Understanding Corporations

Abdus Samad Khan

 Revived Interest in Corporations
• In 2002 a series of corporate meltdowns, frauds,
and other catastrophes led to the destruction of
billions of dollars of shareholder wealth leading
to
– the loss of thousands of jobs,
– the criminal investigation of dozens of executives,
– and record-breaking bankruptcy filings

• Seven of the 12 largest bankruptcies in American

history were filed in 2002 alone
 The Fallen
• These names have eclipsed past great scandals
– Enron,
– Tyco,
– Adelphia,
– WorldCom, and
– Global Crossing

• They occurred in the context of a falling market, a drop off

from the longest, strongest bull market in US history fueled
by the dot.com companies

• Every one of the mechanisms set up to provide checks and

balances at Corporations failed at the same time
 The Dilemma of Corporations
• Just as people will always be imaginative and
aggressive in creating new ways to make
money legally, there will be some who will
devote that same talent to doing it illegally

• If the rising tide of a bull market lifts all the

boats, then when the tide goes out some of
those boats are going to founder on the rocks
IDEAS ABOUT CORPORATIONS?
 What is a Corporation ?
• Definitions of the term corporation reflect the
perspectives (and the biases) of the people
writing the definitions

• Anyone who tries to come up with a definition

is like “the blind men who tried to describe an
elephant”
 The Definitions
• “A corporation is an artificial being, invisible,
intangible, and existing only in the contemplation of
the law. Being the mere creature of the law, it
possesses only those properties which the charter of
its creation confers on it, either expressly or as
incidental to its very existence. These are such as are
supposed best calculated to effect the object for which
it was created. Among the most important are
immortality, and, if the expression be allowed,
individuality; properties by which a perpetual
succession of many persons are considered the same,
and may act as a single individual.” Chief Justice John
Marshall
 The Definitions (cont’d)
• “An artificial person or legal entity created by,
or under the authority of, the laws of a state . .
. The corporation is distinct from the
individuals who comprise it.” Black’s Law
Dictionary, 6th edition, 1990

• “An ingenious device for obtaining individual

profit without individual responsibility.”
Ambrose Bierce, The Devil’s Dictionary
 Corporation’s Key Feature
• Its ability to draw its resources from a variety
of groups
• Establish and maintain its own persona
separate from all of them

– Henry Ford once said, “A great business is really

too big to be human.”
 By the Book
• “a corporation is a mechanism established to
allow different parties to contribute capital,
expertise, and labor, for the maximum benefit
of all of them”
 The Stakeholders
• The investor gets the chance to participate in the
profits of the enterprise without taking
responsibility for the operations

• The management gets the chance to run the

company without taking the responsibility of
personally providing the funds

• In order to make both of these possible, the

shareholders have limited liability and limited
involvement in the company’s affairs
 The Constituents
• This independent entity must still relate to a wide
variety of “constituents,” including
– its directors,
– managers,
– employees,
– shareholders,
– customers,
– creditors
– suppliers,
– the community,
– the Government
EVOLUTION OF THE CORPORATE
STRUCTURE
 Core of the Corporation
• While, in law, a corporation is, at least for
some purposes, considered to be a fictional
“person,” at its core each corporation is in fact
a structure

• It evolved through a Darwinian process in

which each development made it stronger,
more resilient, and more impervious to
control by outsiders
 Tracking Back
• In their earliest Anglo-Saxon form, municipal and
educational corporations were granted perpetual
existence and control over their own functions as
a way of insuring independence from the
otherwise all-encompassing power of the king

• By the seventeenth century, corporations were

created by the state for specific purposes, like the
settlement of India and the American colonies
 What made the corporate form so
appealing, so essential?
• According to Dean Robert Clark of Harvard
Law School, the four characteristics essential
to the vitality and appeal of the corporate
form
– limited liability for investors;
– free transferability of investor interests;
– legal personality (entity-attributable powers, life
span, and purpose); and
– centralized management
 The Three Developments
• He adds that three developments, starting in the late
nineteenth century, made these attributes particularly
important
– The first was the need for firms far larger than had
previously been the norm
– The second was the accompanying need for capital from a
range of sources broader than in the past, when the only
game in town was a small group of wealthy individuals
who had previously invested by private negotiation
– The third condition was that private ownership of
investment property had to be “accepted as a social
norm.”
 Clark’s Four Characteristics
• Limited liability
– if a corporation goes bankrupt and is sued by its
creditors for recovery of debts, the individual
members of the corporation are not individually liable

– on the other hand, if a dozen people pool their funds

to create a partnership, they risk losing not just their
stakes, but everything they have

– There is a catch here, however. With limited liability

comes limited authority.
 Clark’s Four Characteristics
• Transferability
– just as important as limited liability in achieving an
acceptable level of risk is the ability to transfer
one’s holding freely

– a partnership interest is complicated and difficult

to value, and there is no stock exchange where
partnership interests can be traded

– By contrast, stock is almost as liquid as cash!

 Clark’s Four Characteristics
• Legal personality
– A partnership dies with its partners
– A corporation lives on for as long as it has capital

• Legal personality has other benefits as well

– Jail sentence,
– Ownership
– Legal personality allows the corporation to act, to
own, and to continue past the life span of any
individual or group.
 Clark’s Four Characteristics
• Centralized management
– In a corporation, the power to determine the
company’s overall direction is given to the
directors and the power to control its day-today
operations is given to the managers

– In order to allow the company to operate with

maximum efficiency, the shareholders give up the
right to make decisions on all but the most general
issues facing the company
Understanding Corporations II

Abdus Samad Khan

 Corporate Law
• The corporation is a complex set of explicit
and implicit contracts, and corporate law
enables the participants to select the optimal
arrangement for the many different sets of
risks and opportunities that are available in a
large economy

• No one set of terms will be best for all; hence

the “enabling” structure of corporate law
 Essential Elements of Corp.
Structure
• Shareholders can “choose” which companies
to invest in, and companies court them on
that basis

• Once shareholders have invested, however,

their power to influence the company is all
but a trace
 The Enablers: Corporate Law
• There simply isn’t a lot of law on most of the
other forms of doing business

• In the case of entities like business trusts, the

applicable law is common law, harder to
determine, understand, and predict than
statute
 The Enablers: Financial Markets
• The financial markets have been developed to
easily accommodate the mechanics of share
issuance and transfer

• Those who put up the money can decide on

the management and changes in extreme
cases
 The right to transfer the Interest
• A share of stock is,
– highly transferable,
– the system puts a premium (in the most literal
terms) on making sure that anyone who wants to
sell (or buy) a share of stock can do so,
immediately!
 Share of Stock
• One does not really “use” a share of stock,
beyond
– cashing the dividend checks
– possibly using the stock to secure a loan
– giving some or all of it as a gift

• What the owner of a corporation “owns” is a

certificate representing entitlement to a
proportional share of the corporation
 Rights of a Shareholder
• The rights of a shareholder are classically defined
as
– the right to sell the stock,
– the right to vote the proxy,
– the right to bring suit for damages if the corporation’s
directors or managers fail to meet their obligations,
– the right to certain information from the company,
and
– certain residual rights following the company’s
liquidation (or its filing for reorganization under
bankruptcy laws), once creditors and other claimants
are paid off
THE STOCK
 What are Stocks?
• Plain and simple, stock is a share in the
ownership of a company

• Stock represents a claim on the company's assets

and earnings
– As you acquire more stock, your ownership stake in
the company becomes greater

• Whether you say

– shares,
– equity, or
– stock, it all means the same thing!
 Being an Owner
• Holding a company's stock means that you are
one of the many owners (shareholders) of a
company and, as such, you have a claim
(albeit usually very small) to everything the
company owns

• Yes, this means that technically you own a tiny

sliver of every piece of furniture, every
trademark, and every contract of the company
 Stock Certificate
• A stock is represented by a “stock certificate”
– This is a fancy piece of paper that is proof of your
ownership

• In today's computer age, you won't actually

get to see this document because your
brokerage keeps these records electronically,
 lets be very clear about this!
• being a Microsoft shareholder doesn't mean
you can call up Bill Gates and tell him how you
think the company should be run

• In the same line of thinking, being a

shareholder of PepsiCo doesn't mean you can
walk into the factory and grab a free case of
Pepsi!
 Who Decides ?
• individual investors like you and I don't own
enough shares to have a material influence on
the company.

• It's really the big boys like large institutional

investors and billionaire entrepreneurs who
make the decisions
 Ownership entitlements
• The importance of being a shareholder is that
you are entitled to a portion of the company’s
profits
– dividend

• the importance of stock ownership is your

claim on assets and earnings
– Without this, the stock wouldn't be worth the
paper it's printed on
 Debt vs Equity
• At some point every company needs to raise
money

• Debt Financing
– A company can borrow by taking a loan from a
bank or by issuing bonds

• Equity Financing
– Issuing stock
 Initial Public Offering (IPO)
• The first sale of a stock, which is issued by the
private company itself

• Issuing stock is advantageous for the company

because it does not require the company to
pay back the money or make interest
payments along the way
 Absolute Priority
• if a company goes bankrupt and liquidates,
you, as a shareholder, don't get any money
until the banks and bondholders have been
paid out

• Shareholders earn a lot if a company is

successful, but they also stand to lose their
entire investment if the company isn't
successful
 Risk
• there is no obligation to pay out dividends even
for those firms that have traditionally given them

• On the downside, any stock may go bankrupt, in

which case your investment is worth nothing

• Although risk might sound all negative,

– stocks have historically outperformed other
investments such as bonds or savings accounts
– Over the long term, an investment in stocks has
historically had an average return of around 10-12%.
appreciation
 Types of Stock
• Common Stock
– Common shares represent ownership in a
company and a claim (dividends) on a portion of
profits

– Investors get one vote per share to elect the board

members, who oversee the major decisions made
by management
 Types of Stock
• Preferred Stock
– With preferred shares, investors are usually
guaranteed a fixed dividend forever

– Another advantage is that in the event of liquidation,

preferred shareholders are paid off before the
common shareholder (but still after debt holders)

– Preferred stock may also be callable, meaning that the

company has the option to purchase the shares from
shareholders at anytime for any reason (usually for a
premium)
THE STOCK EXCHANGE
 Purpose
• The purpose of a stock market is to facilitate the
exchange of securities between buyers and
sellers, reducing the risks of investing

• Primary Market
– The primary market is where securities are created (by
means of an IPO)

• Secondary Market
– investors trade previously-issued securities without
the involvement of the issuing-companies
 The New York Stock Exchange
• The "Big Board" was founded over 200 years ago in 1792
with the signing of the Buttonwood Agreement by 24 New
York City stockbrokers and merchants

• Currently the NYSE, with stocks like

– General Electric,
– McDonald's,
– Citigroup,
– Coca-Cola,
– Gillette and
– Wal-mart,

• NYSE is the market of choice for the largest companies in

America.
 How the NYSE trades?
• The NYSE is the first type of exchange, where
much of the trading is done face-to-face on a
trading floor.
– This is also referred to as a listed exchange.

• Orders come in through brokerage firms that are

members of the exchange and flow down to floor
brokers who go to a specific spot on the floor
where the stock trades.
– At this location, known as the trading post, there is a
specific person known as the specialist whose job is to
 How the NYSE trades?
• Prices are determined using an auction
method: the current price is the highest
amount any buyer is willing to pay and the
lowest price at which someone is willing to
sell.

• Once a trade has been made, the details are

sent back to the brokerage firm, who then
notifies the investor who placed the order.
– Although there is human contact in this process,
 Nasdaq: The virtual exchange
• These markets have no central location or floor
brokers whatsoever
– Trading is done through a computer and
telecommunications network of dealers

• Nasdaq is home to several big technology

companies such as
– Microsoft,
– Cisco,
– Intel,
– Dell and
– Oracle
 What causes the stock prices to
change?
• Stock prices change every day as a result of
market forces.
– By this we mean that share prices change because of
supply and demand

• the principal theory is that the price movement

of a stock indicates what investors feel a company
is worth

• analysts base their future value of a company on

their earnings projection
 What causes the stock prices to
change?
• there are factors other than current earnings
that influence stocks

• Investors have developed literally hundreds of

these variables, ratios and indicators

• So, why do stock prices change? The best

answer is that “nobody really knows for sure”
The Bulls, The Bears And The Farm
• A bull market is when everything in the
economy is great, people are finding jobs,
gross domestic product (GDP) is growing, and
stocks are rising

• If a person is optimistic and believes that

stocks will go up, he or she is called a "bull"
and is said to have a "bullish outlook"
The Bulls, The Bears And The Farm
• A bear market is when the economy is bad,
recession is looming and stock prices are
falling

• If a person is pessimistic, believing that stocks

are going to drop, he or she is called a "bear"
and said to have a "bearish outlook“

• Short Selling
 The Farm: Chickens and Pigs
• Chickens
– Their fear overrides their need to make profits

• Pigs
– high-risk investors looking for the one big score in
a short period of time