CORPORATIONS
Artificial entities that are created by state statute,
and that are treated much like individuals under
the law, having legally enforceable rights, the ability
to acquire debt and to pay out profits, the ability
to hold and transfer property, the ability to
enter into contracts, the requirement to pay taxes,
and the ability to sue and be sued.
The rights and responsibilities of a corporation
are independent and distinct from the people
who own or invest in them. A corporation
simply provides a way for individuals to run a
business and to share in profits and losses.
History
The concept of a corporate personality
traces its roots to ROMAN LAW and found its way
to the American colonies through the British.
After gaining independence, the states, not the
federal government, assumed authority over
corporations.
Although corporations initially served only
limited purposes, the Industrial Revolution
spurred their development. The corporation
became the ideal way to run a large enterprise,
combining centralized control and direction
with moderate investments by a potentially
unlimited number of people.
The corporation today remains the most
common form of business organization
because, theoretically, a corporation can exist
forever and because a corporation, not its owners
or investors, is liable for its contracts. But
these benefits do not come free. A corporation
must follow many formalities, is subject to publicity,
and is governed by state and federal regulations.
Many states have drafted their statutes governing
corporations based upon the Model
Business Corporation Act. This document, prepared
by the American Bar Association Section
of Business Law, Committee on Corporate Laws,
and approved by the AMERICAN LAW INSTITUTE,
provides a framework for all aspects of corporate
governance as well as other aspects of corporations.
Like other MODEL ACTS, the Model
Business Corporation Act is not necessarily
designed to be adopted wholesale by the various
states, but rather is designed to provide guidance
to states when they adopt their own acts.
Types of Corporations
Corporations can be private, nonprofit,
municipal, or quasi-public. Private corporations
are in business to make money, whereas nonprofit
corporations generally are designed to
benefit the general public. Municipal corporations
are typically cities and towns that help the
state to function at the local level. Quasi-public
corporations would be considered private, but
their business serves the public’s needs, such as
by offering utilities or telephone service.
There are two types of private corporations.
One is the public corporation, which has a large
number of investors, called shareholders. Corporations
that trade their shares, or investment
stakes, on SECURITIES exchanges or that regularly
publish share prices are typical publicly
held corporations.
The other type of private corporation is the
closely held corporation. Closely held corporations
have relatively few shareholders (usually 15
to 35 or fewer), often all in a single family; little
or no outside market exists for sale of the shares;
all or most of the shareholders help run the
business; and the sale or transfer of shares is
restricted. The vast majority of corporations are
closely held.
Getting a Corporation Started
Many corporations get their start through
the efforts of a person called a promoter, who
goes about developing and organizing a business
venture. A promoter’s efforts typically involve
arranging the needed capital, or financing, using
loans, money from investors, or the promoter’s
own money; assembling the people and assets
(such as land, buildings, and leases) necessary to
run the corporation; and fulfilling the legal
requirements for forming the corporation.
A corporation cannot be automatically liable
for obligations that a promoter incurred on its
behalf. Technically, a corporation does not exist
during a promoter’s pre-incorporation activities.
A promoter therefore cannot serve as a legal
agent, who could bind a corporation to a contract. After formation, a corporation must somehow
assent before it can be bound by an obligation
that a promoter has made on its behalf.
Usually, if a corporation gets the benefits of a
promoter’s contract, it will be treated as though
it has assented to, and accepted, the contract.
The first question facing incorporators
(those forming a corporation) is where to incorporate.
The answer often depends on the type of
corporation. Theoretically, both closely held and
large public corporations may incorporate in
any state. Small businesses operating in a single
state usually incorporate in that state.Most large
corporations select Delaware as their state of
incorporation because of its sophistication in
dealing with corporation law.
Incorporators then must follow the mechanics
that are set forth in the state’s statutes. Corporation
statutes vary from state to state, but
most require basically the same essentials in
forming a corporation. Every statute requires
incorporators to file a document, usually called
the articles of incorporation, and pay a filing fee
to the secretary of state’s office, which reviews
the filing. If the filing receives approval, the corporation
is considered to have started existing
on the date of the first filing.
The articles of incorporation typically must
contain (1) the name of the corporation, which
often must include an element like Company,
Corporation, Incorporated, or Limited,” and may
not resemble too closely the names of other corporations
in the state; (2) the length of time the
corporation will exist, which can be perpetual or
renewable; (3) the corporation’s purpose, usually
described as “any lawful business purpose”;
(4) the number and types of shares that the corporation
may issue and the rights and preferences
of those shares; (5) the address of the
corporation’s registered office, which need not
be the corporation’s business office, and the registered
agent at that office who can accept legal
SERVICE OF PROCESS; (6) the number of directors
and the names and addresses of the first
directors; and (7) each incorporator’s name and
address.
A corporation’s bylaws usually contain the
rules for the actual running of the corporation.
Bylaws normally are not filed with the SECRETARY
OF STATE and are easier to amend than are
the articles of incorporation. The bylaws should
be complete enough so that corporate officers
can rely on them to manage the corporation’s
affairs. The bylaws regulate the conduct of directors, officers, and shareholders and set forth
rules governing internal affairs. They can
include definitions of management’s duties, as
well as times, locations, and voting procedures
for meetings that affect the corporation.
People Behind a Corporation: Rights
and Responsibilities
Proctor and Gamble president and CEO A.G. Lafley addresses shareholders at the company’s annual meeting in 2002. A corporation’s officers are responsible for running day-to-day business affairs and carrying out policies established by the directors.
The primary players in a corporation are the
shareholders, directors, and officers. Shareholders
are the investors in, and owners of, a corporation.
They elect, and sometimes remove, the
directors, and occasionally they must vote on
specific corporate transactions or operations.
The board of directors is the top governing
body. Directors establish corporate policy and
hire officers, to whom they usually delegate their
obligations to administer and manage the corporation’s
affairs. Officers run the day-to-day
business affairs and carry out the policies the
directors establish.
Shareholders Shareholders’ financial interests
in the corporation is determined by the percentage
of the total outstanding shares of stock
that they own. Along with their financial stakes,
shareholders generally receive a number of
rights, all designed to protect their investments.
Foremost among these rights is the power to
vote. Shareholders vote to elect and remove
directors, to change or add to the bylaws, to ratify
(i.e., approve after the fact) directors’ actions
where the bylaws require shareholder approval,
and to accept or reject changes that are not part
of the regular course of business, such as mergers
or dissolution. This power to vote, although
limited, gives the shareholders some role in running
a corporation.
Shareholders typically exercise their VOTING
RIGHTS at annual or special meetings. Most
statutes provide for an annual meeting, with
requirements for some advance notice, and any
shareholder can get a court order to hold an
annual meeting when one has not been held
within a specified period of time. Although the
main purpose of the annual meeting is to elect
directors, the meeting may address any relevant
matter, even one that has not been mentioned
specifically in the advance notice. Almost all
states allow shareholders to conduct business
by unanimous written consent, without a
meeting.
Shareholders elect directors each year at the
annual meeting. Most statutes provide that
directors be elected by a majority of the voting
shares that are present at the meeting. The same
number of shares needed to elect a director normally
is required to remove a director, usually
without proof of cause, such as FRAUD or abuse
of authority.
A special meeting is any meeting other than
an annual meeting. The bylaws govern the persons
who may call a special meeting; typically,
the directors, certain officers, or the holders of a
specified percentage of outstanding shares may
do so. The only subjects that a special meeting
may address are those that are specifically listed
in an advance notice.
Statutes require that a quorum exist at any
corporation meeting. A quorum exists when a
specified number of a corporation’s outstanding
shares are represented. Statutes determine what
level of representation constitutes a quorum;
most require one-third. Once a quorum exists,
most statutes require an affirmative vote of the
majority of the shares present before a vote can
bind a corporation. Generally, once a quorum is
present, it continues, and the withdrawal of a
faction of voters does not prevent the others
from acting.
A corporation determines who may vote
based on its records. Corporations issue share
certificates in the name of a person, who
becomes the record owner (i.e., the owner according to company records) and is treated as
the sole owner of the shares. The company
records of these transactions are called stocktransfer
books or share registers. A shareholder
who does not receive a new certificate is called
the beneficial owner and cannot vote, but the
beneficial owner is the real owner and can compel
the record owner to act as the beneficial
owner desires.
Those who hold shares by a specified date
before a meeting, called the record date, may
vote at the meeting. Before each meeting, a corporation
must prepare a list of shareholders who
are eligible to vote, and each shareholder has an
unqualified right to inspect this voting list.
Shareholders typically have two ways of voting:
straight voting or cumulative voting. Under
straight voting, a shareholder may vote his or
her shares once for each position on the board.
For example, if a shareholder owns 50 shares
and there are three director positions, the shareholder
may cast 50 votes for each position.
Under cumulative voting, the same shareholder
has the option of casting all 150 votes for a single
candidate. Cumulative voting increases the
participation of minority shareholders by boosting
the power of their votes.
Shareholders also may vote as a group or
block. A shareholder voting agreement is a contract
among a group of shareholders to vote in a
specified manner on certain issues; this is also
called a pooling agreement. Such an agreement
is designed to maintain control or to maximize
voting power. Another arrangement is a voting
trust. This has the same objectives as a pooling
agreement, but in a voting trust, shareholders
assign their voting rights to a trustee who votes
on behalf of all the shares in the trust.
Shareholders need not attend meetings in
order to vote; they may authorize a person,
called a proxy, to vote their shares. Proxy
appointment often is solicited by parties who
are interested in gaining control of the board of
directors or in passing a particular proposal;
their request is called a proxy solicitation. Proxy
appointment must be in writing. It usually may
last no longer than a year, and it can be revoked.
Federal law generates most proxy regulation,
and the Securities and Exchange Commission
(SEC) has comprehensive and detailed regulations.
These rules define the form of proxysolicitation
documents and require the
distribution of substantial information about
director candidates and other issues that are up
for shareholder vote. Not all corporations are
subject to federal proxy law; generally, the law
covers only large corporations with many shareholders
and with shares that are traded on a
national securities exchange. These regulations
aim to protect investors from promiscuous
proxy solicitation by irresponsible outsiders
who seek to gain control of a corporation, and
from unscrupulous officers who seek to retain
control of management by hiding or distorting
facts.
In addition to voting rights, shareholders
also have a right to inspect a corporation’s books
and records. A corporation almost always views
the invocation of this right as hostile. Shareholders
may only inspect records if they do so
for a “proper purpose”; that is, is a purpose that
is reasonably relevant to the shareholder’s financial
interest, such as determining the worth of
his or her holdings. Shareholders can be
required to own a specified amount of shares or
to have held the shares for a specified period of
time before inspection is allowed. Shareholders
generally may review all relevant records that are
needed, in order to gather information in which
they have a legitimate interest. Shareholders also
may examine a corporation’s record of shareholders,
including names and addresses and
classes of shares.
Directors Statutes contemplate that a corporation’s
business and affairs will be managed
by the board of directors or under the board’s
authority or direction. Directors often delegate
to corporate officers their authority to formulate
policy and to manage the business. In closely
held corporations, directors normally involve
themselves more in management than do their
counterparts in large corporations. Statutes
empower directors to decide whether to declare
dividends; to formulate proposed important
corporate changes, such as mergers or amendments
to the articles of incorporation; and to
submit proposed changes to shareholders.Many
boards appoint committees to handle technical
matters, such as litigation, but the board itself
must address important matters. Directors customarily
are paid a salary and often receive
incentive plans that can supplement that salary.
A corporation’s articles or bylaws typically
control the number of directors, the terms of the
directors’ service, and the directors’ ability to
change their number and terms. The shareholders’
power of removal functions as a check on
directors who may wish to act in a way that is contrary to the majority shareholders’ wishes.
The directors’ own fiduciary duties, or obligations
to act for the benefit of the corporation,
also serve as checks on directors.
The bylaws usually regulate the frequency of
regular board meetings. Directors also may hold
special board meetings, which are any meetings
other than regular board meetings. Special
meetings require some advance notice, but the
agenda of special directors’ meetings is not limited
to what is set forth in the notice, as it is with
shareholders’ special meetings. In most states,
directors may hold board meetings by phone
and may act by unanimous written consent
without a meeting.
A quorum for board meetings usually exists
if a majority of the directors in office immediately
before the meeting are present. The quorum
number may be increased or decreased by
amending the bylaws, although it may not be
decreased below any statutory minimum. A
quorum must be present for directors to act,
except when the board is filling a vacancy. Most
statutes allow either the board itself or shareholders
to fill vacancies.
Directors’ fiduciary duties fall under three
broad categories: the duty of care, the duty of
loyalty, and duties imposed by statute. Generally,
a fiduciary duty is the duty to act for the benefit
of another—here, the corporation— while subordinating
personal interests. A fiduciary occupies
a position of trust for another and owes the
other a high degree of fidelity and loyalty.
A director owes the corporation the duty to
manage the entity’s business with due care.
Statutes typically define using due care as acting
in GOOD FAITH, using the care that an ordinarily
prudent person would use in a similar position
and situation, and acting in a manner that the
director reasonably thinks is in the corporation’s
best interests. Courts seldom second-guess
directors, but they usually find personal liability
for corporate losses where there is self-dealing or
NEGLIGENCE.
Self-dealing transactions raise questions
about directors’ duty of loyalty. A self-dealing
transaction occurs when a director is on both
sides of the same transaction, representing both
the corporation and another person or entity
who is involved in the transaction. Self-dealing
may endanger a corporation because the corporation
may be treated unfairly. If a transaction is
questioned, the director bears the burden of
proving that it was in fact satisfactory.
Self-dealing usually occurs in one of four
types of situations: transactions between a
director and the corporation; transactions
between corporations where the same director
serves on both corporations’ boards; by a director
who takes advantage of an opportunity for
business that arguably may belong to the corporation;
and by a director who competes with the
corporation.
The usurping of a corporate opportunity
poses the most significant challenge to a director’s
duty of loyalty. A director cannot exploit
the position of director by taking for himself or
herself a business opportunity that rightly
belongs to the corporation. Most courts facing
this question compare how closely related the
opportunity is to the corporation’s current or
potential business. Part of this analysis involves
assessing the fairness of taking the opportunity.
Simply taking a corporation’s opportunity does
not automatically violate the duty of loyalty. A
corporation may relinquish the opportunity, or
the corporation may be incapable of taking the
opportunity for itself.
Directors who are charged with violating
their duty of care usually are protected by what
courts call the BUSINESS JUDGMENT RULE.
Essentially, the rule states that even if the directors’
decisions turn out badly for the corporation,
the directors themselves will not be
personally liable for losses if those decisions
were based on reasonable information and if the
directors acted rationally. Unless the directors
commit fraud, a breach of good faith, or an illegal
act, courts presume that their judgment was
formed to promote the best interests of the corporation.
In other words, courts focus on the
process of reaching a decision, not on the decision
itself, and require directors to make
informed, not passive, decisions.
State statutes often impose additional duties
and liabilities on directors as fiduciaries to a corporation.
These laws may govern conduct such
as paying dividends when a statute or the articles
prohibit doing so; buying shares when a statute
or the articles prohibit doing so; giving assets to
shareholders during liquidation without resolving
a corporation’s debts, liabilities, or obligations;
and making a prohibited loan to another
director, an officer, or a shareholder.
If a court finds that a director has violated a
duty, the director still might not face personal
liability. Some statutes require or permit corporations
to indemnify a director who violated a duty but acted in good faith, who received no
improper personal benefit, and who reasonably
thought that the action was lawful and in the
corporation’s best interests. Indemnification
means that the corporation reimburses the
director for expenses incurred defending himself
or herself and for amounts he or she paid
after losing or settling a claim.
Officers The duties and powers of corporate
officers can be found in statutes, articles of
incorporation, bylaws, or corporate resolutions.
Some statutes require a corporation to have specific
officers; others merely require that the
bylaws contain a description of the officers. Officers
usually serve at the will of those who
appointed them, and they generally can be fired
with or without cause, although some officers
sign employment contracts.
Corporations typically have as officers a
president, one or more vice presidents, a secretary,
and a treasurer. The president is the primary
officer and supervises the corporation’s business
affairs. This officer sometimes is referred to as
the chief executive officer, but the ultimate
authority lies with the directors. The vice president
fills in for the president when the latter cannot
or will not act. The secretary keeps minutes
of meetings, oversees notices, and manages the
corporation’s records. The treasurer manages
and is responsible for the corporation’s finances.
Officers act as a corporation’s agents and can
bind the corporation to contracts and agreements.
Many parties who deal with corporations
require that the board pass a resolution approving
any contract negotiated by an officer, as a
sure way to bind the corporation to the contract.
In the absence of a specific resolution, the corporation
still may be bound if it ratified the contract
by accepting its benefits or if the officer
appeared to have the authority to bind the corporation.
Courts treat corporations as having
knowledge of information if a corporate officer
or employee has that knowledge.
Like directors, officers owe fiduciary duties
to the corporation: good faith, diligence, and a
high degree of honesty. But most litigation about
fiduciary duties involves directors, not officers.
An officer does not face personal liability for
a transaction if he or she merely acts as the corporation’s
agent. Nevertheless, the officer may
be personally liable for a transaction where the
officer intends to be bound personally or creates
the impression that he or she will be so bound;
where the officer exceeds his or her authority;
and where a statute imposes liability on the officer,
such as for failure to pay taxes.
Finances
Shares A corporation divides its ownership
units into shares, and can issue more than one
type or class of shares. The articles of incorporation
must state the type or types and the number
of shares that can be issued. A corporation
may offer additional shares once it has begun
operating, sometimes subject to current shareholders’
preemptive rights to buy new shares in
proportion to their current ownership.
Directors usually determine the price of
shares. Some states require corporations to
assign a nominal or minimum value to shares,
called a par value, although many states are
eliminating this practice. Many states allow
some types of non-cash property to be
exchanged for shares. Corporations also raise
money through debt financing—also called debt
securities—which gives the creditor an interest
in the corporation that ultimately must be paid
back by the corporation, much like a loan.
If a corporation issues only one type of
share, its shares are called common stock or
common shares. Holders of common stock typically
have the power to vote and a right to their
share of the corporation’s net assets. Statutes
allow corporations to create different classes of
common stock, with varying voting power and
dividend rights.
A corporation also may issue preferred
shares. These are typically nonvoting shares, and
their holders receive a preference over holders of
common shares for payment of dividends or liquidations.
Some preferred dividends may be carried
over into another year, either in whole or in
part.
Dividends A dividend is a payment to
shareholders, in proportion to their holdings, of
current or past earnings or profits, usually on a
regular and periodic basis. Directors determine
whether to issue dividends. A dividend can take
the form of cash, property, or additional shares.
Shareholders have the right to force payment of
a dividend, but they usually succeed only if the
directors abused their discretion.
Restrictions on the distribution of dividends
can be found in the articles of incorporation and
in statutes, which seek to ensure that the dividends
come out of current and past earnings.
Directors who vote for illegal dividends can be
held personally liable to the corporation. In addition, a corporation’s creditors often will
contractually restrict the corporation’s power to
make distributions.
Changes and Challenges Faced
by Corporations
Amendments The most straightforward
and common changes faced by corporations are
amendments to their bylaws and articles. The
directors or incorporators initially adopt the
bylaws. After that, the shareholders or directors,
or both, hold the power to repeal or amend the
bylaws, usually at shareholders’ meetings and
subject to a corporation’s voting regulations.
Those who hold this power can adopt or change
quorum requirements; prescribe procedures for
the removal or replacement of directors; or fix
the qualifications, terms, and numbers of directors.
Most modern statutes limit the authority to
amend articles only by requiring that an amendment
would have been legal to include in the original articles. Some statutes shield minority
shareholders from harmful majority-approved
amendments.
Mergers and Acquisitions A merger or
acquisition generally is a transaction or device
that allows one corporation to merge into or to
take over another corporation. MERGERS AND
ACQUISITIONS are complicated processes that
require the involvement and approval of the
directors and the shareholders.
In a merger or consolidation, two corporations
become one by either maintaining one of
the original corporations or creating a new corporation
consisting of the prior corporations.
Where statutes authorize these combinations,
these changes are called statutory mergers. The
statutes allow the surviving or new corporation
to automatically assume ownership of the assets
and liabilities of the disappearing corporation or
corporations.
Statutes protect shareholder interests during
mergers, and state courts assess these combinations
using the fiduciary principles that are
applied in self-dealing transactions. Most
statutes require a majority of the shareholders in
order to approve a merger; some require twothirds.
Statutes also allow shareholders to dissent
from such transactions, to have a court
appraise the value of their stake, and to force
payment at a judicially determined price.
Mergers can involve sophisticated transactions
that are designed simply to combine corporations
or to create a new corporation or to
eliminate minority shareholder interests. In
some mergers, an acquiring corporation creates
a subsidiary as the form for the merged or
acquired entity. A subsidiary is a corporation
that is majority-owned or wholly owned by
another corporation. Creating a subsidiary
allows an acquiring corporation to avoid
responsibility for an acquired corporation’s liabilities,
while providing shareholders in the
acquired corporation with an interest in the
acquiring corporation.
Mergers also can involve parent corporations
and their subsidiaries. A similar, though distinct,
transaction is the sale, lease, or exchange of all or
practically all of a corporation’s property and
assets. The purchaser in such a transaction typically
continues operating the business, although
its scope may be narrowed or broadened. In most
states, shareholders have a statutory right of dissent
and appraisal in these transactions, unless
the sale is part of ordinary business dealings,
such as issuing a mortgage or deed of trust covering
all of a corporation’s assets.
Not all business combinations are consensual.
Often, an aggressor corporation will use
takeover techniques to acquire a target corporation.
Aggressor corporations primarily use the
cash tender offer in a takeover: The aggressor
attempts to persuade the target corporation’s
shareholders to sell, or tender, their shares at a
price that the aggressor will pay in cash. The
aggressor sets the purchase price above the current
market price, usually 25 to 50 percent
higher, to make the offer attractive. This practice
often requires the aggressor to assume significant
debts in the takeover, and these debts often
are paid for by selling off parts of the target corporation’s
business.
Restraints and protections exist for these situations.
In takeovers of registered or large, publicly
held corporations, federal law requires the
disclosure of certain information, such as the
source of the money in the tender offer. In
smaller corporations, a controlling shareholder,
who holds a majority of a corporation’s shares,
may not transfer control to someone outside the
corporation without a reasonable investigation
of the potential buyer. A controlling shareholder
also may not transfer control where there is a
suspicion that the buyer will use the corporation’s
assets to pay the purchase price or otherwise
wrongfully take the corporation’s assets.
Corporations can employ defensive tactics
to fend off a takeover. They can find a more
compatible buyer (a “white knight”); issue additional
shares to make the takeover less attractive
(a “lock-up”); create new classes of stock whose
rights increase if any person obtains more than
a prescribed percentage (a “poison pill”); or
boost share prices to make the takeover price
less appealing.
Dissolution A corporation can terminate its
legal existence by engaging in the dissolution
process. Most statutes allow corporations to dissolve
before they begin to operate as well as after
they get started. The normal process requires the
directors to adopt a resolution for dissolution,
and the shareholders to approve it, by either a
simple majority or, in some states, a two-thirds
majority.After approval, the corporation engages
in a “winding-up” period, during which it fulfills
its obligations for taxes and debts, before making
final, liquidation distributions to shareholders.
Derivative Suits Shareholders can bring
suit on behalf of a corporation to enforce a right
or to remedy a wrong that has been done to the
corporation. Shareholders “derive” their right to
bring suit from a corporation’s right. One common
claim in a derivative suit would allege misappropriation
of corporate assets or other
breaches of duty by the directors or officers.
Shareholders most often bring derivative suits in
federal courts.
Shareholders must maneuver through several
procedural hoops before actually filing suit.
Many statutes require them to put up security,
often in the form of a bond, for the corporation’s
expenses and attorneys’ fees from the suit,
to be paid if the suit fails; this requirement often
kills a suit before it even begins. The shareholders
must have held stock at the time of the contested
action and must have owned it
continuously ever since. The shareholders first
must demand that the directors enforce the
right or remedy the wrong; if they fail to make a demand, they must offer sufficient proof of the
futility of such a demand. Normally, a committee
formed by the directors handles—and dismisses—
the demand, and informed decisions
are protected by the business judgment rule.
Proxy Contests A proxy contest is a struggle
for control of a public corporation. In a typical
proxy contest, a nonmanagement group vies
with management to gain enough proxy votes to
elect a majority of the board and to gain control
of the corporation. A proxy contest may be a
part of a takeover attempt.
Management holds most of the cards in such
disputes: It has the current list of shareholders;
shareholders normally are biased in its favor;
and the nonmanagement group must finance its
part of the proxy contest, but if management
acts in good faith, it can use corporate money
for its solicitation of proxy votes. In proxy contests
over large, publicly held corporations, federal
regulations prohibit, among other things,
false or misleading statements in solicitations
for proxy votes.
Insider Trading Federal, and often state,
laws prohibit a corporate insider from using
nonpublic information to buy or sell stock.Most
cases involving violations of these laws are
brought before federal courts because the federal
law governing this conduct is extensive. The
federal law, which is essentially an antifraud
statute, states that anyone who knowingly or
recklessly misrepresents, omits, or fails to correct
a material or important fact that causes
reliance in a sale or purchase, is liable to the
buyer or seller. Those with inside information
must either disclose the information or abstain
from buying or selling.
Permutations
Corporations do not represent the only, or
necessarily the best, type of business. Several
other forms of business offer varying degrees of
organizational, financial, and tax benefits and
drawbacks. The selection of a particular form
depends upon the investors’ or owners’ objectives
and preferences, and upon the type of business
to be conducted.
A partnership is the simplest business
organization involving more than one person. It
is an association of two or more people to carry
on business as co-owners, with shared rights to
manage and to gain profits and with shared personal
liability for business debts. A sole proprietorship
is more or less a one-person
partnership. It is a business owned by one person,
who alone manages its operation and takes
its profits and is personally liable for all of its
debts. A limited partnership is a partnership
with two or more general partners, who manage
the business and have personal and unlimited
liability for its debts, and one or more limited
partners, who have almost no management
powers and whose liability is limited to the
amount of their investment. In a LIMITED LIABILITY
COMPANY, the limited liability of a limited
partnership is combined with the tax
treatment of a partnership, and all partners have
limited liability and the authority to manage.
This is a relatively new business form.
A corporation thus provides limited liability
for shareholders, unlike a partnership, a sole
proprietorship, or a limited partnership, each of
which exposes owners to unlimited liability. A
corporation is taxed like a separate entity on
earnings, out of which the corporation pays dividends,
which are then taxed (again) to the
shareholders; this is considered double taxation.
Partnerships and limited partnerships are not
taxed as separate entities, and income or losses
are allocated to the partners, who are directly
taxed; this “flow-through” or “pass-through”
taxation allocates income or losses only once.
Corporations centralize management in the
directors and officers, whereas partnerships
divide management among all partners or general
partners. Corporations can continue indefinitely
despite the death or withdrawal of a
shareholder; partnerships and limited partnerships,
however, dissolve with the death or withdrawal
of a partner. Shareholders in a publicly
held corporation generally can sell or transfer
their stock without limitation. Holders of interest
in a partnership or limited partnership, however,
can convey their interest only if the other
partners approve. Corporations must abide by
significant formalities and must cope with a
great volume of paperwork; partnerships and
limited partnerships face few formalities and
few limitations in operating their business.
New Issues Faced by Corporations
Corporations in the United States have suffered
a series of major fiascos in recent years that
have cost investors and employees billions of dollars
and have eroded public confidence in the
governance of major corporations. During the
mid to late 1990s, the U.S. economy grew in
record numbers,much to the delight of investors
and the public in general. Adding to this elation was the success of Internet-based companies,
known generally as “dot-coms.” Business commentators
and the general press referred to this
collective success as the “dot-com bubble.”
The “bubble” burst during the early part of
2000. Marketing analysts in 1999 predicted that
the enormous flow of capital, coupled with a
limited range of business models that tended to
copy from one another, would lead to a severe
downturn or shakedown. Early in 2000, stock in
several of these companies sank rapidly, leading
to hundreds of BANKRUPTCY filings and thousands
of employees losing their jobs. Although
not all of the companies shut down, entrepreneurs
and investors have been weary to follow
this model since the collapse.
Confidence in American corporations
decreased further with a series of corporate failure
based largely upon mismanagement by
directors and officers. In 2001, Enron Corporation,
a large energy, commodities, and service
company, suffered an enormous collapse that
led to the largest bankruptcy in U.S. history.
Many of the company’s employees lost their
401(k) retirements plans that held company
stock. The controversy also extended to the
company’s auditor, Arthur Andersen, L.L.P.,
which was accused of destroying thousands of
Enron documents.
Enron reported annual revenues of $101 billion
in 2000, but stock prices began to fall
throughout 2001. In the third quarter of 2001
alone, Enron reported losses of $638 million,
leading to an announcement that the company
was reducing shareholder EQUITY by $1.2 billion.
The SEC began an inquiry into possible
conflicts of interest within the company regarding
outside partnerships. The SEC investigation
became formal in October 2001, and initial
reports focused on problems with Enron’s dealings
with partnerships run by the company’s
chief financial offer.
Federal law prohibits a corporate insider from using nonpublic information to buy or sell stock. In a highly publicized case of insider trading, Samuel Waksal, founder of ImClone Systems Inc., was sentenced in June 2003 to over seven years in prison for his role in an insider trading scheme.
Many additional allegations continued to
surface throughout November 2001, including
rumors suggesting that company officials sought
the assistance of top-level White House officials,
including Treasury Secretary Paul O’Neill. In
December 2001, Enron’s stock prices fell below
$1 per share in the largest single-day trading volume
on either the New York Stock Exchange or
the NASDAQ. Because the company’s employees’
401(k) plans were tied into company stock,
these employees lost their retirement plans.
Concerns over corporate governance continued
to dominate business news in 2002, as
WorldCom, Inc., the second-largest long-distance
provider in the United States, filed for
bankruptcy. Like Enron employees,WorldCom’s
employee 401(k) plans held company stock, and
by 2003, the value of these plans had decreased
by 98 percent from their value in 1999. Moreover,
similar to the Enron fiasco, many allegations
focused upon the accounting methods that
WorldCom’s accountants employed. The company’s
board of directors and chief executive
officer expressed “shock” that the company had
misstated $38 billion in capital expenses and
that the company may have lost money in 2001
and 2002 when, instead, it had claimed a profit.
The SEC has responded to these problems by
requiring greater oversight of the accounting
profession in the United States. New regulations
have also modified the accounting methods that
by these companies employed. Nevertheless,
public confidence in U.S. corporations and the
capital markets remains shaken, and much of
the criticism has focused upon the lack of oversight
regarding corporate directors and officers.
Many have called for reforms that will hold these
directors and officers responsible in instances of
malfeasance.
FURTHER READINGS
Cox, James D., Thomas L.Hazen, and F.Hodge O’Neal. 1995.
Corporations I, II, III. Boston: Little, Brown.
CROSS-REFERENCES
Bonds “Michael R. Milken: Genius, Villain, or Scapegoat?”
(Sidebar); Golden Parachute; Greenmail; Instrumentality
Rule; Preferred Stock; Stockholder’s Derivative Suit;
Transnational Corporation.
Delaware: The Mighty Mite of Corporations
Delaware may be among the United States’
smallest states, but it is the biggest when it
comes to corporations: more than a third of all corporations
listed by the New York Stock Exchange are
incorporated in Delaware.
Delaware’s allure is explained through a combination
of history and law. Although today the state’s
corporations law is not necessarily less restrictive
and less rigid than other states’ corporation laws,
Delaware could boast more corporation friendly
statutes before model corporation laws came into
vogue. As a result, corporate lawyers nationwide are
more familiar with Delaware’s law, and its statutes
and case law provide certainty and easy access.
Delaware, more than any other state, relies on
franchise tax revenues; thus, Delaware, more than
any other state, is committed to remaining a responsive
and desirable incorporation site. In addition,
Delaware offers a level of certainty and stability: the
state’s constitution requires a two-thirds vote of both
legislative houses to change its corporations
statutes.
Delaware also has a specialized court that is
staffed by lawyers from the corporate bar, and its
highest court has similar expertise. Lawyers in the
state continually work to keep Delaware’s corporate
law current, effective, and flexible. All combine to
make Delaware the first state for incorporation.
Piercing the Corporate Veil
When a corporation is a sham,
engages in FRAUD or other
wrongful acts, or is used solely for the
personal benefit of its directors, officers,
or shareholders, courts may disregard the
separate corporate existence and impose
personal liability on the directors, officers,
or shareholders. In other words,
courts may pierce the “veil” that the law
uses to divide the corporation (and its
liabilities and assets) from the people
behind the corporation. The veil creates a
separate, legally recognized corporate
entity and shields the people behind the
corporation from personal liability.
In these cases, courts look
beyond the form to the substance
of the corporation’s
actions. The facts of a particular
case must show some
misuse of the corporate privilege
or show a reason to cut
back or limit the corporate
privilege to prevent fraud, MISREPRESENTATION,
or illegality or to achieve
EQUITY or fairness.
Courts traditionally require fraud,
illegality, or misrepresentation before they
will pierce the corporate veil. Courts also
may ignore the corporate existence where
the controlling shareholder or shareholders
use the corporation as merely their
instrumentality or alter ego, where the
corporation is undercapitalized, and
where the corporation ignores the formalities
required by law or commingles
its assets with those of a controlling shareholder
or shareholders. In addition,
courts may refuse to recognize a separate
corporate existence when doing so would
violate a clearly defined statutory policy.
Courts may pierce the corporate veil
in taxation or BANKRUPTCY cases, in
addition to cases involving plaintiffs with
contract or TORT claims. Federal law in
this area is usually similar to state law.
The instrumentality and alter ego
doctrines used by courts are practically
indistinguishable. Courts following the
instrumentality doctrine concentrate on
finding three factors: (1) the people
behind the corporation dominate the
corporation’s finances and business practices
so much that the corporate
entity has no separate will
or existence; (2) the control has
resulted in a fraud or wrong, or
a dishonest or unjust act; and
(3) the control and harm
directly caused the plaintiff ’s
injury or unjust loss.
The alter ego doctrine allows courts
to pierce the corporate veil when two factors
exist: (1) the shareholder or shareholders
disregard the separate corporate
entity and use the corporation as a tool
for personal business, merging their separate
entities with that of the corporation
and making the corporation merely their
alter ego; and (2) recognizing the corporation
and shareholders as separate entities
would give court approval to fraud or
cause an unfair result.
It may appear that a corporation
owned by one or two persons or a single
family would almost automatically lose
its separate legal existence under these
doctrines, but this is not necessarily so. A
sole owner of a business, for example, can
incorporate herself or himself, or the
business; issue all shares to herself or
himself; and set up dummy directors to
follow the necessary corporate formalities.
However, the sole shareholder may
lose the protection of limited liability—
just as any other corporation would—if
the corporate affairs and assets are confused
or commingled with personal
affairs and assets, if the sole shareholder
abuses her or his control, or if the sole
shareholder ignores the necessary corporate
formalities.
When courts ponder piercing the
corporate veil, they consider undercapitalization
to exist when a corporation’s
assets or the value it receives for issuing
shares or bonds is disproportionately
small considering the nature of the business
and the risks of engaging in that
business. Courts assess undercapitalization
by examining the capitalization at
the time the corporation was formed or
entered a new business. For example, if a
corporation that faces or may face obligations
to creditors and potential lawsuits
has received only a token or minimal
amount for its shares, or has siphoned off
its assets through dividends or salaries,
courts may find undercapitalization.
Such corporations are called shells or
shams designed to take advantage of limited
liability protections while not exposing
to a risk of loss any of the profits or
assets they gained by incorporating.
The undercapitalization doctrine
especially comes into play when courts
must determine who should bear a loss—
a corporation’s shareholders or a third
person. This determination usually
depends on whether the claim involves a
contract or a tort (civil wrong or injury).
In contract cases, the third party usually
has had some earlier dealings with the
corporation and should know that the
corporation is a shell. So, unless there has
been deception, courts typically find that
the third party assumes the risk and
should suffer the loss. In tort cases, the
third party normally has not dealt voluntarily
with the corporation. Courts thus
must decide whether the owners of the
business can shift the risk of loss or
injury off themselves and onto the innocent
general public simply by creating a
marginally financed corporation to conduct
their business.
Courts may disregard the separate
corporate existence when a corporation
fails to follow the formalities required by
corporation statutes. Courts often cite
the lack of corporate formalities in finding
that a corporation has become the
alter ego or instrumentality of the controlling
shareholder or shareholders. For
example, a court may justify piercing the
corporate veil if a corporation began to
conduct business before its incorporation
was completed; failed to hold shareholders’
and directors’ meetings; failed to file
an ANNUAL REPORT or tax return; or
directed the corporation’s business receipts
straight to the controlling shareholder’s or
shareholders’ personal accounts.
Courts also may ignore the corporate
existence when a corporation’s funds or
assets are commingled with the controlling
shareholder’s or shareholders’ funds
or assets. For example, they may pierce
the corporate veil when no sharp distinction
is drawn between corporate
and PERSONAL PROPERTY; corporate
money has been used to pay personal
debts without the appropriate accounting,
and vice versa; the controlling shareholder’s
or shareholders’ personal assets
have been depreciated along with corporate
assets; or the controlling shareholder
or shareholders have endorsed company
checks in their own name.
Many times, a controlling shareholder
is itself a corporation: the controlling
shareholder is the parent
corporation, and the controlled corporation
is a subsidiary. In some circumstances
courts may pierce the corporate
veil protecting the parent and hold the
parent liable for the subsidiary’s obligations.
This happens where the subsidiary
loses its independent existence because
the parent dominates the subsidiary’s
affairs by participating in day-to-day
operations, resolving important policy
decisions, making business decisions
without consulting the subsidiary’s directors
or officers, and issuing instructions
directly to the subsidiary’s employees or
instructing its own employees to conduct
the subsidiary’s business.
Courts also hold the parent liable
where the parent runs the subsidiary in
an unfair manner by allocating profits to
the parent and losses to the subsidiary;
the parent represents the subsidiary as a
division or branch rather than as a subsidiary;
the subsidiary does not follow its
own corporate formalities; or the parent
and subsidiary are engaged in essentially
the same business, and the subsidiary is
undercapitalized.
A final scenario in which courts may
pierce the corporate veil involves an
enterprise entity, which is a single business
enterprise divided into separate
corporations. For example, a taxicab
enterprise may consist of five corporations
with two taxis each, a corporation
for the dispatching unit, and a corporation
for the parking garage. All the corporations,
though separate, essentially
engage in a single business—providing
taxi service.
Courts often harbor suspicions that
such arrangements are made in an
attempt to minimize each corporation’s
assets that would be subject to claims by
creditors or injured persons. Courts
often will, in essence, put the corporations
together as a single entity and
make that entity liable to a creditor or
injured person, perhaps because treating
them as separate entities is unfair to
those who believe they really form a single
unit.
FURTHER READINGS
Bainbridge, Stephen M. 2001. “Abolishing Veil
Piercing.” The Journal of Corporation Law
26 (spring): 479–535.
Huss, Rebecca J. 2001. “Revamping Veil Piercing
for All Limited Liability Entities: Forcing
the Common Law Doctrine into the
Statutory Age.” University of Cincinnati
Law Review 70 (fall): 93–135.
Roche, Vincent M. 2003. “Bashing the Corporate
Shield: The Untenable Evisceration of
Freedom of Contract in the Corporate
Context.” The Journal of Corporation Law
28 (winter): 289–312.
