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
§
Jesse By
Reinecke v. Danforth
·
The entity rule
contemplates that where a lawyer represents a corporation, the client is the
corporation, not the corporation’s constituents
·
The clear
purpose of the entity rule was to enhance the corporate lawyer’s ability to
represent the best interests of the corporation without automatically having
the additional and potentially conflicting burden of representing the
corporation’s constituents
·
If a person who
retains a lawyer for the purpose of organizing an entity is considered the
client, however, then any subsequent representation of the corporate entity by
the very lawyer who incorporated the entity would automatically result in dual
representation.
·
RULE: Where (1)
a person retains a lawyer for the purpose of organizing an entity and (2) the
lawyer’s involvement with that person is directly related to that incorporation
and (3) such entity is eventually incorporated, the entity rule applies
retroactively such that the lawyer’s pre-incorporation involvement with the
person is deemed to be representation of the entity, not the person.
·
Where the
person who retained the lawyer provides information to the lawyer not directly
related to the purpose of organizing an entity, then it is the person, not the
corporation which holds the privilege for that communication.
§
State Bar of
·
Can a lawyer
represent an entity that does not yet exist?
o
Yes, as long as
the incorporators understand that they are retaining counsel on behalf of the
yet to be formed entity and will need to ratify this corporate action once the
entity is formed.
o
Two views:
§
(1) A lawyer
hired to form an entity can represent the to be formed entity, not the
incorporators, and the entity rule applies retroactively
§
(2) Aggregate
theory – The lawyer is found to represent the incorporators/constituents
collectively as joint clients
·
A lawyer
represents multiple co-clients during formation of the corporationa nd then
once the entity is formed,t he clients must determine whether the lawyer will
continue to represent all of the constituents and the entity, or just the
entity.
·
Who a lawyer
may represent depends upon whether the lawyer’s independent professional
judgment would be materially limited because of the lawyer’s duties to another
client of third person.
·
Can a lawyer
represent only the yet to be formed entity and not the constituents?
o
Who a lawyer
represents depends upon the reasonable perceptions of those who have consulted
with the lawyer
o
When to or more
individuals consult with a lawyer about forming an entity, it is the
responsibility of the lawyer at that initial meeting to clarify who the lawyer
will represent
·
What
disclosures should a lawyer make to the incorporating constituents to obtain
their informed consent to the limited representation of the entity?
o
Loyalty to
clients
o
It is crucial
for lawyers to specify exactly who they represent, who they do not represent,
and how information conveyed to the lawyer by constituents of an entity client
will be treated, for confidentiality purposes
§
The Reasonable
Expectations Test
·
Under this
test, if an attorney leads an individual or entity to believe that they are a
client and the belief is reasonable under the circumstances, and attorney
client relationship will be created, whether or not the client pays the
attorney any money or enters into a formal retainer agreement
·
The Process of
Incorporation
o
The
organization is formally accomplished by an incorporator who, after
incorporation, usually plays no other role in the corporation
o
The
incorporator signs and files the articles of incorporation with the Secretary
of State
o
What is
required in the articles of incorporation: the name of the corporation, the
number of shares it is authorized to issue, the name and address of each
incorporator and the name and address of the corporation’s registered office
and registered agent
o
After the
corporation has come into legal existence, the statute requires that an
organizational meeting be held, either by the incorporators, who select the
first members of the board of directors, or, where the initial board is names
in the articles of incorporation, by the board members so named.
o
At its first
meeting, the board accomplishes a number of standard tasks, including the
election of additional directors, if any; the adoption of bylaws; the
appointment of officers; the adoption of a corporate seal; the designation of a
bank as a depository for corporate funds; and often the sale of stock to the
initial shareholders
o
Choice of the
State of
§
If the company
will conduct its business primarily in a single state, incorporating in that
state will reduce filing, reporting and tax burdens
§
If, however, a
company intends to operate in more than one state, it may be required to
qualify to do business as a foreign corporation in other jurisdictions
§
Some of the
other factors to be considered in deciding where to incorporate are the
organization tax rates and the franchise tax rates; the ease of operation of
the corporation; the regulation of the sale of stock and the payment of
dividends; the existence of specific provisions for a close corporations; and
the possible liability of shareholders for wages
·
Ultra Vires
o
“Beyond the
power” – Common law doctrine
o
Under this
doctrine, a corporation could not engage in activities outside the scope of its
defined purposes
o
Attorneys can
circumvent this doctrine by drafting the articles of incorporation in broad
terms
o
Statutes
typically provide that every corporation under this act has the purpose of
engaging in any lawful business unless a more limited purpose is set forth in
the articles of incorporation
·
Defective
Incorporation
o
Courts
developed the concept that the business association could be a “de facto”
corporation, even if it was not a corporation “de jure”
o
Courts also
developed the concept of corporation by estoppel to achieve results deemed just
where the de facto corporation doctrine could not be used
o
The MBCA
imposes liability only on those persons who act as or on behalf of a
corporation knowing that no corporation actually exists
o
If some steps
have been taken to bring about the corporation, liability will not be imposed
on the parties who do not know that the steps to achieve corporateness were not
completed
·
Pre-Incorporation
Activities of Promoters
o
As a general
rule, when a promoter contracts for the benefit of a corporation which is
contemplated but has not been organized, she is personally liable on the contract
in the absence of an agreement to the contrary
o
Furthermore,
she is not discharged from liability simply because the corporation is later
organized and receives the benefits of the contract, even where the corporation
adopts the contract
o
However, the
parties may expressly agree to discharge the liability of the promoter
o
Pre-incorporation
contracts may not expressly address promoter liability
o
Thus, the
intentions of the parties, as determined from the contract and the facts and
circumstances of the parties’ dealings, determine whether the promoter is
personally liable
o
Factors used in
analyzing whether a promoter will be held liable for a pre-incorporation
contract include:
§
(1) Form of
signature – did the promoter sign as an agent of the corporation?
§
(2) Action of
seller – Did the seller intend to look only to the corporation for payment?
§
(3) Partial
performance – Did the promoter’s partial performance of the contract indicate
an intent to be held personally liable?
§
(4) Novation –
Did action taken by the parties discharge the promoter’s liability?
·
A novation is a
three-party arrangement in which a new corporation assumes all of a promoter’s
rights and liabilities under a pre-incorporation contract thereby discharging
the promoter
§
The intention
of the contracting parties is the principal focus of judicial opinions on the
question of promoter liability
o
Restatement
§326 – Unless otherwise agreed, a person who, in dealing with another, purports
to act as agent for a principal whom both know to be non-existent or wholly
incompetent, becomes a party to such contract.
o
The third
party’s intentions are also a factor to be considered.
Chapter 8: An Introduction to Financial Accounting
and Valuation
·
Introduction to
Accounting Principles
o
Two basic
financial statements are the balance sheet and the income statement
o
Balance sheet
§
The “snapshot”
§
Presents a
picture of the firm at some given moment, listing all property it owns (its
assets), all amounts it owes (its liabilities), and the value, at least
conceptually, of the owners’ interest in fhr form (its equity)
o
Income
statement
§
The “motion
picture”
§
Presents a
picture of the results of the firm’s operations during the period between the
dates of successive balance sheets
o
Financial
statements are produced through a three-stage process
§
1. A company
records in its books information concerning every transaction in which it is
involved – the recording and controls state
§
2. The company
verifies the accuracy of the information it has recorded – the audit stage
§
3. The company
classifies and analyzes the audited information and presents it in a set of
financial statements – the accounting stage
o
MBCA §16.20
requires corporations to furnish their shareholders with annual balance sheets
and income statements, but allows corporations to decide what accounting
principles to use when preparing those statements
o
Most firms use
generally accepted accounting principles, or GAAP
o
Assumptions and
Principles – Page 202-03
§
Separate entity
assumption
§
Continuity
assumption
§
Unit of measure
assumption
§
Time period
assumption
§
Cost principle
§
Consistency
principle
§
Full disclosure
principle
§
Modifying
principles
o
The goals of
the accounting process include presenting information about a firm’s financial
position and the results of its operations that (i) is as accurate as possible,
(ii) is as reliable as possible, and (iii) can be prepared at reasonable cost
·
The Fundamental
Equation
o
Assets =
Liabilities + Equity
o
Assets – Refers
to property, both tangible and intangible, owned by the reporting firm
o
Liabilities –
Refers to the amounts that firm owes to others, whether pursuant to written
evidence of indebtedness or otherwise
o
Equity –
Represents the accounting value of the interest of the firm’s owners
§
Initially
includes the value of the property (including money) the owners contribute when
they organize the firm
§
Since the
owners bear the risk of the firm’s operations, equity increases thereafter
whenever the firm earns a profit and decreases when it incurs a loss
§
Equity also
increases whenever they withdraw property from it
§
Equity reflects
the value of the owner’s residual interest, assuming that all assets could be
sold for their balance sheet values and that all liabilities will be paid in
full
·
Financial
Statement Terms and Concepts
o
Realization
Principle – A firm must recognize revenue in the period that services are
rendered or goods are shipped, even if payment is not received in that period
o
Matching
Principle – A firm must allocate to the period in which revenues are recognized
the expenses it incurred to generate those revenues
o
Third financial
statement:
§
Statement of
Cash Flows
·
A firm must use
cash, not income, to pay its bills, repay its debts, and make distributions to
its owners
·
Cash, not
income, must be on hand when the firm needs it
·
The statement
of cash flows reports on the movement of cash into and out of a firm
·
The statement
reflects all transactions that involve the receipt or disbursement of cash,
whether they relate to operations or involve only balance sheet accounts such
as purchases of plant and equipment, new borrowings, repayment of loans, equity
investments, or distributions to equity holders.
o
Balance Sheet
Terms and Concepts
§
1. Assets – Are
listed in the balance sheet in the order of their liquidity, beginning with
cash, followed by assets that the firm expects to convert to cash in the
reasonable near future, and continuing to other assets, such as plant and
equipment, that the firm uses in its business.
·
A. Current
assets – Include cash and other assets which in the normal course of business will
be converted into cash in the reasonable near future, generally within one year
of the date of the balance sheet
o
1. Cash – Is
money in the till and money in demand deposits in the bank
o
2. Marketable
securities – Are securities purchased with cash not needed for current
operations
o
3. Accounts
receivable – Are amounts not yet collected from customers to whom goods have
been shipped or services delivered (GAAP required that accounts receivable be
adjusted by deducting an allowance for bad debts)
§
Notes or loans
receivable – Are somewhat analogous to accounts receivable. The usually represent a very large portion of
the assets of firms engaged in financing businesses.
o
4. Inventory –
Represents goods held for use in production or for sale to customers
§
GAAP require
inventory to be valued at the lower of cost or markey
§
Items sold from
inventory, called cost of goods sold, often represent a firm’s largest single
expense
§
Firms that hold
a relatively small number of identifiable items in inventory often use the specific
identification method
§
To computer
cost of goods sold, firms add their purchases during a reporting period to the
value of their inventory at the start of the period (called opening inventory)
and the subtracts the value of their closing inventory.
§
The firm can
then use one of three methods to value its closing inventory:
·
Average cost
method – Which visualizes inventory as sold at random from a bin
·
First in, first
out method – Which visualizes inventory as flowing through a pipeline
·
Last in, first
out method – Which visualizes inventory as being added to and sold from the top
of a stack
o
5. Prepaid
expenses – Are payments a firm has made in advance for services it will receive
in the coming year, such as the value of ten months of on-year insurance policy
that a firm purchased and paid for two months before the year ended
§
Deferred
charges – Represent a type of asset similar to prepaid expenses, in that they
reflect payments made in the current period for goods or services that will
generate income in subsequent periods, such as advertising to introduce a new
product
·
B. Fixed assets
– Sometimes referred to as property, plant and equipment, are the assets a firm
uses to conduct its operations (as opposed to assets it holds for sale)
o
Depreciation
expense
o
Allowance for
depreciation or accumulated depreciation
·
C. Intangible
assets – Have no physical existence, but often have substantial value – a cable
TV franchise granting a company the exclusive right to service certain areas,
or a patent or trade name, etc
o
Amortization –
The equivalent of depreciation, applied to intangibles
o
Goodwill
§
2. Liabilities
– Usually are divided into current liabilities and long-term liabilities
·
A. Current
liabilities – Are the debts a firm owes that must be paid within one year of the
balance sheet date.
·
B. Long-term
liabilities – Are debts due more than one year from the balance sheet date
o
Off balance
sheet financing – Transactions that involve long-term financial obligations,
but which, because of their form, are not recorded as liabilities on the
balance sheet
o
Contingent
liabilities
§
3. Equity –
Represents the owner’s interest in a firm
·
Also referred
to as its net worth
·
Par or stated
value
·
Stated capital
·
Paid-in capital
·
Retained
earnings or earned surplus – Reflects the cumulative results of the
corporation’s operations over the period since it was formed
·
Dividends – Or
any amounts the corporation has paid to repurchase its stock
Chapter 9: Financial Structure of the Corporation
·
Corporate
Securities
o
Introduction
§
Corporate
securities can be divided into two broad categories: equity securities and debt
securities
§
Equity
securities
·
Represent more
or less permanent commitments of capital to a corporation
·
Returns on
equity securities are generally contingent on the corporation earning a profit
and the right of holders of equity securities to share in the corporation’s
assets in the event of liquidation are subordinated to the claims of creditors,
including those who hold the corporation’s debt securities
·
Holders of
equity securities typically elect the corporation’s board of directors and thus
exert more control over the conduct of the corporation’s business and the risks
it incurs
§
Debt securities
·
Represent
capital invested for a limited period of time
·
Holders of debt
securities bear less risk, their claims are fixed, as is their right to be
repaid their capital at some fixed future date
·
Debtholders can
secure their rights by placing liens on some or all of a corporation’s assets
or by negotiating contractual covenants restricting the corporation’s
operations
·
Debtholders
ordinarily play no role in the management of the firm
o
Equity
Securities
§
Two kinds:
Common stock and Preferred Stock
§
Corporate
statutes require that at least one class of security must have voting rights
and the right to receive the net assets of the corporation in the event the
corporation is dissolved or liquidated.
These rights are usually assigned to common stock.
§
Common Stock
·
The most basic
of all corporate securities
·
Holders of
common stock usually have the exclusive power to elect a corporation’s board of
directors, although in some corporations one or more classes of common stock is
non-voting and in many corporations preferred stock has limited voting rights
·
Common stock
represents a residual claim on both the current income and the assets of the a
corporation
·
All income that
remains after a corporation has satisfied the claims of creditors and holders
of its more senior securities – debt and preferred stock – belongs, in a
conceptual sense, to the holders of common stock
·
If no income
remains, shareholders receive nothing
·
If some income
does remain, the board of directors can distribute it to shareholders, in the
form of a dividend, or can reinvest it in the business
·
The board
should reinvest income only if it believes that the future returns from the
investment will be greater than those that shareholders could generate by
reinvesting that income on their own
·
If the
corporation is liquidated, common stock also represents a residual claim in
that the corporation’s assets first must be used to pay the claims of creditors
and holders of preferred stock
·
Holders of
common stock receive whatever remains
·
Holders of
common stock are the first to lose their investment if the corporation
experiences economic difficulties and have the greatest potential for gain if
the corporation is successful
·
Holders of
common stock, if they wish to exit a firm, generally do so by selling their
stock to other investors, who buy it at a price that reflects the firm’s
current value
·
Holders of common
stock are first in line with respect to control
·
They often have
the exclusive right to elect the board of directors and to vote on other
matters that require shareholders’ approval
·
Holders of
common stock also are the primary beneficiaries of the fiduciary duties that
corporate law imposes on the board of directors
§
Preferred Stock
·
Stock is
classified as preferred stock when the articles of incorporation assign to it
economic rights senior to those customarily assigned to common stock
·
If no attribute
is assigned to a class of stock with respect to its voting rights, right to
dividends, or right to redemption or in liquidation, courts generally will
presume that stock is stock – that stock with certain preferences otherwise has
the same rights as does common stock
·
Preferred stock
almost always have dividend rights senior to those of common stock
·
The seniority
of preferred stock arises out of provisions limiting the payment of dividends
on common stock until dividends due on preferred stock have been aid
·
A preferred
stock’s dividend preference usually will be stated as a fixed amount that must
be paid annually or quarterly
·
The preference
may expire if a dividend due for a given period is not paid or it may be
cumulative – meaning that if a dividend is not paid when due, the right to
receive that dividend accumulates and all accrued dividend arrearages must be
paid before any dividends can be paid on common stock
·
Preferred stock
also may be participating
o
Such preferred
stock will receive dividends whenever they are paid on common stock, either in
the same amount as or as a multiple of the amount paid on common stock
·
Preferred stock
often has a preference on liquidation, generally stated as a right to receive a
specified amount before any amounts are distributed with respect to common
stock
·
The amount of
this preference most often is the amount that the corporation received when it
sold the preferred stock plus, in the case of cumulative preferred, any
accumulated dividends
·
The preferred
stock’s equity of redemption is subordinate tot eh claims of creditors
·
The amount for
which stock is to be redeemed generally is equal to the preference to which it
is entitled in the event of liquidation, although it is not uncommon to provide
that, when stock can be redeemed by the corporation, some premium must be paid
·
Preferred stock
can have voting rights, and will be deemed to have voting rights equal to those
of common stock unless the articles of incorporation provide otherwise
·
But the voting
rights of preferred stock often are limited to specified issues and
circumstances
·
Preferred stock
usually has a statutory right to vote on changes in the corporate structure
that affect adversely its right and preferences
·
Preferred stock
often is given the right to elect some or all of a corporation’s directors if
dividends due on such stock are not paid for some designated period
·
Right to
convert preferred stock into common stock at some specified ratio, the right to
vote on certain transactions, or the right to require the corporation to redeem
preferred stock if and when specified events should occur
o
These rights
are essentially contractual in nature and must be spelled out in the articles
of incorporation
·
Corporations
often sell preferred stock in lieu of debt
o
The price at
which a company can sell preferred stock is influenced by factors similar to
those that determine the price at which it can borrow – the dividend rate, the
redemption features, whether the preferred can be converted into common stock,
and, if so, at what price
·
Blank check
preferred stock – can be set by the board of directors at the time the stock is
sold
o
Debt Securities
§
Usually
denominated as bonds or debentures – represent liabilities of a corporation
§
They constitute
a part of a corporation’s long-term capital structure
§
Bonds differ
from debentures in that bonds are secured by a mortgage on corporate assets,
whereas debentures are backed only by the general credit of the corporation
§
Bonds also
generally have longer maturities than debentures
§
The terms of a
bond usually are fixed by a complex contract known as an indenture
§
It is
fundamental that the debt contract set forth a fixed obligation to repay a
fixed amount of principal on a particular date
§
The instrument
should also require that interest in a fixed amount be paid at periodic
intervals
§
A corporation
that fails to pay interest on a bond when due will be in default
§
If a bond is
secured, the best contract also must specify the terms of the security
arrangement
§
Covenants or
negative covenants require the borrower to refrain from taking certain actions
that might jeopardize the position of the bondholders
§
Bonds may be
made redeemable or callable at a fixed price at the option of the borrower
§
Bonds usually
do not carry the right to vote
§
A borrower
corporation’s directors owe bondholders only such obligations as are spelled
out int eh debt contract
§
Their interests
are protected only to the extent that they have negotiated appropriate
covenants as part of their debt contracts
§
A corporation’s
board of directors has the authority to issue debt securities without
shareholder approval
o
Designating a
Corporation’s Capital Structure
§
Tax
Considerations
·
The IRS
provides a corporation with a powerful incentive to rely as heavily as possible
on debt financing
·
It allows
corporations to deduct from their taxable income all interest paid on bonds
they have issued, but does not allow the deduction of dividends paid on
preferred or common stock
§
Leverage and
the Allocation of Risk
·
A corporation
will find it profitable to finance business activities with borrowed money
whenever it can earn more income from those activities than it will pay in
interest on the borrowed money – this is known as leverage
·
Leverage also
increases the shareholders’ risk
o
If a
corporation earns less from the activities being financed than the interest on
the borrowed money, the corporation’s income will decline because the
corporation must then pay interest on the borrowed funds whether or not the
investment they financed proved to be profitable
o
If a
corporation is not confident that leverage will work to its advantage, it often
will choose to issue new equity rather than rely on borrowed money to finance
its activities
§
Equity-Linked
Investors v.
§
Whether an
instrument is classified as equity or debt – factors on page 452
·
Authorization
and Issuance of Equity Securities
o
Authorized
shares – Are those shares of stock created by an appropriate clause in the
articles of incorporation
o
Until shares
are first sold to stockholders, they are authorized but unissued
o
When sold, they
are authorized and issued or authorized and outstanding
o
If they are
repurchased by the corporation, they become authorized and issued, but not
outstanding
o
Shares that are
authorized and issued, but not outstanding are commonly referred to as treasury
shares
o
The statutes
require that the articles of incorporation include the number of shares that a
corporation is authorized to issue and describe certain characteristics of
those shares
o
Before a
corporation that has issued all the shares authorized in its articles of
incorporation can issue more stock, it must amend the articles of incorporation
to authorize additional shares
o
The board of
directors must recommend the amendment, which must then be approved by holders
of at least a majority of its outstanding stock
o
However, if a
corporation has not issued all the shares authorized in its articles of
incorporation, then its board of directors ordinarily has the authority to
decide on what terms to issue authorized but not yet issued shares
o
If a
corporation’s shareholders authorize more shares than the corporation currently
plans to issue, they also delegate ot eh board of directors authority to decide
if, when and on what terms additional shares should be issued
o
The
Significance of Authorizing Stock
§
Convenience
usually decides the question in favor of an initial (and subsequent)
authorization of many more shares than the corporation currently has plans to
issue
§
Shareholder
approval is required if the corporation issues, for consideration other than
cash or a cash equivalent, shares with voting power equal to more than 20% of
the voting power outstanding immediately before the transaction
o
Blank Check
Preferred Stock and Poison Pills
§
Poison pill
plans which constituted powerful defenses against uninvited takeover bids
·
Such plans were
based on the availability of authorized but unissued blank check preferred
·
A corporation’s
board of directors would create a new class of preferred stock with unusual
features, such as a right to require the corporation to redeem the preferred at
a price equal to some multiple of its market value
·
Then the board
would authorize distribution to shareholders, as a dividend, of rights to
purchase shares of the newly created preferred at its market value
·
Shareholders
would be entitled to exercise these rights only after some triggering event
occurred, such as acquisition by a bidder, without the board’s consent, of more
than a given percentage of the corporation’s stock
·
Until such an
even occurred, the corporation would have the option of redeeming the rights
for nominal consideration
·
While the
rights remained outstanding, they had the potential to make a hostile takeover
prohibitively expensive and thus effectively deterred uninvited bids
o
Preemptive
Rights and Other Duties in the Issuance of Shares
§
Equity dilution
§
Economic
dilution – The possibility that sales of additional shares will reduce the
value of the shares held
§
Preemptive
rights
·
A shareholder
had an inherent right to maintain her interest in a corporation by purchasing a
proportionate share of any new stock issued for cash
·
Courts
developed several exceptions to the rule that shareholders always were entitled
to preemptive rights
o
Legislatures
modified state corporate laws to provide corporations with the option of
avoiding preemptive rights and almost all public corporations have exercised
this option
o
MBCA §6.30
adopts an “opt-in” approach to preemptive rights – if a corporation wishes to
provide its shareholders with such rights, it must include an appropriate
provision in its articles of incorporation – absent such a declaration, no
preemptive rights exist
·
Unless the
articles provide otherwise, no preemptive rights exist with respect to shares
issued to compensate executives, shares issued within six months after a
company is organized, or shares sold for consideration other than cash
·
Preemptive
rights are limited in corporations with multiple classes of stock
·
Regulation of
Legal Capital
o
Legal capital –
The terms and conditions on which a corporation is permitted to sell stock and
pay dividends
o
The principal
purpose served by legal capital rules today is to provide a benchmark for the
propriety of the declaration of dividends
o
A Concise
History of Legal Capital and Par Value
§
Par value –
What the shareholder ought to have paid for his stock
§
Stock issued
without a corresponding pay in of assets valued at an amount equal to par value
was called watered stock – stock issued not against assets but against water
§
Low par stock
§
The general
idea of the legal capital scheme is that no distribution may be made to
shareholders unless, after a distribution, the corporation has not only enough
assets to pay its creditors but also an additional specified amount. This amount is called stated capital. Anything over the sum of the stated capital
and liabilities is known as surplus.
o
The Issuance of
Stock and Stockholders’ Liabilities
§
Statutes that
retain legal capital rules all hold shareholders liable for watered stock
§
Corporate
lawyers avoid these problems by setting the par value far below the price at which
the corporation plans to sell its stock and by monitoring carefully
transactions in which stock is issued
o
Dividends and
Other Distributions
§
Statutes
generally classify both dividends and payments made to repurchase stock as
“distributions”
§
More common are
statutes that allow dividends and other distributions to be paid out of
surplus, without regard to whether it is earned or not
§
Klang v.
Smith’s Food and Drug Centers
·
A corporation
may not repurchase its shares if, in doing so, it would cause an impairment of
capital, unless expressly authorized
·
A repurchase
impairs capital if the funds used in the repurchase exceed the amount of the
corporation’s surplus
§
Unless a
corporation’s articles provide otherwise, MBCA §6.40(c) simply prohibits
distributions as defined in §1.40(6), if after the distribution
·
(1) The
corporation would not be able to pay its debts as they become due in the usual
course of business – equity insolvency test, or
·
(2) The
corporation’s total assets would be less than its total liabilities plus any
sum needed to satisfy the claims of preferred stockholders in the event of
dissolution – balance sheet test
Chapter 10: The Regulation of Securities Issuance
·
When a
corporation issues its securities, it implicitly represents to investors that future
payments by the corporation justify the investment
·
The Securities
Act of 1933 requires issuers of securities to provide investors with detailed
information about the company, its management, its plans and finances, and the
securities being offered
·
Federal
Regulation of Securities Offerings
o
Overview of the
1933 Act
§
Two basic
objectives:
·
Require that
investors receive financial and other significant information concerning
securities being offered for public sale; and
·
Prohibit
deceit, misrepresentations, and other fraud in the sale of securities
§
Securities sold
in the
§
Registration
forms call for: a description of the company’s properties and business; a
description of the security to be offered for sale; information about the
management of the company; and financial statements certified by independent
accountants
§
Exceptions to
having to be registered:
·
Private
offerings to a limited number of persons or institutions who have access to the
kind of information that registration would disclose and who do not plan to
redistribute the securities
·
Offerings
restricted to residents of the state in which the issuing company is organized
and doing business
·
Securities of
municipal, state, federal and other domestic governmental instrumentalities as
well as charitable institutions and banks
·
Small issues
not exceeding certain specified amounts made in compliance with SEC regulations
·
Offerings of
small business investment companies made in accordance with SEC regulations
§
The
Registration Process
·
Should my
company go public?
o
Benefits:
§
Access to
capital will increase
§
Company will
become widely known
§
You may obtain
financing easier from investor interest
§
There may be a
read market for the shares
§
The company
will be able to attract higher qualified personnel
o
New Obligations
§
Must keep
shareholders informed about the company’s business operations
§
You may be
liable if you do not fulfill these legal obligations
§
You may lose
flexibility in managing the company
§
The public
offering will taken money and time to accomplish
·
How does my
small business register a public offering?
o
SEC requires
the company to file a registration statement with the SEC before the company
can offer its securities for sale
o
You cannot sell
the securities until the SEC declares the registration effective
o
Two principal
parts of registration statements:
§
Prospectus –
the legal offering or selling document; must describe the important facts about
its business operations, financial condition, and management
§
Additional
information that the company does not have to deliver to investors
·
State Blue Sky
Laws
o
Speculative
schemes which have no more basis than so many feet of blue sky, these statutes
regulate the sale of securities to purchasers within the jurisdiction
o
Generally
speaking these laws contain some form of one or more of three basic regulatory
devices
§
Anti fraud
provisions hat prohibited a false or misleading statement in connection with
the sale of a security
§
Registration or
licensing of securities brokers, dealers, agents and investment advisers prior
to their operating within the state
§
Registration of
securities prior to their sale or trading, frequently through administrative
approval of the merits of a particular security
Chapter 11: Protection of Creditors: Limitations on
Limited Liability
·
Overview
o
A corporation’s
creditors can look only to the corporation’s assets for payment of their
claims; they are not entitled to recover from the corporation’s shareholders
unless shareholders have agreed to guarantee or otherwise secure a corporate obligation
o
In certain
circumstances, however, courts allow claimants to disregard the corporate
entity and recover directly from its shareholders
o
This result is
described metaphorically as allowing a plaintiff to pierce the corporate veil
·
Tort Creditors
o
Walkovsky v.
§
The courts will
disregard the corporate form, or pierce the corporate veil whenever necessary
to prevent fraud or to achieve equity
§
Whenever anyone
uses control of the corporation to further his own rather than the
corporation’s business, he will be liable for the corporation’s acts upon the
principle of respondeat superior applicable even where the agent is a natural
person
o
Radaszewski
v. Telecom Corp
§
Factors for
piercing the corporate veil:
·
Complete
domination of the subsidiary by the parent
·
This control
must have been used to commit fraud or wrong
·
This control
and breach of duty must have proximately caused the injury
·
Undercapitalization
·
Financial
responsibility
·
Contract
Creditors
o
Kinney Shoe Corp v. Polan
·
Parent-Subsidiary
Corporations
o
Gardemal v.
Westin Hotel
§
The alter ego
doctrine allows the imposition of liability on a corporation for the acts of
another corporation when the subject corporation is organized or operated as a
mere tool or business conduit
·
Alter ego is
demonstrated by evidence showing a blending of identities, or a blurring of
lines of distinction, both formal and substantive, between two corporations
·
An important
consideration is whether a corporation is underfunded or undercapitalized,
which is an indication that the company is a mere conduit or business tool
·
There must be
evidence of complete domination by the parent
·
The control
necessary is not mere majority or complete stock control, but such domination
of finances, policies, and practices that the controlled corporation, has no
separate mind, will or existence of its own and is but a business conduit for
its principal
§
Single Business
·
When
corporations are not operated as separate entities, but integrate their
resources to achieve a common business purpose, each constituent corporation
may be held liable for the debts incurred in pursuit of that business purpose
·
The single
business enterprise doctrine is an equitable remedy which applies when the
corporate form is used as part of an unfair device to achieve an inequitable
result
o
OTR
Associates v. IBC Servces
§
Where a
corporation holds stock of another, not for the purpose of participating in the
affairs of the other corporation, not for the purpose of participating in the
affairs of the other corporation, in the normal and usual manner, but for the
purpose of control, so that the subsidiary company may be used as a mere agency
or instrumentality for the stockholding company, such company will be liable
for injuries due to the negligence of the subsidiary
§
It is where the
corporate form is used as a shield behind which injustice is sought to be done
by those who have control of it that equity penetrates the corporate veil
§
Thus, the basic
finding that must be made to enable the court to pierce the corporate veil is
that the parent so dominated the subsidiary that it had no separate existence
but was merely a conduit for the parent
§
The court must
also find that the parent has abused the privilege of incorporation by using
the subsidiary to perpetrate a fraud or injustice or otherwise to circumvent
the law
§
And the
hallmarks of that abuse are typically the engagement of the subsidiary in no
independent business of its own but exclusively the performance of a service
for the parent, and, even more importantly, the undercapitalization of the
subsidiary rendering it judgment proof
·
Piercing the
Veil of Other Limited Liability Entities
o
LLCs should be
governed by rules similar to those applicable to corporations
o
LLPs have not
been tested
·
Alternatives to
Limited Liability
o
Imposing
Shareholder Liability Under Federal Law
o
Fraudulent
Conveyance and Equitable Subordination Concepts
Chapter 12: Actions Binding the Corporation
·
The board of
directors has the central role in the conduct of the corporation’s business
·
Delegation of
Board Authority to Corporate Executives
o
Introduction:
Some Basic Agency Concepts
§
An agency is a
consensual relationship between two parties, the principal and the agent
§
The principal
selects the agent, who then must agree to act on the principal’s behalf
§
The principal
has the power to terminate the agency relationship unilaterally and can dictate
to the agent how the agent will perform her duties
§
The agent is a
fiduciary of the principal, which means the agent owes to the principal duties
of care, loyalty and obedience
§
The agent must
always put the interests of the principal above her own
§
An agent has
the legal power to bind the principal in legal relationships with third parties
§
(1) Actual
Authority
·
Is the power of
the agent to affect the legal relations of the principal by acts done in
accordance with the principal’s manifestations of consent to her
·
Actual
authority may be express, growing out of explicit words or conduct granting the
agent power to bind the principal, or may be implied from words or conduct
taken in the context of the relations between the principal and the agent
§
(2) Apparent
Authority
·
May be created
by written or spoken words or any other conduct which, reasonably interpreted,
causes the third person to believe that the principal consents to have the act
done on her behalf by the person purporting to act for her
·
To create
apparent authority the principal must do or say something that induces a third
party to believe that the agent has authority
§
(3) Inherent
Agency Power
·
Example:
respondeat superior
§
(4) A principal
can become obligated to a third party by ratifying the act of another who, at
the time of the act, lacked the power to bind the principal
o
Agency in
Corporations: The Authority of Officers
§
Chief executive
officer (president)
§
Chief financial
officer (treasurer)
§
Secretary
§
What is the
authority of corporate officers?
·
In some cases,
courts find that officers have express authority by being appointed to their
office by the board of directors
·
In other cases,
courts find that the officer has apparent authority because a person dealing
with the corporation reasonably believes the officer has authority
·
Or, sometimes
courts find implied authority because of prior dealings between the officer and
third party that the board never challenged
§
The rule most
widely cited is that the president only has authority to bind his company by
acts arising in the usual and regular course of business but nor for contracts
of an extraordinary nature
§
Courts require
a third party who knows that a given transaction will benefit some officer
personally to inquire in greater depth as to whether the officer has valid
authority to enter into the transaction
§
Menard v.
Dage-MTI
·
Actual
authority is created by written or spoken words or other conduct of the
principal which, reasonably interpreted, causes the agent to believe that the
principal desires him so to act on the principal’s account
·
Apparent
authority refers to a third party’s reasonable belief that the principal has
authorized the acts of its agent; it arises from the principal’s indirect or
direct manifestations to a third party and not from the representations or acts
of the agent
·
Inherent agency
power is a term used to indicate the power of an agent which is derived not
from authority, apparent authority or estoppel, but solely from the agency
relation and exists for the protection of persons harmed by or dealing with a
servant or other agent
o
This status
based form of vicarious liability rests upon certain important social and
commercial policies, primarily that the business enterprise should bear the
burden of the losses created by the mistakes or overzealousness of its agents
because such liability stimulates the watchfulness of the employer in selecting
and supervising the agents
o
Originates from
the customary authority of a person in the particular type of agency
relationship so that no representations beyond the fact of the existence of the
agency need be shown
·
An agent’s
inherent authority subjects his principal to liability for acts done on his
account which (1) usually accompany or are incidental to transactions which the
agent is authorized to conduct, if although they are forbidden by the
principal, (2) the other party reasonably believes that the agent is authorized
to do them and (3) has no notice that he is not so authorized
o
Ascertaining
Corporate Authority
§
Counsel
representing a party involved in a major transaction with a corporation usually
will insist on receiving adequate evidence that the individuals who purport to
act on behalf of the corporation have authority
§
Wheat is
required is evidence that the officer has been delegated to act on behalf of
the corporation
§
This can come
from a number of sources: (1) a provision of statutory law, (2) the articles of
incorporation, (3) a bylaw of the company, (4) a resolution of the board of
directors, or (5) evidence that the corporation has allowed the officer to act
in similar matters and has recognized, approved or ratified those actions
§
Usually, the
best evidence of delegated authority will be a copy of the minutes of the board
of directors’ meeting at which a resolution formalizing the board’s grant of
authority was adopted
·
Formalities of
Board Action
o
Board Action at
a Meeting
§
Unless the
articles or bylaws provide otherwise, the vote of a majority of the directors
present at a board meeting at which there is a quorum is necessary to pass a
resolution
§
Underlying
almost all decisions is a single policy: to protect shareholders and their
investment from arbitrary, irresponsible or unwise acts on the part of the
directors
§
Different
justifications to bind corporations on agreements never approved at formal
board meetings (exceptions for holding formal meetings)
·
Unanimous
director approval
·
Emergency
·
Unanimous
shareholder approval
·
Majority
shareholder-director approval
o
Notice
§
Notice
facilitates personal attendance by directors
§
For special
meetings, MBCA 8.22(b) requires that two days’ notice be given of the date,
time and place of the meeting, unless the articles or bylaws impose different
requirements
§
For regular meetings,
directors are assumed to know the schedule and MBCA 8.22(a) does not require
notice
§
Any director
who does not receive proper notice may waive notice by signing a waiver before
or after the meeting, or by attending or participating in the meeting and not
protesting the absence of notice (8.23)
§
A director who
attends a meeting solely to protest the manner it was convened is not deemed to
have waived notice (8.23)
o
Quorum
§
The quorum
requirement precludes action by a minority of the directors
§
The statutory
norm for a quorum is a majority of the total number of directors, although the
articles or bylaws may increase the quorum requirement or reduce it to no less
than one third of the board
o
Committees of
the Board
§
The executive
committee is a common board committee because it can have the full authority of
the board in all but a few essential transactions such as the declaration of a
dividend or approval of a merger
§
The audit
committee’s functions include selection of the company’s auditors,
specification of the scope of the audit, review of audit results, and oversight
of internal accounting procedures
§
Other common
committees include: finance, nomination, compensation
§
A board
committee can be permanent or temporary
§
Its functions
can be active or passive
§
Committees are
desirable because directors who are committee members have more incentive to
develop expertise in the area of the committee’s responsibility
·
Third-Party
Legal Opinions
o
Clean (or flat)
opinions state the lawyer’s views in simple, conclusory terms – such as a
straightforward statement without reservations that the corporation has been
duly formed
o
Reasoned
opinions provide fuller explanations and analysis, are used when the facts are
unclear or the legal rules are subject to differing opinions
§
It will often
state doubts and express reservations, particularly when it relates to actual
or potential litigation
o
Qualified
opinion – a lawyer will have one if his knowledge of the matter, role in the
transaction, or level of inquiry is limited
§
The opinion may
also be qualified if its scope narrowly focuses on specified matters
§
A qualified
opinion typically will state what matters the opinion does not cover or which
inquiries were not made
o
Unqualified
opinion
o
Lawyers are not
liable simply because her opinion was mistaken
§
Instead, it
must be shown that the opinion was negligently rendered and that any losses
were proximately caused by the lawyer’s failure to meet the relevant
professional standard
Chapter 13: Governance Role of Shareholders
·
Shareholders
have the right to vote on certain fundamental transactions, such as mergers,
sale of the corporation’s significant business assets, voluntary dissolution of
the corporation, and amendments to the articles of incorporation
·
Basics of
Shareholder Voting
o
Shareholders
act at regularly scheduled annual meetings and at special meetings conveyed for
particular purposes
o
All directors
are up for election at the annual meeting, unless the articles provide
otherwise
o
If an annual
meeting has not been held in the previous 15 month, any holder of voting stock
can require the corporation to convene an annual meeting, at which new
directors can be elected
o
Shareholders
may vote by proxy
§
A proxy is
simply a limited form of agency power by which a shareholder authorizes
another, who will be present at the meeting, to exercise the shareholder’s
voting rights
o
The general
principle governing shareholder voting is majority rule
o
Simple majority
– Affirmative vote of the majority of shares present in person or represented
by proxy at the meeting and entitled to vote on the subject matter
o
Absolute
majority – A majority of all shares entitled to vote
o
Majority voting
is a default rule
o
When the
directors act in good faith in a contest over policy, they have the right to
incur reasonable and proper expenses for solicitation of proxies and in defense
of their corporate policies, and are not obliged to sit idly by
o
The members of
the so-called new group could be reimbursed by the corporation for their
expenditures in this contest by affirmative vote of the stockholders
o
Reimbursement
rule
o
Shareholder
Rights in Fundamental Transactions
§
The
transactions that trigger shareholder voting rights generally include
amendments to the articles of incorporation, significant mergers, the sale of
all or substantially all of a corporation’s assets, and dissolution – that is,
transactions that change a firm’s firm, scope or continuity of existence
§
Shareholders
can only block fundamental changes, they have no power to initiate them
§
A shareholder
can dissent from certain transactions and demand that the corporation pay her
in case the value of her shares as determined by a court in an appraisal
proceeding, even thought he requisite majority approves the transaction - “opt out”
o
The Mechanics
of Corporate Combinations
·
A corporate
combination places the business of two or more corporations under the control
of one management
·
Four basic
negotiated combination techniques:
o
(1) A statutory
merger
o
(2) A
triangular merger
o
(3) A statutory
share exchange, and
o
(4) A purchase
by one corporation of the assets of another
·
The MBCA
focuses on whether a business combination will dilute substantially the voting
power of the acquiring corporation’s shareholders
·
If the
combination involves issuance of shares with voting power equal to more than
20% of the voting power that existed prior to the combination, the acquiring
corporation’s shareholders must vote to approve the combination
·
The MBCA also
requires shareholder approval of dilutive share issuances whenever shares are
issued for non-cash consideration, not only when shares are issued in business
combinations
·
The MBCA makes
appraisal rights available only when a corporate transaction fundamentally
affects share rights and there is uncertainty about the fairness of the
transaction’s price, not merely because a shareholder opposes the transaction
·
(1) Statutory
Merger
o
A statutory
merger means a combination effected pursuant to a corporate statute’s merger
provisions, as distinguished from other forms of business combinations often
described by the generic term merger
o
To effectuate a
statutory merger, the boards of directors of P and T first adopt a plan of
merger that
§
(a) Designates
which corporation is to survive the merger,
§
(b) Describes
the terms and conditions of the merger,
§
(c) Describes
the basis on which shares of T will be converted into shares of P, and
§
(d) Sets forth
any amendments of P’s articles of incorporation necessary to effectuate the
plan of merger
o
Short form merger
o
Voting
requirements
o
Appraisal
rights
§
Market
exception – Assumes that shareholder dissatisfied with the terms of a merger do
not need the protection of a judicial valuation if there is a public market for
their stock.
§
The market
exception reflects the view that a stock’s current market price is more likely
to reflect accurately the stock’s value than a later valuation by a judge or
judicially appointed appraiser
·
(2) Triangular
Merger
o
Is a variant
form of statutory merger in which P uses a wholly owned subsidiary to acquire
and hold T’s business
o
Rather than
having P distribute its own shares tot eh shareholders of T, S distributes
shares of P to the shareholders of T
o
The
shareholders of P do not vote on the merger because P is not formally a party
to the merger agreement
o
S becomes the
owner of T’s property and assumes T’s liabilities
o
T’s
shareholders are entitles to vote on the transaction, and, if they dissent from
the merger and do not have a market option, they can exercise appraisal rights
·
(3) Exchange of
Shares
o
First, the
boards of P and T must approve an agreement, called a plan of exchange that
spells out the terms on which shares of T will be exchanged for shares of P
o
Stockholders of
T must then approve the plan of exchange and may seek appraisal, subject to the
market exception
·
(4) Purchase of
Assets
o
First step is
approval of the relevant agreement by the boards of directors of P and T
o
The
shareholders of T then must approve the terms of the sale agreement and, under
the MBCA, T’s shareholders also have appraisal rights, subject to a market
exception
o
P’s shareholders
have voting rights if P must issue stock equal to more than 20% of the stock
outstanding prior to P’s purchase of T’s assets
o
P’s
shareholders do not have appraisal rights since P is not disposing of assets
o
If a corporate
combination is structured as an exchange for assets, T’s assets must be
transferred by deed or other form of conveyance, a process that can generate a
good deal of paperwork
·
(5) Tender
Offers
o
T’s
shareholders approval the transaction by individually accepting P’s offer
rather than through a formal vote
o
There are no
appraisal rights; T’s shareholders who do not wish to accept P’s offer can
simply refuse to tender their shares
o
If holders of a
majority of T’s shares tender their stock
o
P will have the
power to control T after it purchases this majority interests
o
P then will
seek to acquire the remaining T shares in some form of second step transaction
(such as a statutory or short form merger) so P can operate T without the
presence of a minority interest in T
o
P can make a
tender offer without any vote by its shareholders, unless P offers its shares
as consideration and either lacks sufficient authorized shares to effectuate
the exchange or the issuance would constitute a dilutive share issuance
o
P’s
shareholders do not have appraisal rights in the tender offer, since their
shares are not reduced in the transaction
o
Whether either
company’s shareholders have voting or appraisal rights in the second step will
depend on the form of that transaction and the corporate statutes that govern
shareholder rights
o
De Facto Merger
Doctrine
§
Under the de
facto merger doctrine, some courts have looked beyond the form of the
corporation, and recognized shareholder rights if the substance of the
combination is that of a merger
§
A transfer of
assets from one corporation to another, and the subsequent dissolution of the
former corporation, constituted a de facto merger
§
Hariton v. ARCO Electronics
o
§
Gimbel v. Signal Companuies
·
The statute
requires shareholder approval upon the sale of all or substantially all of the
corporation’s assets
·
The critical
factor in determining the character of a sale of assets is generally considered
not the amount of property sold but whether the sale is in fact an unusual
transaction or one made in the regular course of business of the seller
·
Every
transaction out of normal routine does not require shareholder approval
·
If the
corporation would leave the corporation without a significant continuing
business activity
·
A corporation
retains a significant continuing business activity if the retained business
constituted at least 25% of the corporation’s consolidated assets and 25% of
either its consolidated revenues or pre-tax earnings from pre-transaction
operations
§
Absent some
statutory requirement for shareholder approval, a board has the power to take
all actions it deems necessary or appropriate in managing a corporation’s
business
§
The
shareholders’ most appropriate vehicle for expressing disapproval of directors’
business judgment is the election of new directors
·
Shareholders’
Power to Initiate Action
o
Procedures for
Shareholder Meeting
§
Calling the
meeting
§
Notice
·
Shareholders
can waive notice either in writing or by attending the meeting and not
objecting to the absence of notice
·
To satisfy the
notice requirement, a board must set a record date, prior to the meeting and
provide that only shareholders of record as of that date will be entitled to
vote at the meeting
·
A meeting can
generally be set for anywhere between 10 and 60 days after notice is sent
§
Quorum
·
Usually
consists of a majority of the shares entitled to vote, unless the articles
provide otherwise
·
The MBCA sets
no minimum or maximum quorum, but requires an amendment establishing (or
reducing) a supermajority quorum requirement to meet that same requirement
§
Action by
written counsel
·
Unless the
bylaws provide otherwise, the record date for determining which shareholders
must consent to an action is the date the first shareholder consents in writing
to that action
o
What Actions
Can Shareholders Initiate?
§
Shareholder
Recommendations
·
Auer v. Dressel
o
The
stockholders who are empowered to elect directors have the inherent power to
remove them for cause
·
Amendment of
Bylaws
o
International
Brotherhood of Teamsters
§
There is no
exclusive authority granted boards of directors to create and implement
shareholder rights plans, where shareholder objection is brought and passed
through official channels of corporate governance
§
Shareholders
may propose bylaws which restrict board implementation of shareholder rights
plans, assuming the certificate of incorporation does not provide otherwise
o
Whether
shareholders of
·
Removal and
Replacement of Directors
o
§
The stockholders
have the power to remove a director for cause
§
When the
shareholders attempt to remove a director for cause, there must be the service
of specific charges, adequate notice, and full opportunity of meeting the
accusation
§
The charge of a
planned scheme of harassment constitutes a justifiable basis for removing a
director
§
An opportunity
must be provided such directors to present their defense to the stockholders by
a statement which must accompany or precede the initial solicitation of proxies
seeking authority to vote for the removal of such director for cause
§
If not provided
then such proxies may not be voted for removal
§
And the
corporation has a duty to see that this opportunity is given the directors at
its expense
Chapter 14: The Role of the Shareholder
·
Introduction
o
There is a
requirement that the shareholders approve certain transactions that affect the
structure of a corporation, such as amendments to the articles, mergers, and
sales of assets
o
Most
corporation statutes permit shareholders to amend corporate bylaws
o
Vote by written
proxy
§
First, the
statute permits shareholders to vote in person or by proxy
§
Second, it
limits the validity of the proxy to a period of 11 months form the date of its
execution unless the appointment form specified a longer period
§
Under certain
circumstances, not relevant in a public corporation, the shareholder can make
her appointment of a proxy irrevocable
§
Proxy is simply
another word for agent
§
State law
validates the process of proxy voting, and federal law prescribes the
conditions on which it may proceed
§
SEC Act of 1934
delegated the specifics of federal proxy registration to the SEC by making it
unlawful to solicit any proxy in contravention of such rules and regulations as
the commission may prescribe as necessary or appropriate in the public interest
or for the protection of investors
o
How the Proxy
Process Works: Law and Practice
§
The Annual
Meeting
·
The board of
directors selects the date of the annual meeting which is fixed in the bylaws
·
It is necessary
to fix a record date to determine which shareholders are entitled to receive
notice and to vote at the meeting
§
Shareholder
Voting
·
The board of
directors must select the nominees for election as directors on whose behalf
proxies will be solicited
·
That is, the
material sent to the shareholders solicits authorization for the proxy holder
to vote in favor of specified persons who will be placed in nomination at the
annual meeting
·
No one is
actually nominated until the meeting has convened, but by that time the
shareholder voters will have already instructed their proxy for whom to vote
·
SEC rule
require those soliciting a proxy to disclose for whom they intend to vote, and
not deviate from that choice except under unusual circumstances
·
Other
candidates may be nominated at the meeting, but in effect, the votes have been
cast and the election decided before the candidates have been nominated
·
The board of
directors must also decide what other matters to submit for action at the
meeting
§
Filing Proxy
Material
·
The proxy
materials must be prepared for filing with the SEC
·
Ordinarily the
proxy materials are reviewed by the board of directors but most of the work
must be performed by management, which has the data, and by counsel who
understands the legal requirements
§
Identifying the
Shareholders: Street Names
·
Largely for
convenience, many shareholders choose to have their shares registered in the
name of their broker where the shares are kept on deposit
·
When shares are
transferred from one brokerage firm to another on behalf of a customer the
change may be reflected only on the records of a central clearing house
depository, which is used to minimize the danger of losing stock certificates
by eliminating their physical movement
·
Many shares are
owned in trust or custodial accounts under the supervision of a bank
·
Much of the
ownership of securities is recorded in what is known as street name
·
From the list
of record owners, the corporation is unaware of who are the beneficial owners
of the stock; all it knows is the name of the record holder and at least the
number of beneficial owners
·
If an insurer
requests, however, brokers and banks will furnish the names and addresses of
non-objecting or consenting beneficial owners with whom the insurer may
communicate directly
·
In many cases,
insurers will not request these lists because they will be required to give
them to a plaintiff seeking a shareholder list in litigation
·
Without such
lists, the insurer can communicate only with the record holder
·
SEC rules
require corporations to attempt to communicate with the beneficial owners
through the record owners, and establish procedures for doing so
§
Control of the
Machinery
·
The expenses
are borne by the company
·
If a
shareholder seeks to oppose management’s proposals, or if she wishes to offer a
candidate in opposition to those nominated by the board of directors, she must
duplicate the entire process and bear the expense on her own, subject to
obtaining reimbursement of expenses in limited circumstance
§
Counting the
Proxies
·
If a contested
election of directors is involved or if there has been opposition to a proposed
transaction, or if approval of a transaction requires more than a majority
vote, then the count of the proxies becomes crucial
·
Proxies are
revocable and they may be revoked either by notice to the company or by a later
designation of someone else as a proxy to vote in a different way
·
In the latter
case, the later dated proxy constitutes the valid designation of an agent and
automatically cancels the earlier designation
·
Ordinarily, the
board of directors designates inspectors of election, and, in some cases, state
law requires the appointment of inspectors of election
·
Generally,
these people are not members of management, but are professionals hired to do
the job
·
If there is an
election campaign with two sides actively seeking proxies, the lawyers for each
side customarily agree on a set of rules in advance of the meeting to serve as
the ground rules applicable to that election
·
In some
instances, courts have intervened in the practices of those who act as
inspectors of election at shareholder meetings
o
The Collective
Action Problem
§
(1) Rationally
Apathetic
§
(2) Free rider
§
(3) The
systematic exploitation of the large by the small
Chapter 17: The Duty of Care of Corporate Directors
·
Introduction
o
Fiduciary duty
is perhaps the most important concept in the law of corporations
o
It means faith
or confidence
o
The basic
notion survives that officers, directors, and controlling shareholders owe
enforceable duties to the corporation and, through the corporation, to the
shareholders
o
A duty of care
and a duty of loyalty
·
Standards of
Care
o
A director
should exercise independent judgment for the overall benefit of the corporation
and all of its shareholders, even if elected at the request of a controlling
shareholder, a union, a creditor, or an institutional shareholder or pursuant
to contractual rights
o
A director
should become familiar with the corporation’s business
o
A director
should be satisfied that an effective system is in place for periodic and
timely reporting to the board
o
Directors
should do their homework. They should
review board and committee meeting agendas and related materials sufficiently
in advance of meetings to enable them to participate in an informed manner. They should receive and review reports of all
board and committee meetings.
o
Each member of
the board of directors, when discharging the duties of a director, shall act
(1) in good faith, and (2) in a manner the director reasonably believes to be
in the best interest of the corporation
o
The members of
the board of directors should discharge their duties with the care that a
person in a like position would reasonably believe appropriate under similar
circumstances
o
The good faith
and best interest standards apply to each director and describe the director’s
duties generally – whether in a decision making or oversight capacity
o
The standards
concerning becoming informed and devoting attention to oversight apply when
directors act together and focus on specific aspects of the directors’ decision
making and oversight functions
o
Compliance with
the duty of care is based on diligence applied to the ordinary and
extraordinary needs of the corporation, including the following:
§
Regular
attendance
§
Agendas
§
Adequate
information
§
The right to
rely on others and the need to keep informed
§
Inquiry
o
The duty of
care is tempered by the business judgment rule, which presumes directors act in
good faith, with the care and diligence of reasonably prudent persons
·
Duty of
Oversight
o
Supervision of
Ongoing Business
§
Francis v. United Jersey Bank
·
General
directors are accorded broad immunity and are not insurers of corporate
activities
·
Determination
of the liability of a director requires findings that she had a duty to her
clients, that she breached that duty and they her breach was a proximate cause
of their losses
·
As a general
rule, a director should acquire at least a rudimentary understanding of the
business of the corporation
·
A director
should become familiar with the fundamentals of the business in which the
corporation is engaged
·
If one feels
that he has not had sufficient business experience to qualify him to perform
the duties of a director, he should either acquire the knowledge or refuse to
act
·
Directors are
under a continuing obligation to keep informed about the activities of the
corporation
·
Directors may
not shut their eyes to corporate misconduct and then claim that because they
did not see the misconduct, they did not have a duty to look
·
Directorial
management does not require a detailed inspection of day to day activities, but
rather a general monitoring of corporate affairs and policies
·
A director is
well advised to attend board meetings regularly
o
Regular
attendance does not mean that directors must attend every meeting, but that
directors should attend meetings as a matter of practice
·
Directors
should maintain familiarity with the financial status of the corporation by a
regular review of financial statements
·
In some
circumstances, directors may be charged with assuring that bookkeeping methods
conform to industry custom and usage
·
The review of
financial statements, however, may give rise to a duty to inquire further into
matters revealed by those statements
·
Upon discovery
of an illegal course of action, a director has a duty to object and, if the
corporation does not correct the conduct, to resign
·
Sometimes a
director may be required to seek the advice of counsel concerning the propriety
of his conduct, the conduct of other officers and directors or the conduct of
the corporation
·
A director may
have a duty to take reasonable means to prevent illegal conduct by
co-directors; in any appropriate case, this may include threat of suit
·
A director
cannot protect himself behind a paper shield bearing the motto, dummy director
·
Shareholders
have a right to expect that directors will exercise reasonable supervision and
control over the policies and practices of a corporation
·
When directors
may owe a fiduciary duty to creditors also, that obligation generally has not
been recognized in the absence of insolvency
·
With certain
corporations, however, directors are deemed to owe a duty to creditors and
other third parties even when the corporation is solvent
o
Monitoring of
Legal Compliance
§
Compliance
programs
§
Plaintiffs are
forced to rely solely upon the legal proposition advanced by them that
directors of a corporation, as a matter lf law, are liable for losses suffered
by their corporations by reason of their gross inattention to the common law
duty of actively supervising and managing the corporate affairs
§
Directors are
entitled to rely on the honesty and integrity of their subordinates until
something occurs to put them on suspicion that something is wrong
·
If such occurs
and goes unheeded, then liability of the directors might well follow, but
absent cause for suspicion there is no duty upon the directors to install and
operate a corporate system of espionage to ferret out wrongdoing which they
have no reason to suspect exists
§
The question of
whether a corporate director has become liable for losses to the corporation
through neglect of duty is determined by the circumstances
·
If he has
recklessly reposed confidence in an obviously untrustworthy employee, has
refused or neglected cavalierly to perform his duty as a director, or has
ignored either willfully or through inattention obvious danger signs of
employee wrongdoing, the law will cast the burden of liability upon him
§
In Re
Caremark International
·
Director
liability for a breach of duty to exercise appropriate attention may, arise in
two distinct contexts:
o
(1) Such
liability may be said to follow from a board decision that results in a loss
because that decision was ill advised or negligent
§
This will
typically be subject to review under the director-protective business judgment
rule
o
(2) Liability
to the corporation for a loss may be said to arise from an unconsidered failure
of the board to act in circumstances in which due attention would, arguably,
have presented the loss
§
Entail
circumstances in which a loss eventuates not from a decision but, from
unconsidered inaction
·
The business
judgment rule is process oriented and informed by a deep respect for all good
faith board decisions
·
The core
element of any corporate law duty of care inquiry: whether there is a good
faith effort to be informed and exercise judgment
·
Absent cause
for suspicion there is no duty upon the directors to install and operate a
corporate system of espionage to ferret out wrongdoing which they have no
reason to suspect exists
·
Absent grounds
to suspect deception, neither corporate boards nor senior officers can be
charged with wrongdoing simply for assuming the integrity of employees and the
honesty of their dealings on the company’s behalf
·
A corporate
board has no responsibility to assure that appropriate information and
reporting systems are established by management
·
A director’s
obligation includes a duty to attempt in good faith to assure that a corporate
information and reporting system, which the board concludes is adequate,
exists, and that failure to do so under some circumstances may, in theory at
least, render a director liable for losses caused by non compliance with
applicable legal standards
·
In order to
show that directors breached their duty of care by failing to control their
employees, plaintiffs would have to show either (1) that the directors knew or
(2) should have known that violations of law were occurring and, in either
event, (3) that the directors took no steps in a good faith effort to prevent
or remedy that situation, and (4) that such failure proximately resulted in the
losses complained of
§
Internal Controls
Under Sarbanes-Oxley
·
Mandates
oversight by corporate boards, senior management, and even company lawyers of
company financial reporting
o
Director’s
Criminal Liability
§
Corporate
managers are liable for criminal acts committed by their subordinates
·
Business
Judgment Rule
o
Intro
§
The business
judgment rule traditionally protects directors from liability for specific
business decisions that result in losses to the corporation
§
The rule is a
rebuttable presumption that directors are better equipped than the courts to
make business judgments and that the directors acted without self dealing or
personal interest and exercised reasonable diligence and acted with good faith
§
A party
challenging a board of directors’ decisions bears the burden of rebutting the
presumption that the decision was a proper exercise of the business judgment of
the board
o
Business
Judgment Rule and Directorial Negligence
§
Under the
business judgment rule, directors are not measured by a reasonable director
standard
§
The rule calls
on directors to discharge their duties with the care that a person in a like
position would reasonably believe appropriate under similar circumstances
§
Policies for
Business Judgment Rule
·
(1)
Shareholders to a very real degree voluntarily undertake the risk of bad business
judgment
o
since
shareholders can and do select among investments partly on the basis of
management, the business judgment rule merely recognizes a certain
voluntariness in undertaking the risk of bad business decisions
·
(2) Courts
recognize that after the fact litigation is a most imperfect device to evaluate
a corporate business decision
·
(3) Because
potential profit often corresponds to the potential risk, it is very much in
the interest of shareholders that the law not create incentives for overly cautious
corporate decisions
o
Duty to Become
Informed
§
Smith v. Van
Gorkom
·
The rule in
itself is a presumption that in making a business decision, the directors of a
corporation acted on an informed basis, in good faith and in the honest belief
that the action taken was in the best interests of the company
·
The party
attacking a board decision as uninformed must rebut the presumption that its
business judgment was an informed one
·
The
determination of whether a business judgment is an informed one turns on whether
the directors have informed themselves prior to making a business decision, of
all material information reasonable available to them
·
A director’s
duty to exercise an informed business judgment is in the nature of a duty of
care
·
The concept of
gross negligence is the proper standard for determining whether a business
judgment reached by a board of directors was an informed one
·
Since all of
the defendant directors take a unified position, they were all treated as one
as to whether they are entitled to protection of the business judgment rule
·
That
considerations acted in good faith, are irrelevant in determining the threshold
issue of whether the directors as a board exercised an informed business
judgment
·
The burden must
fall on the defendants who claim ratification based on shareholder vote to
establish that the shareholder approval resulted from a fully informed
electorate
o
Reliance of
Directors on Information from and Action by Others
§
In Van
Gorkom, the court rejected the directors’ argument that they were protected
from liability because they relied on the information that the CEO presented to
them
§
Directors,
especially outside directors, who are necessarily less involved in the everyday
affairs of a corporation – routinely rely on the CEO and other top management
for information and recommendations in connection with their decision making
§
Such reliance
is clearly efficient, and it is sound policy that directors generally should be
entitled to rely on that information when the care with which they have acted
is challenged
§
There may be
limits on the extent to which reliance may be justified
§
Directors also
frequently rely on opinions provided by attorneys, accountants, engineers,
financial specialists, and other expert professional advisors
§
The general
rule is that such reliance is justified and protects directors who relied in
good faith on such advice against liability if the advice turns out to be poor
§
A director must
reasonably believe her decisions are in the corporation’s best interests after
becoming sufficiently informed
·
Limitation of
Directors’ Liability: Statutory Exculpation, Indemnification and Directors’ and
Officers’ Insurance
Chapter 18: Duty of Loyalty
·
Intro
o
The duty of
loyalty runs to the corporation and to the stockholders
o
In the most
basic terms, the duty of loyalty requires a director to place the corporation’s
best interests above her own
o
Even though the
director is subject to competing demands because of her financial stake in the
transaction, the existence of a conflict does not mean that the consummated
transaction will be unfair to the corporation
o
The law
requires that the transaction be fair to the corporation
·
The Common Law
Standard
·
The Statutory
Approach
o
Remillard
Brick v. Remillard Dandini
§
CA statute – An
interested director transaction will not automatically be void or voidable
either because there has been disclosure to, and approval by, a disinterested
decision maker or because the transaction is fair to the corporation
o
The
·
Corporate
o
The doctrine
forbids a director, officer or managerial employee from diverting to herself a
business opportunity that belongs to the corporation
o
What is a
corporate opportunity? –Tests to determine whether it exists
§
(1) Interest or
Expectancy
§
(2) Line of
business
§
(3) Fairness
§
(4) Financial
or economic capacity
Chapter 19: Duty of Controlling Shareholders
·
Intro
o
A person who
owns a large block of stock that is less than 50% often has de facto control,
because he usually is in the best position to mobilize sufficient votes to
elect a majority of the board unless another person owns a comparable block
o
Courts
determine minority control on a transaction basis, rather the deciding whether
a minority is generally in control
·
Transactions
Between the Controlling Shareholder and the Controlled Corporation
o
Sinclair Oil
v. Levien
§
When the
situation involves a parent and a subsidiary, with the parent controlling the
transaction and fixing the terms, the test of intrinsic fairness, with its
resulting shifting of the burden of proof, is applied
§
A parent does
indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary
dealings
·
However, this
alone will not evoke the intrinsic fairness standard
·
This standard
will be applied only when the fiduciary duty is accompanied by self-dealing –
the situation when a parent is on both sides of a transaction with its
subsidiary
·
Self-dealing
occurs when the parent, by virtue of its domination of the subsidiary, causes
the subsidiary to act in such a way that the parent receives something from the
subsidiary to the exclusion of, and detriment to, the minority stockholders of
the subsidiary
·
Cash Out
Mergers
o
Introduction
§
The most common
form of controlling shareholder transaction is the cash out merger in which the
person who controls a corporation seeks to terminate, or cash out, other
shareholders’ equity interest in that corporation, usually by forcing those
shareholders to accept cash for their stock
§
Three factors
limit the ability of S’s non-controlling shareholders, other than by judicial means,
to block cash out mergers that they believe are unfair: collective action
problems, the absence of real bargaining between P and those shareholders, and
the obstacles those shareholders would face were they to seek to oust P from
control of S
o
Weinberger
v. UOP
§
When directors
of a
§
Individuals who
act in a dual capacity as directors of two corporations, one of whom is parent
and the other subsidiary, owe the same duty of good management to both
corporations, and in the absence of an independent negotiating structure, or
the directors’ total abstention from any participation in the matter, this duty
is to be exercised in light of what is best for both companies
§
The concept of
fairness has two basic aspects: fair dealing and fair price
§
Fair dealing
embraces questions of when the transaction was timed, how it was initiated,
structured, negotiated, disclosed to the directors, and how the approvals of
the directors and the stockholders were obtained
§
Fair price
relates to the economic and financial considerations of the proposed merger,
including all relevant factors: assets, market value, earnings, future
prospects, and any other elements that affect the intrinsic or inherent value
of a company’s stock
§
All aspects of
the issue must be examined as a whole since the question is one of entire
fairness
§
Fair dealing –
one possessing superior knowledge may not mislead any stockholder by use of
corporate information to which the latter is not privy
§
This case
suggests that in a cash out merger, the parent might have a duty to the
minority shareholders to disclose its own internal reports
o
Short Form Mergers
(838)
·
Effect of
Shareholder Ratification
o
In re
Wheelabrator Technologies
§
The
ratification decisions that involve a duty of loyalty are two kinds: (1)
interested transaction cases between a corporation and its directors and (2)
cases involving a transaction between the corporation and its controlling
shareholder
§
(1)
·
An interested
transaction of this kind will not be voidable if it is approved in good faith
by a majority of disinterested stockholders
·
This will
invoke the business judgment rule and limits judicial review to issues of gift
or waste with the burden of proof upon the party attacking the transaction
§
(2)
·
These involve
primarily parent subsidiary mergers
·
In a parent
subsidiary merger, the standard of review is ordinarily entire fairness with
the directors having the burden of proving that the merger was entirely fair
·
But where the
merger is conditioned upon approval by a majority of the minority stockholder
vote, and such approval is granted, the standard of review remains entire
fairness, but the burden of demonstrating that the merger was unfair shifts to
the plaintiff
Chapter 20: Shareholder Litigation
·
Direct and
Derivative Actions
o
A derivative
suit typically is brought by a shareholder on behalf of a corporation in whom
she holds stock
o
The shareholder
is allowed to assert rights belonging to the corporation, even though she
normally cannot act as the corporation’s decision maker, because the board of
directors has failed to do so
o
The corporation
is names as a nominal defendant; an amounts recovered belong to the
corporation, not the shareholder-plaintiff
o
A shareholder
can bring a derivative suit against any party who has harmed the corporation,
not only against directors or controlling shareholders who have breached duties
they owe to the corporation
o
A
shareholder-plaintiff who brings a derivative suit acts as representative of
all injured shareholders
o
The plaintiff
is required to fairly and accurately represent the interests of the
shareholders similarly situated in enforcing the rights of the corporation
o
The
shareholder-plaintiff also takes on certain fiduciary responsibilities
o
Direct
§
In certain
circumstances, a shareholder also can sue a corporation’s managers or
controlling shareholders directly
§
To do so, she
must be able to show that the defendants’ actions harmed her directly; if the
harm is indirect, resulting from damages incurred by the corporation, only a
derivative suit will lie
o
A wrongful act
that depletes corporate assets and thereby injures shareholders only
indirectly, by reason of the prior injury to the corporation, should be seen as
derivative in nature
o
A wrongful act
that is separate and distinct from any corporate injury, such as one that
denies or interferes with the rightful incidents of share ownership, gives rise
to a direct action
o
The plaintiff
typically wants to characterize the action as direct, while the defendant
prefers to characterize it as derivative
o
The policy
reasons for requiring a shareholder to sue derivatively when her claim is based
on the alleged injury to the corporation may not be present when the suit
involves a close corporation in which there is a close identity between
shareholders and managers
·
The Requirement
of Demand on Directors
o
Marx v.
Akers
§
Requirement of
plaintiff in derivative action to demand that the corporation initiate an
action, unless such demand was futile, before commencing an action on the
corporation’s behalf
§
The purposes of
the demand requirement are: (1) to relieve courts from deciding matters of
internal corporate governance by providing corporate directors with
opportunities to correct alleged abuses, (2) to provide corporate boards with
reasonable protection from harassment by litigation on matters clearly within
the discretion of directors, and (3) to discourage strike suits commenced by
shareholders for personal gain rather than for the benefit of the corporation
§
The
·
Two prong test
for determining the futility of a demand: (1) the directors are disinterested
and independent and (2) the challenged transaction was otherwise the product of
a valid exercise of business judgment
§
Universal
Demand
·
Demand in all
cases, without exception, and permits of the commencement of a derivative
proceeding within 90 days of the demand unless the demand is rejected earlier
§
·
A demand would
be futile under the following circumstances:
o
(1) Demand is
excused because of futility when a complaint alleges with particularity that a
majority of the board of directors is interested in the challenged transaction
o
(2) Demand is
excused because of futility when a complaint alleges with particularity that
the board of directors did not fully inform themselves about the challenged
transaction to the extent reasonably appropriate under the circumstances
o
(3) Demand is
excused because of futility when a complaint alleges with particularity that
the challenged transaction was so egregious on its face that it could not have
been the product of sound business judgment of the directors
Chapter 23: Closely Held Corporations
·
Close
Corporation Dilemma
·
Methods of
Electing Directors
o
Cumulative
Voting
§
Straight voting
·
Each share is
entitled to one vote for each open directorship, but a shareholder is limited
in the number of votes she may cast for any given director to the number of
shares she owns
·
Directors are
elected by a plurality of the votes cast, so those who receives the most votes
are elected, even if they receive less than a majority
·
That means that
any shareholder or group of shareholders controlling 51% of the shares may
elect all of the members of the board
§
Cumulative
Voting
·
Allows
shareholders to elect directors in rough proportion to the shares held by each
group and thus to be guaranteed minority representation on the board
·
Under
cumulative voting, each share carries a number of votes equal to the number of
directors to be elected, but a shareholder may cumulate her votes
·
Cumulating
simply means multiplying the number of votes a shareholder is entitled to cast
by the number of directors for whom she is entitled to vote
·
If there is cumulative
voting, the shareholder may cast all her votes for one candidate or allocate
them in any manner among a number of candidates
·
The number of
shares required to elect a given number of directors under a cumulative voting
regime may be calculated by the following formula:
o
Number of
shares represented at the meeting (x) Number of directors it is desired to
elect
o
--------------------------------------------------------
o
Total number of
directors to be elected (+) 1
·
+
·
1
o
Class Voting
§
Class voting
entails dividing the stock into two or more classes, each of which is entitled
to elect one or more directors
·
Shareholder
Voting Arrangements
o
Shareholders
typically use one of three classes of devises to limit or control the manner in
which shares will be voted: (1) voting trusts, (2) irrevocable proxies, and (3)
vote pooling agreements
o
(1) Voting
Trust
§
Shareholders
create a voting trust by conveying legal title to their stock to a voting
trustee or a group of trustees pursuant to the terms of a trust agreement
§
The
transferring shareholders – now beneficiaries of the trust – receive voting
trust certificates in exchange for their shares; these evidence their equitable
ownership of their stock
§
Voting trust
certificates usually are transferable and entitle the owner to receive whatever
dividends are paid on the underlying stock
o
(2) Irrevocable
Proxy
§
Sometimes the
parties want to make the grant of the proxy irrevocable, subject perhaps to
some contingency or to the passage of a specified time
§
In such a case,
the shareholder loses control of her vote for the period of the proxy, and it
can be said that the vote is separated from the stock
§
The modern
trend in corporate law is to recognize this principle and to uphold irrevocable
proxies that are coupled with an interest
§
The more
conservative view is that the interest must be in the stock itself, such as
when a shareholder pledges her stock and grants the pledgee an irrevocable
proxy to vote the stock
§
Irrevocable
proxies have been upheld where the proxy has been given as an inducement to the
holder to furnish money to the corporation
§
MBCA permits
irrevocable proxies when given to (1) a pledgee; (2) a person who purchased or
agreed to purchase the shares; (3) a creditor of the corporation who extended
it credit under terms requiring the appointment; (4) an employee of the
corporation whose employment contract requires the appointment or (5) a party
to a voting agreement
o
(3) Vote
Pooling Agreement
§
Their basic
purpose is to bind some of the shareholders to vote together – either in a
particular way or pursuant to some specified procedure
·
Restrictions on
Board Discretion
o
Shareholder
Agreements
§
Triggs v. Triggs
o
Smith v. Atlantic Properties
·
Dissention and
Oppression in the Close Corporation
o
Two kinds of
dissension recur frequently:
§
(1) There are
cases in which the majority cut off minority shareholders from any returns,
thus leaving them holding illiquid stock that generates no current income
§
(2) There are
cases in which the majority exercised control to frustrate the preferences of the
minority
o
How courts
respond to dissention in close corporations has turned on two factors:
§
(1) How the
courts view close corporations
§
(2) Whether the
legislature in the relevant jurisdiction has incurred in its corporate statute
provisions aimed at protecting shareholders in close corporations
·
Fiduciary
Protection of Minority Interests
o
Wilkes v. Springside Nursing Home
§
Freeze outs –
one device is to deprive the minority stockholders of corporate offices and
employment with the corporation
§
By terminating
a minority stockholder’s employment or be severing him from a position as an
officer or director, the majority effectively frustrate the minority
stockholder’s purposes in entering on the corporate venture and also deny him
an equal return on his investment
§
When an
asserted business purpose for their action is advanced by the majority,
however, we think it is open to minority stockholders to demonstrate than the
same legitimate objective could have been achieved through an alternative
course of action less harmful to the minority’s interest
§
If called on to
settle a dispute, our courts must weigh the legitimate business purpose, if
any, against the practicability of a less harmful alternative
o
Nixon v. Blackwell
§
One cannot read
into the situation presented in the case at bar any special relief for minority
stockholders in this closely held, but not statutorily close corporation
because the provisions of the statute relating to close corporations preempt
the field in their respective areas
·
Statutory
Remedies for Oppression
o
Many modern
statutes grant a court power to dissolve a corporation is a shareholder
establishes that (a) the directors are deadlocked, the shareholders cannot
break the deadlock, and the deadlock is injuring the corporation or impairing
the conduct of its business; (b) the shareholders are deadlocked and have not
been able to elect directors for two years; (c) corporate assets are being
wasted; or (d) those in control of the corporation are acting in a manner that
is illegal, oppressive, or fraudulent
o
Court should be
cautious when considering claims of oppression to genuine abuse rather than
instances of acceptable tactics in a power struggle for control of a
corporation
o
Corporate
statutes usually provide that a corporation can be dissolved with the approval
of the board of directors and the shareholders
o
Corporate
existence is terminated in an orderly fashion: the corporation sells off its
assets, pays off its creditors, and distributes whatever remains to its
shareholders
o
Matter of Kemp & Beatley
§
The statute
permits dissolution when a corporation’s controlling faction is found guilty of
oppressive action toward the complaining shareholders
§
Oppression
arises when those in control of the corporation have acted in such a manner as
to defeat those expectations of the minority stockholders which formed the
basis of their participation in the venture
§
A court
considering a petition alleging oppressive conduct must investigate what the
majority shareholders knew, or should have known, to be the petitioner’s
expectations in entering the particular enterprise
§
Oppression
should be deemed to arise only when the majority conduct substantially defeats
expectations that, objectively viewed, were both reasonable under the
circumstances and were central to the petitioner’s decision to join the venture
§
Implicit in
this direction is that once oppressive conduct is found, consideration must be
given to the totality of the circumstances surrounding the current state of
corporate affairs and relations to determine whether some remedy short of or
other than dissolution constitutes a feasible means of satisfying both the
petitioner’s expectations and the rights and interests of any other substantial
group of shareholders
§
Every order of
dissolution must be conditioned upon permitting any shareholder of the
corporation to elect to purchase the complaining shareholder’s stock at fair
value
·
Non-Dissolution
Remedies in Oppression Cases
o
Buy Outs
§
Electing to buy
out at fair value the shares of a shareholder who petitions for involuntary
dissolution
§
Gives the
majority a call right of minority’s shares to prevent strategic abuse of the
dissolution procedure
§
Under this
optional procedure, the shareholders who elect to purchase must give notice to
the court within 90 days of the petition and then negotiate with the
petitioning shareholder
§
If after 60
days the negotiations fail, the court must stay the proceedings for involuntary
dissolution and order a buyout and determine the fair value of the petitioner’s
shares