Chapter 19: Corporations

Chapter Objectives

• Identify the various classifications of corporations.

• Explain the process for forming a corporation.

• Describe the duties of officers and directors in a corporation.

• Describe the role of the board of directors in a corporation.

• Identify liability protections for corporations, their promoters, and their shareholders.

• Summarize the rights of shareholders.

Importance of Corporations

• Corporations are considered legal “persons” existing under state statutes.

• The laws governing corporations can differ significantly between states, particularly between those following the Model Business Corporation Act (MBCA) and those that do not.

• Individual state corporate laws must be referenced to determine applicable regulations instead of relying solely on the MBCA.

Nature and Classification of Corporations

Definition of Corporation

• A corporation is defined as an “artificial legal person” and a “creature of statute,” meaning:

  • Created and recognized under state statutory law.

  • Possesses rights similar to those of individuals, such as due process and freedom of speech.

Corporate Personnel

• Management Structure:

  • The board of directors oversees overall management.

  • Corporate officers and employees handle daily operations.

Limited Liability of Shareholders

• Key feature under corporate law where shareholders' liability is restricted to their investment in the corporation.

Corporate Earnings and Taxation

• Corporations can either:

  • Pay out profits to shareholders as dividends, or

  • Retain profits as retained earnings.

  • There is dual taxation: the corporation pays taxes on profits, and individuals pay taxes on dividends received.

Torts and Criminal Acts

• Corporations can be held liable for the negligent acts of their employees under the doctrine of respondeat superior.

  • Example: Case 19.1, Wulf v. Bravo Brio Restaurant Group, Inc. (2019) demonstrates a scenario where the corporation can be liable for the negligent actions of its employees.

Classification of Corporations

Overview

• Corporations can be classified by various categories:

Domestic, Foreign, and Alien Corporations

• Domestic Corporation: Incorporated in its home state.

• Foreign Corporation: Incorporated in another state.

• Alien Corporation: Incorporated in another country.

Public and Private Corporations

• Public Corporation: Formed by government entities for public purposes (e.g., U.S. Postal Service).

• Publicly Held Corporation: Private corporations whose shares are traded publicly.

• Nonprofit Corporations: Formed for purposes other than making a profit (e.g., hospitals, charities).

Close Corporations

• Defined as having shares held by few individuals, often family members.

• Management of close corporations resembles that of a sole proprietorship or partnership, but legal requirements must still be met.

• Issues may arise in share transfer due to management complications.

S Corporations

• Governed by Subchapter S of the Internal Revenue Code with requirements including:

  • Must be a domestic corporation.

  • Cannot be affiliated with other corporations.

  • Limited to 100 shareholders, who must be individuals, estates, or certain trusts.

  • Must have only one class of stock.

  • Nonresident aliens cannot be shareholders.

• Taxation as partnerships allows for pass-through taxation benefits.

Professional Corporations (PCs)

• Established by professionals (e.g., doctors, lawyers) where liability protection from malpractice applies for acts committed by the corporation but not by individual shareholders.

Benefit Corporations

• For-profit entities designed:

  • To produce a positive impact on society and the environment.

  • Shareholders can enforce actions if the corporation fails to pursue its intended public benefit.

  • Required to issue annual transparency reports to shareholders detailing their impact.

Case Example: Fidrych v. Marriott International, Inc. (2020)

• Situation: Bud Fidrych, a South Carolina resident injured at a hotel in Italy, filed a negligence lawsuit.

• Conclusion: Despite being a foreign corporation, Marriott had complied with local law by obtaining a certificate to operate in South Carolina and did not have enough contacts to be considered a domestic entity.

Formation and Powers of Corporations

Incorporation Process

1. Pre-incorporation Activities: Individuals involved are personally liable for contracts made before incorporation until the corporation assumes these contracts.

2. Formal Steps to Incorporation:

   • Selection of incorporation state.

   • Preparation of articles of incorporation, including:

     • Corporate name.

     • Number of authorized shares.

     • Name and address of initial registered agent.

     • Names and addresses of incorporators.

   • Filing the articles with the appropriate state official.

   • First Organizational Meeting: Shareholders adopt articles, elect board members, and set bylaws.

Improper Incorporation

• Challenges to the existence may arise from improper incorporation, leading to potential personal liability for shareholders.

• De Jure Corporations: Existence established by substantial compliance with incorporation laws.

• De Facto Corporations: Protects against challenges if there is legislation providing for valid incorporation, parties attempted compliance in good faith, and conducted business as a corporation.

• Corporation by Estoppel: A corporation may be recognized for contract purposes despite incorporation issues, as seen in Case 19.2: TY Builders II, Inc. v. 55 Day Spa, Inc. (2018).

Corporate Financing

Methods of Financing

• Corporations finance through:

  • Issuing bonds (debt financing).

  • Issuing stock (equity financing).

Types of Capital

• Venture Capital: Funds from investors to support high-risk businesses.

• Private Equity Capital: Investments by private equity firms aiming to purchase and reorganize existing corporations.

• Crowdfunding: Raising capital through public solicitation, allowed by recent SEC rulings to cover smaller companies and safeguard investors.

Corporate Powers

Types of Powers

• Express Powers: Defined in articles of incorporation, state laws, and corporate bylaws.

• Implied Powers: Corporations may conduct acts reasonably appropriate to fulfill corporate purposes, such as entering into contracts or borrowing money. Officers have specific implied powers for operational affairs.

Ultra Vires Doctrine

• Acts that exceed corporation's express and implied powers.

• Typically involve challenges against nonprofit or municipal corporations, allowing shareholders to seek injunctions against ultra vires acts.

Piercing the Corporate Veil

Conditions for Piercing

• Occurs if corporate owners misuse the legal entity for fraud or illegitimate purposes.

• Common reasons:

  • Misleading dealings with individuals rather than the corporation.

  • A corporation created to ensure insolvency or is inadequately capitalized.

  • Failure to adhere to statutory corporate formalities.

  • Commingling personal and corporate assets, blurring the identity of the corporation.

Implications for Close Corporations

• Greater risk of asset misuse for personal gain; practices like commingling funds can lead to piercing the veil.

Case Example: Denny v. Breawick, LLC (2019)

• A close corporation maintained some corporate formalities despite lacking others, and the court did not pierce the corporate veil due to adequate corporate record-keeping, even without formal meetings.

Directors and Officers

Directors

• Responsibilities: Act on behalf of the corporation, overseeing overall management; they hold ultimate authority.

  • Inside Directors: An officer who also serves as a director.

  • Outside Directors: Non-management individuals serving on the board.

• Election: Based on the number stipulated in corporate articles or bylaws, they are compensated for their roles and participate in meetings, adhering to quorum regulations.

Rights of Directors

• Participation: Right to attend and engage in all meetings.

• Inspection: Essential for informed decision-making.

• Indemnification: Right to reimbursement for legal costs if sued.

Officers and Executives

• Hired by the Board of Directors to manage daily operations and execute board policies. The board can terminate officers anytime, with or without cause.

Duties and Liabilities of Directors and Officers

Duty of Care

• Directors are expected to make informed, reasonable decisions and supervise effectively.

• Business Judgment Rule: Provides protection from liability for honest mistakes in judgment when they acted in good faith and had rational bases for their decisions without conflicts of interest.

Duty of Loyalty

• Requires prioritization of corporate interests over personal interests, including:

  • Avoiding competition with the corporation.

  • Not usurping corporate opportunities.

  • Avoiding conflicts of interest or engaging in insider trading.

  • Ensuring fairness for minority shareholders in corporate transactions.

Disclosure of Conflicts of Interest

• Directors must disclose potential conflicts that may arise in transactions.

Liability of Directors and Officers

• They remain liable for their individual criminal acts and torts, as well as those committed by employees under their supervision.

Discussion: Oliveira v. Sugarman (2016)

• The board altered the terms of employee stock awards after performance targets were missed. Shareholders questioned the legality and fidelity of the board's decisions, raising issues regarding fiduciary duties and the business judgment rule.

Group Breakout: Guth v. Loft, Inc. (1939)

• Guth appropriated an opportunity to acquire a trademark for personal gain without the board's knowledge. The court found a violation of the duty of loyalty, emphasizing that it belonged to Loft, Inc.

Shareholders

Powers of Shareholders

• Approval of Changes: Fundamental changes must receive shareholder approval before implementation.

• Voting: Shareholders can vote in person or via proxies, allowing representatives to act on their behalf at meetings.

Shareholder Voting Mechanisms

• Quorum must be present for valid voting. Specific voting requirements may be dictated by state laws.

• Cumulative Voting: Increases representation for minority shareholders on the board.

• Voting Agreements: Groups of shareholders may agree to vote together.

Rights of Shareholders

Key Rights

• Stock Certificates: Represent ownership of shares.

• Preemptive Rights: Right to purchase new stock before others can to maintain ownership ratio.

• Dividends: Must be declared and can lead to liability if improperly distributed.

• Inspection Rights: Shareholders can examine corporate records with proper notice.

Transfer of Shares

• Generally unrestricted but can have restrictions, especially in close corporations.

Shareholder Derivative Suit

• Lawsuit by shareholders on behalf of the corporation against third parties for wrongs against the corporation, with recovery going to the corporation's funds after a written demand is made. This reflects the guardianship role of shareholders.

Duties of Majority Shareholders

• Majority shareholders may owe fiduciary duties to minority shareholders, including valuation requests and the payment of dividends. In specific cases, breaches of duty can lead to litigation by minority shareholders.

Comparison of Major Business Forms (Exhibit 19-2)

• Forms Include: Sole Proprietorship, Partnership, Corporation, Limited Partnership, Limited Liability Company, Limited Liability Partnership.

Conclusion

• Through this chapter, students will learn to identify corporate classifications, understand corporate formation processes, clarify the roles and duties of corporate officers and directors, recognize liability protections for involved parties, and summarize shareholders' rights and protections.

Knowledge Check and Discussion

• Engage with questions on shareholder voting, corporate powers, fiduciary duties, and the impact of business decisions as they relate to real-life scenarios.

Self-Assessment and Review

• Reflect on the understanding of corporate structures and responsibilities, the applicability of this knowledge in personal or professional contexts, and strategies for improving class contributions.