Corporations

Question 1

The promoter is liable even after the corporation has been formed unless what occurs?

Answer 1

The promoter is liable even after the corporation has been formed unless:

(i) the corporation formally releases the promoter from responsibility through a novation,
(ii) the third party looks only to the corporation for performance, or
(iii) the promoter had no actual knowledge that the corporation’s charter has not yet been issued.

Question 2

Under what theory can someone avoid personal liability when acting in good-faith in complying with the state’s incorporation requirements and operating his business as a corporation without knowing that the requirements were not met?

Answer 2

When a person makes a good-faith but unsuccessful effort to comply with the incorporation requirements, that person may be able to escape personal liability under the de facto corporation doctrine. In this case, the business entity is treated as a defacto corporation, and the owner is not personally liable for obligations incurred in the purported corporation’s name.

Question 3

What is a corporation’s key constitutional document called and what must this document contain?

Answer 3

A corporation’s key constitutional document is called the Articles of Incorporation, and it must contain the corporation’s name including one of the following words: “corporation,” “company,” “incorporated,” “limited,” or an abbreviation thereof.

Question 4

In what three situations can an ultra vires act be challenged?

Answer 4

An ultra vires act can be challenged in only the following situations:

(1) A shareholder can file suit to enjoin the corporation’s ultra vires action,
(2) The corporation can take action against a director, officer, or employee who engaged in the action, or
(3) The state can initiate a proceeding to enjoin the corporation’s ultra vires action.

Question 5

What is par-value stock?

Answer 5

Par value is the minimum price for which the stock can be sold by the corporation (need not be its market value).

Note: Par value applies only when the stock is first sold by the corporation (as opposed to a shareholder selling to another).

Question 6

Who may a director rely on in making decisions?

Answer 6

Reliance Protection: A director may rely on information and opinions of officers, employees, outside experts (e.g., attorneys, accountants), or committees, so long as the director reasonably believes them to be reliable and competent.

Question 7

What is a shareholder’s preemptive right?

Answer 7

Definition: A preemptive right is the right to buy enough stock to maintain your ownership percentage in the corporation if the corporation sells more stock; a waiver of preemptive rights in writing is irrevocable.

Question 8

Generally, SHs have only limited liability for corporate acts and are only at risk to the extent of their investment. What is the exception to this rule?

Answer 8

Piercing the corporate veil–if a plaintiff can pierce the corporate veil, then the SHs can be held personally liable.

Question 9

What is a director’s liability for unlawful distributions to shareholders? If liable, is the director entitled to contributions from other directors or shareholders?

Answer 9

If a director violates the duty of care or loyalty in approving an improper dividend, the director is personally liable for any amount above the lawful distribution amount.

A director is entitled to contributions from other directors who have also violated their duties and from the excess amount received by shareholders who knowingly accepted unlawful distributions.

Question 10

How can you distinguish between a direct suit by a shareholder and a shareholder derivative suit?

Answer 10

The distinctions between direct suits and derivative suits can be murky, but the basic idea is that an action that principally harms the shareholder is a direct action while an action that harms the corporation as an entity is a derivative action. (For example, an allegation that directors mismanaged the corporation is usually derivative.)

Question 11

A corporate insider can be forced to return short-swing profits to the corporation through a Section 16(b) action. What 4 elements are necessary for a Section 16(b) cause of action?

Answer 11

The following four elements are necessary for a Section 16(b) cause of action:

1) Only publicly traded corporations that have securities traded on a national securities exchange or have assets of more than $10 million and more than 500 SHs
2) Only corporate insiders (directors, officers, and SHs holding more than 10% of a class of stock) are subject to a Section 16(b) action
3) Short swing profits—a corporate insider both bought and sold C’s stock during any six-month period
4) SEC report of change in stock ownership

Question 12

When does a corporation engage in an ultra vires act?

Answer 12

A corporation engages in an ultra vires act when it has stated a narrow business purpose in its articles but subsequently engages in activities outside that stated purpose.

Question 13

What is the general rule for a corporation’s liability for pre-incorporation transactions entered into by a promoter? What is the exception?

Answer 13

The corporation is not liable for contracts entered into by the promoter (because there is no fiduciary relationship between the promoter and corporation before the corporation exists).

However, the corporation is liable if it expressly or impliedly adopts a contract by accepting the benefits of the transaction, or gives an express acceptance of liability for the debt.

Question 14

While the articles of incorporation must be filed to incorporate, they need not spell out the manner in which the corporation is governed. The bylaws contain any lawful provision for the management of the corporation’s business. If there is a conflict between the articles and bylaws, which of the two controls?

Answer 14

In the event of a conflict between a corporation’s articles of incorporation and its bylaws, the articles of incorporation control.

Question 15

Other than using the de facto corporation doctrine, how else can someone who acted in good faith avoid personal liability when a company was not in compliance with a state’s incorporation requirements?

Answer 15

Corporation by Estoppel Doctrine: A person who deals with an entity as if it were a corporation is estopped from denying its existence and thereby prevented from seeking the personal liability of the business owner.

Question 16

There are two types of SH meetings: annual and special. SHs entitled to vote must be given notice of either type of meeting in a timely manner. What is considered to be a timely manner, and how do SHs waive their rights to notice?

Answer 16

Voting SHs must be notified of the time, date, and place in a timely manner no less than 10 days and no more than 60 days before the meeting; SHs may waive notice either in writing or by attending the meeting

Question 17

Unless the articles provide otherwise, corporations may choose directors by cumulative voting. Rather than having separate votes for each directorial slot, SHs are given a number of votes equal to the number of shares multiplied by the number of positions being voted on. What is the effect of this?

Answer 17

The effect of cumulative voting is to allow minority SHs to elect representatives to the board. (In other words, SHs can stack their votes on one or a small number of candidates if they wish, making it easier for minority shareholders to elect at least one director.)

Question 18

When is the presumption of good faith afforded by the business judgment rule overcome?

Answer 18

The presumption of good faith afforded by the business judgment rule is overcome if the challenger shows fraud, dereliction of duty, condoning illegal conduct, or a conflict of interest.

Question 19

If a shareholder wins a derivative suit, who recovers the judgment?

Answer 19

While a SH may have suffered harm directly, in a derivative action, the SH is suing on behalf of the corporation for harm suffered by the corporation. Thus, recovery generally goes to the corporation.

Question 20

How does a court determine whether to pierce the corporate veil?

Answer 20

Courts are generally reluctant to pierce the corporate veil. A court’s analysis whether to do so is generally very fact intensive, and a court will look at the totality of circumstances (whether the corporation is being used as a façade for a dominant SH’s personal dealings).

Common factors courts use in deciding whether to pierce the corporate veil are:

• Undercapitalization
• Disregard of corporate formalities
• Using corporate assets as SH’s own assets
• Self-dealing with the corporation
• Siphoning of the corporation’s funds
• Using corporate form to avoid statutory requirements
• SH’s domination over the corporation
• Fraudulent dealings with a corporate creditor

Question 21

Who, if anyone, is responsible for contracts entered into before the corporation is actually formed?

Answer 21

A promoter is personally liable for knowingly acting on behalf of a corporation before incorporation, and remains liable after the corporation comes into existence.

Question 22

What are the two types of stock?

Answer 22

The two types of stock are:

Common stock - a basic ownership interest that entitles the owner to vote on corporate governance matters

Preferred stock - has preference over other stock with regards to distributions

Question 23

When does a controlling SH owe a fiduciary duty to other SHs, what is that duty, and when is the duty breached?

Answer 23

Although SHs do not owe fiduciary duties to the corporation or to each other, a fiduciary duty to the minority SHs may arise if a controlling SH is:

1) selling that interest to an outsider,
2) seeking to eliminate other SHs, or
3) receiving a distribution denied to the other SHs

A controlling SH has a duty to disclose information that a reasonable person would consider important in deciding how to vote on a transaction, and a duty of fair dealing when purchasing a minority SH’s interest.

A controlling SH breaches the duty if nondisclosure causes a loss to the minority SHs.

Question 24

In an LLC, what document governs any or all aspects of its business?

Answer 24

An LLC may adopt an operating agreement to govern its business. The operating agreement can be oral, in a record, or implied by conduct. (Statutory default provisions apply when the operating agreement is silent.)

Question 25

What are the three ways SHs can vote together?

Answer 25

The three ways SHs can vote together are:

1) Voting pool—a binding voting agreement under which SHs retain legal ownership; does not need to be filed with the corporation; no time limit
2) Voting trust —a trust to which legal ownership of SH’s stock is transferred; the trustee votes the shares and distributes the dividends in accord with trust; must be in writing, limited to 10 years, and filed with the corporation
3) Management agreement —allows SHs to alter the way the C is managed even if the agreement is inconsistent with statutory provisions

Question 26

In an LLC, how are profits and losses allocated and distributed if the operating agreement fails to determine the manner?

Answer 26

In the absence of an operating agreement provision stating otherwise, profits and losses are allocated and distributions are made according to each member’s contributions to the LLC.

Question 27

How does an S corporation differ from a C corporation?

Answer 27

A C corporation is a basic corporation and is a separate taxable entity from its SHs, causing the corporation to face double taxation. (i.e., profits are taxed when they are brought in, and shareholders are also taxed on the distributions they receive.)

S corporations, however, have “pass through” taxation (as with a partnership). The income and expenses of the corporation are passed through to the shareholders, who are then taxed on such items directly.

Question 28

Shareholders who have the right to vote on a merger, asset sale, share exchange, or amendment of the articles of incorporation are entitled to appraisal rights (in some states these are known as dissenters’ rights). What exactly do these rights give to a dissenting shareholder?

Answer 28

A SH who objects to a merger or acquisition, or whose rights are materially and adversely affected by an amendment to a corporation’s articles, may be able to force the corporation to buy his stock at fair market value.

Question 29

Who may bring a derivative SH action?

Answer 29

To have standing to bring a suit, a plaintiff:

1) must have been a SH at the time of the harm,
2) must be a SH at the time the action is filed, and
3) must continue to be a SH during the litigation

Question 30

What is the minimum number of directors required for a board?

Answer 30

Traditionally, a board needed three or more directors, but today a board can have as few as one director, regardless of the number of shareholders.

Question 31

Who selects directors and when? What if there is a vacancy on the board?

Answer 31

Directors are selected by the SHs at the annual meeting and may be elected by straight or cumulative voting and by one or more classes of stock.

When there is a vacancy (or an increase in the number of directors), either the SHs or the directors may fill the vacancy. If the vacancy leaves the board without a quorum, the remaining directors can elect a replacement director by a majority vote.

Question 32

In the time between when the articles are filed, but before the directors are elected, people may subscribe to purchase stock from the corporation for when it comes into existence. Can a person who subscribed to purchase stock cancel that subscription?

Answer 32

Absent agreement, the subscriber does not have the unilateral right to cancel a subscription, as a pre-incorporation subscription is irrevocable for six months from the date of subscription.

Question 33

How would you fill in the blanks below?:

Unlike a SH, a director must be ________ at the time that a vote is taken in order to be counted for quorum purposes.

Generally, a __________ is a majority of all directors (unless a higher or lower number is required by the articles of incorporation or bylaws).

Answer 33

Unlike a SH, a director must be PRESENT at the time that a vote is taken in order to be counted for quorum purposes. (Note: Use of communications equipment constitutes presence.)

Generally, a QUORUM is a majority of all directors (unless a higher or lower number is required by the articles of incorporation or bylaws).

Question 34

What are the benefits of an LLC?

Answer 34

Like an S corporation, an LLC combines the (federal) tax advantages of a partnership with the limited liability of a corporation. An LLC also provides flexibility in management.

Question 35

Under what circumstances may a SH bring an action for corporate dissolution?

Answer 35

SHs can pursue involuntary dissolution if:

1) A corporation’s assets are being misapplied/wasted;
2) Directors are acting illegally, oppressively, or fraudulently;
3) SHs are unable to break directors’ deadlock causing irreparable injury; or
4) SHs are deadlocked in voting power and fail to elect successor directors

Question 36

What are the two basic duties directors owe to their corporation and how must directors act in discharging these duties?

Answer 36

Directors owe two basic duties to their corporation:

1) Duty of care; and
2) Duty of loyalty

In discharging these duties, a director must act in good faith and in a manner that a director reasonably believes (prudent person standard) to be in the best interests of the corporation. A director is also required to use any additional knowledge or special skills possessed.

Question 37

In what ways can a plaintiff overcome the business judgment rule?

Answer 37

To overcome the business judgment rule, it must be shown that:

1) Director did not act in good faith;
2) Director was not informed to the extent she reasonably believed was necessary;
3) Director had material interests in challenged conduct and was not objective;
4) Director failed to devote attention to the corporation’s affairs;
5) Director failed to timely investigate matters of material concern; or
6) Director received financial benefits to which he was not entitled

Question 38

A fraudulent purchase or sale of a stock or security can give rise to a Rule 10b-5 action. For a private person to pursue a Rule 10b-5 action, what 7 elements must be met?

Answer 38

For a private person to pursue a Rule 10b-5 action, all of the following elements must be met:

1) Plaintiff purchased or sold the security
2) Transaction involved the use of interstate commerce
3) Defendant engaged in fraudulent or deceptive conduct
4) Conduct related to material information
5) Defendant acted with scienter
6) Plaintiff relied on defendant’s conduct
7) Plaintiff suffered harm because of defendant’s conduct

Question 39

Define controlling shareholder.

Answer 39

A controlling SH is one (or a group of SHs acting in concert) who holds a high enough percentage of ownership in a company to enact changes at the highest level. Anyone controlling 50% of a corporation’s shares, plus one, is automatically a controlling SH.

Question 40

What are the safe harbors by which a conflict-of-interest transaction may be protected?

Answer 40

The standards for upholding a conflict of interest transaction are:

Disclosure of all material facts and majority approval by BD or SHs without a conflicting interest and fairness of the transaction to the corporation at the time of commencement.

Question 41

What are three ways distributions can be made to shareholders?

Answer 41

Three ways distributions can be made to shareholders are:

1) Paying out a dividend (cash payment or stock)
2) Buying stock from shareholders
3) Distribution of indebtedness

Question 42

In addition to a conflict-of-interest transaction, a director may violate the duty of loyalty by usurping a corporate opportunity rather than first offering the opportunity to the corporation. What are the two main tests courts apply in determining if an opportunity should have first been offered to the corporation?

Answer 42

The two main tests courts apply in determining if an opportunity should have first been offered to the corporation are:

1) Interest or expectancy test—does the corporation have an existing interest or an expectancy arising from an existing right in the opportunity
2) Line-of-business test—is the opportunity within the corporation’s current or prospective line of business, and how expansive is the corporation’s line of business

[Note: There are other factors courts look at in determining whether an opportunity belongs to a corporation, such as: relationship of the third party to the director and of the director to the corporation; how and when the director acquired knowledge of the opportunity].

Question 43

What must be filed to create an LLC, and what must it include?

Answer 43

An LLC is created by filing articles of organization with the state, and it must include the LLC’s name, mailing address, and, if there are no members upon filing, a statement to that effect. [Note, an LLC does not come into existence until it has at least one member.]

Question 44

What are the three officers that a corporation typically has?

Answer 44

Typically, a corporation’s officers are composed of a president, secretary, and treasurer.

Question 45

What are the three types of authority an officer has?

Answer 45

An officer’s authority can be:

1) Actual—as defined by the corporate bylaws or board
2) Implied—to perform those tasks necessary to carry out an officer’s duties by virtue of her status or position, so long as the matter is within the scope of ordinary business (i.e., not “extraordinary” transactions)
3) Apparent—if a corporation holds the officer out has having the authority to bind the corporation to third parties

Question 46

What are the procedural requirements to merge two or more corporations?

Answer 46

In order to merge two or more corporations:

1) The board of directors for each corporation must approve the merger;
2) The SHs of each corporation must usually approve* the merger; and
3) The required documents must be filed with the state.

• Mergers without SH approval: Parent-subsidiary merger and minnow-whale merger

Question 47

When will an asset acquisition require approval by both the board of directors and the SHs of the transferor corporation?

Answer 47

A transfer involving all, or substantially all, of the corporation’s assets outside the usual course of business is a fundamental corporate change for the transferor corporation, and the corporation must follow the fundamental change procedures.

Question 48

How can a corporation acquire control of another corporation without going through the process of a merger?

Answer 48

A corporation can acquire stock in another corporation and thereby secure control of that corporation without doing a merger by exchanging its own stock for that stock or by paying cash or other property for the stock.

Question 49

If stock has already been issued by a corporation, what needs to happen in order to voluntarily dissolve the corporation?

Answer 49

Voluntary dissolution of a corporation is a fundamental change and requires a resolution by the directors and shareholder approval.

Question 50

A dissolved corporation may continue to exist as a corporation for the limited purpose of doing what?

Answer 50

A dissolved corporation may continue to exist as a corporation for the limited purpose of winding up its affairs and liquidating its business. This includes collecting assets, disposing of property not distributed to SHs, discharging liabilities, and distributing property among SHs according to their interests.