Chapter 26Corporate Formation

and Financing

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What are the express and implied powers of corporations?

What steps are involved in bringing a corporation into existence?

What is the difference between a de jure and de facto corporation?

When might a court disregard the corporate entity and hold shareholders personally liable?

How are corporations financed?

Learning ObjectivesLearning Objectives

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The Nature of the Corporation

A corporation is a creature of statute, an artificial “person.”Most states follow the Model Business

Corporation Act (MBCA) or the RMBCA, that are model corporation laws.

The shares (stock) of a corporation are owned by at least one shareholder (stockholder).

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Constitutional Rights of Corporations

A corporation is an artificial “person” and has constitutional rights to:Equal protection; Access to the courts, can sue and be sued;Right to due process before denial of life,

liability or property.

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Constitutional Rights of Corporations

Corporation’s rights (cont’d):Freedom from unreasonable search and

seizure and double jeopardy.Freedom of speech.

• Only officers and directors have protection against self-incrimination.

However, corporations do not have full protection of privileges and immunities clause.

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Limited Liability of Shareholders

The corporation provides limited liability for stockholders.

In certain situations, the corporate “veil” of limited liability can be pierced, holding the shareholders personally liable.

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Corporate TaxationCorporate profits can either be kept as retained

earnings or passed on to the shareholders as dividends.

Corporate profits are taxed under federal and state law as a separate “person” from its shareholders.

Regular “C” corporations are taxed twice: at the corporate level and at the shareholder level.

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Torts and Criminal Acts A corporation is liable for the torts

committed by its agents or officers within the course and scope of their employment under the doctrine of respondeat superior.

Corporation can be liable for criminal acts, but only fined. Responsible officers may go to prison.

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Corporate PowersA corporation may act and enter into contracts

as any natural person, except as limited by:U.S. Constitution.State constitutions.State statutes. Its own articles of incorporation. Its own corporate bylaws.Resolutions by its own board.

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Express Corporate Powers

The express powers of a corporation are found in the corporation’s articles of incorporation, the laws of the state of incorporation, and in the state and federal corporations.

Corporate by-laws may also grant or limit a corporation’s express powers.

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Implied Corporate Powers Corporation has implied powers to: to

perform all acts reasonably necessary to accomplish its corporate purposes, e.g.,:

• Borrow and lend money.• Extend credit.• Make charitable contributions.

A corporate officer can bind corporation in contract in matters connected with the ordinary business affairs of the enterprise.

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Ultra Vires Doctrine Corporate acts are beyond the express

or implied powers of the corporation as stated in state statute or the corporation’s own articles of incorporations and are considered to be “ultra vires” (beyond the powers).

Corporate articles of incorporations now adopt very broad purposes to prevent lawsuits against the corporation.

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Ultra Vires Doctrine [2] The Following remedies are available for

ultra vires acts: Shareholders can bring action for

corporation.Corporation can recover damages from its

officers and directors.Attorney general of state may bring action

to dissolve corporation for ultra vires acts.

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Classification of Corporations

Domestic corporation does business in its state of incorporation.

Foreign corporation from X state doing business in Z state.

Alien Corporation: formed in another country doing business in United States.

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Classification of Corporations

Public and Private.Nonprofit.Close Corporations.

Shares held by few shareholders.More informal management,similar to a

partnership.Restriction on transfer of shares.

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Classification of Corporations

“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:Corporation is domestic, fewer than 75 shareholders,

only one class of stock, no shareholder can be a non-resident alien.

Professional Corporations.

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Corporate FormationThe process of incorporation

generally involves two steps:Preliminary and Promotional Activities;

andThe Legal Process of Incorporation.

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Incorporation Process

Promotion

Name Search

File Articles of Incorporation

Subscribers

1st Organiza-tional Meeting

State Charter

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Promotional Activities Before corporation is formed, promoters

are the persons who take the preliminary steps of organizing the venture and attracting subscribers (investors) via subscription agreements.

A Promoter (or corporation) can create a prospectus required by federal and state securities laws to inform and protect investors.

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Promoter’s Liabilities Promoter is personally liable for pre-

incorporation contracts on behalf of the corporation, unless 3rd party agrees to hold future corporation liable.

After corporate formation, corporation can adopt the pre-incorporation contract and release the promoter by creating a “novation”.

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Incorporation ProceduresState Chartering: Select state (some states

such as Delaware cater to corporations).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 incorporation rules at the

Texas Secretary of State.

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Incorporation Procedures Choose and reserve a Corporate Name:

(Example: name search at Texas Secretary of State). Name must have the proper suffix: “corporation,” “corp.,” “Incorporated.”

You should also consider registering the corporation as a “dot com” at networksolutions.com or register.com.

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Purpose: trend towards “any legal business.”

Duration: usually perpetual. 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.

Incorporation Procedures

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Internal Organization: usually included in the bylaws.

Registered Office and Agent: specific person that will receive any legal notice and documents from state and/or 3rd parties.

Incorporators (usually the promoter): at least one with name and address.

Incorporation Procedures

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First Organizational Meeting

After the corporation is “chartered” (created) it and can do business.

Shareholders should have the first organizational meeting to: approve the bylaws, elect directors, hire officers and adopt pre-incorporation contracts and activities.

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Corporate Status Errors in incorporation procedures when

a 3rd party seeks to bring an action against a corporation that may not have complied perfectly with every incorporation law.

Problematic for shareholders who may be personally liable.

In addition, entity may not be able to enforce contracts.

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Improperly Formed Corporations

De Jure: substantial statutory requirements are met; cannot be attacked by state or 3rd parties.

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.

By Estoppel: if it acts like a corporation, cannot avoid liability by claiming that no corporation exists.

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Disregarding the Corporate Entity

“Piercing the Corporate Veil” occurs when a court, in the interest of justice or fairness,” holds shareholders personally liable for corporate acts.

Court concludes that shareholders used corporation as a “shield” from illegal activity. Case: Hoskins Chevrolet v. Hochberg (1998).

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Factors a court considers: 3rd party tricked into dealing with a corporation

rather than the individual.Corporation is set up never to make a profit or

remain insolvent or is under capitalized.Statutory formalities are not followed.Corporation is “alter ego” of majority shareholder

and personal and corporate interest are commingled such that the corporation has no separate identity.

Disregarding the Corporate Entity

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Corporate FinancingBonds vs.

Stocks

Debt Ownership/equity

Fixed ROI Dividends (variable)

No votes Vote for Management

Optional Required

Priority over stock Paid last

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Bonds (click for Bond Primer)

Type DefinitionDebentures No specific corporate assets are pledged as

collateral. Backed by corporation’s general credit rating.

Mortgages Pledge specific real estate. If corporation defaults, bondholders can foreclose.

Convertible Conditions trigger bonds to convert to corporate stock.

Callable Can be “called in” by principal and repaid according to bond conditions.

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StocksCommon Stock: represents true ownership of a

corporation. Provides pro-rata (proportional) ownership interest reflected in control, earnings and assets.

Preferred Stock: has preferences over common stock.Cumulative Preferred.Participating Preferred.Convertible Preferred.Redeemable or Callable Preferred.