Article by Lawrence E. Mitchell
Close corporation law has reached maturity. Although it lacks the venerable and ancient common-law history of such seemingly timeless bodies of law as property and crimes, close corporation law has developed in the twentieth century to the point at which it has engendered a voluminous body of case law and literature.
A review of close corporation materials reveals an overwhelming focus on one central question: How can we modify formalistic general incorporation statutes to fulfill the needs of this hybrid form of business organization? In particular, how can we adapt a form that separates ownership and control (and is premised on that separation) to an organization in which that separation is typically minimal, if not absent? The judicial and legislative responses to the needs of close corporation shareholders, although somewhat varied, usually address the problems of close corporations within the traditional corporate framework.
Past attempts to develop a law of close corporations have been misdirected. Corporate legislation, case law, and commentary have focused on the problems of minority shareholders and the development of a less formal corporate structure. Legislators, judges, and commentators have devoted insufficient attention to the theoretical and societal problems of close corporations, and to how those problems bear on the wisdom of treating close corporations within the traditional corporate context.
The failure of the legal system to develop a theoretical framework for close corporations is understandable. Close corporation law originated as practitioner's law. Before legislatures and scholars recognized the need to address the problems of close corporations, practitioners and their clients experimented with ways to mold the corporate structure to satisfy the need for a more intimate associational arrangement. The law responded to these experiments with ad hoc and piecemeal solutions, grounded in the traditional corporate structure. Thus, the body of law now known as the law of close corporations grew without the benefit of a theoretical foundation.
The time has come to reassess the law of close corporations and to resolve some underlying questions—questions rarely asked and seldom answered: Should the law accommodate the desires of close corporation shareholders for freedom to alter the corporate form? Is the close corporation truly a “corporation” in the economic and behavioral sense in which our society has come to conceptualize that term? Do close corporations serve the same efficiency and social functions as more widely held corporations? Are the characteristics of corporations, reflected in general incorporation statutes, mere technical formalities, or do those characteristics serve some other functions? And is it appropriate to dispense with these characteristics in close corporations?
The answers to these questions depend upon a theoretical understanding of close corporations. In attempting to reach such an understanding, I propose a restructuring of business organization law. Instead of working to modify the corporate structure, we should abandon the attempt to develop a separate body of corporate law governing close corporations and instead should encourage businesspersons to select only those forms of business organization that balance their needs with society's legitimate concerns. My proposal focuses on the unity of ownership and control in close corporations as it relates to the policy of limited liability. As this Article will demonstrate, the only way in which the close corporation fulfills the modern notion of corporations is through the filing by its incorporators of a certificate of incorporation. Therefore, I conclude that close corporations should not exist as corporations at all.
First, I will briefly identify those characteristics that mark the typical close corporation and distinguish it from the model envisioned by general incorporation statutes. Next, I will analyze the history and function of limited liability, lauded as the sine qua non of the corporation and generally identified as the major reason small businesspersons choose to incorporate, and conclude that from a social welfare perspective, limited liability misallocates resources. I will then examine how limited liability addresses, in part, agency problems in the traditional corporate structure, and how unlimited liability in the partnership form induces monitoring activity equally desirable in the close corporation context. Finally, I will show how the availability of limited liability affects the other traditional characteristics of corporations—the right to hold property and to be sued in the corporate name, free transferability of shares, and perpetual succession—and how the need for limited liability diminishes when these characteristics are contracted away in the close corporation.
In conclusion, I will propose that we abandon the attempt to develop a separate law of close corporations within the corporate framework. Rather than permit shareholders to modify the corporate form and retain the advantage of limited liability, the law should encourage businesspersons to select the form of business organization that best suits their (and society's) needs. The logical determinant of the proper form of organization of a business is whether ownership and control are separated—that is, the presence of passive investment. Passive investment marks the distinction between close and public corporations and ultimately justifies the distinctive characteristics of corporations. Thus, shareholders should only be permitted to acquire the traditional corporate characteristics of limited liability, centralized management, free transferability of shares, and perpetual succession when ownership and control are separated to a significant degree.
In making this proposal, I do not seek an immediate change in the corporation laws of all fifty states. Rather, I wish to redirect thinking about close corporations by denying the inevitability of the corporate form as the ultimate framework for business organizations. Only after such a denial can the problems of close corporations effectively be understood from a theoretically consistent perspective.
About the Author
Lawrence E. Mitchell. Assistant Professor, Albany Law School of Union University; B.A. Williams College 1978; J.D. Columbia University School of Law 1981.
Citation
63 Tul. L. Rev. 1143 (1989)