ADW DRAFT 9/3/11

AP comments 9/5/11

Chapter 2. Corporate Basics

[Alan: I tightened up some of the formatting, mostly to keep spacing consistent]

Primary Sources Used in this Chapter

  • DGCL § 211. Meetings of Stockholders
  • DGCL § 222. Notice of Meetings and Adjourned Meetings
  • Bayer v. Beran
  • Schnell v. Chris-Craft Industries, Inc.
  • Stahl v. Apple Bancorp, Inc.

Concepts for this Chapter

  • Corporation as “private constitution”
  • Basic corporate vocabulary
  • corporate categories
  • corporate characteristics
  • organic documents
  • corporate actors
  • corporate securities
  • fiduciary duties (derivative suit)
  • corporate law vs. other law
  • Corporate Powers
  • change annual meeting
  • equitable limitations

Introduction

This chapter explains some fundamental notions about corporations (what they are, what shareholders do), walks through some basic vocabulary, and applies that vocabulary using a basic corporate fact pattern: a board’s decision to change the time and location of the corporation’s annual meeting.

Question: Why focus on corporations? Why not partnerships? Or LLCs?

Answer: As explained in the breakout box on page 25, there are more than 13 million business firms registered in the 50 U.S. states, and most are small entities, closely held by their private owners. Only about 8000 of those entities are publicly traded corporations which have their shares listed on stock markets like the New York Stock Exchange.

Nevertheless, corporations are the dominant structure through which joint business enterprise is conducted in the United States and throughout the world.

Of course, the book also covers partnerships and LLCs.

Note: The “13 million” estimate was produced by finding the number of limited-liability entities (LLCs, LLPs, LPs, and corporations) organized in North Carolina and, assuming it is a typical state, extrapolating for the country as a whole based on population.

A.Corporation as Private Constitution (with Fundamental Rights)

Question: What is a corporation?

Answer: There is no one definition of a corporation. There are instead a number of overlapping ways to understand them:

  • Legal entity: a corporation can own property, enter into contracts, sue, be sued and make certain political contributions (see the discussion of Citizens United in Chapter 5)
  • Team of people: a corporation includes suppliers of money (e.g. shareholders) and labor (e.g. management), who work together to earn a return on their investments
  • Web of contracts: a corporation is created by contracts between investors, employees, customers and the community
  • Investment vehicle: a corporation is simply a way to invest money in order to earn a return
  • Drama: a corporation is a series of interactions among a set of standard players (shareholders, directors, officers and other employees) as they work through conflicts that result from their different incentives, investments and goals.

The Corporation as Private Constitution

The corporation is a “private” constitution that allocates powers and immunities, rights and duties, and risks and rewards among its constituents.

Question: What is the law of a corporation?

Answer: The law of a corporation includes a number of overlapping public and private corporate legal documents: statutes, case decisions, articles, bylaws, board resolutions, etc.

The hierarchy is:

  • U.S. Constitution, the “supreme law of the land,” and the relevant state constitution.

↓

  • Relevant state statute (such as the Delaware General Corporate Law (DGCL)), which authorizes and specifies the content of the private articles of incorporation and bylaws.

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  • Articles of incorporation

↓

  • Bylaws, which detail the corporate functioning (the how and where of shareholder and board meetings, the titles and functions of corporate officers, the responsibility of the corporation if directors or officers are sued, etc).

Court decisions are also a huge part of corporate law, sometimes interpreting statutes, articles, bylaws but often defining shareholder fundamental rights and enforcing the duties of directors/officers to the corporation and shareholders.

Many cases come down to recognizing and applying the hierarchy: the Constitution trumps statutes (see Citizens United in Chapter 5), corporate statutes trump articles of incorporation and bylaws (seeQuickturn in Chapter 14), corporate case law trumps bylaws (see Blasius in Chapter 14),articles of incorporation trump bylaws (see DGCL and MBCA).

Question: What rights do shareholders have in a corporation?

Answer: The governing documents for the corporation allocate rights and responsibilities among the corporation’s “citizens” and “officials.” The shareholders (as principals) appoint members of the board of directors (as agents) to act on their behalf. The directors further delegate responsibilities to the corporation’s officers and directors (also agents). As a result of this structure, the shareholders retain only limited rights, having elected representatives (the corporation’s directors) to make business decisions and act on behalf of the shareholders. It is analogous to a representative democracy.

Shareholders are left with three fundamental rights:

  • Vote: shareholders may elect directors, vote on specified transactions and voice concerns at shareholder meetings. (This is covered in Module VI – Corporate Governance.)
  • Sue: Shareholders may file litigation claiming that the corporation’s directors or controlling shareholders have breached their duties. (This is covered in Module VII – Fiduciary Duties)
  • Sell: Shareholders may sell their shares in the market or to an acquirer in a corporate takeover. (This is covered in Modules VIII and IX – Stock Trading and Corporate Deals.)

Question: If you are a shareholder and you do not like how the managers are running the corporation’s business, what should you do?

Answer: You might try to influence the directors and officers by speaking out, sponsoring a shareholder resolution, attending an annual shareholders meeting or even mounting a voting contest to replace the directors. Traditionally “voice” has been a costly path; not worth it for investors who own a relatively small number of shares. However, technological advances have brought some costs down, and some institutional investors do own a sufficient number of shares to make exercising their voice worthwhile.

Your other option is simply to sell your shares. Exit is often the cheapest option. Of course, if everyone who is concerned about management’s practices sells, the corporation will be left with shareholders who are unaware of or unable to help with its problems.

Question: Is the decision to sell shares a matter of loyalty?

Answer: Probably not. People do not tend to feel loyalty toward economic organizations. In contrast to small groups such as families or other organizations, corporations do not inspire loyalty. There is a discussion on p. 28 of Adam Smith’s observation that a person dealing with strangers would be more disposed to cheat them than a person dealing with neighbors in repeated transactions. Shareholders may not feel accountable when the issue involves a seemingly anonymous investment in a non-local entity.

B.Basic Corporate Vocabulary

1.The Corporation

Question: What are the typical characteristics of a corporation?

Answer: Typical corporate characteristics include:

  • Separate entity (from its managers and investors)
  • Perpetual existence (although the managers and shareholders may change)
  • Shareholder liability limited (to the amount paid for the shares)
  • Centralized management (board of directors)
  • Transferability of ownership interests (shares)

Of course, most of these are default arrangements and, except for being a separate entity, are not mandatory. In many cases, corporate actors may agree to alter or customize these arrangements to suit their particular circumstances or goals.

Question: What is the difference between a “for-profit” and a “non-profit” corporation

Answer: A “for-profit” corporation is established primarily to generate wealth. A “non-profit” corporation is a corporation without shareholders (persons having a financial interest in surplus funds) dedicated to some educational, religious or charitable purpose (e.g. hospitals, universities, charities).

Question: What is the difference between a public corporation and a close corporation?

Answer: A “public corporation” refers to a for-profit corporation created under state law whose ownership interests (shares) are owned by a large group of shareholders who trade their shares on stock markets open to the public – thus, making it publicly owned. Shareholders of public corporations can typically sell their shares easily. Shareholders of public corporations do not usually have a relationship with the corporation and are not involved in the management of the corporation. A public corporation cannot be one that is non-profit.

In contrast, a close corporation is a for-profit corporation created under state law whose shares are not publicly traded, but closely held. There is no ready market for the shares of close corporations. It is typical for the participants in a close corporation to play more than one role (e.g. directors and officers with ownership stakes, owners involved in the management).

So what is a “private corporation”? As explained in the breakout box on p. 29, “private corporation” is sometimes used to mean a corporation that is not part of the government, i.e., either a publicly-held or closely-held corporation.

2.Articles of Incorporation (also called “Certificate of Incorporation” and “Corporate Charter”) and Bylaws

The articles of incorporation are filed with the appropriate Secretary of State, Corporations Division, by the people who are forming the corporation. If the articles of incorporation are in order, and the required fee is paid, then the Secretary of State then accepts them for filing.

The required contents of the articles of incorporation are laid out in the particular state corporation statute, and usually include:

  • The name of the corporation
  • The agent and address for service of process
  • The number of authorized shares

The corporate bylaws are drafted at the same time as the articles of incorporation, but are not filed with the state. The bylaws include the rules for how the corporation will operate. For example:

  • Powers of directors and officers
  • Procedures for electing directors and filling director vacancies
  • Procedures for calling and holding shareholder meetings

Question: Which “trumps”: the articles of incorporation or the bylaws?

Answer: The articles of incorporation.

3.Corporate Actors

Shareholders (also called “Stockholders”)

The shareholders contribute capital to the corporation in exchange for “common shares,” which represent a divided ownership stake in the corporation. The shares typically confer certain claims on the corporation’s income.

The shareholders usually have the right to vote to elect the board of directors, and the directors then hire the corporate officers. Shareholders must also, after board initiation, vote on certain fundamental transactions such as amendments to the articles of incorporation or a merger with another corporation.

Board of Directors (also called “the Board”) made up of “Directors”

The members of a corporation’s board of directors are elected by the shareholders and are responsible for managing or supervising the corporation’s business. The directors owe duties to act on behalf of the corporation, and to represent the interests of the corporation.

Officers

The officers of a corporation are employees chosen by the directors. The directors delegate responsibility to the officers for the day-to-day operations of the corporation. The officers typically include:

  • the Chief Executive Officer
  • the Chief Financial Officer
  • other officers (e.g. Executive Vice-Presidents, Secretary, Treasurer, Controller)

Note: In this book, the term “management” refers to both directors and officers.

Question: Which are employees of the corporation: directors or officers?

Answer: The officers of a corporation are employees by virtue of their positions. Directors may or may not be employees. If a director also happens to be an employee, he/she is known as an “inside director.” If a director is not an employee of a corporation, he/she is known as an “outside director.”

Question: Which is better for a corporation, an inside director or an outside director?

Answer: Both. Inside directors may offer detailed knowledge of the workings of the corporation. Outside directors offer a more objective perspective on the corporation, and knowledge of the industry or economy as a whole.

Question: Who else has a stake in a corporation?

Answer: Other corporate stakeholders include:

  • Creditors
  • Employees
  • Suppliers and customers
  • Community

Question: For whose benefit should the corporation be run?

Answer: The question of who the corporation serves is a fundamental one. Several possible interests include:

  • Only the shareholders
  • All of society
  • The stakeholders

For now, a discussion of the possible choices is enough. This question will be explored more fully in Chapter 4 (Corporate Social Responsibility).

Bonus Question: Can shareholders decide to sell the corporation?

Answer: No. Shareholders own shares, but not the corporation. The sale of the corporation (either all its assets or in a merger) requires action first by the board of directors and then (sometimes) approval by the shareholders. Under corporate statutes, the power to initiate a sale of the corporation rests exclusively with the board.

This question illustrates that shareholders are not really “owners” in the usual sense of the word.

What about a tender offer? Shareholders can sell to an outside bidder (hostile to incumbent management), but this is not the sale of the corporation, but merely its shares to a new shareholder. Of course, once somebody controls a majority of shares that person can elect a board that can initiate a sale.

4.Corporate Securities

The typical characteristics of the three basic categories of securities are:

Debt

  • Least risk
  • Lowest expected return
  • Fixed interest payments over a set term
  • Priority in liquidation of corporate assets

Equity: Common Shares

  • Greater risk
  • Greater expected return
  • Dividends (at board discretion)
  • Vote
  • Residual financial rights to assets

Equity: Preferred Shares (generally)

  • Risk level between debt and common shares
  • Senior right to dividends (still, at board discretion)
  • Less risk than common shares, but more risk than debt
  • Lower expected return than common shares, but higher expected return than debt
  • Priority over common shares if corporation becomes insolvent

Question: What do the typical characteristics of the three categories of corporate securities suggest about the relationship between risk and return?

Answer: As securities become riskier, investors demand greater returns. The breakout box on page 36 provides a real world illustration of this in the form of the 2009 expected returns on General Electric securities:

  • Short-Term Corporate Debt:4.1% interest
  • Preferred Shares:10% dividend rate
  • Common Shares:24.4% returns

Increasing risk, increasing expected return.

The breakout box at the top of page 37 clarifies the different names used for debt and equity instruments:

Equity: Stock, Shares

Debt: Bonds, Debentures, Notes

Corporate shares can occupy three stages:

“Authorized shares” refers to how many shares the articles of incorporation authorized the company to issue.

“Issued shares” refers to how many of those shares the corporation has sold to investors

“Outstanding shares” refers to how many of the authorized shares are owned by shareholders

In addition, “treasury shares” are shares that the company has bought back so they are issued, but not outstanding.

The breakout box at the bottom of page 37 provides a good example for working through share status:

Example 2.1

Question: The XYZ articles of incorporation authorize the issuance of 100 common shares. The board approves the issuance of 80 shares. XYZ sells 80 shares to investors. How many shares are authorized? Issued? Outstanding?

Answer:

100 authorized

80 issued

80 outstanding

(leaving 20 authorized but unissued)

Question: XYZ then repurchases 10 of the 80 shares that were issued and outstanding. How many shares are authorized? Issued? Outstanding?

Answer:

100 authorized

80 issued

70 outstanding

10 treasury (repurchased and unissued) [[IS THIS CORRECT?]] ALAN: YES – from what I remember of Manning on Legal Capital

20 authorized but unissued [and my understanding is that the MBCA would say that after the repurchase there are now 30 that are authorized, but unissued]

5.Corporate Fiduciary Duties

The Business Judgment Rule

Corporate managers have significant discretion in making corporate decisions, and courts often defer to management judgment. Courts presume that director decisions:

  • Are informed
  • Serve a rational business purpose (i.e. do not constitute waste)
  • Are disinterested
  • Are made independently

The “business judgment rule” creates a presumption thatdirectors (and other corporate decision makers) perform their duties in good faith. The rule is really an abstention principle of corporate law that says to judges: hands off!

Fiduciary Duties

The basic fiduciary duties owed by directors and officers to the corporation are the duty of care and the duty of loyalty.

  • Duty of Care The duty of care requires managers to be attentive and prudent in making decisions. To allow risk taking and strategic moves, judges will not find a breach of the duty of care unless the decision makers’ behavior is egregious – completely uninformed or without business justification for what they were doing.
  • Duty of Loyalty The duty of loyalty requires managers to put the corporation’s interests ahead of their own. The duty of loyalty is not subject to the business judgment rule. Judges will jump in to scrutinize business decisions if the decision makers had conflicts. Unlike the duty of care, issues arising under the duty of loyalty raise questions of loyalty and conflicts of interest, not business acumen. Directors and other decision makers breach their duty of loyalty when they shortchange the corporation for personal gain.

Bayer v. Beran, 49 N.Y.S. 2d 2 (Sup. Ct. 1944) (Example 2.2, p. 39)

Facts: The Board of Directors of Celanese Corporationdecided during WWII to spend $1 million to sponsor a variety radio show as part of an advertising campaign. The company hired the wife of the company president (Miss Jean Tennyson) as one of the performers on the show. Shareholders of the company brought derivative suits against the board for violating their fiduciary duties.

Issues: Did the directors violate

(1)their duty of care for spending so much without clear marketing benefits?

(2)their duty of loyalty for spending money on a show for the benefit of the wife of the company president?