(16) Capitalization of Corporation

What is capitalization of a corporation?

The process of authorizing and issuing shares in exchange for legally sufficient consideration.

What must exist before shares can be issued?

The shares must be authorized in the articles or charter.

What is authorization of shares?

The inclusion of shares in the corporation's articles or charter so they may be issued.

May a corporation issue more shares than are authorized?

No.

What must occur before additional shares may be issued if all authorized shares have already been issued?

The articles must be amended to authorize additional shares.

What is the issuance of shares?

The process by which all or part of the corporation's authorized shares are sold.

Who must approve the issuance of shares?

The board of directors.

What board actions are required to issue shares?

The board must accept the subscription offer and direct the secretary to issue the share certificates upon receipt of the required consideration.

What shareholder right should you always consider when new shares are issued?

Preemptive rights.

What do statutes regulate regarding consideration for shares?

Both the form (quality) and amount (quantity) of consideration received by the corporation.

What is bonus stock?

Stock issued for which no consideration is paid.

What is discount stock?

Stock sold for cash in an amount less than its par value.

What is watered stock?

Stock issued for overvalued property or services or, in the case of par-value stock, issued for less than par value.

What forms of consideration are valid for issuing shares?

Money paid, labor performed, property acquired, secured promissory notes, and cancellation of corporate debt.

Is money valid consideration for shares?

Yes.

Is labor already performed valid consideration for shares?

Yes.

Is property transferred to the corporation valid consideration for shares?

Yes.

Is a secured promissory note valid consideration for shares?

Yes.

Is cancellation of corporate debt valid consideration for shares?

Yes.

Are pre-incorporation services valid consideration under the majority rule?

No.

Are future services valid consideration under the common law?

No.

Are future services valid consideration under modern law?

Yes.

Is an unsecured promissory note valid consideration for shares?

No.

Is goodwill valid consideration for shares?

No.

What is the effect of issuing shares without valid consideration?

The shares are void as between the corporation and the issuee and may be canceled by the corporation.

When does a watered stock problem commonly arise?

When par-value stock is issued for less than par value.

What should you look for in a watered stock fact pattern?

The corporation requests less than par value and the shareholder pays the requested amount.

What are par-value shares?

Shares that have a stated minimum value that generally must be paid upon issuance.

When are par-value shares fully paid?

When they are sold for par value or more.

When may par-value shares be sold below par?

When the corporation cannot sell them at par, is a going concern, and its capital is impaired.

What are examples of situations allowing par-value shares to be sold below par?

A desperate need for capital or the resale of treasury shares.

Who establishes the stated value of no-par stock?

The board of directors.

How may no-par stock without a stated value be sold?

For a reasonable amount.

Under the majority rule, when does property transferred for shares create watered stock?

Only if there is bad faith or overvaluation of the property.

What is the majority rule for valuing property transferred for shares called?

The good faith rule.

Under the minority rule, when does property transferred for shares create watered stock?

Whenever there is a substantial variance between the property's value and the value assigned.

What is the minority rule for valuing property transferred for shares called?

The true value rule.

What remedy allows the corporation to eliminate watered stock?

The corporation may cancel the stock to the extent it is watered.

What equitable remedy may prevent the issuance of watered stock?

An injunction or specific performance.

Who may generally recover damages for watered stock?

The corporation's creditors.

What is the trust fund theory?

The stated capital of the corporation is held in trust for the benefit of all creditors.

Who may recover under the trust fund theory?

All creditors, whether they became creditors before or after the issuance.

When does a cause of action arise under the trust fund theory?

When the corporation becomes insolvent.

What must occur before creditors may sue under the trust fund theory?

They must obtain a judgment against the corporation that is returned unsatisfied.

What is the rationale behind the trust fund theory?

Creditors rely on the corporation's stated capital when extending credit.

What is the misrepresentation theory?

A theory allowing only subsequent creditors to recover for watered stock because they relied on the corporation's capitalization.

Who may recover under the misrepresentation theory?

Only creditors who extended credit after the watered stock was issued.

Why are prior creditors barred under the misrepresentation theory?

Because they could not have relied on the watered stock when extending credit.

When does a creditor suffer damage under the misrepresentation theory?

When the corporation becomes insolvent.

Who owns the cause of action under the misrepresentation theory?

The individual creditor.

What is the statutory obligation theory?

A public policy theory allowing creditors to sue if the corporation does not.

Who may recover under the statutory obligation theory?

All creditors.

Is a transferee of watered stock automatically liable?

No.

When is a transferee of watered stock liable?

Only if the transferee participated in or knew about the watering.

What is underwriting?

The process by which a securities dealer takes stock from the corporation and arranges for its sale to the public.

Why does a corporation use underwriting?

To obtain financing and expand by offering stock to the public.

What is an underwriter?

A person engaged in the business of distributing corporate securities.

What duty does an underwriter owe regarding the sale of securities?

To use best efforts and special skills to market and sell the securities.

Is an underwriter responsible for unsold shares?

No.

Is an underwriter subject to the securities laws?

Yes.

Which anti-fraud rule applies to underwriters?

Rule 10b-5.

What disclosure must an underwriter make?

Full disclosure of compensation arrangements with the issuer.

Testable Issue:What must occur before shares may be issued?

The shares must be authorized in the articles or charter.

Testable Issue:What forms of consideration are valid for issuing shares?

Money paid, labor performed, property acquired, secured promissory notes, and cancellation of corporate debt.

Testable Issue:What forms of consideration are not valid?

Pre-incorporation services under the majority rule, unsecured promissory notes, goodwill, and future services under the common law.

Testable Issue:What is watered stock?

Par-value stock issued for less than par value or stock issued for overvalued property or services.

Testable Issue:What is the difference between the majority and minority rules for valuing property transferred for shares?

The majority follows the good faith rule, while the minority follows the true value rule.

Testable Issue:What are the three creditor theories for watered stock?

Trust fund theory, misrepresentation theory, and statutory obligation theory.

Testable Issue:When is a transferee of watered stock liable?

Only upon participation in or knowledge of the watering.

Testable Issue:What is an underwriter's duty?

To use best efforts to market and sell securities while complying with Rule 10b-5 and disclosure requirements.

Essay Rule:How do you analyze a capitalization issue?

Determine whether the shares were properly authorized and issued, analyze whether legally sufficient consideration was received, determine whether watered stock exists, apply the appropriate valuation and creditor theory, determine the available remedies and liability, and analyze any underwriting issues if public securities are involved.

Master Synthesis:What is the framework for analyzing capitalization of a corporation?

Determine whether the shares were authorized and properly issued, verify that valid consideration was received, identify any watered stock issues, apply the majority or minority valuation rule and appropriate creditor theory, determine remedies and liability, and evaluate any underwriting obligations under the securities laws.