Ch.

IV The Foundations of a Corporation

Prof. M. Lao Fall 2011

Choice of organizational form: incorporate or not?

Consider characteristics A separate legal entity 5 main important features relating to:

Liability Management Transfer Continuity Tax

Liability toward outsiders

Limited liability: Derives from separate legal entity concept No personal liability for s/h (limited exception) No personal liability for D, O, and managers

Contrast with general partnership: full personal liability for all Ps.

Management
Centralized Derived from separation of ownership and management principle. Contrast with partnership: Ps have equal right to manage (absent contrary agreement).

Transferability of ownership interests

Free transferability of entire bundle of ownership interests (absent specific written restrictions) Contrast with General Partnership: No transfer of non-monetary rights absent unanimous consent.

Continuity of Existence
Based on separate legal entity principle Existence is perpetual Not dependent on identity of owners.

Dissolution requires board action and s/h approval.

Contrast with Partnership

Tax Law Considerations

Entity vs. flow-through Corp: entity double-taxation, except for S Corp But some tax advantage compared to Pships Available strategies to minimize doubletaxation effect Partnership: flow-through

Choosing State of Incorporation

Source of governance law: state, not federal, predominates Federal law on limited issues only Governance laws tend to favor management: Internal Affairs Doctrine Laws of state of incorporation govern corps internal affairs

Important State Corporate Statutes

Delaware our focus Model Business Corporation Act (MBCA) Drafted by ABA committee on corporate laws in 1980s Many states corporation acts based on MBCA, with modifications

Dominance of Delaware
Rich body of case law Infrastructure Specialized judiciary (Ct of Chancery) Responsive legislature Knowledgeable state officials Sophisticated corp bar. Stability

Some Federal intrusion

Federal securities law Disclosure Periodic fed reporting requirements for corps reaching certain thresholds Regulates trading of securities Sarbanes Oxley Act (SOX) Responding to Enron Dodd-Frank Financial Reform Act of 2010

Mechanics of Incorporation
Reserve corp name Prepare certificate (articles) of incorporation & file; pay fees Organizational meeting of initial board Adopt bylaws Issue stock

Intro to some terms

issuance of stock/shares authorized shares authorized and unissued authorized and outstanding treasury stock

Basic Modes of Corp Finance

Two major ways to raise capital: Equity financing Investor (Shareholder) has ownership interest

Debt financing *Not the focus of this course

Corp is debtor, investor is creditor Investors have no ownership interest

Debt financing
Bonds: Corp sale of bonds: similar to bank selling certificates of deposit Corp = debtor

Bondholder = creditor
Corp pays agreed-upon interest; and pays principal upon maturity.

 E.g. $10,000 10 yr, 3% bond means: 3% interest per year for 10 yrs; Upon maturity, corp pays back $10,000 Value of bond fluctuates inversely w/ interest rate

Equity Common Stock

Voting Rights: For Ds; on a few significant corp matters approved by Bd Dividends (pymt of corp earnings to SHs) Pro-rata, if Bd declares dividend Liquidation rights

Residual claimants

Preferred Stock
Hybrid between common stock and bonds Earns fixed dividends; entitled to fixed liquidation rights
Senior to common shareholders as to dividends and liquidation rights but
Junior to debtholder claims.

Dividend Preferences
Cumulative preferred Partially cumulative Non-cumulative

Convertible preferred

Traditional Theory of Corp

Structure Officers/Execs Board of Directors Inside Ds (execs) Outside Ds (independent) Shareholders

Shareholders:
No agency or management authority Elects Bd of Directors Right to vote only on a few matters Dividends Upon dissolution: right to share in residual prorata

Bd of Directors
Elected by shareholders Bd collectively has exclusive right to manage Individual Ds have no agency authority Inherent conflicts of interests Thus, law imposes fiduciary obligations on them inside (exec.) vs. outside (independent) Ds

Officers (Executives)
Hired by Board and reports to Board Usually are also Ds (inside Ds) In practice:

officers manage day-to-day affairs;

Bd advises and oversees execs.

Structure, in practice
Control by senior execs, esp CEO Shareholders: rational apathy Board: Outside (independent) Ds: time constraints; no expertise; limited info Inside (exec) Ds: hard to be independent

How Ds are nominated encourage deference to CEO

Valid Board Action

2 questions: Who can act for corp? Board, as a collective body When is action valid? Formalities Number of votes required

Formalities for Valid Bd Action

Properly called meeting w/ proper notice (or conference call; or unanimous consent) Quorum requirement Default: majority of full board Corp may increase/decrease, but not to below 1/3

 Number of votes required, assuming quorum: Default: majority of Ds present Corp may require higher percentage (called super-majority)

Alternatives to Meeting
Conference call But not sequential calls Written consents ALL Ds must sign

SH Powers
Two main powers: Election and removal of Ds Yes/No on a few significant corp matters, e.g.: Amendment to certificate of incorp Fundamental changes not in regular course of business Mergers, dissolution

Formalities of SH action
Properly called meeting Proper notice: place, time, date, purpose Given to: SH of record on designated record date

SH meetings
One annual meeting for election of Ds Special SH meetings: May be called by Bd any time SH right to call? DE: No MBCA: SHs holding 10% or more of stock -- Yes

Quorum

Default: majority of shares entitled to vote Certificate of incorp can set higher or lower requirement, but no lower than 1/3 Reason: for legitimacy

 Assuming quorum, what % of SH votes required? Default: For election of Ds: plurality

On other matters:
Ordinary SH matter: simple majority

Fundamental changes: absolute majority

Supermajority provisions:

Can change default to require more than majority.

Fundamental Changes
SHs have right to vote, BUT Must be initiated by Bd, and approved by Board first

Written Consents
Permissible, in lieu of SH meeting Votes required: Most jurisdictions: unanimity DE: same as for actual meeting

Cumulative Voting
Applies only to election of Ds

Review of Straight Voting -- default

One vote per share per D seat One year term If quorum present, plurality vote Implications of straight voting for minority SH?

Example
Assume 100 outstanding shares; Management controls 85 shares Minority owns 15 shares 9-person board Result under:

Straight voting?

Straight Voting
A: 85 votes B: 85

Managements Nominees

Minoritys Nominees
C1: 15 C2: 15

C: 85
D: 85 E: 85 F: 85 G: 85 H: 85 I: 85

C3: 15
C4: 15 C5: 15 C6: 15 C7: 15

C8: 15
C9: 15

 Results of election under straight voting? Any of minoritys candidates get seat on Bd?

Cumulative Voting
Only applies to voting for Ds, not for voting on other SH matters Still one vote per share, but Multiply # of shares by # of seats up for election SH may distribute total votes among candidates in any way

Same example as above:

Assume 100 outstanding shares; Management controls 85 shares Minority owns 15 shares 9-person board Result under cumulative voting?

Example Under Cumulative Voting

Management Minority

85 shares
9 seats Thus, total votes: 85 x 9 = 765 Can allocate total votes in any manner

15 shares
9 seats Thus, total vote: 15 x 9 = 135 Can allocate total votes in any manner

Cumulative Voting contd

Math formula: comes out to proportionate representation i.e., Minority has 15% of total shares; will be able to win approximately 15% of seats up for election. Since 9 Ds being elected, Minority will get 1 seat (15% of 9)

Cumulative Voting
Managements Nominees
A: 85 B: 85 C: 85 D: 85 E: 85

Minoritys Nominees
C1: 135

F: 85
G: 85 H: 85

I: 85
Total: 765 votes
Total: 135 votes

To illustrate Minority can only get 1 seat, in example

Management
A: 86 B: 86 C: 86 D: 86 E: 86 F: 86 G: 86 H: 86

Minority
C1: 86 C2: 49

Total: 135 votes

I: 77
Total: 765

Rationale for cumulative voting:

Voice for minority SH But note all Ds owe fiduciary duty to corp

Classified or Staggered Board

Assume Bd of 9 directors Generally, all serve one year term; all up for election annually Example of classifying or staggering board:

Divided into 3 groups of 3

Each serves 3-yr term Thus, each year, only 3 seats up for election.

Implications of Staggered Bd
Earlier example: Minority w/ 15% interest wins 1 seat on 9-member Bd If Board is staggered into 3 groups of 3, serving 3-yr terms Can minority win any seat? Prevents corp raider/dissident from gaining majority control of Bd in one year.

Explanation?
Management
Total votes? 85 x 3 = 255 vote
Managements Nominees: A: 85 B: 85 C: 85

Minority
Total votes? 15 x 3 = 45 votes
Minoritys Nominees: M1: 45 M1 receives fewer votes than A, B, or C.

Synthesis:
Cumulative voting applies only to elections, not to other s/h matters. Also, knowing implications of staggered board, If mgmt regrets agreeing to cumulative voting, what can it do? Call SH meeting to amend cert of incorp to stagger terms Amendment easily passes since mgmt controls 85% of shares

Solution to Minoritys Problem?

Ensure cert of incorp cannot be amended so easily (at least for this purpose):

Change default and adopt supermajority rule:

E.g., 86% of voting shares required to amend certificate to stagger board Termed supermajority provision

Class Voting
Another way to ensure minority rep on Bd Corp issues different classes of stock (e.g. A & B) with identical financial rights, but Each class has specified # of Ds, and Only s/h of class may vote for Ds of that class.

Recap:
Straight voting (default):
One vote per share per open seat One year term Thus, whoever controls significant percentage of shares would win all seats

Cumulative voting:
Still one vote per share, but multiply by # of open seats; may distribute total votes as s/h wishes. Result: proportionate rep (based on # of open seats

 Staggered board:
Divide board into groups; each group is up for election in different years. Thus, minority s/h needs larger % of votes to get rep.

Cumulative voting only applies to elections, not to other s/h matters.

Unless default is changed for voting on other s/h matters, majority can amend cert of incorp to stagger board.

Removal of Ds
Only by SHs, not by other Ds DE, MBCA, & most jurisdictions:
Generally, may remove with or without cause, by majority vote.

Removal of Directors Where There is Cumulative Voting

What if there is no deviation from gen. rule?
Board calls for s/h meeting for vote on removal:

85% for removal 15% against removal D is removed.

Thus, Statutory Exception

MBCA 8.08-8.10
Class: Only s/h of class can vote to remove D for class
Cumulative: no removal of D if the votes against removal are sufficient to elect D under cumulative voting

DE DGCL 141(k), 223

SHs may still remove any D by majority vote, but
Only for cause Cause not required under general rule.

Authority of Corp Officers

Bd, as a collective body, is authorized to act for corp.
Can delegate authority to corp officers (execs)

Sources to look to for actual authority of execs: Certificate of incorporation (not often) Bylaws (general categories) Corp resolution (usually specific matters)

Any apparent authority?

Generally, very little President or CEO:
Ks in ordinary course: Yes Ks of extraordinary nature: No

Any apparent authority?

VP almost none Treasurer almost none Secretary
Certify corp records, such as corp resolutions

Chairman of the Bd none Exception: closely-held corp

Expansive, analogous to Pships

 For both publicly-held and closely-held corps:

Ratification Acquiescence concepts apply

Ultra vires doctrine

Literal meaning: beyond corps power Historical: Act was void Implication? Both sides can renege

Modern Doctrine, e.g. DGCL 124

No one can assert ultra vires offensively or defensively except: If corp has not yet performed, shareholder can sue corp to enjoin act. If equitable, Ct may set aside K and enjoin act (w/ damages to other party).

Corp may sue the responsible D/O

AG can sue to enjoin act (very limited).

Interests other than maximizing SH wealth

Is it legitimate for fiduciaries to consider other (non-SH) interests in corp decisions?

E.g., Dodge v. Ford Motor Co.

Maximizing SH wealth is ultimate goal of corps. May consider other constituencies interests, but they have to be incidental.