Corporate Organization and Management
1. Corporate Form
Characteristics
Limited Liability
Free Transferability of Ownership Interests
Continuity of Existence
Centralized management
Entity Status
Articles and Bylaws
Articles control over bylaws
Articles give the corporation is authority to operate.
Bylaws govern day to day affairs, but cannot exceed scope of articles.
Pre-Incorporation Contracts
A pre-incorporation contract is a contracts that is entered into before the corporation is formed
Liability for pre-incorporation contracts.
Promoter's Liability: The promoter is personally liable for a pre-incorporation contract.
The promoter is not released from liability when the corporation accepts the contract
The promoter may be released from the contract if there is a novation
The promoter is not bound if the other party knew the corp was not formed and agreed to look solely to the corporation for performance
Corporation's Liability: The corporation is not bound by a pre-incorporation contract until it accepts it.
Express Acceptance: The corporation is bound if it explicitly accepts the contract
Implied Acceptance: The corporation is bound if it impliedly accepts the contract
Accepting the benefit of the contact
With knowledge of its terms
Acceptance by the corporation does not release the promoter unless there is a novation
Defective Incorporation
Defective incorporation occurs when the promoters fail to fully comply with the applicable corporate statute.
The effect of defective incorporation is the promoters and would-be shareholders do not have protection of limited liability
Active participants will loose limited liability if not a de facto or de jure corporation
Passive investors may still claim limited liability
De Jure Corporation
A de jure corporation is in full compliance with all aspects of the corporate statute.
Once the corporation has de jure status, the shareholders have limited liability
De Facto Corporation
De Facto Corporation is a defense to personal liability focusing on the acts of the defendant
There must be a statute under which incorporation is possible
Defendant makes a "colorable" attempt to comply with the statute
Defendant acts as a corporation
Defendant had a good faith belief that the corporation was formed
Corporation by Estoppel
A defense to personal liability focusing on the acts of the plaintiff
Plaintiff dealt with the business as a corporation
Plaintiff never expected to be able to look to the "shareholders" for personal liability.
The defendants must have acted in good faith and not have mislead the plaintiff
Corporation by Estoppel is not valid against non-contract creditors, i.e., tort creditors
Ultra Vires Doctrine
Common Law
Acts done outside the scope of the corporate powers were void
Modern Law
Modern corporate statutes have mostly abolished the doctrine of ultra vires by authorizing corporations to engage in all lawful businesses.
The Objective of the Corporation
The purpose of the corporation is to make money for the benefit of its shareholders.
The corporation is allowed to engage in charitable behavior if it has some benefit to the corporation.
2. Corporate Structure
Shareholders
Shareholders are the owners of the corporation.
Shareholders invest equity in the corporation and share in the profits and losses through increased or decreased value of their shares or through distribution of dividends
Shareholders act by voting at shareholder meetings.
Notice
All shareholder meetings (annual and special meetings) require advance notice
Quorum
Generally a majority of shares represented is required for quorum;
A few states allow the articles of incorporation to set a lower quorum
Voting
Regular shareholder action requires majority of the shares present (some states say a majority of the shares voting)
Fundamental changes require approval of majority shares outstanding
Shareholders can vote by proxy
Shareholders elect the directors
Shareholders elect directors, but cannot tell directors how to act.
Shareholders can remove directors for cause
Some states authorize shareholders to remove directors for no cause
Shareholders approve or disapprove fundamental changes
Directors
Directors are elected by the shareholder
In the absence of a specific statute, the board cannot remove a director with or without cause.
Directors are the managers of the business
Directors set corporate policy and make key decisions
Directors appoint the officers to carry out the corporate policies
Directors only act by voting at board meetings.
Notice
Regular board meetings are set in the bylaws.
Special board meetings require notice.
Quorum
A quorum is a majority of the full board, even if positions unfilled.
Voting
To pass a proposal requires a majority vote of those present.
Board members cannot vote by proxy.
The board can act by unanimous written consent.
Officers
The officers are appointed by the board of directors
The officers carry out the policies determined by the board of directors.
The officers run the day-to-day affairs of the business under the general supervision of the board of directors.
The officers act as the agents of the corporation,
Piercing the Corporate Veil
Under certain circumstances, the court may disregard the corporate entity
Fraud
The court may pierce the corporate veil if the acts of a shareholder amount to fraud
Alter Ego Doctrine
Inadequate capitalization
Inadequate capitalization is the most important factor
Majority of states say inadequate capitalization is just one factor, but typically treat it as the most important factor
Minority of states say that inadequate capitalization alone is sufficient to pierce the corporate veil
Inadequate capitalization is the factor most likely to cause harm
Inadequate capitalization has to exist when corporation is formed—there is no obligation to add more money later
Consider whether insurance is a reasonable substitute for the corporation to meet its expected financial liabilities.
Failure to follow formalities,
Funds siphoned or commingled
Corporation functioned as a façade of shareholders so that they were treating the assets as their own.
There must be some element of injustice that would occur if the shareholder was allowed to avoid personal liability.
Effect of piercing the corporate veil
If the court pierces the corporate veil then the shareholders may be personally liable for the obligations of the corporation
Enterprise Liability
Enterprise liability is similar to piercing the corporate veil.
Instead of finding shareholder personally liable, enterprise liability seeks to hold one or more companies liable for the obligations of an affiliated brother/sister company
Apply the same elements that are used for piercing the corporate veil
Equitable Subordination of Shareholder Claims (“Deep Rock” doctrine)
The corporation is in bankruptcy
An insider (officer, director or shareholder) is a creditor that loaned money to the corporation
The insider committed some misconduct that harmed other creditors to the advantage to the insider-creditor
The court may allow the other creditors to be paid before the insider-creditor is paid.
Must otherwise comply with bankruptcy law
Interference with Shareholder Franchise
Blasius Test
If purpose of board action is to impede or preclude the shareholder franchise, then the board has a “heavy burden to show compelling justification.”
Unocal Test
The board is allowed to take defensive measures in response to a threat to the corporation.
Board must make reasonable investigation into the takeover attempt and determine in good faith that it represents a threat to the corporation.
Board can take defensive actions if the action is proportionate and reasonable in light of the magnitude of the threat.
Revlon Test
When takeover becomes inevitable, management cannot continue to resist takeover attempts.
Management must maximize shareholder value in the takeover.
Management cannot favor one bidder over another, except for the purpose of maximizing shareholder value.
3. Special Problems of Close Corporations
What is a close corporation?
Small number of shareholders
No ready market for corporate stock
Shareholders participate in management, direction and operation of the corporation.
Similar to partners carrying out a joint business for profit.
The corporation may be their only source of income.
Their investment in the business may also represent the majority of their personal assets.
Shareholders depend upon the corporation for their livelihood
Shareholders in close corporations may use various means to change the traditional allocation of corporate control.
Shareholder voting agreements
Classified stock
Voting trusts
Restrictions on share transfer
Super-majority voting or quorum
Fiduciary obligations in close corporation,
Shareholders in close corporations have a duty of reasonable care.
Shareholders in close corporations have a duty to further the interests of each other within the scope of the relationship.
Shareholders in close corporations have a duty not to withhold relevant information regarding the affairs of the relationship.
Shareholders in close corporations have a duty not to use their positions to gain special advantage over the other people involved.
Shareholders in close corporations are susceptible to economic coercion
Freeze-outs
A freeze-out occurs when majority deprives a minority from the economic benefit of owing shares in order to coerce them to sell their shares at an unfairly low price.
This denial is "especially pernicious" in close corporations where the opportunity of employment is one of the basic reasons for investing capital in the business and the shareholder depends on a salary as the principal return on his investment.
Oppression
Oppression occurs when a controlling shareholder in a close corporation causes the corporation to act in some way that frustrates the reasonable expectations of the minority shareholders
A shareholder in a close corporation may reasonably expect ownership will entitle him or her to a job, a place in management, a regular dividend, or some other form of security.
Expectation must be reasonable under the circumstances.
Expectation must be central to the decision to join the corporation.
Reasonable expectations may change over time.
Proper Purpose
Majority has opportunity to show that they took action for a proper business purpose.
The injured shareholder then has the right to show that there were alternative methods to achieve the business purposes that were less harmful to the minority.
Capitalization and Finance
1. Issuance of Stock
Articles determine how many share of stock are authorized.
Board has power to issue stock up to the amount authorized in the articles.
Authorized and Issued Stock
Stock that has been issued by the board. Also known as “authorized and outstanding” stock
Authorized but Unissued Stock
Stock that has been authorized by articles, but the board has not issued
Treasury Stock
Stock that has been issued by the board, and subsequently repurchased by the corp
Preemptive Rights
Common law rule: Each shareholder had the right to purchase a proportion of all newly issued stock to maintain his or her same percentage of ownership.
Modern majority rule: Shareholders have no preemptive rights unless specifically stated in articles.
Modern minority rule: Shareholders have preemptive rights unless denied in the articles.
Subscription Agreements
A subscription agreement is considered an open offer to purchase shares of the corporation.
A subscription agreement is generally revocable at any time prior to acceptance.
Some states make subscription agreements irrevocable for 6 months.
A subscription agreement is always revocable if all other subscribers agree.
2. Watered Stock
Par Value
Par Value is the lowest price at which the corporation can sell its stock
Modern statues allow low-par and no-par value stock
Stock sold for less than par value is generically called “watered stock.”
Bonus Stock: Shares sold for no consideration; given away for free.
Discount Stock: Shares sold for cash, but cash less than par value.
Watered Stock: Shares sold for property or services worth less than par value.
Liability for Watered Stock
Shareholder who holds watered stock may be liable to the corporation or to its creditors for the difference between amount paid and par value
Corporation Solvent
Liability to Creditors: If the corporation is solvent, the creditors have no right to recover for watered stock.
Liability to other Shareholders: In a minority of states other shareholders may recover for watered stock if the holder explicitly promised to pay the full amount; otherwise no liability.
Corporation Insolvent: Split of authority
Majority Rule: “Misrepresentation” theory
Only creditors who become creditors after the watered stock was issued are allowed to recover.
Someone who become a creditor before the watered stock was issued is not entitled to recover because he or she did not rely on the representation.
Minority Rule: “Trust Fund” Theory
Par value of the corporation is treated as a trust fund for the benefit of all creditors.
Board is liable to the creditors for the difference between amount paid and par value
3. Distributions to Shareholders
Dividends
Dividend is a payment to all shareholders pro-rata based on the number of shares owned.
Discretion to Pay Dividends
Courts will not interfere with a corporate policy to pay a dividend, absent breach of a duty or injury to creditors
Limits on Dividends
The corporation cannot pay a dividend if it would harm the rights of its creditors.
Insolvency test
The corporation cannot pay a dividend if it is insolvent
Equity or “Cash Flow” Insolvency Test: The corporation is insolvent if it cannot pay its obligations when they come due.
Bankruptcy or "balance sheet" insolvency Test: The corporation is insolvent if its debts exceed its assets.
Capital impairment test
The corporation cannot pay a dividend if its capital is impaired
The corporation's capital is impaired if it does not have sufficient amount in its surplus accounts.
Stated capital is par value times number of shares outstanding.
Capital surplus (aka paid-in surplus) is the amount that the shares where sold for above par value.
Reduction surplus is created by reducing par value which reduces stated capital.
Revaluation surplus is created by revaluing assets on the books.
Earned surplus (aka Retained Earnings) is the amount earned by the corporation.
All states allow dividends to be paid from earned surplus (aka retained earnings).
In the majority of states, this is the only account that can be used to pay dividends.
Nimble Dividend
A small minority of states also allow a "nimble dividend" to be paid out of current earnings, even if no there is no surplus
Liability for Improper Dividend
Directors' liability
The directors are liable for any harm to the creditor, up to the amount of the improper dividends.
Shareholders' Liability
The liability of a shareholder for an improper dividend depends on whether the corporation is solvent or insolvent.
Solvent Corp: Shareholder is liable only if they knew the dividend was improper.
Insolvent Corp: Shareholder is liable for the amount of the dividend.
Stock Repurchases
A stock repurchase is distribution of funds to shareholders
For stock repurchases, apply same rules apply as for dividends
Corporation cannot repurchase shares if the corporation is insolvent.
Corporation cannot repurchase shares if its capital is impaired
Exceptions: If the corporation's capital is impaired, but it remains solvent, the corporation can repurchase shares in certain specified circumstances.
Eliminate fractional shares
Setoff to shareholder debtor
Pay a court-ordered appraisal remedy
Redeem redeemable shares
Fiduciary Duties
1. Duty of Care
Officers and directors of corporations have a fiduciary duty to the corporation to use reasonable care in conducting its business.
Must act in good faith
Good faith is violated if the decision involves a self-dealing,
Good faith is violated if the director knows that the action violates the law, or involves some form of fraud.
Decision must be believed to be in the best interests of the corporation and its shareholders
This element is satisfied if there is any rational reason why a director would believe that the decision would benefit the corporation.
This is an easy test to pass. The only way to fail this test is for the director to involve the corporation in a no-win situation.
For public policy reasons, an illegal act is never considered in the best interests of the corporation
Must use such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under the circumstances.
Similar to negligence standard under tort law.
Example of specific duties
Duty to understand the business
Duty to keep informed
Duty to attend meetings
Duty to monitor financial status
Duty to inquire further when notice of wrongdoing
Duty to object or resign upon finding wrongdoing
Duty to seek advice of experts
Duty to use any expert knowledge possessed by the officer or director (lawyer, accountant, etc.)
Business Judgment Rule
The business judgment rule is a defense to allegations of breach of the duty of care.
If the elements of the business judgment rule are met, then there is a presumption that officers and directors met their duty of care.
Elements
Decision cannot involve a self-interested transaction
If there is any conflict of interest or breach of the duty of loyalty, the business judgment rule no longer protects the decision.
Decision must be an informed decision
The officer or director must show that he or she has gathered sufficient information to make an informed decision under the circumstances.
The officer or director must reasonably believe that the decision is in the best interests of the corporation.
2. Duty of Loyalty
Self dealing transactions
A self dealing transaction is one where the officer or director is on both sides of a transaction
The officer or director is in a position to influence the corporation in entering into the transaction
The officer or director is in a position to profit from the transaction (often at the corporation's expense, but not always.)
Usurpation of corporate opportunity
Usurpation of a corporation opportunity is a form of self-dealing, but where the officer or director is not on both sides of the transaction.
Usurpation occurs when an insider competes with the corporation
Usurpation occurs when an insider uses corporate property for his own benefit or to the detriment of the corporation
Usurpation occurs when an insider takes an opportunity that “belongs” to the corporation.
Interest or expectancy test: The corporation has existing right or can reasonably expect to take advantage of some opportunity
Line of business test: The opportunity is closely related to existing or prospective business
Fairness test: Measure the fairness of the transaction.
Historical rules
Pre 1900's Rule: Complete prohibition
A self-dealing transaction was voidable even if the transaction was fair to the corporation and fully disclosed
Early 1900s Rule: Disclosure
A self-dealing transaction could be upheld if fully disclosed.
Transaction fully disclosed
Interested party took no part in the decision (majority rule: interested director could not even count for quorum)
Transaction approved by disinterested majority of the board
Interested party took no unfair advantage
Modern fairness test.
Completely fair: transactions will be upheld.
If the transaction is completely fair to the corporation, it will usually be upheld.
Middle ground: shifting the burden of proof.
If the transaction is not completely fair but not so unfair as to be fraud or waste, then the defendant will have the burden to prove fairness.
Defendant can shift the burden of proof to the plaintiff.
The transaction must be fully disclosed.
The transaction must be approved by disinterested board or ratified by fully informed, uncoerced, disinterested shareholder vote
If burden shifts, then the plaintiff will have the burden to show the transaction was unfair
Fraud or waste: transaction is voidable.
If the transaction is so unfair as to amount to a fraud or waste, it will usually voided
3. Duty of Controlling Shareholder
Exercising control over the corporation.
Controlling shareholder is allowed to use controlling interest to exercise control over the corporation
Controlling shareholder must make full disclosure of all facts “germane” to the transaction (or “material” facts)
Self-interested transactions
Controlling shareholder allowed to engage in self-interested transactions as long as intrinsically fair
Intrinsic fairness test
Two elements
Fair dealing
Procedural aspects: How was the transaction was timed, initiated, structured, negotiated, disclosed and approved? Was it rushed by the controlling shareholder?
Fair price
Considering all relevant factors, was the price fair?
Burden of proof
Burden to prove fairness is on the Defendant
Defendant can shift the burden of proof to the plaintiff
Transaction must be fully disclosed
Transaction must be approved by independent, disinterested special committee
Look for relationships between controlling shareholder and members of the special committee
If burden shifts, then the plaintiff will have the burden to show the transaction was unfair
Sale of control for a premium
Controlling shareholder can sell his or her controlling interest for a premium and keep the premium.
Controlling shareholder cannot sell to a corporate looter.
An unreasonably large premium may put seller on notice of intent to loot
Controlling shareholder has a duty to investigate further if on notice of potential looter.
Control premium cannot be a sale of a corporate opportunity or corporate asset.
Cannot be any fraud, or other acts of bad faith.
Liability is the damage to the corporation up to the amount of the premium.
Sale of corporate office
Controlling shareholder generally prohibited from keeping premium paid for sale of corporate office
Split of Authority
Some jurisdictions prohibit sale of corporate office as “per se” illegal
Some jurisdictions allow sale of corporate office if taking control of the office would be a “mere formality.”
Mergers, Acquisitions, and Structural Changes
1. Statutory Mergers
General Rules
Two companies merge together upon filing articles of merger with the secretary of state.
Shareholders have approval rights
The decision to enter into the transaction must be submitted to the vote of the shareholders
Shareholders have appraisal rights.
The objecting shareholders are entitled to have their shares appraised and bought-out by the corporation.
Valuation determined by court
Valuation method must be generally acceptable in the financial community
Any valuation method is admissible as long as evidence is otherwise admissible in court.
Court not limited to "Delaware Block" method
Surviving corporation takes assets and debts of disappearing corporation by operation of law.
May trigger tax issues.
Small- Scale Merger
Typical statute allows acquiring company to increase its common stock by up to 20% to acquire another company.
Does not trigger approval or appraisal rights in the acquiring company’s shareholders.
Short-Form Merger
Typical statute allows parent company to merge with subsidiary company where the parent already owns 90% or more of the subsidiary.
Parent company can use short-form merger to cash out a minority interest.
Does not trigger approval rights for shareholders of parent or subsidiary company.
May trigger appraisal rights for minority shareholders in subsidiary.
2. Sale of All or Substantially All Assets
Corporation may attempt to purchase assets of target company rather than purchasing the company.
Court may give shareholders approval and appraisal rights.
If the assets are "quantitatively vital" to the operation of the corporation.
If the sale is "out of the ordinary" course of business.
If the sale substantially affects the existence and purpose of the corporation.
3. De Facto Merger Theory
Remedy for shareholders when corporations engage in transactions that are not technically mergers, but have same result as a merger.
Does the transaction cause the corporation to lose its essential or fundamental nature?
Does the transaction alter the original fundamental relationships of the shareholders among themselves and to the corporation?
Similar analysis as a sale of all or substantially all assets.
Court may treat transaction as a merger for purposes of triggering shareholder appraisal rights.
Many statutes limit de facto merger remedy to situations where shares of smaller company are used to acquire larger company.
Look for a corporation issuing new shares sufficient to elect a majority of the board of directors
4. Tender Offers
Regulated by Williams Act which amends the Securities Exchange Act of 1934
Must file disclosure with SEC if acquiring or offering to acquire 5% or more shares.
Must keep offer open for 20 days.
Must make offer available to all holders.
Must give best price to all tenders.
Must prorate among all tenders.
Must comply with Section 14(e), anti-fraud provision.
Anti-Fraud provisions for tender offers similar to Rule 10b-5
Cannot make misstatement or omission of material fact in connection with tender offer.
Defensive Measures
Management of target corporation allowed to take defensive measures to resist tender offer.
Defensive measures subject to certain limits.
Unocal
Management must use good faith and reasonable investigation.
Identify the tender offer as a threat to the corporation.
Defensive measures must be reasonable in light of the magnitude of the threat.
Blasius
If the purpose of defensive measure is to interfere with shareholder franchise (right to elect majority of directors) then management must show “compelling justification.”
Revlon
When takeover becomes inevitable, management cannot continue to resist takeover attempts.