corporations
TRANSCRIPT
Copyright © 2021 by BARBRI, Inc.
LECTURE HANDOUT
CORPORATIONS
PROFESSOR RICHARD D. FREER
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CORPORATIONS BY PROFESSOR RICHARD D. FREER
FIVE FACT PATTERNS: 1. Organization of a corporation 2. Issuance of stock 3. Directors and officers 4. Shareholders 5. Fundamental corporate changes A corporation is owned by its shareholders The group in charge of management is the board of directors Members of the board of directors are elected by the shareholders The board appoints people to carry out its policy. Who are they? Officers
FACT PATTERN 1: SETTING UP A BUSINESS AS A CORPORATION
I. TO FORM A CORPORATION, WE NEED A PERSON, PAPER, AND AN ACT
A. PERSON: INCORPORATOR. MUST HAVE ONE OR MORE. WHAT
DOES AN INCORPORATOR DO?
Execute articles and deliver to Secretary of State Who may serve as an incorporator? A person or entity.
Must incorporators be a citizen of the state of incorporation? No
B. PAPER: ARTICLES OF INCORPORATION.
1. Required contents:
a. Name of the corporation.
Can I form a corporation with the name Bubba’s Burritos? No. It must include one of these “magic words” (or an abbreviation): Corporation, company, incorporated, or limited
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b. Name and address of each incorporator.
c. Registered agent and street address of the registered office
(in this state). Registered agent is the company’s legal representative, so she can receive service of process for the corporation.
d. Information regarding stock.
Authorized stock: Maximum number of shares the corporation can sell
If the company will have different classes of stock, many states require that the articles state the number of shares per class and the voting rights and preferences of each class of stock. Other things may be put in the articles but are not required. For example, the initial directors may be named in the articles (with their addresses).
C. ACT.
The incorporators have notarized articles delivered to the Secretary of State and pay the required fees. What happens if the Secretary of State’s office accepts the articles for filing?
Forms of the corporation
-- At that point, we have a de jure corporation.
II. OTHER STEPS TO ORGANIZE THE CORPORATION
A. ORGANIZATIONAL MEETING.
If the initial directors were named in the articles, the directors hold the “organizational meeting.” If they were not, incorporators hold the organizational meeting, where they elect the initial directors (who then take over management). At the meeting, the board of directors (or the incorporators if no directors were named in the articles) must “complete the organization of the corporation.”
–What does that mean? Appoint officers and adopt initial bylaws
B. BYLAWS.
Bylaws are an internal document. They comprise an operating manual, with things like setting record dates and methods of giving notice, etc.
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1. Are bylaws filed with the state? No
2. If bylaws and articles conflict, which governs? Articles
3. Who can amend or repeal the bylaws or adopt new ones?
Board or shareholders
III. CONSEQUENCES OF FORMING A CORPORATION
A. INTERNAL AFFAIRS RULE.
Suppose we form a corporation in State X but the company only does business in State Y. What law governs the internal affairs of the corporation (e.g., roles and duties of directors, officers, and shareholders)?
State X
B. ENTITY STATUS.
A corporation is a legal person. It can sue and be sued, hold property, be a partner in a partnership, invest in other companies or commodities.
a. Can a for-profit corporation (which is what we are talking
about) make contributions to charity?
Yes
b. A “benefit corporation” (B Corp.) is one formed for profit and also to pursue some benefit to a broader social-policy cause. Things work as with a regular corporation, but the articles must say it’s a “benefit corporation.” Files an annual benefit report assessing how it pursued its stated social mission. Decision-makers consider not just impact of decisions on shareholders, but on the broader community or environment.
c. Ordinarily, a corporation pays income tax on its profits. In addition,
shareholders are taxed on distributions to them, so there’s “double taxation.” That is a disadvantage. To avoid (legally) having it pay income tax at the corporate level, we should qualify as:
An S Corporation
-- S Corps have no more than 100 shareholders, all of whom are human U.S. citizens or residents; one class of stock and it is not publicly traded.
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C. LIMITED LIABILITY.
If the corporation incurs a debt, commits a tort, or breaches a contract, are the shareholders personally liable for that debt? No
This is “limited liability”: shareholders generally are liable only to pay for their stock, not for corporate debts. (We’ll see an exception in Fact Pattern 4.)
BTW, are directors or officers vicariously liable for corporate debts? No
So who is liable for corporate debts? The corporation itself
IV. DEFECTIVE INCORPORATION (WE WRONGLY THOUGHT THERE WAS A CORPORATION) The proprietors thought they formed a corporation, but they failed to do so. That means they are personally liable for business debts (because they have formed a partnership and partners are liable for business debts).
Two doctrines allow the proprietors to escape liability. Anyone asserting either doctrine must be unaware of failure to form de jure corporation.
A. DE FACTO CORPORATION (“DFC”). REQUIREMENTS:
1. There is a relevant incorporation statute (there is!).
2. The parties made a good faith, colorable attempt to comply with it. And
3. There has been some exercise of corporate privileges (they are acting
as though they thought it was a corporation).
-- If this doctrine applies, the business is treated as a corporation for all purposes except in an action by the state. (Such an action would be quo warranto).
-- Incorporators put together the proper documents and mail them to the Secretary of State. Unbeknownst to them, the documents are lost in the mail. In the meantime, the business is being operated as a corporation, and enters a contract. Are the shareholders personally liable on the contract?
Yes unless court applies de facto corporation
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B. CORPORATION BY ESTOPPEL: THIS MEANS THAT SOMEONE
WHO TREATS A BUSINESS AS A CORPORATION MAY BE ESTOPPED FROM DENYING THAT IT IS A CORPORATION.
-- You do business with people who hold their business out as a corporation. They think it’s a corporation. You think it’s a corporation. You write checks to the “corporation” and deal with it as a corporation. Turns out it’s not a corporation. You sue the proprietors individually. Under this doctrine, you cannot win. You are estopped to deny that the business was a corporation.
-- It can also prevent the improperly-formed “corporation” from avoiding liability by saying it was not properly formed.
-- Corporation by estoppel applies only in what kinds of cases?
Contract not tort
C. WHAT IS THE STATUS OF THESE TWO DOCTRINES?
Abolished in many states
V. PRE-INCORPORATION CONTRACTS (we knew there was NOT a corporation)
A. A promoter is a person acting on behalf of a corporation not yet formed.
She might enter a contract on behalf of a corporation not yet formed.
B. Is the corporation liable on these contracts? The corporation is liable on a pre-incorporation contract ONLY if it adopts the contract.
On January 10, P, acting as a promoter for a corporation not yet formed, leases a building from Don Draper and signs the lease "Oscar de la Rental Cars, Inc." On February 20, Oscar de la Rental Cars, Inc. is formed. -- Is the corporation liable on the contract? Yes, if it adopted the contract. How can that happen?
1. Express: board takes an action adopting the contract. See below.
2. Implied adoption arises when: corporation accepts a benefit of the contract
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C. Is the promoter liable on these contracts? Unless the contract clearly says
otherwise, the promoter is liable on pre-incorporation contracts until there is a novation.
-- A novation is an agreement of the promoter, the corporation, and the other contracting party that the corporation replaces the promoter under the contract. -- Will P be liable on the lease if Oscar de la Rental Cars, Inc. is never formed? Yes - Will P be liable on the lease if Oscar de la Rental Cars, Inc. is formed and adopts the lease? Yes – here there is no novation
-- Remember: Adoption makes the corporation liable too, but does not relieve P. So on this fact pattern, both the corporation and P are liable.
VI. FOREIGN CORPORATIONS Foreign corporations transacting business in this state must qualify and pay prescribed fees.
A. Let’s say we are in State A. Is a corporation formed in State B considered
“foreign?”
Yes, anything outside State A is foreign
B. Transacting business means the regular course of intrastate (not interstate) business activity. So, it doesn’t include occasional or sporadic activity in this state, and not simply owning property here.
C. The foreign corporation qualifies by getting a certificate of authority from
the Secretary of State. It gives information from its articles and proves good standing in its home state. The foreign corporation must also appoint a registered agent and maintain a registered office in this state.
D. What happens if a foreign corporation transacts business without
qualifying?
Civil fine and cannot assert a claim in state -- But the foreign corporation can be sued and defend in this state.
Once the corporation qualifies and pays back fees and fines, can it then assert a claim here?
Yes
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FACT PATTERN 2: ISSUANCE OF STOCK
I. BACKGROUND To start and operate a corporation, we need money (capital). The corporation can either borrow the money or raise it by selling stock (or both). Either way, the corporation will “issue” a “security” to the person. Security is a fancy word for investment.
A. Debt securities. Here, the corporation borrows money from X and agrees
to repay her with interest. Debt securities are usually called bonds
The person holding a bond is a creditor not an owner
B. Equity securities. Here, the corporation sells an ownership interest to X.
Equity securities are called stock
The person holding stock (a shareholder or stockholder) is an owner not a creditor
II. WHAT IS AN ISSUANCE OF STOCK? Corporation sells its own stock
The rules in Fact Pattern 2 apply only when there is an issuance. That means they apply only when the corporation is selling its own stock.
III. SUBSCRIPTIONS (written offers to buy stock from corporation)
A. Revocation of pre-incorporation subscriptions.
On January 10, S signs a subscription, offering to buy 100 shares of C Corp., a corporation not yet formed. A week later, S changes his mind. Can S revoke? No, irrevocable for six months (Unless it says otherwise or all subscribers agree to let you revoke.)
B. Is post-incorporation subscription revocable?
Yes until accepted by the corporation
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C. What does that mean? At what point are the corporation and the
subscriber obligated under a subscription agreement? When the board accepts the offer
IV. CONSIDERATION—What must the corporation receive when it issues stock?
A. FORM OF CONSIDERATION. Stock (or an option to buy stock) may be issued for “any tangible or intangible property or benefit to the corporation.” This includes money (cash or check), property, services already performed for the corporation, and discharge of a debt. Does it also include: Promissory notes to the corporation? Yes
Future services to the corporation? Yes
-- Can X Corp. give employees options to buy stock as payment for services? Yes
B. AMOUNT OF CONSIDERATION.
1. Par means “minimum issuance price.”
-- C Corp. is issuing 10,000 shares of $3 par stock. It must receive at least $30,000
-- Could it get more than $30,000? Yes
2. No par means “no minimum issuance price.”
-- That means the board can have the stock issued for any price it sets
3. Treasury stock. This is stock the company issued and then
reacquired. It is considered authorized, and the corporation can then resell it. If it does, the board sets any issuance price it wants.
4. Let’s say the corporation issues stock in exchange for property or
past services. Who determines the value of the property or services? The board
-- Is the board’s valuation conclusive? Yes if made in good faith
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5. On the bar exam, if they give you par stock, watch for watered stock.
-- C Corp. issues 10,000 shares of $3 par to X for $22,000. The corporation wants to recover the $8,000 of “water.” Who is liable?
a. Directors? Yes if they knowingly authorized the issuance
b. X (the guy who bought the stock)? Yes
(There is no defense; he is charged with notice of the par value.)
c. What if X transfers the stock to third-party (TP). TP is not
liable if she acted in good faith. That means: Did not know about the water
6. Trick question: I own 10 shares of $3 par stock of X Corp. I sell it to you for less than $3 per share. Why is there no problem? This is not an issuance
V. PREEMPTIVE RIGHT
A. This is the right of an existing shareholder of common stock to maintain her percentage of ownership by buying stock whenever there is a new issuance of stock for money (cash or its equivalent, like a check).
-- S owns 1,000 shares of C Corp. There are 5,000 shares outstanding. C Corp. is planning to issue an additional 3,000 shares. If S has preemptive rights, then S has the right to buy as many as 600 shares
B. If the articles are silent, do we have pre-emptive rights? No
Suppose the C Corp. articles provide for pre-emptive rights. You own 20 percent of the stock of C Corp. C Corp. issues stock to Susie to purchase property from Susie (or to pay Susie for services performed for the corporation). Do you have preemptive rights? No, not an issuance for money
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FACT PATTERN 3: DIRECTORS AND OFFICERS
I. STATUTORY REQUIREMENTS — DIRECTORS (adult natural person)
A. NUMBER.
One or more
-- The number can be set in the articles or bylaws.
B. ELECTION. Initial directors may be named in the articles. If not, they are elected by the incorporator(s) at the organizational meeting. After that, who elects directors?
Shareholders
-- The entire board is elected each year unless there is a “staggered” (or “classified”) board. A staggered board is divided into half or thirds, with one-half or one-third elected each year. Staggered board is usually set in the articles.
-- Say there are 9 directors. Instead of electing all 9 each year we could divide the board into 3 classes of 3 directors each; they would serve 3-year terms.
C. SHAREHOLDERS CAN REMOVE DIRECTORS BEFORE THEIR
TERMS EXPIRE.
-- On what bases can shareholders remove a director? With or without cause -- In some states, if there is a staggered board, shareholders can remove a director only: With cause
D. SUPPOSE THERE’S A VACANCY ON THE BOARD (E.G., A
DIRECTOR RESIGNS BEFORE HER TERM IS UP). WHO SELECTS THE PERSON WHO WILL SERVE AS DIRECTOR FOR THE REST OF THE TERM?
Board or shareholders
-- But if the shareholders created the vacancy by removing a director, the shareholders generally must select the replacement.
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E. THE BOARD OF DIRECTORS MUST ACT AS A GROUP.
-- Is an individual director an agent of the corporation? No
-- So individual directors have no authority to speak for or bind the corporation. The directors must act as a group (even if there is only one director). How?
1. Unanimous agreement in writing (e-mail is OK); separate documents
are OK.
2. At a meeting (which must satisfy the quorum and voting requirements below).
-- Does a conference call (simultaneous oral communication so each can hear all others) count as a meeting? Yes
-- What if directors agree to have the corporation take an act by having individual conversations, without a meeting or unanimous written agreement? Act is void unless ratified by a valid act
3. If there is a board meeting, the method for giving notice is set in the
bylaws.
Regular meetings: is notice required? No
Special meetings: is notice required? Yes. Unless the bylaws say otherwise, the corporation must give:
At least two days’ notice of date, time, and place; need not state purpose -- Failure to give required notice means that whatever happened at the meeting is voidable (maybe void), unless the directors not notified waive the notice defect. They can do this (1) in writing anytime or (2) by attending the meeting without objecting at the outset of the meeting.
-- Can directors give proxies or enter voting agreements for how they will vote as directors? NO! Such efforts are void. Why?
Directors owe the corporation non-delegable fiduciary duties
-- This is different from shareholders, who can vote by proxy and enter into voting agreements. See below.
4. Quorum for meetings of the board — for any meeting of the board,
we must have a quorum. Unless bylaws say otherwise, a quorum is a majority of all directors. Without a quorum, the board cannot act.
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-- If a quorum is present at a meeting, passing a resolution (which is how the board takes an act at a meeting) requires only a majority vote of those present.
-- So, if there are nine directors, at least five directors must attend the meeting to constitute a quorum. If five directors attend, at least three must vote for a resolution for it to pass. -- Quorum of the board can be lost ("broken") if people leave. Once a quorum is no longer present, Board cannot take an act at that meeting. -- The rule on this is also different for shareholder voting. See below.
II. ROLE OF THE BOARD OF DIRECTORS
A. The board manages the corporation: sets policy, supervises officers, declares distributions, determines when stock will be issued, recommends fundamental corporate changes to shareholders, etc.
B. The board can delegate to a committee of one or more directors. But a
committee cannot do what?
Declare a distribution, fill a board vacancy, recommend a fundamental change to shareholders
Can a committee recommend such things to the full board for its action?
Yes
III. FIDUCIARY DUTIES OWED TO THE CORPORATION The Standard: A director must discharge her duties in good faith and with the reasonable belief that her actions are in the best interest of the corporation. She must also use the care that a prudent person in like position would reasonably believe appropriate under the circumstances.
-- The first sentence is the duty of loyalty
-- The second sentence is the duty of care
A. DUTY OF CARE.
This can come up in two ways. The burden is on the plaintiff.
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1. Nonfeasance (a director does nothing – he’s lazy).
Doofus, a director of C Corp., fails to attend any of the board of directors' meetings or to keep abreast of the company business in any way. Will he be held liable for breach of the duty of care?
-- State the standard in full, then focus on the duty of care portion. A person in like position would do some work. This guy did nothing, so he has breached the duty of care.
-- BUT HE IS LIABLE ONLY IF:
His breach causes a loss to the corporation
Example of causation. Suppose D was an antitrust expert and breached the duty of care by never attending meetings. In his absence the board approved a contract that violated the antitrust laws and subjected the corporation to liability. Would D be liable for this? Arguably yes because:
His breach harmed the corporation
2. Misfeasance (here, the board makes a decision that hurts the
business – so here, causation is clear).
The directors of Hedonists' Hot Tubs, Inc., vote to start a new line of hot tubs with built-in wine coolers and video cameras. The idea is a disaster and the corporation loses money. Are the directors liable for breach of the duty of care? -- State the standard in full, then focus on the duty of care portion. Here, the directors' action caused a loss to the corporation, so causation is clear. BUT, a director is not liable if she meets the business judgment rule (“BJR”). A prudent person in a like position would do appropriate homework, if they did appropriate homework, they are not liable
BJR is a presumption that when the board took the act, it did appropriate homework. That’s why the burden is on the plaintiff to show that the board either did not do appropriate homework or did something galactically stupid. The court will not second-guess a business decision if it was made in good faith, was informed, and had a rational basis.
Director is not a guarantor of success
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B. DUTY OF LOYALTY. These cases are about conflict of interest.
The BJR DOES NOT apply in duty of loyalty cases. Why? Because it can never apply when the fiduciary has a conflict of interest.
So the burden in these cases is on defendant
1. Self-dealing (also known as interested director transactions). This
is any deal between the corporation and one of its directors (or a close relative of a director) or another business of the director’s.
Martha is a director of XYZ, Inc. If she sells wreaths to XYZ, Inc., it is an interested director transaction.
-- State the standard in full, then focus on the duty of loyalty portion. Interested director transaction will be set aside (or the director liable in damages) UNLESS the director shows either: (1) the deal was fair to the corporation when entered, OR
(2) her interest and the relevant facts were disclosed or known,
and the deal was approved by either of these:
Majority (at least two) of disinterested directors or majority of disinterested shares
-- Special quorum rule: a quorum is a majority (at least two) of disinterested directors.
-- Even if the deal is approved by an appropriate group, say this:
Some courts also require a showing of fairness
-- Can directors set their own compensation as directors or officers? Yes, but it must be reasonable and in good faith. If it is excessive, they are wasting corporate assets and breaching the duty of loyalty.
2. Competing Ventures.
Sharon is a director of Ozzie's Music Co. She can also serve on the board of directors of Home Depot because it does not compete with Ozzie's. But can Sharon start her own music company?
-- State the standard in full, then focus on the duty of loyalty portion. What else do we say?
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Director cannot compete directly with her corporation
-- Remedy against Sharon if she goes into competition: Ozzie’s gets a constructive trust on profits Sharon made from the competing venture.
3. Corporate Opportunity (Expectancy).
Cheatem is a director of C Realty Corp., which develops condo projects. Cheatem learns of land that has been zoned for condos and buys it for himself as an investment. What are C's rights, if any, against Cheatem?
-- State the standard in full, then focus on the duty of loyalty portion. A director cannot USURP a corporate opportunity. That means the director cannot take it until he (1) tells the board about it and (2) waits for the board to reject the opportunity.
-- What is a corporate opportunity? Some say it’s something in the corporation’s business line. There are other tests to throw in:
Something the company has an interest or expectancy in; something defendant found on company time or with company resources
-- Is the company’s financial inability to pay for the opportunity a defense?
Probably not -- Remedy: If Cheatem still has it, he must sell it to the corporation at his cost. If Cheatem has sold it at a profit, the corporation gets the profit. (Constructive trust).
C. LOANS. Can the corporation make a loan to a director?
Yes if reasonably expected to benefit the corporation
IV. WHICH DIRECTORS MAY BE LIABLE?
A. Directors may be liable to the corporation for improper distributions (see below), improper loans, “ultra vires” acts (making the company do things it has no power to do) and for breaches of fiduciary duties. But exactly which directors?
B. A director is presumed to concur with board action unless her dissent or abstention is noted in writing in corporate records.
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1. In writing means (1) in the minutes or (2) delivered in writing to the presiding officer at the meeting or (3) written dissent to the corporation immediately after the meeting. So is an oral dissent effective? Not by itself
-- Director cannot dissent if she voted for the resolution at the meeting.
2. Exceptions.
a. Not liable if you were absent from the meeting (e.g., sick that day).
b. Good faith reliance on info (including financial info)
presented by an officer, employee, or committee (of which the director relying was not a member), or professional reasonably believed competent. Reliance must be in good faith (no good if you knew the person giving info was a bozo).
V. OFFICERS (OWE THE SAME DUTIES OF CARE AND LOYALTY AS DIRECTORS)
A. Status. Officers are agents of the corporation. The corporation is the
principal and the officer is the agent. Whether the officer can bind the corporation is determined by whether she has agency authority to do so (like actual or apparent authority).
-- Example: The president generally has inherent authority to bind the corporation to contracts in the ordinary course of business.
B. Traditionally, corporations were required to have a president, a secretary,
and a treasurer. It can have others. Today, can one person hold multiple offices simultaneously? Yes
C. Selection and removal of officers.
Officers are selected by and removed by the board, which also sets officer compensation.
-- The board of directors of Hair Care Extraordinaire, Inc. appoints John Stamos as president. What happens if it fires him from the presidency? John loses the job, but: Company may be liable for breach of contract damages -- Shareholders hire and fire directors (we saw that above). Do shareholders hire and fire officers? No
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VI. INDEMNIFICATION OF DIRECTORS AND OFFICERS
A. Someone has been sued by (or on behalf of) the corporation in her
capacity as an officer or director. She has incurred costs, attorneys' fees, maybe even fines, a judgment or settlement in that litigation. Now, she seeks indemnification (reimbursement) from the corporation.
Category 1. The corporation CANNOT indemnify a director or officer who:
was held liable to the corporation or to have received an improper benefit
Category 2. The corporation MUST indemnify a director or officer who:
was successful in defending merits or otherwise
-- In some states, she must win the entire case; in others, she is entitled to indemnification “to the extent” that she wins the case.
Category 3. The corporation MAY indemnify (“permissive indemnification”) a director or officer her litigation expenses if she shows:
acted in good faith with the reasonable belief what she did was in the company’s best interest
-- This standard sounds familiar. Why? It’s the duty of loyalty part of the standard from earlier.
-- Who determines her eligibility for permissive indemnification? Disinterested directors, disinterested shares, or independent legal counsel.
-- Suppose D is sued for breaching duties to the corporation. She then settles that case. Does this case fall into Category 1, Category 2, or Category 3? Three
B. Notwithstanding these rules, court where director or officer was sued can order reimbursement if it is justified in view of all circumstances. If she was held liable to the corporation, this is limited to costs and attorneys' fees (cannot include judgment).
C. The articles can eliminate director (and in some states officer) liability to the
corporation for damages, but not for intentional misconduct, usurping corporate opportunities, unlawful distributions, or improper personal benefit.
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-- So these provisions can eliminate liability only for what kinds of cases?
Duty of care
FACT PATTERN 4: SHAREHOLDERS
I. DO SHAREHOLDERS GET TO MANAGE THE CORPORATION?
A. The general answer is NO. Why? The board of directors manages
B. BUT shareholders can run the corporation directly in a close corporation. What are the characteristics of a close corporation?
Few shareholders, stock not publicly traded
In a close corporation, we can set up management with a board of directors and run it like a regular corporation. Or we can set up management differently – eliminate the board and have shareholders run the business or appoint a manager, etc.
C. Shareholder management agreement (SMA). This sets up alternative
management for the close corporation. 1. There are two ways to do this:
a. In the articles and approved by all shareholders OR b. By unanimous written shareholder agreement.
Either way, the agreement should be conspicuously noted on the front and back of the stock certificates. (Failure to do so, though, does not affect validity.)
2. If the shareholders do this and set up management by shareholders or by a manager, who owes the duties of care and loyalty to the corporation?
Whoever manages
D. Special fiduciary duty in close corporations.
We just saw that whoever manages the corporation owes the duties of care and loyalty to the corporation. In many states, courts impose a fiduciary duty on shareholders owed to other shareholders. Why? Because a close
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corporation looks like a partnership (with few owners, who usually are employed by the business). Because partners owe each other a fiduciary duty of utmost good faith, these courts apply the same duty in the close corporation.
-- If there is oppression of minority shareholders, they can sue the controlling shareholders who oppress them for breach of this fiduciary duty. For example, the controlling shareholders might deny the minority any voice in corporate affairs, fire them from employment, refuse to declare dividends, and refuse to buy the minority’s stock (so the minority is getting no return on investment).
-- Why do some courts let the minority shareholder sue here?
Oppression thwarts her legitimate goals for investing and she has no way out
E. Licensed professionals, including lawyers, medical professionals, and CPAs, may incorporate as a “professional corporation” or “professional association.” The name must have one of those phrases or “P.C.” or “P.A.” The articles must state that the purpose is to practice in a particular profession.
1. Directors, officers, and shareholders usually must be licensed
professionals. May the P.C. employ non-professionals?
Yes but not to practice the profession -- Are the professionals personally liable for their malpractice? Yes
2. Shareholders are generally not liable for corporate obligations or for
other professionals’ malpractice.
3. Generally, the rules governing regular corporations apply to the P.C.
II. CAN SHAREHOLDERS BE HELD LIABLE FOR CORPORATE DEBTS?
A. The general answer is NO. Why? Corporation is liable for what it does
B. But a shareholder might be personally liable for what the corporation did if the court “pierces the corporate veil” (PCV). In what kinds of corporations can this happen?
Close corporations only
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-- To PCV and hold shareholders personally liable,
1. They must have abused the privilege of incorporating and 2. Fairness must require holding them liable.
-- So courts may PCV to avoid fraud or unfairness by shareholders in a close corporation. Sloppy administration is not enough for PCV. 1. Alter ego (identity of interests)
X and Y are the only shareholders of Close Corp. X commingles personal and corporate funds, uses the corporate car as his own, and uses the corporate credit card to pay for personal purchases. Close Corp fails to pay its bills.
-- Can a creditor of the corporation who has been unable to collect its claim from the corporation collect from either X or Y?
-- We start with general rule (shareholders not liable for acts or debts of corporation). Then give the PCV standard. Here a court might PCV. Why? -- First, did a shareholder abuse the corporation?
Yes, X treated corporate assets as his own
-- Second, would it be unfair for X to have limited liability?
Arguably yes because creditors are not being paid
-- If the court does PCV, only X would be liable. Y did nothing wrong. Only X treated corporate assets as his own.
2. Undercapitalization
S is a shareholder of Glowco, Inc., a close corporation that hauls and disposes of nuclear waste. Glowco does not carry insurance. Glowco has an initial capitalization of $1,000. V is injured when one of Glowco's trucks melts down. Can V sue S?
-- General rule (shareholders not liable for corporate obligations); PCV standard. Here a court MIGHT PCV because the corporation was undercapitalized when formed.
Why? Shareholders failed to invest enough to cover prospective
-- Say this: courts may be more willing to PCV for a tort victim than for a contract claimant.
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-- Remember, PCV allows imposition of liability on a shareholder. That shareholder might be another corporation. Example: a parent corporation forms a subsidiary to avoid its own obligations. The court might PCV and hold the parent corporation liable just as it could if the shareholder were a human.
III. SHAREHOLDER AS PLAINTIFF: DERIVATIVE SUITS
A. In a derivative suit, a shareholder is suing to enforce the corporation's claim, not her own personal claim. It’s a case in which the corporation is not pursuing its own claim, so a shareholder steps in to prosecute it for the corporation.
Always ask: Could the corporation have brought this suit? If so, derivative
-- S, a shareholder of C Corp., sues the board of directors of C Corp. for breaching the duty of care or loyalty. That is always derivative. Why?
Corporation could sue, these duties are owed to the corporation
-- S sues board of directors of C Corp. for issuing new stock without honoring her preemptive rights. Is this a derivative suit?
No, this is a direct suit -- S sues to force the company to declare dividends. Derivative?
No, corporation is not hurt -- S sues another shareholder for oppression in a close corporation. Derivative?
No, this is also a direct suit
B. If the shareholder plaintiff wins the derivative suit:
Who gets the money from the judgment? The corporation
-- What does the shareholder plaintiff recover? Costs and attorney’s fees, usually from the judgment won for the corporation. After all, she did a favor for the corporation by suing and winning.
C. If the shareholder plaintiff (S) loses the derivative suit:
-- Can S still recover costs and attorneys' fees? No
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-- Is S liable to the defendant he sued for that defendant’s attorney’s fees? Yes, if he sued without reasonable cause.
-- Suppose a shareholder brings a derivative suit and loses. Can other shareholders later sue the same defendants on the same transaction?
No
D. What are the requirements for bringing a shareholder derivative suit?
1. Stock ownership when the claim arose and throughout the suit.
The person bringing suit must have owned stock at the time the claim arose or have gotten it by operation of law from someone who did own it then. What are examples of “operation of law?”
Inheritance and divorce decree
-- S does not own stock when the claim arose, but his uncle did. His uncle then dies and S inherits Uncle’s stock. S has standing because he got the stock by operation of law from someone who owned it when the claim arose.
2. Plaintiff must provide adequate representation of the corporation’s
interest.
3. Plaintiff must make written demand on corporation (usually that means the board) that the corporation bring the suit. In some states you must always make this demand and cannot sue until 90 days after making the demand.
-- BUT in other states, shareholders are not required to make this demand if the demand would be futile. What is a good example?
When the directors will be the defendant
4. The corporation is joined as a defendant. Even though the suit asserts the corporation's claim, the corporation did not do so, so it is joined as a defendant.
5. Can the parties settle or dismiss a derivative suit?
Only with court approval
-- The court may give notice to shareholders and get their input on whether to settle or dismiss.
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E. After the derivative suit is filed, the corporation may move to dismiss. This is based upon an independent investigation that concluded that suit is not in the corporation’s best interest (e.g., low chance of success or expense of the case would exceed recovery the corporation would win).
-- Who must make this investigation?
Independent directors or court appointed panel of one or more independent persons
(Usually it’s a “special litigation committee” of independent directors.)
-- In ruling on the motion to dismiss, if the court finds that (1) those recommending dismissal were truly independent and (2) they made a reasonable investigation, what will the court in most states do?
Dismiss
IV. SHAREHOLDER VOTING
A. Who votes. We know that authorized stock is the number of shares the corporation may issue (it is set in the articles). We know that issued stock is the number of shares the corporation has sold. What is outstanding stock? Shares the company issued and has not reacquired.
-- Articles allow for 10,000 authorized shares. Corporation issues 7,000 shares. Then Corporation reacquires 1,000 of those shares. How many shares are outstanding? 6,000
-- Unless the question says otherwise, assume that each outstanding share gets one vote. BUT you must be the “record shareholder” of the outstanding stock as of the “record date” to vote.
1. The record shareholder is the person shown as the owner in the
corporate records. The record date is a voter eligibility cut-off.
-- C Corp. sets its annual meeting for July 7 and record date for June 8. S sells B her C Corp. stock on June 25. Who is entitled to vote the shares at the meeting, S or B?
S. Because she owned it on June 8
2. Exceptions to the general rule that record owner on record date votes.
a. The corporation re-acquires stock before the record date, so
it is the owner of this “treasury stock” as of the record date. Does it vote this stock?
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No one votes it, because it was outstanding on the record date
b. Death of shareholder.
-- S owns stock in C Corp.; S is the record shareholder. After the record date, S dies. Can S's executor vote the shares?
Yes
c. Voting by proxy.
A proxy is a (i) writing (fax and e-mail are OK), (ii) signed by record shareholder (e-mail OK if can identify sender), (iii) directed to secretary of corporation, (iv) authorizing another to vote the shares.
-- On February 2, 2018, S sent a letter to secretary of C Corp. authorizing Pam to vote her shares. Can Pam vote S's shares at the 2018 annual meeting in July 2018?
Yes, this is a proxy
-- Can Pam vote S's shares at the 2019 annual meeting in July 2019?
No, it is good for 11 months unless it says otherwise
-- How can S revoke the proxy she gave to Pam?
In writing to the corporate secretary or by attending the meeting and voting
-- Can S revoke the proxy even though it states that it is irrevocable? Yes
-- To have an irrevocable proxy, it must be a “proxy coupled with an interest.” This requires (1) the proxy says it’s irrevocable and (2) the proxy-holder has some interest in the shares other than voting.
-- A gives B an option to buy A’s stock. A gives B an “irrevocable proxy” to vote that stock at a meeting. Can A revoke this proxy?
No, it says irrevocable and it is coupled with an interest
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-- Here, the proxyholder has an interest because she has an option to buy the shares. It can be any interest beyond the simple interest in voting the shares.
3. Shareholder voting trusts and voting agreements.
X, Y, and Z own relatively few shares of C Corp. They ask for your advice on how they might pool their voting power.
a. Requirements for voting trust. (10-year maximum.)
1) Written trust agreement, controlling how the shares
will be voted; 2) Copy to the corporation; 3) Transfer legal title to the voting trustee; 4) Original shareholders receive trust certificates and
retain all shareholder rights except for voting.
b. Requirements for voting ("pooling") agreement.
1) Can shareholders enter into voting agreements?
Yes
2) What is required? In writing and signed
3) Are voting agreements specifically enforceable?
Increasingly yes
-- In states that will grant specific performance of a voting agreement, there is no need to use the voting trust.
B. Where do shareholders vote?
1. Shareholders usually take action at a meeting. Instead, they can act
by unanimous written consent signed by holders of all voting shares (e-mail is OK).
-- If they have a meeting, must it be held in the state of incorporation? No
2. There are two kinds of shareholder meetings.
a. Annual meeting. If no annual meeting is held within 15
months, a shareholder can petition the court to order one.
Annual meeting is required
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-- What do shareholders do at the annual meeting?
Elect directors
b. Special meeting can be called by (1) the board or (2) the president, or (3) the holders of at least 10 percent of the outstanding shares, or (4) anyone else authorized in the bylaws.
Trick question: ten percent of the outstanding shares want to call a special shareholder meeting to remove an officer. Is that OK?
No, because shareholders do not remove officers
3. Notice requirement—must give written notice (fax or e-mail OK) to every shareholder entitled to vote. Deliver it between 10-60 days before the meeting.
a. Contents of the notice: must state the date, time, and place of
the meeting.
b. For special meetings, you must also state the purpose of the meeting. Why is the statement of purpose important?
Cannot do anything else at that meeting
c. Consequence of failure to give proper notice to all shareholders—whatever action was taken at the meeting is voidable (maybe void), unless those not sent notice waive the notice defect.
-- How can such waiver occur? In either of two ways:
1) Express–in writing and signed anytime (fax and e-mail
are OK) 2) Implied–attend the meeting without objecting at the
outset.
C. How do shareholders vote?
Shareholders generally get to vote on these things: (1) to elect directors (2) to remove directors and (3) on fundamental corporate changes. They may also vote on other things if the board asks for a shareholder vote on those things.
-- Every time the shareholders vote, we must have a quorum represented at the meeting. Determination of a quorum focuses on the number of shares represented, not the number of shareholders. General rule: a quorum requires a majority of outstanding shares.
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-- X Corporation has 12,000 shares entitled to vote. X Corporation has 700 shareholders. What or who must be represented at the meeting to constitute a quorum?
At least 6,001 shares
-- Can a shareholder quorum be lost if people leave the meeting? No
-- If the quorum requirement is met, the shareholders vote. What vote is required?
1. To elect a director: plurality (the person who gets more votes for
that seat on the board than anyone else).
2. To approve a fundamental corporate change: we do this below.
3. To remove a director, traditionally needed majority of the shares entitled to vote. Increasingly, though, treat this the same as “other matters.”
4. Other matters: majority of the shares that actually vote on the issue.
-- X Corp. has 12,000 shares outstanding. They have a meeting to decide whether to amend the bylaws. Say 8,000 shares are represented at the meeting (so we have a quorum), but only 6,000 shares actually vote on the proposal. How many shares must vote yes for this to pass?
At least 3,001, which is a majority of the shares that actually voted
D. Cumulative voting. Usually only in close corporations; gives smaller shareholders a better chance of electing someone to the board of directors.
1. This is available ONLY when shareholders elect directors.
2. Usually, with “straight” voting, we have a separate election for each
seat on the board being elected. Each outstanding share gets one vote for each seat. The candidate who gets more votes than another is elected to that seat.
-- A and B are the only shareholders. A owns 30 shares, B owns 40 shares. They go to a meeting to elect two directors.
For Seat #1, A votes 30 for herself; B votes 40 for herself. B is elected. For seat #2, A votes 30 for herself; B votes 40 for her friend. B’s friend is elected. A has no representation on the board.
3. With cumulative voting, we don’t vote for each seat individually. We
have one at-large election. The top two (or whatever) finishers are elected to the board.
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-- To determine your voting power when cumulative voting exists: multiply the number of shares times number of directors to be elected. So if there are two directors to be elected, how many votes does each person have?
-- A (who owns 30 shares) 60 votes
-- B (who owns 40 shares) 80 votes
-- Each allocates her votes however she wants. And the top two finishers are elected to the board. Here, A can get elected to the board. If she puts all 60 of her votes on herself, she is guaranteed to finish in the top two. B can put 80 votes on herself, but A will finish in the top two. So cumulating two seats’ worth of votes in one election helped A get representation on the board.
4. If the articles are silent about cumulative voting, does it exist? No
V. STOCK TRANSFER RESTRICTIONS
One great thing about corporations is transferability of the ownership interest. A shareholder can sell or give her stock away. Sometimes people want to restrict transferability, especially in a close corporation (to keep outsiders out). Can they?
-- Kardashian is a shareholder of Corporation, Inc. Her stock is subject to a stock transfer restriction that requires her to offer it first to the corporation (this is a "right of first refusal" (RFR)). Kardashian sells the stock to X in breach of the agreement.
A. Stock transfer restrictions are OK if they are reasonable. What does that
mean?
Not an undue restraint on alienation, RFR is valid
B. If the restriction is valid, can it be enforced against the transferee (X)?
Yes if (a) the restriction is conspicuously noted on the stock certificate or (b) the transferee had actual knowledge of the restriction.
-- Stockholder pledges her stock to Lender as collateral for a loan. The stock certificate says nothing about the RFR and Lender knows nothing about it. After Stockholder defaults on the loan and Lender gets the stock, can the stock transfer restriction be enforced against Lender?
No, not noted on stock certificate and Lender has no knowledge
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VI. RIGHT OF SHAREHOLDER (PERSONALLY OR
BY AGENT) TO INSPECT (AND COPY) THE BOOKS AND RECORDS OF THE CORPORATION
A. Standing: who can demand access? Any shareholder
B. Procedure for non-controversial things: shareholder makes a written
demand at least five business days in advance. She need NOT state a proper purpose for these things. They include: articles, bylaws, minutes of shareholder’s meetings for past three years, names and addresses of current directors and officers, most recent annual report of corporation.
C. Procedure for more controversial things: same as above except here the
demand must state a proper purpose for the demand. What is a “proper purpose”?
One related to her interest as a shareholder
-- What are these more controversial things?
1. Excerpts of minutes of board meetings; 2. Accounting records; 3. Record of shareholders.
D. If the corporation fails to allow proper inspection, shareholder seeks a court
order. If she wins, she can recover costs and attorney’s fees incurred in making the motion.
E. By the way, must directors go through this procedure to get access to
corporate books and records?
No, they have unfettered access
VII. DISTRIBUTIONS
These are payments by the corporation to shareholders. There are different types of distributions: (1) dividends or (2) to repurchase shareholder's stock or (3) redemption (a forced sale to corporation at price set in articles).
A. Distributions are in the board's discretion. At what point does a
shareholder have a “right” to a dividend or other distribution?
When the board declares it
-- Because this is a decision for the board to make, it is difficult to win a case to force the declaration of a distribution. To win, plaintiff must make a very strong showing of abuse of discretion. For example, maybe if the
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corporation consistently makes profits and the board refuses to declare a dividend while paying themselves a bonus. -- Is a suit to compel the declaration of a distribution direct or derivative? Direct, because the harm is to the shareholder and not the corporation
B. Which shareholders get dividends?
-- We’ll do two hypos on dividends. For each, the board of directors declares dividends totaling $400,000. We need to figure who gets what.
Who receives dividends if the outstanding stock is:
1. 100,000 shares of common stock. Four dollars per share
2. 100,000 shares of common and 20,000 shares of preferred with $2
preference.
-- Preferred means pay first. 20,000 preferred shares multiplied by $2 preference equals a total preference of $40,000. That is paid first. That leaves $360,000, which goes to the common shares. Because there are 100,000 of those, each common share gets $3.60.
Nothing to add
C. For any distribution (dividend, repurchase, redemption), which funds can be used?
--The modern view does not look at funds. It says a corporation cannot make a distribution if it is insolvent or if the distribution would render it insolvent. Insolvent means either:
a. The corporation is unable to pay its debts as they come due;
or b. Total assets are less than total liabilities. Liabilities include
preferential liquidation rights. Huh? Those are discussed below.
D. Directors are jointly and severally liable for improper distributions.
Remember the directors’ good faith reliance defense (see above).
-- Shareholders are personally liable only if they knew the distribution was improper when they received it.
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FACT PATTERN 5: FUNDAMENTAL CORPORATE CHANGES
I. CHARACTERISTICS OF FUNDAMENTAL CORPORATE CHANGE
A. These are extraordinary, so the board generally cannot do them alone.
What are they?
1. Amend the articles; 2. Merge or consolidate into another company; 3. Transfer substantially all assets (or having stock acquired in “share
exchange”); 4. Convert to another form of business; 5. Dissolve.
B. Generally, to do any of these, we need:
1. Board action adopting a resolution of fundamental change.
2. Board submits proposal to shareholders with written notice.
3. Shareholder approval. What shareholder vote is required?
Majority of shares entitled to vote -- This is changing. An increasing number of states require only a majority of the shares that actually vote on the proposed fundamental change. But to be safe, we will apply the traditional rule.
4. In most of these changes, we need to deliver a document to
Secretary of State.
C. Dissenting shareholder right of appraisal. What is this? Right to force the corporation to buy your stock for fair value
1. Only these changes trigger the right of appraisal:
a. Merging or consolidating; b. Transferring substantially all assets; c. Stock being acquired in a share exchange; or d. Conversion to another form of business.
2. BUT even if the company is doing one of these, there is no appraisal if
the company’s stock is listed on a national exchange or if the company has 2,000 or more shareholders (not shares, shareholders).
-- So this means the right of appraisal exists in Close corporations
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-- This makes sense. If you don’t like a fundamental change in a public corporation, just sell your stock on the public market. But with a close corporation, there is no market for the stock, so you can force the company to buy your stock. In our hypos below, we will assume it’s a close corporation.
3. To perfect your right of appraisal:
a. Before the shareholders vote, file with the corporation a
written notice of objection and intent to demand payment; b. At the shareholder vote, abstain or vote against the proposed
change; and c. After the vote, within time set by corporation, make written a
demand to be bought out and deposit stock with the corporation.
4. If the shareholder and the corporation cannot agree on fair value of
the shares, the corporation sues and the court may appoint an appraiser.
5. Is the right of appraisal the shareholder’s exclusive remedy if she
does not like a fundamental change?
Yes, absent fraud
II. AMENDMENT OF THE ARTICLES
A. Board of director action and notice to shareholders.
B. Shareholder approval.
If there are 4,000 shares entitled to vote, how many must vote for the amendment?
At least 2,001 -- Say there are 4,000 shares entitled to vote. 3,000 shares attend the meeting and 2,400 shares actually vote on the proposed amendment. How many would have to vote yes for the amended articles to pass? At least 2,001, which is a majority of the shares entitled to vote
-- Again, this is changing. In many states, all you would need is a majority of those that actually voted. Since 2,400 voted, you would only need 1,201.
C. If approved, deliver amended articles to the Secretary of State.
D. Are there dissenting shareholder rights of appraisal? Generally not
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III. MERGERS (B, Inc. merges into A Corp.) OR CONSOLIDATIONS (A Corp. and B, Inc. form C Corp.)
A. Board of director action (both corporations), and notice to shareholders.
B. Shareholder approval (generally both corporations). Same as with
amending articles.
C. No shareholder approval required if a 90 percent-or-more owned subsidiary is merged into a parent corporation. What is this called?
Short form merger
D. If approved, surviving corporation delivers articles of merger or
consolidation to Secretary of State.
E. Remember the right of appraisal. Generally, for shareholders entitled to vote on the merger or consolidation and also for shareholders of subsidiary in short-form merger.
F. Effect of merger or consolidation: surviving corporation succeeds to all
rights and liabilities of the constituents. This makes sense because the constituent corporation disappeared. So a creditor of that corporation can sue the survivor. What is this called? Successor liability
IV. TRANSFER OF ALL OR SUBSTANTIALLY ALL OF THE ASSETS NOT IN THE ORDINARY COURSE OF BUSINESS OR A “SHARE EXCHANGE” (one company acquires all the stock of another)
What constitutes “substantially all of the assets” varies from state to state. A rule of thumb is that it requires transfer of at least 75 percent of the assets.
Most important point – these are fundamental corporate changes for which corporation? For the selling corporation only – not for the buyer. -- S Corp. wants to sell all of its assets to B, Inc. or B, Inc. wants to buy all stock of S Corp.
A. Board action (both corporations), and notice to selling company’s
shareholders.
B. Approval by the selling corporation's shareholders. 1. Number of shares of S Corp. that must approve the sale? Same as
with amending articles.
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2. Number of shares of B, Inc. that must approve? None. They do not vote, because it is not a fundamental change for
the buyer.
C. Are there dissenting shareholders' rights of appraisal? Yes, for shareholders of the selling corporation (but not for the shareholders of the buying corporation).
D. Deliver to Secretary of State articles of exchange in share exchange.
Usually, there is no filing in a transfer of assets.
E. Do we expect successor liability in the sale of substantially all assets? No, because the selling corporation still exists. So creditors can sue it.
-- So the company that buys assets is not liable for the debts of the company that sold the assets. There is an exception if the buyer is a “mere continuation” of the seller – has the same management, shareholders, etc. Also there will be successor liability if a court concludes that the deal was really a disguised (de facto) merger.
V. CONVERSION. Business converts to another form (e.g., corporation converts to LLC). Board approval notice to shareholders, shareholder approval, deliver document to Secretary of State, dissenting shareholders’ right of appraisal.
VI. DISSOLUTION
A. Voluntary. Board of directors action and shareholder approval. File notice of intent to dissolve with Secretary of State. Corporation stays in existence to wind up. Notify creditors so they can make claims.
B. Involuntary (by court order).
1. A shareholder can petition because of:
a. Director abuse, waste of assets, misconduct; b. Director deadlock that harms the corporation; or c. Shareholders fail at consecutive annual meetings to fill a
board vacancy.
-- As an alternative to ordering involuntary dissolution, court might order buy-out of the objecting shareholder. When might this be especially likely?
Close corporations
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2. A creditor can petition because corporation is insolvent and (1) he
has an unsatisfied judgment or (2) the corporation admits the debt in writing.
C. Dissolution is not the end of the corporation. It is the beginning of a
process that will end the corporate existence. The corporation continues to exist, so it can sue and be sued. It cannot start new business but must wind up (liquidate).
-- Steps taken in winding up:
1. Give written notice to known creditors and publish notice of
dissolution in a newspaper in the county of its principal place of business;
2. Gather all assets; 3. Convert assets to cash; 4. Pay creditors; and 5. Distribute any remaining sums to shareholders, pro-rata by share
unless there is a liquidation preference.
-- What's a liquidation preference? It means "pay first," so it works like a dividend preference. Articles may set out dividend preference or liquidation preference, if any
-- After paying creditors, there is $10,000 left for shareholders. If there were a class of 1,000 shares with a $2 liquidation preference, the first $2,000 would go to those shares, with the remaining $8,000 going to the common shares.
-- Remember, liquidation preferences may be relevant to insolvency, which we saw above.
LAST POINT: If you have any questions, call me. Please do not e-mail. Call and, if I'm not there, leave your specific questions and phone number. My phone number is: 404-727-6838
