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  1. 1. Chapter 18 Corporations
  2. 2. § 1: The Nature of the Corporation <ul><li>A corporation is a creature of statute, an artificial “person.” </li></ul><ul><ul><li>Most states follow the Model Business Corporation Act (MBCA) or the RMBCA, that are model corporation laws. </li></ul></ul><ul><li>The shares (stock) of a corporation are owned by at least one shareholder (stockholder). </li></ul>
  3. 3. Nature of the Corporation <ul><li>The corporation substitutes itself for the natural persons in conducting corporate business and incurring liability, but its authority and liability are separate and apart from the shareholders. </li></ul><ul><li>In certain situations, the corporate “veil” of limited liability can be pierced, holding the shareholders personally liable. </li></ul>
  4. 4. Corporate Personnel <ul><li>Individual shareholders own corporation. </li></ul><ul><li>Shareholders elect board of directors to manage corporation. </li></ul><ul><li>Board of directors hires officers to run corporation on a daily basis. </li></ul>
  5. 5. Corporate Personnel <ul><li>Body of shareholders can change constantly without affecting the continued existence of the corporation. </li></ul><ul><li>Shareholder can sue corporation and be sued by corporation and bring suit for corporation in some instances (derivative action). </li></ul>
  6. 6. Corporate Taxation <ul><li>Corporate profits can either be kept as retained earnings or passed on to the shareholders as dividends . </li></ul><ul><li>Corporate profits are taxed under federal and state law as a separate “person” from its shareholders. </li></ul><ul><li>Regular “C” corporations are taxed twice: at the corporate level and at the shareholder level. </li></ul>
  7. 7. § 2: Classification of Corporations <ul><li>Domestic corporation does business in its state of incorporation. </li></ul><ul><li>Foreign corporation from X state doing business in Z state. </li></ul><ul><li>Alien Corporation: formed in another country doing business in United States. </li></ul>
  8. 8. Classification of Corporations <ul><li>Public and Private. </li></ul><ul><li>Nonprofit. </li></ul><ul><li>Close Corporations. </li></ul><ul><ul><li>Shares held by few shareholders. </li></ul></ul><ul><ul><li>More informal management,similar to a partnership. </li></ul></ul><ul><ul><li>Restriction on transfer of shares. </li></ul></ul>
  9. 9. Classification of Corporations <ul><li>“ S Corporations”: Avoids the federal “double taxation” of regular corporations at the corporate level. Only dividends are taxed to the shareholders as personal income. IRS requirements: </li></ul><ul><ul><li>Corporation is domestic, fewer than 75 shareholders, only one class of stock, no shareholder can be a non-resident alien. </li></ul></ul><ul><li>Professional Corporations. </li></ul>
  10. 10. § 3: Corporate Formation <ul><li>The process of incorporation generally involves two steps: </li></ul><ul><ul><li>Preliminary and Promotional Activities; and </li></ul></ul><ul><ul><li>The Legal Process of Incorporation. </li></ul></ul>
  11. 11. Incorporation Process Promotion Name Search File Articles of Incorporation Subscribers 1st Organiza-tional Meeting State Charter
  12. 12. Promotional Activities <ul><li>Before corporation is formed, promoters are the persons who take the preliminary steps of organizing the venture and attracting investors via subscription agreements. </li></ul>
  13. 13. Promoter’s Liabilities <ul><li>A Promoter (or corporation) can create a prospectus required by federal and state securities laws to inform and protect investors. </li></ul><ul><li>Promoter is personally liable for pre-incorporation contracts on behalf of the corporation, unless 3 rd party agrees to hold future corporation liable. </li></ul>
  14. 14. Promoter’s Liabilities <ul><li>After corporate formation, corporation can adopt the pre-incorporation contract and release the promoter by creating a “novation” . </li></ul><ul><li>Subscribers and Subscription Agreements: continuing contracts to purchase stock. Generally, subscribers become stockholders upon corporate formation. </li></ul>
  15. 15. Articles of Incorporation <ul><li>State Chartering: </li></ul><ul><ul><li>Select state (some states such as Delaware cater to corporations http://www.state.de.us/corp/ ). </li></ul></ul><ul><ul><li>Articles of Incorporation : primary enabling document filed with the Secretary of State that includes basic information about the corporation. Person(s) who execute the articles are the incorporators. See sample articles of incorporation at the Texas Secretary of State http://www.sos.state.tx.us/corp/forms.shtml </li></ul></ul>
  16. 16. Articles of Incorporation <ul><li>Choose and reserve a Corporate Name. Name must have the proper suffix: “Corporation,” “Corp.,” “Incorporated.” </li></ul><ul><li>You should also consider registering the corporation as a “dot com” at networksolutions .com or register.com . </li></ul>
  17. 17. Articles of Incorporation <ul><li>Purpose: trend towards “any legal business.” </li></ul><ul><li>Duration: usually perpetual. </li></ul><ul><li>Capital Structure: Most states requires some minimal capitalization (Texas requires $1,000), plus number and class(es) of shares authorized and “par value” of shares at incorporation. </li></ul>
  18. 18. Articles of Incorporation <ul><li>Internal Organization: usually included in the bylaws. </li></ul><ul><li>Registered Office and Agent: specific person that will receive any legal notice and documents from state and/or 3 rd parties. </li></ul><ul><li>Incorporators (usually the promoter): at least one with name and address. </li></ul>
  19. 19. § 4: Improper Incorporation <ul><li>Errors in incorporation procedures when a 3 rd party seeks to bring an action against a corporation that may not have complied perfectly with every incorporation law. </li></ul><ul><li>Problematic for shareholders who may be personally liable. </li></ul><ul><li>In addition, entity may not be able to enforce contracts. </li></ul>
  20. 20. Improper Incorporation <ul><li>De Jure: substantial statutory requirements are met; cannot be attacked by state or 3 rd parties. </li></ul><ul><li>De Facto : statutory requirements not met, but promoters made good faith effort to comply with corporate law;corporate status can only be attacked by state. </li></ul><ul><li>By Estoppel : if it acts like a corporation, cannot avoid liability by claiming that no corporation exists. </li></ul>
  21. 21. § 5: Disregarding the Corporate Entity <ul><li>“ Piercing the Corporate Veil” occurs when a court, in the interest of justice or fairness,” holds shareholders personally liable for corporate acts. </li></ul><ul><li>Court concludes that shareholders used corporation as a “shield” from illegal activity . </li></ul>
  22. 22. Piercing the Corporate Veil <ul><li>Factors a court considers: </li></ul><ul><ul><li>3 rd party tricked into dealing with a corporation rather than the individual. </li></ul></ul><ul><ul><li>Corporation is set up never to make a profit or remain insolvent or is under capitalized. </li></ul></ul><ul><ul><li>Statutory formalities are not followed. </li></ul></ul>
  23. 23. <ul><li>Corporation is “alter ego” of majority shareholder and personal and corporate interest are commingled such that the corporation has no separate identity. </li></ul><ul><li>Case 18.1: Dimmitt & Owens Financial, Inc. v. Superior Sports Products, Inc. (2002). </li></ul>Commingling of Personal and Corporate Assets
  24. 24. § 6: Directors, Officers and Shareholders <ul><li>Every corporation is governed by a board of directors that are elected by the shareholders. </li></ul><ul><li>Individual directors are not agents of corporation, only the board itself can act as a “super-agent” and bind the corporation. </li></ul><ul><li>A director can also be a shareholder, especially in closely-held corporations. </li></ul>
  25. 25. Role of Directors <ul><li>Subject to statutory limitations, the number of directors is set forth in the articles of incorporation: </li></ul><ul><ul><li>Directors appointed at the first organizational meeting. </li></ul></ul><ul><ul><li>In closely held companies, directors are generally the incorporators and/or the shareholders. </li></ul></ul><ul><ul><li>Term of office is generally for one year. </li></ul></ul><ul><ul><li>Director can be removed for cause (for failing to perform a required duty). </li></ul></ul>
  26. 26. Directors’ Meetings <ul><li>Directors hold meetings pursuant to bylaws with recorded minutes. </li></ul><ul><li>Special meetings may be called with sufficient notice. </li></ul><ul><li>Meetings require QUORUM (minimum number of directors to conduct official corporate business, usually majority). </li></ul><ul><li>Each director generally has one vote. </li></ul>
  27. 27. Rights of Directors <ul><li>Directors have the right to: </li></ul><ul><ul><li>Participate in corporate decisions and inspect corporate books and records. </li></ul></ul><ul><ul><li>Compensation (usually a nominal sum) and indemnification . If a director is sued for acts as director, the corporation should guarantee reimbursement (indemnification) or purchase liability insurance to protect the board from personal liability. </li></ul></ul>
  28. 28. Directors’ Management Responsibilities <ul><li>Directors have general responsibility for all management decisions: </li></ul><ul><ul><li>All major corporate policies </li></ul></ul><ul><ul><li>Appointment and removal of all corporate officers and their compensation. </li></ul></ul><ul><ul><li>Financial decisions, including dividends and retained earnings. </li></ul></ul>
  29. 29. Role of Corporate Officers and Executives <ul><li>Officers serve at the pleasure of the Board of Directors but have fiduciary duties to company as well. </li></ul><ul><li>Their employment relationships are generally governed by contract law and employment law. </li></ul><ul><li>Officers may be terminated for cause. </li></ul>
  30. 30. Role of Corporate Officers and Executives <ul><li>Officers and executives are hired by the board of directors. </li></ul><ul><li>Act as agents for the corporation. </li></ul><ul><li>Most states same person can be both officer and director. </li></ul><ul><li>Officers are employees of the corporation and have fiduciary and loyalty duties. </li></ul>
  31. 31. Fiduciary Duties of Directors and Officers <ul><li>Directors and officers are fiduciaries of the corporation. They owe ethical and legal duties to the corporation and shareholders: </li></ul><ul><li>Duty of Care : Directors/officers are expected to act in good faith and the best interests of the corporation. Failure to exercise due care may subject individual directors or officers personally liable. </li></ul>
  32. 32. Fiduciary Duties of Directors and Officers <ul><li>Duty of Care ( cont’d ): </li></ul><ul><ul><li>Make informed and reasonable decisions; </li></ul></ul><ul><ul><li>Rely on competent consultants and experts; and </li></ul></ul><ul><ul><li>Exercise reasonable supervision. </li></ul></ul><ul><li>A dissenting director is rarely held liable for mismanagement of corporation. Dissent must be registered with the corporate secretary and posted in the minutes of the meetings. </li></ul>
  33. 33. <ul><li>Duty of Loyalty : subordination of personal interests to the welfare of the corporation. </li></ul><ul><ul><li>No competition with Corporation. </li></ul></ul><ul><ul><li>No “corporate opportunity.” </li></ul></ul><ul><ul><li>No conflict of interests. </li></ul></ul><ul><ul><li>No insider trading. </li></ul></ul><ul><ul><li>No transaction that is detrimental to minority shareholders </li></ul></ul><ul><li>Case 18.2: In Re Cumberland Farms (2002). </li></ul>Fiduciary Duties of Directors and Officers
  34. 34. <ul><li>No Conflicts of Interest: full disclosure of any potential conflicts of interest and abstain from voting on any transaction that may benefit the director/officer personally. </li></ul><ul><li>However, if transaction was fair and reasonable, it will not be voidable if approved by majority of disinterested directors. </li></ul>Fiduciary Duties of Directors and Officers
  35. 35. Liability of Directors and Officers <ul><li>Directors and officers may be liable for negligent acts that breach the standard of due care: </li></ul><ul><ul><li>Crimes and torts committed by individually and/or those committed by employees under their supervision. </li></ul></ul><ul><ul><li>Shareholder derivative suits where shareholder(s) sue directors on behalf of corporation]. </li></ul></ul>
  36. 36. Business Judgment Rule <ul><li>Immunizes a director or officer from liability from consequences of a business decision that turned sour. </li></ul><ul><li>Court will not require directors or officers to manage “in hindsight.” </li></ul><ul><li>As long as decision was reasonable, informed, made in good faith and in the best interests of the corporation, BJR will apply. </li></ul><ul><li>Case 18.3: FDIC v. Castetter (1999). </li></ul>
  37. 37. Role of Shareholders <ul><li>Ownership of shares grants an equitable ownership interest in a corporation. </li></ul><ul><li>Shareholders generally have no right to manage the daily affairs of the corporation, but do so indirectly by electing directors. </li></ul><ul><li>Shareholders are generally protected from personally liability by the corporate veil of limited liability. </li></ul>
  38. 38. Shareholder Powers <ul><li>Shareholder powers include approving all fundamental changes to the corporation: </li></ul><ul><ul><li>Amending articles of incorporation or bylaws. </li></ul></ul><ul><ul><li>Approval of mergers or acquisition. </li></ul></ul><ul><ul><li>Sale of all corporate assets or dissolution. </li></ul></ul><ul><li>Shareholders also elect and remove the board of directors. </li></ul>
  39. 39. Shareholder Meetings <ul><li>Shareholders’ meetings must occur at least annually. Voting requirements and procedures are: </li></ul><ul><ul><li>Quorum of shareholders owning more than 50% of shares must be present to conduct business; </li></ul></ul><ul><ul><li>Shareholders may appoint a proxy or enter into a voting trust agreement. </li></ul></ul>
  40. 40. Shareholder Meetings <ul><li>For special shareholder meetings: </li></ul><ul><ul><li>Notice and time of meetings must be sent in writing to each shareholder within a reasonable time ahead of the meeting. </li></ul></ul><ul><ul><li>Notice must state reason for meeting and only deal with this matter. </li></ul></ul>
  41. 41. Shareholder Voting <ul><li>Common shareholder entitled to one vote per share. </li></ul><ul><li>Articles and by-laws can exclude or limit voting rights of certain classes of stock. </li></ul><ul><li>Quorum must be present -- shareholders representing more than 50% of outstanding shares must be present. </li></ul>
  42. 42. Shareholder Voting <ul><li>Shareholders may vote on resolutions. </li></ul><ul><ul><li>Need majority present for most resolutions. </li></ul></ul><ul><ul><li>Need a “super majority” (e.g., 67%) for important matters: sale of assets, etc.. </li></ul></ul><ul><li>Voting lists by corporate secretary contains record of stock ownership. [Cut off date 70 days ahead of action (notice, dividends, etc..)] </li></ul>
  43. 43. Shareholder Voting <ul><li>Methods of Increasing Minority Shareholder Power Within the Corporation: </li></ul><ul><ul><li>Cumulative Voting allows minority shareholders to get a board member elected. </li></ul></ul><ul><ul><ul><li>x # to be elected x shareholders # of shares = shareholder can cast them all for one board nominee. </li></ul></ul></ul><ul><ul><li>Shareholder Voting Agreements. </li></ul></ul><ul><ul><li>Voting Trusts—Trustee votes the shares. </li></ul></ul>
  44. 44. Shareholder Voting <ul><li>Proxies and Shareholder proposals under Securities and Exchange Commission Rule 14a-8: </li></ul><ul><ul><li>Proxy solicitation must include proposals which will be discussed at the meeting. </li></ul></ul><ul><ul><li>Shareholders who own $1,000 worth of stock may submit their own proxy solicitations. </li></ul></ul><ul><ul><li>Company does not have to include shareholder proposals which relate to “ordinary business operations.” </li></ul></ul>
  45. 45. Rights of Shareholders <ul><li>Shareholders have the right: </li></ul><ul><ul><li>To vote. </li></ul></ul><ul><ul><li>To have a stock certificate. </li></ul></ul><ul><ul><li>To purchase newly issued stock. </li></ul></ul><ul><ul><li>To dividends, when declared by board. </li></ul></ul><ul><ul><li>To inspect corporate records. </li></ul></ul><ul><ul><li>To transfer shares, with some exceptions. </li></ul></ul><ul><ul><li>To a proportionate share of corporate assets on dissolution. </li></ul></ul><ul><ul><li>To file suit on behalf of corporation. </li></ul></ul>
  46. 46. Stock Certificates <ul><li>Certificate which evidences ownership in a certain number of shares in the corporation given to person of record (regardless of who has certificate) gets notices, dividends & reports. </li></ul><ul><li>Corporate ownership is intangible personal property. </li></ul><ul><li>Some states allow uncertificated stock -- no tangible certificate. </li></ul>
  47. 47. Preemptive Rights <ul><li>Common law concept which is a preference to existing shareholders to purchase a pro-rated share of newly-issued stock within a certain period of time. </li></ul><ul><li>Provided for in the articles of incorporation. </li></ul><ul><li>Significant in a close corporation to prevent dilution and loss of control. </li></ul>
  48. 48. Stock Warrants <ul><li>Transferable options to purchase newly-issued stock at a stated price. </li></ul><ul><li>Warrants are publicly traded. </li></ul><ul><li>Called “rights” when option is for a short period of time. </li></ul>
  49. 49. Dividends <ul><li>Distribution of corporate profits or income. </li></ul><ul><li>Only as ordered by the Board. </li></ul><ul><li>Can be stock, cash, property, stock of other corporations. </li></ul><ul><li>State laws control the sources of revenues for dividends, which may be paid from retained earnings, net profits and surplus. </li></ul>
  50. 50. Illegal Dividends <ul><li>If dividends paid from an unauthorized account shareholder must return if she knew they were illegal when received. </li></ul><ul><li>Directors can be held personally liable for the amount of payment. </li></ul><ul><li>Dividends paid when corporation is insolvent are automatically illegal. </li></ul>
  51. 51. Directors’ Failure to Declare Dividends <ul><li>When directors fail to declare a dividend, shareholders can sue. </li></ul><ul><li>Directors do not have to declare if they have a rational basis for withholding a dividend (a bona fide purpose). </li></ul><ul><li>Often, profits are retained for expansion, research or upgrades. </li></ul>
  52. 52. Inspection Rights <ul><li>Shareholders can inspect books for a proper purpose. </li></ul><ul><ul><li>But corporation can protect trade secrets, other confidential information. </li></ul></ul><ul><ul><li>Shareholder must have held a minimum number of shares for a minimum amount of time. </li></ul></ul><ul><li>All shareholders can see list of other shareholders of record. </li></ul>
  53. 53. Transfer of Shares <ul><li>Shares are freely transferable unless restricted by articles and noted on the stock certificate. </li></ul><ul><li>Closely held corporations may have “right of first refusal” or preemptive rights. </li></ul><ul><li>Transfer accomplished by delivery or endorsement to corporate secretary. </li></ul><ul><li>New shareholder must be recorded on corporate books. </li></ul>
  54. 54. Rights on Dissolution <ul><li>Shareholders have right to pro-rata share of assets upon liquidation. </li></ul><ul><li>Shareholder may petition the court for dissolution of the corporation for following reasons: </li></ul><ul><ul><li>Board mishandling corporate assets. </li></ul></ul><ul><ul><li>Board deadlocked and irreparable injury will result. </li></ul></ul><ul><ul><li>Acts of directors are illegal, oppressive, or fraudulent. </li></ul></ul><ul><ul><li>Shareholders are deadlocked for two meetings and can’t elect directors. </li></ul></ul>
  55. 55. Shareholder Derivative Suit <ul><li>Shareholders can sue a 3 rd party on behalf of the corporation if the Directors fail or refuse to correct the wrong or injury. </li></ul><ul><li>Directors may refuse to take action because they might personally be liable. </li></ul><ul><li>Any damages recovered go to corporation’s treasury. </li></ul>
  56. 56. Liability of Shareholders <ul><li>Shareholders are generally not liable for the contracts or torts of the corporation. </li></ul><ul><li>If the corporation fails, shareholders cannot lose more than their investment, except when: </li></ul><ul><ul><li>A shareholder hasn’t paid for stock pursuant to the subscription agreement. </li></ul></ul><ul><ul><li>Shareholder buys “watered stock” which is below the stock’s par value. </li></ul></ul>
  57. 57. Liability of Shareholders <ul><li>Stock subscriptions are written irrevocable contracts to purchase capital stock of a corporation prior to incorporation. Failure to sell or buy shares is a breach of contract. </li></ul><ul><li>Par-value shares: corporation must have a value equal to the total value of the shares. </li></ul><ul><li>Watered stock : worth less than FMV of stock. Shareholder is personally liable for difference. </li></ul>
  58. 58. Duties of Majority Shareholders <ul><li>Majority shareholders own enough shares to exercise de facto (actual) control over the corporation. </li></ul><ul><li>Majority shareholders owe a fiduciary duty to corporation and the minority shareholders and creditors when they sell their shares because of the possibility of transfer of control. </li></ul><ul><li>Case 18.4: Hayes v. Olmsted & Assoc. (2001). </li></ul>
  59. 59. Law on the Web <ul><li>SEC Edgar database. </li></ul><ul><li>State Corporation Statutes at Cornell U. </li></ul><ul><li>The Texas Business Corporation Act . </li></ul><ul><li>Center for Corporate Law at Cincinnati U College of Law . </li></ul><ul><li>FAQ’s on incorporation at Bizfilings .com </li></ul><ul><li>Legal Research Exercises on the Web. </li></ul>