1. Evolution of Corporate Law & Finance Business Associations Section 7c Evolution: Forces shaping modern corporate law Prof. Amitai Aviram Aviram@illinois.edu College of Law University of Illinois Copyright © Amitai Aviram. All Rights Reserved S12D

2. Evolution Overview of Section 7c 1. Regulatory competition Race to the bottom? Race to the top? Competition with federal law 2. The business cycle 3. Political economy of the primacy debate 4. Legal origins 5. The future of business entities

3. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Competition & the market In a market, competition forces firms to offer better terms to customers Example I go to the Meijer to buy milk. I did not comparison shop and have no idea what a “good” price would be. Nonetheless, I am likely to benefit from a competitive price Meijer faces competition (e.g., Wal-Mart, IGA)  I.e., shoppers don’t lose much by turning to competing firms A sufficient number of other shoppers do comparison shop, and they would shift to a rival if prices were not competitive

4. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Competition & the market for law Law was traditionally seen as offering no competition State can use violence to enforce its laws State has monopoly over law in its jurisdiction But some activities can move between jurisdictions E.g., use a Delaware or an Illinois corporation; have my manufacturing activities in US or in China; keep my money in UK or in France Laws governing such activities may be subject to the same constraining forces that face firms in a competitive market

5. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition How much competition? The extent & impact of regulatory competition depends on the same forces as in other markets How easy is it to shift the activity to another jurisdiction People have preferences as to where they live; likely won’t leave Illinois just because I find another state’s criminal laws a bit better Likewise, some assets are tied to a specific location (e.g., distribution facilities, proximity to complementary services) But money is easy to move around & constitutional doctrines restrict a state’s ability to thwart regulation by another state Who are the “comparison shoppers” & how attentive are they to the details of the law? Most people have little knowledge of details of the local law But for big transactions one can hire professionals (lawyers, accountants, investment bankers) who pay attention to the law

6. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Competing over corporate law Therefore, competition over corporate law is stronger than most areas of law Involves money, which is easy to transport Dormant commerce clause prevents states from forcing businesses to use their corporate law Big financial stakes, so stakeholders can hire professionals to figure out where to incorporate

7. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Who is competing? Traditional view State vs. state The narrative: states want franchise fees from corporations, so they adjust their laws to attract incorporations But how do states adjust the laws? “Race to the bottom”: Since directors & officers, rather than SHs, decide where to incorporate, states compete by preferring efficiency to accountability (“pro-management”) “Rate to the top”: SHs don’t decide where to incorporate, but they decide which company to invest in. If they didn’t like a given state’s laws, they would look to invest in other companies that incorporate in a state with better laws Thus, directors & officers would choose a state that prefer accountability to efficiency (“pro-SH”), in order to entice SHs to invest in their corporation So, to appeal to directors & officers, states need to be “pro-SH”

8. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Problem with the traditional view Not much is going on in state v. state competition NJ was the dominant player until it voluntarily bowed out when Woodrow Wilson was its governor (1913) Since then, Delaware dominated Where’s the competition? Response 1: Only small states can credibly compete Why don’t we see vigorous competition from Wyoming, Vermont, Montana, Rhode Island? Response 2: Competition is vigorous, but Del. keeps winning Staying on top under vigorous competition for 100 years? Why doesn’t a plausible #2 emerging? If Del. always wins & #2 gets nothing, why bother competing?

9. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition Problem with the traditional view So what’s going on? Perhaps there’s room for just one national standard, and as long as any state offers this, it has the entire market No incentive for other states to compete unless incumbent bows out What maintains the standard? Perhaps nothing – as long as the law allows current transactions to go through, business world converges on a single corporate law Perhaps some level of concern to efficiency vs. accountability – if Delaware gets it really wrong, it might create room for a rival  This is a weakened version of the “race to” theories Perhaps process & not substance – efficient, knowledgeable courts

10. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition An alternative view Federal v. state The narrative: Del. competes against the Fed. government, which uses securities laws to regulate same issues But what kind of competition is that? Federal government has power to preempt states

11. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition A nuanced alternative view Delaware plays “divide & conquer” with federal gov Positions itself to preempt agreement bw/ House & Senate “Pro-SHs” (accountability at expense of efficiency) “Pro- management” (efficiency at expense of accountability) HouseSenateDelaware A B House Senate Delaware A B House Senate Delaware A B

12. Copyright © Amitai Aviram. All Rights Reserved Regulatory competition A nuanced alternative view Delaware acts to address has two interests Avoid preemption This was explained in the previous slide Maximize incorporations This is where the “race to” theories still matter – will it maximize incorporations by being “pro-SH”, or “pro-management”? Previous slide assumed Delaware prefers “pro-management”  If it preferred “pro-SH” & House is still to left of Senate, Delaware could flank House from the left “Pro-SHs” (accountability at expense of efficiency) “Pro- management” (efficiency at expense of accountability) HouseSenateDelaware A B

13. Evolution Overview of Section 7c 1. Regulatory competition 2. The business cycle The business cycle & development of corporate law The bubble law problem Case study: the Sarbanes-Oxley Act Law as a tool to manipulate the public’s risk perceptions 3. Political economy of the primacy debate 4. Legal origins 5. The future of business entities

14. Effect of conspicuous law enforcement on behavior of non-perpetrators How the business cycle affects law Economic effect of the “perp walk” Conspicuous law enforcement Individuals’ risk perception Individuals’ behavior “Nothing paints a picture as well as people being led away in handcuffs” – Walter Ricciardi, SEC

15. When Do Prosecutors Enforce Securities Laws? Empirical Evidence Cyclical Enforcement: Little during boom, plenty after bust

16. When Do Prosecutors Enforce Securities Laws? Theory Conspicuous enforcement is greatest when the perception gap (perceived risk - actual risk) is greatest

17. Example Assume risk of company insiders committing fraud is 0.002% (1:50K) But public misperceives risk to be 1% AG launches anti-fraud initiative (conspicuous law enforcement) Insiders deterred: 50% reduction in objective risk, to 0.001% AG “oversells” initiative; Claims 99% reduction (to perceived risk of 0.01%) Private benefits to AG: Public observes that actual occurrences are closer to 0.01% than 1%; lends credibility to AG’s claims

18. Narrowing the perception gap: Over-estimation of fraud reduced from 0.998% to 0.009% ~111 times less misperception Perceived Risk (%) Actual Risk (%) Perception Gap Before10.0020.998% After0.010.0010.009% Example

19. Perception gap reduces social welfare: Excessive avoidance of equity investments Excessive self-policing of companies Excessive political pressure to regulate Narrowing the perception gap increases social welfare Example Effect on Social Welfare

20. Bias Arbitrage Commodity Arbitrage Identify gap in price of gold in NY & London Take an action that creates private profits while also closing the price gap Bias Arbitrage Identify gap between objective & perceived risk Take an action that creates private benefits while also closing the perception gap

21. Is Cyclical Enforcement a Form of Bias Arbitrage? I.e., does the public over-estimate fraud more following a bust?

22. Does the public over-estimate fraud more following a bust? Cognitive Biases

23. Does the public over-estimate fraud more following a bust? Relevant Cognitive Biases Self-serving bias Stock goes up – must be my investment skills Stock goes down – must be fraud Availability bias Economic hardship removes veil that masks fraud Economic downturn causes hardship to many firms at once Attribution discounting Fraud rises as a possible cause of downturn Causes people to discount other causes

24. This could have been the end, but then this paper would be called … Counter- Cyclical Enforcement of Corporate Law

25. The Dual Message of Conspicuous Law Enforcement When Jane Doe hears that the SEC is investigating Acme Corp. for fraud, does she think: “The SEC is effective in catching fraud!” (i.e., Ajax Corp. is less susceptible to fraud) Need to invest less in addressing risk Or: “I didn’t realize there’s so much fraud going on!” (i.e., Ajax Corp. is more susceptible to fraud that I thought) Need to invest more in addressing risk

26. Reworking the Example Same assumptions as before, except that enforcement exacerbates perceived risk by 99% (to 1.99%) Perceived Risk (%) Actual Risk (%) Perception Gap Before10.0020.998% After1.990.0011.989% Perception gap increased Excessive avoidance Excessive self-policing Excessive political pressure

27. A vicious enforcement cycle… Public over- estimates risk Incentives for conspicuous law enforcement Conspicuous law enforcement Excessive avoidance / self-policing / political pressure Enforcement increases perception of risk

28. Solution? Counter-cyclical enforcement Enforce more when public under-estimates fraud (boom) to increase risk perception Enforce less when public over-estimates fraud (after bust) to prevent exacerbating risk perception But prosecutors’ incentives favor cyclical enforcement… Article suggests mechanisms to modify these incentives

29. Evolution Overview of Section 7c 1. Regulatory competition 2. The business cycle 3. Political economy of the primacy debate [Omitted] 4. Legal origins 5. The future of business entities

30. Evolution Overview of Section 7c 1. Regulatory competition 2. The business cycle 3. Political economy of the primacy debate 4. Legal origins [Omitted] 5. The future of business entities

31. Evolution Overview of Section 7c 1. Regulatory competition 2. The business cycle 3. Political economy of the primacy debate 4. Legal origins 5. The future of business entities A brief history of business entities End of the public corporation? End of private equity? Resurgence of large-scale unincorporated business entities?

32. A brief history of business entities

33. A brief history of business entities Dawn of civilization Initially, business activity was conducted by the Tribal Firm (and later - the Family Firm). No rights to individuals Enforcement by the family/tribe, not by a legal system.

34. A brief history of business entities Pre-classical era As civilizations developed legal systems that granted rights and imposed obligations on individuals, two business entities formed: Sole Proprietorship (General) Partnership

35. A brief history of business entities Early middle ages A new entity develops under Byzantine, Jewish & Muslim laws to allow participation in profits without control of the business: the Limited Partnership One of the original purposes of this entity was to avoid prohibitions on charging interest on loans This entity is not adopted by U.S. law until the 19 th Century

36. A brief history of business entities Early middle ages Also at the same time, a specialized form of partnership forms for mining and shipping ventures – the Joint Stock Company. It is a general partnership in which membership is evidenced by the ownership of shares, and those shares can be sold to others. Stora Kopparberg, a Swedish company, is likely the oldest surviving JSC. It issued stock at least as early as 1288.

37. A brief history of business entities Late middle ages Two institutions, that will later give birth to the modern corporation, develop: The guild is a club that receives from the ruler a monopoly on trade in the region, and self-regulates its members. The ”body corporate” (“corporation”) is a legal fiction, used first for the king and the church, and later for religious and educational entities. Gradually, it was accepted that the king could create corporations. Later this power was also given to parliament. At that time, corporations were not used for commercial purposes.

38. A brief history of business entities Age of exploration Exploration and exploitation of the new world requires a large initial investment. European powers “privatize” exploration by granting groups of merchants monopoly over trade (and plunder) overseas. So much capital was needed that many investors had to be tapped, and receive the monopoly together. The chartered corporation, a hybrid of the guild & (old) corporation, begins to be used for semi- commercial purposes. E.g.: The Hudson Bay Company, The Virginia Company, The Massachusetts Bay Company

39. A brief history of business entities Early industrial age Industrialization exploited economies of scale, which required huge investments. It was expensive to get the king or parliament to charter a corporation, and government liked to intervene in the business of chartered corporations. To avoid regulation, businesspeople use the Joint Stock Company. Trade in shares soars.

40. A brief history of business entities The south sea bubble In 1711, the South Sea Company was chartered with a monopoly on trade with Spanish South America. Bad relations between Spain and England made such trade unviable. So, the company decided instead to buy all of England’s national debt in return for shares in the company. The company was very successful in selling its shares. In a financial frenzy, shares went up from £128 in January 1720, to £890 in June.

41. A brief history of business entities The Bubble Act Many unchartered JSCs jumped on the bandwagon, promising quick fortunes. To protect the South Sea Company from rivals (and maybe to protect investors from fraud), Parliament passed the Bubble Act in June 1720, prohibiting JSCs unless they were chartered.

42. A brief history of business entities The bust of the south sea bubble Bursting the JSC bubble led to the burst of the South Sea Company bubble. Its shares dropped from £1,000 in August to £150 in September. Bankrupt investors defaulted on loans, which resulted in a bankruptcy of banks. Inquiries revealed widespread fraud among the company’s directors. The result was a deep-seated suspicion of corporations. The Bubble Act was not repealed until 1825, and corporate charters were sparsely granted.

43. A brief history of business entities In the aftermath of the bubble JSCs now illegal; corporate charters are rarely granted. But investors still needed a business entity that would allow raising large amounts of money (i.e., that would accommodate many investors). They modified the common law institution of a trust to form the Business Trust – a creature that was trust in form and corporation in substance. The trustee would manage the trust for the benefit of the beneficiaries, who could transfer their rights by selling their certificates.

44. A brief history of business entities Moving to the U.S. In colonial times, states claimed the power to form corporations. An early conflict with England over the purported incorporation by Massachusetts of Harvard University. Following independence, U.S. courts clarified that the Bubble Act did not apply, so JSCs were legal. States chartered corporations, but the process was rare and expensive, and mostly used for public utilities: turnpikes, canals, etc. As an alternative to chartered corporations, the business trust thrived in Massachusetts, and became known as the “Massachusetts trust”.

45. A brief history of business entities General incorporation statutes U.S. states had general incorporation statutes to allow churches to incorporate without legislative “permission” Seen as a protection of religious freedom.

46. A brief history of business entities General incorporation statutes States competed in attracting business by expanding general incorporation statutes to commercial enterprises The first commercial U.S. general incorporation statues was passed by New York in 1811, boosting industries hurt by the Embargo Act. Early statutes were straightjackets, limited the life of the corporation (e.g., to 20 years) and the business activities that it can engage in, and did not always limit liability.

47. A brief history of business entities The dominance of the corporation The development of railroads and other industries that required raising massive amounts of capital created an increasing demand for corporations. Over time, general incorporation statues became more flexible, allowed for limited liability and unlimited duration, and applied to all business activities. Corporation dominated the business scene, pushing the business trust & limited partnership to niches.

48. A brief history of business entities Proliferation of corporation types As corporations became ubiquitous, law begins to distinguish between different types of corporations: Distinction between Close Corporations (which were treated similar to partnerships) and Public Corporations (around which extensive corporate and securities laws developed). Distinction in the tax code between C Corporations, which were taxed as separate entities, and S Corporations, which allowed their shareholders to consider the corporation’s gains and losses as their own for tax purposes.

49. A brief history of business entities The end of corporate dominance? The dominance of the corporation made public opinion more accepting of the concept of limited liability Ironically, this acceptance is now leading to a challenge to the corporation’s hegemony

50. A brief history of business entities The end of corporate dominance? A more flexible business entity In 1977, Wyoming introduced a new business entity: the Limited Liability Company (LLC). The LLC offered limited liability and allowed the forming businesspeople to choose either a partnership-like model of member- operation, or a corporation-like model of manager-operation. It was unclear initially whether this entity could be considered for tax purposes as a partnership. Tax law ceases to be a barrier 1988: IRS rules that LLCs could qualify for partnership-like tax treatment. 1997: IRS further liberalizes tax treatment, making it easy for most entities with limited liability and centralized management to be taxed as a partnership, if they wished to do so. Result: Explosive growth in using LLCs.

51. A brief history of business entities The end of corporate dominance? As LLCs gained ground, use of other entities declined Hit hardest: entities that did not provide complete limited liability Other entities change to become more competitive vs. the LLC To compete with the booming popularity of LLCs, older entities changed to become more attractive: General Partnerships developed the LLP (Limited Liability Partnership) Limited Partnerships developed the LLLP (Limited Liability Limited Partnership) The business trust developed into the Statutory Business Trust