BUSINESS ORGANISATIONS AND CORPORATE FINANCE LAW
Business organisations theory vs property rights theory vs contractual theory
+ different features of business organisations, origins, evolution
Before: business organisations theory based on contract approach
Now: business organisations theory based on property rights
Main argument: Organisational law as set of proprietary rights arrangements, creating rights in rem
(attached to assets) among individuals allowing for the partition of assets with third party effects, in
addition to contractual obligations ⇒ whole purpose of organisational law is to separate between
ownership and control → separate assets in legally recognisable way
Week 1. Contracts approach [traditional view]
● [Jensen and Meckling] Corporations are legal fictions serving as nexus of several contracts
among individuals who form and interact with the organisation, and with residual claims on
assets [firm = nexus of contracts]
○ Agency costs: sum of (positive) cost of monitoring, cost of bonding, residual loss
(reduction in welfare from divergences between agent’s decisions and decisions that
would maximise the principal’s welfare) ⇒ aim to solve agency problems from moral
hazard and information asymmetries arising from observability issues
🟪🔷lending/nutella/tesla: Affects financing decisions! Inside / outside equity & debt
- Equity: from separation of ownership and control – different incentives, moral hazard
- Debt: risk shifting (asset substitution) and debt opportunism
→ different agency costs related to each method, choose the one that limits P-A problem
⇒ choosing bonding / monitoring costs depending on whether profitable or not
★ [Alchian and Demsetz] Linked to shrinking and monitoring costs for team production
Building upon this and saying that firm is not only team production, but about all A-P
relationships!
● [Berle and Means]: Ownership and control separated in large corporations
⚠️this is a problem in contractual view, but a feature under proprietary view! Whole point is
to separate assets from individuals in legally recognizable way.
Shortcomings
⇒ Need additional theory complementing contracts approach!!
1. Problems arising from third parties outside those contracts (because privity in contract law)
2. Firm as a black box, not explaining organisation, how conflicting interest into equilibrium
3. ROLE OF LAW: Organisation law as set of default rules (customisable contractual arrangements)
→ little to no role given to mandatory rules! law not doing much to shape organisations
, - Facilitating these contractual processes by providing set of default rules because both parties
with incentive to solve issue because both with a stake in the firm
- Enforcing the contracts based on free governance structure
Firm as nexus of Organisations as legal fictions serving as nexus for contracting relationships among
contracts individuals, and promoting efficiency. Separation of ownership and control in these
contractual relationships leading to agency problem
Agency theory Moral hazard where if P and A are utility maximisers, will not be doing things in the others'
interests, leading to monitoring, bonding costs and residual loss
Outside equity Agency problem influences ownership structure and financing decisions --> outside
investors willing to pay less because expecting manager to be subject to moral hazard
because of separation between ownership and control >< higher costs of capital so
manager choosing something else. Equity and debt generate different agency costs so
these will determine which one chosen!
Role of the law Organisational law is contract law (set of default rules that can be tailored), main role is to
address agency problem (agent not doing things in the interest of the principal) --> little to
no role for the state because parties themselves know best how to solve this issue. Provide
set of default organisational arrangements that most P-A will adopt, facilitate parties'
organisational choices
Property rights
Different meanings given to it
Stable ownership (vertical) Residual control right Right in rem
Set of protected mandatory rules Property as owner’s residual Property rights attached to
embedded in set of institutions right to control assets after the assets and they are good
(serving as protection against rights assigned to others by erga omnes, enforceable
expropriation from the elite, contract have been satisfied against third parties +
constraining rulers and other [Grossman, Hart and Moore] notice!!
potential takers) = theory of the firm Valid irrespective of express
agreements.
Solving negotiation problems in Solving incomplete contracts Solving issues arising from
contracts because unmodifiable issue, assigning residual privity of contracts &
ones have greater impact on contingencies incompatible contracts
economy [Coase] assigning incompatible rights
Criticisms: to different individuals1
- contracts can be completed ex
post by courts (interpretative + problem of notice (third
and gap filling function) parties entering into contracts
- leaving contracts incomplete not knowing that they are
on purpose bad, because contracts are
- residual control rights can still invisible)
be allocated through contracts
1
Ownership with sequential structure (rights following from previous owners) and can have mistakes, abuses
leading to two competing claims on same assets!
Business organisations theory vs property rights theory vs contractual theory
+ different features of business organisations, origins, evolution
Before: business organisations theory based on contract approach
Now: business organisations theory based on property rights
Main argument: Organisational law as set of proprietary rights arrangements, creating rights in rem
(attached to assets) among individuals allowing for the partition of assets with third party effects, in
addition to contractual obligations ⇒ whole purpose of organisational law is to separate between
ownership and control → separate assets in legally recognisable way
Week 1. Contracts approach [traditional view]
● [Jensen and Meckling] Corporations are legal fictions serving as nexus of several contracts
among individuals who form and interact with the organisation, and with residual claims on
assets [firm = nexus of contracts]
○ Agency costs: sum of (positive) cost of monitoring, cost of bonding, residual loss
(reduction in welfare from divergences between agent’s decisions and decisions that
would maximise the principal’s welfare) ⇒ aim to solve agency problems from moral
hazard and information asymmetries arising from observability issues
🟪🔷lending/nutella/tesla: Affects financing decisions! Inside / outside equity & debt
- Equity: from separation of ownership and control – different incentives, moral hazard
- Debt: risk shifting (asset substitution) and debt opportunism
→ different agency costs related to each method, choose the one that limits P-A problem
⇒ choosing bonding / monitoring costs depending on whether profitable or not
★ [Alchian and Demsetz] Linked to shrinking and monitoring costs for team production
Building upon this and saying that firm is not only team production, but about all A-P
relationships!
● [Berle and Means]: Ownership and control separated in large corporations
⚠️this is a problem in contractual view, but a feature under proprietary view! Whole point is
to separate assets from individuals in legally recognizable way.
Shortcomings
⇒ Need additional theory complementing contracts approach!!
1. Problems arising from third parties outside those contracts (because privity in contract law)
2. Firm as a black box, not explaining organisation, how conflicting interest into equilibrium
3. ROLE OF LAW: Organisation law as set of default rules (customisable contractual arrangements)
→ little to no role given to mandatory rules! law not doing much to shape organisations
, - Facilitating these contractual processes by providing set of default rules because both parties
with incentive to solve issue because both with a stake in the firm
- Enforcing the contracts based on free governance structure
Firm as nexus of Organisations as legal fictions serving as nexus for contracting relationships among
contracts individuals, and promoting efficiency. Separation of ownership and control in these
contractual relationships leading to agency problem
Agency theory Moral hazard where if P and A are utility maximisers, will not be doing things in the others'
interests, leading to monitoring, bonding costs and residual loss
Outside equity Agency problem influences ownership structure and financing decisions --> outside
investors willing to pay less because expecting manager to be subject to moral hazard
because of separation between ownership and control >< higher costs of capital so
manager choosing something else. Equity and debt generate different agency costs so
these will determine which one chosen!
Role of the law Organisational law is contract law (set of default rules that can be tailored), main role is to
address agency problem (agent not doing things in the interest of the principal) --> little to
no role for the state because parties themselves know best how to solve this issue. Provide
set of default organisational arrangements that most P-A will adopt, facilitate parties'
organisational choices
Property rights
Different meanings given to it
Stable ownership (vertical) Residual control right Right in rem
Set of protected mandatory rules Property as owner’s residual Property rights attached to
embedded in set of institutions right to control assets after the assets and they are good
(serving as protection against rights assigned to others by erga omnes, enforceable
expropriation from the elite, contract have been satisfied against third parties +
constraining rulers and other [Grossman, Hart and Moore] notice!!
potential takers) = theory of the firm Valid irrespective of express
agreements.
Solving negotiation problems in Solving incomplete contracts Solving issues arising from
contracts because unmodifiable issue, assigning residual privity of contracts &
ones have greater impact on contingencies incompatible contracts
economy [Coase] assigning incompatible rights
Criticisms: to different individuals1
- contracts can be completed ex
post by courts (interpretative + problem of notice (third
and gap filling function) parties entering into contracts
- leaving contracts incomplete not knowing that they are
on purpose bad, because contracts are
- residual control rights can still invisible)
be allocated through contracts
1
Ownership with sequential structure (rights following from previous owners) and can have mistakes, abuses
leading to two competing claims on same assets!
