Corporation Law

By Ashley Castellanos
It has been said that one of the best qualities of US corporation law, is its federalist organization. A firm may choose its state of incorporation, a domicile that is independent of its actual physical presence, and one that can be changed at any time with shareholder approval. The corporation codes in each state contain the standard provisions for corporate governance and function as default provisions in corporate charters. The firm therefore can tailor their corporate charters to fit their needs more precisely under the state code. Just as important to them, firms may also look for a state whose corporation law best matches their needs.

The provisions in various corporation laws run the gamut from trivial housekeeping to the more fundamental need for fashioning the relationship between shareholders and managers. Corporation laws may provide for things as mundane as specifying that a corporation’s name be placed in its charter, to as esoteric a thing as specifying the fiduciary duties of managers and voting rights of shareholders, when these can be waived and procedures for corporate combinations, including when managers’ – as opposed to shareholders’ – decisions are controlling. States have provided a different set of governance defaults for small privately held firms, which are called ‘close corporation codes’. The varieties of corporation laws have an enabling approach thereby accommodating the diversity in organization, capital structure, and lines of business found in different business firms.

Most corporation laws have to wrestle with the problem of separation of ownership from control in the modern public corporation. The big, publicly held firms typically have numerous shareholders with small holdings, who cannot actively exercise control over the firm or monitor management. The holdings of the managers running such firms are usually infinitesimal. This creates what is called an ‘agency’ problem, in which the managers’ operation of a firm may deviate from the shareholders’ wishes to maximize the value of the firm.

It is not inconceivable, for example, to find managers implementing a policy that makes their jobs more secure, such as engaging in defensive tactics to thwart a corporate takeover, even though this policy may reduce the company’s value. Or, because the managers’ wealth is indexed to both present and prospective compensation in the firm, they may follow a corporate strategy to reduce firm-specific risk. A typical example is the diversification of corporate acquisitions, in spite of the knowledge that the shareholders will not benefit because they are holding diversified stock portfolios which are subject to market, not firm-specific, risks.

The primary role of corporation laws in this regard is to establish corporate governance policies that mitigate this agency problem by aligning managerial incentives with shareholder interests. Corporation laws have governance devices such as promoting shareholder-elected boards of directors to monitor managers, strengthening shareholder voting rights for fundamental corporate changes, and defining fiduciary duties that impose liability on managers and directors who act negligently or with divided loyalty (i.e. favor their own financial interest over that of shareholders). Perhaps, managers should be reminded that corporation law presumes that firms should be managed for shareholders’ interests, not those of managers, in situations when those interests are in conflict.

My name is Ashley Castellanos, and I have been helping Internet business owners set up and run their businesses correctly since 1997. I own Corporation Soft, a company that was created for, and is dedicated to teaching business owners about corporation law.
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