Corporations
Spring 2004 – Professor McGovern
Chapter 1: Introduction
·
Four basic
attributes of a corporation:
o
(1) Separate
entity with perpetual existence
o
(2) Limited liability
o
(3) Centralized
management
o
(4)
Transferability of ownership interests
Chapter 2: Introduction to the Economics of the Firm
·
Business Risks
o
Two categories:
§
(1)
Non-controllable
·
The weather,
the state of the economy, the level of interest rates, market prices, etc
·
They cannot be
completely eliminated
·
Ways to limit
non-controllable risks
o
(1) They could
pool the cost of these risks with others who also bear them – by purchasing
insurance, for example
o
(2) To
participate in numerous ventures, each involving risks different from the
others
o
(3) To allocate
the burden (and benefits) of the risk to the person most willing to bear it –
which may well turn on who is in a better position to insure or diversify
§
(2)
Controllable
·
Relates to the
specific business: its competitive position, its product line, the quality of
its management, the adequacy of its physical plant, etc
·
Are those which
the parties, by acting or not acting, can affect
·
Shirking – When
a person does less than is optimal to control a risk
·
Moral hazard –
The danger that a person who does not bear a risk will not take steps to control
that risk
·
To avoid the
agent’s self-interested shirking, the principal must monitor the agent to
ensure that he takes risk reducing precautions
o
Risk Preference
§
(1) Risk
Neutral
·
Make decisions
based solely on expected returns (the sum of each possible return multiplied by
the probability of that return)
§
(2) Risk Averse
·
A risk averse
person takes the magnitude of risk (along with expected return) into account
when making a decision
§
Risk Premium –
How much a risk avoider would pay to obtain certainty
§
(3) Risk Loving
·
Takes the
magnitude of risk (along with the expected return) into account
·
Allocating
Business Risks Within the Firm
o
Allocating
risks to the principal
o
Allocating
risks to the agent
o
Searching for a
middle ground
·
The Role of Law
in Allocating Business Risks
o
Mandatory and
Default Rules
§
Defaults
specify the parties’ relationship, unless they provide otherwise.
§
Enabling rules
·
The parties can
take them or not
·
Significantly
lower the costs of entering into a firm relationship by providing the rules
that the parties presumably would have identified and negotiated for themselves
o
Types of
Default Rules
§
Majoritarian
defaults
·
Rules that most
similarly situated parties would likely have bargained for
·
Bright line
standards that specify the parties’ relationship from an ex ante prospective
·
Seek to provide
an efficient result in common situations
§
Tailored
defaults
·
Rules meant to
give parties what they would have chosen had they bargained
§
Penalty rules
·
Rules to which
the parties probably would not have agreed had they actually bargained
·
By imposing a
penalty on one of the parties, the rule motivates that party to bargain for a
party specific solution
Chapter 3: An Introduction to the Law of
Corporations
·
Some Basic
Terms and Concepts
o
1. Corporate
statutes
o
2. Judge-made
corporate law
o
3. Corporate
choice of law
§
The
relationships between owners and managers are governed by the corporate
statutes and case law of the state where the corporation is incorporated
§
Choice of law
rule, also known as the internal affairs doctrine
o
4. Organic
documents
§
Articles of
incorporation
·
Sometimes
called the charter of the certificate of incorporation
·
Must be filed
with state officials and represents the constitution of the corporation
§
Bylaws
·
Set forth the
details of the corporation’s internal governance arrangements, such as
procedures for calling and holding meetings
§
A corporation’s
articles cannot conflict with the statute under which the corporation is
organized, and a corporation’s bylaws cannot conflict with the statute or the
articles.
o
5. The
corporate actors
§
Stockholders or
shareholders – Own the corporation
§
Board of
directors – Responsible for managing or supervising the corporation’s business
·
Inside
directors – Individuals who are corporate employees and affiliates
·
Outside
directors – Individuals who generally have no other affiliation with the
corporation
·
When directors
act in their capacity as directors, they are supposed to represent the
interests of the corporation and are not considered employees of the
corporation.
o
6. Corporate
securities
§
Common stock
§
Preferred stock
·
Represent
financial rights with certain priorities over the common stock
§
The
corporation’s articles of incorporation specify how many shares of common and
preferred stock the corporation is authorized to issue
§
More stock can
be issued only if the articles are amended
§
The portion of
the authorized stock that has been sold and remains in the hands of
stockholders is the stock outstanding
§
A corporation’s
board of directors generally is free to sell authorized, but unissued stock on
whatever terms it decides are reasonable
§
Equity security
·
Relates to the
stockholders’ position at the end of the line when it comes to distributions of
corporate funds
·
(1) Debt
securities – Represent claims on a corporation’s assets that have priority over
the claims represented by equity securities
·
(2) Debt
securities – Include bonds, debentures and notes
o
7. Fiduciary
principles
§
The basic
fiduciary duties that officers and directors owe to the corporation are the
duty of care and the duty of loyalty
§
Business
judgment rule – A rule of abstention under which courts defer to the judgment
of the board of directors absent highly unusual circumstances, such as a
conflict of interest of gross inattention.
o
8. Litigation
by shareholders
§
Corporate
managers who breach their fiduciary duties can be held liable for any losses
they cause the corporation
§
Derivative suit
·
An action in
equity brought by a shareholder on behalf of the corporation
·
The action is
brought against the corporation for failure to bring an action in law against
some third party, most often a careless or unfaithful manager
·
The corporation
is a nominal defendant and the plaintiff-shareholder controls prosecution of
the suit
·
Any recovery
belongs to the corporation for whose benefit the suit has been brought
o
Bayer v.
Beran
§
The fiduciary
must subordinate his individual and private interests to his duty to the
corporation whenever the two conflict.
§
The court must
determine whether the action of the directors was intended or calculated to
subserve some outside purpose, regardless of the consequences to the company,
and in a manner inconsistent with its interests
o
Note: The
Business Judgment Rule
§
Creates a
presumption that, absent evidence of self-dealing or the directors not being
reasonably informed, all board decisions are intended to advance the interest
of the corporation and its shareholders
§
Courts will not
entertain shareholder suits that challenge the wisdom of such decisions
§
Implements the
basic corporate attribute of centralized management by insulating the board’s
decision-making prerogatives from shareholder (and judicial) second guessing
o
Gamble v.
Queens County Water Co
§
A shareholder
has a legal right at a meeting of the shareholders to vote upon a measure, even
though he has a personal interest therein separate from other shareholders
§
In such a
meeting, each shareholder represents himself and his own interests solely, and
he in no sense acts as a trustee or representative of others
§
The general
rule is that the will of the majority shall govern
·
Equitable
Limitations on Corporate Actions
o
Schnell v.
Chris-Craft Industries Inc
§
When the bylaws
of a corporation designate the date of the annual meeting of stockholders, it
is to be expected that those who intended to contest the reelection of incumbent
management will gear their campaign to the bylaw date. It is not to be expected that management will
attempt to advance that date in order to obtain an inequitable advantage in the
contest
§
Inequitable
action does not become permissible simply because it is legally possible
·
Choice of the
State of
o
A small
corporation will usually incorporate in the state in which it will conduct most
of its business
o
A business can
choose to incorporate under the laws of whatever state best suits its needs
o
It can
reincorporate in another state if subsequent needs are better served by the
laws of the other state
o
Internal
affairs doctrine - The law of the state of incorporation governs the internal
affairs of the corporation
§
Means that
relationships between shareholders and managers will be governed by the
corporate statutes and case law of the state where the corporation is
incorporated
o
The external
affairs of a corporation are generally governed by the law of the place where
the activities occur and by federal and state regulatory statutes rather than
by the place of incorporation
Chapter 5: The Corporation and Society
·
Corporate
Social Responsibility Trends
o
Dodge v.
Ford Motor Co
o
Comment
§
The business
corporation is an instrument through which capital is assembled for the
activities of producing and distributing goods and services and making
investments.
§
A business
corporation should have as its objective the conduct of such activities with a
view to enhancing corporate profit and shareholder gain – this is known as the
“economic objective”
§
The corporation
is a social as well as an economic institution, and accordingly that its
pursuit of the economic objective must be constrained by social imperatives and
may be qualified by social needs.
o
Corporate
Charitable Contributions and Social Responsibility
§
Theodora
Holding Corp v.
·
The test to be
applied in passing on the validity of a gift is that of reasonableness
§
Kahn v.
Sullivan
·
The test to be
applied in examining the merits of a claim alleging corporate waste is that of
reasonableness, a test in which the provisions of the IRS Code pertaining to
charitable gifts by corporations furnish a helpful guide
Chapter 6: The Choice of Organizational Form
·
Introduction
o
Three primary
forms of business organizations available to joint owners: the partnership, the
corporation, and the limited liability company
o
A general
partnership is an entity in which all the participants have unlimited
liability, an equal voice in management, and the authority to act as agents for
the partnership and incur obligations that will bind all the partners
o
A corporation
is based upon principles of centralized management and limited liability for
the participants
o
A partnership
can be a limited partnership, a limited liability partnership (LLP), or a
limited liability limited partnership (LLLP)
o
Partnership –
an association of two or more persons to carry on as co-owners a business for
profit
o
In a general
partnership, each partner possess an equal voice in management and the authority
to act as agent for the partnership
o
In a limited
partnership, a limited partner has no voice in the active management of the
partnership, which is conducted by the general partner
o
In a general
partnership, each partner can be held personally liable for all debts of the
partnership, as well as for torts committed by other partners within the course
of the partnership’s business
o
In a limited
partnership, the general partners have comparable liability but a limited
partner’s liability is limited to the capital she has contributed to the
partnership
o
Most statutes
provide that by electing to operate as an LLP or LLLP, a general partner can
limit her liability to whatever amount she has invested, subject to the caveat
that she can be held personally liable for tortuous conduct for which she or
employees operating under her supervision is responsible
o
A corporation
is a legal entity distinct from its owners
o
The management
of the corporation is centralized in a board of directors
o
Shareholders’
liability is limited to whatever amounts they have agreed to contribute to the
corporation and does not extend to any debts of or liabilities incurred by the
corporation
o
An LLC is a
legal entity distinct from its owners, who are called members
o
Members, like
shareholders receive the benefits of limited liability
o
Management
arrangements generally are specified in an operating agreement and can involve
either decentralized member management or centralized manager management
o
An LLC can also
elect to be taxed as a partnership – which attribute makes the LLC an
attractive choice in a variety of business settings
·
Non-Tax Aspects
o
Formation
§
Forming a
corporation requires formal action with the state
·
In order to
incorporate, the person creating the corporation, or incorporators, must file
articles of incorporation containing certain information about the company and
its incorporators, such as the corporate name, the number of authorized shares,
and the name and address of each incorporator
§
Forming a
general partnership requires no filing with the state
§
A partnership
also may be created by operation of law
§
A limited
partnership requires the filing with the state of a certificate setting forth
the rights and duties of the partners among themselves and identifying the
general partners
§
The formation
of an LLC also requires the filing of articles of organization, which must
include the name of the LLC and the address of its registered agent, with the
appropriate state agency
§
The members
enter into an operating agreement that sets forth the members’ rights and
duties
o
Limited
Liability
§
There are three
major exceptions to shareholder limited liability
§
Shareholders
will be personally liable (1) where the corporation is not properly formed, (2)
for unpaid capital contributions that they have agreed to make, and (3) where
the veil of limited liability is pierced
§
A general
partnership differs from a corporation in that the partners, as individuals,
can be held liable for all unpaid obligations of the partnership
§
Partners’
liability for the torts of the partnership is joint and several, while
partners’ liability for the partnership’s contractual obligations is only joint
§
Each partner
has the power to bind the partnership
§
In limited
partnerships, the general partners dace the same unlimited liability as
partners in a general partnership
·
But it is
limited to the amount of their investment in the partnership, so long as they
do not participate in the management of the partnership
§
An LLP is
liable for all tort and contract obligations that arise in the ordinary course
of the LLP’s business
·
A general
partner in an LLP can be held personally liable only for partnership
obligations that arise as a consequence of the wrongful or negligent acts
committed by that partner or an employee under her supervision
§
All LLC
statutes limit the liability of the entity’s members and managers for all of
its obligations
o
Management and
Control
§
The management
of a corporation is centralized in its board of directors
§
In a general
partnership, absent provisions in the partnership agreement, responsibility for
management is vested in all the partners
·
Each partner
has an equal voice, regardless of the amount of her capital contribution
·
Decisions are
generally made on the basis of a majority vote of the partners, but major
changes require unanimous consent of all partners
·
Many
partnership agreements provide that a partner’s voice in management will be in
proportion to her capital contribution
·
Some
partnership agreements assign exclusive responsibility for managing various
aspects of the partnership’s business to one partner or a committee of partners
§
In a limited
partnership, the limited partners may nor participate in the management of the
business without losing the protection of limited liability
§
An LLC can be
either member managed or manager managed
·
In a member
managed LLC, all members have the authority to make management decisions and to
act as agents for the LLC
·
IN a manager
managed LLC, members are not agents of the entity and make only major decisions
– the managers, who do not have to be members, make most ordinary business
decisions and have the authority to act as agents
·
The basic
document controlling management of an LLC is its operating agreement
·
If there is
conflict between provisions of the articles of organization of an LLC and its
operating agreement, the operating agreement usually governs, reflecting the
explicitly contractual nature of the LLC
o
Continuity of
Existence
§
A general
partnership is dissolved upon the death, bankruptcy or withdrawal of a partner
·
Most
partnership agreements provide that, upon the death of a partner, the surviving
partners will continue the business and pay the estate of the deceased partner
the value of her partnerships interest
·
A partner may
withdraw at any time and thereby dissolve the partnership, even if that act
violates a provision of the partnership agreement
·
If a partner
causes the dissolution of the firm in contravention of the partnership
agreement, that partner is subject to various penalties
·
The other
partners also have the option of continuing the partnership’s business without
the consent or participation of the partner causing the dissolution, and of
buying out that partner’s interest
§
The business of
a limited partnership generally continues upon the death, bankruptcy or
voluntary withdrawal of a limited partner, but the limited partnership
agreement must specify the latest date upon which the partnership must be
dissolved
o
Transferability
of Interests
o
Financing
Matters
§
The sole method
by which a general partnership can raise equity capital is to create new
partnership interests
·
Planning
Considerations
o
Balancing
Ownership Interests
o
The Economics
of the Choice
·
The Tax
Consequences of the Choice: A Brief Examination
o
Partnership vs.
Corporation
o
S Corporations
§
An S
corporation is a corporation that has elected the tax treatment specified in
Subchapter S of the IRS Code
§
It pays no tax
itself, rather, its income is attributed to its shareholder, whether or not it
is distributed to them
§
The
shareholders then add their shares of the S corporation’s income to their
individual incomes and pay tax at the rates applicable to individuals
§
Operation of an
S Corporation
·
To qualify for
Subchapter S treatment, a corporation must be a domestic corporation with no
more than 75 shareholders
·
The corporation
can have only one class of stock, although shares that have different voting
rights may be treated as part of the same class if they are otherwise alike
·
All the
shareholders of the corporation must consent to its decision to elect
Subchapter S treatment for that election to be valid
§
Termination of
a Subchapter S Election
·
A Subchapter S
election terminates if over any three year period more than 25% of the
corporation’s gross receipts constitute passive investment income
·
It will also
terminate if the number of shareholders exceeds 75, or if any of the
shareholders are nonresident aliens, or are not an individual, estate, or
qualified trust
·
If a second
class of stock is issued, the election will also be terminated
·
Can also be
revoked by the holders of a majority of a corporation’s stock
·
Once a
Subchapter S election is terminated or revoked, a corporation cannot make
another election before the 5th taxable year
Chapter 7: Forming the Corporation
·
Lawyers’
Professional Responsibilities: Who is the Client?
o
Model Rules
§
1.6 –
Confidentiality of Information
§
1.7 – Conflict
of Interest: Current Clients
§
1.13 –
Organization as Client
o
Entity Theory
of Representation
§