Analytical Approach for Exam

Question 1

corporations

IN A NUTSHELL /approach to exams

Answer 1

• A corporation is a legal entity apart from its owners (the shareholders).
• Generally, only the corporation (and not the people who own or work for the corporation) is liable for the corporation’s obligations.
• To qualify for this entity treatment, the corporation must be formed by filing a document with the state (in most states “the articles of incorporation”) setting out certain information.
• Rules for corporate governance may be set out in the articles or in bylaws adopted by the corporation.
• Ownership interests in the corporation are then sold in the form of stock or shares which give the shareholders certain rights (e.g., to receive distributions when declared and to vote).
• Shareholders elect directors to oversee the corporation, and the directors appoint officers to run the company on a day-to-day basis.
• Directors and officers owe the corporation a duty to act as similarly situated prudent persons and cannot “self-deal” for their own benefit.
• Before a fundamental change can be made to the corporation, shareholders must be informed and given an opportunity to vote on the change.

Question 2

Have Articles of Incorporation Been Filed? (4)

/ORGANIZATION AND FORMATION OF CORPORATION

Answer 2

1. Name of corporation must be included; cannot be similar to existing names
2. Number of authorized shares must be included
3. Also must include name and address of incorporators and of registered agent
4. Watch for clause limiting corporation’s purpose—activities beyond scope of purpose are ultra vires and may be enjoined or directors held liable for authorizing such acts

Question 3

When Does Corporate Existence Begin? (2)

/ORGANIZATION AND FORMATION OF CORPORATION

Answer 3

1. When articles filed by state
2. Promoters generally liable for preincorporation contracts
   a. Liability continues even after corporation formed absent a novation
   b. Corporation does not become liable unless it adopts

Question 4

What if There Are Defects in Formation? (5)

/ORGANIZATION AND FORMATION OF CORPORATION

Answer 4

1. A person who purports to act on behalf of a corporation knowing there was no valid incorporation is personally liable
2. No liability if de facto corporation:
   a. Colorable compliance with the incorporation statute; and
   b. Exercise of corporate privileges
3. No liability if corporation by estoppel—people treating business as valid corporation are estopped from denying corporation’s existence
4. Some states do not recognize de facto and estoppel doctrines
5. Where no corporation recognized, only those who acted on behalf of the business will be held liable; passive investors not liable

Question 5

Will Court Disregard Corporate Entity (Pierce the Corporate Veil)? (4)
/ORGANIZATION AND FORMATION OF CORPORATION

Answer 5

1. Alter ego doctrine
   a. Grounds—harm caused to third party because:
   - 1) Owners do not treat corporation as a separate entity
   - 2) Commingle personal and corporate funds
   - 3) Use corporate assets for personal purposes
   - 4) Owners do not hold meetings
   b. Parent/subsidiary corporations or affiliated corporations can be held liable for this
2. Inadequate capitalization at inception
   a. Must start corporation with sufficient unencumbered capital to meet its prospective liabilities
3. Perpetrating a fraud
   a. Cannot be formed to avoid existing liabilities
   b. Can be formed to limit future liabilities
4. If court pierces:
   a. Generally only active shareholders liable b. Generally liable only for tort obligations

Question 6

Capital Structure of Corporation (2)

/ORGANIZATION AND FORMATION OF CORPORATION

Answer 6

1. Debt securities (bonds) create debtor-creditor relationship
2. Equity securities (stocks) create ownership interest
   a. Terminology
   - 1) Authorized but unissued shares—shares described in the articles
   but not currently issued
   - 2) Issued and outstanding—shares sold to investors
   - 3) Treasury shares—former name for shares repurchased by corporation; now called authorized but unissued shares
   b. Subscription agreements—agreements to purchase shares from corporation
   - 1) Preincorporation subscription agreements are irrevocable for six
   months
   c. Consideration for shares
   - 1) Acceptable form
   — a) Under Revised Model Business Corporations Act
   (“RMBCA”), any benefit to the corporation
   — b) Traditionally only cash, property, or services already
   performed
   - 2) Amount
   — a) Under RMBCA, amount set by directors, and their good faith valuation of the consideration received is conclusive
   — b) Traditionally shares often had a par value (minimum consideration) and could not be sold for less

Question 7

Voting (6)

/SHAREHOLDERS

Answer 7

1. Generally shareholders do not run corporation on a day-to-day basis
   a. Exception: Closely held corporation may dispense with board by share-
   holders’ agreement and run corporation through a different scheme
   b. Shareholders indirectly control corporation by electing directors,
   amending bylaws, and approving fundamental changes
2. Record shareholders
   a. Shareholders of record on the record date have a right to vote:
   1) At the annual meeting to elect directors
   2) Regarding fundamental corporate changes
3. Notice of meetings must be given to shareholders
   a. Annual meeting—date, time, location
   b. Special meeting—date, time, location, and purpose c. Improper notice
   - 1) Action taken at the meeting can be nullified
   - 2) Can be waived by attending without complaint
4. Proxies
   a. Written proxies valid for 11 months
   b. Generally revocable unless they specifically provide otherwise and are coupled with an interest
   c. May be revoked by attendance or later appointment d. Federal law
   - 1) Proxy solicitations must fully and fairly disclose all material facts
   - 2) Prohibits material misstatements and fraud in connection with a proxy solicitation
   - 3) Materiality—a reasonable shareholder would consider it important in deciding how to vote
5. Quorum
   a. Generally a majority of the outstanding voting shares must be present for valid vote
   b. Once quorum reached, shareholder leaving does not invalidate voting
6. Approval
   a. RMBCA—if quorum present, action approved if votes cast in favor exceed votes cast against
   b. Some states require greater vote for fundamental corporate change
   c. Cumulative voting for directors
   - 1) RMBCA allows articles to provide for cumulative voting
   - 2) Cumulative voting is automatic in some states
   - 3) Mechanics—shareholder can vote shares owned x number of directors being elected; can cast all votes for one candidate or split

Question 8

Shareholder Agreements (3)
/SHAREHOLDERS

Answer 8

1. Voting trusts
   a. Shareholders transfer share ownership to a trustee who votes shares as agreed
   b. Valid in most states for up to 10 years but renewable
2. Shareholder management agreements
   a. Used in small corporations
   b. Shareholders may agree to run the corporation in any way
   c. Can even dispense with board
3. Share transfer restrictions
   a. Ownership interests (shares) generally are freely transferable
   b. Shares may conspicuously provide for restriction
   c. Restrictions must be reasonable

Question 9

Inspection Rights (2)
/SHAREHOLDERS

Answer 9

1. Limited—books, papers, accounting records, etc.
   a. With five days’ written notice, and
   b. Proper purpose (purpose related to the shareholder’s rights)
2. Unqualified right (regardless of purpose)—articles and bylaws, minutes of shareholder meetings, names and addresses of current directors, and recent annual reports

Question 10

Preemptive Right (3)
/SHAREHOLDERS

Answer 10

1. Right to purchase shares to maintain proportionate ownership interest
2. Under RMBCA exists only if provided for
3. Where provided for, does not apply to:
   a. Shares issued as compensation
   b. Shares issued within six months of incorporation
   c. Shares issued for consideration other than money
   d. Nonvoting shares with a distribution preference

Question 11

Shareholder Suits (3)
/SHAREHOLDERS

Answer 11

1. Direct vs. derivative
   a. Direct suit is to enforce right of shareholder
   b. Derivative suit is to enforce a right belonging to corporation
   - 1) Must have owned shares at time of wrong
   - 2) Must maintain ownership throughout suit
   - 3) Demand board to bring suit (unless futile in some states)
2. Dismissal—if a majority of directors with no personal interest determine in good faith that suit is not in best interests of corporation
3. Recovery
   a. Direct suit—goes to shareholder
   b. Derivative suit—goes corporation (usually)

Question 12

Distributions (2)

/SHAREHOLDERS

Answer 12

1. Generally are in the form of dividends or of assets after dissolution
2. No right to receive unless/until declared by board
   - a. Insolvency limitations—no distribution if:
   1) Corporation unable to pay its debts as they become due
   2) Total assets are less than total liabilities
   - b. Preferences—shares may have a preference to distributions
   1) Cumulative—if distribution not declared or paid in a certain
   year, it accumulates until paid
   2) Cumulative if earned—preference accumulates only if profits for
   year were sufficient to pay preference
   3) Participating—receive stated preference and a share of the distribution made to common shareholders
   - c. Director liability
   1) Director who votes for an unlawful distribution is personally liable for the excess
   2) Director may seek contribution from other directors who voted for distribution
   3) Directors may recover from a shareholder who received a distribution knowing it was unlawful
   4) Good faith defense—may rely on accountants or reliable officers and employees who indicate distribution is lawful

Question 13

Shareholder Liabilities (2)
/SHAREHOLDERS

Answer 13

1. Shareholders not fiduciaries—may act in self-interest
2. Exception—controlling shareholder cannot use control to obtain a special
   advantage at the expense of the minority shareholders

Question 14

Voting (2)

/DIRECTORS

Answer 14

MEETINGS

• a. Directors must attend in person (no proxies) or through telecommunications equipment if all participating directors can simultaneously hear each other
• b. No particular notice required for regular meetings
• c. Special meetings typically require two days’ notice of date, time, and place (but not purpose)
• d. Quorum of directors must be present at time vote is taken
• e. Approval of action requires affirmative vote of a majority of the directors present

2. Delegation to executive committees—may exercise authority given to them by
   board
   - a. Comprised of two or more directors (in most states)
   - b. Exceptions: In most states committees may not declare distributions, fill board vacancies, or amend the bylaws

Question 15

Liabilities

/DIRECTORS

Answer 15

a. Business judgment rule generally protects directors from personal
liability to corporation/shareholder
1) Director must act in good faith
2) With the care that an ordinarily prudent person in a like position would exercise, and
3) In a manner reasonably believed to be in the best interests of the corporation

b. Articles may further limit or eliminate director personal liability to
corporation or shareholders except:
1) To the extent director received improper benefit;
2) For liability for unlawful distributions; or
3) For intentionally inflicted harms or criminal violations of law

c. Reasonable reliance defense
1) Director may defend suits with a claim of reasonable reliance on opinions, reports, etc., prepared by experts or reliable employees

d. Waste—a director has a duty to prevent corporate waste

e. No self-dealing without disclosure and approval—duty of loyalty
1) A transaction between a corporation and a director will not be set aside for self-dealing if:
a) The director disclosed all material facts, and transaction was approved by disinterested directors or shareholders; or
b) The transaction was fair to the corporation

f. Corporate opportunity doctrine
1) A director may not divert to himself a business opportunity within the corporation’s line of business without first giving the corporation an opportunity to act (a.k.a. usurpation)
2) Remedy—corporation may recover director’s profits or force director to convey the opportunity to the corporation

Question 16

Indemnification

/DIRECTORS

Answer 16

a. Successful defense—if director is sued as a director and successfully defends, corporation must indemnify for expenses

b. Unsuccessful—if director is unsuccessful in defending, corporation
has discretion to indemnify if the director complied with the business judgment rule standards
1) Exceptions: Director is found liable to the corporation or received an improper benefit

c. Corporations may purchase liability insurance to cover directors even if they would not be entitled to indemnification under the circumstances

Question 17

Required Officers (3)
/OFFICERS

Answer 17

1. RMBCA does not require any particular officers but rather allows corporations to have officers described in bylaws or appointed by directors
2. Some states require at least two officers—a president and a secretary (to certify corporate acts and records)
3. Generally, a person may hold more than one office (but some states prohibit president and secretary from being same person)

Question 18

Appointment and Removal (3)

/OFFICERS

Answer 18

1. Officers are appointed by board of directors (not by shareholders)
2. Officers may be removed by the board of directors
3. If removal is in breach of contract, officer entitled to damages

Question 19

Authority (2)

/OFFICERS

Answer 19

1. Officers have the actual authority given by the board, articles, and bylaws
2. Officers have apparent authority to do whatever someone in their position
   would normally have authority to do

Question 20

Liabilities and Indemnification (2)

/OFFICERS

Answer 20

1. Officers owe corporation duties similar to those owed by directors
2. Officers have right to indemnification similar to directors

Question 21

Rule 10b-5

/RULE 10b-5, SECTION 16(b), AND SARBANES-OXLEY ACT

Answer 21

Rule 10b-5 makes it illegal for any person:
(i) To use any means or instrumentality of interstate commerce
(ii) In connection with the purchase or sale of any security
(iii) To employ any scheme to defraud, make an untrue statement of material
fact (or omit a material fact), or engage in any practice that operates as a
fraud

a. Materiality—a substantial likelihood that a reasonable investor would
consider it important in making an investment decision

b. Intent—the conduct must have been undertaken with an intent to deceive, manipulate, or defraud (that is, scienter). Recklessness as to truth also appears to be sufficient culpability
c. The defendant need not have purchased or sold any securities; e.g., a nontrading defendant can be held liable to a person who purchased or sold securities on the market on the basis of a misleading press release

d. A private plaintiff must prove reliance on defendant’s fraudulent statement
or conduct; in cases of omission, reliance generally will be presumed

e. A private plaintiff must show that defendant’s fraud caused plaintiff
damages
1) Damages are limited to the difference between the price paid (or
received) and the average share price in the 90-day period after
corrective information is disseminated

f. Rule 10b-5 also prohibits most instances of trading securities on the
basis of inside information (that is, information not disclosed to the public that an investor would think is important when deciding whether or not to invest in a security)
1) A person violates rule 10b-5 if by trading he breaches a duty of
trust and confidence owed to: (i) the issuer, (ii) shareholders of the issuer, or (iii) in the case of misappropriators, another person who is the source of the material nonpublic information
2) Anyone who breaches a duty not to use inside information for personal benefit can be held liable under rule 10b-5
3) If an insider gives a tip of inside information to someone else who trades on the basis of the inside information, the tipper can be liable under rule 10b-5 if the tip was made for any improper purpose (e.g., in exchange for money or a kickback, as a gift, for a reputational benefit, etc.)
4) A tippee can be held liable only if the tipper breached a duty and the tippee knew that the tipper was breaching the duty

Question 22

Section 16(b) (3)
/RULE 10b-5, SECTION 16(b), AND SARBANES-OXLEY ACT

Answer 22

1. Requires surrender to the corporation of any profit realized by any director, officer, or shareholder owning more than 10% of a class of the corporation’s stock from the purchase and sale, or sale and purchase, of any equity security within a six-month period
   a. Sale or purchase test—type of sale in which abuse of inside information is likely to occur?
   b. Transactions occurring before one becomes an officer or director are excluded, but transactions occurring within six months after ceasing to be an officer or director can be covered
2. The section applies to publicly held corporations (i) with more than $10 million in assets and 2,000 or more shareholders (or 500 shareholders who are not accredited investors) in any outstanding class or (ii) whose shares are traded on a national exchange
   a. “Accredited investors” include high income or net worth individuals and officers or directors of the issuer
3. Profit is determined by matching the highest sales price against the lowest purchase price for any six-month period
   a. May be either a gain or an avoided loss

Question 23

Sarbanes-Oxley Act of 2002 (“SOX”) (6)

/RULE 10b-5, SECTION 16(b), AND SARBANES-OXLEY ACT

Answer 23

1. Applies to companies
   (i) with more than $10 million in assets and 2,000 or more shareholders (or 500 shareholders who are not accredited investors) in any outstanding class or
   (ii) whose shares are traded on a national exchange
2. Requires covered companies to establish an audit committee of board members which:
   a. Oversees work performed by the registered public accounting firm
   b. Establishes internal procedures for receiving and handling complaints
   about the company’s accounting, internal accounting controls, and
   auditing procedures
3. The CEO, CFO, or similar person of covered companies must certify in each
   report, among other things, that:
   a. The officer has reviewed the report;
   b. Based on the officer’s knowledge, the report is true and does not contain
   any material omissions; and
   c. The signing officer is responsible for establishing internal controls,
   has designed such controls to ensure that material information is made known to the officer, and has evaluated the controls within 90 days prior to the report
4. If a company is required to restate financial reports because of misconduct
   with respect to the reports, the company’s CEO and CFO must reimburse the company for any bonus or other incentive-based compensation received by them during the 12-month period after the inaccurate reports were filed with the SEC or made public
5. SOX generally prohibits covered companies from making any personal loans to directors and executive officers
6. SOX provides that the statute of limitations for private cases of securities fraud is the later of two years after discovery of the facts giving rise to the cause of action or five years after the action accrued