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E-MailRichard Squire is Professor of Law and Alpin J. Cameron Chair in Law at Fordham Law School. This post is based on his recent paper, forthcoming in the Vanderbilt Law Review.
Each partner in an at-will partnership can obtain a cash payout of his interest at any time. The corporation, by contrast, locks in shareholder capital, denying general payout rights to shareholders unless the charter states otherwise. What explains this difference? In a paper recently published in the Vanderbilt Law Review, I argue that partner payout rights reduce the costs of two other characteristics of the partnership: the non-transferability of partner control rights, and the possibility for partnerships to be formed inadvertently. While these characteristics serve valuable functions, they can introduce a bilateral-monopoly problem and a special freezeout hazard unless each partner can force the firm to cash out his interest. The corporation lacks these characteristics: shares are freely transferable, and no one can commit capital to a corporation without intending to do so. Therefore, in most corporations the costs of shareholder payout rights—which would include the cash-raising burden and a hazard of appraisal arbitrage—would exceed the benefits.
Background
In her celebrated article Locking in Capital: What Corporate Law Achieved for Business Organizers in the Nineteenth Century, Professor Margaret Blair drew the attention of scholars to one of the distinctive attributes of the corporate form: that it locks in capital, denying each shareholder the power to obtain a payout of his investment without the consent of the board of directors. By locking in shareholder capital, the corporate form creates a freezeout hazard if the board refuses to authorize distributions and the shareholders cannot find buyers for their shares. However, Blair emphasized that capital lock-in can also provide an important economic benefit. Expanding upon a thesis introduced by Professors Henry Hansmann and Reinier Kraakman, she showed that capital lock-in protects the corporation’s going-concern value, in particular by preventing shareholders from withdrawing assets with firm-specific value.
The idea that a business can protect its going-concern value by organizing as a corporation has proven to be highly influential. It has lead some scholars to inquire whether the partnership, the traditional organizational alternative to the corporation, might also protect going-concern value, albeit by different means. Unlike the corporation, the partnership does not lock in financial capital: the default rule is that any partner may withdraw at any time and thereupon receive a payout of his interest in the business. However, in an innovative recent article, Morgan Ricks showed that partnership law has developed rules that preserve the underlying business’s particular “asset configuration,” which includes its holdings of complementary assets, when a partner withdraws.
Besides its asset configuration, a second potential source of a business’s going-concern value is its contractual relationships. A firm can use contracts to capture the surplus from relationship-specific investments and to lock in favorable supply prices. In my paper, I show that partnership law also protects this source of going-concern value when a partner withdraws. Even though the default rule is that a partner’s withdrawal dissolves the partnership and leads to its termination, courts have consistently held that the partnership’s contracts remain enforceable, by and against the partners jointly, unless the contracts say otherwise.
Thesis
The fact that partnership law has developed rules for shielding the principal components of going-concern value when a partner withdraws does not mean that the partner’s exercise of his payout right is costless. Most obviously, the exercise of the right forces the partnership to come up with the cash needed to honor the right. And, perhaps more importantly, it requires resort to an independent valuation method when the partners disagree about how much the departing partner’s interest is worth.
What are the offsetting benefits of partner payout rights that might justify these costs? I argue that such rights complement two other characteristics of the partnership: its restriction on transfers of partner control rights; and the possibility for partnerships to be formed inadvertently, without each partner’s intention to convey his property to a distinct legal entity. These characteristics can introduce a bilateral-monopoly problem and a heightened freezeout hazard if each partner cannot withdraw and obtain a cash payout of his interest at any time.
The rule that no partner may transfer his control rights without permission from all the others is a corollary of the principle that no person may join a partnership without all partners’ consent. That principle makes sense given that any partner can use partnership property, bind the partnership in contract, and incur tort liabilities for which all partners are liable. However, if partners lacked payout rights, then the principle would produce a bilateral-monopoly problem whenever a partner wished to exit, since the other partners are, collectively, the only possible buyers of his control rights. The payout right breaks the deadlock, forcing the non-withdrawing partners to come to the bargaining table, and framing the bargaining space around the parties’ respective estimates of the price that a sale of the firm would assign to a partnership interest.
The rule whereby co-owners of a business can be deemed to have formed a partnership even if they did not intend that result also serves valuable functions, such as by forcing co-owners of a business to bear the costs of injuries caused by persons acting on their behalf. But the rule would be unduly harsh if the resulting partnership locked in the owners’ capital, because a coalition of owners that controlled this partnership could then freeze out the others. By granting payout rights as a default rule, partnership law ensures that business owners assume freezeout risk only when they have consented to do so, such as by agreeing to a partnership for a term.
The corporation lacks both of these attributes of the partnership. All rights appurtenant to share ownership—comprising both cash-flow rights and control rights—are freely transferable along with the shares themselves, a benefit of incorporation that corporate law makes possible by assigning agency authority and most management powers to the board. In consequence, when a shareholder wishes to exit, his fellow shareholders (or the corporation itself) are not the only possible buyers of his full bundle of rights. In addition, a corporation cannot be formed unintentionally. Would-be shareholders are thus on notice of the freezeout hazard presented by the corporate form and can adjust for it accordingly.
Not only would payout rights not serve the same special purposes in the corporation that they serve in the partnership, but they would also be costlier. Because corporate shares are, by default rule, freely transferable, they would create an onerous hold-up hazard if they came with payout rights. Investors could then buy shares for the sole purpose of threatening to force the corporation to buy them back, which would require the corporation not just to come up with the needed cash but also to employ an independent valuation method that could overvalue the shares or force a change in control, depending on the method used. The contrast between the partnership and corporation in this regard suggests that payout rights and free transferability of equity interests are mutually incompatible sources of liquidity for a firm’s investors. Many firms will grant one or the other, but almost none will allow both.
The complete paper is available for download here.
