.
6. Benefiting from interpretive activities of courts.
7. Benefiting from the network effect created by common standard terms.

1.4.3 Choice of legal regime

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 There is some flexibility in corporate law in choosing specially drafted charter provisions and
default provisions, selecting one default rule over another and opting for a specific
statuatory form.

US: “place of incorporation” rule permits a business corporation to be incorporated under the
law of any of the fifty individual states (or any foreign country), regardless of where the firm’s
principal place of business are located.

The same rule has been adopted by EU.

Place of incorporation rule vs. former ‘real seat’ doctrine: a firm must incorporate under the
law of the state where it has its principal place of business.

Regulatory competition: law systems that are driven primarily by market forces based on
companies’ demand. Regulatory competition creates a “race tot he bottom”.

1.5 What is the goal of Corporate Law?

GOAL: to serve the interests of society as a whole by advancing the aggregate welfare of all
stakeholders affected by a firm’s activities.

While the persuit of overall social welfare may align with different immediate goals for
corporate law, reducing costs among the corporation’ s constituencies is seen as a way to
enhance social welfare.