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    Property Rights and Legal Forms of Business

    This lecture note begins with a brief description of property rights (section I). Property rights are essential to business entities (and individuals, as well). Property can be held by individuals or by business entities. Sections II and III of this note describe several legal forms that business entities (enterprises) might have, and how those legal forms differ along certain dimensions, including the liability of owners, the life of the enterprise, and the ability of owners to buy and sell (transfer) their ownership interests. Regardless of their legal forms, enterprises operate within legal systems whose features provide institutional structures for commercial transactions and arrangements. Among the most important of those institutional structures is the system of corporate governance, introduced in Section VII. This note defines and describes corporate governance, and provides an overview of the two major types of legal systems within which enterprises and their governance systems operate: common law systems and code law (or civil law) systems (Section IV). The note also provides brief descriptions of contract law (Section V) and bankruptcy law (Section VI)

    I. Property Rights
    Property can be any physical or intangible thing (typically, a resource of some kind) that is owned by a person or a group of persons. Property rights include the following:

    - Right to consume, use or otherwise benefit from the property, including changing the property in various ways

    - Right to sell (or transfer or exchange in other ways)
    - Right to mortgage (borrow using the property as collateral)
    - Right to exclude others from the property

    Property rights are commonly thought of as combining possession with title. Possession implies control and title implies that others will recognize the rights of the property owner even if the owner is not in physical possession of the property.

    However, property rights typically do not include the following:

    - Rights to use that unreasonably interfere with the property rights of another person
    or entity
    - Rights to use that unreasonably interfere with public property rights, including uses that are contrary to public health and safety.

    Property differs along several dimensions, including ownership (public versus private) and nature (for example, real, personal and intellectual property). Public property is owned by a government (that is, the state), including governmental subunits (for example, a village or town). Private property is property that is not public property, and may be owned by persons, groups of persons and legal entities (described in Section II). Real property is land; personal property is physical items other than land; financial property is claims to the cash or other benefits generated by resources; and intellectual property is intangible, in the sense of lacking physical existence (for example, knowing how to do something). Property rights over these differing types of property are protected by laws that vary considerably across jurisdictions, are subject to change by legislative bodies, and are enforced with varying degrees of rigor. One branch of law that is closely aligned with property rights is contract law, described in Section V.

    The State (that is, the government) can both change and limit property rights. For example, it may be illegal in certain jurisdictions to own certain firearms as personal property. As another example, the government can seize private property under circumstances that are specified by each jurisdiction. For example, in the United States, the Constitution, as amended, specifies that governments may take private property (1) only for a public purpose; (2) after due process of law; and (3) upon paying a fair price. Other jurisdictions have different laws for this process of taking or seizing property. The inherent power of the State (a government) to compel a private property owner to sell his property goes by various names, including eminent domain (the United States), compulsory purchase (the United Kingdom and Ireland), and expropriation (South Africa and Canada).

    II. Features of Legal Forms of Business Entities (Enterprises)
    Much commercial activity is undertaken by business entities. These entities can, for example, own property and enter into binding contracts. The legal form of a business enterprise affects (1) who is liable for the enterprise's obligations; (2) the duration of the enterprise; (3) the transferability of ownership interests. We describe each of these in turn.

    Limited liability. An investor's financial liability is said to be limited if, regardless of the enterprise's obligations, that investor cannot lose more than his original investment. Limited liability creates a clear separation between the obligations of the enterprise and the obligations of its owners. In contrast, unlimited liability means that the obligations of the enterprise become the obligations of its ownersâ?"each owner is liable for all the debts and other obligations of the enterprise. A business that is organized as a limited liability corporation offers limited liability to its owners. Each shareholder's (owner's) loss is limited to his investment in the corporation. Proprietorships and some partnerships have unlimited liability; corporations and some forms of partnerships have limited liability.

    Limited liability, as an institutional arrangement, is a precondition for the existence of large scale enterprises with many owners that undertake risky projects. There are at least three reasons for this. First, if liability is unlimited, a given prospective investor would evaluate both the prospects of the enterprise where he is considering making an investment and the wealth positions of all other existing and potential investors. If all investors are jointly liable for the enterprise's obligations, each investor would like to be the poorest of all investors. (To put this another way, if you and every other owner of an enterprise were personally liable for all the obligations of that enterprise, wouldn't you want the other investors to be extremely wealthy?) Each investor's evaluation of the other investors takes time and effort and thereby deters investment. Second, unlimited liability creates significant disincentives to undertake large, risky projects with potentially large payoffs. Third, each investor would want to make a very small number of investments - because each investment exposes the investor's entire wealth to risk of loss. Holding a small number of investments makes the investor under-diversified and more vulnerable to the success or failure of each project, thereby also reducing the investor's appetite for risky projects.

    In some cases, owners of an enterprise might be willing to accept additionalâ?"but not unlimitedâ?"liability. For example, some entrepreneurs provide personal guarantees of some of the obligations of the enterprises that they are startingâ?"for example, guarantees of specific bank loans. Such guarantees increase the entrepreneur-owner's liability, up to the limits of the guarantee provided.

    The corporate legal form is characterized by limited liability. Proprietorships (enterprises owned by one person) have unlimited liability and partnerships (enterprises owned by several partners) may or may not have limited liability. However, in most jurisdictions there is nothing to prevent a proprietorship from assuming the corporate legal form, if the proprietor files the necessary legal documents to incorporate.

    Duration of the enterprise. Some legal forms allow an enterprise to exist beyond the lifetimes of its owners. An indefinite life attaches to the corporate form, but not to proprietorships or partnerships (which end with the death of the sole proprietor and the deaths of the partners, respectively). The perpetual life of the corporation allows for stability and accumulation of capital, which permits larger scale of operations and longer investment horizons. Enterprises organized as partnerships may make arrangements, as part of the governing documents of the partnership, for partnership interests to be transferred so that the partnership can continue beyond the life spans of the original partners.

    Transferability of ownership interests. The ownership interests of a corporation are the shares of the corporation. The corporate legal form provides for the ability of owners (shareholders) to change their ownership interests (i.e., buy or sell their shares) without affecting the legal existence of the corporation. While the governing documents of a corporation may place restrictions on the transferability of shares, (1) the corporate form itself does not. In contrast, a sole proprietor can sell the entire enterprise but not a portion (share) of it. Some partnerships provide for transferability of ownership interests but many do not.

    III. Legal Forms for Organizing Business Enterprises
    The preceding section mentions three common organizational forms for a business enterprise: the corporation, the partnership (in a variety of forms) and the proprietorship. This section describes these three organizational forms (as well as hybrids of them) in more detail.
    Corporation. A corporation is a legally distinct entity that has a legal personality and legal rights that are separate from the legal personality and legal rights of its owners. The key legal rights of the corporation are:

    To hold assets
    To hire employees and other agents
    To sue and be sued To enter into binding contracts

    Corporations have a perpetual life, shares (ownership interests) of the corporation typically are transferable (subject to applicable laws and the governing documents of the corporation), and shareholders (owners) of the corporation have limited liability.

    The legal separation of a corporation from its owners occurs by means of laws that grant the corporation this special legal status. In the United States, these laws are promulgated by the states, and each corporation follows the state corporation laws of the state where it is registered.

    (2) Some systems of corporation laws operate at the national level.

    Corporations are owned by their shareholders, whose ownership interests take the form of shares of stock. Each share of stock represents a proportionate claim in the corporation. So, for example, if a corporation has 1,000 shares, each of those shares represents a 1/1,000 proportionate ownership interest.

    (3) In such a firm, a shareholder who owned 501 shares would have a majority ownership interest.

    corporation risky, in the sense that if the corporation performs well, the shareholders reap the benefits; and if the corporation performs poorly, they (shareholders) are the first to lose.

    In some jurisdictions, the corporation is viewed as a separate legal entity for tax purposes; it may, for example, be taxed on its income while its owners are taxed only if that income is distributed to them.

    (4) Distributions of profits to shareholders are called dividends. One tax issue that arises for corporations concerns the double taxation of dividends. In the United States, a firm may not deduct dividends paid to shareholders as an expense in computing its taxable income. Because dividends are paid out of after-tax income and then taxed again when they are distributed to shareholders, taxes are essentially paid twice: once by the firm (at the current U.S. statutory corporate tax rate of 35%) and again by the individual who receives the dividend (the current U.S. federal tax rate on dividend income for individuals is 15%). Double taxation of dividends does not exist in all jurisdictions.

    Partnership. A partnership is a business entity in which partners share with each other the profits or losses of the business in which all have invested. The key advantage of the partnership over the corporation in some jurisdictions concerns tax status; partners are taxed on the profits of the partnership and the partnership itself does not pay taxes. Profits and losses of the partnership are treated as profits and losses of the partners, for tax purposes. Partnerships vary concerning whether and to whom they offer limited liability protection. Partnerships sometimes allow for transferability of shares, subject to certain possibly restrictive conditions.
    (1) General partnership: all partners manage the business and are personally liable for all debts of the business (i.e., they have unlimited liability). Each partner has joint and several liability, meaning that each partner is liable for the debts of the entire business, not merely his proportion or share of the partnership. Earnings of a general partnership are attributed to the general partners according to the partnership agreement; taxes are payable based on the partner's share of the profits of the business. To see what this means, consider the following example. Assume a general partnership that is owned 80% by Partner A and 20% by Partner B; further assume that the partnership earns $5,000,000 in income (after payroll costs and after all relevant taxes). Assume that both partners are also employees and earn $100,000 in this capacity. Partner A's personal tax return would show income of $4,000,000 (80% of $5,000,000) plus $100,000, or $4,100,000. Partner B would report $1,100,000 in income (or 20% of $5,000,000 plus $100,000). Taxes are assessed on partnership income even if the income is not paid out as a cash distribution.

    (2) Limited partnership: has both general partners and limited partners. General partners have management responsibility for the business and must have a minimum of 1% interest in the business's profit/loss. General partners have unlimited liability. Limited partners have no management responsibilities, and in general they have limited liability (their maximum loss is equal to their partnership investment, measured as their proportionate share of the partnership). A limited partnership may have a large number of limited partners and their ownership interests may be transferable, subject to possibly restrictive conditions.

    Proprietorship (or sole proprietorship). A business entity that has no legal identity separate from its owner is a proprietorship. In a sole proprietorship, one person does business in his own name, so there is only one owner. The sole proprietor has unlimited liability. A proprietorship does not pay corporate taxes; rather, the income or loss of the proprietorship is taxed at the personal tax rate of the proprietor(s). The duration of the proprietorship is linked directly to the lifespan of the proprietor(s): when the last owner dies or decides that the business should dissolve, the business also ceases to exist. There is no separate instrument evidencing legal ownership of a proprietorship, so there is no mechanism for no transferability of ownership except sale of all the assets.

    Hybrid forms. Some jurisdictions permit legal forms to have characteristics of both partnerships and corporations. For example, an S-corporation (under U.S. law) is taxed like a partnership, but also receives the protection of limited liability typically attached to the legal form of the corporation. An S-corporation generally pays no corporate income taxes on its profits. Instead, shareholders of the S-corporation pay taxes on their proportionate shares of the S-corporation's profits, provided that all shareholders of the S- corporation elect this treatment. In order to qualify as an S-corporation in the United States, an entity must have fewer than 100 shareholders (all of whom must be U.S. citizens or residents, and none of which may be corporations or partnerships), one class of stock, and restrictions on revenues (i.e., no more than 80% may come from sources outside the U.S. and no more than 25% may be derived from passive sources (passive sources include interest income, dividends, royalties)); and profits and losses must be allocated to shareholders proportionately based on their ownership interests in thE business.

    IV. Legal Systems: Common Law and Code Law
    Corporation law and law in general can be distinguished at the country level by whether the country has a common law legal system or a code law legal system. Common law systems are found in countries which were (essentially) colonized by the United Kingdom, including Australia, Hong Kong, India (which has a mixture of common law and Hindu law), Malaysia, New Zealand, Pakistan, Singapore, and the United States. Code law systems are common in continental European countries (such as France, Germany, Italy, Spain) and much of the rest of the world.

    In common law systems, statutes passed by legislative bodies5 generally provide brief statements of general principle and do not address nuances or fine points of law. In a common law system, there is an intentional lack of detail in the statutes to cover every situation, and common law judges have the authority and duty to create legal authorities to cover situations not addressed in statutes by setting precedent (sometimes called "case

    law"). (6) Once a court has ruled on a particular issue, and assuming the facts and circumstances of a new case are similar to the facts and circumstances that gave rise to the ruling, that court's decision sets a precedent that binds future decisions of the same court, and binds all lower courts, until and unless there is another authoritative statement of the law.

    Relative to a common law system that places considerable weight on judges, case law and precedent as a means of creating law, code law systems (also called civil law systems) rely more on detailed statutes that are enacted by legislative bodies. Civil law systems are viewed by some as being slower to change (that is, less flexible and responsive to changing circumstances) than common law systems.

    Some observers view common law systems as institutions that contribute significantly to the growth of trade, and more so than code law systems. The reason is that the case law (that is, the law created by judges in courts) provides reasonably precise guidance on most legal issues, and the case law system provides a ready and timely mechanism for updating the guidance to reflect changes in economic conditions. Therefore, parties to a commercial transaction are able to predict, reasonably well, how a given course of action is likely to be viewed in legal terms once there has been a ruling on the relevant issues. This predictability reduces uncertainty, which in turn reduces the costs of the parties entering into the arrangement, thereby increasing efficiency. Reducing uncertainty about legal matters also increases the likelihood that a given (legal) commercial transaction will occur.

    In contrast, it is less easy to determine the likely answer to a fine question of law under a code law system, since in such systems, law is defined by statute, for each transaction. To the extent that existing statutes do not anticipate every transaction, or their details, that might give rise to dispute, code law systems will be slow to adjust when unforeseen (by those who created the statutes) transactions and circumstances and arise. Specifically, unforeseen items necessitate a new round of statute making. To the extent that the process of statute making is occurs with a lag, is slow, or is uncertain as to outcome, this system suggests less efficiency and greater uncertainty than does a common law system. (7)

    We note two observations about any association between common law systems and greater economic growth. First, the existence and strength of any association is a matter of continued debate and research. Second, and as a practical matter, the distinction between common law systems and code law systems is much less defined than it used to be. Many code law countries are placing more weight on precedent (or what they call jurisprudence), which is analogous to case law, while common law countries appear to place a growing importance on statute-based law in the form of, for example, uniform commercial codes.

    V. Contract Law
    Contract. A contract is a legally binding and enforceable exchange of promises between parties.8 In common law systems, contracts have three key components: offer and acceptance, consideration, and an intent to be legally bound by the contract. In civil law systems the concept of consideration is not central to a contract.
    (1) Offer and acceptance: One party makes an offer (for some transaction) that another party accepts. Neither offer nor acceptance need be in writing. Informal exchanges of promises (such as in an oral contract) may be as legally binding and enforceable as a written contract. In some jurisdictions some oral contracts will not be enforceable if there is an explicit statute requiring written contracts; for example, if the law requires written contracts for exchanges involving the sale of a house, then an oral contract for the sale of a house will not be enforceable.

    (2) Consideration: Consideration is given (paid) by each party to the contract; consideration may involve money, physical goods, services or rights (such as licenses).

    (3) Intent to be legally bound: There is a presumption for commercial agreements that parties intend to be legally bound by the terms of the contract.

    Contract terms. The set of promises that makes up the contract is specified by the terms of the contract. Each term in a contract gives rise to a potential legal obligation. If a party to the contract fails to keep his promise (that is, he breaches a contract term) the other party can litigate (request a legal remedy). The most common legal remedy is damages, which might involve cash paid by the breaching party to the other party to the contract. Not all contract terms carry equal weight; indeed, most contract law would distinguish between conditions and warranties of a contract. Conditions are at the heart of the contract; warranties are more peripheral. While breach of either a condition or a warranty would likely give rise to damages, breach of conditions would be more severe and likely entail larger damages.

    VI. Bankruptcy and Bankruptcy Laws
    Bankruptcy law provides a mechanism for a debtor, who is unable to pay his creditors, to resolve his debts through the division of his assets among his creditors, even if those assets are not sufficient to pay all the debts. A corporation that is unable to pay its creditors is said to be insolvent. The bankruptcy itself, that is, the division of assets among creditors, is supervised by a trustee, who is charged with ensuring fair treatment across the interests of creditors and the debtor.

    There are two primary forms of bankruptcy: liquidations and reorganizations. In a liquidation, a trustee sells the property (assets) of the debtor, either in a piecemeal sale of individual assets and groups of assets, or possibly the enterprise as a whole, and distributes the proceeds to creditors. Not all creditors will receive all the amounts they are owed, and some will receive greater amounts than others, depending on the terms of the original borrowing agreement. If the proceeds of that sale are not sufficient to pay the bankrupt entity's debts, the remaining debts are forgiven. A corporation that is liquidated in bankruptcy will typically have no assets and no meaningful existence. Owners typically receive nothing in a bankruptcy, whether reorganization or liquidation.

    In a reorganization, the debtor works out a plan to pay all or part of the claims of creditors, while retaining many assets. A corporate bankruptcy typically involves eliminating all the claims of existing shareholders (as residual claimants, they would be paid only after all creditors are paid), exchanging existing creditor claims for (new) shares so that the lenders to the pre-bankrupt firm become the owners of the reorganized firm and renegotiating other contracts (such as labor agreements). Reorganization preserves the corporation, with different owners and (probably) different managers.
    Bankruptcy proceedings can be entered into voluntarily by a debtor ("voluntary bankruptcy") or initiated by creditors ("involuntary bankruptcy"). In some countries, after a bankruptcy proceeding is filed, creditors are generally not permitted to attempt to collect their debts outside of the bankruptcy proceeding, and the debtor is not permitted to transfer non-exempt assets during this time. Provisions of the bankruptcy code establish the priority of creditor claims for distributed assets and proceeds. Claims in the highest priority are paid in full before the lower priority claims are reviewed.
    A less severe form of debt enforcement than bankruptcy is foreclosure in which a senior creditor seizes one or more assets to recover the amount owed. However, only debt which is secured by assets as collateral offers this form of enforcement.

    As an institutional arrangement, bankruptcy is a mechanism for enforcing the claims of creditors (debt enforcement), while preventing creditors from seizing assets prematurely and thereby destroying an enterprise that can become an economically viable via reorganization. However, bankruptcy proceedings can be expensive and time consuming; they are generally viewed as leading to an overall loss in valueâ?"but still less of a loss than would occur in their absence.

    Bankruptcy, or more generally debt enforcement, varies greatly across countries. For example, recent research notes that reorganization is more common in Japan, Canada, and the United States than in the Netherlands, Germany and Greece, where liquidation is more common.9 (In fact, reorganization is not legally available in all countries). In addition, this research reports that the time for debt enforcement proceedings also varies greatly, for example, from about seven months in Japan to about three years in Switzerland. Debt enforcement costs also vary greatly, consuming about 5% of the debtor's assets in

    Singapore and Japan and as much as 90% in Angola. Finally, this research reports that common law countries tend to have more efficient (less costly) debt enforcement procedures.

    VII. Corporate Governance
    Governance refers to arrangements and processes that define what is expected, that specify decision rights, and that verify that the expected performance has, or has not, occurred. Governance occurs in any organizationâ?"a national government, a partnership, a corporation, the Catholic Church, the European Union, the United Nations, the World Bank. The complexity of the organization affects the size and complexity of the governance apparatus. At one extreme, a sole proprietorship with one owner-employee has essentially no governance issues. At the other extreme, some large multinational corporations have tens of thousands of employees and operations in dozens of jurisdictions, including sub-operations with their own governance complexities. For example, Sony- Ericsson Mobile Communications is jointly (and equally) owned by Sony and Ericsson, each of which is a very large multinational corporation. Sony-Ericsson has 7,500 employees, with management located in London and operations in Sweden, France, India, China, Japan and the United States. The arrangements to provide incentives and accountability for Sony-Ericsson provide its corporate governance structure, and are established by its two owners (Sony and Ericsson).

    Many definitions of governance appear to focus on political units (nations). For example, a paraphrase of the World Bank's definition of governance is: the exercise of political authority and the use of institutional resources to manage society's problems and affairs, including the process by which governments are selected, monitored and replaced, the capacity of the government to formulate and implement sound policies and the institutions that govern the social and economic interactions among citizens.
    Corporate governance describes the manner in which a corporation's activities are directed, the rules that apply to that direction, and the relationships among the stakeholders in the corporation. Corporate governance specifies the decision rights and obligations of the parties that make up the corporation (managers, other employees, creditors and owners, for example). An example of decision rights is voting rights to elect the governing board. An example of an obligation is the governing board's duty to act in the best interests of the corporation and its shareholders.

    Common sense and intuition suggest that good governance will assist an organization to achieve its objectives, whether that organization is the Red Cross or Cathay Pacific Airlines. However, what constitutes "good" governance is the subject of ongoing debate. In addition, governance structures vary considerably by type of organization (e.g., the European Central Bank versus the World Health Organization versus Toyota Motors) and also by jurisdiction, further confounding the analysis of these arrangements.

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    Solution Preview

    Step 1
    This is a note on property rights and the forms of business recognized by law. In the first part of the note the property rights are listed because it is important for businesses to have property rights so that they can function effectively. The different types of business forms recognized by law are listed. Next the issue of corporate governance is introduced. The impact of civil law on business, the importance of the contract law and the bankruptcy law are explained.

    Step 2
    First, the note gives property rights. The property rights give some rights to the person. He can consume, sell, mortgage, or exclude people from the property. Property rights cease if these interfere with rights of others or with public rights. Usually, the government has the ability of taking away property rights.
    Later the note describes the features of different forms of businesses. These features include the liability for the business, the time for which the business will operate, and the manner in which the ownership may be transferred. ...

    Solution Summary

    Legal Forms of Business are discussed in great detail in this solution.