INTRODUCTION TO AMERICAN CORPORATE LAW PRINCIPLES Rafael A. Porrata-Doria, Jr. Professor of Law May...

INTRODUCTION TO AMERICAN CORPORATE LAW PRINCIPLES

Rafael A. Porrata-Doria, Jr.Professor of Law

May 13, 2013

Corporate Law Principles

General ConsiderationsCorporations in the United States are created by statute and

regulated by STATE, not Federal law. Although a corporation may operate throughout the United States

regardless of its state of incorporation, its internal affairs are governed by its state of incorporation, not the state in which it conducts its operations.

Most states in the United States have adopted a version of the Model Business Corporation Law (“MBCA”), a model statute drafted and revised by a committee of the American Bar Association. It seeks to strike a balance between management and shareholder rights and powers.

The other preeminent corporate statute in the United States is the Delaware General Corporation Law (“DGCL”) which has a very different philosophy from the MBCA. The DGCL is strongly pro-management, and has much fewer mandatory rules than the MBCA. The MBCA has, however, borrowed some provisions and concepts from the DGCL.


General ConsiderationsThe general rules found in the statutes are heavily

supplemented/explained by jurisprudence. Some concepts are primarily the creature of jurisprudence.

A corporation has two principal attributes that make it a very attractive venue for the operation of a business: separate personhood and perpetual life. Separate Personhood: A corporation is considered a separate

“person” from its shareholders. That means that the shareholders are not personally responsible for the liabilities of the corporation. That can be a good and bad thing.

Perpetual Life: A corporation has perpetual life and ceases to exist only when its shareholders decide to dissolve it. That means that it is free to accumulate assets during a lengthy period of time without having to dissolve (like a partnership) or distribute its assets. A good example is Exxon/Mobil.


General Considerations The formation of a corporation requires formal action with the state. Its

creators must file articles of incorporation with the state. The corporation is centrally managed: all of its business and affairs are

in the hands of its board of directors, who are elected by the shareholders. Corporate law favors the interests of majority shareholders.

Shares of a corporation are freely transferrable, and the consent of other shareholders or the corporation is NOT generally required.

Directors, officers and controlling shareholders owe fiduciary duties of care and loyalty to the corporation.

For tax purposes, a corporation is a separate taxpayer from its shareholders. This means that the corporation files its own tax returns, pays taxes and takes advantage of any favorable tax treatment.

Shareholders only pay taxes on the dividends they receive. This can be problematic, since it means that the corporation AND its shareholders may be taxed on the same income.

That rule can be changed in limited circumstances by the corporation electing Subchapter S status. This status is not available to a corporation with nonresident alien shareholders.


Additional Business Organization Choices General Partnership

A creature of state law, generally regulated by the Uniform Partnership Act. Formation: No formal process or written partnership agreement required. Liability: All partners, as individuals, can be held jointly and severally liable

for partnership obligations and has the power to bind the partnership while acting in the ordinary course of the partnership’s business.

Management and Control: Management authority is vested in all the partners, with each partner having an equal voice, regardless of capital contribution. Decisions are generally made by a majority. These rules may be, and usually are changed.

Existence: General partnership can either be at will or for a definite period of time. An at will partnership is dissolved on the death, bankruptcy or withdrawal of any partner.

Transferability: All current partners must consent to the transfer of a partnership interest and the admission of a new partner. These rules can also be change.

Fiduciary duties: Decided upon by contract. Taxes: Treated as an aggregation of individuals rather than as a separate

entity.


Additional Business Organization Choices Limited Partnership

Again, a creature of state law, generally regulated by the Uniform/Revised Limited Partnership Act.

Formation: A certificate of limited partnership must be filed with the state. Liability: Only the general partner can be held jointly and severally liable

for partnership obligations and has the power to bind the partnership. Limited partners are not subject to liability, but may not participate in the management of the business.

Management and Control: Management authority is vested in the general partner.

Existence: A LP exists for a definite period of time. It is dissolved either when the general partner withdraws or its existence comes to a close.

Transferability: Limited partners may generally transfer their interests freely. Some agreements may restrict a limited partner’s right to withdraw her capital.

Fiduciary duties: Decided upon by contract. Taxes: Treated as an aggregation of individuals rather than as a separate

entity. This is GOOD!


Additional Business Organization ChoicesLimited Liability Company

Generally regulated by one of many statutes. Loosely based on the S.R.L.

Formation: Articles of Organization must be filed with the state. The members also enter into an operating agreement.

Liability: Neither members nor managers are personally liable for the debts or liabilities of the LLC.

Management and Control: Either member-managed or manager-managed.

Existence: Perpetual existence. Transferability: Many current statutes allow free transferability of

member rights. Fiduciary duties: Decided upon by contract. Taxes: The members are allowed to select how the entity will be

taxed, either as a corporation or as a partnership.


Incorporation Process. Preparation of Articles of Incorporation. One or more “incorporators” sign

the document, which essentially requires the name, number and kind of shares the corporation is allowed to issue; registered office address and the name of the incorporator. Other provisions may be added. Corporate existence begins when the articles of incorporation are filed. No minimum capital requirements.

The initial board of directors is either designated in the articles or in a separate document. It then has an initial meeting, where bylaws are approved, stock issued, bank accounts opened, appointment of officers, etc.

If there is a problem with the incorporation process, persons who acted in good faith on behalf of the corporation not knowing that the corporation did not exist, are protected from personal liability (MBCA s.2.04)

Promoters: When an individual contracts for the benefit of a corporation not yet organized, she is generally liable for that contract in the absence of an agreement to the contrary. The promoter is not necessarily released from liability simply because the corporation is later incorporated. A CORPORATION CANNOT BE BOUND BY A CONTRACT ENTERED INTO BEFORE ITS EXISTENCE UNLESS IT CHOOSES TO RATIFY IT. This is an issue of contract interpretation.

Corporate Law Principles Corporate Securities.

Equity Securities Common Stock Preferred Stock

Attributes vary widely, but usually include dividend/dissolution rights. They can have limited voting rights.

Debt Securities Notes and Debentures Bonds

Options Calls (buy) or put (sell) They give the holder the right to buy/sell at the strike price. They are valid until their expiration or maturity date.

Sales to the Public. Securities cannot generally be sold to the public, in a stock exchange or

otherwise, unless they have been registered with the Federal Securities and Exchange Commission (SEC) or its state equivalent in case of purely intra state sales.


Corporate Securities. Delaware (DGCL section 155)

All shares must have a par value or their equivalent. Shares cannot be sold below their par value but can be sold above their par value. Par value can be changed by amending the articles of incorporation.

The par value x the number of issued shares of the corporation becomes the corporation’s stated capital. The stated capital is a notional number that usually appears in the “equity” section of a corporation’s balance sheet. The remainder of the equity is denominated “surplus.”

Example: $1000 in equity, 100 shares, with $1.00 par value each:

o Stated Capital (100 shares x $1.00 par value) = $100o Surplus = $900o Total Equity =$1000


Corporate Securities. MBCA (MBCA section 6.21)

There is no minimum price at which stock may be sold. The balance sheet of an MBCA corporation does not list

“stated capital” in the equity section of the balance sheet. These Delaware concepts do not exist in the MBCA.

Dividends. Delaware. (DGCL sections 170-174) Dividends may be paid only out of surplus. They are NOT

obligatory. Example: $1000 in equity, 100 shares, with $1.00 par value each:

o Stated Capital (100 shares x $1.00 par value) = $100o Surplus = $900o Total Equity =$1000

This corporation may not issue more than $900 in dividends, because that is the amount of its surplus.


Dividends.MBCA. (MBCA section 6.40) Dividends are NOT obligatory, but may be paid only to the degree

that a corporation has equity AND if the distribution will not render the corporation unable to pay its debts as they become due in the normal course of business.

Example: $1000 in equity:o Equity = $1000o Total Equity =$1000

This corporation may not issue more than $1000 in dividends, as long as this distribution will not render the corporation unable to pay its debts as they become due (insolvent).


Piercing the Corporate Veil This is a judicially created doctrine in which a court, under certain

limited circumstances, may ignore the separate identity between the corporation and its shareholders and hold the shareholders responsible for a corporate debt or liability.

This is a doctrine that is very often invoked, but very rarely applied. The thought is that, in situations where the shareholders have

“abused” corporate status, equity demands that corporate status be disregarded in the interest of justice.

The parameters of this doctrine vary considerably from state to state, and can be extremely confusing.

The doctrine has NEVER been applied to a public corporation (one whose securities are registered with the SEC and sold in the stock markets).

This doctrine imposed liability ONLY on shareholders, not on officers or directors.

The doctrine is applied differently in tort and contract cases. In contract cases, the plaintiff made a choice to deal with the corporation, while in tort cases the plaintiff interacted with the corporation involuntarily.


Piercing the Corporate VeilGenerally speaking, the corporate “veil” is “pierced” when

the corporation is a mere “instrumentality” or “alter ego” of the corporation.

The factors in determining whether a corporation is an “instrumentality or alter ego” of a corporation may include: 1) failure to observe corporate formalities, 2) non-payment of dividends, 3) insolvency of the corporation, 4) siphoning of corporate assets by the principal shareholder, 5) “non-functioning” of the board of directors, 6) absence of corporate records, and 7) the corporation was a façade for its dominant shareholders.

Which of these factors is applied and how they are applied depends on the jurisdiction involved


Management and Control of the CorporationThe business and affairs of a corporation shall be managed by

or under the direction of, and all corporate powers shall be exercised by, the board of directors. (MBCA s. 8.01)

The board may delegate some of these powers to officers or other agents.

The bylaws of a corporation designate the number of directors in the board, as well as their terms. Directors are elected by the shareholders. Vacancies on the board may be filled by the board.

Board action may occur at a meeting or through a unanimous consent.

Board meetings Regular or Special Notice/Waiver Quorum Committees


Management and Control of the Corporation Shareholders

In the United States, shareholders have limited powers. They are limited to: electing and removing directors, amending the articles of incorporation, approving a merger or consolidation, selling all of its assets and dissolving the corporation.

Shareholders can act by meeting or unanimous consent. Meetings

Annual or Special Special can be called by demand of at least 10% of all votes

entitled to be cast. Notice Record date (no more than 70 days prior to meeting) Shareholders may vote by proxy.


Fiduciary Duties of Corporate DirectorsDuty of Care

Originally (and still in Delaware) articulated by court decisions. Codified in the MBCA (section 8.30):

Decision-Making Function: Each member of a board of directors, when discharging his duties, shall act in good faith and in a manner the directors reasonably believes to be in the best interests of the corporation.

Oversight Function: A director is expected become informed about the business, and establish monitoring systems to ensure that management and other employees are complying with their legal responsibilities ( MBCA 8.30 and In re Caremark International Inc. Derivative Litigation (Del. Ch. 1996). See In re Citigroup Derivative Litigation (Del Ch. 2009-sustained or systemic failure)


Fiduciary Duties of Corporate DirectorsDuty of Care

Business Judgment Rule Created by jurisprudence and based on the concept that judges are

ill-suited to second guess, with hindsight, decisions taken by the board in the heat of discussion.

In litigation, it is presumed that, in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, the judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting it.

Traditionally, if any rational justification could be established for the decision, the courts would allow it to stand.

Currently, a decision that is made in a grossly negligent manner (Smith v. Van Gorkhom (Del. 1985)) or that is clearly bad substantively could be overturned.

It is VERY hard to overturn this presumption.


Fiduciary Duties of Corporate Directors Duty of Loyalty.

Originally created by judicial decision. The duty is based on the early concept that a trustee could not directly

deal with the assets of the trust. Briefly stated, it creates a presumption that a transaction between a corporation and one of its directors is voidable by the corporation. The only way in which the presumption could be overturned was to prove that the transaction itself was “fair and equitable” to the corporation. Generally very narrowly interpreted.

Statutes such as DGCL 144 and MBCA 8.31, 8.60-8.64 have changed this original configuration a bit.

These statutes provide that a conflict of interest transaction is NOT voidable IF After disclosure of the material facts of the transaction, the majority of

the disinterested directors approved it; or After disclosure of the material facts of the transaction, the majority of

the disinterested shareholders approved it; or The transaction is fair an equitable to the corporation.


Fiduciary Duties of Corporate Directors Duty of Loyalty.

These norms have generated a substantial amount of litigation on a number of topics, which include: What is a “conflict of interest transaction”? What is an “interested” director or shareholder?

o A director who, because of a family, financial or business relationship with another director is not objective may be an “interested director.”

o A director who is under the domination or control of another director (who in turn is a party to the transaction) may also be an interested director.

What is “fair and equitable to the corporation”? o Procedural fairness: was the process itself fair?o Substantive fairness: did the terms of the transaction itself

provide an appropriate benefit to the corporation? These norms have been very broadly interpreted by many courts.


Derivative Actions Under certain circumstances, a shareholder may bring a law suit on

behalf of the corporation against a third party or against an individual (such as an officer or director) who have breached a duty to the corporation. They seek to impose personal liability on the defendant and are cases that would have been brought by the corporation had the board decided to have the corporation sue.

Any monetary recovery by the plaintiff goes to the benefit of the corporation, and not the individual who brought the law suit.

Determining whether an action is derivative (the corporation’s) or direct (the shareholder’s) can be tricky and has been the subject of much litigation.

On termination of the law suit, the court MAY order the corporation to pay the plaintiff’s legal fees expenses, if it finds that the proceeding resulted in a substantial benefit to the corporation. The court may also order the plaintiff to pay the defendant’s legal fees if it finds that the law suit was started without reasonable cause or for an improper purpose.

INTRODUCTION TO AMERICAN CORPORATE LAW PRINCIPLES Rafael A. Porrata-Doria, Jr. Professor of Law May...

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