Chapter 42: Organization and Financial Structure of Corporations
I. Promoters and Preincorporation Transactions
A. Promoter
1. Incorporates a business
2. Organizes its initial management
3. Raises its initial capital
B. Corporation’s Liability on Preincorporation Contracts
1. No liability on contracts made by a promoter prior to incorporation
a. Not automatically liable after becoming a corporation
b. Must adopt promoter’s preincorporation contract in order to become liable
i. Must accept the contract with knowledge of all its material facts
ii. May be express or implied
C. Promoter’s Liability on Preincorporation Contracts
1. Jointly and severally liable with copromoters, including the torts committed prior to incorporation
2. Liability exists even if the promoter’s name is not on the contract
3. Novation must occur to remove liability
a. Corporation and third party agree to release the promoter from liability; and
b. To substitute the corporation for the promoter as the party liable on the contract
c. Can be express or implied agreement
D. Obtaining a Binding Preincorporation Contract
1. In order for the third party to be liable, the promoter must be liable
2. Once the corporation adopts the contract, both the corporation and third party are liable and cannot rescind without consent
3. Automatic novation clause: wording in a contract to indicate the promoter’s liability ceases upon adoption by the corporation
E. Preincorporation Share Subscriptions
1. A prospective shareholder offers to buy a specific number of shares at a stated price
2. Ensure that the corporation will have enough capital
3. MBCA does not allow the prospective shareholder to revoke for a 6-month period
4. Promoters have no liability in the absence of fraud or other wrongdoing, but they have a duty to make a good faith effort to bring the corporation into existence
F. Relation of Promoter and Prospective Corporation
1. Promoter is not an agent
2. Promoter does owe fiduciary duties: full disclosure and honesty
a. Cannot divert money from prospective shareholders to pay own expenses
b. Cannot divert a business opportunity from the corporation and give to him or herself
c. May not purchase shares at a price lower than that paid by public shareholders
d. May not profit personally via secret transactions
G. Liability of Corporation to Promoter
1. Generally, no compensation for promotional services or expenses is required
2. MBCA permits shares to be issued for a promoter’s preincorporation services
II. Incorporation
A. Steps in Incorporation
1. Preparation of articles of incorporation
a. Basic governing documents of a corporation
b. Contain many of the rights and responsibilities of the corporation, management and shareholders
2. Signing and authenticating the articles
a. Signed by incorporators
b. No special liability attaches to incorporators
3. Filing the articles
a. Must be delivered to the office of the secretary of state
b. Fee must be paid
4. Receipt of a copy of the articles with “Filed” stamp and fee receipt
a. Existence of corporation begins when the articles are filed by the secretary of state
b. Shareholders must approve most changes in the articles as the articles are a contract between shareholders and the corporation
5. Holding an organizational meeting to adopt bylaws, elect officers, and transact other business
a. First formal meeting of the directors
b. Defines the powers, rights and responsibilities of the parties more precisely
c. MBCA authorizes incorporators or initial directors to adopt the preliminary bylaws
d. Board of directors has the power to repeal and amend the bylaws unless articles state otherwise
e. As the ultimate owners of the corporation, the shareholders always retain power to amend the bylaws as well
6. Filing Annual Report
B. Close Corporation Elections
1. Most statutes require a corporation make an election to be treated like a close corporation
2. Statutory Close Corporation Supplement to the MBCA allows a corporation with less than 50 shareholders to elect to be a close corporation
3. No penalty for a failure to make election
4. Courts may apply common law rules applicable to close corporations even in the absence of statutory election
III. Defective Attempts to Incorporate
A. Failure to comply with all the conditions for incorporation may result in the following consequences
1. Managers and purported shareholders become personally liable for obligations
2. A party to a contract with the defectively formed corporation may refuse to perform
3. Defectively formed corporation may escape liability on the contract due to its nonexistence
B. 3 Classifications of Defectively Formed Corporations
1. De Jure Corporation
a. Formed when promoters substantially comply with each of the mandatory conditions for incorporation
b. Treated like a corporation for all purposes
c. Can only be attacked in a quo warranto proceeding: state asserts noncompliance with a condition subsequent to incorporation, like failure to file an annual report
2. De Facto Corporation
a. Formed when incorporators fail in a material respect to comply with all of the mandatory provisions of the incorporation statute, yet comply with most
b. 3 requirements
i. Valid statute exists under which the corporation could be organized
ii. Promoters make an honest attempt to organize under statute
iii. Promoters or managers exercise corporate powers
c. Treated as a corporation with respect to
i. An attack by a third party
ii. An attempt by the business itself to deny that it is a corporation
d. State may attack in a quo warranto proceeding
3. Corporation by Estoppel
a. Court will not deny the existence of a corporation when
i. People hold themselves out as representing a corporation; or
ii. Believe themselves to be dealing with a corporation
b. Each contract must be considered individually to determine if either party is prevented from denying the corporation’s existence
C. Liability for Defective Incorporation
1. Persons are generally deemed to be partners with unlimited liability for contracts and torts of the business
2. Most courts only impose contractual liability on those who are
a. Actively engaged in the management of the business; or
b. Responsible for the defects in organization
3. Tort liability is generally imposed on everyone, managers and purported shareholders alike
D. Modern Approaches to the Defective Incorporation Problem
1. MBCA states that the filing of the articles is conclusive proof of a corporation’s existence, except in proceeding brought by the state
2. Courts have then found the opposite: failure to obtain a filing of the articles is conclusive proof of nonexistence
3. Liability for those purporting to act an behalf of a corporation with knowledge of its nonexistence is joint and several
4. MBCA releases shareholders and others from liability who
a. Take no part in the management of the defectively formed corporation; or
b. Mistakenly believe that the corporation is in existence
5. Christmas Lumber Co., Inc. v. Valiga: court held parties liable as partners when appellant did not establish lack of knowledge that a corporation was not yet formed
IV. Incorporation of Nonprofit Corporations
A. Incorporated in substantially the same manner as for-profit corporations
B. Unlike a for-profit corporation, must state it is either a public benefit corporation, a mutual benefit corporation or a religious corporation
C. Normally members and managers are shielded from personal liability, but those acting for a nonexistent corporation will have the same liabilities as for-profit nonexistent corporations
V. Financing For-Profit Corporations
A. Equity Securities
1. Commonly called stock or shares
2. Creates an ownership relationship: stockholders or shareholders are owners of the corporation
3. Types
a. Common Shares
i. Often occupy a position inferior to that of other classes
ii. Shareholders have the exclusive right to elect the directors, who manage the corporation
iii. Have an exclusive claim to the corporate earnings and assets that exceed the claims of creditors and other shareholders
b. Preferred Shares
i. Have preferences over other classes of shares
ii. Shareholders are customarily given liquidation and dividend preferences over common shareholders
iii. MBCA: preferences must be set out in the articles of incorporation
a) Liquidated preferences: a stated dollar amount that must be distributed
b) Dividend preferences: can be cumulative or noncumulative
c) Participating preferred shares: have priority up to a stated amount or percentage of the dividends to be paid
d) Mandatory dividend: generally held to be illegal
e) Redemption: allows a corporation to repurchase shares at its option, despite shareholders’ unwillingness
iv. May be convertible into another class of shares
v. Have voting rights, unless articles state differently
B. Authorized, Issued, and Outstanding Shares
1. Authorized: shares that a corporation is permitted to issue pursuant to its articles of incorporation
2. Issued: shares that have been sold to shareholders
3. Outstanding: shares currently held by shareholders
4. Cancelled Shares: repurchased shares no longer in existence; cannot be reissued
5. Shares Restored to Unissued Status
6. Treasury Shares:
a. Repurchased shares that are neither cancelled nor restored to unissued status
b. MBCA has abolished the concept
C. Options, Warrants, and Rights
1. Options: MBCA allows the board of directors to issue options for the purchase of a corporation’s shares
2. Warrants: options evidenced by certificates
3. Rights: short-term, generally transferable, certificated options
4. Preemptive right: requires a corporation to offer each existing shareholder the opportunity to buy newly issued shares in the same proportion as shareholder’s current ownership
D. Debt Securities
1. Debentures
a. Long-term
b. Unsecured
c. Typically have a term of 10 to 30 years
d. Usually have indentures: contract that states the rights of debenture holders
2. Bonds
a. Long-term
b. Secured by collateral
c. Usually have indentures
3. Notes
a. Shorter duration than other debt securities
b. May be secured or unsecured
c. Seldom have terms exceeding 5 years
d. Often convertible into other securities, such as common shares
VI. Consideration for Shares
A. Quality of Consideration
1. Statutes require legal consideration to have real value
2. MBCA permits share to be issued in return for tangible or intangible property or benefit, including
a. Cash
b. Promissory notes
c. Services
d. Contracts for services
e. Securities
3. MBCA allows corporations to issue shares to their promoters in consideration for the promoters’ preincorporation services
B. Quantity of Consideration
1. Par value: arbitrary dollar amount assigned to shares by articles of incorporation
a. Does not reflect the fair market value
b. Minimum amount of consideration for which the shares may be issued
c. Discount shares
i. Issued for less than par value
ii. Board of directors is liable to corporation for issuance
2. Fair value: shares are often worth more than their par value
a. Board’s judgment as to the amount of consideration received for shares is conclusive when it
i. Acts in good faith
ii. Exercises the care of ordinarily prudent directors; and
iii. Acts in the best interests of the corporation
b. Board’s valuation of consideration is also conclusive when it
i. Acts in good faith
ii. Exercises the care of ordinarily prudent directors; and
iii. Acts in the best interests of the corporation
c. Watered shares
i. Board impermissibly overvalues the consideration for shares
ii. Both board and shareholders are liable to the corporation
d. Fully paid and nonassessable: shareholder has paid proper amount of consideration
3. Accounting for Consideration Received
a. Stated capital account: the number of shares outstanding multiplied by the par value of each share
b. Capital surplus: excess or surplus consideration received when shares are sold for more than par value
c. MBCA has eliminated the terms stated capital and capital surplus
4. Resales of Shares
a. Board may sell treasury sales for less than par value, if it sells them for an amount equal to their fair value
b. A shareholder may buy shares from another shareholder for less than par value or fair value and no liability results
VII. Share Subscriptions
A. A prospective shareholder promises to buy a specific number of shares at a stated price
B. Subscriber is a shareholder, even if the shares have not been issued
C. MBCA: subscriptions do not have to be in writing to be enforceable
D. Postincoporation subscriptions bind the corporation and subscriber
E. When the Board demands payment from subscribers, it must demand from all subscribers of a class of shares or none of them: no discrimination
VIII. Issuance of Shares
A. Uniform Commercial Code (UCC) Article 8
1. Regulates the issuance of securities
2. Permits a corporation to only issue the number of shares authorized by its articles
3. Overissued shares are void
a. Two remedies for someone entitled to overissued shares
i. Corporation must obtain identical shares and deliver them to the person; or
ii. Corporation must reimburse the person for the value paid for the shares plus interest
b. Directors may incur liability, including criminal
B. Share certificate: evidence that a person has been issued shares, owns the shares, and is a shareholder
C. MBCA: does not require a corporation to issue share certificates; a written statement with the information required in the certificate suffices
IX. Transfer of Shares
A. Transfer occurs through
1. Either
a. Indorsement of share certificate on it back by its registered owner; and
b. The delivery of the certificate to another person
2. Or (street certificate)
a. Delivery of share certificate
b. Without indorsement
B. UCC requires corporation to register the transfer of any registered shares if properly indorsed
C. Bona fide purchaser:
1. Buys shares in good faith
2. With no notice of any adverse claim against the shares
D. Corporation must register the transfer to a bona fide purchaser unless overissuance would result
E. Restrictions
1. Historically, shareholders are free to sell shares to whomever they want whenever they want
2. In close corporations, free transferability threatens the balance of power among shareholders