Corporations
Corporations/1
Introduction
(1)Broad themes:
(a)How corporate control is exercised for and against the owners within the legal regime framing the operation of corporations.
(b)Why do all corporations flock to DL?
1)Consistently sided with insiders.
2)Not amenable to takeovers.
3)Most market friendly.
I. Some Basics
(1)Corporations are a common form of organization of business undertakings.
(2)Forms of corporations reflect and frame division of labor issues. Labor, capital, rent.
(a)Labor Suppliers of labor.
(b)CapitalStockholders, lenders (bondholders and short term creditors).
(c)ManagementHybrid of capital and labor. Agents of owners. Fiduciary obligation to owners.
(3)Most important legal aspect of a corporation is that it is a separate entity.
(a)Compare: Partnership Assets are coowned by partners. Corporation Owner of its assets.
(4)Main aspects of the corporate form. Forms of undertaking with standardized mechanisms of control and distributions of risk and return.
(a)Limited liability. Owners (shareholders) are not liable for the corporation’s obligations.
(b)Centralization of management.
(c)Free transferability of interest/ownership. Look to the degree of separation between ownership and control (contrast publicly held with closely held, etc). Also note the potential role of controlling shareholders.
(d)Distribution of risk and return.
(5)Compare publicly held and closely held corporations.
(a)Publicly heldFreely traded on stock exchanges. Large, high profile, corporations. Division between ownership and control is much more clearly marked. Enhanced liquidity.
(b)Closely held Owned by a much smaller group of shareholders, often in one family.
(6)Shareholder voting. Owners of common stock have right to vote on fundamental matters including:
(a)Election of directors.
(b)Mergers involving corporations.
(c)Any amendment to certificate of incorporation.
(d)Sale of substantially all of corporation’s assets.
(e)Liquidation.
(f)Note that major stock exchanges do not allow corporations that give some shareholders disproportionate voting power.
(g)Usually shareholders vote in favor of incumbents’ recommendation.
(7)The Players.
(a)Shareholders Supply capital. Beneficial ownership.
(b)Directors Legal power and responsibility to manage affairs of the firm.
1)Principal responsibility is to monitor and not to manage.
2)Authority is collectiveno individual director can bind corporation.
3)Fiduciary duty to corporation.
4)Afforded wide discretionSee Business Judgment Rule.
(c)Officers/Insiders Govern day to day operations of corporation. Agents of the corporation rather than agents of the shareholders.
(8)Implications of separation between ownership and control.
(a)Berle/Means ThesisManagement in a publicly held corporation is largely autonomous. This is due to the fact that management can choose not to pay dividends of corporate earnings and instead to reinvest it in the corporation itself.
1)NeoclassicalManagers have strong incentive to contract with shareholders so as to reduce opportunities to depart from shareholder interest. If managers divert firm’s earnings for their own benefit, there will be an impact in terms of reduced market value, and the managers’ own shares will decline in value due to incentive compensation arrangements. Moreover, consider the role of ability of mangers to implement monitoring safeguards and the role of agency costs.
2)ManagerialistsCorporate managers tend not to pursue profit maximization, but instead size or growth maximization. Must note empirical studies that show that return on internally generated funds lower than that on funds raised in capital markets (more efficient to pay out dividend than reinvest). Also note the trend away from growth maximization evinced by: hostile tender offer, corporate restructuring, and downsizing.
3)Transaction Cost School – Evolution of the M-form or multi-unit firm (holding company structure) Market may have lower transaction costs than firm. However recognize that firms may grow to an inefficient size.
II. The Formation of Corporations
- Starting a Corporation
- Formation
(1)Formation of corporation is self-started by individuals without the benefit of specific legislative action.
(2)Rule of ultra vires Beyond the powers. Corporation cannot engage in transactions beyond its stated powers.
(3)Steps for starting a corporation.
(a)Need an incorporator.
(b)Files articles of incorporation with Secretary of State.
(c)Secretary of State issues a certificate of incorporation. Corporation’s existence commences.
(d)Incorporator conducts an organization meeting.
1)Appoint interim board of directors.
2)Appoint officers.
3)Issue shares.
4)Adopt bylaws.
(4)Considerations in forming a corporation:
(a)Voting Rights.
(b)Proportion of capital contribution responsibilities.
(c)Dissolution rights.
(d)Salaries.
(e)Whether to incorporate as a “C” or “S” corporation.
- Defective Formation
(1)Liabilities follow agency law. When an agent operates for a non-existent principal, agent himself is personally liable. Thus, directors and promoters should be liable.
(2)Mitigating factors:
(a)De facto incorporation Defect is technical and not enormous; steps were taken to incorporate; directors had reason to believe that corporation was incorporated. Black letter requirements to be a de facto corporation. Cranson v IBM.
1)Must have valid possibility of being a corporation but ultimately failed.
2)Incorporation was attempted in good faith. Link in chain had no reason to know that it was not a de jure corporation.
3)Defect is unknown to principal.
4)Corporate form is actually used.
(b)Incorporation by estoppelParty who dealt with corporation as if it were a corporation (then defect hasn’t done any real harm as opposed to director misrepresenting corporation’s assets), party is estopped from denying that corporation is incorporated to avoid its own obligations. Cranson v IBM. Southern Gulf Marine.
1)Note that corporation by estoppel has a much more limited scope than de facto corporation because only relevant to how one party deals with the defectively formed corporation.
(3)Cranson v IBM (MD 1963), M1 Held IBM estopped from asserting that corporation did not exist and holding individual liable because IBM dealt with Bureau as if it were a corporation and relied on its credit rather than individual’s.
(4)Southern Gulf Marine No 9 Inc v Camcraft, Inc (La 1982), p207 Held not a de facto TX corporation because everyone involved knew it was not a TX corporation.
B.Pre-Incorporation Questions
(1)Role of promoter Fiduciary obligation to corporation, but not necessarily to outside investors.
(a)A fiduciary cannot make an undisclosed profit when dealing with a principal, or someone to whom there is a fiduciary obligation.
(b)In the context of promoters, ask whether the promoter’s knowledge is imputable to the corporation (assuming promoter is 100% shareholder at the time). Under federal law Imputable. State law May not be. E.g., Mass.
(c)Thus, to be completely safe, promoter should never deal with corporation in capacity of promoter.
(d)Key is to ensure transparency.
(2)Obligation of promoter Promoters have full liability for any harm they incur during organization of corporation unless they expressly disclaim it. MBCA § 2.04.
(a)If the corporation does go through promoter’s liability is discharged.
(b)Subsequent adoptions of obligation by promoter do not obviate the promoter’s obligation.
(3)How v Boss (S D Iowa 1963), M3 Held a promoter, though he may assume to act on behalf of the projected corporation and not for himself, will be personally liable on his contract unless the other party agreed to look to some other person or fund for payment.
(a)Promoter is freed from liability if:
1)Other party agreed to look solely to new corporation for payment.
2)Promoter did not have any duty toward the to form the corporation and give the corporation opportunity to assume and pay the liability.
(b)Boss should have expressly stated in contract that once corporation is formed, he is no longer an obligor.
C.Limited Liability
- Limited Liability of Corporations
(1)Different from other entities because liability limited to assets only. Beneficial owners are not answerable from their own assets to obligations of corporation.
(2)Compare publicly held and closely held corporations:
(a)Publicly held Liability has to be limited so that capital will flow in. Efficient allocation of risk and return outweighs risk of individual creditors losing loan in insolvency.
(b)Closely held Limited liability still clarifies risks and returns of voluntary transactions between corporation and creditor. Creditor can adjust interest rates in order to efficiently allocate risk and return. Moreover, can ask for personal guarantee of shareholder.
(3)High degree of legal formulas. If corporate formalities are rigorously observed, the separate identity of the corporation will not be disregarded in order to expose the individual shareholder to liability. Even if corporation set up to protect shareholder from various schemes. Walkovsky v Carlton.
(4)Factors for disregarding separate entities:
(a)Failure to maintain corporate records or formalities.
(b)Commingling of funds and assets.
(c)Undercapitalization.
(d)One corporation treating the assets of another corporation as its own.
- Tort cases.
(1)Although limited liability initially seems inefficient, if it weren’t for limited liability, shareholders would have to closely supervise all corporate activities, thus deterring them from investing. Thus, more efficient to have regulatory bodies.
(2)Walkovsky v Carlton (NY 1966), p.211 W conducted 10 separate corporations in order to only hold the statutory minimum of liability insurance for each and to maintain a minimum of assets in each. Held if the corporate forms are strictly followed, so that the players themselves treat the corporations as having a separate identity, there is essentially no possibility that the corporate identity will be disregarded and its obligations to the individual shareholders, unless its shareholders are corporations themselves engaged in the same economic enterprise. Adherence to form governs, and is an inoculation against liability by the individual shareholders.
(3)Thus, essential formalism is the prevalent doctrine. Three ideas:
(a)Possible disregard for the separate identity of the corporation if the shareholders have broken down or disregarded the separate identity themselves.
1)Commingling of assets is most crucial because maintaining separate identity implies separate ownership of assets.
(b)Notion of enterprise liability (all of the assets of corporations that are engaged in the same line of business under the same control are able to satisfy the claims of all other corporations.
1)Walkovsky v Carlton Might be a successful claim by . Within the corporate environment, assets and services were passed around without formality.
(c)Notion of direct liability (agency theory). By virtue of their control, the shareholders or owners of a corporation make the corporate their agent. Essentially subsidiary = agent of parent corporation.
1)In re Silicone Gel Breast Implants Porduct Liability Litigation (1995), p230 Summary judgment on 1. classic disregard of separate identity of ME, 2. agency theory whereby BM enlisted sub as agent in distribution of cosmetic devices.
a)Here BM made some management decisions for ME, and ME used BM’s name when distributing its products.
b)Note that BM did not receive any compensation for its contribution of assets to ME.
c)Clearly there were elements of common control/influence.
- Contracts cases.
(1)Sea-Land Services, Inc v Pepper Source (7th Cir 1991), p217 Sole shareholder of dissolved corporation did not follow corporate formalities. Held the corporate veil will be pierced where there is a unity of interest and ownership between the corporation and an individual and where adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice.
(2)Kinney Shoe Corporation v Polan (4th Cir 1991), p223 P’s first company merely a shell in order to enter into initial lease with KS. Held the corporate veil will be pierced where there is a unity of interest and ownership between the corporation and the individual shareholder and an inequitable result would occur if the acts were treated as those of the corporation alone. There were no elements of unfairness or deceit, instead case suggests that can immunize yourself from disregard of entity by providing systematic formalities and respecting the separateness of corporate assets and your own.
(3)Perpetual Real Estate Services, Inc v Michaelson Properties (4th Cir 1992), p226 Held where a sole shareholder exercises undue domination and control over the corporation, the corporate veil will be pierced only if the sole shareholder also used the corporate form to obscure fraud or conceal crime. Because that was not the case here, even if the corporation was M’s alter ego, there is no personal liability. Note that M also did not personally guarantee the contracts, and thus the court is reluctant to rewrite the parties’ obligations.
- Limited Partnership
(1)Frigidaire Sales Corporation v Union Properties, Inc (Wa 1977), p238 Held limited partners do not incur general liability for the limited partnership’s obligations simply because they are officers, directors, or shareholders of the corporate general partner. Note that the s here were limited partners in the company, as well as directors and officers of the corporate general partner. However, because they acted as management of the limited partnership in their representative capacities (of the corporate general partner), then they could not be held personally liable.
- Corporate Powers
- Business Judgment Rule
(1)The primary interest of a corporation is the maximize shareholder wealth. However, must consider both long-term and short-term goals.
(2)The Business Judgment Rule helps to shield corporate managers from challenge on ethical differences.
- Charitable Contributions
(1)Business Judgment Rule typically shields charitable contributions.
(2)AP Smith Manufacturing Co v Barlow (NJ 1953), p280 Held state legislation adopted in the public interest can be constitutionally applied to preexisting corporations under the reserved power.
(3)Theodora Holding Corporation v Henderson (DL 1969), M9 Gift to family foundation. Minority shareholder objected. Note element of familial discord. Held that the charitable gift was valid because it passed the test of reasonableness. Look to tax benefits of charitable contributions by corporations rather than by individual shareholders.
(a)There is a double tax benefit if the charitable contribution is made through the corporation rather than the shareholder: 1) Deduction at corporate level. 2) Donation never taxed at individual rate because donation bypasses individual’s income.
(b)Triple tax benefit Another solution is for the corporation to donate stock with an unrealized appreciation because then corporation is entitled to deduction of FMV of stock.
- Corporate Powers
(1)Dodge v Ford Motor Co (Mich 1919), p286 Ford, founder and principal shareholder, wanted to cut back on dividends and reinvest in corporation to develop industrial empire and philanthropy. Dodge bros brought suit to prevent expansion of plant and compel distribution of profits as dividends. Held Ford must return certain %age of profits as dividends to shareholders. A corporation’s primary purpose is to provide profits for shareholders.
(a)Compare this rationale to the thinking today Business Judgment Rule.
(b)Isenbergh Holding is consistent with corporate law and Business Judgment Rule because Ford had redundant assets that could fund both the expansion and make a large distribution. He cannot pursue the greater good before shareholder wealth.
(c)Moreover, there would be a disproportionate benefit to himself if he were to pursue this plan. Principle of corporation law Cannot discriminate between shareholders.
(d)Note that this situation only arises in context of closely held corporation If the corporation were publicly held, there would be pressure on the share price and the majority shareholders to do what’s in the share price’s interest.
(e)Note now shareholders do not care about dividends because of enormous tax cost.
(2)Shlensky v Wrigley (Illinois 1968), p291 Held a shareholder’s derivative suit can only be based on conduct by the directors which borders on fraud, illegality, or conflict of interest.
(a)Note that the court was unwilling to even begin to review management’s position.
(b)Cf. Ford Ford was so explicit about his non-financial goals that he did himself in.
(c)Thus, reformulate Business Judgment Rule As long as it’s possible that the disproportionate effect on the corporation’s shareholders is within some broad range of discretion, then the discretionary judgment will be upheld.
III. Financial Structure of Corporations
A.Forms of Equity and Debt
(1)Corporate debtholdersHave the least control, but also the most risk averse position.
(a)Interest Some portion of income stream.
(b)Repayment of principal upon agreed upon timetable Some portion of corporation’s assets.
(c)Option of foreclosure.
(d)May be secured with corporate assets.
(e)Because of the preferred position of common shareholders, creditors often require bond indentures in order to ensure the security of their loan.
(f)Insiders only have a fiduciary obligation to creditors once the corporation is on the brink of insolvency.
(2)Equity holders Have highest degree of control in corporation because they are the constituents of the insiders (fiduciary obligation).
(a)Dividend distributions Income stream
(b)Balance of assets after claims of debtholders met.
(c)Types of equity holders.
1)Common stock Pure residual equities in firm, voting rights (high degree of control).
2)Preferred stock Fixed return and may or may not have voting rights (more risk averse). Although dividend rights may be cumulative, it is up to the corporation whether to pay dividends in any given year. If dividends are build up in arrearages, unlikely that preferred shareholders will get the full amount because requires unanimous vote by all shareholders to force distribution of dividends (thus must share with common in order to secure vote).
(3)Leverage A corporation that has debt in its capital structure magnifies the results of residual claimants. Small change in income magnifies the return for residual shareholders. See Notes.
(4)Modigliani-Miller PostulateObservation of indifference of capital structure in valuing totality of a firm. Choice of capital structure does not affect value of income stream. Idea that sum of parts = whole. Only effect of various types of capital structure is distribution of returns.
(5)Corollary of MM Postulate There is not a specific kind of equity that you must provide in order to attract certain investors because they can roll their own (assume frictionless).
(6)Big problem is taxation. Stock and debt have dramatically different tax ramifications. Interest payment for debt is a deduction at the corporate level. However, distributions to shareholders is subject to double taxation. Thus, changing capital structure in context of taxation will increase income stream. Note temptation of junk bond financing.
(7)If debt and stocks are held proportionately by a single shareholder, then there is no allocation of risk and return or priority of payment because whatever benefits A receives as shareholder, A loses as debtholder.