Corporations

Question 1

Overview

Answer 1

A corporation is a legal entity apart from its owners (the shareholders). Generally, only the corporation (and not the people who own or work for the corporation) is liable for the corpo- ration’s obligations. To qualify for this entity treatment, the corporation must be formed by filing a document with the state (in most states “the articles of incorporation”) setting out certain information. Rules for corporate governance may be set out in the articles or in bylaws adopted by the corporation. Ownership interests in the corporation are then sold in the form of stock or shares which give the shareholders certain rights (e.g., to receive distributions when declared and to vote). Shareholders elect directors to oversee the corporation, and the directors appoint officers to run the company on a day-to-day basis. Directors and officers owe the corporation a duty to act as similarly situated prudent persons and cannot “self-deal” for their own benefit. Before a fundamental change can be made to the corporation, share- holders must be informed and given an opportunity to vote on the change.

Question 2

ORGANIZATION AND FORMATION OF CORPORATION - Have Articles of Incorporation Been Filed?

Answer 2

1. Name of corporation must be included; cannot be similar to existing names
2. Number of authorized shares must be included
3. Also must include name and address of incorporators and of registered agent
4. Watch for clause limiting corporation’s purpose—activities beyond scope of purpose are ultra vires and may be enjoined or directors held liable for authorizing such acts

Question 3

ORGANIZATION AND FORMATION OF CORPORATION - When Does Corporate Existence Begin?

Answer 3

1. When articles filed by state
2. Promoters generally liable for pre-incorporation contracts
   a. Liability continues even after corporation formed absent a novation
   b. Corporation does not become liable unless it adopts (can be express or implied)

Exception: Promoter will not be liable on a pre-incorproation K if the agreement between the parties expressly indicates that the promoter is not to be bound

Question 4

ORGANIZATION AND FORMATION OF CORPORATION - What if There Are Defects in Formation?

Answer 4

1. A person who purports to act on behalf of a corporation knowing there was no valid incorporation is personally liable
2. No liability if de facto corporation:
   a. Colorable compliance with the incorporation statute; and
   b. Exercise of corporate privileges
3. No liability if corporation by estoppel—people treating business as valid corporation are estopped from denying corporation’s existence
4. Some states do not recognize de facto and estoppel doctrines
5. Where no corporation recognized, only those who acted on behalf of the business will be held liable; passive investors not liable

Question 5

ORGANIZATION AND FORMATION OF CORPORATION - Will Court Disregard Corporate Entity (Pierce the Corporate Veil)?

Answer 5

1. Alter ego doctrine
   a. Grounds—harm caused to third party because:
   1) Owners do not treat corporation as a separate entity
   2) Commingle personal and corporate funds
   3) Use corporate assets for personal purposes
   4) Owners do not hold meetings
   b. Parent/subsidiary corporations or affiliated corporations can be held liable for this
2. Inadequate capitalization at inception
   a. Must start corporation with sufficient unencumbered capital to meet its prospective liabilities
3. Perpetrating a fraud
   a. Cannot be formed to avoid existing liabilities
   b. Can be formed to limit future liabilities
4. If court pierces:
   a. Generally only active shareholders liable
   b. Generally liable only for tort obligations

Question 6

ORGANIZATION AND FORMATION OF CORPORATION - Capital Structure of Corporation

Answer 6

1. Debt securities (bonds) create debtor-creditor relationship
2. Equity securities (stocks) create ownership interest
   a. Terminology
   1) Authorized but unissued shares—shares described in the articles but not currently issued
   2) Issued and outstanding—shares sold to investors
   3) Treasury shares—former name for shares repurchased by corporation; now called authorized but unissued shares
   b. Subscription agreements—agreements to purchase shares from corporation
   1) Preincorporation subscription agreements are irrevocable for six months
   c. Consideration for shares
   1) Acceptable form
   a) Under Revised Model Business Corporations Act (“MBCA”), any benefit to the corporation
   b) Traditionally only cash, property, or services already performed
   2) Amount
   a) Under MBCA, amount set by directors, and their good faith valuation of the consideration received is conclusive
   b) Traditionally shares often had a par value (minimum consideration) and could not be sold for less

Question 7

SHAREHOLDERS - Voting

Answer 7

1. Generally shareholders do not run corporation on a day-to-day basis
   a. Exception: Closely held corporation may dispense with board by shareholders’ agreement and run corporation through a different scheme
   b. Shareholders indirectly control corporation by electing directors, amending bylaws, and approving fundamental changes
2. Record shareholders
   a. Shareholders of record on the record date have a right to vote:
   1) At the annual meeting to elect directors
   2) Regarding fundamental corporate changes
3. Notice of meetings must be given to shareholders
   a. Annual meeting—date, time, location
   b. Special meeting—date, time, location, and purpose
   c. Improper notice
   1) Action taken at the meeting can be nullified
   2) Can be waived by attending without complaint
4. Proxies
   a. Written proxies valid for 11 months
   b. Generally revocable unless they specifically provide otherwise and are coupled with an interest
   c. May be revoked by attendance or later appointment
   d. Federal law
   1) Proxy solicitations must fully and fairly disclose all material facts
   2) Prohibits material misstatements and fraud in connection with a proxy solicitation
   3) Materiality—a reasonable shareholder would consider it important in deciding how to vote
5. Quorum
   a. Generally a majority of the outstanding voting shares must be present for valid vote
   b. Once quorum reached, shareholder leaving does not invalidate voting
6. Approval
   a. MBCA—if quorum present, action approved if votes cast in favor exceed votes cast against
   b. Some states require greater vote for fundamental corporate change
   c. Cumulative voting for directors
   1) MBCA allows articles to provide for cumulative voting
   2) Cumulative voting is automatic in some states
   3) Mechanics—shareholder can vote shares owned x number of directors being elected; can cast all votes for one candidate or split

Question 8

SHAREHOLDERS - Shareholder Agreements

Answer 8

1. Voting trusts
   a. Shareholders transfer share ownership to a trustee who votes shares as agreed
   b. Valid in most states for up to 10 years but renewable
2. Shareholder management agreements
   a. Used in small corporations
   b. Shareholders may agree to run the corporation in any way
   c. Can even dispense with board
3. Share transfer restrictions
   a. Ownership interests (shares) generally are freely transferable
   b. Shares may conspicuously provide for restriction
   c. Restrictions must be reasonable

Question 9

SHAREHOLDERS - Inspection Rights

Answer 9

1. Limited—books, papers, accounting records, etc.
   a. With five days’ written notice, and
   b. Proper purpose (purpose related to the shareholder’s rights)
2. Unqualified right (regardless of purpose)—articles and bylaws, minutes of share- holder meetings, names and addresses of current directors, and recent annual reports

Question 10

SHAREHOLDERS - Preemptive Right

Answer 10

1. Right to purchase shares to maintain proportionate ownership interest
2. Under MBCA exists only if provided for
3. Where provided for, does not apply to:
   a. Shares issued as compensation
   b. Shares issued within six months of incorporation
   c. Shares issued for consideration other than money
   d. Nonvoting shares with a distribution preference

Question 11

SHAREHOLDERS - Shareholder Suits

Answer 11

1. Direct vs. derivative
   a. Direct suit is to enforce right of shareholder
   b. Derivative suit is to enforce a right belonging to corporation
   1) Must have owned shares at time of wrong
   2) Must maintain ownership throughout suit
   3) Demand board to bring suit (unless futile in some states)
2. Dismissal—if a majority of directors with no personal interest determine in good faith that suit is not in best interests of corporation
3. Recovery
   a. Direct suit—goes to shareholder
   b. Derivative suit—goes corporation (usually)

Question 12

SHAREHOLDERS - Distributions

Answer 12

1. Generally are in the form of dividends or of assets after dissolution
2. No right to receive unless/until declared by board
   a. Insolvency limitations—no distribution if:
   1) Corporation unable to pay its debts as they become due
   2) Total assets are less than total liabilities
   b. Preferences—shares may have a preference to distributions
   1) Cumulative—if distribution not declared or paid in a certain year, it accumulates until paid
   2) Cumulative if earned—preference accumulates only if profits for year were sufficient to pay preference
   3) Participating—receive stated preference and a share of the distribution made to common shareholders
   c. Director liability
   1) Director who votes for an unlawful distribution is personally liable for the excess
   2) Director may seek contribution from other directors who voted for distribution
   3) Directors may recover from a shareholder who received a distribution knowing it was unlawful
   4) Good faith defense—may rely on accountants or reliable officers and employees who indicate distribution is lawful

Question 13

SHAREHOLDERS - Shareholder Liabilities

Answer 13

1. Shareholders not fiduciaries—may act in self-interest
2. Exception—controlling shareholder cannot use control to obtain a special advantage at the expense of the minority shareholders

Question 14

DIRECTORS - Voting

Answer 14

1. Meetings
   a. Directors must attend in person (no proxies) or through telecommunications equipment if all participating directors can simultaneously hear each other
   b. No particular notice required for regular meetings
   c. Special meetings typically require two days’ notice of date, time, and place (but not purpose)
   d. Quorum of directors must be present at time vote is taken
   e. Approval of action requires affirmative vote of a majority of the directors present
2. Delegation to executive committees—may exercise authority given to them by board
   a. Comprised of two or more directors (in most states)
   b. Exceptions: In most states committees may not declare distributions, fill board vacancies, or amend the bylaws

Question 15

DIRECTORS - Liabilities and Indemnification

Answer 15

1. Liabilities
   a. Business judgment rule generally protects directors from personal liability to corporation/shareholder
   1) Director must act in good faith
   2) With the care that an ordinarily prudent person in a like position would exercise, and
   3) In a manner reasonably believed to be in the best interests of the corporation
   b. **Articles may further limit or eliminate director personal liability to corporation or shareholders except:
   1) To the extent director received improper benefit;
   2) For liability for unlawful distributions; or
   3) For intentionally inflicted harms or criminal violations of law
   c. Reasonable reliance defense
   1) Director may defend suits with a claim of reasonable reliance on opinions, reports, etc., prepared by experts or reliable employees
   d. Waste—a director has a duty to prevent corporate waste
   e. **No self-dealing without disclosure and approval—duty of loyalty
   1) A transaction between a corporation and a director will not be set aside for self-dealing if:
   a) The director disclosed all material facts, and transaction was approved by disinterested directors or shareholders; or
   b) The transaction was fair to the corporation
   f. Corporate opportunity doctrine
   1) A director may not divert to himself a business opportunity within the corporation’s line of business without first giving the corporation an opportunity to act (a.k.a. usurpation)
   2) Remedy—corporation may recover director’s profits or force director to convey the opportunity to the corporation
2. Indemnification
   a. Successful defense—if director is sued as a director and successfully defends, corporation must indemnify for expenses
   b. Unsuccessful—if director is unsuccessful in defending, corporation has discretion to indemnify if the director complied with the business judgment rule standards
   1) Exceptions: Director is found liable to the corporation or received an improper benefit
   c. Corporations may purchase liability insurance to cover directors even if they would not be entitled to indemnification under the circumstances

Question 16

OFFICERS - Required Officers

Answer 16

1. MBCA does not require any particular officers but rather allows corporations to have officers described in bylaws or appointed by directors
2. Some states require at least two officers—a president and a secretary (to certify corporate acts and records)
3. Generally, a person may hold more than one office (but some states prohibit presi- dent and secretary from being same person)

Question 17

OFFICERS - Appointment and Removal

Answer 17

1. Officers are appointed by board of directors (not by shareholders)
2. Officers may be removed by the board of directors
3. If removal is in breach of contract, officer entitled to damages

Question 18

OFFICERS - Authority

Answer 18

1. Officers have the actual authority given by the board, articles, and bylaws
2. Officers have apparent authority to do whatever someone in their position would normally have authority to do

Question 19

OFFICERS - Liabilities and Indemnification

Answer 19

1. Officers owe corporation duties similar to those owed by directors
2. Officers have right to indemnification similar to directors

Question 20

FUNDAMENTAL CORPORATE CHANGES - Voluntary Dissolution

Answer 20

1. If shares have not yet been issued or business has not yet commenced, a majority of the incorporators or initial directors may dissolve corporation by delivering articles of dissolution to the state
2. After shares have been issued, corporation may dissolve by a corporate act approved under the fundamental change procedure

Question 21

FUNDAMENTAL CORPORATE CHANGES - Effect of Dissolution

Answer 21

1. Corporate existence continues
2. Corporation not allowed to carry on any business except business appropriate to winding up and liquidating its affairs
3. A claim can be asserted against a dissolved corporation, even if it does not arise until after dissolution, to the extent of the corporation’s undistributed assets
   a. If the assets have been distributed to the shareholders, a claim can be asserted against each shareholder for a pro rata share of the claim, to the extent of the assets distributed to the shareholder
   b. A corporation can cut short the time for bringing known claims by notifying claimants of a filing deadline
   c. Unknown claims can be limited to five years by publishing notice of the disso- lution in a newspaper in the county where the corporation’s known place of business is located

Question 22

FUNDAMENTAL CORPORATE CHANGES - Administrative Dissolution

Answer 22

The state may bring an action to administratively dissolve a corporation for reasons such as the failure to pay fees or penalties, failure to file an annual report, and failure to maintain a registered agent in the state

Question 23

FUNDAMENTAL CORPORATE CHANGES - Judicial Dissolution

Answer 23

1. The attorney general may seek judicial dissolution on the ground that the corpo- ration fraudulently obtained its articles of incorporation or that the corporation is exceeding or abusing its authority
2. Shareholders may seek judicial dissolution on any of the following grounds:
   a. The directors are deadlocked in the management of corporate affairs, the share- holders are unable to break the deadlock, and irreparable injury to the corporation is threatened, or corporate affairs cannot be conducted to the advantage of the shareholders because of the deadlock;
   b. The directors have acted or will act in a manner that is illegal, oppressive, or fraudulent;
   c. The shareholders are deadlocked in voting power and have failed to elect one or more directors for a period that includes at least two consecutive annual meeting dates; or
   d. Corporate assets are being wasted, misapplied, or diverted for noncorporate purposes
3. Creditors may seek judicial dissolution if:
   a. The corporation has admitted in writing that the creditor’s claim is due and owing and the corporation is insolvent or
   b. The creditor’s claim has been reduced to judgment, execution of the judgment has been returned unsatisfied, and the corporation is insolvent