Corporate Formation& Organization

What is a corporation?A business entity characterized by the

following attributes:Limited liabilityCentralized decision makingPerpetual existenceFree transferability of ownership

In short, corporations are everything that general partnerships are not

Challenge for business planners: construct an entity that provides the best of both worlds

Eliminates messy problems of personal liability: creditors rely only on business assets.

Allows investors to enter and exit the firm: all they have to do is buy or sell shares.

Prevents minority investors from trying to hold up the firm by threatening to dissolve it.

Makes it easy for third parties who contract with the firm to know whom they are dealing with as an authorized agent. All they need is a board resolution.

Benefits of the Corporate Form

U.S. firms are not constrained by headquarters, place of business, or other operational factors in choosing where to incorporate.

State of incorporation dictates which corporate law rules apply under “internal affairs” doctrine.

States charge annual franchise taxes ranging from $10 flat fees to $100,000+ based on income, assets, etc.

Mechanics of reincorporation are straightforward: creation of a new firm in the destination state, followed by tax-free merger of the existing corporation into the new one. Typical reincorporation costs are $70,000 in 2000.

Reincorporation requires shareholder approval.

Structural Features of the Corporate Charter Marketplace

Headquarters State

U.S. Public Corporations (2000)

From: Guhan Subramanian, The Influence of Antitakeover Statutes on Incorporation Choice: Evidence on the “Race” Debate and Antitakeover Overreaching, 150 U. Penn. L. Rev. 1795, Figures 1 & 2 (2002) . N = 7,841 companies.

State of Incorporation

Germany, France, Portugal apply the “real seat” theory: e.g., Germany requires a company having its principal place of business in Germany to incorporate under German law; a company that has its headquarters outside of Germany cannot incorporate under German law.

Netherlands, Ireland, Denmark, U.K. apply U.S.-style incorporation theory, I.e., a corporation is regulated by the country in which it is incorporated, which can differ from where it is incorporated or does business.

BUT: European Court of Justice in Centros decision (March 1999) and the EC Fourteenth Company Law Directive (proposed but not yet formally tabled for Council of Ministers) likely requires U.S.-style incorporation theory.

International Comparison -- Europe

Selecting a State of IncorporationPublicly traded corporations: Delaware is home

to about half of the Fortune 500High technology firms seem to choose Delaware at an

even higher rateWhy Delaware? Statute? Specialized courts? Closely held corporations: home state

Corporate law is not as important because the important issues are contracted

Maintaining local incorporation is cheaper

Promoter LiabilityPromoters are personally liable on all pre-

incorporation contracts:“All persons purporting to act as or on behalf of a

corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.” MBCA § 2.04

However, If one party urges another to sign in the name of the corporation, even though both know it does not exist, estoppel may prevail

Third party may agree to look to corporation

Incorporation ProcessDraft articles of incorporation

Called “certificate of incorporation” in DEGeneric term is “charter”

“One or more persons may act as the incorporator or incorporators of a corporation by delivering articles of incorporation to the secretary of state for filing” MBCA § 2.01

“[T}he corporate existence begins when the articles of incorporation are filed” MBCA § 2.03

Defective IncorporationDrafters of MBCA § 2.04 meant to displace de

facto corporations, which arise from a “colorable attempt” to form and exercise of corporate powerDespite a few cases eliminating the de facto

corporation doctrine, many courts still rely on de facto corporations

Corporations by estoppel may be used to uphold limited liabilityNote that this is backwards because the person relying

on the false representation is estopped

Post-IncorporationIncorporator usually elects directors, who

complete the organization process (MBCA § 2.05)Adopt by-lawsAppoint officersIssue stock

The existence of the corporation does not depend on the maintenance of corporate formalities

BUT the benefits of limited liability may depend on the maintenance of corporate formalities (see “piercing the corporate veil”)

Drafting the Charter

Statutory requirements minimal:Name (indicate corporate status, MBCA 4.01)Number of shares (check MBCA 6.01)Registered office and registered agent (MBCA § 5.01)Incorporator name and address

Optional items:Some optional items may be effective only if they

appear in the charter (e.g., limitation on director liability)

Most optional items could appear in the bylaws or a board resolution; place them in the charter only if you want to insulate them from change

Charter & Bylaws – Typical Contents

Articles of Incorporation: Name of Company, Address, Purpose (usually “any lawful act”), capital structure (classes, number of common shares, rights of preferred shareholders if any), other miscellaneous provisions.

Bylaws (sample structure):

Article I: StockholdersArticle II: Board of DirectorsArticle III: CommitteesArticle IV: OfficersArticle V: StockArticle VI: IndemnificationArticle VII: Miscellaneous

Core Characteristics of the Corporate Form

Centralized management under an elected board

Transferable shares

Limited liability

Legal personality

X

X

X

X

X

X

X

X

X

X

XInvestor Ownership

Corp.LLCGPCore Characteristics

Corporate Form – Key Benefits

Benefits of Limited Liability:1. Reduces need to monitor agents (managers)2. Reduces need to monitor other shareholders3. Makes shares fungible (which also facilitates takeovers, see

below)4. Facilitates diversification (without LL, minimize exposure by

holding only one company)5. Enlists creditors in monitoring managers (because creditors

bear some downside risk)

Benefits of Transferable Shares:1. Permits takeovers => disciplines management2. Allows shareholders to exit without disrupting business3. And because of LL, shares are fungible => facilitates active

stock markets, increasing liquidity

Derived from: Easterbrook & Fischel, The Rationale of Limited Liability, 52 U. Chi. L. Rev. 8 9(1985)

Basic Decisionmaking Structure

Shareholders

Directors

Officers

The Board of Directors

Shareholders

Directors

Officers“[E]ach corporation must have a board of directors”

MBCA § 8.01(a)

The Board of Directors

Directors

“[E]ach corporation must have a board of directors”

MBCA § 8.01(a)

Shareholder agreement may “eliminate the board of directors or restrict the

discretion or powers of the board of directors” MBCA §

7.32(a)(1)

“All corporate powers …”

MBCA § 8.01(b)

The Board of Directors

Directors

“All corporate powers …”

MBCA § 8.01(b)

The Board of Directors

Directors

“inside” directors = employees

The Board of Directors

Directors

“outside” directors = non-employees

The Board of Directors

Directors

“independent” directors = non-employees without substantial ties to the

corporation

The Board of Directors

Directors

“disinterested” directors =directors without a financial

interest in the relevant transaction

Board SizeOne director is enough (MBCA § 8.03(a))Number of directors (or a range) usually fixed

by the charter or a bylaw (MBCA § 8.03(c))

Election of Directors

Directors elected at annual meeting of shareholders (MBCA § 8.03(d))“Staggered” boards have special rules (MBCA § 8.06)

Directors hold office until their successors are elected and qualified

Meetings of the BoardDirectors act at regular or special meetings of

the board (MBCA § 8.20(a))Directors may act without meeting, by

unanimous written consent (MBCA § 8.21(a))Quorum: unless altered by the charter or

bylaws, a majority of the board forms a quorum (MBCA § 8.24(a) & (b))

The board of directors acts by majority vote, unless the charter or bylaws require a supermajority (MBCA § 8.24(c))

Board Committees The board of directors may act through committees

comprised of fewer than the total number of directors (MBCA § 8.25(a)

The rules governing meetings of the board also govern meetings of committees (MBCA § 8.25(c))

Committees may be authorized to act on behalf of the whole board (MBCA § 8.25(d))

Stock exchange rules may require committees and certain composition of the committee – e.g., audit committee have at least one financial expert

Federal regulation also has focused on committees (S-OX) Audit, Nominating, Compensation Legal Compliance???

Removal of Directors: MBCADirectors may be removed by shareholders

with or without cause. MBCA § 8.08(a)If a director is elected by a specific class of

shares, only those shares may remove the directors. MBCA § 8.08(b)

Special rules for cumulative voting. MBCA § 8.08(c)

Directors may be removed in a judicial proceeding for bad behavior, if the court finds that removal is in the best interests of the corporation. MBCA § 8.09

Removal of Directors: DGCLUnder DGCL, directors may always be removed

for causeUnder DGCL § 141(k)(1), removal of directors in

staggered board is only for cause

Vacancies and New DirectorshipsVacancies are caused by death, removal,

resignationCreation of a new directorship functionally the same

as a vacancyShareholders or directors may fill vacancies or

new directorships. MBCA § 8.10; DGCL § 223

Basic Decisionmaking Structure

Shareholders

Directors

Officers

Shareholder Voting Generally“[E]ach outstanding share … is entitled to one vote

on each matter voted on at a shareholders’ meeting” (MBCA § 7.21(a))

Subject matterElecting of directors (MBCA § 8.03(d))Removing of directors (MBCA § 8.08)Amending the charter (MBCA § 10.03)Amending the bylaws (MBCA § 10.20)Approving a merger (MBCA § 11.03)Approving sale of all the company’s assets (MBCA § 12.02)Approving dissolution (MBCA § 14.02)Ratifying conflict-of-interest transactions (MBCA § 8.61(b)

(2))

The Voting System -- Basic Features

Shareholders vote on three kinds of matters: (1) election of directors; (2) “organic” or “fundamental” changes, e.g., mergers, sales of all assets, corporate dissolutions, charter amendments; and (3) shareholder resolutions.

Registered shares: each share has a holder of record, which facilitates getting in touch with the ultimate beneficial holder (unlike bearer system in France & Germany).

Proxy system: if you can’t attend the annual shareholder meeting (ASM), you can still vote by finding a representative (proxy) who goes to the meeting and votes on your behalf.

State law mandatory rules: all state statutes except one require an annual meeting for election of directors; quorum requirements.

State law default rules: all state statute statutes permit special meetings and action by written consent, though default varies.

Voting RulesDirector elections

Straight Voting v. Cumulative VotingPlurality wins

Other mattersOne share, one voteMajority wins, unless supermajority specified

Cumulative Voting -- Mechanics

Cumulative Voting: each shareholder gets votes equal to number of shares owned times number of seats to be filled.

Example: Family Corp. has 300 shares outstanding; A owns 199 shares and B owns 101 shares. Family Corp. has a three-person board elected to annual terms.

Straight Voting: A would win each seat 199 to 101.

Cumulative Voting: B casts 303 shares all for one candidate => guaranteed to get one seat on the board, because A’s 597 votes cannot be divided three ways so that all three are greater than 303.

Implication: Cumulative voting system improves likelihood of minority representation on the board.

Shareholder MeetingsTwo types: annual (MBCA § 7.01) and special

(MBCA § 7.02)Special Meetings: DGCL § 211(d) allows board

to call a special meeting. RMBCA § 7.02 allows board or 10% of shareholders to call a special meeting.

Modern statutes also allow for written consent:MBCA § 7.04(a): requires unanimous consentDGCL § 228: number of votes required in meeting

Shareholders may vote in person or by proxy (MBCA § 7.22(a))

Calling a Shareholder MeetingAnnual Meetings

MBCA § 7.01(a): in accord with bylaws (if silent, presumably by board)

DGCL § 211(a): in accord with charter or bylaws; if silent by board

Special MeetingsMBCA § 7.02: called by board or other person

authorized by charter or bylaws; 10% shareholders (or a different percentage not in excess of 25%) may demand

DGCL § 211(d): called by board or other person authorized by charter or bylaws (note that no default provision for shareholder action)

Setting an Annual Meeting DateMBCA § 7.01(a): in accord with bylaws

Court may order if meeting is not held within 6 months of the end of the fiscal year or 15 months after its last annual meeting (§ 7.03(a)(1))

DGCL § 211(b): in accord with bylawsIf not held within 30 days after the designated date,

the court may order a meeting (§ 211(c))If no date is designated and 13 months have passed

since the last annual meeting (or written consent in lieu thereof), the court may order a meeting (§ 211(c)

Setting a Special Meeting Date Special Meetings (MBCA):

Board must give notice no fewer than 10 nor more than 60 days before the meeting date (§ 7.05(a))

Court may order if notice is not given within 30 days of shareholder demand or the meeting was not held (§ 7.03(a)(2))

Under MBCA, board has 90 days after shareholder demand to hold the meeting

Special Meetings (DGCL):Board must give notice no fewer than 10 nor more than 60

days before the meeting date (§ 222(b))But DGCL § 211(d) does not provide for shareholder right to

call special meetings; therefore, date regulations are less critical here

Fiduciary Limits on Setting the Meeting DateGeneral Principle: directors must act in the

interests of shareholders, not for the purpose of entrenchment

Two situationsSetting the date: boards are given broad discretionChanging the date: courts want specific evidence of

shareholder benefitFiduciary duties fill gaps left by the statute and

organizational documents (charter and bylaws)

Record DatesThe record date is the date on which the right to

vote is determinedMBCA § 7.07(a) in accord with bylaws; absent bylaw

provision, the board sets a “future date”Not be more than 70 days before the meeting (§ 7.07(b))If no date is set, it is the day before notice of the meeting

DGCL § 213(a): board fixes record dateCannot precede the date of the board resolutionNot more than 60 nor less than 10 days before meetingIf no date is set, it is the day before notice of the meeting