Corporations and the Law

References to textbook Anatomy of Corporate Law’s Chapter One

Commercial Law
Class V
alessandro.pomelli@unibo.it

Subject to copyright. Do not reproduce or circulate without the Author’s consent 1

Partnerships and Corporations Compared
• Partnerships: Today
1. Arising out of a contract
2. No legal personality (and yet
legal capacity and some weak
form of entity shielding)
3. Unlimited liability for partners
(no “owner shielding”), save
for limited exceptions
4. Limited transferability of
equity holdings
5. No necessary separation
between management and
partners.
6. Shared ownership by
contributors of equity capital
• Public Companies:
1. Arising out of a contract
2. Legal personality (and
“strong-form entity
shielding”)
3. Limited liability for
shareholders (full “owner
shielding”)
4. Fully transferable shares
5. Centralized management
under a board structure
6. Shared ownership by
contributors of equity
capital
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 Legal Personality of Public Company
 Corporations enjoy full-blown legal personality and, as
a result, all the rights and powers that a jurisdiction
ties to the concept of legal personality.

 Corporations, in particular, are provided with:

 Legal capacity (same for partnerships: see above)

 Strong-form entity shielding (unlike partnerships)

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 Legal Capacity
 Company managers are allowed by the law to enter
into (all kinds of) contracts, sue third parties in court
and be sued, in the name and on behalf of the
company.
 It is the company that becomes directly liable for
contractual obligations entered into in its name and
face trial in court for breach of contract and for
damages following torts inflicted on third parties,
- Contracts are materially undersigned by the authorized
managers, but rights and obligations accrue to the
company
- Tortious acts may materially be committed by its
managers or employees, but it is the company that
becomes liable to those who get damaged.
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 Strong-Form Entity Shielding (I):
Priority Rule

 Priority rule is a conventional phrase describing a

specific feature of the entity shielding applicable to
companies and shared by most jurisdictions
 What does the priority rule consist of in general
terms?

 It is a set of rules according to which company’s

creditors are given claims on company’s assets that are
prior (or senior) to the concurring claims of the
individual owners and those of their personal creditors
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 How does the priority rule apply in the context of
corporations?

 Creditors of the corporation have prior claims on its

assets.
– The firm’s assets are by law pledged as a security for the
firm’s debts.
– Owners and their personal creditors cannot seek
satisfaction on the company’s assets, whether directly or
indirectly, before firm’s creditors are, or may fully be
satisfied.

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 Strong-Form Entity Shielding (II):
Liquidation Protection Rule
 Liquidation protection rule is a conventional phrase to
describing another specific feature of the entity shielding
applicable to companies and shared by most jurisdictions
 What does the liquidation protection rule consist of in general
terms?
 It is a set of rules which establish to what extent members are
allowed to withdraw from (i.e., exit) the organization before
its expiry so as to obtain the monetary equivalent of their
equity holding’s value from the entity itself.
 At the same time, it is set of rules also establishing, should the
personal assets of the debtor-partner be insufficient to meet
his/her personal debt obligations, what actions his/her
personal creditors are allowed to take, or barred from taking
in respect of the firm assets. 7
1. Members (shareholders)’ withdrawal rights
– To what extent does protection against individual equity
holding liquidation apply to corporations?
 The law generally provides members with a very
limited right of withdrawal (exit).
– No jurisdiction allows withdrawal at will.
– A few jurisdictions allow withdrawal for just cause.
– Most jurisdictions set out very limited circumstances
under which withdrawal becomes available.
• Usually these circumstances regard fundamental
changes to the corporate contract or major corporate
reorganizations (transformations, mergers, divisions)
from which the individual shareholder dissents. 8
2. Personal creditors’ rights
– As is the case with partnerships, personal creditors can
never seek a direct satisfaction on them. Personal
creditors are barred from directly attaching firm’s assets.

Whatever the actions (see next) taken by the personal

creditors, all options leave the corporation indifferent
and unaffected by the personal liabilities of its members.

What can personal creditors do?

– See next slide for permissible actions
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 To obtain a charging order for the collection of cash
distributions
 To foreclose on the equity holding itself (i.e., the shares)
so as to:
– seek satisfaction by withholding the profits it generates
annually, if any, or upon reimbursement of the equity
holding, or
– sell it to any interested third party and keep the proceeds
from sale.
• Usually this happens through a formal court-led auction in
order to elicit as many bids as possible and the equity
holding is awarded to the highest bidder
– Should the sale be infeasible for lack of interested parties or
reasonable offers, they may take that shareholding for
themselves and replace the former owners, thereby
becoming new equityholders. 10
 !! In contrast to partnerships, in no jurisdiction (including
the US) can personal creditors of a public company’s
shareholders force a liquidation of the equity holding
upon their debtor-shareholder and the corporation !!.

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 Shareholder Limited Liability
 Equity-holders enjoy limited liability, which means they are
not liable for corporate debts and obligations.
– To put it differently, their liability is limited to what they have contributed
in the corporation and no more.
– They are not made guarantors of the corporate debts in case of corporate
insolvency.
– If the corporation goes bankrupt, they are under no duty to pay off
corporate creditors, nor do they suffer from other personal consequences
in case of corporate default (no risk of personal bankruptcy).
– They cannot lose more than they invested in it. Their investment risk is
capped.
 Corporate creditors may only rely on corporate assets to get
paid back.
– However, there apply rules on formation and maintanance of equity
capital for creditor protection.
– Besides, if insolvency arises from managers’ wrongdoing, corporate
creditors may hold managers directly liable for damages. 12
 Transferability and Tradability of Shares
 In principle, ownership interests in a company may be
represented by percentage interests out of the total equity
capital or by shares (hence the term shareholders) and such
shares are made freely transferable, which means that their
owners are free to dispose of them without need of anyone
else’s consent.
– Although the sale of shares entails the sale of the position of party
to the corporate contract from the seller to the buyer, which
results in a modification of the original parties to the corporate
contract, the law chooses not to apply the rules ordinarily
applicable to the modification of contracts .
– By incorporating shares into tangible paper documents, the law
fictitiously treats shares as a movable property and applies to the
circulation of shares the very same rules usually applicable to the
circulation of movables.
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 – In other words, the law turns what would be a sale of a contract
commanding the application of ordinary contract law into a sale
of movables commanding the application of ordinary property
law.
– As a result, the transferability of shares is made subject solely to
the consent of the seller and the buyer, without the need of the
consent of all other counterparties to the corporate contract
(i.e., the other shareholders).
 The law, however, permits corporate charter to provide for
restrictions in the sale of shares, for instances conditioning
the sale on the prior consent of a majority of the other
shareholders, or requiring the potential seller to first offer
his shares to the other shareholders to see if they match the
third party offer (“right of first refusal”)

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 Different from and beyond the concept of free transferability is
that of free tradability
– Shares are freely tradable if they can be listed on stock exchanges and
as a result be bought and sold daily on these public markets.
– In order to be freely tradable, shares must first be freely transferable.
– But in addition to free transferability, shares must meet the specific
listing requirements depending on the stock exchange.
 Corporations whose shares are freely tradable are called “open
or public corporations/companies” in our textbook
– Corporations whose shares are not freely tradable because their
transferability is subject to limits or because their tradability is
somewhat restricted for other reasons are called “statutory close
corporations” or “private companies” (for the private co. see next).
– Caution!: Public/private has nothing to do with the legal nature of the
firm. They all are private legal persons regulated by private law! Public
law has nothing to do with them.
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 Corporations whose shares are fully transferable and freely
tradable may then demand that their shares be admitted
for listing on organized stock exchanges.
– Only after admission to listing, their shares can be daily
negotiated on stock exchanges.
– Corporations whose shares are listed on organized stock
exchanges are called “listed or publicly-traded corporations”.
– Corporations whose shares are not listed, though fully and freely
transferable and tradable, are called “unlisted or privately-held
corporations”
• Warning! Distinguish between the concept of a statutory
close or private corporation from that of a privately-held
public corporation, the first referring to the existence of legal
restrictions to the tradability of its shares while the second
focusing on the fact of its shares not being traded in spite of
the absence of any legal impediment.
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 Another distinction: “Widely-held v. closely-held corporations”!
– It does not refer to restrictions on transferability/tradability of
shares.
– It does not refer to their shares being admitted on a stock
exchange or not.
– It solely refers to the fragmentation/dispersion or, on the
contrary, the concentration of the share ownership, i.e. total
number of shareholders and relative size of their
shareholdings.
 When the number of shareholders is large and each of them
holds a small shareholding so that share ownership is widely
diffused, the corporation is said to be widely-held
 When the number of shareholders is small so that each or some
of them possesses a large shareholding, the share ownership
becomes concentrated in the hands of few members, and the
corporation is termed closely-held 17
 The same corporation may simultaneously be:
– open or public to the extent its shares are freely tradable.
– listed or publicly traded to the extent its shares are admitted to
listing on a public market, but also
– closely-held to the extent its shareholder base is made up of a
small number of highly concentrated shareholders.
• A few Italian listed corporations (“società per azioni quotate”)
display these features.
 The opposite may be true as well. The same corporation may
simultaneously be:
– private or close to the extent its shares are not freely tradable
– unlisted or privately-held to the extent its shares are not admitted
to listing on a public market, but also
– widely-held because the shareholder base is made up of a very
large number of shareholders, each owning a tiny fraction of the
equity capital.
• Example: cooperative corporations (limited by shares). 18
 Delegated Management under a Board
Structure
 Management is made formally separate from ownership
of shares. What does it mean?
1. Almost all business decisions are by law delegated to a
board of directors and the management team the latter
appoints (see next).
– Shareholders are left with very limited managerial powers.
They mostly have control powers.
2. The board of directors is formed by way of periodic
elections. Directorship is not per se an attribute of share
ownership.
 What are the main features of the corporate
management structure?
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 Corporate Directors and Management of
Public Companies
 Corporate law typically vests principal authority over corporate affairs
in a board of directors (“consiglio di amministrazione”), a formal
corporate organ that is periodically elected, exclusively or primarily, by
the firm’s shareholders.
 Art. 2380-bis, Italian Civil Code (ICC): “The management of a [società
per azioni] is vested exclusively in the company’s directors, who are
empowered to take all necessary decisions to pursue the corporate
objectives.”
 § 141(a), Delaware General Corporation Law: “The business and affairs
of every corporation shall be managed by or under the direction of a
board of directors, except as may be otherwise provided by the law or
in its certificate of incorporation”.
 Par. 76(1), German Corporate Law (Aktiengesetz): “The managing
board [board of managing directors] manages the company under its
own responsibility”
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 In all systems the board of directors nominates the top
management team, and this in turn appoints the lower
management.
– It selects the chief executive officer (CEO), who becomes the head of
the operative management.
– It usually selects other high-ranking executive officers, such as the chief
operating officer (COO) in charge of the daily operation of the company
(number two in the ranking), the chief financial officer (CFO) in charge
of the financial affairs and financial statements, the chief administrative
officer (CAO) in charge of managing human resources, the chief
compliance officer (CCO), primarily responsible for legal and regulatory
compliance issues within an organization. They often are referred to as
the “C-Suite” to signal their prominent status within the firm.
– The board may appoint its own members as chief executives, as often is
the case in Italy: the Italian CEO is typically the “amministratore
delegato”
– Chief executives then appoint lower managers and so on..
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 Shareholder Ownership of Public Co.
 Who are the owners?
 The shareholders, because only the shareholders are vested with
voting, decision and control rights (even though they are not vested
with the authority of direct management), on the one hand, and
have title to the firm’s profits.
 In corporations, as well as in partnerships, typical ownership
features are enjoyed by those who contribute equity capital and are
made residual claimants.
 Here, more than there, however, the shareholders’ powers and
rights are made proportional to the size of their holding.
– A shareholder who owns 10% of the equity capital will benefit
from 10% of profits and 10% of voting rights (“one share/ one
vote” principle).
– Nevertheless, proportionality is not mandatory. The law allows the
charter to assign shareholders rights being more than, or less than
proportionate to the size of their holding. 22
 An alternative corporate form: Private
Limited Liability Company
 The private company is a type of company that shares
most features with the public company/corporation but
also shares some features with the partnership.
 In particular, it shares with corporations most rules that
generate positive or negative externalities on third
parties.
 It shares with the partnership the flexibility allowed for
internal governance rules.
 It is usually the most popular business entity in any
jurisdiction in which it is available
– In Italy there are something like 1,500,000 LLCs (società a
responsabilità limitata) versus 50,000 public companies
(società per azioni).
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 Similarities with Public Company
 The LLC enjoys full legal personality in the form of
possession of both legal capacity and the strong-form
entity shielding
– If the priority rule works the same, on the contrary the
liquidation protection rule is weaker, since the right to
withdraw from the company is permitted to a larger extent
than in the public company
 Members of the LLC benefit from personal limited liability
as do shareholders of the public company
 Members of the LLC retain ownership rights (right to
profits and to control the company) as do shareholders of
the public company.
– However, there is more flexibility in allocating these rights
among its members
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 Deviations from Public Company
 Ownership interests are generally not represented by
shares (but for few jurisdictions, which allow their
issuance), nor are they treated as financial securities by
the law.
– They are not necessarily standardized as are shares.
– Although they are freely transferable in principle, they are
not meant to be systematically traded and, in particular,
they usually are not admitted to trading on public markets.
• Their transferability is by law subject to formal
requirements that raise obstacles to their trading on a
continuous basis.
– Besides, free transferability of such ownership interests can
be constrained to a larger extent or excluded altogether.
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 A simpler management structure
– As with the public company and unlike the partnership, the
management is formally separate from the membership
• Membership does not entitle per se to be a managing
member or director of the company
– However, unless the contract provides otherwise, the
management must usually be vested in one or more of its
members
– …And the directorship can be vested in any member for an
indefinite term (with no expiry date)
 Besides, management is not ordinarily subject to
monitoring by internal or external supervisors

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Non-Corporate Alternative Business Forms
 Limited liability partnership (US, UK)
– Yes: Weak-form entity shielding [though it can be made
stronger by contract]; Limited liability
– No: Free transferability and tradability of ownership
interests on securities markets; formal separation of
management from ownership [though achievable by
contract]
 Statutory business trust (US)
– Yes: Legal personality (strong-form entity shielding); limited
liability of beneficiaries; transferability and tradability of
interests of beneficial owners (trust units); separation of
management (trustees) from ownership (beneficiaries)

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