Hunter Business Law Chapter 42 Notes - Corporation Structure

**Chapter 42: Organization and Financial Structure of Corporations** A **promoter** of a corporation incorporates a business, organizes its initial management, and raises its initial capital. Typically, a **promoter** creates or discovers a business or an idea to be developed, finds people who are...

**Chapter 42: Organization and Financial Structure of Corporations** A **promoter** of a corporation incorporates a business, organizes its initial management, and raises its initial capital. Typically, a **promoter** creates or discovers a business or an idea to be developed, finds people who are willing to invest in the business, negotiates the contracts necessary for the initial operation of the personal venture, incorporates the business, and helps management start the operation of the business. A nonexistent corporation has no liability on contracts made by a promoter prior to its incorporation. The only way a corporation may become bound on a promoter's pre-incorporation contracts is by the corporation's **adoption** of the promoter's contract. Adoption is similar to the agency concept of ratification. For a corporation to adopt a promotors contract, the corporation must accept the contract with knowledge of all its material facts. Acceptance may be express or implied. Example: Pg. 42-2 A promotor and his co-promotors are jointly liable on pre-incorporation contracts the promotor negotiates in the name of the nonexistent corporation. This liability exists even when the promoter's name does not appear on the contract. The mere formation of the corporation does not release a promoter from liability. A promoter retains liability on a pre-incorporation contract until **novation** occurs, which will be the substitution of a new contract in place of an old contract. In a Novation both the corporation and the third party must agree to relieve the promoter of the liability of the contract. A promoter can have his liability cease automatically upon adoption by adding an **automatic novation clause** to the contract. ***SmithStearn Yachts, Inc. v. Gyrographic Communications Inc*.** **Pre-incorporation Share Subscriptions**: is when a prospective shareholder offers to buy a specific number of the corporation's shares at a stated price. This is used to ensure that the corporation will have adequate capital when it begins business. Promoters have no liability on pre-incorporation share subscriptions. **Relation of a Promoter and the Prospective Corporation:** A promoter of a nonexistent corporation is not an agent of the prospective corporation. A promoter is also not an agent of the prospective investors in the business, because they did not appoint him, and they have no power to control him. But a promoter does owe a fiduciary duty to the corporation and to its prospective investors. A promotor owes such parties a duty of full disclosure and honesty. Example: Pg. 42-4 **Liability of a Corporation to a Promoter:** A corporation is not required to compensate a promoter for her promotional services, or even her expenses, unless the corporation has agreed expressly to compensate the promoter. The justification of this rule is that the promoter is self-appointed and acts for a corporation that is not in existence. Corporations often compensate their promoters with shares. But to ensure that she is compensated for her services, a promoter might tie herself to a person or property that the corporation needs to succeed. Example: Pg. 42-4 **Incorporation:** Promoters usually choose to incorporate in a state whose incorporation statute and court decisions grant managers broad management discretion. Delaware has been a popular state because its fees and taxes tend to be low. It also has judges experienced in resolving corporate disputes. Steps in Incorporation: 1. Preparing the articles of Incorporation 2. Signing and authenticating the articles by one or more incorporators. 3. Filling the articles with the secretary of state, accompanied by the payment of specified fees. 4. Receiving a copy of the articles of incorporation stamped "Filed" by the secretary of state. 5. Holding an organization meeting for the purpose of adopting bylaws, electing officers, and transacting other business. 1. The articles are similar to a constitution. 2. They state many rights and responsibilities of the corporation, its management, and its shareholders. 3. The Business's name must include the word corporation, incorporated, company, or limited, or an abbreviation of any of the prior. 4. Most of the state corporation statutes require the articles to recite the initial capitalization of the business. 1. There is a valid statute under which the corporation can be organized. 2. The promoters or managers make an honest attempt to organize under the statute. This requires substantial compliance with the mandatory provisions taken as a whole. 3. The promoters or managers exercise corporate powers, they act as if they were acting for a corporation. 1. Managers and shareholders who both participate in the operational decisions of the business and know that the corporation does not exist are liable for the purported corporation's contracts and torts. 2. Shareholders and others are released from liability who either take no part in the management of the defectively formed corporation or mistakenly believe that the corporation is in existence. **Equity Securities:** Every business corporation issues equity securities, which are called stock or shares. The issuance of shares creates an ownership relationship, the holders of the shares are now owners of the corporation. Modern statutes permit corporations to issue several classes of shares and to determine the rights of various classes subject to minimum guarantees contained in the state business corporation law. **Common Shareholders:** have the exclusive right to elect the directors who manage the corporation. The common shareholder occupies a position inferior to that of other investors, such as creditors and preferred shareholders. The common shareholders bear the major risks of the corporate venture yet stand to profit the most if it is successful. **Preferred Shareholders**: are shares that have preferences with regard to assets or dividends over other classes of shares. Preferred Shareholders are customarily given liquidation and dividend preferences over common shareholders. **Liquidation Preference**: of preferred shares is usually a stated dollar amount. During a liquidation this amount must be paid to each preferred shareholder before any common shareholder or other shareholder subordinate to the preferred class may receive his share of the corporation's assets. **Dividends Preference**: are paid to preferred shareholders before common shareholders and can be cumulative or non-cumulative. Example: Pg. 42-12 **Participating:** preferred shares have priority up to a stated amount or percentage of the dividends to be paid by the corporation. **Redemption provision**: allows a corporation at its option to repurchase preferred shareholders' shares at a price stated in the articles despite the shareholders unwillingness to sell. Conversion Rights: allows a preferred shareholder to exchange her preferred shares for another class of shares, usually common shares. The conversion rate or price is stated in the articles. Example: Pg. 42-12 Rarely are preferred shareholders given the right to vote for directors, except in the event of a corporation's default on the payment of dividends. **Authorized Shares**: are shares that a corporation is permitted to issue by its articles of incorporation. A corporation may not issue more shares than it has authorized. **Issued Shares:** are shares that have been sold to shareholders. **Outstanding Shares**: are shares that are currently held by shareholders. Example: Pg. 42-12 **Canceled Shares**: when a corporation purchases its owns shares and cancels them. Canceled shares do not exist and cannot be reissued. Shares restored to unused status: when a corporation purchases its owns shares and these shares are merely authorized and may be reissued at a later time. **Treasury Shares**: is when repurchased shares are neither canceled nor restored to unissued status. Such shares are authorized and issued, but not outstanding. 1. They may be sold by the corporation at a later time. 2. The corporation may not vote on them at shareholders meetings. 3. And it may not pay a cash or property dividend on them. **Options:** permit their holders to purchase a specific number of shares at a specified price during a specified time period. Share options are often issued to top level managers as an incentive to increase the profitability of the corporation. An increase in profitability should increase the market value of the corporation's shares, resulting in increased compensation to the employees who own and exercise share options. **Warrants:** are options evidenced by certificates. They are sometimes part of a package of securities sold as a unit. Example: Pg. 42-12 **Rights:** are short-term certified options that are usually transferrable. Rights are used to give present security holders an option to subscribe to a proportional quantity of the same or different security of the corporation. **Debt Securities:** Corporations have inherent power to borrow money necessary for their operations by issuing debt securities. With the typical debt security, the corporation is obligated to pay interest periodically and to pay the amount of the debt (principal)on the maturity date. **Debentures:** are long-term, unsecured debt securities, with a term of 10 to 30 years. Debentures usually have indentures. **Indentures**: is a contract that states the rights of the debenture holders. Example: Pg. 42-13 **Bonds**: are long-term, secured debt securities that usually have indentures. They are identical to debentures, but they are secured by collateral. The collateral may be real property or personal property. **Notes:** have a shorter duration than debentures or bonds, usually terms not exceeding five years. Notes may be secured or unsecured. **Convertibility:** Notes or debentures can be convertible into other securities, usually preferred or common shares. 1. The right to convert belongs to the holder of the convertible note or debenture. 2. This conversion right permits an investor to receive interest as a debt holder and after conversion, to share in the increased value of the corporation as a shareholder. **Consideration for Shares:** The board of directors has the power to issue shares on behalf of the corporation. The board must decide at what price and for what type of consideration it will issue the shares. The MBCA permits shares to be issued in return for any tangible or intangible property or benefit to the corporation, including cash, promissory notes, services performed for the corporation, contracts for services to be performed for the corporation, and securities of the corporation or another corporation. Example: Pg. 42-13 **Par Value**: is an arbitrary dollar amount that may be assigned to the shares by the articles of incorporation. Par value is also the minimum amount of consideration for which the shares may be issued. **Discount Shares**: are shares issued for less than par value. 1. The board of directors is liable to the corporation for issuing shares for less than par value. 2. A shareholder who purchases shares from the corporation for less than par value is liable to the corporation for the difference between the par value and the amount paid. Disputes may arise concerning the value of the property that the corporation receives for its shares. The board's valuation of the consideration is conclusive if it acts in good faith with the care of prudent directors and in a manner, it reasonably believes to be in the best interest of the corporation. **Watered Shares:** is when the board overvalues the consideration of the shares. Bothe the board and the shareholder are liable to the corporation when the shares are watered. ***Tedeton v. Tedeton*** **Accounting for Consideration Received:** **Accounting terminology:** **Stated Capital account:** records the product of the number of shares outstanding multiplied by the par value of each share. **Capital surplus:** is when the shares are sold for more than the par value. Under the MBCA, the terms stated capital and capital surplus have been eliminated. Legally, all considerations received for shares are lumped under one accounting entry for that class of shares, such as common equity. **Transfer of share restrictions:** 1. **Rights of first refusal:** grants to the corporation or the other shareholders the right to match the offer that a selling shareholder receives for her shares. 2. **Buy and sell agreements** compel a shareholder to sell his shares to the corporation or to the other shareholders at the price stated in the agreement. The price of the shares is usually determined by a stated formula. 3. **Consent restraints**: requires the selling shareholder to obtain the consent of the corporation or the other shareholders before they may sell her shares. 4. **A Provision disqualifying purchasers**: may be used to exclude unwanted persons from the corporation. (Ex. Prohibit selling to a competitor to the business). A corporation and its shareholders may use transfer restrictions to maintain the balance of shareholder power in the corporation. Example: Pg. 42-18 A buy and sell agreement are the preferred transfer restrictions for nearly every context in well planned close corporations because certainty is obtained by both sides being obligated: One required to buy and the other to sell. Example: Pg.42-18 To be enforceable against a shareholder a transfer restriction must be contained in the articles of incorporation, the bylaws, an agreement among the shareholders, or an agreement between the corporation and the shareholders. ***Coyle v. Schwartz*** \-