Law and the Rise of the Firm

Organizational law empowers firms to hold assets and enter contracts as entities that are legally distinct from their owners and managers. Legal scholars and economists have commented extensively on one form of this partitioning between firms and owners: namely, the rule of limited liability that insulates firm owners from business debts. But a less-noticed form of legal partitioning, which we call entity shielding, is both economically and historically more significant than limited liability. While limited liability shields owners\u27 personal assets from a firm\u27s creditors, entity shielding protects firm assets from the owners\u27 personal creditors (and from creditors of other business ventures), thus reserving those assets for the firm\u27s creditors. Entity shielding creates important economic benefits, including a lower cost of credit for firm owners, reduced bankruptcy administration costs, enhanced stability, and the possibility of a market in shares. But entity shielding also imposes costs by requiring specialized legal and business institutions and inviting opportunism vis-d-vis both personal and business creditors. The changing balance of these benefits and costs illuminates the evolution of legal entities across time and societies. To both illustrate and test this proposition, we describe the development of entity shielding in four historical epochs: ancient Rome, the Italian Middle Ages, England of the seventeenth to nineteenth centuries, and the United States from the nineteenth century to the present

New Business Entities in Evolutionary Perspective

The new types of business forms that have developed over the past thirty years all combine the freedom of contracting that is traditional to the partnership with the pattern of creditors\u27 rights that is traditional to the business corporation. Legal scholars differ on the issue of whether these new business forms are more partnership-like or corporation-like. Those taking the partnership-like view argue that the degree of freedom of contract is the essential difference between the traditional corporation and partnership forms, while those adhering to the corporation-like view argue that the pattern of creditors\u27 rights is the essential difference. The authors support the latter view. They argue that an examination of the evolution of business entities reveals that the traditional inflexibility in corporations served importantly to protect creditors\u27 rights, but as substitute sources developed to protect the rights of all investors, the need for inflexibility diminished and freedom of contracting in the corporate form flourished. In this essay, the authors first discuss the historical evolution of business entities, focusing on the primary role that creditor protection has played in that evolution. Next, the authors argue that, although legal scholars generally focus on limited liability when discussing creditor protection and the distinction between the corporation and the partnership, the principal feature distinguishing the corporation from the partnership is entity shielding -a term referring to the allocation of different rights to different groups of creditors in the assets of a firm. After discussing the importance of strong entity shieldinga characteristic of the corporation but not the partnership -and how it complements limited liability, the authors conclude that the development of new business forms is the culmination of the process of extending strong entity shielding to unrestricted types of entities and, therefore, the new business forms should be viewed as generalizations of the business corporation rather than the partnership