Chapter 34 Corporations — Formation and Financing

2 § 1: The Nature of the Corporation A corporation is a creature of statute, an artificial “person.” Most states follow the Model Business Corporation Act (MBCA) or the RMBCA, that are model corporation laws. The shares (stock) of a corporation are owned by at least one shareholder (stockholder).

3 Nature of the Corporation [2] The corporation substitutes itself for the natural persons in conducting corporate business and incurring liability, but its authority and liability are separate and apart from the shareholders. In certain situations, the corporate “veil” of limited liability can be pierced, holding the shareholders personally liable.

4 Corporate Personnel Individual shareholders own corporation. Shareholders elect board of directors to manage corporation. Board of directors hires officers to run corporation on a daily basis.

5 Corporate Personnel [2] Body of shareholders can change constantly without affecting the continued existence of the corporation. Shareholder can sue corporation and be sued by corporation and bring suit for corporation in some instances (derivative action).

6 Corporate Taxation Corporate profits can either be kept as retained earnings or passed on to the shareholders as dividends. Corporate profits are taxed under federal and state law as a separate “person” from its shareholders. Regular “C” corporations are taxed twice: at the corporate level and at the shareholder level.

7 Constitutional Rights of Corporations [1] A corporation is an artificial “person” and has constitutional rights to: Equal protection; Access to the courts, can sue and be sued; Right to due process before denial of life, liability or property.

8 Constitutional Rights of Corporations [2] Corporation’s rights (cont’d): Freedom from unreasonable search and seizure and double jeopardy. Freedom of speech. Only officers and directors have protection against self-incrimination. However, corporations do not have full protection of privileges and immunities clause.

9 Torts and Criminal Acts A corporation is liable for the torts committed by its agents or officers within the course and scope of their employment under the doctrine of respondeat superior. Corporation can be liable for criminal acts, but only fined. Responsible officers may go to prison.

10 Corporate Sentencing Guidelines Federal Organizational Corporate Sentencing Guidelines provide specific sentencing guidelines for crimes committed by corporate employees (white collar crime). 32 levels of offenses: Culpability score. Credits can be applied.

11 § 2: Corporate Powers A corporation may act and enter into contracts as any natural person, except as limited by: U.S. Constitution. State constitutions. State statutes. Its own articles of incorporation. Its own corporate bylaws. Resolutions by its own board.

12 Express Corporate Powers [2] The express powers of a corporation are found in the corporation’s articles of incorporation, the laws of the state of incorporation, and in the state and federal corporations. Corporate by-laws may also grant or limit a corporation’s express powers.

13 Implied Corporate Powers [3] Corporation has implied powers to: to perform all acts reasonably necessary to accomplish its corporate purposes, e.g.,: Borrow and lend money. Extend credit. Make charitable contributions. A corporate officer can bind corporation in contract in matters connected with the ordinary business affairs of the enterprise.

14 Ultra Vires Doctrine Corporate acts are beyond the express or implied powers of the corporation as stated in state statute or the corporation’s own articles of incorporations and are considered to be “ultra vires” (beyond the powers). Corporate articles of incorporations now adopt very broad purposes to prevent lawsuits against the corporation.

15 Ultra Vires Doctrine [2] The Following remedies are available for ultra vires acts: Shareholders can bring action for corporation. Corporation can recover damages from its officers and directors. Attorney general of state may bring action to dissolve corporation for ultra vires acts.

16 § 3: Classification of Corporations Domestic corporation does business in its state of incorporation. Foreign corporation from X state doing business in Z state. Alien Corporation: formed in another country doing business in United States.

17 Classification of Corporations [2] Public and Private. Nonprofit. Close Corporations. Shares held by few shareholders. More informal management,similar to a partnership. Restriction on transfer of shares.

18 Classification of Corporations [3] “S Corporations”: Avoids the federal “double taxation” of regular corporations at the corporate level. Only dividends are taxed to the shareholders as personal income. IRS requirements: Corporation is domestic, fewer than 75 shareholders, only one class of stock, no shareholder can be a non- resident alien. Professional Corporations.

19 § 4: Corporate Formation The process of incorporation generally involves two steps: Preliminary and Promotional Activities; and The Legal Process of Incorporation.

20 Incorporation Process Promotion Name Search File Articles of Incorporation Subscribers 1st Organiza- tional Meeting State Charter

21 Promotional Activities Before corporation is formed, promoters are the persons who take the preliminary steps of organizing the venture and attracting investors via subscription agreements.

22 Promoter’s Liabilities A Promoter (or corporation) can create a prospectus required by federal and state securities laws to inform and protect investors. prospectus Promoter is personally liable for pre- incorporation contracts on behalf of the corporation, unless 3 rd party agrees to hold future corporation liable.

23 Promoter’s Liabilities [2] After corporate formation, corporation can adopt the pre-incorporation contract and release the promoter by creating a “novation”. Subscribers and Subscription Agreements: continuing contracts to purchase stock. Generally, subscribers become stockholders upon corporate formation.

24 Articles of Incorporation State Chartering: Select state (some states such as Delaware cater to corporations).Delaware Articles of Incorporation: primary enabling document filed with the Secretary of State that includes basic information about the corporation. Person(s) who execute the articles are the incorporators.

25 Articles of Incorporation [2] Choose and reserve a Corporate Name: (Example: name search at Texas Secretary of State). Name must have the proper suffix: “corporation,” “corp.,” “Incorporated.”name search You should also consider registering the corporation as a “dot com” at networksolutions.com or register.com. networksolutions.comregister.com.

26 Articles of Incorporation [3] Purpose: trend towards “any legal business.” Duration: usually perpetual. Capital Structure: Most states requires some minimal capitalization (Texas requires $1,000), plus number and class(es) of shares authorized and “par value” of shares at incorporation.

27 Articles of Incorporation [4] Internal Organization: usually included in the bylaws. Registered Office and Agent: specific person that will receive any legal notice and documents from state and/or 3 rd parties. Incorporators (usually the promoter): at least one with name and address.

28 First Organizational Meeting After the corporation is “chartered” (created) it and can do business. Shareholders should have the first organizational meeting to: approve the bylaws, elect directors, hire officers and adopt pre-incorporation contracts and activities.

29 § 5: Improper Incorporation Errors in incorporation procedures when a 3 rd party seeks to bring an action against a corporation that may not have complied perfectly with every incorporation law. Problematic for shareholders who may be personally liable. In addition, entity may not be able to enforce contracts.

30 Improperly Formed Corporations De Jure: substantial statutory requirements are met; cannot be attacked by state or 3 rd parties. De Facto: statutory requirements not met, but promoters made good faith effort to comply with corporate law;corporate status can only be attacked by state. By Estoppel: if it acts like a corporation, cannot avoid liability by claiming that no corporation exists.

31 § 6: Disregarding the Corporate Entity “ Piercing the Corporate Veil” occurs when a court, in the interest of justice or fairness,” holds shareholders personally liable for corporate acts. Court concludes that shareholders used corporation as a “shield” from illegal activity.

32 Piercing the Corporate Veil Factors a court considers: 3 rd party tricked into dealing with a corporation rather than the individual. Corporation is set up never to make a profit or remain insolvent or is under capitalized. Statutory formalities are not followed. Corporation is “alter ego” of majority shareholder and personal and corporate interest are commingled such that the corporation has no separate identity.

33 § 7: Corporate Financing Bonds v. Stocks DebtOwnership/equity Fixed ROI Dividends (variable) No votesVote for Management OptionalRequired Priority over stockPaid last Stocks: Common vs. Preferred

34 Bonds TypeDefinition DebenturesNo specific corporate assets are pledged as collateral. Backed by corporation’s general credit rating. MortgagesPledge specific real estate. If corporation defaults, bondholders can foreclose. ConvertibleConditions trigger bonds to convert to corporate stock. CallableCan be “called in” by principal and repaid according to bond conditions.

35 Stocks Common Stock: represents true ownership of a corporation. Provides pro-rata (proportional) ownership interest reflected in control, earnings and assets. Preferred Stock: has preferences over common stock. Cumulative Preferred. Participating Preferred. Convertible Preferred. Redeemable or Callable Preferred.

36 Case 34.1: Bullington v. Palangio (Corporate Taxation) FACTS: Bullington, DBA Bullington Builders, Inc. (BBI), entered into a contract with Palangio for the construction of a new house. BBI was incorporated in 1993 with only Bullington and his wife were shareholders. Bullington signed the contract “Jerry Bullington, d/b/a Bullington Builders, Inc.,” but did not indicate any official capacity as a corporate officer. Later BBI’s charter was revoked before he finished the house. Palangio complained about deficiencies in the workmanship. Palangio sued BBI and Bullington personally.

37 HELD: FOR PALANGIO. BULLINGTON PERSONALLY LIABLE. Bullington was personally liable for the unsatisfactory performance of the contract with Palangio. The corporate charter was revoked and “to exempt any association of persons from personal liability for the debts of a proposed corporation, they must comply fully with the [law] under which the corporation is created and that partial compliance with the [law] is not sufficient.” Case 34.1: Bullington v. Palangio (Corporate Taxation)

38 Case 34.2: Crowder v. Kiser (Transfer of Shares in Close Corporations) FACTS: Crowder Construction Company (CCC) allowed key employees to buy company stock. If a key employee was terminated, the employee was required to sell his or her shares to the company, which was required to buy them. If the shares had been held for less than seven years, the price was less. Kiser, CFO of Crowder, was fired but worked there less than seven years. He refused to sell the shares that he had held for less than seven years. CCC sued and Kiser argued that he had been discharged so the firm would not have to pay the full price for his stock.

39 HELD: FOR CROWDER. There was no evidence that Kiser had been discharged so that Crowder could avoid paying him a higher price for his shares in the company. In the absence of such proof, neither the shareholder agreement nor Kiser’s termination was unreasonable. Case 34.2: Crowder v. Kiser (Transfer of Shares in Close Corporations)

40 Case 34.3: Hoskins v. Hochberg (Disregarding the Corporate Entity) FACTS: Hochberg (Buyer) is the president of Diamond Auto. Hochberg ordered and received parts from Hoskins (Seller) under the name “Diamond Auto Construction.” Hoskins sent invoices to “Diamond Auto Construction.” Buyer paid some of the invoices with checks drawn on the bank account of “Diamond Auto Construction.” With unpaid invoices totaled more than $40,000, Seller sued Hochberg personally.

41 HELD: FOR HOSKINS. HOCHBERG PERSONALLY LIABLE. “Diamond Auto Construction” was not registered with the state as the name of a corporation. State statutes allowed a corporation to use an assumed name if certain procedures were followed. If those procedures were not followed, the corporation was required to do business under its corporate name. In this case, Diamond Auto Body & Repair, Inc., used the name of “Diamond Auto Construction” without following those procedures. Case 34.3: Hoskins v. Hochberg (Disregarding the Corporate Entity)