Law and the Rise of the Firm

Tuesday, February 5, 2008

LAW AND THE RISE OF THE FIRM by Henry Hansmann, Reinier Kraakman, and Richard Squire 119 Harvard Law Rev. 1333 (2006)

While doing your business taxes, have you ever wondered about the difference between filing as a “sole proprietor” versus a “corporation”? As far as we are concerned, the former is “easier” and the latter is “safer.” If we don’t have a lot to lose potentially, we choose the former, else we choose the latter, unless of course, other factors force us to choose the latter. This 70+ pages paper offers a history lesson in the evolution of organizational law. Below is my summary.

For ages, scholars believed that protecting the firm’s owners’ assets from the claims against the enterprise by firm’s creditors was a one of the most important advancements in business organizations. This was termed as “owner shielding” (OS) aka “limited liability.” Our authors argue just the reverse — that is, protection of firm’s assets from claims against the firm’s owners by owners’ creditors was more significant. This is termed as “entity shielding” (ES) previously known as “affirmative asset partitioning.”

Among many benefits of ES are lower cost of credit, reduced administrative costs in case of bankruptcy filings, increased stability and a market in shares. But it also comes at a cost by requiring specialized institutions and practices and opportunism. Especially because of the latter, that is, opportunism on the part of the owners toward creditors and minority owners, ES took a long time coming. First, a mechanism had to be developed that would protect the non-controlling owners and outside creditors. A number of developments in the United States in the 20th century, particularly corporate income tax adoption in 1913, requiring disclosure by stock exchanges and the government, the use of credit reporting agencies, and the legal instruments to protect the equity investors were instrumental in the rise of ES because its benefits outweigh its costs.

The authors study four Western commercial societies: ancient Rome, medieval and Renaissance Italy, early modern England, and the contemporary United States. In all these societies, the factor of decreasing cost to implement it was the primary reason for the rise of ES. There are three contemporary forms of ES:

  • Weak ES: Grants firm creditors priority over personal creditors in the division of firm assets;
  • Strong ES: Adds a rule of liquidation protection to the protections of weak ES. Most popular form currently;
  • Complete ES: This denies non-firm creditors any claim to firm assets.

There is a discussion of various kinds of entity shielding organizations, from LLC to LLP to LLLP. Needless to say, the forms offering stronger ES are better and popular. There is a discussion of a business form called "statutory business trust" introduced in Delaware as recently as 1988. The authors claim to be the natural culmination in the historical evolution of entities, and offering full limited liability (aka OS) and strong ES while giving the owners flexibility in prescribing all other aspects of their firm.

While declining costs in implementing ES gave rise to ES, ES itself imposed increased costs particularly on the firm’s owners’ personal creditors by subordinating their claims without obtaining their consent to do so. This created the possibility of opportunism which has been recently exploited by firms such as WorldCom and Enron which sub-partitioned the assets and liabilities of the firm into new entities, but kept them out of the parent firm’s balance sheets. Disadvantages of ES were exploited by firms such as Enron and WorldCom.

The authors conclude by asserting that while ES has made possible today’s strong entities, it still has to figure out how to protect third-party creditors unaffiliated with the entity itself. Some unaddressed questions are regarding the increase in the skill of accountants, lawyers and judges that has accompanied the rise of ES—was this increase in skill what made ES possible or was this a response to the rise of ES?