© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Corporations: Formation and Organization 1 Copyright © 2016 McGraw-Hill Education. All rights reserved.

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Case Hypothetical and Ethical Dilemma Dr. Charles Finnegan is a newly-appointed member of the Board of Directors of Walnut Grove Community College (W.G.C.C.) in Walnut Grove, California. The position is unpaid, but does come with the “perks” of positive exposure and prestige in the local community. At his first board meeting, the directors are discussing and considering for approval service contracts between W.G.C.C. and the local business community. The third contract for consideration is a janitorial service contract, valued at $150,000, between W.G.C.C. and Antiseptic Andy Cleaning Service, Inc. Finnegan is quite surprised; after all, “Antiseptic Andy” is owned and operated by his first cousin, Andrew Deere. Cousins Finnegan and Deere have not seen each other in three years, nor have they otherwise communicated during that period of time. The chairperson of the Board of Directors calls for a vote on the janitorial service contract. According to W.G.C.C. regulations, the board must unanimously approve contracts with the business community. Finnegan is perplexed. If he votes and says nothing about his kinship to Deere, he still feels he can “sleep at night,” since he will not receive any financial gain from the contract. If he discloses his kinship to Deere, he fears that Deere’s business opportunity will be jeopardized. Does Finnegan have a legal obligation to disclose his relationship to Deere? Would it be a “conflict of interest” for Finnegan to vote in favor of the contract? Does he have an ethical obligation to disclose the relationship? 2

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Case Hypothetical and Ethical Dilemma Zaxxon-Mobile Oil Company, Inc., headquartered in Mobile, Alabama, is a multinational corporation with 2009 annual profits of $45 billion. Zaxxon-Mobile has twelve (12) board members who serve the company on a part-time basis, with each board member receiving an average of $300,000 per year in compensation. Emily D. Chanel, a pre-law student at The University of Alabama at Mobile, is very familiar with Zaxxon- Mobile Oil Company, Inc., and she has studied her business law textbook material on corporations and their directors, officers and shareholders very carefully. She recalls that the board of directors and its members owe a strict fiduciary duty to the corporation; as part of this fiduciary duty, the board must exercise oversight in monitoring the actions of corporate employees, including the executives and officers of the corporation. Emily ponders, “How can board members of a major corporation be truly objective when they are being paid such lavish sums of money? Would not board members have a “Don’t rock the boat” mentality in terms of exercising their oversight function? Why, for example, would a Zaxxon-Mobile board member question the practices of the company’s high-ranking executives and officers, when such an inquiry might jeopardize his or her $300,000 per year annual compensation? ‘Make no bones about it,’ if I were a board member at Zaxxon-Mobile, I would probably be a ‘yes-woman” and approve of everything the chief executive officer, the chief financial officer and the chief operating officer wanted to do!” How do you respond to Emily D. Chanel’s questions and overall concerns about board member compensation and objectivity? 3

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Case Hypothetical and Ethical Dilemma Clyde Monett has been operating an art restoration business since 2010, specializing in the refurbishment of portraits and paintings. He operated the enterprise as a sole proprietorship (called Monett’s Art Restoration Services) until 2012, when he attended a “Business Structures, Licenses and Permits” workshop at the local community college, at which time the presenting attorney suggested he convert his business to a corporation, in order to “shield” Monett’s personal property and real estate from liability for his business’ financial obligations (Monett’s personal net worth is approximately $150,000.) Through the incorporation process, the only change to the business name was the addition of the word “Incorporated.” Monett was the only incorporator of the business. He serves as the president, vice-president and treasurer of the corporation; his sister, Georgette O’Keeffe, is the secretary. Since the corporation was formed in 2012, Clyde and Georgette have only convened one “official” corporate meeting; the meeting lasted approximately one hour, and the two shared family gossip for forty-five minutes of that hour. Monett’s Art Restoration Services, Incorporated has maintained an average daily balance of $45.22 in the corporate checking account at Homeland National Bank. Yesterday, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning solution was too acidic,) and the oversight resulted in irreparable damage to a painting conservatively valued at $75,000. The owner of the painting, Paul Picasso, demands $75,000 in damages from Monett; Monett apologizes, offers two free coupons for future restoration services, and refuses to pay the $75,000. The current corporate checking account balance is $ Is Clyde Monett personally liable for the $75,000 damage claim? Is he ethically obligated to pay Paul $75,000? 4

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Case Hypothetical Phoebe Main and Franklin Kilbride, best friends, love to cook. The two are so inseparable that some time ago, those who knew them began to jokingly refer to Phoebe and Franklin as “Ma and Pa.” One of their kitchen concoctions, kettle corn, became so popular (Phoebe and Franklin loved to share their caloric creations) that others have encouraged them go into business and sell their kettle corn as a product. Phoebe and Franklin agree. They have decided to form a traditional corporation as co-owners, and they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc. In the articles of incorporation (the document Phoebe and Franklin will send to the Kansas Secretary of State’s office for approval of corporate status), the two are required to indicate the total number of stock shares the company is authorized to issue. “Ma and Pa” are perplexed. Both have always considered themselves “good with numbers,” but they cannot decide what number of shares of stock to indicate in the articles of incorporation. What is your recommendation to Phoebe Main and Franklin Kilbride? 5

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Characteristics of Corporations Legal entity Rights as person and citizen Creature of state Limited liability of shareholders Unrestricted transferability of corporate shares Perpetual existence Centralized management Corporate taxation Liability for Officers and Employees 6

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Corporate Powers Corporations have both “express” and “implied” powers -Express Powers: Perpetual existence; right to litigate; right to make contracts; right to borrow/loan money; right to make charitable donations; ability to establish rules for managing corporation -Implied Powers: Whatever actions necessary (within the law) to execute express powers “Ultra Vires” Act: Corporate action beyond scope of corporation’s authority (i.e., beyond its express and implied powers) 7

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Classifications of Corporations Public/Private For-Profit/Non-Profit Domestic/Foreign/Alien Publicly Held/Closely Held S-Corporation Professional Corporation 8

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Public Versus Private Corporation Public Corporation: Corporation created by government to administer law, with specific government duties to fulfill -Example: Federal Deposit Insurance Corporation (FDIC) Private Corporation: Corporation created for private purposes 9

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. For-Profit Versus Non-Profit Corporations For-Profit Corporation: Objective is to operate for profit; shareholders seeking to make profit purchase stock these corporations issue Non-Profit Corporation: May earn profits, but they do not distribute these profits to shareholders (non-profit corporation does not issue stock, nor does it have shareholders); instead, corporation reinvests profits in business 10

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Domestic, Foreign, and Alien Corporations Domestic Corporation: Doing business within state of incorporation Foreign Corporation: Doing business in states other than state of incorporation Alien Corporation: Doing business country other than country of incorporation 11

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Publicly Held Versus Closely Held Corporation Publicly Held Corporation: -Stock available to public Closely Held Corporation (a.k.a. “Close”, “Family”, “Privately Held” Corporation): -Generally does not offer stock to public 12

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. “Subchapter S” Corporation Named after provision of Internal Revenue Service (IRS) code that provides for it Particular type of closely held corporation (no more than one hundred shareholders) Combines advantages of limited liability and single taxation 13

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Formation of Corporation Promoters organize corporate formation Subscribers offer to purchase stock in corporation in formation process State selected for incorporation 14

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Questions to Consider in Selecting a State For Incorporation How much flexibility does the state grant to corporate management? What rights do state statutes give to shareholders? What restrictions does the state place on the distribution of dividends? Does the state offer any kind of protection against takeovers? 15

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Legal Process of Incorporation Selection of corporate name Drafting and filing articles of incorporation First organizational meeting held 16

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Remedies For Defective Incorporation: “De jure” corporation: Lawful corporation that has met the substantial elements of incorporation process “De facto” corporation: Corporation that has not met the requirements of state incorporation statute, but courts recognize it as a corporation for most purposes to avoid unfairness to third parties who reasonably believed it was properly incorporated Corporation by estoppel: Corporation prevented by court from denying its corporate status Piercing corporate veil: Shareholders personally liable when they have used corporation to engage in illegal/wrongful acts 17

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Situations When Courts Likely To Pierce Corporate Veil Corporation lacked adequate capital when initially formed Corporation did not follow statutory mandates regarding corporate business Shareholders’ personal interests and corporate interests are commingled (corporation has no separate identity) Shareholders attempt to commit fraud through corporation 18

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Debt Securities Versus Equity Securities Debt Securities: Bonds (representing loans to corporation from another party) Equity Securities: Stock 19

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Equity Securities: Preferred Stock Versus Common Stock Preferred Stock: Stockholder enjoys preferences regarding assets and dividends Common Stock: Stockholder owns portion of corporation, but no preferences regarding assets and dividends 20

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Corporate Directors, Officers, and Shareholders 21

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Summary of Roles of Directors, Officers, and Shareholders Directors-- Officers-- Shareholders-- Vote on important corporate decisions Appoint and supervise officers Make financial decisions Manage corporation Run “day-to-day” business of firm Agents of corporation Elect board of directors Approve major corporate decisions 22

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Fiduciary Duties Definition: Duties to corporation that individuals within corporation have Primary fiduciary duties include: Duty of Care Duty of Loyalty Duty to Disclose Conflict of Interest 23

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Business Judgment Rule Definition: Provides that directors and officers are not liable for decisions that harm corporation if they were acting in good faith at time of decision 24

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Corporations: Directors, Officers, and Shareholders--Other Relevant Terminology Stock-Subscription Agreement: Contractually obliges individual to buy shares in corporation Par-Value Shares: Fixed face value noted on stock certificate No-Par Shares: Stock shares without a par value Watered Stock: Stock issued to individuals at a value below fair market value. Pre-emptive Rights: Preferential rights given to existing shareholders to purchase shares of new stock issue; preference given in proportion to percentage of stock shareholder already owns 25

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Corporations: Directors, Officers, and Shareholders-- Other Relevant Terminology (Continued): Stock Warrants: Vouchers issued to shareholders, entitling them to given number of shares at specified price Inspection Rights: Protect shareholders’ interests by giving them right to inspect corporation’s books and records after asking in advance to inspect and having proper purpose Right of First Refusal: Given to existing shareholders to purchase any shares of stock offered for resale by shareholder within specified period of time Shareholder’s Derivative Suit: Filed by corporate shareholder when corporate directors fail to sue in situation where corporation has been harmed by individual/another corporation 26

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Summary of Rights of Directors, Officers, and Shareholders Directors-- Officers-- Shareholders-- Right to Compensation Right to Participation Right to Inspection Right to Indemnification Rights determined in employment contract Stock certificates Preemptive rights Right to Dividends Right to Transfer Shares Inspection Rights Right to Corporate Dissolution Right to File Derivative Suit Right to File Direct Suit 27

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Mergers and Consolidations 28

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Merger Definition: A legal contract combining two or more corporations such that only one of the corporations continues to exist; in essence, one corporation “absorbs” another corporation 29

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Consolidation Definition: A legal contract combining two or more corporations, resulting in an entirely new corporation; in consolidation, neither of the original corporations continues to exist 30

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Procedures for Mergers and Consolidations Boards of directors of all involved corporations must approve the plan Shareholders must approve the plan through a vote at a shareholder meeting The corporations must submit their plan to the secretary of state The state must review the plan, and if it satisfies legal requirements, grant an approval certificate 31

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Other Terminology/Rights Regarding Mergers and Consolidations Rights of shareholders: Shareholders vote only on exceptional matters regarding the corporation Appraisal right: Shareholder’s right to have his/her shares appraised, and to receive monetary compensation for their value 32

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. “Hostile” Takeover Definition: A takeover to which management of the target corporation objects 33

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Types of Takeovers Tender Offer: Aggressor (acquiring corporation) offers target shareholders a price above current market value of their stock Exchange Tender Offer: Aggressor offers to exchange target shareholders’ current stock for stock in aggressor’s corporation Cash Tender Offer: Aggressor offers target shareholders cash for their stock 34

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Leveraged Buyout Definition: Occurs when group within a corporation (usually management) buys all outstanding corporate stock held by the public; group gains control over corporate operations by “going private” (i.e., becoming a privately-held corporation) 35

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. “Legal Death” of Corporation Occurs in two phases: Dissolution: Legal termination of corporation Liquidation: Process by which trustee converts corporation’s assets into cash, and distributes them among corporation’s creditors and shareholders 36

© 2013 The McGraw-Hill Companies, Inc. All rights reserved. Voluntary Versus Involuntary Dissolution Voluntary Dissolution: Occurs when directors or shareholders initiate the dissolution process Involuntary Dissolution: State government forces the corporation to close 37