ORGANIZATIONAL LAW IN CONTRACTUAL PERSPECTIVE


Henry Hansmann

Yale Law School

October 1995

Paper prepared for the conference on "Achievements and Failures of Law and Economics: 35 Years Later" in Milan, Italy, October 27 and 28, 1995.

  1. Introduction
  2. Legal Entities as Loci for Contracting
  3. Legal Entities as Standard Form Contracts among Owners and Managers
  4. Legal Entities as Standard Form Contracts with Creditors
  5. Organizational Law vs. Tort Law
  6. Legal Entities as Standard Form Contracts with Patrons
  7. Legal Entities as Devices for Signalling
  8. Organizational Law vs. Tax Law
  9. Conclusion

I. INTRODUCTION

When, as a law student in 1968, I took the basic course in corporate law at the Yale Law School, the professor stated on the first day of class that the subject had been intellectually dead for fifty years. Whether or not that statement was accurate when it was made, it certainly would not describe the subject today. Over the past several decades, economic analysis has revolutionized the way we think about corporate law, and about organizational law in general.

One of the basic contributions of the law and economics revolution has been an increasing tendency to view organizational law in contractual terms. More particularly, the economist is inclined to see nearly all aspects of organizational law as terms in an explicit or implicit contract among the affected parties. Moreover, since most of the parties who have some relationship with an organization -- whether as owners, creditors, directors, employees, or customers -- enter into that relationship voluntarily, economic analysts tend to view those relationships in much the same terms that they would view other types of explicit voluntary contracts. In particular, economists tend to assume that, as with other contracts, efficiency will generally best be served if the parties are left free to alter the terms of organizational relationships as they choose.

This approach, which we might term the contractualization of organizational law, naturally leads us to ask what it is that organizational law adds to contract law. That is, why does the law establish a set of basic organizational forms for organizing enterprise, rather than leaving the whole field to contract? What would we lose if we were to eliminate all of organizational law, or any part of it, and simply rely upon contracting under the general rules of contract law to fill the gap?

American law, for example, provides for a number of distinct forms for organizing economic activity. Just confining ourselves to the most general forms, these include the business corporation, the cooperative corporation, the nonprofit corporation, the municipal corporation, the limited liability company, the general partnership, the limited partnership, the limited liability partnership, the private trust, the charitable trust, and marriage. What function is served by these forms? Why do we have this particular set, instead of more, fewer, or different ones?

This question is of practical as well as theoretical interest. The available set of organizational forms often varies from one jurisdiction to another, sometimes in substantial ways. This is true even within the United States. Some states, for example, have separate statutory forms for closely held and publicly held business corporations, roughly following the European model, while other states have only a single statute for both. Some states have a separate statute for consumer cooperatives, while others have a single statute intended to cover all types of cooperatives. The limited liability company did not exist anywhere two decades ago, and although that form has recently spread rapidly, it still does exist in every state and exhibits only modest uniformity among the states that have adopted it.

Moreover, when we turn to international comparisons, the differences are even more striking. For example, European countries, in general, lack the private trust and the nonprofit corporation. And the nations that formerly belonged to the Soviet Union have long lacked many of the legal forms of organization found in free market countries, and are now struggling to decide which of those forms to adopt and how to structure them.

In what follows I would like to address, in very general terms, this question of the role of organizational forms. My purpose is to use this question both to illustrate the uses of economic analysis in organizational law and to pull together some of the basic things we have learned about organizational law from economic analysis. Of course, in the brief space available, I'll have to be selective in the issues I choose and the illustrations I offer. Moreover, I'll indulge myself by drawing those issues and illustrations disproportionately from areas on which my own work has focused. I should also confess that some of what I shall say here is rather preliminary or exploratory; I hope to deepen my own understanding in the course of this conference, and to expand on these themes further in future work.

For convenience, I shall use the term "legal entities" here to refer to organizational forms -- such as the business corporation, the general partnership, and marriage -- that are established by law, and I shall refer to the law that creates and regulates legal entities as "organizational law."

II. LEGAL ENTITIES AS LOCI FOR CONTRACTING

There are, broadly speaking, two ways to coordinate economic activity by two (or more) parties: (1) by having the parties contract with each other on their own account; (2) by having both parties enter into individual contracts with a third party who undertakes the coordination through design of the individual contracts and through exercise of the discretion given him by those contracts. Legal entities facilitate the latter form of coordination. They are, as the economists say, the "nexus of contracts" (that is, the common party to contracts) for the persons to be coordinated.

By providing for the formation of legal entities as juridical persons that can contract in their own name, organizational law performs a vital function. Absent organizational law, large transaction costs would be involved in establishing, with only the tools supplied by the general law of contracts, a single and stable nexus of contracts for a numerous and changing group of actors (including investors, suppliers, workers, and customers).

III. LEGAL ENTITIES AS STANDARD FORM CONTRACTS AMONG OWNERS AND MANAGERS

Legal entities also serve as standard forms for the relations of authority and responsibility among the owners and managers of an organization. They provide rules by which the owners of an organization can act collectively to choose and discipline the organization's managers; what powers and responsibilities the owners have among themselves (and particularly what obligations the majority has toward the minority); and what the internal authority structure will be (for example, in a corporation, what are the respective roles of the directors and the officers).

Although these rules are useful, it is questionable whether they constitute a vital contribution of organizational law. In developed economies today, these rules are often default rules that apply only if the parties involved do not choose different rules. The transaction costs of choosing rules that differ from the statutory defaults are low, and in fact it is common for the parties to deviate from the default rules through specific provisions in their partnership agreement, articles of incorporation, or other governing instrument.

To be sure, there are some rules of organizational law governing relations among owners and managers that are mandatory. This is true even in the field of basic business corporation law in the United States, which is among the examples of organizational law that has moved furthest in the direction of flexibility. There has been much debate in the American law and economics literature as to the role that is, or should be, played by these mandatory rules. That debate has not achieved a clear consensus. Among those rules that govern relations among owners and managers, however, it seems fair to say that those rules that are mandatory are relatively unimportant: either they govern minor matters of a formal nature, or they involve rules that would clearly have been contracted for anyway in nearly every situation, or their consequences can be easily avoided and hence they are mandatory only in appearance.

This is not to say that default rules are not useful here. They simplify drafting by removing the amount of detail that must be put in private documents; they help avoid mistakes of omission; and they help put parties on notice when the structure of the organization deviates from common forms in ways that may be disadvantageous. Still, these same functions -- the "standard form" role of organizational law -- could in substantial part be performed as well by privately provided standard form contracts such as articles of incorporation and bylaws, partnership agreements, and premarital agreements.

Moreover, the role of mandatory rules is apparently more important where a legal entity is relatively new to a society. For example, when the American states first adopted general incorporation statutes toward the middle of the nineteenth century, those statutes imposed a relatively rigid structure upon firms formed under them. Over the intervening century and a half, that structure has been made progressively more flexible, yielding the current statutes that are largely enabling rather than proscriptive. Even more tellingly, the Americans currently participating in the drafting of the new Russian business corporation statute, though appreciative of the flexibility of the American statutes with which they are so familiar, are suggesting substantially less flexibility for Russia. Why is rigidity in new forms useful? The answer, it seems, is that where the relevant actors -- such as owners, managers, and judges -- have little experience with the type of entity in question, a clearly defined structure reduces information costs: it creates clear expectations among the parties, simplifies the assessment of differences in structure and performance between different organizations, and eases the burdens placed on judges who are called upon to enforce the arrangement.

One might wonder why the market cannot by itself accommodate the need for simplicity, supplying the appropriate standard forms on a contractual basis. Why, for example, would it not be best for the Russian Republic to adopt a general business corporation statute along the flexible American model, and then leave it to the actors involved to select some simple standard form corporate charter and use that model for most companies if simplicity and standardization is in fact the most efficient approach? Could one not assume that such standard forms would be self policing, in that an effort by any firm to employ a nonstandard corporate charter would lead to failure as the relevant parties -- potential shareholders, creditors, managers, and directors -- all avoided that firm owing to the uncertainty and high information costs that the firm's nonstandard charter would impose upon them? The answer, perhaps, is that a legally imposed standard form quickly solves the coordination problem, leading to the instant emergence of a single winner in the market for standard forms. This is particularly important since, if the market were to fortuitously converge initially to a high cost form, the costs of deviating from that form after it had become embedded might be prohibitive. Legislating an apparently efficient standard form to begin with, and then modifying that form by legislation as experience suggests is necessary, may be the easiest solution to the coordination problem.

In any event, one sees an evolution toward greater generality and flexibility repeated in a variety of legal entities. Nonprofit corporations in the United States, for example, were first (like business corporations) formed with special legislative charters, then formed under general statutes that prescribed fairly rigid forms (particularly with respect to the permissible purposes for formation), and then became increasingly general with time. And now Europe is arguably in the process of evolving toward more general nonprofit corporate forms as well. Similarly, the law of private trusts in the common law countries has evolved from a legal entity designed for a narrow range of real estate transactions to a general device used for a wide variety of commercial purposes.

To be sure, there may be reasons other than mere familiarity with the institutional forms, and the consequent reduction in information costs, that has been leading toward greater flexibility in the structure of legal entities, at least among developed economies today. Marriage, for example, has been growing increasingly contractualized over the past century, yet it is scarcely a new legal entity. Birth control and reductions in child mortality, and the consequent increase in women's freedom to participate in the labor force, may be a special cause of this change. Still, some factors closer to the informational explanation, such as higher levels of education among women, may also play a role here.

IV. LEGAL ENTITIES AS STANDARD FORM CONTRACTS WITH CREDITORS

A much more important function of legal entities, it appears, is to serve as a standard form contract between the principal participants in an organization (its owners and managers) and its creditors, and among the creditors themselves.

More precisely, a legal entity serves as means for partitioning assets for purposes of pledging the assets as security for credit. The entity effectively imposes an implicit term in the contracts between the participants in the entity -- its owners and managers, in particular -- and the entity's creditors that specifies what assets are pledged to the creditors as security, and under what priority vis-a-vis other creditors. With a corporation, for example, creditors know that, unless otherwise specified in their contract with the organization, the assets to which the corporation has title, and only those assets, are pledged to them as security, and that they will have to share that security with other creditors who contract with the corporation, but only with those creditors and not, for example, with the personal creditors of the corporation's owners or managers. With a partnership, in contrast, the creditors know that they not only have the entity's assets to rely upon, but that the personal assets of the entity's owners are also pledged as security, subject to sharing, under priority rules know in advance, with the owner's personal creditors.

Indeed, putting tax considerations aside for the moment (we shall come to them below), the principal reason for using the partnership form rather than the corporate form today is to serve as a convenient means for pledging the personal assets of a firm's owners as security for general credit extended to the firm. Where the owners wish to pledge their personal assets (as they might in a small or start-up firm with few fixed assets), they will use the partnership form; where they wish to reserve their personal assets for pledging to their personal creditors, they will use the corporate form.

In principle, it is possible to alter these security claims by contracting. The shareholders of a corporation, for example, can pledge their personal assets as security to any individual creditor of the corporation by personally endorsed provisions in the creditor's contract with the firm. Similarly, the partners in a partnership can eliminate personal liability for the firm's debts by insisting that creditors include waivers to this effect in their contracts with the firm. But the transaction costs of these contractual variations on the standard forms are very high -- so high as to make them generally unrealistic. In a corporation with any number of shareholders, it would be hopelessly difficult to include personal pledges of security in each of a corporation's contracts. And, while a partnership might well be able to impose terms limiting liability to the partnership's assets for major lenders such as banks, it would be impractical to write such special limited liability terms into each contract with small trade creditors, and particularly with those that use their own standard form contracts. Thus, the legal entity makes trivially simple the creation of a contractual pattern of asset claims that would be extraordinarily difficult to create through individual contracts.

The importance of legal entities in asset partitioning contrasts strongly with their much less important role, described above, in organizing relationships among the owners and managers of an organization. Again, comparison of the partnership and corporate form provides a clear illustration. In the United States today, corporate law has achieved a degree of flexibility that permits the formation of a corporation that has the same relationships among owners and managers -- what we might call the "internal structure" of the firm -- as does a standard partnership. Moreover, altering the corporate charter, bylaws, and shareholder agreements to achieve such a partnership-like structure is a relatively simple matter. Consequently, the partnership form today offers no significant advantages in terms of choosing an internal structure for a firm. Rather, the principal reason (again, taxes aside) for maintaining the partnership form today is as a convenient means of pledging personal assets to a firm's creditors.

This view of the role of legal entities helps clarify the rationale for corporate limited liability. Oddly, this is an area in which Easterbrook and Fischel, who have generally played a vital role in advancing the economic analysis of basic corporate law, seem to have missed the main point. Those authors argue that limited liability serves principally as a means of maintaining the marketability of corporate shares by assuring that those shares will have roughly the same value to any person who purchases them. Their arguments to this effect, however, are premised on the assumption that, in the absence of limited liability, a firm's shareholders would all be jointly and severally liable for the corporation's debts. That assumption is unjustified. In a world of unlimited shareholder liability, the natural rule would be pro rata liability for the firm's shareholders, in which each shareholder is personally liable only for his pro rata share of any liability that cannot be satisfied out of the firm's assets, with the share determined by the proportion of the firm's total outstanding shares that are held by the individual shareholder in question. In the state of California, for example, which imposed unlimited personal liability on all shareholders in California corporations from statehood in 1849 until 1931, personal liability followed such a pro rata rule, rather than a rule of joint and several liability. And, with a pro rata rule, Easterbrook and Fischel's various arguments against unlimited shareholder liability lose their force.

The role of limited shareholder liability in business corporations is not, then, that unlimited liability would have disastrous effects on share pricing and transferability, or that it would be unadministrable. Rather, it is that the most efficient partitioning of assets for purposes of pledging those assets as security for credit is commonly to have the firm's assets pledged to the firm's creditors, and the owners' personal assets pledged to the owners' personal creditors, and that the corporate form makes it easy to implement that pattern of pledges. Why is that pattern of pledges efficient? Presumably for reasons of notice and monitoring. Creditors of the firm are commonly in a reasonably good position to assess a firm's existing assets, the claims of its other creditors, and the firm's future business prospects, but in a relatively poor position to monitor the assets, other outstanding credit, and future prospects of the firm's individual shareholders. The reverse, meanwhile, is true of an individual shareholder's personal creditors (and particularly so when the individual is a shareholder in many firms). The partitioning of assets for security purposes that economizes on information costs, therefore, is that in which the firm's assets are pledged to the firm's creditors and the shareholders' personal assets are pledged to their personal creditors, and that is the pattern that results from choice of the corporate form. And, when this is not the efficient partitioning of assets among creditors, but instead it is efficient to pledge the owner's personal assets as security for the firm's general creditors, then the latter result can be achieved simply by employijng the partnership form rather than the corporate form.

The same reasoning shows why it is appropriate to respect corporate limited liability for contractual creditors even in the case of a subsidiary corporation whose stock is entirely owned by a parent corporation that exercises complete control over the subsidiary. Suppose, for example, that a parent corporation has two separately incorporated subsidiaries, one in the chemical business and the other in the hotel business. With limited liability, creditors of the chemical business need know nothing about the hotel business when deciding how much credit to extend and on what terms. Rather, they need inform themselves only about the assets and prospects of the chemical subsidiary. Since some of those creditors are likely to be suppliers or customers with much experience in the chemical business, but none in the hotel business, and since the reverse is likely to be true of creditors of the hotel business, this arrangement economises on information costs for all of the creditors.

There are some areas of the law in which efficiency might be well served by greater appreciation of this role of the corporate form as an asset partitioning device. That is particularly so in those civil law jurisdictions, such as Germany, where the corporation with a single shareholder is looked on with suspicion as somehow incoherent or inherently fraudulent, with the result that the law is strongly inclined to pierce the veil in such firms -- for example, among the firms in a corporate "group" -- and hence frustrate efforts to use the corporate form to partition assets in ways that reduce the total cost of credit. Here, as elsewhere, viewing legal entities as contracts helps remind us to be cautious in interfering with the free use of that form to structure relations among consenting parties, including a firm and its creditors.

For this type of partitioning of assets among corporate shells to work effectively, owners and managers of a corporation must be able to commit themselves not to move assets into and out of the corporation opportunistically in ways that would prevent those assets from serving as effective security for creditors. This is accomplished by a variety of legal doctrines that bear on corporations, including, in the United States, balance sheet and insolvency tests for payment of dividends, prohibitions on fraudulent conveyances, equitable subordination of owners' debt claims in bankruptcy, veil-piercing, and continuing personal liability of shareholders toward corporate creditors for amounts distributed to shareholders upon liquidation of the corporation.

Interestingly, these rules are more nearly mandatory than are the rules of corporate law that govern relations among owners and managers. In particular, it is not clear that these rules can be modified through provisions placed in the corporation's charter. This is, presumably, not because it would be unreasonable for creditors to agree to waive the protection of one or another of these rules in particular cases, but because such flexibility would put substantial noise into the signal that a firm sends to its creditors by adopting the corporate form, and hence deprive that form of an important element of its signalling value. Thus, if individual creditors wish to waive the protection of one of these rules, this must be done in the creditor's individual contract with the corporation, and not via the corporate charter.

The importance of legal entities as devices for partitioning assets among creditors becomes particularly clear if we turn to the private trust -- a legal entity that is well established in common law jurisdictions but, at least as a general form, lacking in civil law jurisdictions. To what extent does the lack of this legal entity handicap the civil law countries? Very little, it appears, with respect to the relations among the three principal parties to a trust-like arrangement: the settlor, the trustee, and the beneficiary. In the civil law, general contract law and agency law doctrine suffice to permit parties who wish to assume these three roles to create trust-like relationships among themselves with relatively little cost. But, when it comes to liability to third party creditors, the lack of the trust form places a decided handicap on the types of arrangements that can be constructed under the civil law. The common law trust makes the trust assets unavailable to satisfy the debts of the trustee, even though title to those assets is nominally held by the trustee -- a result that seems, in general, to be efficient. But, under the civil law, there is no easy way in which such a partitioning of trust assets from the trustee's personal assets can be accomplished.

This view of the role of legal entities necessarily requires viewing bankruptcy law as an important part of organizational law. For example, one of the most important changes in American partnership law in recent decades was arguably the provision in the 1976 Bankruptcy Reform Act that increased significantly the priority of the partnership's creditors vis-a-vis the personal creditors of the firm's partners. This reform was presumably justified for reasons of just the type that have been suggested here. Since the corporate form has now become sufficiently flexible to be employed for even the smallest of firms, the principal reason to maintain the partnership form as a legal entity is to provide a convenient device for pledging the personal assets of the firm's owners as security to the firm's creditors. Thus it makes sense now to alter the partnership form to accentuate the difference between that form and the corporation in this respect. When, as was the case until well into this century, the partnership was the only legal entity practically available for small firms, and thus owners of small firms did not have a choice of whether they would pledge their personal assets to the firm's creditors, a more limited form of personal liability of partners for partnership debts was appropriate.

V. ORGANIZATIONAL LAW VERSUS TORT LAW

While economic analysis suggests that a key role played by legal entities is the partitioning of assets for claims by voluntary creditors, at the same time it suggests that legal entities should largely be ignored in determining which assets will be available to satisfy the claims of involuntary creditors such as tort victims. The reason is straightforward. Tort victims have no control over the type of legal entity that injurs them. Consequently, to make the amount recovered by the victim depend upon the legal form of the organization responsible for the tort is to permit the externalization of accident costs, and indeed to invite the choice of legal entity to be governed in important part by the desire to seek such externalization.

More particularly, while the intentional use of the corporate form to limit liability in contract makes eminent sense, to permit the intentional use of the corporate form to limit liability in tort does not make sense. Of course, if unlimited shareholder liability for tort damages would induce severe inefficiencies in the pricing of corporate securities, or if collection of excess liability judgments from corporate shareholders would necessarily be a very costly process, then limited liability in tort might be justified as a regrettable necessity. But this does not appear to be the case. So long as the rule of shareholder liability is a pro rata rule as described above, assessment of shareholders for their share of tort judgments that cannot be paid out of the corporation's assets does not seem to threaten important inefficiencies. Rather, corporate limited liability in tort appears to be an historical accident, perhaps encouraged in important part by the rarity, during the formative period of corporate law in the nineteenth and early twentieth century, of tort liability sufficient to bankrupt a corporation. The increasing use of the corporate form for small businesses, together with the recent advent of potentially massive tort liability for environmental harms, workplace hazards, and injurious products, suggests that the issue should be revisited.

VI. LEGAL ENTITIES AS STANDARD FORM CONTRACTS WITH PATRONS

A legal entity can also serve as a standard form contract between the managers of an organization and a class of the organization's patrons other than its creditors -- including, in particular, the organization's customers. The clearest examples are the charitable trusts and nonprofit corporations found in common law systems, and the foundations found in civil law systems.

The basic contracting problem solved by these entities is as follows. An organization's managers wish to collect funds from a large number of patrons, in varying amounts and over time, to be combined into a single fund that will be used either to finance the provision of private services to a numerous group of third parties or to finance the provision of public goods to the patrons themselves. Private charities like Oxfam are examples of the former; political parties and business associations are examples of the latter. Given the structure of the transaction, however, an individual patron typically cannot observe whether his contribution was actually used to purchase a marginal addition to the organization's services or, instead, simply went into somebody's pockets.

A nonprofit corporation (or a charitable trust, or a foundation) solves this problem by effectively establishing a cost-plus contract between the managers of the organization and the organization's patrons as a group -- a contract in which the managers promise to devote all of the funds collected to provision of the promised services, drawing for the managers themselves only reasonable compensation for their own services and no pure profits. It would be nearly impossible to accomplish the same result by forming the organization as, say, an ordinary business corporation, and then simply having the organization enter into contracts with each of its individual contributors. Since the organization must commingle each individual patron's payment with payments received from its other patrons -- and not just contemporaneous patrons, but past and future patrons as well -- any contract with an individual patron must effectively promise that the managers will take only reasonable compensation for their services out of the entire pool of funds they receive. Thus, all patrons must effectively enter into the same contract with the organization, and that contract must bind the organization in its use of the funds of all of its patrons together, including future as well as past and present patrons. That is, each individual contract would effectively have to commit the managers to operating what is in effect a nonprofit firm, and all of those contracts would need to have the same terms. A nonprofit corporate charter effectively creates such a common contract between the firm's managers and all of the firm's patrons, present and future.

There is an important sense in which a business corporation has the same relationship to its shareholders that a nonprofit corporation has to its patrons. The shareholders of a business corporation, like the patrons of a nonprofit, each make a monetary contribution to the firm. The firm then aggregates those payments and invests the pooled funds in projects intended to produce profits for the common benefit of the shareholders, just as a nonprofit spends its funds on projects intended to produce common nonpecuniary benefits for its patrons. The managers do not promise to pay a given return to the shareholders, but rather promise to invest the pooled funds for maximum profit and to take from those funds for themselves no more than reasonable compensation for their services. An individual or entity could, in theory, accomplish this result through separate contracts with individual investors. This would be awkward, however, since the contracts with the individual investors would be interdependent: In each individual contract, the entity would have to pledge that it would not combine the funds contributed by the patron in question with funds raised under different contractual terms. The easy way for the entity to bind itself in a highly visible way to identical terms with all investors is to form as a legal entity that is restricted, by its charter, to act under those terms -- just as this is the easy way for the nonprofit corporation to bind itself to its customers.

VII. LEGAL ENTITIES AS DEVICES FOR SIGNALLING

There are more legal entities available in most societies than are strictly necessary to solve the basic contracting problems described above. For example, most American states offer both a business corporation statute, designed for joint stock companies, and a cooperative corporation statute, designed for producer and consumer cooperatives. A business corporation, however, is in effect just a special kind of producer cooperative -- a lender's, or capital, cooperative -- and could in principal be formed under a general cooperative corporation statute. Why, then, not simply have a general cooperative corporation statute, and eliminate the redundant business corporation statute?

One reason is that there are many detailed default rules that are helpful for joint stock companies but not for other forms of cooperatives, with the consequence that, given the large number of joint stock companies that are formed, it is convenient to have a legal entity -- the business corporation -- that embodies those default rules. Another reason, perhaps, is clarity of signalling. When a consumer contemplates patronizing a given store, for example, she may feel less need to check closely the quality of the merchandise or the terms of sale if the firm is consumer-owned than if it is investor-owned, and formation of the store under a cooperative corporation statute can serve as a signal to this effect.

For legal entities to serve this signalling function effectively, it may be more important that they be subject to some mandatory rules than would be the case if legal entities served only the function of providing default rules. For example, if one could form an investor-owned firm under a cooperative corporation statute, then the kind of signalling just described would not work. Perhaps for this reason, cooperative corporation statutes generally seem to prohibit the formation, under those statutes, of capital cooperatives, hence limiting the flexibility and generality of the cooperative corporation statutes while enhancing their signalling power.

VIII. ORGANIZATIONAL LAW VERSUS TAX LAW

It is common for parties to choose one legal entity over another (say, the partnership over the corporation, or vice-versa) for tax purposes. The reason is that tax law often imposes different rules on different legal entities simply as a matter of form. Most economists would probably agree that this is regrettable, since it increases transaction costs by causing legal entities to be used for transactions for which they are inappropriate. A more efficient approach would be to make the tax system as neutral as possible among legal entities. The most obvious approach to that end is to eliminate the separate taxation of legal entities. To this end, there have long been serious proposals in the United States for abolishing the separate corporate income tax and simply taxing all corporations like partnerships, with the corporations' net income imputed to their shareholders for tax purposes.

At present, however, we must recognize that the influence of taxation is so strong that it not only bears strongly on the choice of legal entity but sometimes even fosters the creation of new legal entities. This appears to have been the case in the United States recently with the limited liability company, an innovation of the past two decades that has now spread through most of the fifty states even though it seems to permit nothing that cannot be done as well with a corporation or a limited partnership. (There may, however, be a signalling function here too: according to U.S. practitioners, the limited liability company looks more familiar to Europeans than does the limited partnership, and hence is preferable in creating American entities designed to appeal to European investors.)

IX. CONCLUSION

With the exception of limited liability in tort, which is arguably a serious mistake, organizational law does not permit any relationships to be established that could not, in principle, be created by employing just the general tools of contract law and agency law. It does not follow, however, that organizational law is unimportant. Legal entities can be employed to establish highly useful multi-party contracts that would otherwise, as a practical matter, be extremely difficult to construct. The partitioning of assets for pledges of security is apparently among the most important of these. Coordinating terms in the contracts between the managers of an organization and its equity investors or (in the case of a nonprofit entity) some other class of patrons is another. A further function of legal entities, though arguably a less vital one, is the provision of default terms for the relations between managers and owners.

Because legal entities serve a function that is essentially contractual, it is important that parties have flexibility in their use. Often, to this end, it is important that the entities be maleable -- that the default rules be only defaults, and not mandatory. But, since one important way of structuring relationships lies in choosing one among a variety of potential legal entities, extreme maleability can also handicap a legal entity in serving a useful contractual role. If the form has no definite structure, then its use signals nothing to the parties who deal with it.