What is Corporate Law – Hansmann, Kraakman
There are five core structural characteristics of the business corporation. In virtually all economically
important jurisdictions, there is a basic statute that provides for the formation of firms with all of
these characteristics, at least as the default regimes (there are some exceptions). These
characteristics have strongly complementary qualities for many firms, together making the
corporation uniquely attractive for organizing productive activity.
(1) Legal personality => as an economic entity, a firm fundamentally serves as a nexus of contracts: a
single contracting party that coordinates the activities of suppliers of inputs and of consumers of
products and services. Law permits a firm to serve this role by providing for the creation of a
legal person – a contracting party distinct from the various individuals who own or manage the
firm, or are suppliers or customers of the firm.
a. Core element: “separate patrimony” => the ability of the firm to own assets that are distinct
from the property of other persons (e.g. investors) and that the firm is free not only to use
and sell but also pledge to creditors.
b. Two relatively distinct rules involves: (1) priority rule that grants creditors of the firm, as
security for the firm’s debts, a claim on the firm’s assets that is prior to the claims of the
personal creditors of the firm’s owners, the advantage is to increase the credibility of the
firm’s contractual commitments; (2) liquidation protection provides that the individual
owners of the corporation (the shareholders) cannot withdraw their share of firm assets at
will, nor foreclose on the owner’s share of firm assets, the advantage is that it protects the
going concern value of the firm against destruction from shareholders or their creditors
(latter not found in some other legal forms of enterprise organization, e.g. partnership, who
have weak form of legal personality instead of strong form).
c. Needs to be protected by law. Only one that cannot just be crafted by contractual means, as contracts among
the parties cannot bind the individual creditors of the firm’s owners.
(2) Limited liability => Creditors are limited to making claims against the assets that are the property
of the firm itself, and have no further claim against the personal assets of the firm’s shareholders
(distinguishes from e.g. partnership).
a. Personal assets are pledged as security to personal creditors, while corporation assets are reserved for
corporation creditors.
b. Together with legal personality reduces the overall cost of capital to the firm and its owners
due to more security.
c. Limited liability also permits firms to isolate different lines of business for the purpose of
obtaining credits, causing the assets associated to each venture to be conveniently pledged
as security just to the creditors who deal with that venture.
d. Permits defensive asset partitioning, as well flexibility in the allocation of risk and return
between equity-holders and debt-holders, reduces transactions costs of collection in case of
insolvency, and simplifies and substantially stabilizes the price of stock. Moreover, it enlists
creditors as monitors of the firm’s managers.
e. Not for those in tort – those who are involuntary creditors of the corporations, like e.g. parties who have been
injured as a consequence of the corporation’s negligent behaviour.
(3) Transferable shares permits the firm to conduct business uninterruptedly as the identity of its
owners changes, thus avoiding the complication of member withdrawal that are common to e.g.
partnerships. This in turn enhances the liquidity of shareholders’ interests and makes it easier for
shareholders to construct and maintain diversified investment portfolios. It also gives the firm
maximal flexibility in raising capital.
, a. Does not necessarily mean freely tradable shares. There might be restrictions to be
transferable among limited groups of individuals with approval of the current shareholders.
b. Can also make it difficult to maintain negotiated control arrangements.
c. Liquidation protection and legal personality make this possible because otherwise the
creditworthiness and value of the company should change with identity of shareholders.
(4) Delegation/Centralized management under a board structure => permits the centralization of
management necessary to coordinate productive activity and notifies third parties as to who in
the firm has the authority to make binding agreements.
a. Organizational forms differ in the way in which they delegate management power and
authority (e.g. limited partnership typically invest full control rights in a general partner or trustee; corporate
law typically vests principal authority over corporate affairs in a board of directors elected primarily by the firm’s
shareholders). Board of directors has four basic features:
i. The board is separate from the operational managers of the corporation. Nature differs. In
two-tier boards, top corporate officers occupy the board’s second (subordinate) tier, but generally are
absent from the first (supervisory) tier. In single-tier boards, hired officers may be members of, or even
dominate, the board itself. Formal distinction between the board and hired officers facilitate double
checking of decisions.
ii. The board is formally distinct from the firm’s shareholders. More likely that they respond to
the interests of all people in the company through moral principles and social pressure.
iii. The board of a corporation is elected (at least in substantial part) by the firm’s
shareholders. So that the board remains responsive to the interests of the firm’s owners, who bear the
costs and benefits of the firm’s decisions and whose interests are not strongly protected by contract.
iv. The board ordinarily has multiple members. Facilitates mutual monitoring.
(5) Shared ownership by contributors of capital/Investor ownership => both the right to participate
in control (generally involves voting in the election of directors and to approve major
transactions) and the right to receive the firm’s residual earnings (profits), are typically
proportional to the amount of capital contributed to the firm.
a. Advantages: protects investors (that are often the most difficult to protect simply by
contractual means); investors of capital have peculiarly homogenous interests among
themselves, hence minimizing he potential for costly conflict among those who share
governance of the firm.
b. Different for partnerships or non-profit.
In short: Legal personality protects the assets of the firm from the creditors of the firm’s owners,
while limited liability protects the assets of the firm’s owners from the claims of the firm’s creditors.
Strong form legal personality reinforces the stability and creditworthiness of the firm and, when
combined with limited liability, isolates the value of the firm from the personal financial affairs of the
firm’s owners sufficiently to permit the firm’s shares to be freely traded.
Partial corporate law statutes provide for separately defined statutory entities that have, or at least
are permitted to have, some but not all of the five core characteristics described (e.g. limited
partnerships, limited liability companies, statutory business trust).
The goal of corporate law should maybe be to support the greater good of entire society but mostly
is based on creating value for shareholders, which might also be good for society in some cases.
Transaction Costs Economics as a Theory of the Firm,
Management, and Governance – Ketokivi, Mahoney
Transaction Costs Economics (TCE) is a theory of how business transactions are structured in
challenging decision environments. TCE is chiefly concerned with transactions that are complex in
,that they are recurring, subject to uncertainty, and involve commitments that are difficult to reverse
without significant economic loss. It is a theory of the firm and management and governance. It seeks
to describe two kinds of heterogeneity: (1) the diversity of transactions; (2) the diversity of
organizations (e.g. differences in responses to transaction governance). The ultimate objective in TCE
is to understand discriminating alignment: which organizational response offers the feasible least-
cost solution to govern a given transaction?
What is the cost of transaction? In less complex settings, the system of institutions and the price
system work to your advantage. In complex settings transactions can still occur but there are costs of
transacting. Contracting parties must seek information that may be costly to obtain; they must agree
upon and enforce a potentially complex buyer-supplier contract; potential disputes may require
renegotiation, arbitration, etc.
TCE started with and is an account for vertical integration that has nothing to do with market power
and everything to do with transacting in an efficient way, without wasting resources.
The General Case of the Governance Decision
Transaction cost economics holds that economizing on transaction costs is mainly responsible for the
choice of one form of capitalist organization over another, applicable to many phenomena – vertical
integration, vertical restrictions, labour organization, corporate transfer, and, more generally, any
issue that can be posed directly or indirectly as a contracting problem.
Three characteristics of a contractual exchange relationship between two exchange parties (the
principal unit of analysis in TCE is the individual transaction):
(1) Frequency refers to the volume of transactions between the two exchange parties. Contractual
relationships are always associated with a cost, and with larger volumes (i.e., recurring
transactions), costs of specialized governance structures can be justified, for instance.
(2) Uncertainty refers to the contracting parties’ limited ability to predict environmental changes
and one another’s behaviour under unforeseen circumstances. Disagreements are a source of
costs. In complex exchange relationships, it is simply impossible to write a complete contract that
covers all possible contingencies. TCE works out the assumption that contracts are incomplete.
a. Other article argues that it depends on the type of uncertainty. E.g. behavioural
uncertainty favours hierarchical but technological uncertainty favours outsourcing to
mitigate obsolescence and preserve flexibility.
(3) Specificity (e.g. site specificity, physical asset specificity, human asset specificity)
refers to the specialized investments made by one party, or both parties, to enable
the exchange. Causes independency: if one terminates the contact, they have to
make the investment themselves or start another contract to get the necessary.
A simple transaction has low frequency, low uncertainty, and low specificity. Such
transactions can be efficiently handled through a market transaction between a
supplier and a buyer. A complex transaction, with e.g. high specificity, might be better
handled through e.g. in-house production.
- E.g. debt and equity financing. Assets of low specificity are more effectively
financed through debt as they are re-deployable and the lender is thus covered in
the case the borrower defaults on the loan. The cost of transacting is thus
relatively low (e.g. car rental company’s vehicle fleet vs. nuclear power plant). If
the assets are specific, the firm either needs to pay a very high interest on the
capital or needs to reduce asset specificity or use equity financing instead.
, o Equity financing has managerial and organizational implications. Residual claimants
(providers of equity) should be protected as there is no contract that provides this.
There has been prove that economic transaction efficiency can be used to account for the choices
about how transactions are governed and that the named characteristics link to governance
decisions in a way that TCE predicts.
Current Discussions, Debates, and Developments
- Many exchange relationships and governance decisions are inseparable from one another and
there might, thus, be a intertemporal network of transactions. The context in which the
individual transaction is embedded might thus be relevant.
- The characteristics of the broader economic and social context in which the transaction occurs
are relevant as well. These broader examinations could unearth governance mechanisms and
safeguards to economic exchange that stem more from the social customs than economic
institutions. Think of, e.g., obligations inherent in personal relationships. .
- TCE acknowledges the idea that firms consist of heterogenous stakeholder groups but also
derives some of the key implications regarding broader governance issues. It embraces firm value
as the main objective: efficient governance decisions are ultimately aimed at increasing firm
value, and consequently, shareholder wealth. This would lead to conclude that TCE is ultimately
primarily interested in just one of the stakeholders: the shareholder. The justification for focusing
on the shareholder at the board level is that no other stakeholder groups require the board’s
attention to ensure they are protected (e.g. employee contract, contract for debt financing).
They are thus a residual claimant who enjoys no contractual safeguards: they receive whatever is
left over once all the contractual obligations to other stakeholders have been met.
o Some disregard this and say that many contracts are incomplete. In this case, maybe the
board should be opened up to other stakeholders => broader participation for those who
supply or finance specialized assets to the firm (e.g. firm-specific knowledge investment).
o However, there are negative consequences to broader participation: (1) giving the board
stakeholder responsibility dilutes the effectiveness of the board with regard to shareholders;
(2) the inclusive stakeholder perspective may provide management with an ad hoc rationale
to make just about any decision whatsoever; (3) sharing of control between multiple
stakeholders may lead to an impasse on decisions.
o In TCE, governance questions are always context specific => e.g. whether the board should
be reserved to focus on shareholder issues depends on the context, might especially be
important when they invest in specific assets.
- TCE is comparative. All governance choices have flaw, but which is less flawed than others?
Organizational Boundaries and Theories of Organization
– Eisenhardt, Santos
Organizational boundaries => The demarcation between the organization and its environment. It has
been mostly shaped by TCE and related exchange-efficiency perspectives => need deeper
understanding of organizational boundaries like the four fundamental conceptions of boundaries.
Each of the four distinct conceptions of boundaries deal with a fundamental organizational issue. All
of them make prediction for both horizontal and vertical boundaries, but also provide a unique view
of boundaries and are distinct reflections of the essence of internal organization.
Boundaries of Efficiency (issue: cost) takes a legal-ownership view of atomistic boundary decisions.
Focusing on minimizing governance costs (organizations have decision-making and property rights to
