An introduction to the fundamentals of dynamic business law and business ethics chap022

She recalls that the board of directors and its members owe a strict fiduciary duty to the corporation; as part of this fiduciary duty, the board must exercise oversight in monitoring t

Chapter 22

Corporations: Formation and

Organization

Chapter 22 Case Hypothetical

Phoebe Main and Franklin Kilbride, best friends, love to cook The two are so

inseparable that some time ago, those who knew them began to jokingly refer to Phoebe and Franklin as “Ma and Pa.” One of their kitchen concoctions, kettle corn, became so

popular (Phoebe and Franklin loved to share their caloric creations) that others have

encouraged them go into business and sell their kettle corn as a product Phoebe and

Franklin agree They have decided to form a traditional corporation as co-owners, and

they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc.

In the articles of incorporation (the document Phoebe and Franklin will send to the

Kansas Secretary of State’s office for approval of corporate status), the two are required

to indicate the total number of stock shares the company is authorized to issue “Ma and Pa” are perplexed Both have always considered themselves “good with numbers,” but

they cannot decide what number of shares of stock to indicate in the articles of

incorporation.

What is your recommendation to Phoebe Main and Franklin Kilbride?

(Access the video clip at http://video.google.com/videoplay?docid=7106559846794044495# to see

Chapter 22 Case Hypothetical and Ethical Dilemma

Clyde Monett has been operating an art restoration business since 1998, specializing in the

refurbishment of portraits and paintings He operated the enterprise as a sole proprietorship (called

Monett’s Art Restoration Services) until 2006, when he attended a “Business Structures, Licenses

and Permits” workshop at the local community college, at which time the presenting attorney

suggested he convert his business to a corporation, in order to “shield” Monett’s personal property

and real estate from liability for his business’ financial obligations (Monett’s personal net worth is

approximately $150,000.) Through the incorporation process, the only change to the business name was the addition of the word “Incorporated.” Monett was the only incorporator of the business He

serves as the president, vice-president and treasurer of the corporation; his sister, Georgette

O’Keeffe, is the secretary Since the corporation was formed in 2006, Clyde and Georgette have only convened one “official” corporate meeting; the meeting lasted approximately one hour, and the two

shared family gossip for forty-five minutes of that hour Monett’s Art Restoration Services,

Incorporated has maintained an average daily balance of $45.22 in the corporate checking account at Homeland National Bank

Yesterday, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning

solution was too acidic,) and the oversight resulted in irreparable damage to a painting conservatively valued at $75,000 The owner of the painting, Paul Picasso, demands $75,000 in damages from

Chapter 22 Case Hypothetical and Ethical Dilemma

Zaxxon-Mobile Oil Company, Inc., headquartered in Mobile, Alabama, is a multinational corporation with 2009 annual profits of $45 billion Zaxxon-Mobile has twelve (12) board members who serve the company on a

part-time basis, with each board member receiving an average of $300,000 per year in compensation.

Emily D Chanel, a pre-law student at The University of Alabama at Mobile, is very familiar with Zaxxon-Mobile Oil Company, Inc., and she has studied her business law textbook material on corporations and their

directors, officers and shareholders very carefully She recalls that the board of directors and its members

owe a strict fiduciary duty to the corporation; as part of this fiduciary duty, the board must exercise oversight in monitoring the actions of corporate employees, including the executives and officers of the corporation.

Emily ponders, “How can board members of a major corporation be truly objective when they are being paid

such lavish sums of money? Would not board members have a “Don’t rock the boat” mentality in terms of

exercising their oversight function? Why, for example, would a Zaxxon-Mobile board member question the

practices of the company’s high-ranking executives and officers, when such an inquiry might jeopardize his or her $300,000 per year annual compensation? ‘Make no bones about it,’ if I were a board member at Zaxxon-

Mobile, I would probably be a ‘yes-woman” and approve of everything the chief executive officer, the chief

financial officer and the chief operating officer wanted to do!”

How do you respond to Emily D Chanel’s questions and overall concerns about board member compensation and objectivity?

Chapter 22 Case Hypothetical and Ethical Dilemma

Dr Charles Finnegan is a newly-appointed member of the Board of Directors of Walnut Grove

Community College (W.G.C.C.) in Walnut Grove, California The position is unpaid, but does come

with the “perks” of positive exposure and prestige in the local community

At his first board meeting, the directors are discussing and considering for approval service contracts between W.G.C.C and the local business community The third contract for consideration is a

janitorial service contract, valued at $150,000, between W.G.C.C and Antiseptic Andy Cleaning

Service, Inc Finnegan is quite surprised; after all, “Antiseptic Andy” is owned and operated by his

first cousin, Andrew Deere Cousins Finnegan and Deere have not seen each other in three years,

nor have they otherwise communicated during that period of time

The chairperson of the Board of Directors calls for a vote on the janitorial service contract According

to W.G.C.C regulations, the board must unanimously approve contracts with the business

community

Finnegan is perplexed If he votes and says nothing about his kinship to Deere, he still feels he can

“sleep at night,” since he will not receive any financial gain from the contract If he discloses his

kinship to Deere, he fears that Deere’s business opportunity will be jeopardized

Does Finnegan have a legal obligation to disclose his relationship to Deere? Would it be a “conflict of

Corporate Powers

• Corporations have both “express” and “implied” powers

-Express Powers: Perpetual existence; right to

litigate; right to make contracts; right to borrow/loan

money; right to make charitable donations; ability to

establish rules for managing corporation

-Implied Powers: Whatever actions necessary (within

the law) to execute express powers

• “Ultra Vires” Act: Corporate action beyond scope of

Public Versus Private Corporation

• Public Corporation: Corporation created by

government to administer law, with specific

government duties to fulfill

-Example: Federal Deposit Insurance

Corporation (FDIC)

• Private Corporation: Corporation created for

private purposes

For-Profit Versus Non-Profit

Corporations

• For-Profit Corporation: Objective is to operate for

profit; shareholders seeking to make profit purchase

stock these corporations issue

• Non-Profit Corporation: May earn profits, but they

do not distribute these profits to shareholders

(non-profit corporation does not issue stock, nor does it

have shareholders); instead, corporation reinvests

profits in business

Domestic, Foreign, and Alien

Corporations

• Domestic Corporation: Doing business within

state of incorporation

• Foreign Corporation: Doing business in states

other than state of incorporation

• Alien Corporation: Doing business country

other than country of incorporation

Publicly Held Versus Closely Held

Corporation

• Publicly Held Corporation:

-Stock available to public

• Closely Held Corporation (a.k.a “Close”,

“Family”, “Privately Held” Corporation):

-Generally does not offer stock to public

“Subchapter S” Corporation

• Named after provision of Internal Revenue

Service (IRS) code that provides for it

• Particular type of closely held corporation

(no more than one hundred shareholders)

• Combines advantages of limited liability and

single taxation

Formation of Corporation

• Promoters organize corporate formation

• Subscribers offer to purchase stock in

corporation in formation process

• State selected for incorporation

Questions to Consider in Selecting a

State For Incorporation

• How much flexibility does the state grant to

Legal Process of Incorporation

• Selection of corporate name

• Drafting and filing articles of incorporation

• First organizational meeting held

Remedies For Defective Incorporation:

• “De jure” corporation: Lawful corporation that has met the

substantial elements of incorporation process

• “De facto” corporation: Corporation that has not met the

requirements of state incorporation statute, but courts

recognize it as a corporation for most purposes to avoid

unfairness to third parties who reasonably believed it was

properly incorporated

• Corporation by estoppel: Corporation prevented by court

from denying its corporate status

• Piercing corporate veil: Shareholders personally liable

Situations When Courts Likely To

Pierce Corporate Veil

• Corporation lacked adequate capital when initially

formed

• Corporation did not follow statutory mandates

regarding corporate business

• Shareholders’ personal interests and corporate

interests are commingled (corporation has no

separate identity)

• Shareholders attempt to commit fraud through

Debt Securities Versus Equity

Securities

• Debt Securities: Bonds (representing loans

to corporation from another party)

• Equity Securities: Stock

Equity Securities: Preferred Stock

Versus Common Stock

• Preferred Stock: Stockholder enjoys

preferences regarding assets and dividends

• Common Stock: Stockholder owns portion

of corporation, but no preferences regarding

assets and dividends

Corporate Directors, Officers,

and Shareholders

Summary of Roles of Directors, Officers, and

• Appoint and supervise officers

• Make financial decisions

Fiduciary Duties

Definition: Duties to corporation that individuals

within corporation have

Primary fiduciary duties include:

• Duty of Care

• Duty of Loyalty

Business Judgment Rule

Definition: Provides that directors and officers

are not liable for decisions that harm

corporation if they were acting in good faith at

time of decision

Corporations: Directors, Officers, and

Shareholders Other Relevant Terminology

• Stock-Subscription Agreement: Contractually

obliges individual to buy shares in corporation

• Par-Value Shares: Fixed face value noted on stock

certificate

• No-Par Shares: Stock shares without a par value

• Watered Stock: Stock issued to individuals at a

value below fair market value.

Corporations: Directors, Officers, and

Shareholders Other Relevant Terminology (Continued):

• Stock Warrants: Vouchers issued to shareholders, entitling

them to given number of shares at specified price

• Inspection Rights: Protect shareholders’ interests by

giving them right to inspect corporation’s books and

records after asking in advance to inspect and having

proper purpose

• Right of First Refusal: Given to existing shareholders to

purchase any shares of stock offered for resale by

shareholder within specified period of time

• Shareholder’s Derivative Suit: Filed by corporate

shareholder when corporate directors fail to sue in

situation where corporation has been harmed by

Summary of Rights of Directors, Officers, and Shareholders

Mergers and Consolidations

Definition: A legal contract combining two or

more corporations such that only one of the

corporations continues to exist; in essence,

one corporation “absorbs” another corporation

Definition: A legal contract combining two or

more corporations, resulting in an entirely

new corporation; in consolidation, neither of

the original corporations continues to exist

Procedures for Mergers and

Consolidations

• Boards of directors of all involved corporations

must approve the plan

• Shareholders must approve the plan through a

vote at a shareholder meeting

• The corporations must submit their plan to the

secretary of state

Other Terminology/Rights Regarding Mergers

and Consolidations

• Short-form merger (Parent-subsidiary merger):

Parent corporation merges with a subsidiary

corporation; does not require shareholder

approval

• Rights of shareholders: Shareholders vote only

on exceptional matters regarding the

corporation

• Appraisal right: Shareholder’s right to have

his/her shares appraised, and to receive

“Hostile” Takeover

Definition: A takeover to which

management of the target corporation

objects

Types of Takeovers

• Tender Offer: Aggressor (acquiring corporation)

offers target shareholders a price above current

market value of their stock

• Exchange Tender Offer: Aggressor offers to

exchange target shareholders’ current stock for

stock in aggressor’s corporation

• Cash Tender Offer: Aggressor offers target

shareholders cash for their stock

Leveraged Buyout

Definition: Occurs when group within a

corporation (usually management) buys all

outstanding corporate stock held by the

public; group gains control over corporate

operations by “going private” (i.e., becoming a

privately-held corporation)

“Legal Death” of Corporation

Occurs in two phases:

• Dissolution: Legal termination of corporation

• Liquidation: Process by which trustee

converts corporation’s assets into cash, and

distributes them among corporation’s creditors

and shareholders

Voluntary Versus Involuntary

Dissolution

• Voluntary Dissolution: Occurs when

directors or shareholders initiate the

dissolution process

• Involuntary Dissolution: State government

forces the corporation to close