The adoption and novation of preincorporation contracts for employment and commercial lease or purchase contracts is standard operating practice. However, the wise promoter will draft a contract has an automatic novation clause : “the promoter’s liability on this contract shall terminate upon the corporation’s adoption of this contract.” The VERY wise promoter will incorporate the business prior to making any contracts for the corporation.
Hyperlink is to the court’s opinion on the LexisNexis Communities website.
The hyperlink is to the text of the MBCA on the American Bar Association wepage.
Fig. 1 may be found on page 1055of the text.
Fig. 2 may be found on page 1056 of the text. Figure 2 Contents of the Bylaws 1. The authority of the officers and the directors, specifying what they may or may not do. 2. The time and place at which the annual shareholders’ meetings will be held. 3. The procedure for calling special meetings of shareholders. 4. The procedures for shareholders’ and directors’ meetings, including whether more than a majority is required for approval of specified actions. 5. Provisions for special committees of the board, defining their membership and the scope of their activities. 6. The procedures for the maintenance of share records. 7. The machinery for the transfer of shares. 8. The procedures and standards for the declaration and payment of dividends.
Hyperlink is to the court’s opinion on the Findlaw.com website. Robert Waddell decided to go into the home construction business and entered into a contract with Robert Valiga on September 12, 1989. When he entered into the contract with Valiga, Waddell signed the contract on behalf of R. H. Waddell Construction, Inc. At the time the contract was entered into with Valiga, Waddell had no knowledge that the corporation’s articles of incorporation had been filed. Although Waddell had signed the articles of incorporation as the incorporator on August 19, 1988, the articles were not filed with the secretary of state’s office until December 9, 1988, and with the registrar’s office in Knox County until January 12, 1989. On September 12, 1988, the same day Waddell entered into the contract with Valiga, John Graves opened an account at Christmas Lumber Company in order to obtain building materials for the Valiga house. Graves opened the account in Waddell’s name, and where the account information stated “type of customer,” Graves marked “individual.” Graves signed the document on behalf of Waddell. In a letter from Valiga to Waddell dated November 9, 1988, Valiga made several requests about the construction of the house. In a letter dated the next day, Valiga terminated Waddell’s services. Sensing potential litigation, Waddell and Graves on November 11, 1988, entered into a joint venture agreement. The only parties to the agreement were Waddell and Graves. R. H. Waddell Construction, Inc., was not a party to the agreement. Pursuant to the terms of the agreement, Waddell and Graves divided funds received from Heritage Federal Credit Union for construction of the Valiga home. After Waddell patched things up with Valiga, he returned to work on the project from November until February of the next year. On February 11, 1989, Waddell received a letter from Valiga wherein Valiga expressed his shock regarding the cost of the construction job. Three days later, Waddell quit as Valiga’s contractor. On January 10, 1990, Christmas Lumber Company filed a lawsuit against Valiga, Waddell, and others seeking to enforce a materialmen’s lien for building materials purchased by Waddell to be used on the house being built for Valiga. On December 2, 1992, Valiga filed a separate lawsuit against Waddell and Graves claiming there was no corporation chartered by the State of Tennessee named R. H.Waddell Construction, Inc., when the contract was entered into on September 12, 1988. After the two lawsuits were consolidated, the trial court found that Waddell and Graves were liable as partners on the construction contract signed in the name of R. H.Waddell Construction, Inc., and awarded Valiga damages of $80,045.79.
Waddell and Graves appealed to the Tennessee Court of Appeals. The court considered Waddell’s argument that he did not know that the corporation was not formed at the time the construction contract was signed. Court: “Waddell argues he signed the necessary paperwork to have his business incorporated and was unaware of the delay in filing the charter with the secretary of state’s office. He claims, therefore, he did not “know” there was no incorporation. Pursuant to Tenn. Code Ann. § 48-12-103, absent a delayed effective date, the “corporate existence begins when the charter is filed by the secretary of state.” Waddell apparently signed the charter on August 19, 1988. On September 12, 1988, the contract was signed between Valiga and R. H.Waddell Construction, Inc. Two months later, on November 11, 1988, Waddell and Graves entered into the Joint Venture Agreement. On December 9, 1988, the charter was filed with the secretary of state’s office. Waddell’s claim he did not “know” the corporate charter had not been filed with the secretary of state is belied by the fact he and Graves essentially memorialized their relationship in writing with the Joint Venture Agreement which was signed after Waddell claims he “thought” there was a corporation and before the corporation actually was formed. Waddell’s assertion is made further suspect by his deposition testimony that he and Graves were “partners.” Based on the roles occupied by Waddell and Graves during the construction of Valiga’s house, coupled with (1) the terms of Joint Venture Agreement; (2) Waddell’s deposition testimony he and Graves were “partners;” (3) Graves’ testimony that he spent a significant amount of time at the work site; and (4)Waddell and Graves dividing the contractor’s fee, we conclude the evidence does not preponderate against the Trial Court’s findings leading to its conclusion that Waddell and Graves were partners. Judgment for Valiga affirmed.”
Dividend preferences may vary greatly. Dividends may be cumulative or noncumulative . Dividends on cumulative preferred shares, if not paid in any year, accumulate until paid. The entire accumulation must be paid before any dividends may be paid to common shareholders. Dividends on noncumulative preferred shares do not accumulate if unpaid. Thus only the current year’s dividends must be paid to preferred shareholders prior to the payment of dividends to common shareholders. Participating preferred shares have priority up to a stated amount or percentage of the dividends to be paid by the corporation. Then, the preferred shareholders participate with the common shareholders in additional dividends paid. A redemption provision in the articles allows a corporation at its option to repurchase preferred shareholders’ shares at a price stated in the articles, despite the shareholders’ unwillingness to sell. Some statutes permit the articles to give the shareholders the right to force the corporation to redeem preferred shares. Preferred shares may be convertible into another class of shares, usually common shares. A conversion right allows a preferred shareholder to exchange her preferred shares for another class of shares, usually common shares. The conversion rate or price is stated in the articles. Preferred shares have voting rights unless the articles provide otherwise. Usually, most voting rights are taken from preferred shares, except for important matters such as voting for a merger or a change in preferred shareholders’ dividend rights. Rarely are preferred shareholders given the right to vote for directors, except in the event of a corporation’s default in the payment of dividends.
The MBCA expressly permits the board of directors to issue options for the purchase of the corporation’s shares. Share options are often issued to top-level managers as an incentive to increase the profitability of the corporation. Warrants are options evidenced by certificates. They are sometimes part of a package of securities sold as a unit. Rights are short-term certificated options that are usually transferable. Rights are used to give present security holders an option to subscribe to a proportional quantity of the same or a different security of the corporation. They are most often issued in connection with a preemptive right requirement, which obligates a corporation to offer each existing shareholder the opportunity to buy the corporation’s newly issued shares in the same proportion as the shareholder’s current ownership of the corporation’s shares.
Debentures are long-term, unsecured debt securities. Typically, a debenture has a term of 10 to 30 years. Debentures usually have indentures. An indenture is a contract that states the rights of the debenture holders. Bonds are long-term, secured debt securities that usually have indentures. They are identical to debentures except that bonds are secured by collateral
The transfer of a share certificate without naming a transferee creates a street certificate. The transfer of a street certificate may be made by delivery without indorsement. Any holder of a street certificate is presumed to be the owner of the shares it represents. Therefore, a transferee should ask the corporation to reregister the shares in his name.
A right of first refusal grants to the corporation or the other shareholders the right to match the offer that a selling shareholder receives for her shares. An option agreement grants the corporation or the other shareholders an option to buy the selling shareholder’s shares at a price determined by the agreement. A buy-and-sell agreement compels a shareholder to sell his shares to the corporation or to the other shareholders at the price stated in the agreement and obligates the corporation or the other shareholders to buy the selling shareholder’s shares at that price. A consent restraint requires a selling shareholder to obtain the consent of the corporation or the other shareholders before she may sell her shares.
The case is a good example of a poorly drafted buy-sell agreement that failed to attain the objectives of all the shareholders.
False. A promoter will be liable for contracts made during the preincorporation period unless the corporation adopts the contracts made by the promoter ( adoption ) and the third party agrees to substitute the corporation for the promoter ( novation ). True. False. A de jure corporation exists when promoters and incorporators substantially comply with each mandatory (shall, must) requirement to incorporate the business. De facto corporation : exists when promoters fail to comply with all of the mandatory requirements, yet comply with most of the mandatory provisions. True.
False. Common shareholders have the exclusive right to elect corporate directors. Preferred shareholders may have the right to elect corporate directors only if the preference is stated. Preferred shareholders have preference over common shareholders with regard to dividend payments. False. For-profit corporations may be financed by issuing securities, obtaining bank loans, or short-term financing (e.g., inventory financing). True.
The correct answer is (a). Stock is an equity security
The correct answer is (c).
Opportunity to discuss current status of market and valuation of companies.
1. C H A P T E ROrganization and Financial 42 Structure of Corporations Our business is company creation. Ann Winblad, venture capitalist, quoted in Fortune magazine (Sellen and Daniels, Oct. 1999) 42-1
2. Learning Objectives• Appreciate the risk of liability for corporate promoters• Understand the process for incorporating a business• Know the appropriate sources for financing a business• Explain share-transfer restrictions 42-2
3. Overview• Each state has enacted laws detailing how a corporation may be created• A promoter of a corporation incorporates the business, organizes initial management team, and raises initial capital• A promoter may be the person who originated the idea for the firm or may be a professional hired to undertake incorporation activities 42-3
4. Preincorporation Contracts• A promoter will be liable for contracts made during the preincorporation period unless the corporation adopts the contracts made by the promoter (adoption) and the third party agrees to substitute the corporation for the promoter (novation) – Like agency ratification, may be express or implied – Contracts adopted typically: employment and real property lease or purchase 42-4
5. SmithStearn Yachts, Inc. v. Gyrographic • Facts: – SmithStearn Yachts, Inc., (Smithstearn) a Delaware corporation providing luxury yachting services in Connecticut, agreed to a contract with Gyrographic Communications, Inc., a California company, for marketing and promotional services to SmithStearn – SmithStearn sued Gyrographic, which argued that it had made a contract with SmithStearn Yachts, LLC, not a corporation 42-5
6. SmithStearn Yachts, Inc. v. Gyrographic Comm., Inc.• Legal Analysis & Holding: – A corporation generally is not bound by contracts entered into on its behalf prior to its existence, but it can acquire rights and subject itself to duties for preincorporation matters – SmithStearn Yachts, Inc. was formed after execution of the agreement, but received benefit of the services pursuant to the agreement and thus ratified the contract 42-6
7. SmithStearn Yachts, Inc. v. Gyrographic Comm., Inc.• Legal Analysis & Holding: – Gyrographic developedg letterheads, business cards, and other marketing material for SmithStearn Yachts, Inc., and SmithStearn Yachts, Inc. made payments to Gyrographic – SmithStearn Yachts, Inc. is a proper party 42-7
8. Share Subscriptions• Preincorporation share subscriptions are contracts in which a prospective shareholder offers to buy a specific number of shares in a new corporation at a stated price• Under the Model Business Corporation Act (MBCA), a prospective shareholder may not revoke a preincorporation subscription for a six-month period 42-8
9. Promoter Duties• A promoter is not an agent of the proposed corporation or investors since they did not appoint the promoter, but a promoter owes a fiduciary duty to the corporation and to its prospective investors – No self-dealing, duty of loyalty, etc.• A corporation may compensate a promoter with shares 42-9
10. Incorporation• A U.S. business may incorporate in any state• Fees, taxes, and laws vary from state to state – See, e.g., Texas corporations section: • www.sos.state.tx.us/corp/index.shtml Stock Certificate of a Texas Corporation 42-10
11. Steps in Incorporation1. Prepare articles of incorporation2. Sign and authenticate articles by one or more incorporators3. File articles with secretary of state, pay fees4. Receive copy of articles of incorporation stamped “Filed” by secretary of state, along with fee receipt5. Hold organizational meeting for purpose of adopting bylaws, electing officers, and transacting other business 42-11
12. Incorporation Details• The articles of incorporation (or charter) is the basic document stating the rights and responsibilities of a corporation, its management, and its shareholders – Must add extension to name indicating corporate form: Inc., Corp., Co., Ltd. – Must include other specifics, such as number of shares authorized, initial registered office and agent’s name, name and address of each incorporator – See Fig. 1 42-12
13. Incorporation Details• Other provisions (not inconsistent with law) may be added to articles of incorporation or included within corporate bylaws – See Fig. 2• To retain corporate status, a corporation must file an annual report with secretary of state of the state of incorporation and pay an annual franchise fee or tax 42-13
14. Defective Incorporation• Sometimes, an attempt to incorporate fails – One consequence is that the corporate shield does not exist to protect shareholders, officers, and directors from personal liability – Another possibility is that a party to a contract involving a defective corporation may claim nonexistence of the corporation to avoid a contract made in the name of the corporation 42-14
15. De Jure Corporation• De jure corporation: exists when promoters and incorporators substantially comply with each mandatory (shall, must) requirement to incorporate the business• The validity of a de jure (by law) corporation cannot be attacked except by the state of incorporation due to noncompliance with state corporation laws 42-15
16. De Facto Corporation• De facto corporation: exists when promoters fail to comply with all of the mandatory requirements, yet comply with most of the mandatory provisions• Validity of a de facto corporation could be attacked by a third party, or itself, or the state of incorporation, but may be treated by as a corporation under the judicial doctrine of corporation by estoppel 42-16
17. The MBCA• Under the MBCA, filing the articles of incorporation is conclusive proof that the corporation exists• MBCA imposes joint and several liability for a purported corporation’s contracts and torts on managers and shareholders who both (1) participate in operational decisions of the business and (2) know the corporation does not exist 42-17
18. Christmas Lumber Co., Inc. v. Valiga• Facts: – Contractor (Waddell) and Valiga entered home construction contract, which fell through – Contractor had purchased construction materials from plaintiff (through Graves) and in 1990, plaintiff filed suit against Valiga and contractor – 1992: Valiga filed separate suit against Waddell and Graves, claiming defective incorporation – Suits consolidated; trial court found Waddell and Graves liable as partners to Valiga 42-18
19. Christmas Lumber Co., Inc. v. Valiga• Legal Reasoning & Holding: – Waddell said he didn’t know incorporation failed – Evidence: Waddell testified he and Graves were “partners,” the two entered a joint venture agreement, and they shared contractor’s fee – Conclusion: Waddell and Graves were partners – Judgment for Valiga affirmed 42-19
20. Non-Profit Incorporation• A non-profit corporation incorporates in same way as a profit corporation, but must declare whether it is a: – public benefit corporation, mutual benefit corporation, or religious corporation• Nonprofit corporation’s articles must also state whether it will have members 42-20
21. Financing Corporations• For-profit corporations are financed by: – Sale of securities: shares, debentures, bonds, and long-term notes payable – Short-term financing (e.g., inventory financing) – Bank loans 42-21
22. Equity Securities• Equity securities, better known as stock or shares, create an ownership relationship, thus stockholders or shareholders own a corporation• State laws permit corporations to issue classes of shares with specific rights: – Common – Preferred 42-22
23. Common Shareholders• Claims for dividend payments or asset distribution on liquidation are subordinate to creditor or preferred shareholder claims• However, common shareholders have the exclusive right to elect corporate directors and exclusive claim to corporate earnings and assets that exceed the claims of creditors and other shareholders 42-23
24. Preferred Shareholders• Preferred shareholders generally receive liquidation and dividend preferences over common shareholders• A corporation may have several classes of preferred shares with specific rights related to dividend payments, asset distribution upon liquidation, voting, stock redemption, and stock conversion 42-24
25. Share Types• Authorized shares are shares a corporation is permitted to issue by its articles of incorporation – A corporation may not issue more shares than authorized• Issued shares have been sold to shareholders• Outstanding shares are currently held by shareholders 42-25
26. Options, Warrants, & Rights• A board of directors may issue options for purchasing the corporation’s shares – Issued to top-level managers as an incentive• Warrants are options evidenced by certificates• Rights are short-term certificated options that are usually transferable – Used to give present security holders an option to subscribe to more shares 42-26
27. Debt Securities• Corporations may borrow money to operate by issuing debt securities, such as bonds, debentures, and notes payable• Debt securities create a debtor–creditor relationship between the corporation and the security holder 42-27
28. Debt Securities• Debentures are long-term, unsecured debt securities with a 10 to 30 years term – Having an indenture, or a contract stating the rights of the debenture holder• Bonds are long-term, secured debt securities – Identical to debentures except that bonds are secured by collateral• Notes generally have less than a five year term and may secured or unsecured 42-28
29. Consideration for Shares• MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation, including cash, promissory notes, contracts for services to be performed for the corporation, services performed for the corporation, and securities of the corporation or another corporation 42-29
30. Consideration for Shares• The board must issue shares for an adequate dollar amount of consideration• Par value is an arbitrary dollar amount that may be assigned to shares by the articles of incorporation – Does not reflect fair market value, but is the minimum amount of consideration for which the shares may be issued 42-30
31. Share Subscriptions• Under the terms of a share subscription, a prospective shareholder promises to buy a specific number of shares at a stated price – Generally in writing, though not required• A share certificate may not be issued to a share subscriber until the share price has been fully paid 42-31
32. Transfer of Shares• Share certificates are registered with the corporation in name of a specific person• Indorsement of a share certificate on back by the registered owner and delivery of the certificate to another person transfers ownership of the shares• Under the UCC, a corporation owes a duty to register transfer of any registered shares, provided it has proper indorsement 42-32
33. Transferability & Restrictions• Shares in a publicly held corporation are freely transferable, but often close corporations (less than 50 shareholders) restrict transfer to ensure control• Four categories of transfer restrictions: (1) rights of first refusal and option agreements, (2) buy-and-sell agreements, (3) consent restraints, and (4) provisions disqualifying purchasers 42-33
34. Coyle v. Schwartz• Court enforced a poorly drafted buy-sell agreement in which the shareholders were to agree from time to time on the price to be paid for the shares, but failed to do so 42-34
35. Test Your Knowledge• True=A, False = B – A promoter is always liable for contracts made during the preincorporation period. – A U.S. business may incorporate in any state. – A de facto corporation exists when promoters and incorporators actually comply with each mandatory requirement to incorporate – Warrants are stock options evidenced by certificates. 42-35
36. Test Your Knowledge• True=A, False = B – Preferred shareholders have exclusive right to elect corporate directors and the exclusive right to dividend payments. – For-profit corporations are financed only by issuing securities in the form of shares. – The MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation. 42-36
37. Test Your Knowledge• Multiple Choice – Which of the following is not a debt security: a) Stock b) Bond c) Debenture d) Note e) none of the above 42-37
38. Test Your Knowledge• Multiple Choice – The Steel Inc. Board of Directors plans to issue dividends this year. Which of the following is false? a) Preferred shareholders receive their dividends before common shareholders b) Creditors receive their dividends before common shareholders c) Common shareholders receive their dividends before either creditors or preferred shareholders 42-38
39. Thought Question• Do you believe that a company’s stock price reflects a company’s value or success in (a) the marketplace, and (b) society? 42-39