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Updated 04/28/11 10:11:00 PMPage 1 of 58
Class 1 (August 18)
§ 1Exam Information
Exam will be take-home. Response of about 1,200 words is expected.
§ 2Overview of Corporations
When we talk about “corporations,” we generally mean publicly tradedcorporations. Publicly traded corporations are distinguished from other types of corporations, such as limited liability corporations (LLCs).
§ 3What is a corporation?
Prof. Goshen: “A corporation is a make-believe game for adults.” A corporation isa legal person whose existence is specified in a paper document. A manager isthen appointed to make the corporation “do” things.
§ 4The First Corporations Case
In
Solomon v. Solomon Inc.
, Adam Solomon owned a business in which producedletter products. Adam wanted to organize his business as a corporation. At thattime, the law required that at least seven people participate in the formation of acorporation. The corporation had 1,000 shares, of which 994 were owned byAdam. The remaining six shares were owned by his wife and children. Adam thensold the letter-making business to his corporation. Of course, the seller was Adamin his personal capacity whereas the buyer was the corporation. Because Adamasked for a price that was higher than what the corporation’s assets allowed, Adamdecided to give a loan to his corporation. The sale created a situation in which thecorporation owed Adam some amount (let’s say £1,000). Adam thereby became asecured creditor.As it turned out, the business ultimately failed. Adam claimed that he, as asecured creditor, meant that he had first dibs to the corporation’s remainingassets. Adam prevailed on appeal, where the court said that the corporation wasnot an “alter-ego” of Adam. Rather, it was to be treated as an entirely separatelegal entity. The court said that the other creditors should have realized thatcorporation was a distinct entity even though Adam had made the loan to“himself.”
§ 5A Second Corporations Case
In
Lee v. Lee’s
, Lee created a corporation that owned one small aircraft used foragricultural purposes. Lee owned the vast majority of the shares and piloted theairplane. One day, the aircraft crashed, with Lee dying in the accident. Thecorporation, however, continued to “live.” The shares that formerly belonged toLee passed via inheritance to his wife. His wife proceeded to sue the corporationfor compensation for Lee’s death. Because the wife was acting as a manager of the corporation, she was effectively on the receiving end of the suit. The point of the exercise was to extract compensation from the British social-security system,
 
Updated 04/28/11 10:11:00 PMPage 2 of 58which provided compensation for deaths in workplace accidents. The social-security system made the argument that Lee was not an employee of thecorporation. The court said nothing prevents a person from being an employee of a corporation while also serving in other capacities (such as a manager). Pointingto the fact that Lee had signed an employment contract with the corporation, thecourt found that Lee was indeed an employee of the corporation. Note that oneparty to the contract was Lee in his individual capacity and the other was Lee in hiscapacity as an agent of the corporation.
§ 6A Hypothetical
Suppose that Lee planned to smuggle drugs using his airplane and that the policehad enough probable cause to arrest Lee. Could Lee be convicted of conspiringwith his corporation to smuggle drugs? (From the standpoint of criminal law, thistheory does not fly because there is no
actus reus
.) Courts have declined toimpose liability for this sort of “self-conspiracy.”Alternatively, suppose that there were two managers of the corporation whoconspired to smuggle drugs. In this case, criminal liability could attach becausethere are three parties: the two managers and the corporation.
§ 7In Summary
A corporation is a fiction, but a fiction that can sign contracts, commit torts, andeven commit crimes under the right circumstances.
§ 8The Business Perspective
Consider the individuals and entities with which a corporation has relationships:shareholders, managers, creditors, suppliers, employees, consumers, othercorporations, the government, and so forth. Each type of contact falls under somelegal regime. Employees, for example, fall under the protection of employmentregulations. Consumers fall under the law of products liability and contracts.Suppliers are likely to have security interests in certain goods. The general publicis likely to fall under the protection of environmental laws. The government islikely to impose taxes and regulations. Other corporations fall under the protectionof antitrust laws.When we speak of “corporate law,” we usually refer to the laws that govern acorporation’s relationships with shareholders, managers, and creditors. Withregard to creditors, corporate law addresses only those obligations thatcorporations have when they are “alive.” (If a corporation is going bankrupt, itsobligations are governed by bankruptcy law.) This view of corporations essentially holds that corporate law addresses the nexusof contracts that sustains its relationships to other parties.
§ 9A Story
Mrs. Fields got a cookie recipe from her grandmother, which is well-received byfriends. Mrs. Fields decided to open a store to sell her cookies, which becomes a
 
Updated 04/28/11 10:11:00 PMPage 3 of 58success. Eventually, Mrs. Fields decides to open a second store and hires John torun it. At this point, she faces the problem of how to make sure that John does anacceptable job of running the store. This is the classic agency problem. The agency problem has two elements: (1) aninformation gap and (2) a conflict of interest. Here, the information gap consists of Mrs. Fields’s not knowing what John is up to at the second store. The conflict of interest is that John wants to shirk whereas Mrs. Fields would prefer that he work ashard as possible. Both ingredients must be present for the agency problem toexist.Mrs. Fields might try to solve the agency problem by entering into a contract with John for the purpose of imposing certain minimum requirements on hisperformance. Alternatively, she might install a camera in the second store in orderto monitor John. She might ask for regular accounting reports. She might sharesome of the profits with John, so that he has an incentive to do well.In practice, the solution is likely involve a mix of these approaches. Of course,implementing these measures will impose costs, known as “agency costs,” on thebusiness.Still, this does not solve the problem entirely. Suppose that John is intent onleaving the store at 5pm to play tennis with this girlfriend and that he valuestennis-playing at $50. On the other hand, the store stands to make $200 if it staysopen for the rest of the evening. If John’s share of the profits amounts to less than$50, he will close the store and leave. Of course, Mrs. Fields would prefer to walkin and offer him a $100 share of the profits, but this is impractical in mostcircumstances. These kinds of losses are known as “residual losses.”Of course, it makes sense to hire an agent only if the profits from the second storeexceed the agency costs. A business owner, such as Mrs. Fields, therefore wantsto minimize agency costs. Many businesses have solved this problem on a largescale. (Consider that McDonald’s manages thousands of stores worldwide.)Suppose that Mrs. Fields has solved the agency problem for the second store andwants to turn her two-store operations into a chain. Mrs. Fields approaches Dianeexpressing a desire for a $2M investment. In exchange, Mrs. Fields offers Diane a40% share in the profits.Now Diane is starting to worry. Perhaps Mrs. Fields will underreport profits. Mrs.Fields might start paying herself a much higher salary, which would reducereportable profits and thereby lower the amount to be paid to Diane.Suppose that Mrs. Fields decides to start a chocolate factory to manufacturechocolate chips for her cookie factories. As long as Mrs. Fields has 100%ownership of both the chocolate factory and the cookie factory, it doesn’t matterwhat price at which the chocolate is sold to the cookie factory. The only party thatcares is the IRS, which collects taxes on such transactions. This, however, creates a problem for Diane. Because Diane’s interest comes solelyfrom the profit from the cookie factory, Mrs. Fields has an incentive to lower the
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