Gale Encyclopedia Of American Law 3Rd Edition Volume 3 P25 potx

The articles of incorporation typically must contain 1 the name of the corporation, which often must include an element such as Com-pany, Corporation, Incorporated, or Limited,” and may

the general public Municipal corporations are typically cities and towns that help the state to function at the local level Quasi-public cor-porations would be considered private, but their business serves the public’s needs, such as by offering utilities or telephone service

There are two types of private corporations

One is the public corporation, which has a large number of investors, called shareholders Cor-porations that trade their shares, or investment stakes, onSECURITIESexchanges or that regularly publish share prices are typical publicly held corporations

The other type of private corporation is the CLOSELY HELDcorporation Closely held corpora-tions have relatively few shareholders (usually

15 to 35 or fewer), often all in a single family;

little or no outside market exists for sale of the shares; all or most of the shareholders help run the business; and the sale or transfer of shares is restricted The vast majority of corporations are closely held

Getting a Corporation Started Many corporations get their start through the efforts of a person called a promoter, who goes about developing and organizing a business venture A promoter’s efforts typically involve arranging the needed capital, or financing, using

loans, money from investors, or the promoter’s own money; assembling the people and assets (such as land, buildings, and leases) necessary to run the corporation; and fulfilling the legal requirements for forming the corporation

A corporation cannot be automatically liable for obligations that a promoter incurred on its behalf Technically, a corporation does not exist during a promoter’s pre-incorporation activi-ties A promoter therefore cannot serve as a legal agent, who could bind a corporation to a contract After formation, a corporation must somehow assent before it can be bound by an obligation that a promoter has made on its behalf Usually, if a corporation gets the benefits

of a promoter’s contract, it will be treated as though it has assented to, and accepted, the contract

The first question facing incorporators (those forming a corporation) is where to incorporate The answer often depends on the type of corporation Theoretically, both closely held and large public corporations may incor-porate in any state Small businesses operating

in a single state usually incorporate in that state Most large corporations select Delaware as their state of incorporation because of its sophistica-tion in dealing with corporasophistica-tion law

Incorporators then must follow the me-chanics that are set forth in the state’s statutes Corporation statutes vary from state to state, but most require basically the same essentials in forming a corporation Every statute requires incorporators to file a document, usually called theARTICLES OF INCORPORATION, and pay a filing fee to the secretary of state’s office, which reviews the filing If the filing receives approval, the corporation is considered to have started existing on the date of the first filing

The articles of incorporation typically must contain (1) the name of the corporation, which often must include an element such as Com-pany, Corporation, Incorporated, or Limited,” and may not resemble too closely the names of other corporations in the state; (2) the length of time the corporation will exist, which can be perpetual or renewable; (3) the corporation’s purpose, usually described as “any lawful business purpose”; (4) the number and types

of shares that the corporation may issue and the rights and preferences of those shares; (5) the address of the corporation’s registered office, which need not be the corporation’s business

Wal-Mart’s Executive

Vice President and

CFO Tom Schoewe

addresses shareholders

at the company’s

annual meeting in

2009 A corporation’s

officers are responsible

for running

day-to-day business affairs

and carrying out

policies established by

the directors.

AP IMAGES

office, and the registered agent at that office

who can accept legalSERVICE OF PROCESS; (6) the

number of directors and the names and

addresses of the first directors; and (7) each

incorporator’s name and address

A corporation’s bylaws usually contain the

rules for the actual running of the corporation

Bylaws normally are not filed with theSECRETARY

OF STATE and are easier to amend than are the

articles of incorporation The bylaws should be

complete enough so that corporate officers can

rely on them to manage the corporation’s

affairs The bylaws regulate the conduct of

directors, officers, and shareholders and set

forth rules governing internal affairs They can

include definitions of management’s duties, as

well as times, locations, and voting procedures

for meetings that affect the corporation

People behind a Corporation: Rights

and Responsibilities

The primary players in a corporation are the

shareholders, directors, and officers

Share-holders are the investors in, and owners of, a

corporation They elect, and sometimes remove,

the directors, and occasionally they must vote

on specific corporate transactions or operations

The BOARD OF DIRECTORS is the top governing

body Directors establish corporate policy and

hire officers, to whom they usually delegate

their obligations to administer and manage the

corporation’s affairs Officers run the

day-to-day business affairs and carry out the policies

the directors establish

Shareholders Shareholders’ financial interests

in the corporation is determined by the

percentage of the total outstanding shares of

stock that they own Along with their financial

stakes, shareholders generally receive a number

of rights, all designed to protect their

invest-ments Foremost among these rights is the power

to vote Shareholders vote to elect and remove

directors, to change or add to the bylaws, to

ratify (i.e., approve after the fact) directors’

actions where the bylaws require shareholder

approval, and to accept or reject changes that are

not part of the regular course of business, such as

mergers or dissolution This power to vote,

although limited, gives the shareholders some

role in running a corporation

Shareholders typically exercise their voting

rights at annual or special meetings Most

statutes provide for an annual meeting, with

requirements for some advance notice, and any shareholder can get a court order to hold an annual meeting when one has not been held within a specified period of time Although the main purpose of the annual meeting is to elect directors, the meeting may address any relevant matter, even one not that has not been mentioned specifically in the advance notice

Almost all states allow shareholders to conduct business by unanimous written consent, with-out a meeting

Shareholders elect directors each year at the annual meeting Most statutes provide that directors be elected by a majority of the voting shares that are present at the meeting The same number of shares needed to elect a director normally is required to remove a director, usually without proof of cause, such asFRAUDor abuse of authority

A special meeting is any meeting other than

an annual meeting The bylaws govern the persons who may call a special meeting;

typically, the directors, certain officers, or the holders of a specified percentage of outstanding shares may do so The only subjects that a special meeting may address are those that are specifically listed in an advance notice

Statutes require that a quorum exist at any corporation meeting A quorum exists when a specified number of a corporation’s outstanding shares are represented Statutes determine what level of representation constitutes a quorum;

most require one-third Once a quorum exists, most statutes require an affirmative vote of the majority of the shares present before a vote can

Federal law prohibits

a corporate insider from using nonpublic information to buy or sell stock In 2009, the SEC charged Joseph Contorinis, a former portfolio manager, with taking part in

an insider trading scheme that produced illegal profits of more than $11 million.

AP IMAGES

bind a corporation Generally, once a quorum is present, it continues, and the withdrawal of a faction of voters does not prevent the others from acting

A corporation determines who may vote based on its records Corporations issue share certificates in the name of a person, who becomes the record owner (i.e., the owner according to company records) and is treated as the sole owner of the shares The company records of these transactions are called stock-transfer books or share registers A shareholder who does not receive a new certificate is called the beneficial owner and cannot vote, but the beneficial owner is the real owner and can compel the record owner to act as the beneficial owner desires

Those who hold shares by a specified date before a meeting, called the record date, may vote at the meeting Before each meeting, a corporation must prepare a list of shareholders who are eligible to vote, and each shareholder has an unqualified right to inspect this voting list

Shareholders typically have two ways of voting: straight voting or CUMULATIVE VOTING Under straight voting, a shareholder may vote his or her shares once for each position on the board For example, if a shareholder owns 50 shares and there are three director positions, the shareholder may cast 50 votes for each position

Under cumulative voting, the same shareholder has the option of casting all 150 votes for a single candidate Cumulative voting increases the participation of minority shareholders by boosting the power of their votes

Shareholders also may vote as a group or block A shareholder voting agreement is a contract among a group of shareholders to vote

in a specified manner on certain issues; this is also called a pooling agreement Such an agreement is designed to maintain control or

to maximize voting power Another arrange-ment is a VOTING TRUST This has the same objectives as a pooling agreement, but in a voting trust, shareholders assign their voting rights to a trustee who votes on behalf of all the shares in the trust

Shareholders need not attend meetings in order to vote; they may authorize a person, called a proxy, to vote their shares Proxy appointment often is solicited by parties who are interested in gaining control of the board of directors or in passing a particular proposal;

their request is called a proxy solicitation Proxy appointment must be in writing It usually may last no longer than a year, and it can be revoked Federal law generates most proxy regula-tion, and the Securities and Exchange Commis-sion (SEC) has comprehensive and detailed regulations These rules define the form of proxy-solicitation documents and require the distribution of substantial information about director candidates and other issues that are up for shareholder vote Not all corporations are subject to federal proxy law; generally, the law covers only large corporations with many shareholders and with shares that are traded

on a national securities exchange These regula-tions aim to protect investors from promiscu-ous proxy solicitation by irresponsible outsiders who seek to gain control of a corporation, and from unscrupulous officers who seek to retain control of management by hiding or distorting facts

In addition to voting rights, shareholders also have a right to inspect a corporation’s books and records A corporation almost always views the invocation of this right as hostile Shareholders may only inspect records if they

do so for a “proper purpose”; that is, is a purpose that is reasonably relevant to the shareholder’s financial interest, such as deter-mining the worth of his or her holdings Shareholders can be required to own a specified amount of shares or to have held the shares for

a specified period of time before inspection is allowed Shareholders generally may review all relevant records that are needed, in order to gather information in which they have a legitimate interest Shareholders also may ex-amine a corporation’s record of shareholders, including names and addresses and classes of shares

Directors Statutes contemplate that a corpora-tion’s business and affairs will be managed by the board of directors or under the board’s authority or direction Directors often delegate

to corporate officers their authority to formu-late policy and to manage the business In closely held corporations, directors normally involve themselves more in management than

do their counterparts in large corporations Statutes empower directors to decide whether to declare dividends; to formulate proposed im-portant corporate changes, such as mergers or amendments to the articles of incorporation;

and to submit proposed changes to

share-holders Many boards appoint committees to

handle technical matters, such as litigation, but

the board itself must address important matters

Directors customarily are paid a salary and

often receive incentive plans that can

supple-ment that salary

A corporation’s articles or bylaws typically

control the number of directors, the terms

of the directors’ service, and the directors’

ability to change their number and terms

The shareholders’ power of removal functions

as a check on directors who may wish to act

in a way that is contrary to the majority

shareholders’ wishes The directors’ own

fidu-ciary duties, or obligations to act for the benefit

of the corporation, also serve as checks on

directors

The bylaws usually regulate the frequency of

regular board meetings Directors also may hold

special board meetings, which are any meetings

other than regular board meetings Special

meetings require some advance notice, but the

agenda of special directors’ meetings is not

limited to what is set forth in the notice, as it is

with shareholders’ special meetings In most

states, directors may hold board meetings by

phone and may act by unanimous written

consent without a meeting

A quorum for board meetings usually exists

if a majority of the directors in office

immedi-ately before the meeting are present The

quorum number may be increased or decreased

by amending the bylaws, although it may not be

decreased below any statutory minimum A

quorum must be present for directors to act,

except when the board is filling a vacancy Most

statutes allow either the board itself or

share-holders to fill vacancies

Directors’ fiduciary duties fall under three

broad categories: the duty of care, the duty of

loyalty, and duties imposed by statute

Gene-rally, a fiduciary duty is the duty to act for the

benefit of another—here, the corporation—

while subordinating personal interests A

fidu-ciary occupies a position of trust for another

and owes the other a high degree of fidelity and

loyalty

A director owes the corporation the duty to

manage the entity’s business with due care

Statutes typically define using due care as acting

inGOOD FAITH, using the care that an ordinarily

prudent person would use in a similar position

and situation, and acting in a manner that the director reasonably thinks is in the corpora-tion’s best interests Courts seldom second-guess directors, but they usually find personal liability for corporate losses where there isSELF -DEALINGorNEGLIGENCE

Self-dealing transactions raise questions about directors’ duty of loyalty A self-dealing transaction occurs when a director is on both sides of the same transaction, representing both the corporation and another person or entity who is involved in the transaction Self-dealing may endanger a corporation because the corpo-ration may be treated unfairly If a transaction is questioned, the director bears the burden of proving that it was in fact satisfactory

Self-dealing usually occurs in one of four types of situations: transactions between a director and the corporation; transactions between corporations where the same director serves on both corporations’ boards; by a director who takes advantage of an opportunity for business that arguably may belong to the corporation; and by a director who competes with the corporation

The usurping of a corporate opportunity poses the most significant challenge to a director’s duty of loyalty A director cannot exploit the position of director by taking for himself or herself a business opportunity that rightly belongs to the corporation Most courts facing this question compare how closely related the opportunity is to the corporation’s current or potential business Part of this analysis involves assessing the fairness of taking the opportunity Simply taking a cor-poration’s opportunity does not automatically violate the duty of loyalty A corporation may relinquish the opportunity, or the corporation may be incapable of taking the opportunity for itself

Directors who are charged with violating their duty of care usually are protected by what courts call theBUSINESS JUDGMENT RULE Essentially, the rule states that even if the directors’ decisions turn out badly for the corporation, the directors themselves will not be personally liable for losses if those decisions were based on reason-able information and if the directors acted rationally Unless the directors commit fraud, a breach of good faith, or an illegal act, courts presume that their judgment was formed to promote the best interests of the corporation In

other words, courts focus on the process of reaching a decision, not on the decision itself, and require directors to make informed, not passive, decisions

State statutes often impose additional duties and liabilities on directors as fiduciaries to a corporation These laws may govern conduct such as paying dividends when a statute or the articles prohibit doing so; buying shares when a statute or the articles prohibit doing so; giving assets to shareholders during liquidation with-out resolving a corporation’s debts, liabilities, or obligations; and making a prohibited loan to another director, an officer, or a shareholder

If a court finds that a director has violated a duty, the director still might not face personal liability Some statutes require or permit corporations to indemnify a director who violated a duty but acted in good faith, who received no improper personal benefit, and who reasonably thought that the action was lawful and in the corporation’s best interests

Indemnification means that the corporation reimburses the director for expenses incurred defending himself or herself and for amounts he

or she paid after losing or settling a claim

Officers The duties and powers of corporate officers can be found in statutes, articles of incorporation, bylaws, or corporate resolutions

Some statutes require a corporation to have specific officers; others merely require that the bylaws contain a description of the officers

Officers usually serve at the will of those who appointed them, and they generally can be fired with or without cause, although some officers sign employment contracts

Corporations typically have as officers a president, one or more vice presidents, a secretary, and a treasurer The president is the primary officer and supervises the corporation’s business affairs This officer sometimes is referred to as the chief executive officer, but the ultimate authority lies with the directors

TheVICE PRESIDENTfills in for the president when the latter cannot or will not act The secretary keeps minutes of meetings, oversees notices, and manages the corporation’s records The treasurer manages and is responsible for the corporation’s finances

Officers act as a corporation’s agents and can bind the corporation to contracts and agree-ments Many parties who deal with corporations

require that the board pass a resolution approv-ing any contract negotiated by an officer, as a sure way to bind the corporation to the contract

In the absence of a specific resolution, the corporation still may be bound if it ratified the contract by accepting its benefits or if the officer appeared to have the authority to bind the corporation Courts treat corporations as having knowledge of information if a corporate officer

or employee has that knowledge

Like directors, officers owe fiduciary duties

to the corporation: good faith, diligence, and a high degree of honesty But most litigation about fiduciary duties involves directors, not officers

An officer does not face personal liability for

a transaction if he or she merely acts as the corporation’s agent Nevertheless, the officer may be personally liable for a transaction where the officer intends to be bound personally or creates the impression that he or she will be so bound; where the officer exceeds his or her authority; and where a statute imposes liability

on the officer, such as for failure to pay taxes Finances

Shares A corporation divides its ownership units into shares, and can issue more than one type or class of shares The articles of incorpo-ration must state the type or types and the number of shares that can be issued A corporation may offer additional shares once

it has begun operating, sometimes subject to current shareholders’ preemptive rights to buy new shares in proportion to their current ownership

Directors usually determine the price of shares Some states require corporations to assign a nominal or minimum value to shares, called a par value, although many states are eliminating this practice Many states allow some types of non-cash property to be exchanged for shares Corporations also raise money through debt financing—also called debt securities—which gives the creditor an interest

in the corporation that ultimately must be paid back by the corporation, much like a loan

If a corporation issues only one type of share, its shares are called COMMON STOCK or common shares Holders of common stock typically have the power to vote and a right to their share of the corporation’s net assets Statutes allow corporations to create different

classes of common stock, with varying voting

power and dividend rights

A corporation also may issue preferred

shares These are typically nonvoting shares,

and their holders receive a preference over

holders of common shares for payment of

dividends or liquidations Some preferred

divi-dends may be carried over into another year,

either in whole or in part

Dividends A dividend is a payment to

share-holders, in proportion to their holdings, of

current or past earnings or profits, usually on a

regular and periodic basis Directors determine

whether to issue dividends A dividend can take

the form of cash, property, or additional shares

Shareholders have the right to force payment of

a dividend, but they usually succeed only if the

directors abused their discretion

Restrictions on the distribution of dividends

can be found in the articles of incorporation

and in statutes, which seek to ensure that the

dividends come out of current and past

earnings Directors who vote for illegal

divi-dends can be held personally liable to the

corporation In addition, a corporation’s

cred-itors often will contractually restrict the

cor-poration’s power to make distributions

Changes and Challenges Faced

by Corporations

Amendments The most straightforward and

common changes faced by corporations are

amendments to their bylaws and articles The

directors or incorporators initially adopt the

bylaws After that, the shareholders or directors,

or both, hold the power to repeal or amend the

bylaws, usually at shareholders’ meetings and

subject to a corporation’s voting regulations

Those who hold this power can adopt or change

quorum requirements; prescribe procedures for

the removal or replacement of directors; or fix

the qualifications, terms, and numbers of

directors Most modern statutes limit the

authority to amend articles only by requiring

that an amendment would have been legal to

include in the original articles Some statutes

shield minority shareholders from harmful

majority-approved amendments

Mergers and Acquisitions A merger or

acqui-sition generally is a transaction or device that

allows one corporation to merge into or to

take over another corporation MERGERS AND

ACQUISITIONS are complicated processes that require the involvement and approval of the directors and the shareholders

In a merger or consolidation, two corpora-tions become one by either maintaining one of the original corporations or creating a new corporation consisting of the prior corporations

Where statutes authorize these combinations, these changes are called statutory mergers The statutes allow the surviving or new corporation

to automatically assume ownership of the assets and liabilities of the disappearing corporation or corporations

Statutes protect shareholder interests during mergers, and state courts assess these combina-tions using the fiduciary principles that are applied in self-dealing transactions Most sta-tutes require a majority of the shareholders in order to approve a merger; some require two-thirds Statutes also allow shareholders to dissent from such transactions, to have a court appraise the value of their stake, and to force payment at a judicially determined price

Mergers can involve sophisticated transac-tions that are designed simply to combine corporations or to create a new corporation or

to eliminate minority shareholder interests

In some mergers, an acquiring corporation creates a subsidiary as the form for the merged

or acquired entity A subsidiary is a corporation that is majority-owned or wholly owned by another corporation Creating a subsidiary allows

an acquiring corporation to avoid responsibility for an acquired corporation’s liabilities, while providing shareholders in the acquired corporation with an interest in the acquiring corporation

Mergers also can involve parent corpora-tions and their subsidiaries A similar, though distinct, transaction is the sale, lease, or exchange of all or practically all of a corpora-tion’s property and assets The purchaser in such a transaction typically continues operating the business, although its scope may be narrowed or broadened In most states, share-holders have a statutory right of dissent and appraisal in these transactions, unless the sale is part of ordinary business dealings, such as issuing a mortgage orDEED OF TRUSTcovering all

of a corporation’s assets

Not all business combinations are consen-sual Often, an aggressor corporation will use takeover techniques to acquire a target

corporation Aggressor corporations primarily use the cash TENDER OFFER in a takeover: The aggressor attempts to persuade the target corporation’s shareholders to sell, or tender, their shares at a price that the aggressor will pay

in cash The aggressor sets the purchase price above the current market price, usually 25 to

50 percent higher, to make the offer attractive

This practice often requires the aggressor to assume significant debts in the takeover, and these debts often are paid for by selling off parts

of the target corporation’s business

Restraints and protections exist for these situations In takeovers of registered or large, publicly held corporations, federal law requires the disclosure of certain information, such as the source of the money in the tender offer In smaller corporations, a controlling shareholder, who holds a majority of a corporation’s shares, may not transfer control to someone outside the corporation without a reasonable investigation

of the potential buyer A controlling shareholder also may not transfer control where there is a suspicion that the buyer will use the corpora-tion’s assets to pay the purchase price or otherwise wrongfully take the corporation’s assets

Corporations can employ defensive tactics

to fend off a takeover They can find a more compatible buyer (a “white knight”); issue additional shares to make the takeover less attractive (a “lock-up”); create new classes of stock whose rights increase if any person obtains more than a prescribed percentage (a

“poison pill”); or boost share prices to make the takeover price less appealing

Dissolution A corporation can terminate its legal existence by engaging in the dissolution process Most statutes allow corporations to dissolve before they begin to operate as well as after they get started The normal process requires the directors to adopt a resolution for dissolution, and the shareholders to approve it,

by either a simple majority or, in some states, a two-thirds majority After approval, the corpo-ration engages in a“winding-up” period, during which it fulfills its obligations for taxes and debts, before making final, liquidation distribu-tions to shareholders

Derivative Suits Shareholders can BRING SUIT

on behalf of a corporation to enforce a right or

to remedy a wrong that has been done to the corporation Shareholders“derive” their right to

bring suit from a corporation’s right One common claim in a derivative suit would allege misappropriation of corporate assets or other breaches of duty by the directors or officers Shareholders most often bring derivative suits

in federal courts

Shareholders must maneuver through several procedural hoops before actually filing suit Many statutes require them to put up security, often in the form of a bond, for the corporation’s expenses and attorneys’ fees from the suit, to be paid if the suit fails; this requirement often kills a suit before it even begins The shareholders must have held stock at the time of the contested action and must have owned it continuously ever since The shareholders first must demand that the directors enforce the right or remedy the wrong; if they fail to make a demand, they must offer sufficient proof of the futility of such a demand Normally, a committee formed by the directors handles—and dismisses—the demand, and in-formed decisions are protected by the business judgment rule

Proxy Contests A proxy contest is a struggle for control of a public corporation In a typical proxy contest, a nonmanagement group vies with management to gain enough proxy votes to elect a majority of the board and to gain control

of the corporation A proxy contest may be a part of a takeover attempt

Management holds most of the cards in such disputes: It has the current list of share-holders; shareholders normally are biased in its favor; and the nonmanagement group must finance its part of the proxy contest, but if management acts in good faith, it can use corporate money for its solicitation of proxy votes In proxy contests over large, publicly held corporations, federal regulations prohibit, among other things, false or misleading state-ments in solicitations for proxy votes

Insider Trading Federal, and often state, laws prohibit a corporate insider from using non-public information to buy or sell stock Most cases involving violations of these laws are brought before federal courts because the federal law governing this conduct is extensive The federal law, which is essentially an antifraud statute, states that anyone who knowingly or recklessly misrepresents, omits, or fails to correct a material or important fact that causes reliance in a sale or purchase, is liable to the buyer or seller Those with inside information

must either disclose the information or abstain

from buying or selling

Permutations

Corporations do not represent the only, or

necessarily the best, type of business Several

other forms of business offer varying degrees of

organizational, financial, and tax benefits and

drawbacks The selection of a particular form

depends upon the investors’ or owners’

objec-tives and preferences, and upon the type of

business to be conducted

A partnership is the simplest business

organization involving more than one person

It is an association of two or more people to

carry on business as co-owners, with shared

rights to manage and to gain profits and with

shared personal liability for business debts A

SOLE PROPRIETORSHIPis more or less a one-person

partnership It is a business owned by one

person, who alone manages its operation and

takes its profits and is personally liable for all of

its debts A limited partnership is a partnership

with two or more general partners, who manage

the business and have personal and unlimited

liability for its debts, and one or more limited

partners, who have almost no management

powers and whose liability is limited to the

amount of their investment In a LIMITED

LIABILITY COMPANY, the limited liability of a

limited partnership is combined with the tax

treatment of a partnership, and all partners have

limited liability and the authority to manage

This is a relatively new business form

A corporation thus provides limited liability

for shareholders, unlike a partnership, a sole

proprietorship, or a limited partnership, each of

which exposes owners to unlimited liability A

corporation is taxed like a separate entity on

earnings, out of which the corporation pays

dividends, which are then taxed (again) to the

shareholders; this is considered double

TAXA-TION Partnerships and limited partnerships are

not taxed as separate entities, and income or

losses are allocated to the partners, who are

directly taxed; this “flow-through” or

“pass-through” taxation allocates income or losses

only once Corporations centralize management

in the directors and officers, whereas

partner-ships divide management among all partners or

general partners Corporations can continue

indefinitely despite the death or withdrawal

of a shareholder; partnerships and limited

partnerships, however, dissolve with the death

or withdrawal of a partner Shareholders in a publicly held corporation generally can sell or transfer their stock without limitation Holders

of interest in a partnership or limited partner-ship, however, can convey their interest only if the other partners approve Corporations must abide by significant formalities and must cope with a great volume of paperwork; partnerships and limited partnerships face few formalities and few limitations in operating their business

New Issues Faced by Corporations Corporations in the United States have suffered

a series of major fiascos in recent years that have cost investors and employees billions of dollars and have eroded public confidence in the governance of major corporations During the mid to late 1990s, the U.S economy grew in record numbers, much to the delight of investors and the public in general Adding to this elation was the success of Internet-based companies, known generally as “dot-coms.” Business com-mentators and the general press referred to this collective success as the“dot-com bubble.”

The“bubble” burst during the early part of

2000 Marketing analysts in 1999 predicted that the enormous flow of capital, coupled with a limited range of business models that tended to copy from one another, would lead to a severe downturn or shakedown Early in 2000, stock in several of these companies sank rapidly, leading

to hundreds of BANKRUPTCY filings and thou-sands of employees losing their jobs Although not all of the companies shut down, entrepre-neurs and investors have been weary to follow this model since the collapse

Confidence in American corporations de-creased further with a series of corporate failure based largely upon mismanagement by directors and officers In 2001 Enron Corporation, a large energy, commodities, and service company, suffered an enormous collapse that led to the largest bankruptcy in U.S history Many of the company’s employees lost their 401(k) retire-ments plans that held company stock The controversy also extended to the company’s auditor, Arthur Andersen, L.L.P., which was accused of destroying thousands of Enron documents

Enron reported annual revenues of $101 billion in 2000, but stock prices began to fall throughout 2001 In the third quarter of 2001 alone, Enron reported losses of $638 million,

leading to an announcement that the company was reducing shareholder equity by $1.2 billion

TheSECbegan an inquiry into possible conflicts

of interest within the company regarding outside partnerships The SEC investigation became formal in October 2001, and initial reports focused on problems with Enron’s dealings with partnerships run by the com-pany’s chief financial offer

Many additional allegations continued to surface throughout November 2001, including rumors suggesting that company officials sought the assistance of top-level White House officials, including Treasury Secretary Paul O’Neill In December 2001, Enron’s stock prices fell below

$1 per share in the largest single-day trading volume on either the New York Stock Exchange

or the NASDAQ Because the company’s

Piercing the Corporate Veil

When a corporation is a sham,

engages inFRAUDor other

wrong-ful acts, or is used solely for the personal

benefit of its directors, officers, or

share-holders, courts may disregard the

sepa-rate corposepa-rate existence and impose

personal liability on the directors,

offi-cers, or shareholders In other words,

courts may pierce the“veil” that the law

uses to divide the corporation (and its

liabilities and assets) from the people

behind the corporation The veil creates a

separate, legally recognized corporate

entity and shields the people behind the

corporation from personal liability

In these cases, courts look beyond

the form to the substance of the

corpora-tion’s actions The facts of a particular

case must show some misuse of the

corporate privilege or show a reason to

cut back or limit the corporate privilege

to prevent fraud, misrepresentation, or

illegality or to achieve equity or fairness

Courts traditionally require fraud,

illegality, or misrepresentation before

they will pierce the corporate veil Courts

also may ignore the corporate existence

where the controlling shareholder or

shareholders use the corporation as

merely their instrumentality or ALTER

EGO, where the corporation is

undercapi-talized, and where the corporation

ignores the formalities required by law

or commingles its assets with those of a

controlling shareholder or shareholders

In addition, courts may refuse to

recognize a separate corporate existence when doing so would violate a clearly defined statutory policy

Courts may pierce the corporate veil

in TAXATION or BANKRUPTCY cases, in addition to cases involving plaintiffs with contract or tort claims Federal law in this area is usually similar to state law

The instrumentality and alter ego doctrines used by courts are practically indistinguishable Courts following the instrumentality doctrine concentrate on finding three factors: (1) the people behind the corporation dominate the corporation’s finances and business prac-tices so much that the corporate entity has no separate will or existence; (2) the control has resulted in a fraud or wrong,

or a dishonest or unjust act; and (3) the control and harm directly caused the plaintiff’s injury or unjust loss

The alter ego doctrine allows courts

to pierce the corporate veil when two factors exist: (1) the shareholder or shareholders disregard the separate cor-porate entity and use the corporation as a tool for personal business, merging their separate entities with that of the corpo-ration and making the corpocorpo-ration merely their alter ego; and (2) recogniz-ing the corporation and shareholders as separate entities would give court ap-proval to fraud or cause an unfair result

It may appear that a corporation owned by one or two persons or a single

family would almost automatically lose its separate legal existence under these doctrines, but this is not necessarily so A sole owner of a business, for example, can incorporate herself or himself, or the business; issue all shares to herself or himself; and set up dummy directors to follow the necessary corporate formali-ties However, the sole shareholder may lose the protection of limited liability— just as any other corporation would—if the corporate affairs and assets are confused or commingled with personal affairs and assets, if the sole shareholder abuses her or his control, or if the sole shareholder ignores the necessary corpo-rate formalities

When courts ponder piercing the corporate veil, they consider undercapi-talization to exist when a corporation’s assets or the value it receives for issuing shares or bonds is disproportionately small considering the nature of the business and the risks of engaging in that business Courts assess undercapita-lization by examining the capitaundercapita-lization

at the time the corporation was formed

or entered a new business For example,

if a corporation that faces or may face obligations to creditors and potential lawsuits has received only a token or minimal amount for its shares, or has siphoned off its assets through dividends

or salaries, courts may find undercapita-lization Such corporations are called shells or shams designed to take

employees’ 401(k) plans were tied into

company stock, these employees lost their

retirement plans

Concerns over corporate governance

con-tinued to dominate business news in 2002,

as WorldCom, Inc., the second-largest

long-distance provider in the United States, filed for

bankruptcy Like Enron employees,

World-Com’s employee 401(k) plans held company

stock, and by 2003, the value of these plans had

decreased by 98 percent from their value in

1999 Moreover, similar to the Enron fiasco, many allegations focused upon the accounting methods that WorldCom’s accountants employed The company’s board of directors and chief executive officer expressed “shock”

that the company had misstated $38 billion in capital expenses and that the company may have lost money in 2001 and 2002 when, instead, it had claimed a profit

advantage of limited liability protections

while not exposing to a risk of loss any of

the profits or assets they gained by

incorporating

The undercapitalization doctrine

es-pecially comes into play when courts

must determine who should bear a

loss—a corporation’s shareholders or a

third person This determination usually

depends on whether the claim involves a

contract or a tort (civil wrong or injury)

In contract cases, theTHIRD PARTYusually

has had some earlier dealings with the

corporation and should know that the

corporation is a shell So, unless there has

been deception, courts typically find that

the third party assumes the risk and

should suffer the loss In tort cases, the

third party normally has not dealt

voluntarily with the corporation Courts

thus must decide whether the owners of

the business can shift the risk of loss or

injury off themselves and onto the

innocent general public simply by

creat-ing a marginally financed corporation to

conduct their business

Courts may disregard the separate

corporate existence when a corporation

fails to follow the formalities required by

corporation statutes Courts often cite

the lack of corporate formalities in

finding that a corporation has become

the alter ego or instrumentality of the

controlling shareholder or shareholders

For example, a court may justify piercing

the corporate veil if a corporation began

to conduct business before its

incorpo-ration was completed; failed to hold

shareholders’ and directors’ meetings;

failed to file an annual report or tax

return; or directed the corporation’s

business receipts straight to the

controlling shareholder’s or share-holders’ personal accounts

Courts also may ignore the corporate existence when a corporation’s funds or assets are commingled with the control-ling shareholder’s or shareholders’ funds

or assets For example, they may pierce the corporate veil when no sharp dis-tinction is drawn between corporate and

PERSONAL PROPERTY; corporate money has been used to pay personal debts without the appropriate accounting, and vice versa; the controlling shareholder’s or shareholders’ personal assets have been depreciated along with corporate assets;

or the controlling shareholder or share-holders have endorsed company checks

in their own name

Many times, a controlling shareholder

is itself a corporation: The controlling shareholder is the parent corporation, and the controlled corporation is a subsid-iary In some circumstances courts may pierce the corporate veil protecting the parent and hold the parent liable for the subsidiary’s obligations This happens where the subsidiary loses its independent existence because the parent dominates the subsidiary’s affairs by participating in day-to-day operations, resolving important policy decisions, making business decisions without consulting the subsidiary’s direc-tors or officers, and issuing instructions directly to the subsidiary’s employees or instructing its own employees to conduct the subsidiary’s business

Courts also hold the parent liable where the parent runs the subsidiary in

an unfair manner by allocating profits to the parent and losses to the subsidiary;

the parent represents the subsidiary as a division or branch rather than as a

subsidiary; the subsidiary does not follow its own corporate formalities; or the parent and subsidiary are engaged in essentially the same business, and the subsidiary is undercapitalized

A final scenario in which courts may pierce the corporate veil involves an enterprise entity, which is a single business enterprise divided into separate corporations For example, a taxicab enterprise may consist of five corpora-tions with two taxis each, a corporation for the dispatching unit, and a corpora-tion for the parking garage All the corporations, though separate, essentially engage in a single business—providing taxi service

Courts often harbor suspicions that such arrangements are made in an attempt to minimize each corporation’s assets that would be subject to claims by creditors or injured persons Courts often will, in essence, put the corpora-tions together as a single entity and make that entity liable to a creditor or injured person, perhaps because treating them as separate entities is unfair to those who believe they really form a single unit

FURTHER READINGS Bainbridge, Stephen M 2001 “Abolishing Veil Piercing.” The Journal of Corporation Law

26 (spring): 479–535.

Huss, Rebecca J 2001 “Revamping Veil Piercing for all Limited Liability Entities: Forcing the Common Law Doctrine into the Statutory Age ” University of Cincin-nati Law Review 70 (fall): 93–135.

Roche, Vincent M 2003 “Bashing the Corpo-rate Shield: The Untenable Evisceration

of Freedom of Contract in the Corporate Context ” The Journal of Corporation Law

28 (winter): 289 –312.