Corporations [Old]

Question 1

What is required to form a corporation?

Answer 1

Forming a corporation requires:
1. Person: One or more persons (incorporators) must undertake to form the corporation by executing the articles of incorporation and delivering them to the Secretary of State
2. Paper: The articles of incorporation are a contract between the corporation and its shareholders, and a contract between the corporation and the state
3. Act: To complete formation, the incorporators will have notarized articles delivered to the Secretary of State and pay required fees; if the Secretary of State’s office accepts the articles for filing, it is conclusive proof of valid formation

NOTE: Corporate existence begins upon the Secretary of State’s filing of the articles of incorporation

Question 2

What must be the articles of incorporation include?

Answer 2

The articles of incorporation must include:
1. the name of the corporation, which cannot be similar to existing names, and must include one of the following words (or an abbreviation): Corporation, company, incorporated, or limited (corp., co., inc., ltd.)
2. the name and address of each incorporator;
3. the name of a registered agent, and the street address of the registered office (which must be in the state)
4. the number of authorized shares;
5. if the corporation has different classes of stock or series within a class, the number of authorized shares per class and a distinguishing designation for each class; AND
6. information on the voting rights, preferences and limitations of each class of stock

Duration: If there is no statement of duration in the articles, perpetual existence is presumed
Statement of Purpose: If a statement of business purposes is not included, the MBCA presumes that a corporation is formed to conduct any lawful business

Question 3

What is a de jure corporation?

Answer 3

A de jure corporation is a corporation formed in accordance with law

Question 4

What are the consequences of failing to form a de jure corporation?

Answer 4

As a general rule, if a corporation is not validly formed, the incorporators will be personally liable for the business’s obligations (essentially a partnership was formed instead) unless either (1) the de facto corporation or (2) corporation by estoppel doctrines apply

Question 5

What is a de facto corporation?

Answer 5

The de facto corporation doctine is an exception to the general rule that incorporators are personally liable for the obligations of an invalidly formed corporation
* If the de facto corporation doctrine applies, the business is treated as a corporation for all purposes except in an action by the state (a “quo warranto” action)

Question 6

What is required to show a de facto corporation?

Answer 6

A de facto corporation exists if:
1. there is a relevant incorporation statute (every state has one);
2. the incorporators made a good faith, colorable attempt to comply with the incorporation statute; AND
3. there has been an exercise of corporate privileges, meaning the incorporators were acting as though they formed a de jure corporation

NOTE: Only a person who was UNAWARE that the corporation was not validly formed may assert the de facto corporation doctrine as a defense

Question 7

What is corporation by estoppel?

Answer 7

Under the corporation by estoppel doctrine, any person or entity who has dealt with the business as if it were a corporation will be estopped from denying the corporation’s existence
* The doctrine will also estop the improperly formed business from avoiding liability by denying its valid existence
* Like the de facto corporation doctrine, corporation by estoppel may only be asserted by a person who was UNAWARE that the corporation was not validly formed

NOTE: The corporation by estoppel doctrine applies only in CONTRACT cases

Question 8

What is a promotor?

Answer 8

A promoter is a person acting on behalf of a corporation that has not yet been formed
* Before a corporation is formed, promoters procure commitments for capital and other instrumentalities that will be used by the corporation after its formation
* In so doing, promoters may enter into a contract on behalf of the corporation not yet formed

Question 9

What does a promoter’s fiduciary duty to the corporation require?

Answer 9

A promoter’s fiduciary duty to the corporation requires full disclosure and good faith
* A promoter who profits by selling property to the corporation may be liable for his profit unless all material facts of the transaction were disclosed
* If the transaction is disclosed to, and approved by, an independent board of directors, the promoter has met his duty and will not be liable for his profits
* If the board is not completely independent, the promoter still will not be liable for his profits if the subscribers knew of the transaction at the time they subscribed or unanimously ratified the transaction after full disclosure
* Promoters may always be liable if plaintiffs can show that they were damaged by the promoters’ fraudulent misrepresentations or fradulent failure to disclose all material facts

Question 10

Is a corporation liable for pre-incorporation contracts?

Answer 10

A corporation does not exist prior to incorporation and is not bound on a pre-incorporation contract entered into by a promoter in the corporate name unless the corporation expressly or impliedly adopts the contract
1. Express Adoption: The board takes an action adopting the contract
2. Implied Adoption: The corporation accepts a benefit of the contract

Question 11

Is a promoter liable for pre-incorporation contracts?

Answer 11

A promoter is personally liable under a pre-incorporation contract and remains liable even after the contract is adopted by the corporation unless:
1. there is a subsequent novation among the promoter, the corporation and the other contract party agreeing to release the promoter from liability and substitute the corporation for the promoter under the contract; OR
2. the agreement expressly relieves the promoter of liability (in which case, there is no contract but, rather, a revocable offer to the proposed corporation)

NOTE: A promoter who is held personally liable on a pre-incorporation contract may have a right to reimbursement from the corporation to the extent of any benefits received by the corporation

Question 12

What does a corporation have the power to do under the MBCA?

Answer 12

Under the MBCA (and in most states), a corporation has the power to do all things necessary or convenient to carry out its business and affairs, including the power:
1. to sue and be sued
2. to own, lease, or convey real or personal property
3. to make contracts, borrow money, or issue notes or bonds
4. to lend money and make investments
5. to own or be involved with another business entity
6. to fix the compensation of directors, officers and employees
7. to lend money to directors, officers and employees
8. to make charitable donations
9. to make payments or donations that further the business and affairs of the corporation
10. to pay or engage in lobbying to aid government policy

Question 13

What is an ultra vires act?

Answer 13

If a corporation includes a narrow statement of business purpose in its articles, it may not undertake activities unrelated to the stated business purpose–an ultra vires act is one that is outside the scope of the articles

Question 14

What is the effect of ultra vires act under common law?

Answer 14

At common law, an ultra vires contract could be voided on the grounds of lack of corporate capacity

Question 15

What is the effect of ultra vires act under the MBCA?

Answer 15

Under the MBCA, ultra vires contracts are valid and generally enforceable
* Today, the ultra vires nature of an act is relevant in three situations:
(i) a shareholder may sue the corporation to enjoin a proposed ultra vires act (but given the equitable nature of injunctive relief, a court is unlikely to grant injunctive relief where the transaction involved an innocent party)
(ii) the corporation may sue an officer or director for damages for approving an ultra vires act
(iii) the state may bring an action to dissolve a corporation for committing an ultra vires act

Question 16

What is the traditional rule regarding the type of consideration that can be received in exchange for issuing stock?

Answer 16

Traditionally, states limited the type of consideration that could be received by a corporation issuing stock to cash, property, or services already rendered

Question 17

What is the MBCA rule regarding the type of consideration that can be received in exchange for issuing stock?

Answer 17

The MBCA allows stock to be issued in exchange for any tangible or intangible property or benefit to the corporation
* BUT: A number of states (including CALIFORNIA) have not gone as far as the MBCA and still prohibit corporations from issuing stock in exchange for promissory notes or future services

Question 18

What is the traditional rule regarding the amount of consideration required for issuing stock?

Answer 18

Traditionally, a corporation’s articles of incorporation would indicate whether the corporation’s shares were to be issued with a stated par value (minimum issuance price) or with no par value
* Stock with a stated par value could not be issued by the corporation for less than the par value, and the money received from the issuance of par value stock had to be deposited in a “stated capital” account

Question 19

What is the MBCA rule regarding the amount of consideration required for issuing stock?

Answer 19

The MBCA allows corporate directors to issue stock for whatever consideration the directors deem appropriate
* The board’s good faith determination as to the adequacy of the consideration received is conclusive as to whether the stock exchanged for the consideration is validly issued, fully paid and nonassessable
* BUT: If the corporation’s articles specify a par value for stock and the directors authorize an issuance of stock for less than the stated par value, the directors who authorized the issuance might still be held liable for the difference

Question 20

What is “watered” stock?

Answer 20

Historically, if par value stock was issued for less than its par value, the original purchaser and the directors who authorized the issuance would be liable for the difference between the par value and the amount received (known as “water”)
* Since the MBCA provides that stock is validly issued, fully paid and nonassessable when the corporation receives the consideration for which the board authorized the issuance, the purchaser will not be liable for the “water”
* BUT: A court might hold that the directors who authorized the issuance of watered stock are personally liable for any damages caused to the corporation

Question 21

What is a shareholder management agreement?

Answer 21

Generally, shareholders have no direct control in management of the corporation; however, the MBCA allows shareholders in a close corporation to enter to dispense with the board and vest management power directly in the shareholders by setting up a shareholder management agreement either:
1. in the articles or bylaws and approved by all shareholders; OR
2. by unanimous written consent of all shareholders

NOTE: The existence of a shareholder management agreement should be conspicuously noted on the front and back of the stock certificates; however, failure to do so does NOT affect the validity of the agreement

Question 22

When may a shareholder vote by proxy?

Answer 22

A shareholder of record may vote their shares at a shareholders’ meeting without physically attending the meeting by a proxy that is:
1. in writing;
2. signed by the shareholder of record (email suffices if the sender can be identified);
3. directed to the corporate secretary; AND
4. authorizes another to vote the shares

Question 23

When is a proxy revocable?

Answer 23

A proxy is generally revocable by the shareholder, and may be revoked:
1. by the shareholder attending the meeting and voting their shares;
2. in writing delivered to the corporate secretary; OR
3. by subsequent appointment of another proxy

Question 24

When is a proxy irrevocable?

Answer 24

A proxy will be irrevocable only if the proxy (1) states that it is irrevocable and (2) is coupled with an interest or given as security

Question 25

What is a voting trust?

Answer 25

A voting trust is a written agreement of shareholders pursuant to which all shares of the parties to the agreement are transferred to a trustee, who votes the shares and distributes any dividends in accordance with the terms of the agreement
* A voting trust is only valid for 10 years unless extended by agreement of the parties (but the most recent version of the MBCA eliminated this 10-year limit)
* A voting trust may be specifically enforced

Question 26

What are the requirements for creating a voting trust?

Answer 26

The requirements for creating a voting trust are:
1. a written trust agreement, controlling how the shares will be voted, is entered into by the applicable shareholders;
2. a copy of the agreement (including names and addresses of the beneficial owners) is given to the corporation;
3. legal title to the beneficial owners’ shares is transferred to the trustee; AND
4. the beneficial owners receive trust certificates and retain all shareholder rights except voting rights

Question 27

What is a voting agreement?

Answer 27

Rather than create a voting trust, shareholders can enter into voting agreements providing for how they will vote their shares
* A valid voting agreement must be in writing and signed by the parties, but it does NOT need to be delivered to the corporation
* Voting agreements may have a perpetual duration
* States are split as to whether voting agreements are specifically enforceable

Question 28

What is the general rule regarding shareholder liability?

Answer 28

Shareholders generally CANNOT be held personally liable for a corporation’s obligations

Question 29

When may a court pierce the corporate veil?

Answer 29

A court may pierce the corporate veil and hold shareholders personally liable for the corporation’s debts when (1) the shareholders abused the privilege of incorporating and (2) fairness requires holding them liable
* Most courts will hold only ACTIVE shareholders liable

NOTE: Courts may be more willing to pierce the corporate veil for tort victims than for contract claimants because parties who contracted with the corporation had an opportunity to perform diligence whereas a tort victim did not voluntarily choose to transact with the corporation and did not knowingly assume the risk of limited liability

Question 30

What are scenarios justifying veil piercing?

Answer 30

A court will often pierce the corporate veil if:
1. the shareholders ignore corporate formalities such that the corporation may be considered the “alter ego” or “mere instrumentality” of the shareholders, and some basic injustice results;
2. the corporation is inadequately capitalized at the time of formation to reasonably cover prospective liabilities; OR
3. necessary to prevent fraud or to prevent an individual shareholder from using the entity to avoid his existing obligations

Question 31

What is a direct action?

Answer 31

A shareholder may bring a direct action for a personal injury or breach of a fiduciary duty owed to that shareholder, as opposed to the corporation generally
* In a direct action, any recovery is for the benefit of the individual shareholder

Question 32

What is a derivative action?

Answer 32

In a derivative action, a shareholder sues to enforce the corporation’s claim, not their own personal claim
* In a derivative action, the corporation receives any damages recovered by a prevailing shareholder-plaintiff
* But a prevailing shareholder-plaintiff may recover costs and attorneys’ fees

Question 33

What is required to commence and maintain a derivative action?

Answer 33

To commence and maintain a derivative action:
1. the shareholder must be a shareholder at the time the corporation’s claim arose;
2. the shareholder must fairly and adequately represent the corporation; AND
3. under the MBCA, the shareholder must first make a written demand on the corporation to take suitable action and wait until 90 days have elapsed from the date of demand to commence suit unless (1) the shareholder received earlier notice that the corporation has rejected the demand or (2) irreparable injury to the corporation would result by waiting 90 days
> NOTE: In some states, shareholders are not required to make a demand if it would be futile

Question 34

How are directors chosen?

Answer 34

Initial directors are usually named in the articles of incorporation or, if not, they are elected by the incorporators at the organizational meeting

Thereafter, the shareholders elect the directors at each annual shareholders’ meeting (subject to contrary provisions in the articles)
* The entire board is selected each year unless the articles provide for a “staggered” (or “classified”) board

Question 35

How are directors removed?

Answer 35

Shareholders can remove a director before his or her term expires if the votes cast in favor of removal exceed the votes cast against removal
* Shareholders may generally remove a director with or without cause; however, in some states, if there is a staggered board, shareholders can remove a director only with cause
* A director elected by a particular voting class of shares can be removed only by that class

Question 36

How may the board of directors take corporate action?

Answer 36

A board of directors must act as a group, and they may only act:
1. by unanimous agreement in writing; OR
2. at a meeting of the board

Question 37

What are the notice requirements for board meetings?

Answer 37

A board of directors may act in regular or special meetings:
* Regular Meetings: No notice is required
* Special Meetings: At least two days’ written notice of the date, time and place of the meeting is required

NOTE: Failure to give required notice results in the actions taken at the meeting being voidable (and perhaps even void) unless the directors who did not receive notice waive the defect (1) in writing anytime or (2) by attending the meeting and not objecting at the outset of the meeting

Question 38

What is the quorum requirement for board meetings?

Answer 38

There must be a quorum of directors in attendance at any board meeting, which is a majority of all directors unless the bylaws provide otherwise (but a quorum can NEVER be fewer than one-third of all directors)
* A quorum of the board can be “broken” if one or more directors leave the meeting

Question 39

What is required for board approval?

Answer 39

If a quorum is present at a board meeting (and not broken), passing a resolution requires approval by a majority vote of directors present

A director is presumed to concur with board action unless his or her dissent or abstention is:
1. noted in the minutes of the meeting;
2. delivered in writing to the presiding officer at the meeting; OR
3. delivered in writing to the corporation immediately after the meeting

NOTE: Of course, a director cannot dissent if they voted for the resolution at issue at the meeting

Question 40

How is director compensation determined?

Answer 40

Unless the articles or bylaws provide otherwise, the board of directors can set director compensation, provided it is reasonable and in good faith

Question 41

How are officers selected and removed?

Answer 41

Officers are selected and removed by the board of directors, which also sets officer compensation
* Despite any contractual term to the contrary, an officer has the power to resign at any time by delivering notice to the board, and the board has the power to remove an officer at any time, with or without cause

NOTE: If the resignation or removal of an officer constitutes a breach of an employment agreement, the nonbreaching party may have a right to damages

Question 42

What are an officer’s powers?

Answer 42

Officers are agents of the corporation, and the ordinary rules of agency law determine the authority and powers of officers
* Actual Authority: An officer has the actual authority to act consistently with the authority expressly granted to the officer by the directors, articles of incorporation, bylaws and applicable statutes, and any authority implied by the express grant
* Apparent Authority: An officer has apparent authority to bind the corporation when the corporation “holds out” the officer as possessing such authority, thereby inducing a third party to reasonably believe such authority exists

Question 43

What is the duty of care?

Answer 43

Directors and officers owe the corporation a duty of care, which requires them to discharge their duties:
1. in good faith;
2. with the degree of care that a person in a like position would exercise under similar circumstances; AND
3. in a manner they reasonably believe to be in the best interests of the corporation

Question 44

What is the business judgment rule?

Answer 44

Directors and officers who comply with the business judgment rule will not be liable for corporate decisions that, in hindsight, turn out to be erroneous

Under the business judgment rule, a court will not second-guess a business decision if it:
1. was informed;
2. was made in good faith;
3. was made without conflicts of interest; AND
4. had a rational basis

Question 45

When may directors and officers rely on information prepared or presented by others?

Answer 45

In discharging their fiduciary duties, directors and officers are entitled to rely on information, opinions, reports or statements (including financial statements) prepared or presented by:
1. corporate officers or employees whom they reasonably believe to be reliable and competent;
2. legal counsel, accountants or other representatives as to matters they reasonably believe are within the professional competence of such persons; OR
3. a committee of the board if they reasonably believe the committee merits confidence (and for directors, the director is not a member)

Question 46

What is the duty of loyalty?

Answer 46

Directors and officers owe the corporation a duty of loyalty and will not be permitted to profit at the expense of the corporation

Question 47

What is a conflicting interest transaction?

Answer 47

A director or officer has a conflicting interest with respect to a transaction (or proposed transaction) if the director or officer knows that they or one of their family members:
1. is a party to the transaction;
2. has a beneficial financial interest in, or is so closely linked to, the transaction that the interest would reasonably be expected to influence their judgment with respect thereto; OR
3. is a director, general partner, agent or employee of another entity with whom the corporation is transacting business, and the transaction is of such importance to the corporation that it would in normal course of business be brought before the board

Question 48

When can a conflicting interest transaction be upheld?

Answer 48

A conflicting interest transaction will NOT be enjoined or give rise to an award of damages if:
1. the transaction was approved by a majority of the directors (but at least two) without a conflicting interest after all material facts have been disclosed to the board;
2. the transaction was approved by a majority of the votes entitled to be cast by shareholders without a conflicting interest after all material facts have been disclosed to the shareholders (notice of the meeting must describe the conflicting interest transaction); OR
3. the transaction was fair to the corporation, considering factors such as:
(i) the adequacy of the consideration;
(ii) the corporation’s need to enter into the transaction;
(iii) the financial position of the corporation; and
(iv) the availability of alternatives

Question 49

May directors and officers compete with the corporation?

Answer 49

Directors and officers may engage in unrelated businesses, but engaging in directly competing businesses raises serious duty of loyalty concerns

Question 50

What is usurpation of a corporate opportunity?

Answer 50

The duty of loyalty prohibits directors and officers from diverting a business opportunity from their corporation to themselves without first giving their corporation an opportunity to act (i.e., usurping a corporate opportunity)
* A “corporate opportunity” is any opportunity in which the corporation would have an interest or expectancy; the closer the opportunity is to the corporation’s line of business, the more likely a court will find that it is a corporate opportunity
* A director/officer may only pursue a corporate opportunity if they (1) first present the opportunity to the corporation’s board of directors and (2) the board rejects the opportunity
* The corporation’s lack of financial ability to take advantage of the opportunity is not a defense

Question 51

What types of distributions can a corporation make to its shareholders?

Answer 51

Distributions are payments by a corporation to its shareholders, which can take the form of, among other things:
* Dividends
* Repurchases of shares (a voluntary sale of a shareholder’s stock to the corporation)
* Redemptions of shares (a forced sale of a shareholder’s stock to the corporation)
* Distributions of assets upon liquidation

Question 52

When does a shareholder have a right to a distribution?

Answer 52

Even if a corporation’s articles authorize distributions, the decision whether to declare a distribution generally is solely within the discretion of the board of directors and any restrictions in a shareholders’ agreement or the articles
* Once a distribution is lawfully declared, the shareholders are generally treated as creditors of the corporation, and their claim for the distribution is equal in priority to claims of other unsecured creditors

Question 53

When can a shareholder compel a distribution?

Answer 53

Shareholders have no general right to compel a distribution
* An action to compel a distribution is a direct action (not a derivative action); to prevail, the plaintiff must make a very strong showing of abuse of discretion on the part of the board of directors

Question 54

What are limitations on distributions?

Answer 54

TRADITIONAL VIEW
Traditionally, a corporation’s board of directors could not use stated capital (the aggregate par value of issued and outstanding shares) to fund distributions, but they could fund a distribution with:
1. Earned surplus (earnings minus losses minus distributions previously paid); OR
2. Capital surplus (payments in excess of par value received for issuances of par value stock plus amounts allocated to capital surplus for issuances of no-par stock), if the shareholders are informed

MODERN VIEW
The modern view does not limit which funds can be used for distributions but, rather, prohibits a corporation from making a distribution if, after giving effect to the distribution, either:
1. the corporation would not be able to pay its debts as they become due in the ordinary course of business; OR
2. the corporation would be rendered “balance sheet” insolvent

Question 55

When is a director liable for an unlawful distribution?

Answer 55

A director who votes for or assents to an unlawful distribution is personally liable to the corporation for the amount of the distribution that exceeds what could have been property distributed
* BUT: Directors have a good faith reliance defense and are not liable for distributions approved in good faith (1) based on financial statements prepared according to reasonable accounting practices, or on a fair valuation or other method that is reasonable under the circumstances, or (2) by relying on information from officers, employees, legal counsel, accountants, etc., or a committee of the board of which is not a member

Question 56

When is a shareholder liable for an unlawful distribution?

Answer 56

Shareholders are personally liable for an unlawful distribution only if they knew the distribution was improper when they received it

Question 57

What are fundamental corporate changes?

Answer 57

Fundamental corporate changes include:
* Most amendments of the articles of incorporation
* Mergers
* Share exchanges
* Dispositions of all or substantially all assets outside the ordinary course of business
* Dissolution

Question 58

What is the procedure for undertaking a fundamental corporate change?

Answer 58

The basic procedure for undertaking any fundamental corporate change is as follows:
1. a majority of the board of directors adopts a resolution recommending the fundamental change;
2. all shareholders (whether or not entitled to vote) are sent notice of the proposed change; the notice must (i) describe the change and inform the shareholders that a vote on the matter will be taken at a shareholders’ meeting and (ii) be given not less than 10 days or more than 60 days before such meeting;
3. the change is approved by the shareholders; AND
4. the change is formalized in articles of amendment, merger, etc. that are filed with the applicable Secretary of State

NOTE: Although the MBCA standard for shareholder approval of a fundamental change only requires that votes for exceed votes against the change, many states require shareholder approval of a fundamental change by a majority of the votes entitled to be cast

Question 59

What does Rule 10b-5 provide?

Answer 59

SEC Rule 10b-5 makes it unlawful for any person, directly or indirectly, to use any means or instrumentality of interstate commerce to (1) employ any device, scheme or artifice to defraud, (2) make any untrue statement of a material fact or omit to state a material fact, or (3) engage in any act practice or course of business that would operate as a fraud, in connection with the purchase or sale of any security

Question 60

What are the elements of a claim under Rule 10b-5?

Answer 60

1. Use of any means or instrumentality of interstate commerce;
2. Misrepresentation of material information, insider trading, misappropriation, or making an insider tip for an improper purpose;
3. Scienter (intent to deceive, omission or conduct);
4. Purchase or sale of a security;
5. Reliance on the fraudulent statement, omission or conduct; and
6. Damages

Question 61

When is a fact “material” under Rule 10b-5?

Answer 61

A fact will be considered material under rule 10b-5 if a reasonable investor would consider it important when making an investment decision

Question 62

What is insider trading?

Answer 62

• One of the most common forms of fraudulent conduct under rule 10b-5 arises from insider trading
• The Supreme Court has held that a corporate insider who breaches a duty not to use inside information for personal benefit can be held liable under rule 10b-5
• Typical securities insiders, such as directors, officers, controlling shareholders, and employees of the issuer are deemed to owe a duty of trust and confidence to their corporation that is breached by trading on inside information
• Moreover, the Court has found that the duty is breached not only when the insider trades on the inside information, but also when the insider gives a tip of inside information to someone else who trades on the basis of the information if the tip was made for an improper purpose