Corporations:
Law & Policy (Bauman, Palmiter, Partnoy)
Chapter 1 – Introduction
Class Outline
Chapter 1
A.
An overview of risk


B.
Types of risk
o
controllable vs. non-controllable
o
risk vs. uncertainty
o
risk aversion vs. preference vs. neutrality
How to manage risks?
o
Insurance:
o
diversification
o
allocating risk
contract or financial product
Allocating risk



Agency costs
o
shirking / moral hazard
o
monitoring - ex ante / ex post
o
disciplining
Two sources of rules to allocate risk
o
law (Section C)
o
contract
Allocating risk through contract
1.
2.
C.
Introduction
Allocating risks to the principal
o
Monitoring devices: direct supervision, specifying duties and prescribing sanctions
o
unforeseen contingencies
Allocating risks to the agent
o
agent “owns” business: debtor-creditor relationship, rent paid by agent
o
principal owns business: pay based on performance, long-term contract, reputation
Role of law in allocating risks
1.
Mandatory and default rules
Basic organizational choices
2.
o
employer-employee
o
partnership
o
corporation
Types of default rules
o
majoritarian:
o
tailored: what specific parties would want for themselves
o
penalty:
Corporations: Law & Policy
Chapter 1 – Introduction
what typical parties would have negotiated
what neither (or one) party would want – thus forcing negotiation
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Chapter 1 Introduction
Class Notes
A.
An Overview of Risk
Problem:
Winemaking
Julia owns a vineyard, but she's not an outdoors type and
wants help. Ernest knows grapes, but he doesn't have a
vineyard.
They both want to make money. How might the two get
together? What will be the issues they must confront?

Julia hires Ernest

Ernest leases from Julia
What are the risks they face?
Can Julia and Ernest avoid these risks? Who is in a better

external v. internal
position to bear non-controllable risks? Controllable risks?

diversifiable v.
Will Julia want to allocate risks to Ernest - he bears all risks
non-diversifiable
and leases vineyard from her? Why might Ernest not want
Are risks bad?
this?
What is "risk profile"?
Which would you prefer - a 50/50 chance of flipping a coin


risk aversion vs. risk
and making $200 or nothing, or a certain reward of
preference
$80? What is the expected return of the coin flip? Do things
Why do capitalists tend to be
change if I say a coin flip for $200,000 vs. $80,000
more risk preferring?
guaranteed? What relevance does this have to Julia and
Ernest?
B.
Allocating Risk
What is gained by specialization?

capital vs. labor

informational advantages

firm-specific capital
What is the allocation of risk if Julia hires Ernest? If Ernest
leases from Julia?
Can Julia ever allocate all risks to Ernest? If Julia takes
some risks, what methods will she use to minimize them?
Does diversification reduce risk?

Why is capital easier to
If Julia owns other vineyards, will that affect whether she
worries about Ernest's shirking or disloyalty?
diversify than labor?

Why is a diversified investor
Will she want to take greater or smaller risks if she is
more risk-preferring?
diversified? How will she accomplish this?
What are agency costs?
Corporations: Law & Policy
Chapter 1 – Introduction
If Julia hires Ernest, what should she worry about? How
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
monitoring efforts
might she minimize her worries? Will Ernest have any

disciplining efforts
incentive to help assuage her fears?

shirking costs / moral hazard
If Ernest leases from Julia, what should she worry
about? Are her worries different when he owns the
business, not she? How might she reduce her risks?
How can agency costs be reduced?
C.
What are the differences between ex post and ex ante

ex ante and ex post
monitoring devices?

contracting vs. legal
What do you think would work best for you, if you were in
constraints
Ernest's position?

profit sharing

reputational stake
The Role of Law in Allocating Risks
Role of law - employment rules
Suppose Julia hires Ernest. Consider
the implications under various legal
rules and the role of law in business
organizations:
Rule 1:
What kind of rule is Rule 1 - minimum wage law? Why do
law-makers (legislatures and courts) create such rules?
Every employer shall pay to each of
Can Julia and Ernest agree as follows:
his employees wages at not less
than $ 10 an hour.
"Compensation will be at $3.50/ hour. Employee
understands that employer would not hire her
otherwise."
Is there any way for them to avoid the minimum-wage law?
Rule 2:
What kind of rule is Rule 2 - employment at-will? How do
you know what kind of rule it is?
What are the advantages
An employment, having no specified
of such a rule?
What are the disadvantages of such a
term, may be terminated at the will
rule? Would most employers and employees have agreed
of either party on notice to the other.
to this rule? Even if most parties to employment
relationships would not have agreed to this, is it the most
Corporations: Law & Policy
Chapter 1 – Introduction
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efficient rule? When is it appropriate for law-makers
(legislatures and judges) to create such rules?
Julia and Ernest sign the following. Is it binding?
"Employee shall have a term of employment of one
year. If Employer discharges Employee, except for
cause, Employer is liable to pay Employee a severance
payment equal to $60,000 less any monthly salaries
already paid during the term of this agreement."
Or perhaps Ernest signs the following:
"I solemnly promise to give my employer thirty (30) days
notice before terminating employment. My employer
can, of course, terminate my employment at any time,
with or without prior notice."
Rule 3:
What kind of rule is Rule 3? Who decides what are
An agent enters into a fiduciary
“reasonable efforts” and whether information is “relevant to
relationship with a principal
the affairs entrusted him”?
requiring that an agent exercise
reasonable diligence. Specifically,
Ernest proposes a contractual stipulation:
an agent is subject to a duty to use
reasonable efforts to give his
“I am not bound to provide you information if I receive a
principal information relevant to
job offer from another vineyard owner.”
affairs entrusted to him and which,
as the agent has notice, the
principal would desire to have.
Rule 4:
What kind of rule is Rule 4? Would an employer ever want
this rule?
Although an employee cannot
compete with his employer during
Julia tells Ernest she will not hire him unless he agrees to the
the term of employment, a
following:
non-compete covenant will not be
implied after the employment
“I will not seek or accept employment as vineyard
terminates.
manager for 2 years after my employment with you ends
with any other vineyard owner in Napa Valley.”
Corporations: Law & Policy
Chapter 1 – Introduction
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Majoritarian - EFFICIENT rule

what most parties would
Tailored - REASONABLE rule

have chosen

specific, bright-line
avoids ex ante
negotiation, ex post
litigation
Corporations: Law & Policy
Chapter 1 – Introduction

would have chosen

standards

what the actual parties
Penalty - TERRIBLE rule
open-ended standards
not have chosen

for judges

reduces ex ante
negotiation cost
what the parties would
rule penalizes party
with bargaining power

forces negotiation;
avoids ex post
interpretation
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