The Essential Role of Organizational Law.

• Author: Hansmann, Henry

1. INTRODUCTION

   In every developed market economy, the law provides for a set of standard-form legal entities. In the United States, these entities include, among others, the business corporation, the cooperative corporation, the nonprofit corporation, the municipal corporation, the limited liability company, the general partnership, the limited partnership, the private trust, the charitable trust, and marriage. To an important degree, these legal entities are simply standard-form contracts among the parties who participate in an enterprise--including, in particular, the organization's owners, managers, and creditors. It is therefore natural to ask what more, if anything, these entities offer. Do they--as the current literature increasingly implies--play essentially the same role performed by privately supplied standard-form contracts, just providing off-the-rack terms that simplify negotiation and drafting of routine agreements?(1) Or do the various legal entities provided by organizational law permit the creation of relationships that could not practicably be formed by contract alone? In short, what, if any, essential role does organizational law play in modern society?

   We offer an answer to that question here. In essence, we argue that the essential role of all forms of organizational law is to provide for the creation of a pattern of creditors' rights--a form of "asset partitioning"-- that could not practicably be established otherwise.(2) One aspect of this asset partitioning is the delimitation of the extent to which creditors of an entity can have recourse against the personal assets of the owners or other beneficiaries of the entity. But this function of organizational law--which includes the limited liability that is a familiar characteristic of most corporate entities--is, we argue, of distinctly secondary importance. The truly essential aspect of asset partitioning is, in effect, the reverse of limited liability--namely, the shielding of the assets of the entity from claims of the creditors of the entity's owners or managers. This means that organizational law is much more important as property law than as contract law. Surprisingly, this crucial function of organizational law has rarely been the explicit focus of commentary or analysis.(3)

2. FIRMS AND LEGAL ENTITIES

   There are a variety of ways to coordinate the economic activity of two or more persons. One common approach is to have each of those persons enter into a contract with a third party who undertakes the coordination through design of the separate contracts and, most importantly, through exercise of the discretion given the third party by those contracts. A third party that serves this coordination function is what we commonly call a "firm." The firm therefore serves--not just metaphorically, but quite literally--as the requisite "nexus of contracts" for the persons whose activity is to be coordinated: It is the common party with whom each of those persons has an individual contract.(4)

   Economic theory does not offer a completely satisfactory explanation for the fact that productive activity is commonly organized in the form of large nexuses of contracts, in which a single central actor contracts simultaneously with employees, suppliers, and customers who may number in the thousands or even millions. Why, for example, are organizational employment relationships not constructed in the form of contractual cascades, in which each employee contracts, not directly with the firm, but rather with his or her immediate superior, so that the pattern of contracts corresponds to the authority relationships we see in a standard pyramidal organization chart? Although this subject is interesting, we will not delve into it here. Rather, we will simply take it for granted that it is essential, in modern market economies, that such large nexuses of contracts can be constructed.(5)

   To serve effectively as a nexus of contracts, a firm must generally have two attributes. The first is well-defined decisionmaking authority. More particularly, there must be one or more persons who have ultimate authority to commit the firm to contracts. We term those persons the "managers" of the firm. In a corporation, the managers (as we use the term here) are the members of the firm's board of directors; in a partnership, they are the firm's general partners.(6) The firm's managers may or may not be distinct from the persons for whose benefit the managers are charged to act--namely, the firm's owners or, in the case of nonproprietary organizations, the firm's beneficial owners or beneficiaries. (For simplicity, we generally use the simple term "owners," rather loosely, to refer to all of these persons: the partners in a general partnership, the shareholders of a business corporation, and the members of a cooperative, as well as the limited partners in a limited partnership, the beneficial owners of a private trust, the beneficiaries of a nonprofit corporation, and the residents of a municipal corporation.)

   The second attribute a firm must have, if it is to serve effectively as a locus of contracts, is the ability to bond its contracts credibly that is, to provide assurance that the firm will perform its contractual obligations. Bonding generally requires that there exist a pool of assets that the firm's managers can offer as satisfaction for the firm's obligations.(7) We term this pool of assets the firm's "bonding assets."

   A natural person has the two attributes just described, and hence can--and very frequently does--serve as a firm, in the form of a sole proprietorship. In this case, the single individual is both manager and owner, and the bonding assets consist of all of the assets owned by that individual. Note, however, that individuals have these attributes because the law provides them. In particular, the law gives an individual the authority to enter into contracts that will bind him in most future states, and the law also provides that, if the individual defaults on a contract, the other party will have (unless waived) the right to levy on all assets owned by that individual (which is to say that the law provides that all assets owned by an individual serve as bonding assets).

   Legal entities, like individuals, are legal (or "juridical") persons in the sense that they also have the two attributes described above: (1) a well-defined ability to contract through designated managers, and (2) a designated pool of assets that are available to satisfy claims by the firm's creditors. Legal entities are distinct from natural persons, however, in that their bonding assets are, at least in part, distinct from assets owned by the firm's owners or managers, in the sense that the firm's creditors have a claim on those assets that is prior to that of the personal creditors of the firm's owners or managers.

   In our view, this latter feature--the separation between the firm's bonding assets and the personal assets of the firm's owners and managers--is the core defining characteristic of a legal entity, and establishing this separation is the principal role that organizational law plays in the organization of enterprise. More particularly, our argument has four elements: (1) that a characteristic of all legal entities, and hence of organizational law in general, is the partitioning off of a separate set of assets in which creditors of the firm itself have a prior security interest; (2) that this partitioning offers important efficiency advantages in the creation of large firms; (3) that it would generally be infeasible to establish this form of asset partitioning without organizational law; and (4) that this attribute--essentially a property attribute--is the only essential contribution that organizational law makes to commercial activity, in the sense that it is the only basic attribute of a firm that could not feasibly be established by contractual means alone.

3. FORMS OF ASSET PARTITIONING

   Asset partitioning has two components. The first is the designation of a separate pool of assets that are associated with the firm, and that are distinct from the personal assets of the firm's owners and managers. In essence, this is done by recognizing juridical persons (or, as we will usually say here, "legal entities") that are distinct from individual human beings and that can own assets in their own name. When a firm is organized as such an entity, the assets owned by that entity in its own name become the designated separate pool of firm assets.

   The second component of asset partitioning is the assignment to creditors of priorities in the distinct pools of assets that result from the formation of a legal entity. This assignment of priorities takes two forms. The first assigns to the firm's creditors a claim on the assets associated with the firm's operations that is prior to the claims of the personal creditors of the firm's owners. We term this "affirmative" asset partitioning, to reflect the notion that it sets forth a distinct pool of firm assets as bonding assets for all the firm's contracts. The second form of asset partitioning is just the opposite, granting to the owners' personal creditors a claim on the owners' separate personal assets that is prior to the claims of the firm's creditors. We term this "defensive" asset partitioning, to reflect the common perception that it serves to shield the owners' assets from the creditors of the firm.

   Both forms are clearly illustrated by the typical business corporation. Under the default rules established by corporate law, a corporation's creditors have first claim on the corporation's assets--which is to say, their claims must be satisfied before the corporation's assets become available to satisfy any claims made against the corporation's shareholders by the shareholders' personal creditors. This is affirmative asset partitioning. Defensive asset partitioning, in turn, is found in the rule of limited liability that bars the...