Business and Commercial Law

Business and commercial law

What is the difference between business law and commercial law?

We have to think of business as an activity (making shoes) and business law as the law of that activity. The same for corporation; we have to think of a corporation as an entity and corporate law as the law of the entity. So, we have to consider a corporation a business entity.

The difference between commercial law and business law is that the first specifically governs how corporations are administered and managed, while business law comprises different practice areas associated with business like employment, tax, contract, etc. Commercial law can be considered as a subset of business law.

There are many types of business law: corporate law, finance law, banking law, insolvency law, competition law, and intellectual property.

Few aspects of business law

Today’s corporations often operate across different jurisdictions and different countries; for this reason, professionals are practicing in a linked business world that produces economic problems treated in different ways in each national law solution. From a comparative point of view, we can see that each solution is at the same time divergent and uniform.

Some goals of this course are the following: define corporate law, identify the key classes of corporate stakeholders, set of agency problems among stakeholders, underline legal strategies to mitigate agency problems, and clarify how those strategies vary with circumstances using a functional approach across jurisdictions.

Corporate law provides students with the legal background necessary to understand the steps of the business law life of a corporation. The course will provide students with important examples like bank regulation and supervision.

Corporate law

Business corporations have a similar set of legal characteristics and face similar legal problems in all jurisdictions around the world. The principal functions of corporate law are twofold: the first is to provide business enterprises with a legal form that possesses these five characteristics: legal personality, limited liability, transferable shares, delegated management under a board structure, and investor ownership. The second principal function of corporate law is to reduce the costs of organizing business through the corporate form. Corporate law also facilitates coordination among participants in the corporate enterprise and minimizes the agency problems.

We study corporate law through a functional approach, organizing discussions around the ways in which corporate laws respond to these problems, and the various forces that have led different jurisdictions to choose roughly similar solutions to them.

Most of corporate law can be understood as responding to three principal sources of opportunism that are spread in the organization: conflicts between managers and shareholders, conflicts between controlling and non-controlling shareholders, and conflicts between shareholders and the corporation’s other contractual counterparties (creditors and employees). These three conflicts are characterized by what is called agency problems.

The five characteristics of business corporations have strongly complementary qualities and together make the corporation more attractive for organizing productive activity but at the same time generate tensions and tradeoffs that corporate law must address.

1. Legal personality

In the economics literature, a firm is often characterized as a nexus of contracts. This is invoked because the most important relationships within a firm are essentially of contractual character, for example, contracts between the firm owner and the managers. This is an important insight but it doesn’t distinguish firms from other networks of contractual relationships, so it is more accurate to describe a firm as a nexus for contracts, in the sense that a firm serves fundamentally as the common counterparty in numerous contracts with suppliers, employees, etc., coordinating the action of these multiple persons through the exercise of its contractual rights. The most important contribution of corporate law is to permit a firm to serve this coordinating role by operating as a single contracting party that is distinct from the various individuals who own or manage the firm.

The core element of the firm as a nexus for contracts is what civil lawyers refer to as separate patrimony. This involves the separation of the assets that are distinct from other assets owned by the firm’s owners (shareholders) and of which the firm itself, acting through its designed manager, is viewed in law as being the owner. The firm ownership over its assets includes the right to use the assets, to sell them, and to make them available for attachment by its creditors. Conversely, because these assets are conceived as belonging to the firm rather than the firm’s owner, they are unavailable for attachment by the owners’ personal creditors, making clear the core function of separate patrimony, called entity shielding. It shields the assets of the entity from the creditors of the entity’s owner.

Entity shielding involves two distinct rules of law. The first is a priority rule that grants 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. The consequence of the priority rule is that firms' assets are automatically made available for the enforcement of contractual liabilities entered into in the name of the firm. The second rule is the liquidation protection, which provides that the individual owners of the corporation (shareholders) cannot withdraw their share of firm assets at will. The liquidation rule serves to protect the going concern value of the firm against destruction by individual shareholders or their creditors, meaning that corporate law protects the value of the firm at the moment in which the firm is going in the market producing its goods.

For a firm to serve effectively as a contracting party, two other types of rules are also needed. First, there must be rules specifying to third parties the individuals who have authority to buy and sell assets in the name of the firm and to enter into contracts that are bonded by those assets. Generally, the manager can buy or sell assets in the name of the firm. Second, there must be rules specifying procedures by which the firm and its counterparties can bring lawsuits on the contracts entered into in the name of the firm. Corporations are subject to rules that make such suits easy, in particular by eliminating any need to name the firm’s owner.

2. Limited liability

The corporate effectively provides a default term in contracts between a firm and its creditors whereby the creditors are limited to making claims against the assets owned by the firm itself and have no claim against assets the firm’s shareholders hold in their own names. Limited liability shields the shareholders from creditors' claims. With unlimited liability, the risk to the shareholders would be big. So, if there is unlimited liability, shareholders want to keep the risk of the company under control, making it difficult to invest in more companies. Instead, with limited liability, there is no risk. Owner shielding is the opposite of entity shielding; the first protects shareholders’ assets from creditors of a firm, while the second protects assets from creditors of shareholders.

These forms of asset shielding (asset partitioning) ensure that business assets are pledged as security to business creditors, while the personal assets of the business owners are reserved for the owner’s personal creditors. When we refer to limited liability, we refer to limited liability in contracts, so to creditors who have contractual claims on the corporation, and not to persons.

3. Transferable shares

Fully transferable shares permit the firm to conduct business uninterruptedly as the identity of owners changes. It enhances the liquidity of shareholder interest and makes it easier to maintain diversified portfolios. Transferability is the flipside of the liquidation protection that the legal personality assures to contractual counterparties. Legal personality permits the free transferability of all of a firm’s contracts taken together (bundle assignability) by transferring the corporation’s shares, while preserving the default rule that requires consent of the counterparty.

Fully transferable shares are different from freely tradable shares; even if they are transferable, they may not be tradable without restrictions in public markets, but rather just transferable among limited groups of individuals or with the approval of shareholders or the corporation. Free tradability maximizes the flexibility of raising capital and also the shareholder’s liquidity and portfolio diversification. All jurisdictions provide for free tradability of at least one class of corporation and mechanisms for restricting transferability (by separate statute or as an option under corporation statute).

We refer to public corporations as the ones with freely transferable shares and listed or publicly traded corporations as the ones with shares listed for trading on a stock exchange. Then we have closely/widely held shares that are shares held by a small/large number of people. Transferability of shares is closely connected both with the liquidation protection and limited liability; the absence of either of these features means that the creditworthiness of the firm could change as the identity of shareholders changes. Consequently, the share’s price is difficult to judge; ensuring a single price for shares permits security markets to aggregate information about future performance.

4. Delegated management with a board structure

Legal forms of enterprise organization differ in their allocation of control rights, including the authority to bind the firms to contracts, to exercise powers granted by contracts, and to direct the uses made of a firm’s assets. Corporate law typically vests principal authority over corporate affairs in a board of directors that is personally elected. Business corporations are distinguished by a governance structure in which fundamental decisions are delegated to a board of directors with four characteristics. First, the board is separated from operational managers: it divides corporation decisions that do not require shareholders’ approval into those requiring the board of directors’ approval and those that can be made by the firm’s hired officers. Second, the board is elected by shareholders to ensure the interests of the firm’s owners. Third, the board is formally distinct from the shareholder; it economizes the cost of decision-making. Fourth, the board ordinarily has multiple members, facilitating mutual monitoring.

5. Investor ownership

There are two key elements in the ownership of a firm: the right to control the firm and the right to receive the firm’s net earnings. The right to control involves voting in the election of directors and approval of major transactions; the net earnings instead are proportional to the amount of capital contributed to the firm. The dominance of investor ownership among large firms is due to the efficiency advantages of that form: investor protection, reduction of costs of conflicts (due to the homogeneous interests among them), and specialization (kind of business).

Sources of corporate law

All jurisdictions have at least one core statute that establishes a basic corporate form and is designated particularly to permit the formation of public corporations. Anyway, it extends well beyond the bounds of core statute.

Special and partial corporate forms

Major jurisdictions have at least one distinct statutory form specialized for the formation of closed corporations. They differ from open or public corporations because their shares are not freely tradable shares; there is the possibility of substitution of the board with direct management by shareholders, and there could be special allocation of control and earning rights. Jurisdictions also have quasi-corporate statutory forms used to form business corporations with all five characteristics, though some must be added by contract.

Other bodies of law

There are bodies of law that are contained in separate statutes or case law that are separated from the core corporation statutes, for example, securities law, stock exchange rules, insolvency law, and tax law.

Law versus contract in corporate affairs

Relationships among a corporation’s participants are contractual. The principal contract that binds them is the corporation charter (constitution), which sets out the basic terms of the relationships among the firm’s shareholders and among shareholders and directors or managers. Corporations are the subject of statutory law, which defines the basic elements of the corporation by contract.

Default vs mandatory laws: parties can depart and negotiate their own default rules; mandatory rules are not subject to contrary agreement. Benefits of legal rules: provide standard information and supplementary function (gap-filling) of incomplete contract rules. Choice of legal regime: choice among multiple regulatory regimes.

Goal of corporate law

The overall objective of corporate law is to serve the interest of society as a whole, in particular to pursue social welfare, reduce costs of contracting among shareholders and maximize financial returns to shareholders and the market price of shares.

Chapter 2: Agency problems and legal strategies

Corporate law performs two general functions: first, it establishes the structure of corporate form, and second, it attempts to control conflicts of interest among corporate constituencies, including those between corporate insiders (shareholders or managers) and outsiders (minority shareholders or creditors). These conflicts all have the character of agency problems.

The core problem lies in motivating the agent to act in the principal’s interest rather than its own interest; the control over the agent’s actions results in costly monitoring (agency costs). Another problem arises whenever one party (principal) relies upon actions taken by another party (agent), which will affect the principal’s welfare. In particular, almost all contractual relationships in which one party promises to perform to another are subject to agency problems.

There are mainly three conflicts of interest: the first is between owners and hired managers, where the owners are the principal and the managers the agents. Here, we need managers to be responsive to the owners’ interests. The second is the conflict between owners who possess the majority or controlling interest in the firm and the minority or non-controlling owners. The third involves the conflict between the firm itself and other parties like employees, creditors, and customers. In each of these situations, the challenge of assuring agent responsiveness is greater where there are multiple principals. In particular, the more difficult it is for the principals to coordinate on a single set of goals for agents, the harder it is to ensure the agent’s right behavior. Moreover, difficulties in coordinating lead the principals to delegate more of their decision-making to agents.

Law can play an important role in reducing agency costs, but paradoxically, mechanisms that impose constraints on agents’ ability to exploit their principals tend to benefit agents as much as principals. The reason is that a principal offers greater compensation to an agent when assured of performance. In general, reducing agency costs is in the interest of all parties to a transaction (one of the normative goals of corporate law is to search for optimal solutions).

Legal strategies for reducing agency costs

In addressing agency problems, the law turns to a basic set of legal strategies (generic methods of developing law instrumentally in a functional way), implemented to mitigate the vulnerability of principals for the opportunism of their agents. The legal strategies can be divided into regulatory strategies: they dictate substantive terms that govern the content of the principal-agent relationship, tending to constrain the agent’s behavior directly. The second is the governance strategies: these tend to focus on facilitating the principal’s control over agents’ behavior.

The efficiency of regulatory strategies depends on the ability of external authority (court) to determine if the agent complied with prescriptions; these strategies rely on a legal institution to protect the principal’s decision-making entitlements but do not specify appropriate courses of action. The efficiency of governance strategies depends on the principal’s ability to exercise their control rights, thus high coordination costs render governance strategies less successful in controlling agents; principals are able to observe agents’ actions.

Regulatory strategies

The table below sets out 10 legal strategies which taken together span the law’s principal methods of dealing with agency problems. Ex-post means that strategies face full effect before an agent acts or respond to the quality of agent’s actions when performed.

The most familiar pair of regulatory strategies constrains agents by commanding them not to take courses of action that would harm the interests of their principals. Such agent constraints are framed as rules or as general standards (both attempt to regulate the substance of the principal-agent relationship directly). Rules require or prohibit specific behaviors, in particular, prescribe specific behaviors ex ante; can be mechanically enforced but require effort invested ex ante by rule-making bodies to ensure they are appropriately drafted. General standards leave the precise determination of compliance to adjudicators after the fact, determine ex post whether violations have occurred, and require courts to become more deeply involved in evaluating corporate decisions ex-post.

A second set of regulatory strategies open to the law involve regulating the terms on which principals affiliate with the agents (rather than regulating the actions of agents after the principal-agent relationship is established as with rules and standards). The law can dictate terms of entry; the entry strategy is important in screening out opportunistic agents in public capital markets or prescribe exit opportunities for principals. The exit strategy allows principals to escape opportunistic agents. Broadly speaking, there are two units of exit rights: the right to withdraw (the value of investment) and the right to transfer (right to sell shares).