Corporations – Opening Paragraphs
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Organization
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De Jure Corporation
In order to form a valid corporation, one or more incorporators must file articles of incorporation with the Secretary of State. When the Secretary accepts the Articles, a de jure corporation is formed.
The articles of incorporation must also state the corporation’s purpose. At common law, where the corporate directors engaged in activities which were beyond the scope of the corporation’s purpose – so called, ultra vires activities – those activities were void. However, under the modern approach ultra vires contracts are valid. But, shareholders may seek an injunction, if the shareholders learn that the corporation is planning an ultra vires activity. Moreover, responsible individuals can be held liable for losses dues to ultra vires activities.
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De Facto Corporation
Where a person makes a good faith effort to comply with the incorporation statute, but unbeknownst to the proposed incorporator, fails to achieve de jure status, the business will nonetheless be treated as a corporation if it asserts some sort of business privilege.
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Corporation by Estoppel
A third party who deals with a business as a corporation, will be estopped from later claiming later denying the validity of the corporation.
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Promoters
A promoter may enter into contracts on behalf of a corporation not yet formed. However, the corporation will not be liable on those contracts unless and until the corporation expressly or impliedly adopts the contracts. Furthermore, the promoter will remain liable on those contracts unless and until there a novation whereby the corporation is substituted for the promoter under the terms of the contract.
The promoter may not make a secret profit on her dealings with the corporation. The rule can be avoided by simply disclosing all material terms of the contract. Absent full disclosure, the promoter must turn over any profits made to the corporation. Where the promoter sells property to the corporation which he acquired before becoming a promoter, profit equals the price paid by the corporation less the fair market value of the property. Where the promoter sells property to the corporation which he acquired after becoming a promoter, profit equals the price paid by the corporation less the price paid by the promoter.
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Issuance of Stock
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Revocation of Subscriptions
Pre-incorporation, a subscription is irrevocable for six months unless provided otherwise. Post-incporation, a subscription is freely revocable until acceptance.
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Consideration
There is a split in authority regarding appropriate forms of consideration for stock. Under the traditional rule, only money, property, or services already performed could qualify as appropriate forms of consideration. However, under the modern trend, any tangible or intangible property or benefit is appropriate consideration, including promissory notes and future services.
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Watered Stock
A corporation’s stock must not be sold for below par value – the minimum issuance price. Where a director authorizes a sale of the corporations stock for below par value – that is where the director authorizes watered stock – both the director and the purchaser are liable to the corporation for the lost value. But, where the purchasers transfers the stock to a third party, the third party is not liable if he acted in good faith.
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Preemptive Rights
Under the traditional view, shareholders were automatically given preemptive rights to purchase shares of stock in order to maintain their percentage ownership whenever the corporation issued new common stock for cash. However, under the modern trend, preemptive rights will not be recognized unless the articles of incorporation specifically provide for them.
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Directors and Officers
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Election and Removal
Directors are elected by the shareholders at the annual meeting. Directors can be removed by the shareholders with or without cause.
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Board Action
There are only two ways the Board of Directions can take valid action: (1) unanimous written consent to act without a meeting or (2) a meeting that satisfies the quorum and voting requirements. If neither of these requirements are met, the act is void unless later ratified by a valid corporate act.
The quorum requirement for director’s meetings is a majority of all directors (unless the bylaws provide otherwise). Where a quorum is present at the meeting, passing a resolution requires only a majority of votes present. However, quorum may be lost if enough directors leave the meeting.
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Duty of Care
A director owes a duty of care to the corporation to act in good faith as a prudent person would act in regards to her own business. A director is liable for nonfeasance only to the extent that she caused loss to the corporation. A director is liable for misfeasance only if she fails to meet the business judgment rule.
Under the business judgment rule, a court will not second guess the decisions of the board of directors if it was made in good faith, on an informed and rational basis.
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Duty of Loyalty
A director owes a duty of loyalty to the corporation to act in good faith in the reasonable belief that she is acting in the best interest of the corporation.
Thus, deals with interested directors will be void unless (1) the terms are fair to the corporation, or (2) the interest and all material facts are disclosed to the corporation and a the deal is approved by a committee of disinterested directors or shares.
A director must not compete with the corporation. Remedy: constructive trust on profits and possibly damages.
A director must not usurp corporate opportunities. A corporate opportunity is anything the corporation could reasonably be expected to be interested in. The director must (1) inform the board of directors of any corporate opportunity and (2) give the board sufficient time to determine whether it wishes to pursue the opportunity before taking advantage of the opportunity himself. Where the director does usurp a corporate opportunity, the corporation is entitled to purchase the opportunity from the director at cost, or where the director has already disposed of the opportunity, the corporation is entitled to a constructive trust on the profits.
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Indemnification
Where a director is entitled to indemnification depends largely on the outcome of the litigation. The corporation must indemnify the director who has been “wholly successful” or to the extent of his success in defending a suit arising from his role as director. A corporation must not indemnify a director where the director has been held liable to the corporation or received an improper personal benefit. In all other circumstances, the corporation may indemnify the officer, the general standard being whether he violated his duty of loyalty to the corporation.
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Loans to Directors
There is no majority view on whether a corporation may make a loan to an officer or a director. Some courts hold that the loan must be approved by a majority of shares. Other courts allow the Board to approve a director loan as long as the board determines that the loan is reasonably expected to benefit the corporation.
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Liability
Generally, all directors are presumed to have concurred in all board activities, unless the directors dissent or abstention is noted in writing. However, there is an exception for directors who were absent when the activity was approved. Also, there is an exception for directors who reasonably relied on the good faith assertions of another director, officer, or auditor whom they reasonably believe is competent.
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Shareholders
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Pierce the Corporate Veil
Generally, a shareholder is not liable for the acts or debts of the corporation, but the court will pierce the corporate veil and hold the shareholder personally liable to avoid fraud or injustice. Courts are inclined to pierce the corporate veil where the shareholder is acting as the alter ego of the corporation, that is there is a serious identity of interests. Also, courts are more inclined to pierce when the shareholders started a corporation which was undercapitalized at formation. Also, where a parent corporation forms a subsidiary for the purpose of avoiding the parent’s debts, the court will pierce the corporate veil and hold the subsidiary personally liable for the debts of the parent.
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Derivative Suit
A shareholder may bring a derivative suit on behalf of the corporation where (1) the plaintiff was a shareholder at the time of the conduct giving rise to the suit, (2) the plaintiff can adequately represent the corporation, and (3) the plaintiff first made a written demand that the corporation bring suit on its own – unless a demand would be futile.
The board of directors may bring a motion to dismiss the suit where a committee of disinterested directors determines that the suit would not be in the best interest of the corporation.
Where the suit is successful, the recovery goes to the corporation. However, the shareholder should be reimbursed for costs and attorney fees.
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Shareholder Voting
The general rule is that the record shareholder as of the record date has the right to vote. Exceptions: (1) where SH dies, the executor of the SH’s estate may cast the vote, (2) proxies.
Proxies allow a shareholder to authorize another to vote her shares. A proxy is generally good for 11 months, unless provided otherwise, and a proxy is freely revocable unless the proxy is coupled with an interest.
A shareholder may enter into a voting trust or a voting agreement to vote her shares as block in order to increase her influence. A voting trust requires (1) written trust agreement controlling how shares will be voted, (2) a copy given to the corporation, (3) transfer of legal titles in the shares to the voting trustee, and (4) original shareholder must receive a trust certification and retains all shareholder rights except voting. The maximum duration for a voting trust is ten years. A voting agreement requires only a signed writing that the votes will be pooled in a certain manner. There is a split in authority regarding whether voting agreements can be specifically enforced.
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Dividends
The board of directors has sole discretion to declare dividends. To force dividends the shareholder must make a very strong showing of abuse of discretion.
Payable out of earned surplus, capital surplus, but never stated capital (par value).
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Fundamental Corporate Change
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Mergers
Before a merge can go through, the directors and shareholders of both corporations must approve the merge, the latter by a majority of all shares entitled to vote.
No shareholder approval is required for a short-form merger – where a 90% or more owned subsidiary is merged into the parent.
Dissenting shareholders are entitled to appraisal rights, whereby a shareholder opposes the change may force the corporation to buy her shares at fair value. In order to enforce her appraisal rights, the shareholder must: (1) file a written objection before the meeting, (2) vote against the merger or abstain from voting, and (3) file a written demand to be bought out.
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Sale of Assets
If a sale, lease or exchange of substantially all the corporation’s assets is outside the ordinary course of business, a majority of directors and a majority of shares entitled to vote must approve the change. Dissenting shareholders of the transferring corporation are entitled to appraisal rights.
Generally, the company acquiring assets is not liable for debts of the transferring company unless the deal says otherwise or the company purchasing the assets is merely a continuation of the selling corporation.
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Amendment of Articles
Amendment of the Articles requires a proposal by the board, notice to the shareholders, and approval of a majority of shares entitled to vote.
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Dissolution and Liquidation
Voluntary dissolution requires a resolution from the board of directors and approval from an absolute majority of shares entitled to vote. Some states require unanimous written shareholder agreement.
Involuntary dissolution results were a shareholder petitions the court for dissolution based on (1) director abuse, waste of assets, or general misconduct, (2) director deadlock that harms the corporation, or (2) shareholder deadlock and failure for at least two annual meeting to fill a vacant board position.
As an alternative to involuntary dissolution, the court may order a buy-out of the complaining shareholder’s shares.
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Stock Transactions
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Common Law Liabilities
A controlling shareholder owes a duty to minority shareholders not to use his control to unduly prejudice their interests. Thus, a controlling shareholder may sell her stock for more than its value, but she may not (1) sale to looters (must make reasonable investigation), (2) sale corporate assets, or (3) sale board positions.
Under the special facts doctrine, many courts impose an affirmative duty on officers and directors to disclose special facts during securities transactions with shareholders. Special facts are those which a reasonable investor would consider important in making an investment decision. Where the D/O fails to disclose special facts, the shareholder may recover the difference between the price paid and the value of the stock after public disclosure.
A D/O may be held liable for common law misrepresentation. To make a prima facie case for misrepresentation the plaintiff must show (1) material misrepresentation of a material fact, (2) which the defendant knew/believed to be false or acted with reckless disregard as to its truth, (3) intent to induce reliance on the misrepresentations, (4) actual reliance, and (5) damages.
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Federal Rule 10b-5
Rule 10b-5 makes it illegal to use any fraudulent scheme in connection with the purchase or sale of security. To make a prima facie case for a 10b-5 violation, the plaintiff must show (1) transaction involves instrument of interstate commerce (2) fraudulent conduct (3) related to a material fact, (4) in connection with either the purchase or sale of security, (5) intent to defraud, and (6) actual reliance.
Tipper/tippee activity gives rise to a 10b-5 violation. The tipper is liable if she (1) passed insider information in breach of a duty, and (2) benefited from the pass. Also, the tippee is also liable if she (1) traded on the tip and (2) knew or should have known that the information was improperly passed.
The corporation may recover the difference between the price paid and the price a reasonable time after public disclosure.
Also, under the misappropriation theory, the government can prosecute a person under rule 10b-5 for trading on market information in breach of a duty of trust and confidence owed to the source of the information. Thus, anyone who has breached a fiduciary duty owed to anyone else is liable on this theory when brought by the government.
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Federal Rule 16(b)
Rule 16(b) allows a corporation to recover profits made by certain insiders by buying or selling the corporation’s stock. Under Rule 16(b), a director, officer, or shareholder with a 10% interest in the corporation will be held strictly liable for profits made from buying or selling stock within a single six-month period. Profits occur where within six months before or after any sale the insider purchases stock at a lower price.
Rule 16(b) only applies to publicly held corporations traded on a national exchange or a corporation that has 500+ shareholders and $10 million in assets.
The corporation may recover all profits (match the highest sales price against the lowest purchase price during any 6-month period).