Understanding Corporations

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Abdus Samad Khan

Understanding Corporations


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Revived Interest in Corporations

In 2002 a series of corporate meltdowns, frauds,and other catastrophes led to the destruction ofbillions 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 Americanhistory were filed in 2002 alone


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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 offfrom the longest, strongest bull market in US history fueled

by the dot.com companies

Every one of the mechanisms set up to provide checks andbalances at Corporations failed at the same time


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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


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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


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The Definitions

A corporation is an artificial being, invisible,intangible, and existing only in the contemplation ofthe law. Being the mere creature of the law, itpossesses only those properties which the charter of

its creation confers on it, either expressly or asincidental to its very existence. These are such as aresupposed best calculated to effect the object for whichit was created. Among the most important areimmortality, and, if the expression be allowed,

individuality; properties by which a perpetualsuccession of many persons are considered the same,and may act as a single individual. Chief Justice JohnMarshall


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The Definitions (contd)

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. Blacks LawDictionary, 6th edition, 1990

An ingenious device for obtaining individualprofit without individual responsibility.Ambrose Bierce, The Devils Dictionary


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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


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The Stakeholders

The investorgets the chance to participate in theprofits of the enterprise without takingresponsibility for the operations

The managementgets the chance to run thecompany without taking the responsibility ofpersonally providing the funds

In order to make both of these possible, theshareholders have limited liability and limitedinvolvement in the companys affairs


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The Constituents

This independent entity must still relate to a widevariety of constituents, including its directors,

managers,

employees,

shareholders,

customers,

creditors

suppliers,

the community,

the Government


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Core of the Corporation

While, in law, a corporation is, at least forsome purposes, considered to be a fictionalperson, 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 tocontrol by outsiders


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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 theotherwise all-encompassing power of the king

By the seventeenth century, corporations werecreated by the state for specific purposes, like the

settlement of India and the American colonies


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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, lifespan, and purpose); and

centralized management


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The Three Developments

He adds that three developments, starting in the latenineteenth century, made these attributes particularlyimportant

The firstwas the need for firms far larger than had

previously been the norm

The secondwas the accompanying need for capital from arange of sources broader than in the past, when the onlygame in town was a small group of wealthy individuals

who had previously invested by private negotiation The thirdcondition was that private ownership of

investment property had to be accepted as a socialnorm.


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Clarks Four Characteristics

Limited liability

if a corporation goes bankrupt and is sued by itscreditors for recovery of debts, the individualmembers of the corporation are not individually liable

on the other hand, if a dozen people pool their fundsto create apartnership, they risk losing not just theirstakes, but everything they have

There is a catch here, however. With limited liabilitycomes limited authority.


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Transferability

just as important as limited liability in achieving anacceptable level of risk is the ability to transfer

ones holding freely

a partnership interest is complicated and difficultto value, and there is no stock exchange where

partnership interests can be traded

By contrast, stock is almost as liquid as cash!


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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, toown, and to continue past the life span of anyindividual or group.


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Centralized management

In a corporation, the power to determine thecompanys overall direction is given to the

directors and the power to control its day-todayoperations is given to the managers

In order to allow the company to operate with

maximum efficiency, the shareholders give up theright to make decisions on all but the most generalissues facing the company


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Abdus Samad Khan

Understanding Corporations II


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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


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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


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The Enablers: Corporate Law

There simply isnt 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


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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


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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!


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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


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THE STOCK


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What are Stocks?

Plain and simple, stock is a share in theownership of a company

Stock represents a claim on the company's assetsand 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!


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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 thecompany owns

Yes, this means that technically you own a tiny

sliver of every piece of furniture, every

trademark, and every contract of the company


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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,


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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!


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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


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Ownership entitlements

The importance of being a shareholder is that

you are entitled to a portion of the companys

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


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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


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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


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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


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Risk

there is no obligation to pay out dividends evenfor those firms that have traditionally given them

On the downside, any stock may go bankrupt, inwhich case your investment is worth nothing

Although risk might sound all negative,

stocks have historically outperformed otherinvestments such as bonds or savings accounts

Over the long term, an investment in stocks hashistorically had an average return of around 10-12%.appreciation


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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 madeby management


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Types of Stock

Preferred Stock

With preferred shares, investors are usuallyguaranteed a fixed dividend forever

Another advantage is that in the event of liquidation,preferred shareholders are paid off before thecommon shareholder (but still after debt holders)

Preferred stock may also be callable, meaning that thecompany has the option to purchase the shares fromshareholders at anytime for any reason (usually for apremium)


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THE STOCK EXCHANGE


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Purpose

The purpose of a stock market is to facilitate theexchange of securities between buyers andsellers, reducing the risks of investing

Primary Market

The primary market is where securities are created (bymeans of an IPO)

Secondary Market

investors trade previously-issued securities withoutthe involvement of the issuing-companies


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The New York Stock Exchange

The "Big Board" was founded over 200 years ago in 1792with the signing of the Buttonwood Agreement by 24 NewYork 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 inAmerica.


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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 floorbrokers 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


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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 tosell.

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,


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Nasdaq: The virtual exchange

These markets have no central location or floorbrokers whatsoever Trading is done through a computer and

telecommunications network of dealers

Nasdaq is home to several big technologycompanies such as Microsoft,

Cisco, Intel,

Dell and

Oracle

Wh t th t k i t


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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 earnin s ro ection

Wh t th t k i t


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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


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The Bulls, The Bears And The Farm

A bull marketis 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"


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The Bulls, The Bears And The Farm

A bear marketis 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


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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

Understanding Corporations

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