Nature of the Corporation - Rules

Question 1

Rule: Promoters

Answer 1

A person who identifies a business opportunity and puts together a deal, forming a corporation as a vehicle for investment by other people.

A promoter is someone who has an idea for a business but has no interest in running it and is considered an agent to the soon-to-be formed corporation and has fiduciary duties to the corporation.

Tasks of the promoter include:

1. discovery,
2. investigation, and
3. assembly.

Question 2

Rule: Steps for Incorporation

Answer 2

Steps to Incorporate:

1. File Articles of Incorporation
2. Incorporate names initial board of directors
3. Initial BoD has organizational meeting, and then
4. Adopt bylaws

Question 3

Articles of Incorporation MUST include:

Answer 3

1. Name
2. Number of shares to issue
3. Street address and name of initial registered agent
4. Name and address of each incorporator

For DEL:

5. Nature of business or purpose
6. Name and address of directors until first annual meeting

Question 4

What is the purpose of Equity and Debt Securities?

Answer 4

They are used to generate capital for corporations.

Question 5

What are Equity Securities?

Answer 5

1. Common stock which is the most basic of all corporate securities and entitles owners to residual interest in the company’s income, issued in the form of dividend payments.
   
   • Common stockholders assume the greatest level of risk, so they receive full voting rights and are the beneficiaries of fiduciary duties.
2. Preferred stock comes in many varieties, and ensures the holder receives dividends before common stockholders (as a function of their preferential contractual right to profits).
   
   • Preferred Stockholders retain less control because they have less risk and no voting power.

Question 6

What are Debt Securities?

Answer 6

• Constitutes a loan or promise of return payment.
• Holders do not own an equity interest in the corporation and are more like a creditor.
• Owners of debt securities are paid off before both the common and preferred stockholders but have no right to vote on corporate matters.

Question 7

What are the three theories of liability under which **shareholders **may be held personally liable for corporate action?

Answer 7

1. Enterprise entity theory
2. Piercing the Corporate Veil
3. Agency Theory

Question 8

What is the Enterprise Entity theory of Shareholder Liability?

Answer 8

A litigant may seek to hold a number of distinct corporate entities liable for the actions of a single such corporation in the event that the distinct corporations are each part of one large corporate enterprise (i.e. the entire enterprise is liable for the actions of any constituent corporate entity).

Question 9

What is Piercing the Corporate Veil?

Answer 9

Piercing the Corporate Veil involves trying to break through the barrier between shareholders, officer or directors and the corporation to hold them personally liable by showing that they deserve to be liable for the debts and obligations of the corporation.

Two-part test:

1. One must show unity of interest and ownership between the shareholder and corporation by four factors:
   
   1. Failure to observe corporate formalities and/or records
   2. Commingling of personal and corporate funds
   3. Undercapitalization and
   4. Sharing of assets between corporation.
2. Adherence to separate corporate existence would sanction a fraud* or promote *injustice.

Question 10

What is the Agency Theory of Liability?

Answer 10

• Under this theory, one must prove control, consent, and acting on behalf of, the same requirements necessary to find the existence of an agency relationship, generally.
• A court will look to whether a parent and subsidiary corporation have common directors, or officers, etc.

Question 11

What is the Substantial Domination Test?

Answer 11

1. What is the relationship between the parent and the subsidiary?
2. How much control is exerted?
   
   • Common directors/officers
   • common business departments
   • consolidated financial statements
   • the parent finances the subsidiary
   • subsidiary operates with grossly inadequate capital
   • parent pays salaries and other expenses of subsidiary
   • parent uses subsidiary’s property as own
   • daily operations are not kept separate, and
   • the subsidiary does not observe corporate formalities.

Question 12

Partner Liability

Answer 12

• Limited partners enjoy the same status as shareholders, take on less risk and have limited liability (i.e. a limited partner is not personally liable for an obligation of the limited partnership solely by reason of being a limited partner) (Uniform Limited Partnership Act § 303).
• As such, they also exercise no control over the partnership. If, however, a limited partner “crosses the line” and exerts control over the partnership, he may be deemed a general partner. A general partner is liable jointly and severally for all obligations of the partnership (Uniform Limited Partnership Act § 404(a)).
• In short, with more control comes greater risk (of personal liability). Limited partners may, however, exert control over a corporation and escape general liability if they are directors, officers or shareholders of a corporation’s general partner (which is, itself, the general partner).
• In essence, parties may manipulate the business structure to exert control only as officers of the corporate general partner.

Question 13

What is a Shareholder Derivative Suit?

Answer 13

It is an equitable action by the shareholder to bring a lawsuit on behalf of the corporation to recover for the corporation’s loss and enforce management’s duties. If a shareholder is successful in bringing suit, the recovery goes to the corporation itself.

Question 14

Direct vs. Derivative suit.

Answer 14

• Derivative = Shareholder claims the management’s breach reduced the residual value of the business
• Direct = Shareholder claims that the management’s breach deprived the shareholder of some other right

Example 1: If a corporation hires a new CEO and agree to pay an exorbitant salary the shareholders believe is too high, such a suit would allege waste of corporate capital and would be brought derivatively.

Example 2: If the president of the corporation contracted with his unqualified sister to perform important tasks for the corporation, and paid her an overly generous sum for her troubles, the president’s contract was likely self dealing and corporate waste, a breach of his fiduciary duty of loyalty to the corporation. As such, the harm is to the corporation and any action brought would be to redress such harm. Verdict: Derivative.

Example 3: If, however, a corporation properly declared a dividend, but failed to pay the dividend to a shareholder, the shareholder would sue directly, because he was harmed in his individual capacity.

Question 15

Shareholder Derivative Suit - Security-for-expense:

Answer 15

• Often times a statute will inform a shareholder that if he/she owns less than a certain percentage of the company, he/she must post a security bond in order to go through with the suit in order to prevent frivolous lawsuits.
• Often times, a corporation will have to pay the plaintiff’s litigation expenses if the suit results in a substantial benefit to the company – this does not mean the plaintiff must win. But the plaintiff may have to pay defendant expenses if found that the suit was for an improper purpose. (different for every state)

Question 16

Strike Suits and Posting Securities

Answer 16

• Strike Suits = Trying to leverage shareholder power to create a nuisance-suit
• Posting Security = To limit strike-suits (nuisance suits) many states have security expense statutes that require a plaintiff shareholder with a small interest to post a bond to pay defendant’ litigation fees if the plaintiff is unsuccessful.

Question 17

What are the Requirements to File a Derivative Suit?

Answer 17

• Demand Requirement
  
  • ​A shareholder may not commence a derivative suit unless he has made a written demand.
    
    • For the MBCA they MUST make a demand and 90 days have to then pass.
    • In CA, NY & Del. have adopted a demand futility rule, which allows a plaintiff-shareholder to dispense with demand when doing so would be futile form the perspective of a reasonable person.
      
      • Demand Futility =
        
        1. Majority of board has material financial or familial interest
        2. Majority of board in incapable of acting independently or
        3. The underlying transaction is not the product of a valid exercise of business judgment.
      • NOTE:
        
        • A shareholder can no longer argue demand futility once he has made a demand, unless such demand was wrongfully rejected.
        • The rejection is subject to analysis under the deferential standard of business judgment rule.
• Special Litigation Committees (SLC)
  
  • Corporation may form a Special Litigation Committee who has the power to take a serious look at the shareholders claim and determine if the corporation should move forward.
  • The committee consists of disinterested and independent directors and will decide whether to go forward with litigation or to suggest that the court dismiss it.
  • Court looks at whether the SLC
    
    1. _​​_Acted independently
    2. Conducted a sufficient and reasonable inquiry into the claim and
    3. Acted in good faith.
  • In CA and NY: the court only looks at procedural factors of the SLC and affords the deference to the SLC, so long as there is sufficient/ reasonable investigation made by independent directors in good faith.
  • Delaware: Two-prong test: the court looks to the SLC’s procedure but also applies its own independent business judgment to determine whether the litigation is meritorious (substance.) If court decides that shareholder has a claim and bad board, then the court will deny the SLC’s motion to dismiss the derivative claim.

Question 18

Liability of Directors - Indemnification

Answer 18

• Most jurisdictions permit the corporation to indemnify a director for legal expense if he conducted himself in good faith pursuant to his business judgment. In Delaware, no indemnification for any claim, issue or matter on which the individual is found to be liable to the corporation. However, a corporation must indemnify a director for reasonable expenses incurred in successfully defending himself in his corporate capacity.
  
  • Delaware: To the extent that a former directors or officer has been successful on the merits or otherwise (so broader)
  • MBCA: wholly successful on the merits
  • But for both if they win or settle = corporation will indemnify the directors or officers.
  • It’s just Delaware defines as successful on the merits or otherwise and do not require the directors to be wholly successful