CORPORATIONS Introduction o The Role of Agency Law in Business Associations Agency: is the fiduciary relationship that arises when one person (a "principal") manifests assent to another person (an "agent") that the agent shall act on the principal's behalf and subject to the principal's control, and the agent manifests assent or otherwise consents so to act – assent is manifested through a writing or spoken words or other conduct all of these elements must be met in order for their to be agency relationship Co-agents: have agency relationships with the same principal. Coagent may be appointed by the principal or by another agent actually or apparently authorized by the principal to do so Disclosed Principal: prin. disclosed if, when an agent and a third party interact, the third party has notice that the agent is acting for a principal and has notice of the principal's identity Undisclosed Principal: undisclosed if, when an agent and a 3rd party interact, the 3rd party has no notice that the agent is acting for a principal Unidentified Principal: unidentified, if when agent and a 3 rd party interact, the 3rd party has notice that the agent is acting for a principal but does not have notice of the principal's id Dual agent; joint principals: a dual agent acts on behalf of more than one principal with regard to the same transaction. Such principals are joint principals. Notice: person has notice of a fact if the person knows the fact, has reason to know the fact, has received an effective notification of the fact, or should know the fact to fulfill a duty owed to another person. Notice of a fact that an agent knows or has reason to know is imputed to the principal. A notification given to an agent is effective as notice to the principal. Person: is an individual; an organization or association that has legal capacity to possess rights and incur obligations; a government or instrument created by the gov; or any other entity that has legal capacity to possess rights and incur obligations Actual Authority: an agent acts with actual authority when, at the time of taking action that has legal consequences for the principal, the agent reasonably believes, in accordance with the principal's manifestations to the agent, that the principal wishes the agent so to act SCOPE of AUTHORITY Agent has actual authority to take action designated or implied in the P's manifestations and acts necessary or incidental to achieving the P's objectives, as the A reasonably understands them when the agent determines how to act A's interpretation of the P's manifestations is reasonable if it reflects any meaning known by the agent to be ascribed by the P and, in the absence of any meaning known to the A, as a reasonable person in the A's position would interpret the manifestations in light of the context, including circs of which the agent has notice and the A's fiduciary duty to the P
A's understanding of the P's objectives is reasonable if it Accords with the principal's manifestations and the inferences that a reasonable person in the A's position would draw from the circs creating the agency Apparent Authority: is the power held by an A or other actor to affect P's legal relations with 3rd parties when a 3rd party reasonably believes the actor has authority to act on behalf of the P and that belief is traceable to the P's manifestations Respondeat Superior Estoppel to deny existence of agency relationship if: P intentionally or carelessly caused such belief, or Having notice of such belief and that it might induce others to change their positions, the person did not take reasonable steps to notify them of the facts Estoppel of Undisclosed P. Restitution of benefit. Manifestation terminating actual authority. A's actual authority terminates if the A renounces to P, or if the P revokes the A's actual authority by a manifestation to A. Revocation or renunciation effective when other party has notice. Termination of Apparent Authority Termination of actual authority does not y itself end any apparent authority held by the agent. Apparent authority ends when it is no longer reasonable for the 3rd party with whom the agent deals to believe that the agent continues to act with actual authority.
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Introduction to Business Forms The Proprietorship: business owned by a single individual. Person is personally liable on all business obligations since there is no legal separation between the owner and the business. Person may limit liability by turning Proprietorship into a corp. This protects personal assets, but person still liable for claims arising or liabilities created before the transfer to the new entity took place. General Partnership: is formed if two or more persons go into a coowned business without any thought or planning or understanding of what the relationship is. Co-ownership need not be express. Oral agreement to share profits in some agreed-upon ratio may be sufficient to establish the existence of a general partnership even though initial financial contributions are unequal. Many partnerships are carefully planned though. Partnership may be dissolved by a partner at any time simply by a statement of his or her express will. The Limited Liability Partnership (LLP): general partnership in all respects except that the statute provides that partners have no personal liability for firm obligations that exceed the assets of the general partnership. Partners in LLP have full personal liability for claims arising from their own misconduct. LLP is a creature of statute. In the absence of statute (or the failure to comply with the mandatory provisions of the applicable statute), all partners are general partners no matter what their private understanding is or how they are designated in the partnership agreement or held out to the public. LLP partner loses the protective shield if he takes part in the
control of the business. LLP can not give any input or exercise any influence. However, if the LLP participates in control of business, he is liable only to persons who transact business with the LLP reasonably believing that the LLP is a general partner. OR the LLP knowingly permits his name to be used in the name of the LLP and creditors rely upon this when giving credit. If filing error occurs causing an LLP to be a general partner, person may remedy this problem by correcting the filing error or by withdrawing from future equity participation in the enterprise. Limited Partnership with a Corporate General Partner: corp can be the sole general partner of a limited partnership. Cts permit officers of corp to be limited partners. Limited Liability Limited Partnership (LLLP): LLLP is a limited partnership with both general and limited partners, but the general partners have the protection of the LLP election. Limited Liability Companies: provides the benefits of incorporation without the limitations and rules applied to corps. Characterized by limited liability, management by members or managers, and limitations on ownership transfer. The Corporation: incorporation results in the creation of a legal entity, a fictitious person with sole responsibility for its own obligations – corp provides LL for all investors and participants. "publicly held" corp has shares that are traded on public securities markets subject to federal regulation. "closely held" corp does not have publicly traded shares even though the number of shareholders may be fairly large. THREE TIERS o 1. shareholders: ultimate owners of the enterprise o 2. board of directors: who are the managers of the corp's affairs o 3. officers: who implement the decisions of the directors
The Limited Partnership: With Special Reference to Federal Income Taxation: liability no longer a major concern when forming a business, tax consequences are most important o Federal Income Taxation: Basic Principles – look at taxation of the individual as well as the taxation of the business corporate tax rates – subchapters S and C of IRC (deduct expenses of doing business from receipts in order to compute taxable income) "marginal" and "average" tax rates (difference between two) tax structure is generally "progressive" because additional income is taxed at increasing rate, in contrast to "regressive" "qualified personal service corp" is taxed at a flat 35% rate individual tax rates – rates for individuals are higher than married TPs filing a joint return taxation of capital gains or losses – (capital asset = asset held for profit making or investment purposes) LTCG are taxed at 20%, and STCG are taxed at ordinary income tax rates, capital losses offset capital gains at a maximum of 3000 dollars, and the difference may be carried over to the next year estate taxes – tax based on size of decedent's gross estate less allowable deductions; however, this tax is being fazed out taxation of partnerships and corporations
proprietorship is not a separate taxable entity, its income or loss is reported on the proprietor's personal income tax return – must file a 1040 and a Schedule C, than they are weighed against each other for TI unincorporated business form – (subchapter K) business that has at least two owners is generally classified as a partnership if no forms filed to contrary – this is taxed as an extension of the individual TP, the amounts allocated are based on the income calculations of the proprietorship and NOT the amounts actually distributed to the proprietor C corporations – ("closely held") the corporate tax is applicable to the corporation; if corporate income is then distributed to the shareholders, that distribution is itself taxed as dividends to the shareholders S corporations – can not have more than 75 shareholders, no nonresidents or artificial entities and must issue one class of stock – has the basic function feature of conduit or pass through taxation that is typical of partnership and proprietorship forms of business Business Tax Planning Strategies: o Taxation is more immediate and certain risk than the risk of unlimited liability for owners o TPs want to minimize their tax liability to the extent they may do so legally o usually concentrate on the marginal rate and NOT the average rate o Total tax liabilities of both business and owners must be taken into account 1986 Tax Reform Act – 1. imposed significant restrictions on the deductibility of passive losses in an effort to ferret out abuse, and 2. it reduced the marginal rates on individuals to a maximum of 28 percent, a rate lower than the corp tax rate, thereby making an S corp more alluring
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"Check the Box" (replace Kinter rules) Entity classified as a corp for tax purposes if it is created under a statute that "describes the entity as incorporated as a corp" or as "joint-stock company" – such entity must be taxed as a C corp or S corp An entity NOT classified as a corp and has at least two members can elect to be classified for tax purposes either as a corp or as a partnership by making an election at the time it files its first tax return. If entity does not formally elect to be taxed as a corp it will be taxed as a partnership. An entity that has only one member may elect to be taxed as a corp or it will be taxed as a "nothing" – i.e. as though it has no separate existence from its owner If an entity elects to change its classification, it may not change its classification back within five years without permission of the Comm. The conversion of an entity that is currently taxable as a corp to a partnership is itself a taxable event, treated as though the corp dissolved and reconstituted itself as a partnership. The conversion from a partnership to a corp is usually tax free.
Limited Liability Companies (LLC) – used for non-publicly traded companies o INTRODUCTION o An LLC is a single business entity which provides limited liability protection for the partners, as well as providing all the owners of the business with federal partnership taxation. o This differs from general and limited partnerships, which offer federal partnership taxation, nut make at least one general partner bear personal liability for the debts and obligations of the business. o The purpose of forming a LLC is to create an entity that offers investors the protections of limited liability and the flow-through status of partnerships o "check the box" allows entities to choose for themselves whether to be taxed as a partnership or as a corporation; however entity NOT eligible for this election and must be taxed as a corporation if: 1. entities organized under a fed or state statute that refers to entity as a "corporation" or as "incorporated" 2. certain foreign entities that are specifically listed in the regs as per se corps 3. business entities that are taxable as corps under other provisions of the IRC LLC may receive pass through treatment even if there is only one owner o *** Some companies still use the S corporation because S corps can engage in mergers, stock-for-stock swaps, and other corp reorganizations on a tax-free basis, while LLCs cannot o LLC best understood in terms of four general characteristics: 1. limited liability 2. partnership tax features 3. chameleon management, the ability to choose between centralized and direct member-management 4. creditor-protection provisions these characteristics best understood in light of LLC as an alternative to existing business forms o LLCs do not protect from members own wrongs o It is usually beneficial for a start-up, who has a strong potential for being bought out in the near future, to incorporate rather than start as an LLC and than incorp o Commentators have speculated that "piercing the corporate veil" will logically apply in the same context to an LLC Most states are in agreement that an LLC member or manager has fiduciary duties to the LLC similar to those of a partner in a partnership For "closely held" entities the corporation is still the predominant business form, rather than an LLC Use of a C corp to take advantage of the 15 and 25% tax rates for relatively small for-profit corps Complexity of forming an LLC as contrasted with corps can be daunting for a small business owner In many situations the difference between S and K taxation may not be important or significant. Businessmen who have used a corp before may feel more comfortable with a business form they have
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already used Some concern that an LLC is more "porous" than a corp in terms of liability Some more expensive fees apply to LLCs in some states, and some apply franchise taxes to LLCs and corps but NOT to partnerships or limited partnerships TAX goals of all Unincorporated entities No double taxation of entity profits (if an LLC, there is no tax at the entity level, only taxed at the holder level) – in C corp, the corp is taxed and than profits to holder are taxed Flow through of entity losses (when have income from other sources the losses of the entity are subtracted against this number which decreases tax liability) – C corp fails this test Avoid taxation on the transfer of assets to the entity when being formed – much more efficient if transfer can be made without tax – for C and S corps meet goal in formation – 'midstream' transfers of assets in corps are taxed because they are not in control of the entity Transfer of assets from entity to holder (liquidation) transfers from entity to holder no tax – for C corp there is a double taxation o if tax considerations are the major goal of the entity there is NO reason to form a corporation
NON TAX GOALS: MOST Important NonTax goal: LIMITED LIABILITY – investor does not want exposure to personal liability. Shell around the LLC is just as thick as it would be in a corporation. Flexibility and ease of operation S corp. – no double tax, flow through, and transfer of assets parity with C o S corp is a regular corp but has special regulations – a corporation may not buy stock in an S corp and non resident aliens – can only have one class of stock o S corps are very difficult to run CORPS advantages to LLC Significant consideration for a corp is whether it can go public or be acquired publicly o S corp can not do this because number of shareholders is limited o An LLC that is publicly traded is now a corp – if take LLC public pay tax and corps are favored entity for public trade o If LLC acquired by a public corp this is a taxable event C corp that sells stock to public does not get taxed Has ability of to sell interest to public or to be acquired by a public company Transfer of stock certificates, greater flexibility to acquire companies Allows entrepreneurs to diversify their investments
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Strategy is to start business: o Start as an LLC when first beginning o Business is successful, than convert LLC to a corp (tax free)
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Than can have an IPO or acquisition by public company
Why people still start corps: o Ignorance o Investors have special tax reasons For federal tax purposes a corp is a business organized under statute and labeled as a corporation. If state law calls it a corp, than for federal tax purposes it will be a corporation. If entity is NOT labeled as a corporation than that entity has a choice on how to be taxed. This is called "check the box". If entity "checks the box" than business is taxed as a corporation. The default choice is a partnership. o Do NOT check the box!!! LLC in contrast with Corporations traditional mandatory internal procedures: Decisions made by boards of directors and shareholders must be voted upon at meetings Notice of meetings must be given unless expressly waived Action is taken by resolution duly proposed at a meeting and adopted by vote Minutes of meetings are prepared and retained permenantly, and so forth LLC statutes contain virtually none of these requirements – however some attorneys argue that these formalities are good because they help to avoid potential "veil piercing" arguments in the future
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The Development of Corporation Law in the United States o Corporations are creatures of the state, and are subject to their rules o States compete for corporations Directors and shareholders want corporate law that is workable and predictable – laws favorable to directors and officers (flexibility to do business,etc.) Internal Affairs Rule – courts of any state will apply the law of the state of incorporation when trying a case in its jurisdiction – including creditors against that corporation o In 1963Delaware statute called for a revision of Delaware Corporate law The revision included much of the same language previously used because "a wealth of judicial decisions helped attract corps to Delaware, and to do away with this body of precedent would be undesirable" "Tobias Q" measures the relationship between the market value of a company's stock, and the book value of the company's assets. The greater the difference between the market value of the firm's stock and the book value of the assets, the more efficiently management is deploying the assets. o Dole Food Company Proxy Statement (REASONS FOR DELAWARE INCORP) Advantages to Delaware Corps: Case law in Delaware is highly developed providing a greater measure of predictability than exist in other jurisdictions D law is acknowledged as most flexible and advanced corp statute D's judiciary is highly skilled and so are their corp lawyers – allows equitable remedies D assembly considers new laws every year in order to keep
pace with state of business affairs "internal affairs law" provides that foreign courts should apply the law of the state of incorporation to issues relating to the internal affairs of a foreign corp. CA is the principal state that has sought to apply specific provisions of its corp statutes to corps formed in other states but whose principal business activities are in CA - § 2115 requires corps with "specified minimum contacts" in CA to comply with designated provisions of the CA statute
The Formation of a Closely Held Corporation o "closely held" corporation: are corporations with relatively few shareholders. There is no public market for their shares. They are typically managed by the shareholders themselves or by persons closely associated with the shareholders. o Where to Incorporate Selection of the state of incorporation involves two factors: A dollars and cents analysis of the relative cost of incorporating under the statutes of the state under consideration; and, Consideration of the advantages and disadvantages of the substantive corporation laws of these states. If the corporation is closely held and its business is to be conducted largely or entirely within a single state, local incorporation is almost always to be preferred. o How to Incorporate In forming a corporation you must first ask, "What substantive provisions should be reduced to writing, and whether these provisions should be placed in the articles of incorporation, the bylaws, or the shareholders' agreement." Modern trend is to limit the articles of incorporation to provisions required by law to appear in that public document. The other provisions are placed in documents such as the bylaws or shareholders' agreement that are not filed in public office. Many corps may be stamped from a single mold and be perfectly satisfactory, BUT some cannot. Process of filing docs with the State varies. Most Secretaries of State have "clout" and therefore most have discretion when reviewing applications. If the form(s) do not conform to standards they may be rejected. A corporate name "must" be distinguishable upon the records of the state from other corp names. States minimum require that name be distinguishable. Most states are not in the business of rejecting names because they are "confusingly similar" Corps may generally conduct business under an assumed or fictitious name. The person can not use this name to defraud. Duration – code grants corp "perpetual duration and succession in its corporate name" unless articles state to contrary Purpose: statement of purpose is important along with the general act because it shows the true measure of the powers of the corp. Corp may have multiple purposes therefore the forms are simplified to say "for the transaction of any lawful business" or similar language that does not require specification of particulars
Some articles may have a "narrow purpose" clause because: o May be subject to state regulation o Some may prefer that their business have a description of their businesses' purpose o In "closely held" corp one partner may wish to narrow the avenues which the business may go Powers - write phrase as "The purpose for which this corp is organized is to engage in the business of ________". It is NOT necessary to reference corporate powers in the articles of incorporation. It is OK to take the language in the form at face value, at least where the powers are sufficiently broad to encompass various acts – a listing of powers may be partial rather than complete thereby narrowing the potential powers, by state inferring that was all the powers you wanted. Registered Office The designation of a registered office and registered agent, and the statutory provisions relating thereto are designed to ensure that every corp has publicly stated a current place where it may be found for purposes of service of process, tax notices, and the like. Number of Incorporators Trend is to reduce the number to one and allow corps or other artificial entities to serve as incorporatorsl Some states require a board of at least three directors; however, though some states say that if there are only one or two shareholders the board may be limited to the number of shareholders Initial Capital No reference is made to dollars: no dollar figure is associated with the shares of stock and no minimum capitalization of the corp is set forth Most states do NOT have a minimum capitalization requirement to offset any indebtedness the corp may incur while beginning its initial transactions After filing articles of incorporation - § 7.32 helps to ameliorate the stringent conditions of corporate governance and the board of directors – in deciding what governance to adopt one must work within the confines of the statute In some instances it may be better to use an LLC The bylaws of a corp constitute the internal set of operating rules for the corp – bylaws may vary from a brief one or two page document to elaborate provisions covering all aspects of corp management and operation
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The Decline of the Doctrine of Ultra Vires - is the common law doctrine relating to the effect of corp acts that exceed the powers or stated purposes of a corp. Corps necessarily have a purpose and a power Old View - Question is NOT the illegality of the K, but whether it is within the corporation's power to make such a K.
711 Kings v. FIM's p. 277
(Modern Trend)
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Def entered into an agreement to lease a warehouse for movie making purposes, the Def's charter limits them to marine activities, is Def liable for lease? Plaintiff (the leasor) is seeking to have the K void because the purpose of the warehouse is outside the scope of Def corporation's authority – this is an offensive use of the doctrine Because the corp entered into an agreement that was beyond their powers the agreement is declared invalid and therefore complaint dismissed Court says three ways to use doctrine: NY law overrules Ultra Vires Trend is now that any LAWFUL business is incorporated into the articles thereby giving corporation unlimited power – corporation has the powers of a natural person UV doctrine may arise if corp has a limited purpose No act of a corp shall be invalidated because the act is outside the scope of the articles of incorporation; But there are three exceptional circs where corp action may be invalidated – 1. in an action brought by a shareholder to enjoin a corp act; 2. derivative suit, shareholder sues the board of directors on behalf of the corp; and , 3. an action of special proceeding brought by the attorney general.
Ultra vires is used to protect shareholders who may have relied on a narrow purpose clause as protection against undesired business expansion. Intervenor must be an agent of the corporation? When a corp acquires a corp that is not part of its designated authority this may be OK because the acquired corp is a distinct entity from the parent corp – therefore it can be said that the parent corp is NOT engaging in wrong behavior but that it is just owning the smaller corp UV can only be invoked by a shareholder or by the state through its attorney-general and not by an employee Theodora v. Henderson p. 280 o Corp sought to give a gift, which was well within a 5% limitation, to a charitable organization – which P claimed was UV – suit arose from a derivative action o Corp is allowed a charitable deduction (5% of AGI) o Delaware laws allow for contributions for the public good – gives corp a better image and the world is better too o Court says that there is no limitation on amount given to charity if it is reasonable o Majority shareholders have a fiduciary duty to the minority shareholders – must be for the corps benefit – amount cannot be unreasonable o Court held gifts are valid so long as they are reasonable in amount
given the corp assets and do not exceed the maximum deduction allowed under the federal income tax law – also alludes that there must be a valid purpose UV Issues: UV issues have arisen with respect to certain transactions that provide no immediate direct benefit to the corp – guidelines state that a corp "has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs" – the validity of corp action may not be challenged on the ground that the corp "lacks or lacked power to act" corp may be investigated for transactions that involve self-dealing or improper conduct by directors or officers SC recognized that corps have the right of free speech – court did not address corp commercial speech – speech that affects property, business, or assets of corp
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FORMATION Liability of person for already formed corporation When a person signs a K on behalf of a corp they must sign on the line with "By" and must also have their title (representative capacity). This shows that the person is acting on behalf of the corp and NOT in an individual capacity. Premature Commencement of Business Business men sometimes overlook the details, and they may be held personally liable when they undertake deals without formation of the corportaion Promoter – includes a "person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business enterprise of an issuer" = 'founder' or 'organizer' o Promoter owes significant fiduciary duties to other participants in the venture In addition to subsequent investors in the enterprise, these other entities may attack transactions between a promoter and the corporation on the ground the transaction violates the promoter's fiduciary duty: o general creditors of the corporation or their representatives – this suit is based on theory that promoters converted corporate assets to their own use in fraud of creditors o co-promoters – co-promoters may be viewed as partners in a venture to create the business o the corporation – the corp. itself may bring suit against its promoters after it has come under the control of subsequent investors or other persons courts hold that promoters stand in the same fiduciary position to the corp. when uninformed shareholders are expected to be brought in after the wrong has been perpetrated as they do when there are current shareholders to whom no disclosure is made Fraud has decreased in recent years with promoters because a new act
makes it unlawful to use means of interstate commerce or the mails to sell publicly a security unless a registration statement has been filed with the SEC setting forth required information: names of promoters, value which the promoters will receive from formation of the corporation any assets acquired or to be acquired by the registrant from a promoter, or identify any third persons who are giving anything of value to registrant or promoter How v. Boss p. 288 sale to corp to be formed. Architect and promoter sign an agreement with regard to architecture fees. Def. signs the K "Edwin Boss, agent for a Minnesota corp. to be formed who will be the obligor." Def. claims he is NOT liable for payment to the architect because the corp. that dissolved, and does not have any assets is liable to the architect. How testimony and business record showed that he did not intend that the new corporation was the sole obligor on the K The issue is whether the K was a continuing offer to the then nonexistent corporation or was an agreement that Boss was a present obligor. The agreement was NOT clear enough to offset the rule that the person signing for the nonexistent corporation is normally to be personally liable. RULE: a promoter, though he may assume to act on behalf of the projected corporation and not for himself, will be personally liable on his contract unless the parties agreed to look to some other person or fund for payment. There was evidence that the corp was to be an obligor but not the sole obligor.
Burden is on promoter to show that he is not liable, by showing that it was intended that the corporation be the sole obligor, or that there was a novation. Promoter is liable under general rule of promoter liability: Burden on promoter to establish that he or she is not liable, by showing that it was intended that the corporation be the sole obligor, then promoter not liable There is a novation (release of liability of promoter and corp assumes the liability). o Don't let client sign K before corp is formed!!!! Promoter might be held liable if he executes a K in the name of a notyet-formed corporation but without including the phrase "a corporation to be formed": agent who warrant authority – person purports to make a K on behalf of another who has full capacity but whom he has no power to bind, thereby becomes subject to liability under implied warranty of authority liability of misrepresentation of authority – person tortiously misrepresents to another that he has authority to make a K is subject to liability agent making no warranty or representation of authority – person purports to make a K, but has no power to bind is NOT liable if he
sufficiently manifests that he does not warrant authority Quaker Hill v. Parr p. 293 Sale to corp to be formed (never formed), corp Two formed and than accepted (but corp never engaged in business) P made a sale to a corporation to be formed, and later accepted another corporation after formation of the latter. The K imposed no obligation on Ds to form the corporation nor did it name them as obligors on the note or as promises in the K Can the promoters be personally liable? Personal liability does NOT attach where the contracting party is shown to be looking solely to the corporation for payment and NOT to the promoters or officers Different from How because in that case P looked to BOTH the promoter and the corp. for liability, in this case P only looked to the corp. Liability of Promoters and Corps A contract made by the promoter of a corporation before the corporate existence does not become a K of the corporation when it is formed. The promoter is NOT liable where the other party knows the corporation does not exist and looks solely to the corporation for liability. Burden is on the promoter. Promoter is liable for the K that he makes on behalf of the corporation that is NOT yet in existence. o Exceptions: Parties agree otherwise novation Absence of an express agreement to release the promoter from liability may be shown by circumstances making it reasonably certain that parties intended and did enter into an agreement A corporation is not bound by engagements made on its behalf by its promoters before its organization, it may, after its organization, make such engagements its own Ks. This is done by either formal action, or acceptance of such K may be inferred from acts or acquiescence in part of the corporation or its agents. So promoter liable as well as the corporation. When an attorney forms a corporation and there is a dispute about the bill the corporation canNOT disavow the work the attorney did to form the corporation, even though this work was technically done before the corporation came into existence.
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Why incorporation defective: o All papers are done, but forget to mail o Mailed to wrong address. o Technical defects. Application not done correctly. What is the liability of the promoter when filed defectively? Corporate existence begins upon the filing of the articles. But in some states there must be a responsive issuance (this is when corp begins in these states).
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DEFECTIVE INCORPORATION §§ 50 and 139 o § 50 – when corp existence begins o § 139 – the consequences of entering into business before corp is in existence Robertson v. Levy p. 297 If the president of an association has its articles rejected but later accepted, can he be held personally liable on an obligation entered into by the "association" before the certificate of incorporation has been issued, or whether the creditor is "estopped" from denying the existence of the "corporation" because, after the certificate of incorporation was issued, he accepted the first installment payment on the note? Corporation comes into existence only when the certificate has been issued. Before the certificate issue, there is no corporation. Only after existence has begun can the corporation commence business. If an individual or group of individuals assumes to act as a corporation before the certificate of incorporation has been issued, joint and several liability attaches. All persons who assume to act like a corp, but who don't have authority to do will be joint and severally liable The certificate of incorporation provides the cut off point; before it is issued, the individuals, and not the corporation, are liable All persons that act as a corporation and corp does NOT exist, thereby having no authority, this person is held to be personally liable. Joint and severally liable. D.C. statute says that if person acts before incorp than person is liable - clearcut (no common law doctrines are used). Only active shareholders will be liable under § 139 Common law doctrines: o De jure corp – results when there has been conformity with the mandatory conditions of the state (no material defects), however, if there are defects in articles of incorp, defects must be relatively inconsequential mistakes (e.g. wrong address) – share holders are NOT liable o De facto corp – 1. a valid law under which such a corp can be lawfully organized, 2. an attempt to organize thereunder (this must involve an engagement of the state in some way), 3. actual user of the corp franchise (acted like a corp), and 4. good faith in claiming to be and in doing business as a corp o Corp by estoppel – one of four elements of de facto corp are not met – but the parties still act like a corp existed – if contracting parties (third party) was satisfied with corp and had no hope of holding an individual liable at the time the obligation was incurred and then learns after the fact that the corp did not exist, then it's unfair for the plaintiff to be able to rely on that defect and cannot impose personal liability on the promoter/shareholder o Limited liability for the promoter/shareholder when there has not be properly formed corp. No limited liability exists before the certificate of incorporation is filed
Corp begins to exist upon the filing of articles of incorporation with the secretary of state What happens when obligations are incurred on the corp before its existence? o Good faith is NOT a factor. All persons who assume to act as a corp without authority to do so shall be joint and severally liable for debts and liabilities incurred as a result – shareholders who are innocent of this are NOT liable o Windfall factor – person who did business with promoter has all intentions of doing business with a corp, but that person is allowed to sue promoter because that person solicited business – MOST STATES REJECT THIS APPROACH THREE TESTS ABOVE ARE REJECTED More liability "Liability is imposed on all persons who assume to act as a corporation. Such persons shall be liable for all debts and liabilities incurred or arising as a result thereof. Persons who assume to act as a corporation does not include those whose only connection with the organization is as an investor." Clerical faults of the county apparently do NOT effect to incorporation of the entity. (Sunshine) If a person hires an attorney, and through no fault of their own, does not incorporate correctly that person will not be held personally liable if the following conditions are met: o The existence of law authorizing incorporation o An effort in good faith to incorporate under the existing law o Actual use or exercise of corporate powers The doctrine of estoppel to deny the corporate existence is applied where the person seeking to hold the officer personally liable has contracted with the association in a manner that recognizes and admits its existence as a corporation. (Cranson)
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Statute o Statutes in many states whether there is liability on promoter for pre-corporation transaction o In many states, there is no statute that states liability for preincorp transaction, and in these state the court shall fall back on CL doctrines o CA says that promoter will be liable, but there is an exception Defective Corps. What is the statute like? Statute in CA that corp begins upon the filing of the articles. There is no counterparty of either § 139 or 204 in CA. Therefore, it is clear that the CL doctrines of DE FACTO and ESTOPPELL apply.
DISREGARD OF THE CORPORATE ENTITY o The common law doctrine of piercing the corporate veil Bartle v. Home Owners p. 315
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Corporation formed a subsidiary to carry on business. The subsidiary built homes for the management of the parent corp. The sub did not turn a profit, it was subsidized by the parent corp, and the profit that it made went to the parent corp. Plaintiff claims that the defendant equitably pledged its assets toward the satisfaction of the debts of the bankrupt's creditors, and that the doctrine of unjust enrichment applied. When such there is such strong control by the parent corporation is the corporate veil pierced? Could NOT pierce because: NO FRAUD involved - Plaintiff on notice that subsidiary is liable for all claims (not parent) NO depletion of assets Corporations, if dealing in commercial dealings with SHs, should deal in an ARMS LENGTH bargaining If dealing with SHs in a NON-armslength fashion IS a factor in favor of piercing the corporate veil Court held that the law permits the incorporation of a business for the very purpose of escaping personal liability. Generally, "piercing the corporate veil" is invoked "to prevent fraud or to achieve equity".
DeWitt Truck v. Ray Flemming p. 317 Selling fruit for a commission, than taking fruit to market to sell it, than corp's compensation is a commission Defendants are the principal SHs of corp – want to hold them personally liable for corp debts o Everything in this case about the corp was MURKY o This is a factor against the SH because the SHs are hiding things from the public o No SH meetings – this shows that the corp was not formed and operated as a SEPARATE ENTITY – must show that activities are the activities of the corp o Corps need to be operated as separate entity – it is ALL formalities o Every instance in PCV there must be some form of UNFAIRNESS or INJUSTICE is an essential element, but not the sole element Creditor seeks to "pierce corporate veil" and hold the owner of corporation personally liable for debts of corporation. It is recognized that a corporation is an entity, separate and distinct from its officers and stockholders, and that its debts are not the individual indebtedness of its SHs. Concept of separation is legal theory and courts decline to recognize it whenever recognition of the corp form would extend the principle of incorporation beyond its legitimate purposes and would produce injustices or inequitable consequences. When there is substantial ownership of all stock in a single individual combined with other factors supporting disregard of the corp fiction courts do not have a problem casting aside the corp shield. MOST IMPORTANT FACTOR IN PIERCING THE CORPORATE VEIL IS OBSERVING CORPORATE FORMALITIES
Factors to consider when "piercing the veil": UNFAIRNESS or INJUSTICE plus one or more of the following – (1) obligation to provide adequate capital this somewhat undercuts the idea of limited liability, but all in agreement that capital must be sufficient in beginning (throughout life of the corp – minority view); (2) failure to observe corp formalities (corp is formed through the formalities, thus must observe such) (e.g. – intermingling); (3) non-payment of dividends (this req. is peculiar to this case); (4) the insolvency of the debtor corp at the time; (5) siphoning of funds of the corp by the dominant SH; (6) non-functioning of other officers or directors; (7) absence of corp records; (8) and the fact that the corp is merely a facade for the operations of the dominant SH, (9) must be injustice or unfairness to the creditors (corp form has been used to prejudice the creditors – this canNOT be adequate in and of itself, must be coupled with other factors) The conclusion to disregard the corp entity may no rest on a single factor, but must involve a number of such factors; in addition, it must present an element of justice or fairness – each situation is fact specific When one, who is sole beneficiary of a corp's operations and who dominates it induces a creditor to extend credit to the corp on such an assurance, that fact has been considered by many authorities sufficient basis for piercing the corp veil
NOTES o Just because the "corp veil" has been pierced does NOT mean that the corp is no longer a corp. It remains a viable business. It also does NOT mean that all SH are personally liable. o PCV is uniquely a closely held corporation problem. In publicly held corporation they canNOT be held liable because they are passive, therefore negating any liability on their part. o When creditor deals with the corp they know who is liable and it is not the SH. Similar in tort cases is that the corporation is the person operating the daily functions. o "any court must start from the general rule that the corp entity should be recognized and upheld, unless specific, unusual circs call for an exception . . . care should be taken on all occasions to avoid making the 'entire theory of the corp entity useless'" o To find a parent corp liable, the party seeking relief must show that there is an overt duty owed to the party seeking to invoke the doctrine of piercing the corp veil, AND that the corp manipulated the legal entities in order to avoid the legal duty o Statistically, piercing the corp veil is entirely a phenomenon of closely held corps, and predominantly one-person corps. The corp form is simply never pierced so as to impose liability against SHs in publicly traded corps. o Most successful piercing cases involve either individuals who serve as both shareholders and managers, or corp groups in which the parent corp was the SH and could name the individuals who managed the subsidiary In most opinions, a failure to follow normal corporate routine appears a most significant consideration in deciding whether a corporation is the 'alter ego' of the SH or whether the "corporate veil should be pierced" A promise to answer for indebtedness on behalf of the corp is usually Unenforceable under the statute of frauds
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Baatz v. Arrow Bar p. 326 Drunk driver hits P causing serious injury. P sues the bar owners personally because they supplied alcohol to the driver even after they knew he was drunk. Corp set up to protect the SHs from personal liability. The only way for SHs to be personally liable is to "pierce the corp veil" Corp was financed through personal loans by the SHs. This is viewed as capitalization of the corp. also financed through stock subscription, where person gives set amount of money and than they get stock in return. There is no indication that there is any inadequacy in terms of capitalization Follows the same factors as Baatz No injustice or inequity because they all show that there was a separation between the corp and SHs FACTORS: o In order to pierce must show that corp: o made fraudulent representations by corp directors; o undercapitalization; o failure to observe corp formalities; o absence of corp records; o payment by the corp of individual obligations; o or use of the corp to promote fraud, injustice, or illegalities. P did not provide sufficient facts to support their claim that the veil should be pierced
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Notes When piercing the corporate veil there should be a distinction made between TORT and CONTRACT cases. TORT cases focus on the adequacy of capitalization more than in contract cases o In contract cases there is an assumption of risk with regard to the creditor o But in a TORT case there is no assumption, the incident just happens – there must be adequate capital to cover the liability o Tort claimants are less successful the PCV than contract claimants In a contract case the P has usually dealt with corp and should be aware that the corp lacks substance. Absent deception, the creditor assumes the risk of loss when dealing with a corp. In a tort case, there is usually no element of voluntary dealing, and the question is whether it is reasonable for businessmen to transfer a risk of loss of injury to members of the general public through the device of a corp that may be marginally financed Radawzewski v. Telecom p. 334 – Bost believes that these factors relates back to the Baatz factors P gets in an accident with truck owned by subsidiary of a major corp. P seeks to sue the parent corp. Question is whether court has jurisdiction over the person of Telecom
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which is the parent corp of Contrux. Missouri developed a three part tes (different wording than other tests): o Control, not mere majority or complete stock control, but complete domination, not only of finances, but of policy and business practice in respect to the transaction attacked so that the corp entity as to this transaction had at the time no separate mind, will or existence of its own o Injustice – Such control must have been used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or dishonest and unjust act in contravention of plaintiff's legal rights – the purchase of insurance remedies the undercapitalization – CORP is not trying to relieve its liability o The aforesaid control and breach of duty must (injustice) proximately cause the injury or unjust loss complained of Insurance covers counts for adequate capitalization, but it only counts to the claim being stated – means of being financially responsible Who is going to bear the insolvency of the insurance carrier, the tort claimant or the SH – burden borne on the tort claimant because the subsidiary acted responsibly Missouri courts will disregard the existence of corp entity that is operated while undercapitalized. Undercapitalization itself is not unlawful, but rather because the creation of an undercapitalized subsidiary justifies an inference that the parent is either deliberately or recklessly creating a business that will not be able to pay its bills or satisfy judgments against it – however, insurance may remedy this by showing responsibility on behalf of the corp The doctrine of limited liability is intended precisely to protect a parent corp whose subsidiary goes broke that is the whole purpose of the doctrine. The legislature believes this entity form to be acceptable. Capitalization at the time of formation must be adequate to cover reasonable claims and anytime that corp changes its business activities, than additional capital should be infused by the SHs at the time Note 6 and 7, page 340 A person who is only "temporary" director of the corp and does not actually exercise discretion in making decisions can still be held personally liable – one can not divorce themselves from the duties of their position In tort cases, inadequate capitalization is the most important factor when piercing the corp veil, and may alone be enough to hold corp liable
Fletcher v. Atex p. 341 o The action of plaintiffs, computer keyboard users, for damages from repetitive stress injuries from computer keyboards made by manufacturer, who was owned by defendant, manufacturer's parent company. o Delaware law permits a court to pierce the corporate veil of a company where there is fraud or where it is in fact a mere instrumentality or alter ego of its owner. Under an alter ego
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theory, there is no requirement of a showing of fraud. To prevail on an alter ego claim under Delaware law, a plaintiff must show (1) that the parent and the subsidiary operated as a single economic entity and (2) that an overall element of injustice or unfairness is present. To prevail on an alter ego theory of liability, a plaintiff must show that the two corporations operated as a single economic entity such that it would be inequitable to uphold a legal distinction between them. Among the factors to be considered in determining whether a subsidiary and parent operate as a single economic entity are: 1. whether the corporation was adequately capitalized for the corporate undertaking; 2. whether the corporation was solvent; 3. whether dividends were paid, corporate records kept, officers and directors functioned properly, and other corporate formalities were observed; (keeping of RECORDS very important because it shows actual existence of corp) – not unusual that there are common board of directors, but it is important that the boards are NOT identical 4. whether the dominant shareholder siphoned corporate funds; and 5. whether, in general, the corporation simply functioned as a façade for the dominant shareholder.
Summation of PCV o Court normally take doctrine of limited liability seriously, heavy burden on plaintiff o Will not pierce veil unless there is evidence of unfairness (misuse of SH corp system to their benefit that is detrimental to claimant) o court goes through list of factors in determining the unfairness. o Use the BAATZ factors (which break down into three categories) Unfairness and Injustice Misrepresentation of corporate form to the SH (Baatz 1 and 5) Failure of SHs to take the corporate form seriously (3 and 4) Inadequate capitalization (2) – in tort cases, would be more important, in CA this is the case, but in general it is NOT o In a parent-subsidiary problem need to look at domination and unfairness, which lead to the BAATZ factors o Is there domination – what does it mean – come back to factors – BAATZ
Basic Accounting o Four Fundamental Principles: 1. financial accounting assumes that the business that is the subject of the financial statements is an entity unto itself 2. all entries have to be in terms of dollars 3. a balance sheet must balance – two sides of the balance sheet restate equality of both sides 4. every transaction that a business enters must be recorded in at least two ways if the balance sheet is to continue to balance (double entry bookkeeping) o Assets = Liabilities + Owner's Equity
o Income = Revenue – Expenses A balance sheet is a snapshoot, while an income statement is a motion picture. Income statement also serves as the bridge between the balance sheet at the beginning of the period and the balance sheet at the end of the period. o Concept of Profit and Loss Accounting rests on several postulates: 1. Accounting assumes the continuing existence and activity of the business enterprise as a going concern 2. Each business must adopt a fiscal or accounting period and must report the results of operations for that period as a separate accounting unit. 3. In determining the results of operations during an accounting period, some kind of logical relationship must be created between the revenues and expenses that are taken into account in determining profit or loss for that period 4. Some principles must be established as to when revenue is realized o accrual accounting: standard method of accounting, calling for recording revenues in the period they are earned and expenses in the period they are incurred. o Cash basis accounting: not recognized under GAAP, a system of accounting that records transactions when cash is paid or received. FINANCIAL MATTERS AND THE CORPORATION and Equity Capital Debt: is associated with the idea of borrowing. This must, at some point, be repaid. Also called "fixed claims" because creditors aren't going anywhere. Equity capital: the value of the OE in a piece of property equals the market value of that property minus the market value of the debts that are liens against that property "residual claims" have a claim on everything that is left over after the fixed claimants Types of Equity Securities Shares: "units into which the proprietary interests in a corporation are divided" Common Shares SHs are entitled to vote for the election of directors and on other matters coming before the SHs They are entitled to the net assets of the corporation (after making allowance for debts), when distributions are made in the form of dividends or liquidation distributions Common share represent the residual ownership interest in the corporation, their financial interest is open-ended in the sense that they benefit as the business prospers and the corporate assets increase Preferred Shares Rights that are usually preferential to common SH Get priority in payment against the holders of common shares o This may be in the form of dividends or in the making of distributions out of the capital of a corporation OR both o These rights are generally prescribed in the articles of incorporation Special Rights of Publicly Traded Preferred Shares Cumulative dividend rights: means that if a preferred dividend is not paid in any year, it accumulates and must be paid before any dividend may be
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paid on the common shares in a later year Voting: PS are usually non-voting, but this may be different if articles state so Liquidation preferences: PS usually have a liquidation preference as well as dividend preference – liquidation usually fixed a certain price per share, payable upon the dissolution of the corporation before anything may be paid to the CS Redemption rights: may be redeemable at the option of the corporation, usually at a price fixed by the articles of incorporation – SH does not have a choice – the corp can redeem at any time Conversion rights: PS may be made convertible at the option of the holder into common shares at a fixed ratio specified in the articles of incorporation; convertible PS are attractive when CS are publicly traded, so that an active market exists for the conversion securities Protective provisions: PS may also have certain financial protections which require the corp to set aside a certain amount of money each year to redeem a specified portion of the PS issue Participating preferred: PPS are entitled to the specified dividend and , after the CS receive a specified amount, they share with the common in additional distributions on some predetermined basis Classes of preferred: a corp may issues different classes of PS – with different rules for each one Series of preferred: refers to "one or more series within a class" o Classes of Common Shares MBCA authorizes the creation of classes of common shares by appropriate provision in the articles of incorporation – sometimes the distinction between shares can just be a matter of title Don't give to much credit to the name of the share – look at the rights of the share Issuance of Shares: Herein of Subscriptions, par value and watered stock o Share subscriptions and agreements to purchase securities "subscription" was the practice of soliciting money from people, than when had enough pledges would form the corp, after corp formed than would try and collect the money o Authorization and issuance of common shares under the MBCA Any number of shares may be issued at any price so long as the combination totals the amount of investment o Par Value and Stated Capital Is permitted under the MBCA, but is not mandated Law departed from uniformity of price to minimum price for purchase of stock, also shifted from protection of the investor to protection of the creditor If sold for less than the "par value" the SH was liable for the difference between the purchase price and the "par value" "stated capital" is the sum of par value of issued stock when company issues "watered stock" it is a fraudulent representation to the creditors that there is stated capital of a certain amount – you are responsible to the creditor for the difference between the actual value of the company and the stated value limitations: if creditor extended credit before issuance of stock OR the creditor knew the stock was watered Practice Tip: set the "par value" as low as possible "par value" is an arbitrary dollar value assigned to shares of stock which,
after being assigned, represents the minimum amount for which each share may be sold. Par value is established in the articles of incorporation "bonus share" usually connotes that nothing was paid for them "watered shares" are technically shares issued for property worth less than their par value "discount shares" are shares issued for cash but less than par
Hanewald v. Bryan's Inc. p. 397 P leases property to D. D issues shares to itself with a par value of 100K. But Ds, don’t pay any money for the shares. P relies on the par value when selling the property. – par value deficiency P is suing on the promissory note and for the rental value of the property Court held that SHs must pay for their shares as a prerequisite Organizing a corp to avoid personally liability is legitimate, but doing so in a fraudulent manner is a no no The lower the par value the lower the chance that there will be a deficiency Issue price MUST equal par value – do NOT have to issue all stock that is authorized, corp can hold some of the stock back Two types of deficiency: 1. par value deficiency 2. issue value deficiency (applies to all 50 states) SHs are liable for the lesser of the issue price deficiency or the outstanding creditor's claim It is the SHs initial capital investment which protects their personal assets from further liability in the corp enterprise. Generally, SHs are NOT liable for corp debts beyond the capital they have contributed to the corp Failure to pay the par value and adequately fund the corp makes SHs personally liable SH is liable to the extent of the difference between the par value and the amount actually paid and to such an extent only as may be necessary for the satisfaction of the creditor's claim o Issue Price Deficiency: the share holders are liable to the corporation for the difference between the sale price and the "par value" o Eligible and Ineligible Consideration for shares MBCA § 19 – the idea that only the actual receipt of certain types of property or services by a corp will support the issuance of shares is not technically a part of the par value structure, but it is closely aligned with i t In general promissory notes and promise to perform future services will NOT be considered payment or part payment for shares of the corporation In general promissory notes and promise to perform future services will NOT be considered payment or part payment for shares of the corporation 1984 MBCA - § 6.21b – the BOD may issue shares for cash, promissory notes, services performed or services to be performed – Board must determine that note is adequate consideration, services, etc. must be equal to the value of the stock determination of adequacy is conclusive as to whether the shares are validly issued – if it is later determined that a mistake was made than the directors may be held liable, but the shares are still issued
disclosure "sunshine provision" – if a corp authorizes the issuance of shares for promissory notes or for future services the corp shall inform the SHs of such dealings An LLC can render an interest in itself for a promissory note or future services Protections for this statute: It was designed to protect creditors of the corporation who may rely on its capital in extending credit, since it attempts to assure that there is something "real" which can be levied against and sold It may protect other investors from dilution of their interests Some jurisdictions allow for the issuance of stock for a combination of past and future services in a jurisdiction in which it is legal to issue shares for services already provided o Par Value in Modern Practice Today most corps use "nominal" par value Carryover from old school is to avoid watered stock liability the issuance price for shares of stock with par value must always be equal to or greater than par value Nominal par shares increase corporate flexibility in making distributions in the future Torres v. Speiser p. 407 Can NOT issue stock in a new corporation for less than par value or before the full purchase price is paid, it has no bearing on a re-sale of issued shares among SHs Par value relates only to the initial issuance of shares, and has no application whatever to subsequent transactions in the shares themselves, which may be bought or sold at any mutually acceptable price "stated capital" is the sum of the par value of all shares of the corporation having a par value that have been issued plus the consideration fixed by the corporation of all shares without par value that have been issued "surplus" is the corporation's net assets less its "stated capital" Debt Financing "debenture" is an unsecured corporate obligation "bond" is secured by a lien or mortgage on corporate property "zeros" is a bond that pays no interest at all, they sell at a substantial discount from face value and upon maturity the holder receives the face value o Concept of Leverage Debt owed to third persons creates leverage Leverage is favorable to the borrower when the borrower is able to earn more on the borrowed capital than the cost of the borrowing You can make money by borrowing money – if you can earn more on the borrowed capital than the cost of the borrowed capital = GOOD o Tax Treatment of Debt Interest payments on debt are deductible by the borrower whereas dividend payments on equity securities are not A loan to a C corp eliminates the double tax problem Need to make a proper determination if there is DEBT or EQUITY Person granting a loan to a corp only recoups their loan plus a modest interest return, while a person who invests capital will not only get money back but also get an increased return if the corp
increases in value Loan will be classified as "capital" when there is consistent failure to repay the debts on the due dates or to seek postponements – also look at relationships of people to corp – to see if a loan was really intended S corp protected when given loan "straight debt" is debt that involves a written unconditional promise to pay a sum certain in money if (a) interest rates and interest payment dates are not contingent on profits, (b) there is no direct or indirect convertibility into stock and (c) the creditor is an eligible SH under Chap S look at the debt/equity ratio of a corporation o junk debt – high yield debt) junior to all other debts in the corp, bottom of debt order, but ahead of all types of equity: debt that is risky and bears a higher interest rate
Issuance of Shares: o Corp doesn't own shares? o If existing corp is issuing shares to additional SHs, the issuing price per share to the additional SHs must be fair to the existing SH When new SHs are brought in the pre-existing SHs maintain the value of their shares, but lose certain amount of control because more SHs When issue shares to additional SHs at less than previous price, you dilute the value of the pre-existing SHs o Corp can NOT authorize the issuance of shares UNLESS it is authorized to do so in the articles of incorporation To change the number of shares the articles must be amended o By creating different classes of stocks may create numerous varieties of voting situations within SHs o Corporation must pay dividends unless there is a legitimate reason not to pay – directors have a fiduciary duty to SHs o Order of payment Debt Preferred SH (return is limited to their investment) Common SH o Convertible Preferred stock: after payment of creditors they receive their money back, BUT the stock can be converted common stock o Difference between shares: Common SHs allowed to vote right to bring derivative suits when value of business increases, the value of CS goes up as well
residual equity interest, after all debt is paid and returns have been paid – common SHs than get paid Preferred SHs (called preferred because it gets its money first) First right to liquidation proceeds They get paid first after payment of debts May be given a vote, but not typical
PUBLIC OFFERINGS o Tax treatment of debt: For a corp. – interest payments on the debt is deductible, while a dividend on a stock is NOT deductible In general terms , a corp is entitle to ad deduction of seventy percent of dividends received from a corp of which the recipient own less than twenty percent, the deduction is increased to eighty percent if the recipient corp own between 20 and 80 percent of the paying corp, and to 100 if the recipient corp owns more than 80 percent of the paying corp o All debt must be paid before anything goes to the SHs o Secured debt is debt secured by property of the organization (most common real estate) o the goal of "going public" is to raise substantial amounts of capital o both costs and benefits to going public o going public usually helps to reduce corporation's reliance on bank debt o public offerings of equity enable a company to use the money for projects with a long-term horizon o selling shares through a public offering gives the existing SH liquidity Cost: Going public involves disclosure Past conflicts of interest, disclosure of balance sheets, etc. Substantial legal risks – company is strictly liable under section 11 for material misstatements and omissions in the registration statement Must file quarterly and annual reports – may sacrifice long-term benefits for short term gains o TREATISE ON SECURITIES "blue sky laws" (state laws) focused on full disclosure and also required that all securities registered thereunder "qualify" on a merit basis federal gov got involved after the stock market crash Section 5 in effect requires registration of a public issue that is offered or sold through the "use of any means or instruments of transportation or communication in interstate commerce or of the mails" o Section 5 Securities act of 1933 – requires the registration of all securities being placed in the hands of the public for the first time, also requires full disclosure theory behind full disclosure is that investors are adequately protected if all aspects of the securities being marketed are fully and fairly disclosed 1933 ACT focus on two key concepts (filing and effectiveness of registration before offering): o 1. securities – law only applies to securities (if not a security than law does not apply – covers interests in NONcorporate enterprises) notes, stocks, investment contract (no standard interests) o 2. Public offering – the permissions and prohibitions apply
only to offering and sales involving a public offering of stock whenever a corporation makes an offering, consideration must be given to the possible application of the state and federal securities laws. If the offering is made to only a few people one or more exemptions may be available To successfully file registration two parts must be met: A "prospectus" is a document that is to be distributed to potential and actual investors Additional information that must be submitted to the SEC and is publicly available but need not be included in the prospectus When decision made to go public company must chose the proper underwriter Attorneys who do corporate offerings are highly specialized – they must perform a "corporate check" which involves two attorneys – one representing the issuer and one representing the underwriter "due diligence" is the process by which attorneys verify the accuracy and completeness of registration statements "full disclosure" reqs are also very complex once registration is complete the attorney files it with the SEC, during this process a preliminary prospectus is circulated to potential investors. In theory a registration statement becomes effective twenty days after issue, but evey change starts over a new twenty day cycle In addition to the 1933 Act there is the 1934 Act which requires every corporation that has Shares registered on a national securities market exchange, OR 500 or more SHs of record and more than 10million of assets to register that class with the SEC this is separate from the 1933 Act this act triggers a variety of continuous disclosure obligations and application of proxy rules Federal government enacted National Securities Markets Improvement Act that rationalized and simplified the registration process for registered public corps by preempting significant portions of the state blue sky laws Preempts to the effect that it simplifies the full-disclosure requirements – but it does NOT preempt blue sky registration that are sold pursuant to an exemption for the federal registration process 1933 Act § 4.2 a private transaction shall NOT fall under the provisions of section 5 SEC v. Purina p. 424 PRIVATE TRANSACTION????? SEC can independently sue the company for violation of rules – Purina does not fall within the exemption Exemptions exist for non-public offerings regarding registration of the stock and disclosure of information – when does this apply? Corp issues stock to some of its employees. It does so not following the disclosure guidelines because it believes itself to be exempt because it is not a "public offering". SEC disagrees. Employees were not forced to buy the stock, but at the same time were not given information regarding the stock either. The court has held that to be "public" an offer need not be open to the whole world
The focus of the inquiry should be on the need of the offerees for the protections afforded by registration Design of the statute is to protect investors by promoting full disclosure of information thought necessary to informed investment decisions An offering to those who are shown to be able to fend for themselves is a transaction "not involving any public offering" NEED TEST – does a person who is being offered the stock NEED protection (no quanitative test – for number of people that constitute a public offering) o People who need protection (need disclosure of information) Disclosure of information OR access to such information People who can "fend" for themselves are people who have access to registration information
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Regulation D 506 Offering - "safe harbor" if meet these certain objective reqs. than it will be deemed private placement P. 435 Meet terms of conditions: Issuers reasonably believes on the number of purchasers (may sell to 35 unaccredited investors, but can be unlimited as to number of accredited investors) Must be a private placement – cannot use advertising Issuer must see if purchaser is purchasing for their own personal investment – for long term financial holding Sophistication requirement – accredited investor – either alone or with his purchasing agent What is an accredited investor: No limitation on number of purchasers No sophistication requirement No information requirement o There is also an income requirement – if you meet a certain amount of money, but are dumb as a 'stick' you still qualify as an accredited investor Corporation can not circumvent the registration req. by selling stock to someone who does not need the protection, and that person selling for the corp. "underwriter" is any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security. "issuer" includes any person under directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer – the idea of this is to impose upon these people the same conditions as the issuer eg – sole SH can not sell shares from personal portfolio without disclosing all important info how can a person that acquires shares in a legitimate transaction ever safely resell those shares? Rule 144 – established a one-year waiting period, but the rule is very complex o SECURITIES ACT RELEASE § 3a11 exempts "any security which is a part of an issue offered and sold only to persons resident within a single State where the issuer of such
security is a person resident and doing business within or, if a corp, incorp'd by and doing business with, such state" – this section was intended to allow issuers with localized operations to sell securities as part of a plan of local financing. To satisfy the exemption, the entire issue must be offered and sold exclusively to residents of the state in which the issuer is resident and doing business. An offer or sale of part of the issue to a single non-resident will destroy the exemption for the entire issue. Section D federal government relaxed standards because it was cost prohibitive for small businesses to raise capital Refer to other outline Smith v. Gross p. 439 Investment Contract Ds solicited Ps to breed earthworms on their property. Ps invested in the plan and were somehow defrauded. Brought a claim under federal securities law. If the agreement is found to be an "investment contract" than it is a security and subject to federal law – than Ps have the statutory right to rescind the transaction under § 12 INVESTMENT CONTRACT TEST - Court set out a test for the scheme: o An investment of money o In a common enterprise o With an expectation of profits o With profits to come solely from the efforts of third parties (Howey Test) "solely" is "whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise"
Test for investment contract (security): o The defendants persuaded the plaintiffs to invest by representing that the efforts required of them would be very minimal; and o That if the plaintiffs diligently exerted themselves, they still would not gain the promised profits because those profits could be achieved only if the defendants secured additional investors at the inflated prices FEDERAL REMEDIES Recession of K allowed if "security" is not registered with the SEC ISSUANCE OF SHARES BY A GOING CONCERN: PREEMPTIVE RIGHTS, DILUTION AND RECAPITALIZATIONS o Stokes v. Continental Trust p. 443 Question presented is whether according to the facts found the plaintiff had the legal right to subscribe for and take the same number of shares of the new stock that he held of the old? What is the nature of the right acquired by a SH through the ownership of shares of stock? A SH has an inherent right to a proportionate share of new stock issued for money only and not to purchase property for the purposes
of the corporation or to effect a consolidation, and while he can waive that right, he cannot be deprived of it without his consent except when the stock is issued at a fixed price not less than par, and he is given the right to take at that price in proportion to his holding, or in some other equitable way that will enable him to protect his interest by acting on his own judgment and using his own resources. o It is now generally accepted that the preemptive right is not an inherent aspect of the ownership of shares but a right that may be granted or withheld by the articles of incorporation. The MBCA adopts and "opt in" clause: under § 6.30 no preemptive right exist unless provision for it is expressly made. As a result, a "plain vanilla" corp. whose articles of incorp contain the statutory minima will not have preemptive rights. COMMENT states that the section "is primarily designed to protect voting power within the corp from dilution" and "may serve in part the function of protecting the equity participation of SHs" Katowitz v. Sidler p. 448 Three SHs, two wanted to oust the third. The third SH agreed to no longer be active in management, but to stay on the board of the corp. This is a closely held corp. All three stipulated that they would remain equal SHs for the remainder of the business. Two SHs did not invest capital to purchase more shares, but forgave their dect to corp for increased shares Concept of preemptive rights is to safeguard two interests of SHs – the fith to protection against dilution of their equity in the corp and protection against dilution of their proportionate voting control In a NON-closely held corp the SH is protected from dilution because he may exercise his right to purchase the stock or he can sell his rights to the stock and compensate himself. In closely held corp there is a limited market for shares therefore different rules apply The corollary of a SH's right to maintain his proportionate equity in a corp by purchasing additional shares is the right not to purchase additional shares without being confronted with dilution of his existing equity if no valid business justification exists for the dilution A corp is not permitted to sell its stock for a legally inadequate price at least where there is objection "freeze out" comes in many forms – one is when inside SHs pay for their additional shares by canceling debts owed to them by the corporation while outside SHs are put to the choice of investing more capital or see their proportionate interest decline MODERN TREND seems clearly to be running in the direction of imposing a fiduciary duty on dilutive transactions such as those involved in Katowitz
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DISTRIBUTIONS BY A CLOSELY HELD CORPORATION o Gottfried v. Gottfried p. 459 Family owned business where the minority SHs are suing for dividends. They claim that there is bad faith on the part of the majority. Can the minority compel the majority to pay dividends?
Dividends are only compelled if there is a breach of fiduciary duty of good faith by exercising bad faith on the part of the majority SHs in refusing to declare dividends There is NO obligation in general to declare dividends But in bad faith, then court can order fair and adequate dividends Existence of retained earnings or surplus does not itself indicate bad faith grounds for compelling dividend distribution UNLESS refusal to pay is motivated by bad faith However, the existence of bad faith indicators still does not show that it was the motivating factor for the failure to declare dividends (have to show actual motivation for not paying dividends to get a freeze out)
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Dodge v. Ford Motor Co. p. 462 Dodge is suing Ford for the payment of dividends. Dodge contends that the non payment is arbitrary and unjustified. Distinct from Gottfried because that was a family case – closely held corp, here the corp is public BUSINESS JUDGMENT RULE: officers are protected in making their decisions when: Decision made in good faith No self interest involved Director is informed Director RATIONALLY believes that it is in the best interest of the corp Court generally adheres to the policy to NON-interference Courts biggest problem was the Ford made it very clear that he wanted to help the consumer and indirectly the SH. "It is not within the lawful powers of a BOD to shape and conduct the affairs of a corp for the merely incidental benefit of SHs and for the primary purpose of benefiting others" A corp is organized and carried on primarily for the profit of the SHs When there is a really large surplus, sometimes the court will order dividends to be distributed Court stepped on the business judgment of the BOD because they wanted to keep the cash on hand for unforeseen incidences – this is a prudent business decision CORP exists for benefit of SH Business judgment will be upheld Directors must satisfy business judgment rule, retained earnings must be done for the benefit of the SH
BUSINESS ORGANIZATIONS: UNINCORPORATED BUSINESSES AND CLOSELY HELD CORPORATIONS p. 470 o When a corp repurchases its OWN stock = distribution o When a corp purchases stock from another corp = investment o CORPORATE BUYBACKS Pro rata redemption: has the same affect (in substance, look at the
proportion of ownership, this does not change under either process) on the SHs as a dividend distribution Disproportionate redemption: the effect is where one person(s) is bought out and the value of remaining SHs remains the same, but what does change is their percentage of ownership This does NOT in and of itself does not hurt the remaining SH The fewer the number of shares being sold will tend to increase the price per unit share
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A corp cannot treat stock in itself that it has purchased as an asset any more than it can treat its authorized but unissued stock as an asset. Treasury shares (they could be shares that are reacquired) are viewed as being held by the corp in a sort of twilight zone until they are either retired permanently or resold to someone else in the future. Treasury shares are NOT an asset of the corp even though they are salable and may be sold at some later time, this can also be said of every authorized but unissued share. A repurchase of shares by the corp is a distribution even if the corp purchases only shares owned by one SH rather than proportionately from each SH. Fiduciary Relationships: Katzowitz – involved a small closely held corp – no public market for shares – There must be a corporate reason for the selling of the stock and there must be a reason for the price Gottfried – business judgment rule, court held that directors are fiduciaries for SH – must have a valid business reason Dodge – directors are fiduciaries for all SHs – the must intend to benefit SHs – Court pays lip service to business judgment rule, but than substitutes their judgment BOD – first duty is to the SHs, and no one else
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Donahue v. Rodd Electrotype p. 472 The controlling shareholder sold his stock to defendants; however, defendants refused to purchase plaintiff's stock. Plaintiff contends that this was an unlawful distribution of corporate assets to controlling SHs. The court held that a controlling shareholder could not utilize its position to create an exclusive market for its shares. In this case, defendants had created a market for the controlling shareholder but refused to extend that market to plaintiff, thereby excluding her. Closely held corp: 1. a small number of SHs; 2. no ready market for the corporate stock; and 3. substantial majority SH participation in the management, direction, and operations of the corp. In a closely held corp the minority is especially suspectible to a variety of oppressive devices that may be inflicted by the majority "close corp" more closely resembles a partnership in the since of personal relationships – need heightened standards of protection – personal dependence / relationship STRICT GOOD FAITH STANDARD P claims that the BOD breached the fiduciary duty by not offering to
purchase the P's shares Ps are complaining that they don't have an opportunity to cash out when the other SH (D) was given the opportunity to cash out – inequality There are NO badges of bad faith (Gottfried) Court found in favor of P because it is a "closed Corp" CASE LIMITED TO CLOSE CORP "freeze out" schemes withhold dividends and are designed to compel the minority to relinquish stock at inadequate prices. When the minority SH agrees to sell out at less the FMV the majority has won. When a corp is reacquiring its own stock is a CLOSE corp, the purchase is subject to the additional requirement, in the light of our holding in this opinion, that the SHs, who, as directors or controlling SHs, caused the corp to enter into the stock purchase agreement, must have acted with the utmost good faith and loyalty to the other SHs Consistent with this strict fiduciary duty, the controlling group may not utilize its control of the corp to establish an exclusive market in previously unmarketable shares from which the minority SHs are excluded Donahue popular case – followed in REDEMPTION scenario Notes When minority SHs in a close corp bring suit against the majority alleging a breach of the strict good faith duty owed to them by the majority, we must carefully analyze the action taken by the controlling SHs in the individual case When an asserted business purpose of their action is advanced by the majority, it is open to minority SHs to demonstrate that the same legitimate objective could have been achieved through an alternative course of action less harmful to the minority's interest Judge Easterbrook – "Drafters of the organizing documents of a closely held corp cannot avoid a tradeoff. On the one hand, they must provide some protection to minority SHs to ensure that they receive an adequate return on the minority SHs investment if the venture succeeds. On the other hand, they cannot give the minority too many rights, for the minority might exercise their rights in a opportunistic fashion to claim returns at the majority's expense.
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Restriction on Distributions MBCA §6.40: A distribution is simply the transfer of money or property from a corp to its SHs Every state has restrictions on distributions Majority view – NO distribution may be made if: Corp not able to pay its debts OR The corp total assets would be less than its total liabilities (board can take into account the FMV of assets – e.g. if bought property for 1M and now worth 20M, corp can use the 20M value)
MANAGEMENT AND CONTROL OF A CORPORATION The Traditional Roles of SHs and Directors o McQuade v. Stoneham p. 499 Plaintiff was ousted from his position as Treasurer when he had a falling out with the majority SH. Both had a K that said they would act in the corps best interest. Was the firing of P unlawful? Partners agreed not to change business strategy without mutual and unanimous consent D's did NOT use their best efforts to keep the P – breached their contract – fired because they had a falling out, not for cause Court held that the contract between the SHs is VOID because it restricts what the BOD can do K is illegal if it restricts the governing nature of the BOD – need to uphold the BOD power – BOD must be able to manage its own decisions SHs can NOT infringe on the BOD's decisions – if the SHs don't like th BOD than they must elect a new BOD Basic function of SHs is to elect BOD, the BOD's job is to run the corp. SHs are allowd to agree to vote in blocks BOD's duty is to the corporation and its SHs, to be exercised according to their unrestricted lawful judgment. They are under NO legal obligation to deal righteously with P if it was against public policy to do so. SHs by agreement canNOT prevent the BOD from managing the corp. The BOD has the power to exercise its independent judgment and discretion in managing the corp and contracting around this is illegal Traditional Roles in Corp (separation of ownership (SH) from management (BOD, BOD may be the same as the SHs) Statute sets the limits on the SHs, BOD, and officers o SHs Elect BOD Approve or disapprove the articles of incorp Under modern statute they may approve or not of major non-reoccurring transactions (life changing events) o BOD Manages the business and affairs, or they may delegate to other agents of the corp To be exercised exclusively by the BOD SHs can NOT infringe on the BOD, management prerogative comes from the statute and NOT from the SHs o Officers Are merely agents of the corp, appointed by the directors to do the everyday functions They operate under the direction of the BOD SHs CAN NOT MANAGE THE CORP, but the can vote the BOD out and replace with a new BOD
SHs may remove the BOD with or without cause, a SH can not tell the BOD what to do, but they may remove them without cause When arrangements are contrary to the statutory schemes of a state, the court may invalidate these "arrangements" on broad public policy grounds. Some courts have upheld variations on the statutory scheme, and the modern trend distinctly appears to be running in the direction of upholding such agreements. Most commentators agree with this theory on corp management. "sui generis theory" that directors are not agents; they are fiduciaries whose duties run to the corporation but their relationship with the corporation is sui generic (constituting a class alone: unique or particular to itself) since they are not trustees
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Galler v. Galler p. 505 Plaintiff and her late husband entered into an agreement with defendants, with whom husband had been a shareholder of a close corporation, which granted plaintiff equal control of corporation with defendant upon the death of her husband, including the power to vote his shares and a support income. If the parties to an action are the complete owners of the corporation, there is no reason why the exercise of the power and discretion of the directors cannot be controlled by valid agreement between themselves, provided that the interests of creditors are not affected. While the SH of a public-issue corp may readily sell his shares on the open market should management fail to use, in his opinion, sound business judgment, his counterpart of the close corp often has a large total of his entire capital invested in the business and has no ready market for his shares should he desire to sell. Appellate court said SHs assumed jurisdiction over things that were really responsible for the BOD Court said that because there was no stated term the K was unenforceable – this K binds future boards, which can NOT be done – BOD must have exclusive duty to manage corp Long term employment agreements and leases are allowed – but other Ks courts have problem with – don't want to bind the board The SC held that in CLOSELY HELD CORPS "any arrangements concerning the management of the corp which are agreeable to all" should be enforced if: No complaining minority interest appears No fraud or apparent injury to the public or creditors is present No clearly prohibitory statutory language is violated Only applies to CLOSED CORPS and the three circs above must apply State statutes permit closely held corps to depart dramatically from the traditional statutory scheme of SHs/directors/officers in specified circumstances. As a result, it is possible – by appropriate planning – to create corps that vary widely from the traditional statutory scheme envisioned in McQuade. It is important, however, to follow whatever statutory scheme has been adopted in the specific state,
since a deviation may risk invalidation of the entire arrangement. Must elect to be a closed corporation in DL or the law of closed corp does NOT apply "The lawyer should deal with those ethical challenges as if you would be evaluated by your harshest critic."
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Matter of Auer v. Dressel p. 522 SHs canNOT restate Auer as president Director objected to calling the meeting because it was NOT a proper purpose for calling the meeting – Court said that the SH can adopt a resolution to put the BOD on notice Class A SHs have a right to elect class A BOD Class A SHs have right to remove class A BOD "for cause" Hence SHs have an inherent power to remove BOD Appellees brought an action for an order to compel appellant president to comply with a positive duty imposed on him by appellant corporation's bylaws. The bylaws required that the president call a special meeting whenever requested in writing to do so by stockholders owning a majority of the capital stock entitled to vote at such meeting. Appellees had requested such a meeting but appellant president failed to call the meeting. The court held: (1) that the bylaws did not allow any discretion to appellant president as to whether or not to call the meeting when one was demanded (2) the court held that the purposes for which appellees wished the meeting called were proper. The stockholders who are empowered to elect directors have the inherent power to remove them for cause.
Cumulative v. Straight Voting p. 534 General rule: unless otherwise provided in the articles of incorp, directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at which a quorum is present SHs do NOT have a right to cumulate their votes from directors unless the articles of incorp so provide (opt-in statute) Straight voting = total number of shares is the total number of votes the SH has Cumulative voting = the number of total votes that each SH may cast is first computed and each SH is permitted to distribute these votes as he sees fit over on or more candidates The effect of cumulative voting is that it increases minority participation on the BOD Following formula helps determine the number of shares needed to elect ONE director: S . D+1 +1 Where S equals the total number of shares voting, and D equals the number
of directors to be elected. The analogous formula to elect n directors is: nS . D+1 +1 o Humphrys v. Winous Co. p. 536 Did the general assembly intend, to guarantee only that the right to vote cumulatively shall not be restricted or qualified? Or did it intend to guarantee that the effectiveness of cumulative voting to ensure minority representation on the BOD shall not be restricted or qualified? FORMER Ohio Rev. Stat. Ann. § 1701.58 guarantees to minority shareholders only the right of cumulative voting and does not necessarily guarantee the effectiveness of the exercise of that right to elect minority representation on the board of directors. Minority shareholder was not re-elected to the board of directors after he failed to give notice of his election to vote cumulatively at an annual meeting. At the meeting, the shareholders adopted a resolution amending the code of regulations and providing that each director, after election at that meeting, would hold office for three years and that three classes of directorships were designated so as to stagger the classes' terms. Purpose of a staggered board is to ensure continuity and stability of the corp's business strategies and policies Under the MBCA cumulative voting is an "opt in" election to be chosen by an appropriate provision in the articles of incorporation "freezing out" may be done to the minority director by denying that director access to information, refusing to appoint him or her to any committees, and then holding "unofficial meetings" and "ramming through decisions with little discussion" Ringling Bros v. Ringling p. 543 SH voting agreement (aka pooling) Voting agreement = K between SHs to vote a certain way, SH retains title to the shares Proxy = is an agency agreement where SH gives over shares to other entity that votes on behalf of SH Court wants to see that there is an EXPRESS proxy – it must be very clear that a proxy exists The pivotal question concerns an agreement between two of the three SHs and the effect of an agreement with relation to the exercise of voting rights by these two SHs. Appellee and individual appellant entered into agreement regarding their voting rights and duties with regard to shares in corporate appellant. After a dispute at a corporate meeting over an election of directors, appellee sued, arguing the agreement had required individual appellant to either vote for an adjournment of the meeting or for a particular slate of directors. The court first held that an arbitration provision within the agreement gave the appointed arbitrator no substantive powers to enforce his decision. The court then followed the rule that a shareholder could enter into a
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binding agreement with respect to the voting rights of corporate shares. Thus, the court held that the agreement was binding. Breach of K – Haley votes do NOT count
Reading 560-573, 584 -593 Management and Control – SH voting and agreements o Brown v. McLanahan p. 560 Trustee – legal ownership (but does everything for the benefit of the people in the trust) Beneficiary – equitable owner Voting trust – a fiduciary relationship in which one party holds legal title to another's property for the benefit of a party who holds equitable title to the property – this person votes on behalf of the beneficiaries Plaintiff brought an action against defendants alleging breach of fiduciary duty after defendants amended the corporate charter to vest voting power in debentures. Plaintiff contended that this action diluted the voting power of the stock and deprived voting trust certificate holders of their right to control the management of the corporation. The court held that defendants were trustees in the equitable sense by their ownership of voting stock, and that as trustees, they owed a fiduciary duty to other certificate holders. By giving voting rights to debentures, defendants abused their power, and an action against them was valid. The court further held that defendants' good faith belief that their actions were proper does not relieve them of liability. o Criteria of a voting trust, the test set forth: The voting rights of the stock are separated from the other attributes of ownership The voting rights granted are intended to be irrevocable for a definite period of time, and The principal purpose of the grant of voting rights is to acquire voting control of the corporation DL requires that the procedural reqs of the voting trust be filed in the articles of incorp because this is such a powerful tool Courts have shown that a voting trust should be viewed as simply another control mechanism that may in certain situations be the subject of abuse but generally is no more subject to criticism than other control devices. Lehrman v. Cohen p. 565 This case involves the application of a DL statute that forbids voting trusts In hopes of avoiding disruption of company business, plaintiff and defendants agreed to transfer ownership of stock in the business. The agreement included establishment of a fifth directorship to obviate the risk of deadlock that the equal division of voting power between defendants' stock and plaintiff's stock perpetuated. Corps made new stock to form the tie-breaker, special stock The one share he held, he was able to elect on director To implement the agreement, the company's certificate of
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incorporation was amended to create a third class of voting stock entitled to elect the fifth director. Abercrombie – (1) the voting rights of the stock are separated from the other attributes of ownership (2) the voting rights granted are intended to be irrevocable for a definite period of time (3) the principal purpose of the grant of voting rights is to acquire voting control of the corp Applying the Abercrombie test, the court concluded that there was no disguised trust, and the new class of voting stock did not illegally alter the attributes of the originally-issued stock. The court affirmed; after application of the Abercrombie test showed that there was no disguised trust, the court held that the voting powers and participating rights of the new class of stockholders were made legal through specification in the company's certificate of incorporation.
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DEADLOCKS Gearing v. Kelly p. 584 Appellants who owned half of the stock of a company sought, within the provisions of N.Y. Gen. Corp. Law § 25, to set aside the election of a corporate director. The court noted that appellants sought to protect their equal ownership of stock through equal representation on the board. However, such balance had been voluntarily surrendered by appellants. The court affirmed the decision, holding that appellants failed to show that justice required a new election, because they could not complain of an irregularity which they themselves caused. She is estopped from asserting wrong – procedures were followed and she had a willful failure to attend the meeting Many state statutes relating to the filling of vacancies on the BOD are based on the first sentence of MBCA § 38: "any vacancy occurring in the BOD may be filled by the affirmative vote of a majority of the remaining directors though less than a quorum of the BODs" Quorum MBCA § 7.25 – must have a quorum to have a valid SH meeting – if there is a quorum the majority of votes present is what is necessary for approval Plurality = however gets most votes, even if not a majority
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In re Radom p. 587 Both the petitioner and respondent owned a one-half interest in the corporation, a printing company. The petitioner had the sole responsibility of running the corporation but alleged that a dispute between the parties prevented the election of a third director and necessitated dissolution of the corporation. There is no absolute right to dissolution under certain circumstances. Even when majority stockholders file a petition because of internal corporate conflicts, the order is granted only when the competing interests are so discordant as to prevent efficient management and the object of its corporate existence cannot be attained. The prime inquiry is, always, as to necessity for dissolution, that is, whether
judicially-imposed death will be beneficial to the stockholders or members and not injurious to the public. o MBCA § 14.30(2), a statute that is typical of many state involuntary dissolution statutes. The official comment to this section makes it clear that the use of the word "may" in the preambular material preserves the Court's discretion (as applied in Radom) "as to whether dissolution is appropriate even though grounds exist under the specific circs."
SARBANES-OXLEY ACT (printout) Know for final o Audit committee o Attorney reporting standards o Opportunities to go outside of corp to reveal confidential inof o About CEO and CFO certification reqs o Primary Goals Reform Public Accounting Title I established the Public Company Accounting Oversight Board to "oversee the audit" of public companies, "protect the interests of investors" and to advance the "preparation of informative, accurate and independent audit reports" for public companies Accounting firms that prepare audit reports for public companies must register with the board To promote audit committee understanding of the audited financial statements, the Act mandates that the auditor issue an annual report to the committee of key assumptions § 303 seeks to further auditor independence by making it unlawful for an officer or director of a company to "fraudulently influence, coerce, etc" an auditor for the purpose of causing the company's audited financial statements to be materially misleading § 802 requires auditors maintain the records for seven years Lawyer Responsibility § 307 sets forth minimum standards of conduct for attys "appearing and practicing" before the SEC in the representation of public companies – lawyer must report a "material violation" or securities law – if designated officer does not respond "appropriately" the lawyer must make a similar report to the company's audit committee these ethics rules pre empt state ethics rules when it comes to securities regulations attorneys need to take a concern "up the ladder" rules of SO applies only to lawyers appearing before the SEC (this is defined very broadly) the attorney may withdraw from representation – the att has the option to make a noisey withdrawal, which means that the att can tell the SEC that there is a material violation – this is a breach of att / client privilege QLCC – qualified legal compliance committee SEC may censure an atty from practicing in front of them Prohibiting Personal Loans
Companies can no longer make personal loans to executives SEC may bar unfit officers and directors from public companies Prohibiting Insider Trades § 306 prohibits the purchase, sale or other acquisition or transfer during a blackout period of an equity security of the company by an executive officer or director of the company if the person acquired the security in connection with his service or employment as an executive officer or director – some exceptions apply Protecting Whistleblowers Act protects company employees who wish to come forward to expose securities fraud. It prohibits a company and its officers, employees, and agents, etc from discharging, demoting, suspending, etc an employee because he or she lawfully provides information to federal agency, congress, or employee's supervisor Enhancing the Power of the Audit Committee Act endows the audit comm. of the stock exchange-listed company with extraordinary power and authority – the Act provides that the audit comm. "shall be directly responsible for the appointment, compensation, and oversight of the work of" the auditor, who shall report directly to the audit committee Strengthening Auditor Independence Accounting companies began to sell "service packs" to companies, which proved to be very lucrative – lost some of their independence because they wanted to stay in good graces of company Title II, together with the SEC's implementing rules, approaches problem by prohibiting a company's audit firm from providing certain types of non audit services Reform Governance of Public Companies Act mandates that the authority and responsibility of a public company's audit committee be enhanced and that the committee be comprised exclusively of independent directors Increase CEO and CFO Responsibility Requires them both to certify the periodic reports, etc CEO and CFO must certify periodic reports that state the financial situation of the company Must say that the records are a "fair representation", which encompasses the selection and proper application of appropriate accounting policies, disclosure of relevant financial information, with an accurate and complete picture of the company's financial situation – this standard is significantly broader, and puts a greater burden on the officers § 906 creates a new criminal statute that ups the ante for officers Disclosure of Off-Balance Sheet Arrangements "off balance sheet arrangement" is defined to include a transaction, an agreement, or other contractual arrangement with an unconsolidated entity under which the company has (1) an obligation under certain Ks, (2) retained or contingent
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interest in assets transferred to the entity as credit, etc Reforming use of Pro Forma Expenses This refers to the disclosure of financial results in a manner differing from GAAP – typically not accounting for "one time" actions which would allegedly not truly reflect the company's earnings There must be a clear reconciliation between the non-GAAP and GAAP measures Disclosing the Code of Ethics for Senior Officers Must disclose if there is one, and if there is and it is changed, must make note of it Enhancing the Objectivity of Securities Analysts Rules are to be designed to address conflicts of interest concerning securities analysts – designed to foster greater public confidence in securities research and to protect the objectivity and independence of analysts Extending the SOL on Securities Fraud Former limitations unfairly impeded the efforts of defrauded investors to recoup losses in cases in which the fraudulent parties had successfully concealed the fraud for a significant period of time Improve Financial Reporting and Disclosure Amends the periodic reporting reqs of the SEC to be more current on changes in financial condition "what is required by both the 33 and 34 acts is full, fair, and accurate disclosure of the facts that are important to the investor as he or she makes a decision whether to purchase the security" must register with the SEC if there are $10M in assets AND more than 500 SHs, if the number of SHs shrinks below 300 you may deapply purpose of SO is to held SHs increase confidence in investing – what you see is what you get PROXY REGULATION p. 723 CA § 705 Proxies are equivalent of SH attendance at meeting Proxy = the act or practice of a person serving as an authorized agent or substitute for another (used esp. in the phrase by proxy) SEC act of 1934 §§ 14a, 12a and 12g 14a - It shall be unlawful of any person, by the use of the mails or by any means … solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security registered pursuant to section 12 of this title 12a – it shall be unlawful for any member, broker, or dealer to effect any transaction in any security on a national securities exchange unless a registration is effective as to such security for such exchange in accordance with the provisions of this title and the rules and regulations thereunder the proxy regulation bears almost exclusively on disclosure stems as a matter of necessity from the nature of proxies. Proxy solicitations are, after all, only communications with potential absentee voters. The goal of federal proxy
regulation was to improve these communications and thereby to enable proxy voters to control the corporation as effectively as they might have by attending a SH meeting Proxy Forms, Proxy Statements, and Annual Reports p. 731 Standards of liability: material misstatements and omissions Material = when used to qualify information, it limits the information, when a reasonable investor would need such information to make an informed decision Form of Proxy: 14a-4 of the proxy regulations contains specific requirements as to the form of proxy documents. The purpose of this rule is to ensure that SHs have the option to vote to approve or disapprove issues submitted to them, and to vote for or against the directors proposed by the persons soliciting the proxy, usually management. Proxy statements: 14a-3 requires that a proxy solicitation be accompanied by a proxy statement containing the information set forth in schedule 14a, which is information relating to financial data AND information relating to nonfinancial data – type of information required depends of course to some extent on the type of issue to be presented Annual Reports: 14a-3 provides that if a solicitation is by management and relates to an annual meeting at which directors are to be elected; the solicitation must be accompanied by preceded by an annual report containing the financial information and other material described in the rule – SEC has held that the annual report is an effective means of communication between the corp and the SH Management's Discussion of Financial Condition and Results of Operations: it consists of a discussion of the registrant's financial condition, changes in financial condition and results of operations, specifically with respect to liquidity and capi tal resources – SEC decided to permit projections of financial data, discussion of management objectives and goals for future performance, and the assumptions underlying such statements – such statements would not be deemed false or misleading unless they were made or reaffirmed without a reasonable basis or were disclosed other than in good faith False and Misleading Statements in Connection with Proxy Statements No solicitation subject to this regulation shall be made by means of any proxy statement, for of proxy, ect, containing any statement which, at the time and in the light of the circs under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary to correct any statement, etc SH PROPOSALS – 14a p. 777 In order to have a SH proposal included on a company's proxy card, and included along with any supporting statement in its proxy statement, you must be eligible and follow certain procedures A proposal is a recommendation or req that the company and or its BOD take action Reqs for getting SH proposal into proxy statement SH has
options: o Have company pay for proxy statements, OR o SH may prepare on his own, and pay for it himself o Corp usually wants to do the mailing because the corp does not want to give up the SH list o STANDING req – must own 1% of 2000 shares, which ever is the least and have held for at least a year Communicating with SHs
DUTY OF CARE o Shlensky v. Wrigley p. 807 The stockholder filed a stockholders' derivative suit against the directors for negligence and mismanagement. The stockholder sought damages and he prayed for an order that required the corporate directors to install lights at the baseball field owned by the corporation, and requested that they schedule night baseball games. The court affirmed, maintaining that courts should not interfere in a corporation's management unless fraud or a breach of faith existed. The decision at issue was one properly before the corporation's directors, and the motives alleged in the amended complaint showed no fraud, illegality, or conflict of interest in their making of that decision. Directors are elected for their business capabilities and judgment and the courts cannot require them to forego their judgment because of the decisions of directors of other companies. Courts may not decide these questions in the absence of a clear showing of dereliction of duty on the part of the specific directors and mere failure to "follow the crowd" is not such a dereliction. Business judgment rule The use of the phrase "ordinarily prudent person" in a basic guideline for director conduct, suggesting caution or circumspection vis-à-vis danger or risk, has long been problematic given the fact that risktaking decisions are central to the directors' role § 8.30 sets forth the standards of conduct for directors by focusing on the manner in which the directors perform their duties, not the correctness of the decisions made as a general rule, a director is not exposed to personal liability for injury or damage caused by an unwise decision; however, he can be held liable for misfeasance or nonfeasance in performing the duties of a director
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Smith v. Van Gorkom p. 818 Business judgment rule is qualified Judgment is not absolute It must be informed Rationally believed that judgment in best interest of corp "ordinarily prudent person" – most state statutes include this language
business judgment rule is supposed to be focused on the PROCESS and NOT the outcome somewhat of a rush to judgment – lacked a sufficient amount of information to give an informed business judgment that 55 was the right price – court held that this constitutes gross negligence SHs can agree to hold directors harmless for not exercising informed business judgment provided that such provisions will not limit the liability for several things Any breach of directors duty to loyalty of corp of SH – conflict of interest For acts or omissions in bad faith (this is intentional) – negligence or gross negligence do NOT count Improper distribution of dividends Any transaction where director received a personal benefit Duty to exercise business judgment is still good law, but the remedies are changed – no monetary damages for failure to exercise business judgment Plaintiffs argued that defendant directors' decision to approve a cash-out merger of their corporation did not warrant business judgment rule protection because defendant directors based their decision on one person's representations, which did not constitute a report on which they could reasonably rely and that they did not seek documentation of either the merger terms or the adequacy of the proposed price per share. The business judgment rule is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Thus, the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one. Where a majority of fully informed stockholders ratify action of even interested directors, an attack on the ratified transaction normally must fail. The question of whether shareholders have been fully informed such that their vote can be said to ratify director action, turns on the fairness and completeness of the proxy materials submitted by the management to the shareholders. Basically, the court pierced the business judgment rule and imposed liability on independent outside directors because the court thought that they had not been careful enough Another side effect of Van Gorkom was the greater formalism on the part of the board, as it goes about the business of cultivating an aura of care
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Gall v. Exxon p. 860 BUSINESS JUDGMENT RULE Derivative suit is brought on behalf of the SHs by the BOD, if you can find BOD people that are not involved with the impropriety than they can bring the case They have the power to pursue or abandon lawsuits – Boards MANAGE the corps – SHs can not decide the lawsuits because if this was allowed they would be managing the company
Whether the special committee, acting as Exxon's BOD and in the sounds exercise of their business judgment, may determine that a suit against any present or former director or officer would be contrary to the best interests of the corp? The decision of corp directors whether or not to assert a cause of action held by the corp rests within the sound business judgment of the management. Courts interfere seldom to control such discretion intra vires the corp, except where the directors are guilty of misconduct equivalent to a breach of trust, or where they stand in a dual relation which prevents an unprejudiced exercise of judgment
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Aronson v. Lewis p. 874 Complaint should allege with PARTICULARITY the actions of defendants and the reason why such actions were not taken – derivative suit Ps must attempt to get the BOD to take up the suit on its own – DEMAND Purpose of DEMAND req. ensures that the SH exhausts the remedies available to him – court wants nonjudicial means to be used first the demand requirement is necessary – the SH do NOT manage the business affairs of the corp. Plaintiff shareholder alleged that certain transactions conducted by defendant directors in connection with a subsidiary corporation violated the business judgment rule. Specifically, plaintiff asserted that defendants involved the corporation in providing unjustified benefits to a financial consultant. The court held that plaintiff's failure to allege facts implicating director bias, lack of independence, or involvement in activities contrary to corporate interest acted as a bar to meeting the requirement of demand futility. In Delaware, mere directorial approval of a transaction, absent particularized facts supporting a breach of fiduciary duty claim, or otherwise establishing the lack of independence or disinterestedness of a majority of the directors, is insufficient to excuse demand.
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No initial demand is required because it would be futile, procedures: No demand req'd where it would be futile (suit cannot be dismissed because of certain facts) The right to prosecute may be terminated depending on business judgment, subsequent action Moreover the BOD may delegate its power to independent disinterested directors ++ heightened level of judicial review of independent committees determination court must inquire into the (1) independence and (2) good faith of the committee was the independent committee's investigation reasonable and in good faith – the court must apply its own business judgment if the court is not satisfied with the independent committee Demand required scenario procedures:
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SH does not posses the right to initiate or continue a derivative action Where demand has been made and refused the business judgment rule is applied unless the P has est'd the business judgment rule does not apply the SH lacks the legal power to continue the suit Self-interest: is defined in terms of direct financial interest in the challenged transaction The persuasive rationale for the demand req is that it allows directors to make business decisions about a business question: whether to invest the time and resources of the corp in litigation If the BOD runs the show, then they must control litigation to the same extent as they make the initial business decision BOD must do a cost v. benefit analysis of litigation If the business judgment rule preserves room for managers to err in making an operational decision, so too they preserve room to err in deciding what remedies to pursue SH plaintiff has a choice (1) not make a demand and thereby accept the burden of convincing the court that seemingly respectable directors should be deemed too biased even to deserve an opportunity to respond to demand OR (2) make demand and thereby acknowledge the applicability of the business judgment rule to the directors' decision whether or not to reject demand
DUTY OF LOYALTY AND CONFLICT OF INTEREST o Corporate Opportunity Northeast Harbor v. Harris p. 956 While she was in office, the president purchased land that adjoined the corporation and subsequently applied for a subdivision permit. She informed the corporation after she purchased the land for her benefit. A fiduciary was required to disclose information concerning any potential conflict of interest. The court adopted a rule to determine whether a fiduciary had improperly taken a corporate opportunity. if there is presented to a corp officer or director a business opp which the corp is financially able to undertake and by embracing the opp the self interest of the officer or director will be brought into conflict with that of his corp, the law will not permit him to seize the opp for himself. o Whether the opp was so closely related with the existing business activities as to bring the transaction within that class of cases where the acquisition of the property would throw the corp officer purchasing it into competition with his company Corporate fiduciaries in Maine must discharge their duties in good faith with a view toward furthering the interests of the corporation. They must disclose and not withhold relevant information concerning any potential conflict of interest with the corporation, and they must refrain from using their position, influence, or knowledge of the affairs of the corporation to gain personal advantage.
Corporate opportunity doctrine recognizes that a corp fiduciary should not serve both corp and personal interest at the same time. Is this a corporate opportunity? Three disjunctive tests (if any of these exist than = corp opportunity) o Even if corp not in this particular business, if a person makes an offer to the corp than it is a corp opportunity o If opportunity would be of interest to the corp than would be valid o (applies only to officers) if related to business of corp the officer has a duty to take it to the corp officer or director may take advantage of the opportunity only after the corporation has rejected the offer – must give advance notice