Strengthening Investment in Public Corporations Through the Uncorporation

Publication year2012
CitationVol. 35 No. 04


Strengthening Investment in Public Corporations Through the Uncorporation

Kelli A. Alces(fn*)

I. Introduction

We cannot completely overcome the difficulties caused by the separation of ownership and control. In The Modern Corporation and Private Property, Adolf A. Berle and G ardiner Means focused our attention on what was then a relatively new phenomenon: widely dispersed public shareholding.(fn1) They marveled at how, for the first time in the history of the American economy, the owners of assets had so little to do with the management of those assets, and managers had so much power over so much wealth that did not belong to them.(fn2) Berle and Means described what we now call the Berle-Means corporation, the publicly traded corporation with widely dispersed share ownership. The agency costs occasioned by the combined power of managers and indifference of shareholders have preoccupied legislators, judges, investors, and scholars. Still, we have no answer.

We do not know how to make the agency costs of a publicly held firm as low as the agency costs of a privately held firm. We cannot make the managers of those significant assets faithful trustees, nor do we care to.(fn3) Public share ownership has a different character than other types of business, or asset, ownership.(fn4)

Those studying the various governance forms used by businesses in our economy have concluded that the corporation is the form devoted to managing the agency costs resulting from public shareholding.(fn5) Tools like the independent board of directors, mandatory fiduciary duties owed by those directors, and capital lock-in define the corporate form, and are supposed to be designed for managing the agency costs of the public firm.(fn6) These governance mechanisms have, at times, spectacularly failed to discipline corporate managers to operate public businesses in a manner consistent with the best interests of rationally apathetic, widely dispersed shareholders.(fn7) The trouble may stem from reserving a role in corporate governance for these indifferent shareholders whom the law regards as owners but who do not meaningfully fulfill that role.

Uncorporations unincorporated firms such as partnerships, limited partnerships, and now limited liability companies are the preferred business forms for small businesses and entrepreneurs, for those who really want to be business owners.(fn8) Because there are fewer owners and the owners tend to be more sophisticated, owners of uncorporations can more closely monitor management. They can require distributions from the firm in a way public shareholders cannot, and they can specify exit rights at the firm's inception.(fn9) Uncorporate managers are often also owners of the firm, so their interests can be more closely tied to the firm's success so they may accept downside risk.(fn10)

Uncorporations often play an important role in the life of a public corporation. For example, during times of financial distress, an investment firm organized as an uncorporation might take the public firm private and reorganize it. Or the investment firm might realize gains by buying debt that it can convert to equity shares, which are later offered to the public in a bankruptcy reorganization.(fn11) Uncorporations influence public firms when agency costs are relatively low, when widely dispersed shareholders have lost interest, and when they can capture most, if not all, of the gains of correcting management mistakes and turning the firm around.(fn12) Uncorporations also hold portfolios of public companies as investments and sometimes take an active role in influencing the management of those firms.(fn13)

In this Article, I argue that by encouraging and enhancing the interaction between corporations and uncorporations, rather than making them more alike, we can realize the best outcomes for investors. If corporations and uncorporations are pushed to adapt the best parts of the other's governance structure, they may begin to share the same problems. Instead of sharing governance forms, it makes more sense to allow the forms to interact, using uncorporate governance to more effectively perform the shareholder role in corporate governance. Then, we broaden access to investment in uncorporations so that it is easier for all kinds of investors to diversify across business forms-to invest, in different ways, both in closely held uncorporations and publicly held corporations. This would involve tweaking access to different investment vehicles rather than tweaking the law of firm governance itself.

Part II of this Article evaluates the advantages and disadvantages of the governance form of the public corporation. The Berle-Means corporation offers access to significant capital and ways to diversify away firm-specific risk, but it places rationally apathetic, widely dispersed "owners" in a position of control, despite their inability to monitor management or reduce agency costs. Part III explores the advantages and disadvantages of investment in private uncorporations. While private uncorporations have lower agency costs than Berle-Means corporations, there are some disadvantages to investors in owning closely held uncorporations, such as an inability to fully diversify away risk. Part IV suggests that the answer to the governance problems confronting both governance forms is to change the ways we think about investment, rather than tinkering with governance mechanisms. If we open public investment to allow investors to choose a number of different vehicles, investors may choose to take a more active role in governance when they want to realize certain gains and may be more able to accept a role that looks less like "ownership" when they want to remain more passive. True interaction between private uncorporations and public corporations and shared investors may allow us to lower the agency costs of each type of investment and may allow the different business forms to operate better by operating together.

II. Advantages and Disadvantages of the Berle-Means Corporation

Different business forms contemplate different ways to organize the management of the assets comprising a business.(fn14) While the many forms of business association share similarities, each has defining characteristics that set it apart from the others and allow it to accommodate different ownership structures and priorities. Of the many kinds of business associations, the corporate form is the one designed to manage the agency costs of public firms with widely dispersed, inattentive shareholder owners.(fn15)

The bulk of the agency costs associated with the public firm are caused by the fact that the "owners" of the firm,(fn16) or the owners of the residual claim, are rationally apathetic: they would much rather exit an underperforming firm than take action to improve or discipline its management.(fn17) When shareholders do not take care to monitor management, they must rely on other mechanisms to constrain agency costs. Those mechanisms are found to some extent, though not exclusively, in the governance structure of the corporate form. The market has devised new governance tools over time, showing that there is some flexibility in the corporate form and that its mandatory structures may be among its weakest features.

This Part discusses the advantages and disadvantages of the corporate form, as well as market-based mechanisms that have arisen to fill in governance gaps.

A. The Corporate Form

The board of directors, mandatory fiduciary duties, and capital lock-in are the defining features of the corporate form. These features set the corporate form apart from its uncorporate cousins. Shareholders are considered the "owners" of the corporation and are supposed to be represented by a board of directors that is responsible for monitoring senior officers who run the day-to-day business of the firm.(fn18) Corporate directors owe a mandatory fiduciary duty of loyalty to the corporation.(fn19) Shareholders, even the rationally apathetic shareholders of the Berle-Means corporation, are expected to enforce those fiduciary duties on the corporation's behalf.

Corporations are not expected to regularly distribute profits to shareholders. Rather, partially because of double corporate taxation, shareholders would prefer that assets stay in the corporation and be used to enhance the firm's business.(fn20) Capital lock-in allows corporate managers to pursue long-term projects with a greater degree of confidence in the amount of capital available; it also gives them power and discretion over significantly more assets.(fn21)

While the corporate form dominates the market of public firms, many of its hallmarks are marginalized in practice. Publicly traded corporations must have a majority of outside directors on their boards, meaning a majority of a firm's board members cannot have other significant financial ties to the firm.(fn22) These "outside directors lack time, information, and inclination to participate effectively in management."(fn23) The pathologies of the board of directors are well-known and well-documented.(fn24) For now, it is enough to say that the board has not proven to be an effective monitoring or management device as currently constituted. As legislative reforms push to make the board increasingly independent, the role of the board in corporate management has become...

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