Basic Business Law Basic Business Law (BPP432/80) (BPP432/80)

2006 Fall Quarter2006 Fall QuarterInstructor: David OliveiriInstructor: David Oliveiri

Week 10: Week 10: Facilitating Exchange Facilitating Exchange Through Business AssociationThrough Business Association;;

Corporations – How To Form and Corporations – How To Form and Why, CharacteristicsWhy, Characteristics

AgendaAgenda

Corporations; NatureCorporations; Nature

--; Formation--; Formation

--; Financial Structure--; Financial Structure

Learning ObjectivesLearning Objectives

Understand Why People Associate Understand Why People Associate as Corporationsas Corporations

Understand How People Associate Understand How People Associate as Corporations, and Consequencesas Corporations, and Consequences

Understand Some Basic Legal Understand Some Basic Legal Characteristics of Corporate Characteristics of Corporate FinanceFinance

Understand Pros and Cons of the Understand Pros and Cons of the Corporate FormCorporate Form

Corporations – Corporations – As Business Association OptionAs Business Association Option

““Evolutionary” Step Beyond Agency, Sole Evolutionary” Step Beyond Agency, Sole Proprietor, and Partnership RelationshipsProprietor, and Partnership Relationships

New Participants – Shareholders, Directors, New Participants – Shareholders, Directors, Officers – In Addition to Employees, Creditors, ...Officers – In Addition to Employees, Creditors, ...

But … Principles of Contract and Agency But … Principles of Contract and Agency InterwovenInterwoven

Deal Point of Risk vs. Control Foremost in Deal Point of Risk vs. Control Foremost in Defining Association RelationshipsDefining Association Relationships

SS

DD OO

XYZ, XYZ, Inc.Inc.

XYZ XYZ Corp.Corp.

XYZ, XYZ, Ltd.Ltd.

Nature of CorporationsNature of CorporationsPrivate ArrangementPrivate Arrangement -- Not State “Gift” or Grant -- Not State “Gift” or Grant

Legal EntityLegal Entity -- “Person” Separate From S, D, O -- “Person” Separate From S, D, O

Creature of the StateCreature of the State – “XYZ, Inc., a New York – “XYZ, Inc., a New York Corporation” – MCBA RMCBA NYBCL…Corporation” – MCBA RMCBA NYBCL…

Limited LiabilityLimited Liability – S, D, O (BUT…Guarantors) – S, D, O (BUT…Guarantors)

Free Transferability of Corporate SharesFree Transferability of Corporate Shares

Perpetual ExistencePerpetual Existence

Centralized ManagementCentralized Management ―― S D O S D O

As a PersonAs a Person – Sue, Be Sued, Contracts – Sue, Be Sued, Contracts ―― XYZ Corp. XYZ Corp. by: by: Sally Sally

SmithSmith its: its:

PresidentPresident

As a CitizenAs a Citizen – Of State of Incorporation -- Rights, – Of State of Incorporation -- Rights, DutiesDuties

Classification of Classification of CorporationsCorporations

Public Public – Governmental Purposes – E.G. OTB, – Governmental Purposes – E.G. OTB, NYRA, Lotto – vs. NYRA, Lotto – vs. PrivatePrivate

For Profit For Profit vs. vs. Nonprofit (Not-for-Profit)Nonprofit (Not-for-Profit)

Domestic Domestic vs. vs. Foreign CorporationForeign Corporation– Certificate of Authority – “Doing Business”Certificate of Authority – “Doing Business”– SanctionsSanctions

– ““Appointing a registered agent is more than a statutory Appointing a registered agent is more than a statutory requirement. It’s also an essential business relationship requirement. It’s also an essential business relationship that helps your company avoid default judgments and that helps your company avoid default judgments and remain in good standing.” – remain in good standing.” – CT Corporation web siteCT Corporation web site

Publicly Held Publicly Held vs. vs. Closely HeldClosely Held

Subchapter S CorporationSubchapter S Corporation

[S&R 34 – Problems [S&R 34 – Problems 9, 10]9, 10]

•AssemblAssembles es CapitalCapital

•Opens Opens AccountsAccounts

•BorrowsBorrows

SALLY SALLY SMITHSMITH

““AskSimon”AskSimon”

TOMTOM ANNANN

• SpreadsheSpreadsheetsets

• PhonePhone

• ManualManual

• Hourly Hourly WageWage

• Sales Force Sales Force ConsultingConsulting

• ““Simon Simon Associates”Associates”

• CustomersCustomers

• SuppliersSuppliers

• CreditorsCreditors

• ““Bystanders”Bystanders”

• ““Colleagues”Colleagues”

•““Simon Simon Associates Associates Business Business Software”Software”

•Big MarketBig Market

•$ Required$ Required

•New New Relationships?Relationships?

•New New Risk/Control Risk/Control IssuesIssues

Forming a Corporation Forming a Corporation ―― Initial DealingsInitial Dealings

Sally – Gets Idea, Talks Others Into Sally – Gets Idea, Talks Others Into It, Lines Up Initial Investors, Goes To It, Lines Up Initial Investors, Goes To Attorney, Makes Some DecisionsAttorney, Makes Some Decisions

““Promoters” – Contract Liability and Promoters” – Contract Liability and Duties Duties

Subscribers – Contract Liability and Subscribers – Contract Liability and DutiesDuties

Selection of State for IncorporationSelection of State for Incorporation

[S&R 34 – Problems 4, 12][S&R 34 – Problems 4, 12]

Promoter’s Preincorporation Promoter’s Preincorporation ContractsContracts

CorporationThirdParty

Promoter bound

Corporation Does NOT Adopt Preincorporation Contract

PromoterThirdParty

bound

Corporation Does Adopt Preincorporation Contract

liable

Corporation

Corporation, Promoter, and Third Party Enter into a Novation

PromoterThirdParty

boundCorporation

[S&R 34 – [S&R 34 – Problem 2]Problem 2]

Example: On Behalf of “Corporation to be Example: On Behalf of “Corporation to be Formed”Formed”

Review of Sally’s SituationReview of Sally’s Situation

Sally/Tom/Ann – “Simon Associates”Sally/Tom/Ann – “Simon Associates”

““Simon Associates Business Software” Simon Associates Business Software” OpportunityOpportunity

Need FundingNeed Funding

Limited Liability ConsiderationsLimited Liability Considerations

Decision to Form “Simon Associates, Inc.”Decision to Form “Simon Associates, Inc.”

Deal Points (Sally, Tom, Ann, Investors)Deal Points (Sally, Tom, Ann, Investors)– ContributionsContributions– Who Directs/ Voting RightsWho Directs/ Voting Rights– Deadlock/DissolutionDeadlock/Dissolution

Sally is PromoterSally is Promoter

Sally Consults Attorney, Decides to Form Sally Consults Attorney, Decides to Form Corp. in NevadaCorp. in Nevada

Formalities/Mechanics of Formalities/Mechanics of IncorporationIncorporation

Attorney Phones CT Corp. – “Clear Name/ Send Attorney Phones CT Corp. – “Clear Name/ Send Copies of Nevada Forms”Copies of Nevada Forms”

Fill Out Tax/Agent Forms, Articles of Incorporation Fill Out Tax/Agent Forms, Articles of Incorporation (Charter)(Charter)

Send to Nevada Secretary of State (Filing Fee)Send to Nevada Secretary of State (Filing Fee)

Articles (Charter) Accepted for Articles (Charter) Accepted for Filing/Stamped/ReturnedFiling/Stamped/Returned

Meanwhile, Draft By-LawsMeanwhile, Draft By-Laws

11stst Organizational Meeting – Adopt By-Laws, Elect Organizational Meeting – Adopt By-Laws, Elect Directors, Subchapter S ConsiderationDirectors, Subchapter S Consideration

Elapsed Time: 1 Day! Elapsed Time: 1 Day!

Sample Articles of Incorporation Sample Articles of Incorporation (Charter)(Charter)

Articles of Incorporation of [Corporate Name]

The undersigned, acting as incorporator(s) of a corporation under the _____________ Business Corporation Act, adopt(s) the following Articles of Incorporation for such corporation:

First: The name of the Corporation is _________________________________________________________________________Second: The period of its duration is __________________________________________________________________________Third: The purpose or purposes for which the corporation is organized are:____________________________________________Fourth: The aggregate number of shares which the corporation shall have authority to issue is _________________________________________Fifth: Provisions granting preemptive rights are:_________________________________________________________________Sixth: Provisions for the regulation of the internal affairs of the corporation are:________________________________________Seventh: The address of the initial registered office of the corporation is ________________________and the name of its initial registered agent at such address is_____________________________________________________________________________Eighth: The number of directors constituting the initial board of directors of the corporation is __________, and the names and addresses of the persons who are to serve as directors until the first annual meeting of share holders or until their successors are elected and shall qualify are:

Name Address_________________________________________ _________________________________________________Ninth: The name and address of each incorporator is:

Name Address_________________________________________ _________________________________________________

Dated __________, 19___. _________________________________________________

Incorporator(s)Source: Reprinted with permission from Henn & Alexander, Corporations, 3rd ed. Copyright 1983 by West Publishing Company.

Comparison of Charter & Comparison of Charter & BylawsBylaws

Charter Bylaws

Filing Publicly Not publicly

Amendment Requires board andshareholder approval

Requires only boardapproval

Availability Must include certainmandatory andoptional provisions. Some optionalprovisions may beelected only in thecharter

Must include certainprovisions unless they areincluded in the charter

Validity May include anyprovision notinconsistent with law

May include any provisionnot inconsistent with lawand the charter

Smith & Roberson’s Business Law

Chapter 34

§

What If A Mistake Is Made In What If A Mistake Is Made In Forming?Forming?

Non-recognition of Corporateness Recognition of Corporateness

RMBCA

Approach

No Filing of Articles of IncorporationNo corporate attributesJoint and several liability for those who act

knowing that there was noincorporation

Filing of Articles of IncorporationCorporate attributesLimited liabilityInsulation from collateral suits

MBCA Approach

No Certificate IssuedNo corporate attributesJoint and several liability for all who

assume to act as a corporation

Certificate IssuedCorporate attributesLimited liabilityInsulation from collateral suits

•RMBCA Evolution – RMBCA Evolution – Favors Intent Over Favors Intent Over Formality!Formality!

•Distinction Between Distinction Between Filing and IssueFiling and Issue

If We Incorporate Correctly If We Incorporate Correctly Are We Guaranteed Limited Are We Guaranteed Limited

Liability?Liability?NOT ALWAYS! NOT ALWAYS! –– “Piercing the Corporate “Piercing the Corporate Veil”Veil”– PCV is Exception to Limited LiabilityPCV is Exception to Limited Liability– Murky Law – Based on Facts and CircumstancesMurky Law – Based on Facts and Circumstances– General RuleGeneral Rule: : Disregard if separateness/ Disregard if separateness/

formality gives rise to injusticeformality gives rise to injustice

Suspicious Circumstances – Suspicious Circumstances – Undercapitalization, Mixing Funds/Assets, Undercapitalization, Mixing Funds/Assets, Alter Ego TheoryAlter Ego Theory– Closely Held CorporationsClosely Held Corporations– Parent-Subsidiary CorporationsParent-Subsidiary Corporations

[S&R 34 – Problem 14][S&R 34 – Problem 14]

Once Incorporated, What Can Once Incorporated, What Can A Corporation Legally Do Or A Corporation Legally Do Or

Not Do?Not Do?Sources of Corporate Powers Sources of Corporate Powers

Corporation Statutes of State of IncorporationCorporation Statutes of State of IncorporationExpress Charter Powers – Express Charter Powers – “Power to do such “Power to do such other things as reasonable and proper to other things as reasonable and proper to conduct business specified.” conduct business specified.” Implied PowersImplied Powers

[S&R 34 – Problem 8][S&R 34 – Problem 8]

What Corporation Can’t Do -- Ultra What Corporation Can’t Do -- Ultra Vires ActsVires Acts

Liability for Torts and CrimesLiability for Torts and CrimesDirect LiabilityDirect LiabilityRespondeat Superior for Officers, Employee ActsRespondeat Superior for Officers, Employee ActsOther Exceptions to Limited Liability – Other Exceptions to Limited Liability – Guarantees, Statutory Liability (Antitrust, SOX, Guarantees, Statutory Liability (Antitrust, SOX, Securities Laws, …)Securities Laws, …)

General Partnership, Limited General Partnership, Limited Partnership, Corporation, and Partnership, Corporation, and

Limited Liability CompanyLimited Liability CompanyGeneralPartnership

LimitedPartnership

PublicCorporation

CloseCorporation

Limited LiabilityCompany

Transferability Financial interestmay be assigned;membershiprequires consentof all partners

Financial interestmay be assigned,and assignee maybecome limitedpartner if allpartners consent

Freely transferable Freely transferableunless shareholdersagree otherwise

Financial interestmay be assigned;membershiprequires consent ofall members

Liability Partners haveunlimited liability

General partnershave unlimitedliability; limitedpartners havelimited liability

Shareholders havelimited liability

Shareholders havelimited liability

All members havelimited liability

Control By all partners By generalpartners, notlimited partners

By board ofdirectors electedby shareholders

By board ofdirectors electedby shareholders

By all members

Continuity Dissolved bydeath, bankruptcy,or withdrawal ofpartner

Dissolved bydeath, bankruptcy,or withdrawal ofgeneral partner

Unaffected bydeath, bankruptcy,or withdrawal ofshareholder

Unaffected bydeath, bankruptcy,or withdrawal ofshareholder

Dissolved bydeath, bankruptcy,or withdrawal ofmember

Taxation Only partnerstaxed

Only partnerstaxed

Corporation andshareholders taxed

Corporation taxedunless SubchapterS applies;shareholders taxed

Only memberstaxed

Financial Structure of Financial Structure of CorporationsCorporations

WhoWho – Major Corporate Stakeholders are Debt – Major Corporate Stakeholders are Debt Holders and StockholdersHolders and Stockholders

WhatWhat – Shares of Stock, Bonds, Notes – Shares of Stock, Bonds, Notes– Evidenced by CertificatesEvidenced by Certificates– Effect of Certificates Determined by Statute/Contract Effect of Certificates Determined by Statute/Contract

LawLaw

WhyWhy – – Stock Certificates, Bond Certificates, etc. are Stock Certificates, Bond Certificates, etc. are pieces of paper – but they are tangible pieces of paper – but they are tangible evidence of an important set of rights, evidence of an important set of rights, interests, claims against assets in an interests, claims against assets in an incorporated business. Differences in the incorporated business. Differences in the terms of arrangements with stockholders, debt terms of arrangements with stockholders, debt holders, are driven by the way in which the holders, are driven by the way in which the various parties deal various parties deal re: risk assumed by their re: risk assumed by their investment vs. control bargained for to investment vs. control bargained for to minimize this risk.minimize this risk.

Debt Securities – Bonds, Debt Securities – Bonds, NotesNotes

WhatWhat –– Source of Capital, No Strict Ownership Source of Capital, No Strict Ownership Interest, Secured by Corporation's Promise to Interest, Secured by Corporation's Promise to RepayRepay

WhenWhen –– Determined by Board of Directors Determined by Board of Directors

HowHow – CONTRACTS; Terms=Covenants – CONTRACTS; Terms=Covenants (Conditions)(Conditions)

Deal PointDeal Point – Protect Equity Cushion – Protect Equity Cushion– Maintenance of PropertyMaintenance of Property– Dividend RestrictionsDividend Restrictions– Additional Debt RestrictionsAdditional Debt Restrictions– Prohibitions on MergersProhibitions on Mergers– Same BusinessSame Business– ……

Stock – Equity SecuritiesStock – Equity Securities

Authorized But Not Issued

Treasury

Issued

Authorized

Outstanding

•Auth=IssuAuth=Issued+ABNIed+ABNI

•Issued=TrIssued=Treas. +Outs.eas. +Outs.

•Auth.Auth.= = ArticleArticless

•IssueIssued=Boad=Boardrd

Stock – Equity SecuritiesStock – Equity Securities

Why IssueWhy Issue – Raise Capital – Raise Capital

Why BuyWhy Buy -- Limited Liability, Market, Low -- Limited Liability, Market, Low Transactions Costs, Management, $... BUT Transactions Costs, Management, $... BUT InactiveInactive

Who IssuesWho Issues – Board of Directors (Securities – Board of Directors (Securities Laws)Laws)

How MuchHow Much – Articles – Articles

Who Can BuyWho Can Buy – Anyone, Unless … Restricted – Anyone, Unless … Restricted Stock, Pre-Emptive RightsStock, Pre-Emptive Rights

What PriceWhat Price – Par Value Stock, No Par Stock, – Par Value Stock, No Par Stock, Treasury StockTreasury Stock

WhatWhat -- Common Stock, Preferred Stock -- Common Stock, Preferred Stock

[S&R 34– [S&R 34– Problem 2]Problem 2]

[S&R 35 – [S&R 35 – Problem 4]Problem 4]

[S&R 35 – [S&R 35 – Problem 1]Problem 1]

Valid Capital Contributions Valid Capital Contributions ―― Diverse State LawsDiverse State Laws

Kind ULPA RULPA MBCA RMBCA

Cash Yes Yes Yes Yes

Property Yes Yes Yes Yes

Services rendered No Yes Yes Yes

Promise to contribute cash No Yes No Yes

Promise to contribute property No Yes No Yes

Promise to perform services No Yes No Yes

Debt and Equity SecuritiesDebt and Equity Securities

Debt Common Preferred

Ownership Interest No Yes Yes

Obligation to RepayPrincipal

Yes No No

Fixed Maturity Yes No No

Obligation to Pay Income Yes No No

Preference on Income Yes No Yes

Preference on Liquidation Yes No Yes

Voting Rights Some states Yes, unless denied Yes, unless denied

Redeemable Yes In some states Yes

Convertible Yes In some states Yes

Dividends and Other Dividends and Other DistributionsDistributions

Types – Cash, Property, Stock, Liquidating Types – Cash, Property, Stock, Liquidating Dividends, …Dividends, …

Dividend Payment IssuesDividend Payment Issues– Unreasonable Accumulation of SurplusUnreasonable Accumulation of Surplus– Tax on Accumulated EarningsTax on Accumulated Earnings– Improper DividendsImproper Dividends

Legal Restrictions – Can’t Render Legal Restrictions – Can’t Render Corporation Insolvent!Corporation Insolvent!– Earned Surplus TestEarned Surplus Test– Surplus TestSurplus Test– Net Assets TestNet Assets Test

Declarations and PaymentDeclarations and Payment– Shareholders’ Right to Compel DividendShareholders’ Right to Compel Dividend– Liability for Improper Dividends and Distributions Liability for Improper Dividends and Distributions

[S&R 35 – Problem 9][S&R 35 – Problem 9]

Key Concepts in Legal Key Concepts in Legal Restrictions Restrictions

Upon DistributionsUpon Distributions

NetAssets

Surplus

Liabilities

(Liquidation Preferences)

Stated Capital(contributed capital*)

Capital Surplus(contributed capital in excess

of par or stated value*)

Earned Surplus(retained earnings*)

*Accounting terminology

TotalAssets

Liability for Improper Liability for Improper DistributionsDistributions

Corporation Solvent Corporation Insolvent

NonbreachingDirector

No No

Breaching Director Yes Yes

Knowing Shareholder Yes Yes

Innocent Shareholder No Yes

Bottom Lines; Q&ABottom Lines; Q&ACorporate Business Associations Are A Popular Corporate Business Associations Are A Popular Form – 5 Million For-Profit US Corporations -- Form – 5 Million For-Profit US Corporations -- $17 Trillion Revenue$17 Trillion Revenue

Benefits of Corporate Form Include Limited Benefits of Corporate Form Include Limited Liability, Transferability of Ownership, Liability, Transferability of Ownership, Centralized Management, Continuity, Prestige, Centralized Management, Continuity, Prestige, Client and Investor PerceptionClient and Investor Perception

Costs of Corporate Form Include Required Costs of Corporate Form Include Required Formalities, Transactions Costs, Extensive Formalities, Transactions Costs, Extensive Default Rules, Double Tax on Distributed Default Rules, Double Tax on Distributed Earnings, Losses Usable by CorporationEarnings, Losses Usable by Corporation

Evolving Favoritism?Evolving Favoritism?– New York Times 7/25/06 – New York Times 7/25/06 – Huge Buyout of Hospital Huge Buyout of Hospital

Group Group [HCA] [HCA] Highlights Era of Going PrivateHighlights Era of Going Private– Increasing Flexibility in LLC’s + Growing Investor Increasing Flexibility in LLC’s + Growing Investor

Acceptance Acceptance