chapter 18 - formation and termination of corporations

Through corporations, people are able to invest money in a business enterprise without

worrying about unlimited liability or management responsibilities.

Thus, corporation law gives business the capability to

raise the capital necessary to achieve the economies of scale vital to economic efficiency.

f you plan to form a new business, you may very well decide that it should be a corporation. After all, not all corporations are huge economic entities; most of them are small businesses. Further, today it is

very easy to form a corporation.

This chapter will look at the basic issues that arise in the incorporation process. Specifically, it will examine

The nature of a corporation.
2\. The preincorporation process.
3\. The actual incorporation.
4\. Liability for defective incorporation.
5\. When courts will pierce the corporate veil. 6. Close corporations.
7\. The termination process.

**Nature of a Corporation** \n **The Principal Characteristics of the Corporation**

The concept of a corporation developed

in early law.

One advantage of the corporate form of business is that

makes it easier to hold property for long periods of time. This is because the corporation is treated as an intangible being with a life separate from the lives of its owners.

Other powers also came to be associated with

the corporate form of organization early on.

Because of its separate identity, the corporation can

hold and convey property in its own name. Further, it can sue and be sued in its own name. Finally, a corporation possesses the right to make bylaws to govern the relations among its members.

**Types of Corporations**

Today, three principal types of corporations are commonly recognized.

governmental, nonprofit, and for-proft

**Governmental Corporations**

The **governmental corporation** is often called a

**municipal corporation**.

Examples are a

city, a school corporation, and a sewage district

Such governmental corporations usually, although not always, have

the power to tax.

They frequently operate much like business corporations except that they do not seek to make a profit. Examples are the

Tennessee Valley Authority and the Federal Home Loan Bank.

**Nonprofit Corporations**

**Nonprofit corporations** are similar to

nontaxing governmental corporations.

They differ, however, in that they are formed and operated by

private persons

Examples include

hospitals, clubs, and some very large businesses, such as Blue Cross-Blue Shield Association.

Their founders and members are not

permitted to make a profit from the operation of the corporation, although the officers and employees are paid salaries

Each of the states has a special statute under which

nonprofit corporations are to be formed and operated.

**For-Profit Corporations**

**For-profit corporations** are by far the

most common of the various types.

The aim of such corporations is usually to

make a profit that may be distributed to the shareholders as dividends.

Sometimes, however, most or all of the profits are

reinvested in the corporation to make the business grow. Then, at a later time, shareholders may sell their stock, or the entire business may be sold. In this way, the shareholders receive their profits while paying only the lower capital gains tax rather than an income tax on the retained profits.

For-profit corporations are often divided into

publicly held and close corporations.

The stock of a *close corporation* is generally held by a

small group of people who know one another, Usually some or all of them intend to be active in management. An example is a family-owned and - operated retail shop.

The close corporation can be contrasted with the

**publicly held corporation**, which sells shares to people who often have little interest in it except as investors. General Motors Corporation is a good example.

Of course, most publicly held corporations are

much smaller than. GM. However, most of the largest corporations are publicly held. In a large corporation with stock owned by many scattered shareholders, ownership of less than 10 percent of the shares may be enough to control the enterprise.

rom here on we shall discuss only the for-profit corporation. However, many of the legal principles and rules are the same for

all types of corporations. Therefore, some of the cases may involve nonprofit corporations.

**Regulation of Corporations**

The Model Business Corporation Act (MBCA), prepared by the Corporation, Banking, and Business Law Section of the American Bar Association, was

drafted as a model statute for adoption by the legislatures of the various states.

The MBCA has been amended many times and was

completely revised in 1984.

Although the old MBCA is still the basis for the statutes of the majority of the states, most of the provisions of the revised MBCA represent the

rule of the majority of the courts in the United States.

Accordingly, this book concentrates on the revised MBCA, although the old MBCA provisions will be noted when

they deviate greatly from the revised model statute.

**The Preincorporation Process Promoters; promotoers are**

people who bring a corporation into being.

Thus, promotion is a vital activity in a

free enterprise system.

The promoter is the person who

has the idea for a business. She finds people who are willing to finance it—to buy shares of stock and/or to lend money and credit.

Contracts must be made for

building or leasing space, buying or renting equipment, hiring employees, buying supplies and advertising, and whatever else is required for the early operation of the business.

Most state incorporation statutes permit reserving a name for a

proposed corporation. This is also done by the promoter.

She must arrange for the filing of the legal papers to

incorporate the business, and she will usually guide the corporation through the early months or years before the new company is a “going concern.”

Although the promoter may start with an idea and build a corporate business around it, this is not

always the case.

In many instances, the promoter will take a sole proprietorship or partnership and

convert it into the corporate form. And, of course, rather than always having a single promoter, frequently the corporation will be created through the vision and efforts of a group of promoters.

**Legal Liability of Promoters Liability to the Corporation**

The relation of promoters to the corporation, to its shareholders, and to those with whom they contract is unique. Promoters are not agents of the corporation

prior to its incorporation because the corporation (the principal) is not yet in existence.

Promoters are not

agents of the persons who are interested in the venture, because the promoters were not appointed by them and are not under their control.

Nevertheless, promoters owe a

fiduciary duty to the corporation and to the persons interested in it. This includes the duties of full disclosure, good faith, and absolute honesty to the corporation and to the original shareholders. Thus, it would be a breach of duty to use money received on stock subscriptions to pay the expenses of forming the corporation unless this intent were disclosed.

A promoter often takes an option on

property or makes an outright purchase on behalf of the corporation. If he or she misrepresents the price paid or to be paid, the corporation may recover the secret profit made by the promoter.

However, if the promoter makes a full disclosure of the expected profit to an independent board of directors, the corporation

cannot recover.

But, if the board of directors is under the control of the promoter, the corporation could

rescind the contract or recover damages for breach of the fiduciary duty.

**Liability to Third Parties**

Promoters are generally held liable on contracts they

make on behalf of corporations that are not yet formed.

If the corporation is never formed, or if it fails to adopt the promoter’s preincorporation agreement, the promoter is

liable.

This is based on agency law:

An agent who makes a contract for a nonexistent principal is personally liable for it.

If there is more than one promoter, they are all liable under a

joint enterprise theory.

Promoters sometimes attempt to escape this potential liability by having the

third party agree, when the preincorporation contract is made, that the promoter is not to be liable. The disadvantage of this strategy, however, is that neither the promoter nor the corporation can force the third party to perform such a contract. This results from the rule for bilateral contracts that if one party is not bound, neither is the other because such contracts lack *mutuality*.

After the corporation comes into existence, it may agree to

assume liability for the promoter’s preincorporation contracts.

Such an agreement between the promoter and the corporation, in and of itself, is not

sufficient to relieve the promoter from all liability on the contracts. This is so because the third party contracted directly with the promoter.

The promoter is released from liability on the

preincorporation contracts only if the corporation, the promoter, and the third party all agree that the corporation will be substituted for the promoter. This agreement is called a *novation*.

Kym Nelson and WinCo Foods maintenance supervisor discussed the possibility of Nelson, performing concrete floor maintenance and repair work for several of WinCo’s stores. Ultimately, WinCo and Nelson (using the name KD Concrete) entered into a contract for the work. Two months later, Nelson incorporated KDN to perform the WinCo contract that had been negotiated. She registered “KD Concrete Design” as an assumed business name of KDN more than two years later. WinCo later sued KDN for breach of contract. KDN responded by asserting that it had no assets or financial resources to defend against WinCo’s claims. WinCo then filed a new complaint against Nelson under a theory of pre-incorporation liability. Is Nelson personally liable for the preincorporation contract?

Yes. WinCo and Nelson, acting on behalf of KD Concrete (the assumed business name of KDN), entered into a contract no later than mid-January, when they agreed to the material terms of the contract. It is undisputed that Nelson did not incorporate KDN until February 18. All persons purporting to act as or on behalf of a corporation, when there was no incorporation, are jointly and severally liable for all liabilities created while so acting. Because KDN was not incorporated until after the contract with WinCo was formed, Nelson was jointly and severally liable with KDN under the theory of pre-incorporation liability.

**Liability of the Corporation Liability to the Promoter**

As a general rule, corporations are not required to

compensate promoters for the services they render during the preincorporation period. However, there is nothing illegal or wrong if promoters are paid for their services.

Profit to the promoters is illegal only if

it is not disclosed.

After formation of the corporation, it may

agree to pay the promoters not only for their expenses but also for their services. Frequently, promoters are issued shares of the stock of the new corporation for their services.

In the past, many states had not permitted promotional services to be used as

consideration for shares in the new corporation.

However, the current trend in law, as evidenced by the revised MBCA, is to

permit the corporation to issue shares in return for the promoters’ preincorporation services.

**Liability to Third Parties**

When the corporation comes into existence, it is not

automatically liable on the contracts made by the promoter.

As indicated above, the corporation cannot be liable as

principal because it was not in existence.

The same fact prevents the corporation from

ratifying the promoter’s contracts; ratification requires capacity to contract at the time the contract was made.

Nevertheless, all American courts, except those of Massachusetts, have held corporations liable if, after incorporation, the

*board acts to adopt the contract* (adoption is similar to ratification in its effect).

Mere acceptance of the benefits of the contract is

generally sufficient to bind the corporation.

Massachusetts, however, requires that the parties

expressly create a novation before the corporation can be held liable for the preincorporation contracts.

**Incorporation** \n **The Right to Incorporate**

All business corporations derive their existence from

the state in which they are incorporated.

The earliest business corporations in the American colonies obtained charters from the

King of England because the colonies were governed by the English monarch.

The Constitutional Convention of 1797 considered giving this power to the federal government; however, no such power was

included in the Constitution. Therefore, this power was left to the states.

To form a corporation, the promoters had to

ind a legislator who was willing to introduce a bill. The legislature then decided whether to grant a charter.

Early legislators feared the growth of corporate power. Charters, therefore, tended to be

for short periods of time.

For example, a charter might have to be renewed after

10 years.

The powers granted and the amount of capital involved were generally rather limited. Most of the earliest corporations were formed to supply

public facilities such as bridges, toll roads, and waterworks. A few, however, were mining and manufacturing businesses.

As commercial and industrial development progressed in the United States, legislators were impressed by the resultant benefits brought to the people and, accordingly, they wanted to

encourage corporations.

At this time, there was also an expanding belief in

greater freedom and equality for all people.

These factors resulted in the passage of

**general incorporation laws**, which made incorporation a right instead of a legislative privilege.

Under these statutes, all that is necessary to form a corporation is to prepare

*articles of incorporation* that comply with the state’s incorporation statute.

If they do, a state official—usually the secretary of state—has a duty

to issue a certificate of incorporation.

**Deciding Where to Incorporate;** Frequently, the corporation will be incorporated in the state where

most of its business will be conducted.

However, if the enterprise is conducting its affairs in interstate commerce, the promoters may

decide to incorporate in a state other than the state in which the principal offices are located. Many large corporations shop around for the state that will offer the most benefits to the enterprise.

Two fundamental considerations frequently arise when the promoters are trying to

decide where to incorporate.

First, the business may be incorporated in a state where the

incorporation fees, taxes, annual fees, and other charges tend to be lower.

Second, the promoters may decide to incorporate in a state where

the corporation statute and judicial decisions grant management considerable freedom from shareholder interference in the operation of corporate affairs. Traditionally, Delaware and, more recently, Ohio have been attractive states for incorporation.

**Steps in Incorporation**

The following steps governing the incorporation process are included in the MBCA:

Preparing the articles of incorporation.
2\. Signing and authenticating the articles by one or more of the incorporators.
3\. Filing the articles with the secretary of state and paying all required fees.
4\. Issuing the certificate of incorporation by the secretary of state.
5\. Holding an initial organizational meeting.

Different states may vary slightly in what they require in order to

incorporate; however, the above requirements are included in the corporation laws of most states.

Further, many states require that a minimum of $1,000 be contributed to the business before it can

receive a certificate of incorporation.

Some states have an additional requirement directing that a copy of the articles of incorporation be

filed in the county where the corporation has its principal place of business.

The articles of incorporation serve the same function as a charter. They are rather like a constitution in that they are the

basic document of the corporation and a major source of its powers. The articles will generally be prepared for the corporation by a lawyer because most states have statutes that prescribe the general form of the document; however, these requirements may vary from state to state.

The MBCA lists the following matters that *must* be included in the articles of incorporation:

1. The name of the corporation, which must not be deceptively similar to that of any other corporation registered earlier. (It must contain the word *corporation, incorporated, company*, or *limited*, or an abbreviation.)
2. The number of shares of capital stock that the corporation shall have authority to issue.
3. The address of the initial registered office of the corporation and the name of its registered agent.

4\. The name and address of each incorporator.

**Optional Contents**

Under the MBCA, the following matters *may* be included in the articles:

The duration of the corporation, which may be, and usually is,
perpetual.
2\. The purpose of the corporation. Frequently, this is stated very broadly, such as to “engage in any lawful activity.”
3\. Page 514The par value of the shares of the corporation.
4\. The number and names of the initial board of directors.
5\. Any additional provisions that are not inconsistent with the state’s corporation law. These may include dividend rights and quorum requirements, as well as procedures for the election and removal of directors.

**Who May Be Incorporators?**

Some states require that at least

three natural persons who are adults serve as the incorporator.

The MBCA relaxes this rule by

permitting a single person, a partnership, an unincorporated association, or even another corporation to act as an incorporator.

The incorporator does not incur any special liabilities as a result of her status. She really has no

function beyond lending her name and signature to the incorporation process.

**The Certificate of Incorporation**

The secretary of state reviews the

articles of incorporation to ensure that they comply with the requirements of the state’s incorporation statute

if they do, the secretary of state issues a

certificate of incorporation, which certifies that the corporation is in existence.

**Organization Meeting**

After approval of the articles of incorporation, the MBCA requires that

an organization meeting be conducted by the board of directors.

In some states, this first meeting is

to be held by the incorporators rather than by the directors.

The MBCA specifies that

bylaws shall be adopted and officers elected at the organization meeting. Usually a corporate seal is adopted, the form of stock certificates is approved, stock subscriptions are accepted, and issuance of stock is authorized.

Other business may include

adoption of the promoter’s contracts, authorization of payment of or reimbursement for expenses of incorporation, and determination of the salaries of officers.

**Corporate Seal**

Generally, a corporation will

adopt a seal

In many states, the corporation must authenticate all

eal estate documents (deeds and mortgages) by affixing the seal to them. The seal is usually kept by the corporate secretary.

**Bylaws**

The function of *bylaws* is to

establish rules for the conduct of the internal affairs of the corporation.