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
S12
Evolution
Overview of Section 7c
Regulatory competition
1.



2.
3.
4.
5.
Race to the bottom?
Race to the top?
Competition with federal law
The business cycle
Political economy of the primacy debate
Legal origins
The future of business entities
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
Copyright © Amitai Aviram. All Rights Reserved
Regulatory competition
Competition & the market for law

Law was traditionally seen as offering no competition



But some activities can move between jurisdictions


State can use violence to enforce its laws
State has monopoly over law in its jurisdiction
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
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
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
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”
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?
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
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
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)
B
A
House
Senate
Senate
Delaware
B
A
House
Delaware
B
A
House
“Promanagement”
Senate
Copyright © Amitai Aviram. All Rights Reserved
Delaware
(efficiency at
expense of
accountability)
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“Pro-SHs”
management”
B
A
(accountability

at expense of
efficiency)
Delaware
House
Senate
Copyright © Amitai Aviram. All Rights Reserved
(efficiency at
expense of
accountability)
Evolution
Overview of Section 7c
Regulatory competition
The business cycle
1.
2.




3.
4.
5.
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
Political economy of the primacy debate
Legal origins
The future of business entities
How the business cycle affects law
Economic effect of the “perp walk”
Effect of conspicuous law
enforcement on behavior of
non-perpetrators
Conspicuous law enforcement
Individuals’ risk perception
Individuals’ behavior
“Nothing paints a picture as well as
people being led away in handcuffs”
– Walter Ricciardi, SEC
When Do Prosecutors
Enforce Securities Laws?
Empirical Evidence
Cyclical Enforcement: Little during boom, plenty after bust
40.00%
30.00%
20.00%
10.00%
0.00%
95
96
97
98
99
00
01
02
03
04
-10.00%
-20.00%
-30.00%
S&P 50 0 Chang e, 1yr Lag
SEC Enf Actio ns Chang e
05
06
When Do Prosecutors
Enforce Securities Laws?
Theory
Conspicuous enforcement
is greatest when the
perception gap (perceived
risk - actual risk) is greatest
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
Example

Narrowing the perception gap: Over-estimation of
fraud reduced from 0.998% to 0.009%

~111 times less misperception
Before
After
Perceived Actual
Risk (%) Risk (%)
1
0.002
0.01
0.001
Perception
Gap
0.998%
0.009%
Example
Effect on Social Welfare

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
Bias Arbitrage
Commodity Arbitrage
Bias Arbitrage
•Identify gap in price of
gold in NY & London
•Identify gap between
objective & perceived risk
• Take an action that
creates private profits
while also closing the
price gap
• Take an action that
creates private benefits
while also closing the
perception gap
Is Cyclical Enforcement a Form
of Bias Arbitrage?

I.e., does the public over-estimate fraud more
following a bust?
Does the public over-estimate fraud
more following a bust?
Cognitive Biases
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


Economic hardship removes veil that masks fraud
Economic downturn causes hardship to many firms at once
 Attribution


bias
discounting
Fraud rises as a possible cause of downturn
Causes people to discount other causes
This could have been the end, but
then this paper would be called …
CounterCyclical
Enforcement
of Corporate
Law
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
Reworking the Example

Same assumptions as before, except that enforcement
exacerbates perceived risk by 99% (to 1.99%)
Before
After
Perceived Actual Perception
Risk (%) Risk (%)
Gap
1
0.002
0.998%
1.99
0.001
1.989%
Excessive avoidance
Perception
gap
increased
Excessive self-policing
Excessive political pressure
A vicious enforcement cycle…
Public overestimates
risk
Excessive avoidance /
self-policing /
political pressure
Enforcement increases
perception of risk
Incentives for
conspicuous law
enforcement
Conspicuous
law
enforcement
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
Evolution
Overview of Section 7c
Regulatory competition
The business cycle
Political economy of the primacy debate
1.
2.
3.

4.
5.
[Omitted]
Legal origins
The future of business entities
Evolution
Overview of Section 7c
Regulatory competition
The business cycle
Political economy of the primacy debate
Legal origins
1.
2.
3.
4.

5.
[Omitted]
The future of business entities
Evolution
Overview of Section 7c
Regulatory competition
The business cycle
Political economy of the primacy debate
Legal origins
The future of business entities
1.
2.
3.
4.
5.




A brief history of business entities
End of the public corporation?
End of private equity?
Resurgence of large-scale unincorporated business entities?
A brief history
of business entities
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.
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
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 19th Century
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.
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.
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 semicommercial purposes.
E.g.: The Hudson Bay Company, The Virginia
Company, The Massachusetts Bay Company
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.
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.
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.
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.
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.
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”.
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.
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.
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.
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.
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
A brief history of business entities
The end of corporate dominance?

A more flexible business entity




Tax law ceases to be a barrier


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 memberoperation, or a corporation-like model of manager-operation.
It was unclear initially whether this entity could be considered for tax
purposes as a partnership.
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.
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