Why does the law provide so many different types of business entities? When I tackle that question in class, I start with a homely example:
The job-interviewing season will soon be upon my students when Business Associations is taught in the fall. Odds are some of them therefore went out and bought a suit this summer. What were their options were when they bought a suit. The correct answers are: Go to a store and buy one off the rack or have one custom made. Most, if not all, will have bought the off the rack suit. Why?
The off the rack suit is cheaper but will not fit as well. The custom-made suit is much more expensive but fits real well. The problem with custom made suits is that you need to go to a very good tailor and spend a lot of time on fittings. If you’re like most people you will probably buy one off the rack; you either can’t afford a custom made suit or the expense isn’t worth the marginal extra fit. To solve the problem of not having a very good fit from the off the rack suit, the student spent a little extra money to get a better fit by having it altered.
The analogy: Setting up a business is just like buying a suit off the rack: By providing a set of standardized—off-the-rack—rules, the state saves the parties from having to invest time and effort in bargaining and money in the form of legal and other costs.
This is a very important point. It is a fundamental offshoot of the core insight that the firm is not a thing, but rather a nexus of contracts. See Stephen M. Bainbridge, Contractarianism in the Business Associations Classroom, 34 Geo. L. Rev. 631 (2000). If you think about it for a minute, it should be fairly obvious that firms (such as corporations) are really just a set of contracts between various constituencies of the organization. For example, the relationship between a manager and the firm is based on an employment contract. If manager A doesn’t want to obey a superior’s command, he doesn’t have to, although that may be a breach of contract. Similarly, the relationship between creditors and the firm is based on the credit agreement. And so forth. To be sure, many of these contracts are implicit, but they are nonetheless contractual.
The nexus of contracts model implies that corporate law is properly viewed as a standardized contract which the firm’s constituencies adopt.
The Rent-a-Car Analogy: Most students have probably rented a car at some point in your life. I ask: What happened when you met with the agent? Did you negotiate a deal that one of you then recorded in writing? No. Of course not. You used a standardized pre-printed contract. Did you do any bargaining? It would not be surprising if there was a limited array of options you were offered on a take-it-or-leave-it basis; usually, insurance coverage is one. So there may have been some slight modifications to the contract. I want students to think of corporate law as though it were the car rental contract. Just as the contract offered them a set of standardized rules to govern the rental relationship, corporate law offers the constituencies of a corporation a set of rules to govern their relationship.
In many cases, the parties probably will not have a detailed written agreement, which is acceptable if it would be expensive for them to take the time to negotiate a comprehensive set of specialized terms and for each to hire a lawyer to protect their own interests. Those costs are likely to be significant. The benefits of a specialized contract, in contrast, are likely to be small in many settings. The standard agency rules should be pretty much satisfactory. So organization law ends up saving them bargaining costs by giving them an off the rack legal relationship which is more or less ready to go.
In some situations, however, it may be much more desirable to have a written contract setting forth detailed terms. Suppose Mary is being hired as a CEO. In that case, the standard form contract provided by agency law is not likely to be satisfactory. A great deal of money is involved and the job is highly specialized. These factors probably make it worthwhile to engage in extensive negotiations and (here’s the good news) to hire a battery of lawyers.
We are tailors. Our task as lawyers in large part is to know the common-law and statutory rules—the bargain implied in the absence of a contrary agreement between the parties—and to appreciate when and how it is appropriate to try to modify that standard form contract. We also of course need to know which of the rules are mandatory, which cannot be altered even if everyone agrees to do so. In that case our job is often finding a way around the mandatory rules or helping our clients to live with them.
What's all that got to do with the multiple forms of business organizations?
Investors are heterogeneous and the best approach may be to offer them standard form contracts--off the rack rules--that provide significant choice. Corporate, LLC, and partnership law therefore should differ in many respects. Society then will maximize investor welfare by letting investors choose the form best suited to their business.
To continue the analogy, we don't tell somebody going out to buy a suit that one size fits all. Instead, we recognize that that's just not true. So we give our suit buyer an array of choices in terms of sizes and fits. If we only offered one size, some people would never find a suit that fits (trust me on that one) or they'll spend an unnecessary fortune on tailoring alterations.
Just so with having multiple entities. If the rules of the various entities differ, we can pick the entity that is closest to what the client needs and set it up with minimal bargaining costs or lawyer fees. If all the entities have basically the same rules, however, we end up forcing clients to bargain over departures from the standard form and expend legal costs having their bargain turned into workable contracts.
And that is just what the Uniform Law Commissioner's moronic harmonization project did. That project was intended to “harmonize nine separate uniform acts dealing with business entities.” Daniel S. Kleinberger, Protecting the Deal: Enforcing and Protecting the Owners' Agreement, Bus. L. Today, April 2015, at 1. “Due to the Harmonization Project, most provisions in these three acts now use essentially identical wording.” Id. As a result, in many cases, it is no longer possible to achieve differing outcomes for one’s clients simply by picking the appropriate business entity form.
I realize the harmonization project was finished in 2013. One of my regrets is that I didn't write about it before it was finished. But I've spent a good chunk of this spring updating my agency and partnership casebook and my agency and partnership treatise. When I finished working on the relevant section of the treatise today, I just needed to vent. And isn't that what having a blog is for?