CHAPTER 30
FINANCING THE CORPORATION AND THE ROLE OF THE SHAREHOLDERS
Outline
I. Financing the Corporation
A. Sources of Corporate Financing
The initial funds and property may come directly from the promoters or it may come from other types of investors.
B.Equity Securities
Equity securities arise from the sale of ownership interests in the business; debt securities, and is typified by bonds and other obligations.
1.Common Stock
If the corporation only has one class of stock, it is common stock. If there is more than one class, the common shareholders usually bear the major risks and benefits of the business.
Example: Levco Alternative Fund Ltd. v. The Reader’s Digest Association: The court issued a preliminary injunction against the corporation’s recapitalization plan. The special committee created to review the fairness of the proposal never considered whether the measure was fair to the Class A shareholders.
2. Preferred Stock
Preferred stock gives shareholders a preference as to dividends and distribution of assets. Rights of preferred shareholders may vary.
C. Consideration for Shares
The stockholders must provide consideration for their shares (money, property, or services already performed).
D. Value of Shares
Shares may be assigned a value, called par value, in the articles of incorporation or a stated value at the time of issuance.
1.Stated Capital is determined by multiplying the number of outstanding shares times the par or stated value of each share.
2.Capital surplus arises when shares sell for more than their par or stated value.
E.Options, Warrants, and Rights
Directors may issue options to purchase shares of the corporation; options represented by certificates are known as warrants.
F.Treasury Stock
A corporation may purchase its securities from any willing seller but it must be purchased with unrestricted earned surplus.
G. Debt securities.
Corporations may borrow money by issuing debt securities. These include notes, debentures, and bonds.
II. Becoming a Shareholder
A. Functions of Shareholders
Shareholders have few functions--their principal function is the election of the directors.
B. Means of Acquiring Stock
A shareholder usually acquires stock by purchase.
III.Shareholders’ Meeting
A. Annual Meeting
Annual Shareholder's meetings are required in all states but Delaware. The main purpose of the meeting is the election of directors. Notice is required before the meeting, but shareholders may waive notice.
B. Special Meetings
Under the MBCA, unless otherwise stated in the bylaws, special meetings may be called by the president, the board of directors, or one-tenth of the shareholders.
C.Notice of Special Meetings
The MBCA requires notice of all shareholders’ meetings to be given.
Example: Accipiter Life Sciences Fund v. Helfer: The court found that the election should not be set aside. LifePoint’s concededly troubling way of announcing its annual meeting does not reach the standard required for equitable relief.
D.Remote Participation
Delaware’s corporation laws now permit directors to allow shareholders to participate in annual meetings by remote communication.
E.Shareholders Entitled to Vote
Shareholders’ right to vote depends on the type of stock owned.
F.Proxy Voting
The MBCA requires a written document to appoint a proxy as an agent to vote for a shareholder, and the SEC (Securities and Exchange Commission) regulates proxy statements.
Example: American Federation v. American International Group: The court found that if a shareholder seeks to submit a proposal, the corporation is generally required to include the proposal in its proxy statement.
G.Shareholder Proposals and Right to Speak
Shareholders have the right to ask questions and to propose resolutions at shareholders' meetings
H.Cumulative Voting
The purpose of allowing shareholders to cumulate their votes is to give minority shareholders an opportunity to be represented on the board.
IV.Rights of Inspection and Preemptive Right
A.The Shareholder’s Right to Inspect
The MBCA requires a corporation to send its latest financial statements to any shareholder on request.
Example: Barasch v. Williams Real Estate: The court found that Barasch did not have a right to examine the communications because they were privileged attorney-client communications.
B.Preemptive Rights
A number of states require corporations in that state to allow current shareholders the first opportunity to purchase new issue of stock.
V.Dividends
A.Directors’ Discretion to Pay Dividends
The declaration of dividends is subject to the business judgment of the board of directors.
B.Types of Dividends
Types of dividends include cash and stock dividends.
C.Legal Limits on Dividends
Under the MBCA, dividends may only be paid out of retained earnings.
D.Stock Splits
A stock split changes the par value or stated value of the shares and the number of outstanding shares.
Example: Lohnes v. Level 3 Communications: Level 3 was not contractually bound to provide Lohnes with individualized notice of its stock split.
E.Dividends on Preferred Stock
A preferred shareholder usually has preference in dividends.
F.Effect of Dividend Declaration
Once the directors have voted to pay a lawful dividend, it becomes a debt of the corporation.
VI. Shareholder Rights in Extraordinary Corporate Transactions
A. Amendment of Articles
Shareholders must approve amendment of the articles of incorporation; merger or consolidation also requires approval. Most states deny the right of appraisal if the shares are traded on a securities exchange.
B.Other Extraordinary Transactions
Approval of all classes of shares is required for a merger or consolidation.
C.Appraisal Rights
If a shareholder votes against certain transactions but the majority vote for the transaction, the shareholder may be permitted to demand the corporation purchase his stock at fair value.
VII.Lawsuits by Shareholders
A.Individual Actions
Shareholders may sue the corporation for a breach of their shareholder contract.
B.Class Actions
A number of shareholders may sue the corporation as a group.
C.Derivative Actions
A shareholder may file a lawsuit on behalf of the corporation in unusual cases.
Example: Pirelli Armstrong Tire Corporation v. Raines: The court found the shareholders were not excused from asking the board to have the corporation pursue the claim.
Example: Lerner v. Immelt: The court found that Lerner could not bring a derivative action. The board was not required to refer a shareholder demand to a special litigation committee.
VIII. Shareholder Liability
A. Liability on Shares
A shareholder that has fully paid for his stock usually has no further liability to the corporation or its creditors.
B. Liability for Illegal Dividends
A shareholder must return dividends that were paid illegally.
IX. Transfer and Redemption of Shares
A. Restrictions
A shareholder has a right to sell or give away her shares unless there is a valid restriction.
B. Transfer Procedure
To transfer stock, the owner endorses the assignment form printed on the back of the stock certificate.
C. Duty to Record
The corporation must record the transfer of its stock.
Learning Objectives
1.You should understand the considerations in a court decision to uphold the board's defensive tactics.
2.You should understand the difference between common and preferred stock.
3.You should understand the rights and obligations of the holders of various types of stock.
4.You should know what types of consideration a corporation may receive in exchange for its shares.
5.You should know when a corporation may redeem its shares and when it may purchase its shares on the open market.
6.You should be able to recognize the many debt instruments a corporation may issue.
7.You should understand the role of the shareholders in a corporation's governance.
8.You should know how shareholder meetings (particularly special meetings) are called, what the notice requirements are for shareholder meetings, and what sorts of actions are taken at shareholder meetings.
9.You should understand what a proxy is.
10.You should know what cumulative voting is and how it enables minority shareholders to elect directors.
11.You should understand what preemptive rights are and what the right of appraisal is.
Learning Hints
1.There are two major sources of corporate financing: equity securities, which arise through the sale of ownership interests in the business, and debt securities, typified by bonds and other obligations of the business.
2.Common stock shareholders usually bear the major risks of the business and benefit most from its success.
3.Preferred stock gives the owner a preference as to dividends and distribution of assets.
4.The par value of shares may be established in the articles of incorporation; par value and stated value reflect the minimum amount of consideration for which the shares can be issued. In many cases, the shares are worth more than par or stated value and the directors have a duty to receive the fair value of the stock.
5.If the directors issue shares to such purchasers for less than the par or stated value of the shares, such a situation presents a "watered stock" problem. Watered stock is an easy problem to detect. For example, corporate directors issue one-dollar par shares for 75 cents per share. The "water" is 25 cents per share. (The term derives from the practice of dishonest cattlemen who took their cattle to the river to drink water before taking them to the stockyards. By doing so, the cattlemen caused their cattle to weigh more. The added weight was misleading, however, because it was attributable to water rather than beef.)
6.Proxies serve as a useful tool for management to control a corporation without management necessarily owning many shares itself. Most shareholders tend to sign and return proxies submitted to them by management, leading to the typical situation that what management wants to happen at a shareholders' meeting generally will happen. Of course, groups of shareholders may also seek the proxies of other shareholders, but such groups rarely have the success management ordinarily has in soliciting proxies.
7.Where cumulative voting is required by statute, as in a number of states, or is allowed by the corporation even though state law does not require it, a group of minority shareholders has an enhanced opportunity to elect a director of that group's choice. Your text sets forth the formula used, under cumulative voting, to determine the number of shares necessary to elect one director. As an illustration of how the formula works, assume that 1000 shares are being voted at the shareholders' meeting, and that four directors are to be elected. Applying the formula, one would divide 1000 (the number of shares being voted) by five (the number of directors to be elected, plus one). The resulting figure of 200 is then increased by one, meaning that 201 shares are needed to elect one director.
8.Some corporate transactions fundamentally change the character of the shareholders' investment. For this reason, the law requires shareholder approval before the fundamental change may occur. For example, a merger significantly increases the assets and liabilities of the corporation the shareholder owns and increases the number of shareholders who own the corporation. Also, an amendment of the articles of incorporation changes the basic governing document of the corporation. Hence, a shareholder vote must approve these transactions. By contrast, the sale of inventory in the ordinary course of business is a minor matter that does not require shareholder approval.
9.Note that before a corporation may pay any dividend to common shareholders, it must pay the preferred shareholders' dividend preference. If there is an arrearage on cumulative preferred shares, the entire arrearage must be paid before any dividend may be paid to common shareholders.
10.The existence of the right of appraisal recognizes that a shareholder needs a remedy when she votes against a merger, consolidation, or sale of substantially all the assets of the corporation that the shareholders as a whole approve. In such transactions, the shareholder's investment is being substantially changed against her will. The right of appraisal allows the shareholder to receive the value of her shares as of the moment before the transaction was effected. Hence, if the shareholder believes the transaction reduced the value of her investment, she may obtain the value of the investment prior to the transaction by enforcing her right of appraisal.
True-False
In the blank provided, put "T" if the statement is True or "F" if the statement is False.
_____1. A corporation can issue a class of stock that carries with it no right to vote for corporate directors.
_____2.Even if a shareholder is consistently dissatisfied with day-to-day operation decisions of the corporate management, the shareholder cannot on that basis enforce the right of appraisal.
_____3.Cumulative voting allows minority shareholders the opportunity to have representation on a corporate board.
_____4.Hardy owns stock in General Motors. Since Hardy is unable to attend the annual shareholder meeting, he can vote by proxy.
_____5.The decision by the board of directors to pursue litigation is not an ordinary business decision protected by the business judgment rule.
_____6.Trish owns debenture in SBA Co. Vern owns bonds in SBA. If SBA liquidates, Trish will likely be repaid more of her investment than will Vern.
_____7.Treasury shares must be resold for more than par value.
_____8.Although a corporation must issue common stock, it need not issue preferred stock.
_____9.Although preferred shareholders usually have a dividend preference over common shareholders, preferred shareholders often do not have the same rights to vote that common shareholders possess.
_____10.Carmen owns 1 percent of the stock of GC Co. If GC issues new shares of stock, Carmen has a preemptive right to purchase a proportionate number of the new shares so that she can maintain her 1 percent ownership in GC.
Multiple Choice
Circle the best answer.
1.Shirley owns preferred stock in BMI Corporation. Which of the following statements is not true concerning Shirley’s investment?
a.Shirley receives dividends on her stock before common shareholders in BMI receive their dividends.
b.If BMI is dissolved, Shirley will be paid her share from the distribution of the assets before common shareholders are paid.
c.Preferred shareholders, such as Shirley, always have voting rights.
d.Shirley’s preferred stock may be convertible into BMI common stock.
2.Sharon owns cumulative preferred stock in XYZ Co. For three years, the company struggled a great deal and no dividends were paid to either preferred or common shareholders. The company was profitable in the fourth year and is ready to pay dividends. Which of the following statements is true concerning Sharon’s investment in XYZ preferred stock?
a.Sharon will never receive dividends for those years the company could not afford to pay them.
b.Sharon is entitled to receive all dividends from past years and the current year before common shareholders receive their dividends.
c.Sharon will never receive more than her “normal” dividend each year even if her stock is participating.
d.Sharon must be paid dividends every year since she owns cumulative preferred stock.
3.Which of the following statements concerning stocks is not true?
a.Stock splits may be used to lower the price of stock so that more investors may buy it.
b.Stock dividends increase a shareholder’s stake in the corporation.
c.The board of directors decides whether to declare dividends.
d.An owner of participating preferred stock may share in profits with common shareholders over and above her “normal” dividend.
4.Dissolution of the corporation:
a.Occurs when all corporate assets have been liquidated and distributed to creditors and shareholders.
b.May be decreed by a court if the majority shareholder sells her shares.
c.May occur as a result of vote by majority of the corporation's initial directors.
d.May be decreed by a court against the will of the corporation's directors and at the request of creditors under appropriate circumstances.
5.Which of the following statements about shareholder rights is not true?
a.Shareholders may sue the corporation for breach of the shareholder contract.
b.A class action suit could be brought against the corporation by the shareholders of the same class of stock.
c.A shareholder may bring a derivative action against the corporation if the board of directors refuses to do so.
d.Damages in a successful derivative action are awarded to the shareholder who brings the action.
6.Cargo Corporation issues 100,000 shares of its $1 par value common shares for a total consideration of $50,000 cash, the fair market value of the shares. Is there anything wrong with this issuance?
a.No, because they were issued for fair market value.
b.No, because cash is a proper type of consideration for shares.
c.Yes, because the fair market value must have been more than $50,000.
d.Yes, because the shares were issued for less than their par value.
7.Which of the following statements regarding stock is true?
a.Shareholders who knowingly receive dividends that were paid illegally must pay the amount back to the corporation.
b.A shareholder can endorse the assignment form printed on the back of the stock certificate to transfer ownership of the stock.
c.Shareholders in a close corporation may have an agreement that gives the other shareholders first right of purchase when another shareholder wants to sell her stock.
d.All of the above.
8.Bing Co., a corporation listed on the New York Stock Exchange, is proposing a merger with Geller, another NYSE listed company. Green, a common stockholder in Bing Co., votes against the merger. Green now demands a right of appraisal. Which of the following statements is most accurate?
a.Green cannot initiate the right of appraisal because she voted against the merger.
b.Green cannot initiate the right of appraisal because she does not have the right to vote.
c.Green does not need to inform the corporation of her intent to exercise the right of appraisal before the vote takes place.
d.Green cannot bring a right of appraisal because Bing Co. is traded on a recognized securities exchange.
9.On September 15, 1990, Whitman signed a preincorporation subscription to buy 1,000 common shares of Slim Corp., a proposed corporation that was to be incorporated in a state that has adopted the Model Business Corporation Act. Slim was incorporated in Oct. 1, 1990 in such a state. Before Slim's board of directors took action to accept Whitman's preincorporation subscription, Whitman informed the board (on Oct. 2, 1990) that he was revoking the subscription. Shortly thereafter, the board voted to accept Whitman's subscription. When Slim attempted to force Whitman to buy the shares, he refused. Slim then sued Whitman. Is Whitman bound by his subscription?