Corporations
Professor Cleveland
Fall 2003
I.Corporate Law
A.Legal Character of the Corporation: Factors Influencing Choice of the Corporate Form
1.Limited Liability of Shareholders:
a.Risk only purchase price of shares and have no additional liability
b.Corporation can ignore claims of owner’s creditors
c.Subject to potential abuse when used to defraud creditors
i.Explains why there are limitations to its use
2.Perpetual Existence of the Corporation
a.Because of perpetual existence, hard to draft contracts that will cover all eventualities and to fully specify rights and obligations of all parties, as well as relationships among parties.
b.Explains importance of B/D andovernance structures
3.Easy Transferability of Ownership Interests
a.Gives rise to impersonal trading market for shares
i.Possibility of fraud or information asymmetry
ii.Disclosure standards/Regs against insider trading
iii.These represent another check on managerial discretion
4.Centralized Management
a.Delegates much discretion to managers from owners
b.Issues arise as to how managers exercise discretion; conflicts between shareholders and management
c.Explains important place of fiduciary duties
d.Shareholder voting is another means to control discretion
i.What is the adequacy and efficiency of these techniques for holding officials accountable?
ii.Rise to remedies—shareholder suits
[5.Tax Considerations]
6.Nature of the corporation increases the potential for certain types of abuse.
a.Master Problem: How to control management discretion and prevent opportunistic behavior without chilling the efficiency and entrepreneurism
of the corporate form through bureaucratic restraints.
i.Some controls too costly because inhibit risk-taking
ii.Most of discussion focuses on alternative control devices: B/D, derivative suits, market controls, voting controls
b.What mixture of controls works to achieve accountability at the lowest cost?
c.Can be described as tension between autonomy and regulation
B.Scorecard of Players: Public Corporations, Directors and Shareholders
1.A Corporate Census
a.OK Law Delaware Law
b.50% of F500/NYSE incorporated in DE
c.Historical reasons, but continue today because
i.DE has a lot of corporate case law, which leads to more certainty for corps
ii.DE judiciary have developed expertise in corporate law
iii. Responsive legislature
d.Roughly 9,000 of 4.5M are publicly traded
2.Individual Participants
Shareholders / B/D / OfficersOwners / §141 / §142
Vote on big issues (b/c rational indifference, may not vote) / Part-time; 14 days/year / Appointed by BoD
-elect directors §211-213 / Gender/Race: not = to society / Full-time
-mergers §251
-amend charter
-sale of all/most assets
-dissolution / Make big decisions; pass some to SHH
Changing nature of shh=institutional investors / “informational disadvantage” / Have all the info
New model coming where independent directors = less need for regulation?
C.Economic Analysis of the Corporation
1.Managerial Discretion: Debate over Berle/Means Thesis
a.Thesis states that shareholder ownership creates a separation of ownership and control under which corporate managers can pursue own interests unconstrained by shareholders.
b.Response includes: market forces are able to control, self-interest of managers is so aligned with shareholders (both want increase in stock price) that won’t overreach.
2.Agency Cost Model
a.Shareholders are able to control management, or at least conflict can be mitigated/interests can be aligned through incentive compensation devices.
b.Shareholders are principals who delegate broad authority to their managers, their agents.
c.Principals control agents by (Cleveland’s babysitting example)
i.Equity incentives (stock options)
ii.“Monitoring,” e.g. independent audit committees, outside directors
iii.“Bonding,” by which management links its compensation to performance.
iv.Some amount of management misbehavior is inevitable (residual loss)
d.These methods have costs, though, and so have to determine appropriate level.
e.“Agency cost” is sum of dollar equivalent of residual misbehavior that is too costly to prevent, the expense of monitoring management, and the bonding expense.
f.Amount of debt may affect agency costs.
3.The Corporation as a Contract
a.Some economists view the corporation as a set of contracts, where participants negotiate an equilibrium among them. Shareholders are the residual claimants as opposed to the owners. Because shareholders are the risk-bearers, and the ones who are interested in capital accumulation (as opposed to fixed claimants), they are entitled to direct the corporation. Creditors have less of an interest in the firm’s overall performance, and so protect themselves through contract.
b.Critics of this view believe that the contract view overstates the negotiating ability of participants. This view also leaves out the aspect of limited liability of the corporation.
c.Statutes: Can create a corporation “off-the-rack”
Certificate of Incorporation/Constitution of Corporation
By-Laws: (less rigid than cert of incorp)
D.Social Responsibility of the Corporation
1.To Whom do Fiduciary Duties Run?
a.Fiduciary to shareholders only, or to community at large?
b.Berle, Dodd and Milton
c.DGCL §121: General Powers
d.DGCL §122 (9)
2.Rise of Corporate Constituency Statutes: consider other groups than just SHH
a.Enacted during heavy takeover activity in the 1980s; allows corporations to consider non-shareholder groups (employees, community). Usually discretionary; DE hasn’t adopted.
3.Objections to Constituency Statutes
a.Fiduciary duties should run only to the shareholders because they have the greatest incentive to maximize corporate value/realize corporate efficiency.
b.Managers shouldn’t serve too many masters
c.Constituency statutes turn directors into unelected civil servants.
4.Case for Constituency Statutes
II.Characteristics of Different Business Organizations
A.Corporations have advantages but these can be costly (incorporation, double taxation, etc. So organizations may want to consider alternative forms.
Corporations / Partnerships(General) / Partnerships
(Limited) / Partnership
(LLP) / Corporation
(LLC)
Formation / Comply with formalities
§102:
Things that MUST be included
§102b: Things that might be included
§102B6: can have provision that allows for SHH liability
§102B5: Can limit duration / No formality;
Some states require intent, others don’t. Some states say that receipt of share of profits is p.f. evidence of partnership, but not if received as payment. May be formed by furnishing a skill. Theories:
Distinct legal entity or aggregation of individuals / Comply with formalities / Comply with formalities / Comply with formalities
Liability / Limited to investment only; see §102b6
§102b7: limits, except
1) violation of loyalty duty
2) not good faith
3) personal benefit from trans / Personal assets at risk; partners are fiduciaries to each other / General partner, unlimited; limited, limited to investment. Cannot exercise control and keep LP status (p. 793). Can vote, advise, consult / All partners exempt from liab for some or all of certain kinds of debt. All liable, J&S for LLP’s debts Not lbl for negl
Corporations / Partnerships
(General) / Partnerships
(Limited) / Partnership
(LLP) / (LLC)
Management / Centralized; managed by D&O
§141: managed by BoD unless otherwise provided; §142A: Power centralized / Partners manage / General partner manages; limited partner is limited in tasks can do / Centralized—partners exercise more managerial control and authority / Centralized by default, but can deviate by contract
Transferability / Free transferability (technical—few; practical—few, if any)
Allows for secondary market. If not limited, SHH would need to watch officers and other shareholders
§202: if want to restrict xfer of securities / Default, no transfer w/o unanimous consent . Tied to liability—don’t want one partner to xfer interest to Moe and Larry. Practical: asymmetrical information; buyer has no independent info because no public filings / Free transferability; may have practical restrictions / Free transfer, but some exceptions / Free Transfer
Perpetual Life / Y
§102b5—to limit life / N—historically, when one partner dies, partnership dissolves. Trend changing to treat as entity / Y
Tax / Double taxation; entity’s income is taxed, SHH taxed on dividends (Bush has changed some) / Pass through;
Tax individuals.
If partnership makes $$ and partners try to shelter income by re-investing, IRS will likely tax partners / Pass through, like general partnerships / Single level taxation / Single level taxation
Can be taxed as partnership or corporation
III.Forming the Corporation
A.Selection of the State of Incorporation
a.Corporate Law is state-based; courts interpret from state law. No federal corporate law.
b.People organizing business look to state with best laws for their needs
c.Size matters—may choose not to incorporate if not cost-effective (multiple tax filings, etc.); or may just incorporate in same state as PPB
d.Del §131: Can incorporate in one state and have PPB be in another.
i.If in multiple states, which law governs? Use “Internal Affairs Doctrine” to decide
- External: Cleveland eating hot dog—meat is bad because Sonic’s truck crashed. He sues. Uses law of state where wrong occurred. Contract, tort
- Internal: How much notice to give SHH for elections. This would be governed by the law of the state where incorporated. Disputes w/r/t biz operations, relationships
B.Compliance with State Requirements
1.Preparation of Documents: File with Sec’y of State (for service of process, tax)
a.Delaware Law
i.§102(a) lists requirements for certificate of incorporation; (b) has optional items.
1)Name
2)Must have one of indicator words: Inc., Ltd, Club, Institute, etc.
Key here is notice (to others that they’re dealing with a corporation) and clarity (so people don’t get confused as to who’s who)
Club is okay, but doesn’t quite give the same kind of notice to person you’re dealing with…; Sonic Corp vs. “Sonic” Corp: §102(a)(1)(ii) name should distinguish the entity from others
3)Address
4)Nature of business (DE: no fill in, says “any lawful biz” OK: has fill in, you should fill in “any lawful biz” in case your biz morphs over time. Ultra Vires (DGCL §124)
5)Stock information:
Number of shares of stock
Authorized number
Number unissued
Outstanding
Sold to public vs treasury stock
ii.§103 has filing details; §104 defines the certificate of incorporation, §106 discusses beginning of corporate existence.
iii.§109 discusses by-laws. B/D can reserve right to amend; easier than changing incorp
2.Meeting Statutory Formalities—sign, verified, delivered, taxes paid. Get formal copy of cert
3.“Domestication” of Foreign Companies (get fees, monitor who’s in state, service of process)
C.Defective Incorporation
1.Thompson & Green Machinery v. Music City Lumber (TN)
a.Facts: Prez bought equipment for business one day before the business was actually incorporated; he signed promissory note for company, which then couldn’t make payments. Pl. sued Prez for money, under the theory that one who acts for a corporation without authorization shall be liable.
b.Holding: Corporations cannot incur debt; those who act on behalf of a nonexistent corporation will be held J&S liable. If person acts before certificate of incorporation is issued, liability attaches.
c.Notes: Court is balancing two laws: the statute and common law that says a person who deals with an entity as if corporation exists, cannot later deny existence of corporation (corporation by estoppel). Thought that one dealing with “corp” could protect herself.
C/L [judges] vs. Statute [Legislature] Here the legislature trumps the judges.
2.Don Swann v. Echols (GA)
a.Facts: Echols thought corporation, Cupid’s, was incorporated early 1980, but wasn’t incorporated until late 1980. Didn’t pay; Don Swann came after.
b.Holding: Where evidence supports a finding that the purported corporation is not a valid corporate entity, there is no doubt that the agent is bound by his purchases on an open account. Here, court goes with CL rather than statutory corporation by estoppel.
c.Notes: GA has two statutes: 1) person dealing with corp as a corp cannot later deny its existence; and 2) Corps can’t incur debt; those that act on behalf of corp = J&S liable.
Court said that an individual claiming to act for a nonexistent corporation cannot escape liability/can’t deny liability by hiding behind a corporation that didn’t exist at all.
3.DGCL §329: No corporation or person sued by corporation can claim want of legal organization as a defense, but can be used to challenge corporate status/power.
4.RMBCA §2.04: J&S liability for liabilities created when knew there was no incorporation.
5.Sulphur Export v. Caribbean Clipper Lines (LA)
a.Facts: Sulphur suing for breach of contract. Carribean’s article’s of incorporation said that the corporation wouldn’t come into existence until $1,000 was paid in. SHH didn’t put money in and contracted with Sulphur anyway.
b.Holding: If a corporation transacts business in violation of the minimum capital requirement, the officers/directors who participated, except those who dissented and caused their dissent to be noted in minutes, shall by J&S liable for debts/liabilities of corporation arising from transaction.
c.Notes: Measure of liability = full corporate debt or liability from transaction done in violation of statute. If weren’t held liable, would frustrate policy. If they had put money in, Pl. would have gotten $1,000. This rule doesn’t seem to fulfill its purpose. DE doesn’t have this minimum contribution law. But!! Limiting liability to unpaid capital would frustrate public policy of statute by limiting penalties, would raise difficult questions as to whether the capital must be paid to corporations or creditors, and would create “race to the courthouse” among competing creditors. Make the connection: piercing corp veil
D.Pre-Formation Transactions
1.Successor Liability
a.Successor Liable if:
i.Explicit/implicit agreement to undertake
ii.Merger (by law obligated to take liabilities) or de facto merger (not in DE) where buy all assets
iii.Continuation of business or product line (some states). See below
iv.Fraudulent conveyance to avoid liability
b.To determine if continuation, consider
- Retained officers
- Retained employees
- Same products
- Same facilities
- Same name. (“Under new management”)
- Assets bought/left behind
- Passage of time
2.Liability of Corporation for Debts of Its Predecessor
a.If a partnership/proprietorship becomes a corporation or if an operating corporation spins off a segment, what are the rights of the creditors of the predecessor? If the assets of the predecessor assigned, no problem
b.Tift v. Forage King (we skipped)
c.Anderson Lumber v. Myers
i.Facts: Leekley had one corporation that was insolvent. Before the creditor received a judgment, Leekley transferred assets to a new company that was in the same business, had same shareholders. In transferring assets, paid fair market value. Motive doesn’t matter.
ii.Holding: Court found that no fraud had occurred because had given value for assets—corp one was also insolvent for several years before formed a new one.
iii.Notes: Some criticize this opinion, because there are a lot of reasons to consider the second corporation a successor to the first…same officers, same employees, offering same service, same assets. Other side is the passage of time, and the fact that the first corporation didn’t assign any contracts to the second. The court glosses over the issue of goodwill, which some people have a problem with. But the policy behind the decision is likely that the market wants assets to be productive, and if corporations who bought the assets of other corporations would be held liable for the other corp’s debts, then there’s no incentive to buy the assets. Selling off the assets piecemeal would be inefficient and expensive.
3.Promoters’ Contracts
a.Introduction to the “Promoter” Concept
i.The “movers and shakers” in corporate formation
ii.May become participants in subsequently formed corporation, but frequently discontinue association after being paid a fee. Also called “business brokers,” “finders,” or “financial consultants”
iii.Examples of pre-incorporation activities undertaken by promoters may include retaining lawyers to prepare proper documents, purchasing, leasing, or getting option on land, buildings, and machinery, and signing contracts for materials.
iv.Frought with potential legal problems, because the promoter is acting on behalf of a corporation that is going to be formed. Can corporations be held liable for the promoter’s activities?
b.Liability of the Corporation
i.Kridelbaugh v. Aldrehn Theaters (IA)
1)Facts: Pl. lawyer seeks fees for (now, thanks to him) incorporated corporation. Pl. attended first meeting of board of directors where, while his fees and expenses were under discussion, he was asked to perform another service and told that he would be paid following the sale of stock.
2)Holding: Corporation held liable for fees and expenses incurred by promoter
3)Notes: Ct. went through a variety of analyses to reach this result
Theories of liability:
[a] Agency law. Principal is bound by acts of agent. Problem: If principal to be bound, needs to be in existence. This is rejected.
[b]Per se liability. When corporation comes into existence, hold it liable for all acts of promoters. Rejected, because court wants to see volition.
[c]Ratification. Principal says nothing to agent, agent acts. Principal uses or benefits from act. Even though principal didn’t authorize, the receipt of the benefit = ratification. The problem is that it is based on the law of agency, which was rejected in #1.
[d]Adoption. Similar to ratification. The court is looking for an act of discretion. In this case, at the first board meeting, one director tells the attorney to sell stock so that they can pay him. No objection from others. Court surmises that Board of Directors approved because no dissent.
3)Some question in class as to whether this was an implied or express adoption. Include info in by-laws that the actions of promoters are approved.
c.Liability of the Promoters
i.Sherwood & Roberts-Oregon v. Alexander (OR)
1)Facts: Pl. would find loan for defendant but required good faith deposit. Note (for 1% of the loan) executed in corporation’s name to avoid usury laws. All parties knew that there was no corporation.
2)Holding: Court said the Pl didn’t protect themselves by asking for personal guarantees (this didn’t matter in Thompson), and the Pl. insisted that everything go through the corporation. The likely distinction here is that the Pl. was bad.
3)Notes: The court had two options. C/L: Deal with corp as a corp, can’t deny its existence (find corporation by estoppel); or Statute: Act for non-existent corp, J&S liable for all debts/liabilities.
ii.How & Associates v. Boss (IA)
1)Facts: At the time the contract for architectural services was signed, Def. crossed out the name of the corporation and wrote in his own name as “agent for a Minnesota corporation to be formed, who will be the Obligor,” a modification approved by Pl.