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This Document Contains Chapters 33 to 34 Part Seven: Corporations CONTENTS Chapter 33 Nature, Formation, and Powers Chapter 34 Financial Structure Chapter 35 Management Structure Chapter 36 Fundamental Changes ETHICS QUESTIONS RAISED IN THIS PART 1. Corporations owe their existence to the issuance of a charter by the state. Historically, both the law and society have taken a very cautious approach to corporations. However, today the corporate form of business is the dominant form of business organization in the United States and corporations wield substantial power nationwide. Are corporations too powerful? Do they owe any special duties to society in general, because they are allowed the privilege of a corporate charter? 2. What should be the primary goal of a corporation? Should it be the maximization of profits, or do the officers and directors of a corporation have a duty that is higher than that of mere profit maximization? 3. Should a company act ethically toward its competitors? If so, how? If a company's primary goal is the maximization of profits, how can it act ethically toward its competitors and fulfill that goal? 4. Do corporations have any ethical duties to conserve our natural resources and avoid pollution of the environment? Why or why not? ACTIVITIES AND RESEARCH PROBLEMS 1. Have groups of students work together to form a "corporation" of their own by drafting Articles of Incorporation and Bylaws. Then have them present their corporation to the class and explain the reasons why they organized it as they did. 2. Research selected provisions of the business corporation statute in your state, such as the standard for the payment of corporate dividends, and compare its provisions to those of the Model Business Corporation Act. How closely does the statute in your state follow the MBCA? 3. Research the application of the business judgment rule in your state, in Delaware, and in other states. There have been recent cases that suggest some courts are retreating from the rule in some situations. When directors make use of special committees, are they leaving themselves open for potential liability? What about when directors rely on the information supplied by the officers and employees of the firm? Do directors have an obligation to do their own independent investigation? Chapter 33 NATURE, FORMATION, AND POWERS Cases in This Chapter Drake MFG. Co., Inc. v. Polyflow, Inc. Coopers & Lybrand v. Fox Harris v. Looney Inter-Tel Technologies, Inc. v. Linn Station Properties, LLC. Chapter Outcomes After reading and studying this chapter, the student should be able to: • Identify the principal attributes and classifications of corporations. • Explain how a corporation is formed and the role, liability, and duties of promoters. • Distinguish between the statutory and common law approaches to defective formation of a corporation. • Explain how the doctrine of piercing the corporate veil applies to closely held corporations and parent-subsidiary corporations. • Identify the sources of corporate powers and explain the legal consequences of a corporation’s exceeding its powers. TEACHING NOTES NATURE OF CORPORATIONS The corporation is the dominant form of business organization in the United States, accounting for 85 percent of the gross revenues of all business entities. Six million domestic corporations, with annual revenues approximating 30 trillion dollars and revenues exceeding 50 trillion dollars, are currently doing business in the United States. Approximately 50 percent of American households own stock directly or indirectly through institutional investors such as mutual funds, pension funds, banks, and insurance companies. In 1946, a committee of the American Bar Association, after careful study and research, submitted a draft of a Model Business Corporation Act (MBCA). The MBCA has been amended frequently since then. Although the provisions of the Act do not become law until enacted by a State, its influence has been widespread; and a majority of the States had adopted it in whole or in part. In 1984, the Committee on Corporate Laws of the Section of Corporation, Banking, and Business Law of the American Bar Association approved a Revised Model Business Corporation Act (RMBCA). The Revised Act is the first complete revision of the Model Act in more than thirty years, although the Act had been amended frequently since it was first published. More than thirty states have adopted it in whole or in part. The Revised Act is “designed to be a convenient guide for revision of state business corporation statutes, reflecting current views as to the appropriate accommodation of the various commercial and social interests involved in modern business corporations. In 2009, a number of sections of the Revised Act were amended to update the Act’s electronic technology provisions to bring them into alignment with Uniform Electronic Transmissions Act (UETA) and the federal Electronic Signatures in Global and National Commerce Act (E-Sign) both of which were discussed in Chapter 15. *** Chapter Outcome *** Identify the principal attributes and classifications of corporations. 33-1 CORPORATE ATTRIBUTES Corporations have attributes which make them distinct from any other form of business entities. 33-1a Legal Entity A corporation is recognized as having a legal existence separate from its shareholders. It may sue or be sued as a legal entity, and it holds title to all corporate property. 33-1b Creature of State All States have general incorporation statutes authorizing the Secretary of State to issue a certificate of incorporation or charter upon compliance with its provision. 33-1c Limited Liability A corporation is liable for payment of debts, and shareholders are usually held liable only to the extent of their investment. The limitation on liability, however, will not affect the liability of a shareholder who committed the wrongful act. A shareholder is also liable for any corporate obligations personally guaranteed by the individual member or manager. 33-1d Free Transferability of Corporate Shares Corporate shares are readily transferable unless there is an agreement to the contrary. Article 8 of the Uniform Commercial Code, Investment Securities, governs transfers of shares of stock. 33-1e Perpetual Existence Where the articles of incorporation do not specify a limited duration, corporations have a perpetual existence. As a result, the withdrawal of a shareholder or officer will not cause dissolution of the firm. A corporation’s existence will terminate upon its dissolution or merger into another business. 33-1f Centralized Management The shareholders elect a board of directors to manage the business of the corporation. The board appoints officers to run the day-to-day operations. Since management responsibility is separated from ownership, shareholders do not as shareholders participate in the running of the company. 33-1g As a Person A corporation is a "person" under the Fifth and Fourteenth Amendments as related to the requirement that no person be deprived of "life, liberty, or property without due process of law" and under the Fourteenth Amendment equal protection clause. Corporations are not persons with regard to the Fifth Amendment right against self-incrimination. 33-1h As a Citizen Corporations are citizens of the state(s) where they are incorporated and they have their principal office located for diversity jurisdiction purposes. They are not citizens with respect to the Fourteenth Amendment privileges and immunities clause. 33-2 CLASSIFICATION OF CORPORATIONS 33-2a Public or Private Public or municipal corporations are those owned and operated by civil governments. Private corporations are formed for profit or not-for-profit. 33-2b Profit or Nonprofit A profit corporation is founded for the purpose of operating a business for profits which are paid to the shareholders. Profits made by a non-profit company must be reinvested in the firm and cannot be distributed to its members, officers or directors. 33-2c Domestic or Foreign A corporation is a domestic corporation in the state in which it is incorporated. It is a foreign corporation in every other state or jurisdiction. To do business in any state other than its home state (with the exception of acts in interstate commerce), a corporation must have authorization from the other state. States also generally provide that a failure to pay taxes, file required reports, or maintaining a registered agent or office in the state will constitute cause for license revocation. Doing Business — Rather than define what IS doing business, the Revised Act defines what IS NOT doing business. (See textbook for detailed list.) Anything more regular, systematic or extensive than the activities on this list will require a corporation to "qualify," or obtain authorization. CASE 33-1 DRAKE MFG. CO., INC. v. POLYFLOW, INC. Superior Court of Pennsylvania, 2015 109 A. 3d 250, 2015 PA Super 16 Jenkins, J. In late 2007, Drake, a Delaware corporation, entered an agreement to sell “couplings” to Polyflow, which the agreement defined as “products designed by Polyflex for use as termination fittings in Polyflex’s Thermoflex Tubing.” The agreement provided that Drake would ship the couplings from Drake’s plant in Sheffield, Pennsylvania to Polyflow. The record includes approximately 75 bills from Drake to Polyflow for couplings between August 2008 and April 2009. These bills indicate that Drake shipped most of the couplings from its plant in Sheffield, Pennsylvania to Polyflow’s business establishment in Oaks, Pennsylvania. Other bills during the same time period indicate that Drake shipped equipment known as “portable swaging machines” to Polyflow. *** On June 10, 2009, Drake filed a civil complaint for breach of contract alleging Polyflow’s failure to pay Drake ***. *** *** Polyflow did not dispute its failure to pay Drake or contend that Drake failed to perform its duties under the 2007 agreement. Polyflow’s only defense was that Drake lacked capacity to sue Polyflow due to Drake’s failure to obtain a certificate of authority from the Department of State authorizing Drake to do business in Pennsylvania as a foreign corporation. Drake did not possess a certificate of authority at the time of trial. Indeed, Drake did not even apply for a certificate of authority until the day of trial. At the close of Drake’s case , Polyflow moved for a compulsory nonsuit due to Drake’s lack of capacity to sue, i.e., its failure to submit a certificate of authority from the Department of State into evidence. The court denied Polyflow’s motion for nonsuit. Polyflow did not present any further evidence, and the court announced its verdict in favor of Drake in the amount of $291,766.61. On March 5, 2014, Polyflow filed timely post-trial motions seeking judgment *** due to Drake’s failure to submit a certificate of authority into evidence. On March 17, 2014, the Department of State issued Drake a certificate of authority to do business in Pennsylvania as a foreign corporation. On April 17, 2014, almost two months after the verdict, Drake submitted its certificate of authority as an exhibit to its response to Polyflow’s post-trial motions. On May 23, 2014, relying on the delinquent certificate of authority, the trial court denied Polyflow’s post-trial motions. Polyflow thereupon *** filed a timely notice of appeal. *** We turn to whether Polyflow was entitled to judgment *** due to Drake’s failure to submit a certificate of authority. *** *** Section 4121 [of the Corporations and Unincorporated Associations Code (“Code”)] provides: “A foreign business corporation, before doing business in this Commonwealth, shall procure a certificate of authority to do so from the Department of State, in the manner provided in this subchapter ...” [Citation.] While the Code does not expressly define “doing business”, section 4122(a) identifies activities which do not constitute “doing business”, either individually or collectively. *** *** *** The Committee Comment to section 4122 explains: [Section 4122] does not attempt to formulate an inclusive definition of what constitutes the transaction of business. Rather, the concept is defined in a negative fashion by subsection (a), which states that certain activities do not constitute the transaction of business. In general terms, any conduct more regular, systematic, or extensive than that described in subsection (a) constitutes the transaction of business and requires the corporation to obtain a certificate of authority. Typical conduct requiring a certificate of authority includes maintaining an office to conduct local intrastate business, selling personal property not in interstate commerce, entering into contracts relating to local business or sales, and owning or using real estate for general corporate purposes *** A corporation is not ‘doing business’ solely because it resorts to the courts of this Commonwealth to recover an indebtedness, enforce an obligation, recover possession of personal property, obtain the appointment of a receiver, intervene in a pending proceeding, bring a petition to compel arbitration, file an appeal bond, or pursue appellate remedies *** The concept of ‘doing business’ involves regular, repeated, and continuing business contacts of a local nature. A single agreement or isolated transaction does not constitute the doing of business if there is no intention to repeat the transaction or engage in similar transactions. *** [Citation,] (emphasis added). Lastly, section 4141(a) provides in relevant part that “[a] nonqualified foreign business corporation doing business in this Commonwealth *** shall not be permitted to maintain any action or proceeding in any court of this Commonwealth until the corporation has obtained a certificate of authority.” [Citation.] A foreign corporation may comply with this requirement by obtaining a certificate of authority “during the course of a lawsuit.” [Citation.] *** *** the evidence demonstrates that Drake failed to submit a certificate of authority into evidence prior to the verdict in violation of *** § 4121(a). Therefore, the trial court should not have permitted Drake to prosecute its action. [Citation.] The trial court contends that Drake is exempt from the certificate of authority requirement because it merely commenced suit in Pennsylvania to collect a debt, conduct that does not constitute “doing business” under section 4122(a) ***. Drake did much more, however, than file suit or attempt to collect a debt. Drake maintains an office in Pennsylvania to conduct local business, conduct which “[typically] require[s] a certificate of authority.” [Citation.] Drake also entered into a contract with Polyflow, and, on dozens of occasions over an eight month period, shipped couplings and portable swaging machines to Polyflow’s place of business in Pennsylvania—far more than the “isolated transaction” exempted under section 4122(a)(10) ***. [Citation.] In short, Drake’s conduct was “more regular, systematic, [and] extensive than that described in section 4122(a), [thus] constitut[ing] the transaction of business and requir[ing] [Drake] to obtain a certificate of authority.” [Citation.] *** The trial court thus erred by denying Polyflow’s [post-trial] motion for judgment ***. Scope of Regulation — The internal affairs of a foreign corporation are governed by the state of incorporation. Sanction — Failure of a foreign corporation to qualify will result in that corporation being denied access to the courts and possibly being fined. 33-2d Publicly Held or Closely Held A publicly held corporation is one whose shares are owned by a large number of people and are widely traded. Any corporation required to register under the Federal Securities and Exchange Act of 1934 is considered to be publicly held. A closely held corporation is one whose outstanding shares of stock are held by just a few people, frequently friends or relatives. The transfer of shares of closely held corporations is often restricted to prevent “outsiders” from obtaining stock. About 20 States have enacted special legislation to accommodate the needs of such corporations, and a Statutory Close Corporation Supplement to the Model and Revised Acts was promulgated. In 1991 the Revised Act was amended to authorize shareholders in closely held corporations to adopt unanimous shareholders’ agreements that depart from the statutory norms. (See text for details.) 33-2e Subchapter S Corporation A Subchapter S corporation meets specified requirements of the Internal Revenue Code and is thereby taxed like a partnership — that is, only at the individual shareholder level. . The requirements for subchapter S treatment are (1) it must be a domestic corporation; (2) it must have no more than 75 shareholders; (3) each shareholder must be an individual and not a business entity; (4) no shareholder may be a nonresident alien; and (5) it may have only one class of stock although classes of common stock differing only in voting rights are permitted. 33-2f Professional Corporations Licensed professionals may practice under a corporate form by state "professional association acts." FORMATION OF A CORPORATION 33-3 ORGANIZING THE CORPORATION 33-3a Promoters A promoter is a person who takes the preliminary steps to organize a corporation in compliance with the incorporation statute. *** Chapter Outcome *** Discuss how a corporation is formed and the role, liability, and duties of promoters. Promoters' Contracts — Promoters remain liable on contracts entered into on behalf of a corporation not yet formed unless the contract provides for a termination of such liability or a novation is effected. Promoters' Fiduciary Duty — Corporate promoters owe a fiduciary duty to one another, the company, its subscribers, and its initial shareholders. The duty encompasses good faith, fair dealing, and full disclosure. NOTE: See Figure 33-1 CASE 33-2 COOPERS & LYBRAND v. FOX Colorado Court of Appeals, Div. IV, 1988 758 P.2d 683 http://scholar.google.com/scholar_case?case=12318371943544580212&q=758+P.2d+683&hl=en&as_sdt=2,34 Kelly, C. J. In an action based on breach of express and implied contracts, the plaintiff, Coopers & Lybrand (Coopers), appeals the judgment of the trial court in favor of the defendant, Garry J. Fox (Fox). Coopers contends that the trial court erred in ruling that Fox, a corporate promoter, could not be held liable on a pre-incorporation contract in the absence of an agreement that he would be so liable, and that Coopers had, and I failed to sustain, the burden of proving any such agreement. We reverse. On November 3, 1981, Fox met with a representative of Coopers, a national accounting firm, to request a tax opinion and other accounting services. Fox informed Coopers at this meeting that he was acting on behalf of a corporation he was in the process of forming, G. Fox and Partners, Inc. Coopers accepted the “engagement” with the knowledge that the corporation was not yet in existence. G. Fox and Partners, Inc., was incorporated on December 4, 1981. Coopers completed its work by mid-December and billed “Mr. Garry R. (sic) Fox, Fox and Partners, Inc.” in the amount of $10,827. When neither Fox nor G. Fox and Partners, Inc., paid the bill, Coopers sued Garry Fox, individually, for breach of express and implied contracts based on a theory of promoter liability. Fox argued at trial that, although Coopers knew the corporation was not in existence when he engaged the firm’s services, it either expressly or impliedly agreed to look solely to the corporation for payment. Coopers argued that its client was Garry Fox, not the corporation. The parties stipulated that Coopers had done the work, and Coopers presented uncontroverted testimony that the fee was fair and reasonable. The trial court failed to make written findings of fact and conclusions of law. However, in its bench findings at the end of trial, the court found that there was no agreement, either express or implied, that would obligate Fox, individually, to pay Coopers’ fee, in effect, because Coopers had failed to prove the existence of any such agreement. The court entered judgment in favor of Fox. As a preliminary matter, we reject Fox’s argument that he was acting only as an agent for the future corporation. One cannot act as the agent of a nonexistent principal. [Citation.] On the contrary, the uncontroverted facts place Fox squarely within the definition of a promoter. A promoter is one who, alone or with others, undertakes to form a corporation and to procure for it the rights, instrumentalities, and capital to enable it to conduct business. [Citations.] When Fox first approached Coopers, he was in the process of forming G. Fox and Partners, Inc. He engaged Coopers’ services for the future corporation’s benefit. In addition, though not dispositive on the issue of his status as a promoter, Fox became the president, a director, and the principal shareholder of the corporation, which he funded, only nominally, with a $100 contribution. Under these circumstances, Fox cannot deny his role as a promoter. Coopers asserts that the trial court erred in finding that Fox was under no obligation to pay Coopers’ fee in the absence of an agreement that he would be personally liable. We agree. As a general rule, promoters are personally liable for the contracts they make, though made on behalf of a corporation to be formed. [Citation.] The well-recognized exception to the general rule of promoter liability is that if the contracting party knows the corporation is not in existence but nevertheless agrees to look solely to the corporation and not to the promoter for payment, then the promoter incurs no personal liability. [Citations.] In the absence of an express agreement, the existence of an agreement to release the promoter from liability may be shown by circumstances making it reasonably certain that the parties intended to and did enter into the agreement. [Citations.] Here, the trial court found there was no agreement, either express or implied, regarding Fox’s liability. Thus, in the absence of an agreement releasing him from liability, Fox is liable. Coopers also contends that the trial court erred in ruling, in effect, that Coopers had the burden of proving any agreement regarding Fox’s personal liability for payment of the fee. We agree. Release of the promoter depends on the intent of the parties. As the proponent of an alleged agreement to release the promoter from liability, the promoter has the burden of proving the release agreement. [Citations.] Fox seeks to bring himself within the exception to the general rule of promoter liability. However, as the proponent of the exception, he must bear the burden of proving the existence of the alleged agreement releasing him from liability. The trial court found that there was no agreement regarding Fox’s liability. Thus, Fox failed to sustain his burden of proof, and the trial court erred in granting judgment in his favor. It is undisputed that the defendant, Garry J. Fox, engaged Coopers’ services, that G. Fox and Partners, Inc., was not in existence at that time, that Coopers performed the work, and that the fee was reasonable. The only dispute, as the trial court found, is whether Garry Fox is liable for payment of the fee. We conclude that Fox is liable, as a matter of law, under the doctrine of promoter liability. Accordingly, the judgment is reversed, and the cause is remanded with directions to enter judgment in favor of Coopers & Lybrand in the amount of $10,827, plus interest to be determined by the trial court pursuant to [citation]. 33-3b Subscribers A subscriber is someone who agrees to purchase stock in a formed (subscription contract) or not yet formed corporation (preincorporation subscription agreement). Contemporary incorporation statutes provide that preincorporation subscription contracts are irrevocable for six months absent a stated agreement to the contrary. 33-3c Selection of a State for Incorporation A corporation usually incorporated in its “home” state, the state where most of the business is located and most transactions take place. It is possible, however, to qualify to incorporate in a state where little or no business activities occur. Therefore, many corporations incorporate in a state with favorable corporate laws, then obtain a certificate of authority to conduct most or all of their business elsewhere. 33-4 FORMALITIES OF INCORPORATION Although the procedure involved in organizing a corporation varies somewhat from State to State, typically the incorporators execute and deliver articles of incorporation to the Secretary of State or another designated official. The Revised Act provides that after incorporation, the board of directors named in the articles of incorporation shall hold an organizational meeting for the purpose of adopting bylaws, appointing officers, and carrying on any other business brought before the meeting. 33-4a Selection of Name State statutes require that the company name indicate that it is a corporation. 33-4b Incorporators Persons who sign the article of incorporation which are then filed with the state. The role of the incorporators ends after the organizational meeting. 33-4c Articles of Incorporation Under the Revised Act the articles (or charter) must include: the corporation’s name, the number of authorized shares, the name and street address of the registered agent, and the name and address of each incorporator. The charter may include optional information such as the initial board of directors, corporate purposes, etc. Some optional provisions can be elected only in the charter, including cumulative voting, supermajority voting requirements, and preemptive rights. NOTE: Figure 33-2 shows a sample charter. See also Figure 33-3: Comparison of Charter and Bylaws 33-4d Organizational Meeting Required by the RMBCA to adopt the bylaws, elect directors and appoint officers, and conduct other appropriate business. 33-4e Bylaws Contain the rules and regulations governing the company's internal management. Bylaws need not be publicly filed and generally may be altered without shareholder approval. Close corporations may avoid adopting bylaws by including all necessary information in a shareholder agreement or in the articles of incorporation. RECOGNITION OR DISREGARD OF CORPORATENESS Errors or omissions in incorporation procedures may or may not cause the courts to regard an organization as a non-corporation. Conversely, even a properly formed corporation may be regarded as a non-corporation if justice requires. *** Chapter Outcome *** Distinguish between statutory and common law approaches to defective formation of a corporation. 33-5 DEFECTIVE INCORPORATION 33-5a Common Law Approach Under the common law, a defectively formed corporation was, under certain circumstances, accorded corporate attributes. Corporation de Jure — Refers to a corporation that has been created in substantial conformance with state law and organizational procedure. Corporation de Facto — A failure to comply substantially with the incorporation statute. A de facto corporation will be recognized if a general corporation statute exists, there is a bona fide effort to meet statutory requirements, and the company transacts business, demonstrating a belief that the corporation has been properly formed. De facto status may not be challenged by anyone other than the state. Corporation by Estoppel — This doctrine will recognize corporate existence despite a substantial defect in statutory compliance if the business has held itself out as a corporation and third parties have relied on this representation. Then neither party may deny the corporate existence of the business. Defective Corporation — Where the de jure, de facto and estoppel principles are inapplicable, the corporate existence is denied and persons involved in the business do not have limited liability protection. Liability among all associates for debts is joint and several as well as unlimited. 33-5b Statutory Approach The common law approach is cumbersome, but incorporation statutes now address the issue more simply. All States provide that corporate existence begins either upon the filing of the articles of incorporation or their acceptance by the Secretary of State. The Revised Act imposes liability only on persons who purport to act as a corporation knowing there was no incorporation. CASE 33-3 HARRIS v. LOONEY Court of Appeals of Arkansas, 1993 43 Ark.App. 127, 862 S.W.2d 282 http://scholar.google.com/scholar_case?case=145280640899400887&q=862+S.W.2d+282&hl=en&as_sclt=2,34 Pittman, J. On February 1, 1988, appellant, Robert L. Harris, sold his business and its assets to J & R Construction. The articles of incorporation for J & R Construction were signed by the incorporators on February 1, 1988, but were not filed with the Secretary of State’s office until February 3, 1988. In 1991, J & R Construetion defaulted on its contract and promissory note, and appellant sued the incorporators of J & R Construction, Joe Alexander and appellees, Avanell Looney and Rita Alexander, for judgment jointly and severally on the corporation’s debt of $49,696.21. In his amended complaint, appellant alleged that the incorporators were jointly and severally liable for the debt of J & R Construction because its articles of incorporation had not been filed with the Secretary of State’s Office at the time Joe Alexander, on behalf of the corporation, entered into the contract with appellant. After a bench trial, the circuit court held that Joe Alexander was personally liable for the debts of J & R Construction because he was the contracting party who dealt on behalf of the corporation. The court refused, however, to hold appellees, Avanell Looney and Rita Alexander, liable, because neither of them had acted for or on behalf of the corporation pursuant to Ark. Code Ann. §4–27–204. On appeal, appellant contends that the trial court erred in not holding appellees jointly and severally liable, along with Joe Alexander. It was undisputed that the contract and promissory note were signed by Joe Alexander on behalf of J & R Construction and that J & R Construction had not yet been incorporated when the contract was executed. [Court’s footnote: Arkansas Code Annotated §4–27–203, which provides that, “[u] nless a delayed effective date is specified, the corporation’s existence begins when the articles of incorporation are filed.”] Appellant concludes that, because Arkansas law imposes joint and several liability on those purporting to act as or on behalf of a corporation knowing there is no incorporation, the trial court erred in not also awarding him judgment against appellees. In support of his argument, appellant cites [citation], where the supreme court held that: [W]here an incorporator signs a contract or agreement in the name of the corporation before the corporation is actually formed and the other party to the agreement believes at the time of the signing that the corporation is already formed, then the incorporators are responsible as a partnership for the obligations contained in the contract or agreement, including damages resulting from any breach of the contract on their part. * * * [Citations.] These cases, however, were decided before the Arkansas General Assembly had specifically addressed the issue of liability of individuals for preincorporation debt. * * * Section 204 of [the Arkansas Business Corporation] Act, [citation], concerns liability for pre-incorporation transactions and is identical to Section 2.04 of the Revised Model Business Corporation Act. It states: “All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.” The official comment to §2.04 of the Revised Model Business Corporation Act explains: Incorporation under modern statutes is so simple and inexpensive that a strong argument may be made that nothing short of filing articles of incorporation should create the privilege of limited liability. A number of situations have arisen, however, in which the protection of limited liability arguably should be recognized even though the simple incorporation process established by modern statutes has not been completed. * * * * * * [I]t seemed appropriate to impose liability only on persons who act as or on behalf of corporations “knowing” that no corporation exists. * * * The Act requires that, in order to find liability under §4–27–204, there must be a finding that the persons sought to be charged acted as or on behalf of the corporation and knew there was no incorporation under the Act. The evidence showed that the contract to purchase appellant’s business and the promissory note were signed only by Joe Alexander on behalf of the corporation. The only evidence introduced to support appellant’s allegation that appellees were acting on behalf of the corporation was Joe Alexander’s and Avanell Looney’s statements that they were present when the contract with appellant was signed; however, these statements were disputed by appellant and his wife. Appellant testified that he, his wife, Kathryn Harris, and Joe Alexander were present when the documents were signed to purchase his business and he did not remember appellee Avanell Looney being present. Kathryn Harris testified that appellees were not present when the contract was signed. The trial court denied appellant judgment against appellees because he found appellees had not acted for or on behalf of J & R Construction as required by §4–27–204. The findings of fact of a trial judge sitting as the fact finder will not be disturbed on appeal unless the findings are clearly erroneous or clearly against the preponderance of the evidence, giving due regard to the opportunity of the trial court to assess the credibility of the witnesses. [Citation.] From our review of the records, we cannot say that the trial court’s finding in this case is clearly against the preponderance of the evidence, and we find no error in the court’s refusal to award appellant judgment against appellees. Affirmed. *** Chapter Outcome *** Explain how the doctrine of piercing the corporate veil applies to closely held corporations and parent-subsidiary corporations. 33-6 PIERCING THE CORPORATE VEIL The courts will disregard the corporate entity when it is used to defeat public convenience, commit a wrongdoing, protect fraud, or circumvent the law. Going behind the corporate entity to confront those involved in wrongdoing is known as piercing the corporate veil, and is not done frequently. 33-6a Closely Held Corporations Creditors unable to recover completely against the corporation will often request that a court impose liability on the individual shareholders. Courts have responded by piercing the corporate veil if business was not conducted on a corporate basis, the company suffered from inadequate capitalization, or the corporation was used to defraud. The Revised Act narrows the grounds for imposing personal liability on shareholders for the liabilities of a corporation for acts or omissions authorized by a shareholder agreement, “even if the agreement or its performance treats the corporation as if it were a partnership or results in failure to observe the corporate formalities otherwise applicable to the matters governed by the agreement.” 33-6b Parent-Subsidiary Corporations A subsidiary is a corporation in which another corporation (the parent) owns at least a majority of the shares. Courts will pierce the corporate veil in this situation if there is inadequate capitalization, formalities are not observed, each corporation is not held out to the public as separate enterprises, funds are co-mingled, or the parent firm dominates the operations of the subsidiary. CASE 33-4 INTER-TEL TECHNOLOGIES, INC. v. LINN STATION PROPERTIES, LLC Supreme Court of Kentucky, 2012 360 S.W.3D 152 http://scholar.google.com/scholar_case?case=17219243320060826011&q=Inter-Tel+Technologies,+Inc.+v.+Linn+Station+Properties,+LLC&hl=en&as_sdt=2,10&as_vis=1 Abramson, J. [Integrated Telecom Services Corp. (ITS) was acquired by and became a wholly-owned subsidiary of Inter–Tel Technologies, Inc. (Technologies), which in turn is a wholly-owned subsidiary of Inter–Tel, Inc. (Inter–Tel). Inter–Tel designs, manufactures, sells, and services telecommunications systems through its subsidiaries and affiliates. Technologies is the retail division of Inter–Tel. ITS was the company’s first retail branch in Kentucky, selling Inter–Tel’s telecommunications products from an office building it leased from Linn Station Properties, LLC (Linn Station). After ITS was acquired by Technologies, ITS was not permitted to maintain a bank account, hold any funds, or pay any bills. All of ITS’s regional offices were transformed from independent dealers of communications equipment into direct sales “branches” of Inter–Tel. ITS employees became employees of Inter–Tel and were paid by Inter–Tel from its headquarters in Arizona. When a customer purchased a telecommunications system from ITS the payment went directly into a depository account controlled by Inter–Tel. Inter–Tel paid all the vendors who provided ITS with goods and services. All of ITS’s inventory was provided by another Inter–Tel subsidiary. Inter–Tel paid ITS’s rent for the Linn Station Road property from the time Technologies acquired ITS until ITS abandoned the premises in 2002. Further, Inter–Tel and Technologies were the named insureds listed on the property damage insurance for ITS’s premises on Linn Station Road. ITS did not hold an annual board of directors or shareholders meeting from 1999 through 2002. Nor did Technologies hold an annual board of directors or shareholders meeting from 1998 through 2002. During the four-year period from 1999 through 2002, ITS and Technologies had identical boards of directors; each ITS and Technologies director served as an officer of Inter–Tel; the President and CEO of Inter–Tel served on the boards of ITS, Technologies and Inter–Tel; and all of ITS’s officers served as officers of both Technologies and Inter–Tel. Although all Inter–Tel business conducted in Kentucky since 2001 was performed by ITS in its own name, Inter–Tel, Technologies, and another Inter–Tel subsidiary filed sales and use tax returns with the Kentucky in 2001, 2002 and 2003. On June 19, 2002, Linn Station filed suit against ITS, seeking damages for failure to repair and maintain the premises and for unpaid rent. ITS failed to respond, and on August 12, 2002, a default judgment was entered against ITS for $332,900.00 plus interest. After repeated, unsuccessful attempts to satisfy the judgment against ITS, on June 20, 2003 Linn Station sued ITS, Technologies and Inter–Tel to pierce the corporate veil and establish Inter–Tel and Technologies’ liability for the judgment against ITS. The trial court granted summary judgment to Linn Station, and the Court of Appeals affirmed, finding it appropriate to pierce the corporate veil where the evidence showed ITS was merely an instrumentality or alter ego of Technologies and Inter–Tel, operated by them to achieve tax benefits and to avoid various liabilities. Technologies and Inter–Tel appealed.] Piercing the corporate veil is an equitable doctrine invoked by courts to allow a creditor recourse against the shareholders of a corporation. In short, the limited liability which is the hallmark of a corporation is disregarded and the debt of the pierced entity becomes enforceable against those who have exercised dominion over the corporation to the point that it has no real separate existence. A successful veil-piercing claim requires both this element of domination and circumstances in which continued recognition of the corporation as a separate entity would sanction a fraud or promote injustice. The leading Kentucky case on piercing, White v. Winchester Land Development Corp., [citation], like decisions from courts across the country, refers to this two-part test as the “alter ego” test. In recent years, courts and commentators have recognized piercing by using various tests and formulations, most commonly the “alter ego” and “instrumentality” tests, and by identifying common characteristics of corporations which have forfeited the right to separate legal existence. * * * This case requires us to consider this important doctrine in the context of an increasingly common scenario, a creditor’s attempt to collect on debt incurred by a wholly-owned subsidiary where the subsidiary has been deprived of all income and rendered asset-less by the acts of its parent (and in this case also grandparent) corporation. * * * * * * The instrumentality theory requires the co-existence of three elements: “(1) that the corporation was a mere instrumentality of the shareholder; (2) that the shareholder exercised control over the corporation in such a way as to defraud or to harm the plaintiff; and (3) that a refusal to disregard the corporate entity would subject the plaintiff to unjust loss.” * * * * * * * * * The Seventh Circuit Court of Appeals, when applying Illinois law, uses the two-part alter ego test and considers the following factors under the first prong of that test: (1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) nonfunctioning of the other officers or directors; (7) absence of corporate records; (8) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm’s-length relationships among related entities; and (11) whether, in fact, the corporation is a mere facade for the operation of the dominant stockholders. [Citations.] * * * * * * * * * The alter ego test * * * expressly refers to “promoting injustice” and, indeed, piercing should not be limited to instances where all the elements of a common law fraud claim can be established. [Citations.] * * * We agree * * *, however, that the injustice must be something beyond the mere inability to collect a debt from the corporation. * * * The trial court and Court of Appeals were correct in concluding the undisputed facts of this case justified piercing ITS’s corporate veil. ITS lost all semblance of separate corporate existence and through the joint acts of Technologies and Inter–Tel was rendered income-less and asset-less. Their diversion of ITS’s corporate income and transfer of ITS’s corporate assets for their own benefit provides the extra “injustice” * * *, something more than simply a creditor’s inability to collect a debt from ITS. In brief, the alter ego test is satisfied and numerous of the equities factors are present. * * * * * * * * * The equitable doctrine of veil piercing cannot be thwarted by having two entities, rather than one, dominate the subsidiary and dividing the conduct between the two so that each can point the finger to some extent at the other. Technologies was 100% owned and controlled by Inter–Tel and the two corporations acted completely in concert in dominating ITS and extracting anything of value from ITS. It is entirely appropriate for this Court to look at the larger picture of the conduct of Inter–Tel and Technologies as opposed to only the individual actions of the parent entity. To do otherwise would render the equitable piercing doctrine hopelessly inadequate, if not meaningless in some cases, based on the sheer number of business entities involved. * * * * * * ITS had grossly inadequate capital for day-to-day operations because it had no funds at all, literally nothing of its own. * * * * * * Inter–Tel paid the employees’ salaries and other expenses of ITS. ITS had no assets of its own, only those it was allowed to use by Technologies or Inter–Tel. ITS simply had no independent financial existence. * * * Both Technologies and Inter–Tel used the Linn Station lease premises and any other assets previously held by ITS solely for the benefit of Inter–Tel, not for ITS’s benefit. Certainly the ITS officers and directors failed to act in that corporation’s best interest because they allowed it to be stripped of its income and assets by Technologies and Inter–Tel, acting in the interest of Inter–Tel to the detriment of any other entity. Finally, the formal legal requirements of ITS were not observed. There were no shareholder or director meetings in 1999, 2000, 2001 and 2002 and * * * there was such unity of ownership and interest that ITS’s separateness from Technologies and Inter–Tel ceased to exist. * * * Courts should not pierce corporate veils lightly but neither should they hesitate in those cases where the circumstances are extreme enough to justify disregard of an allegedly separate corporate entity. This case is clearly within the boundaries of proper application of the equitable doctrine and thus we conclude that the trial court and Court of Appeals did not err in piercing ITS’s veil to hold Inter–Tel and Technologies responsible for ITS’s debt to Linn Station. [The decision of the Court of Appeals is affirmed, and case is remanded to the trial court for entry of judgment against Inter–Tel and Technologies.] CORPORATE POWERS *** Chapter Outcome *** Identify the sources of corporate powers and explain the legal consequences of a corporation’s exceeding its powers. 33-7 SOURCES OF CORPORATE POWER 33-7a Statutory Powers Typical of the powers granted by state incorporation statutes are those provided by the Revised Act, including: to have perpetual succession; to sue and be sued in the corporate name; to acquire and dispose of property; to make contracts, borrow money, and secure corporate obligations; to lend money; to be a promoter, partner, etc., of any other entity; to conduct business in and out of the state of incorporation; to establish pension plans, profit sharing plans, etc.; and to make charitable donations. 33-7b Purposes All State statutes provide that a corporation may be formed for any lawful purposes. The Revised Act permits a corporation’s articles of incorporation to state a more limited purpose. Many State statutes, but not the RMBCA, require that the articles of incorporation specify the corporation's purposes although they usually permit a general statement that the corporation is formed to engage in any lawful purpose 33-8 ULTRA VIRES ACTS Acts that exceed a corporation’s powers are ultra vires — literally, “beyond the powers.” Nowadays, few corporate acts are ultra vires because modern statutes permit incorporation for any lawful purpose, and most articles of incorporation do not limit corporate powers. 33-8a Effect of Ultra Vires Acts The traditional rule was that ultra vires acts were void. Under the modern approach, courts allow the ultra vires defense where the contract is wholly executory on both sides. 33-8b Remedies for Ultra Vires Acts RMBCA remedy options include; a) injunctive action by shareholder to enjoin an ultra vires act, b) action on behalf of the corporation against officers or directors causing the unauthorized act, and c) a dissolution or injunctive action brought by the Attorney General of the state of incorporation. 33-9 LIABILITY FOR TORTS AND CRIMES Under the doctrine of respondeat superior, a corporation is liable for the torts and crimes committed by its agents in the course of their employment. The doctrine of ultra vires is no defense. A corporation may be criminally liable for violations of statutes imposing liability without fault or for an offense perpetrated by a high corporate officer or its board of directors. Chapter 34 FINANCIAL STRUCTURE Debt Securities Authority to Issue Debt Securities [34-1] Types of Debt Securities [34-2] Unsecured Bonds [34-2a] Secured Bonds [34-2b] Income Bonds [34-2c] Convertible Bonds [34-2d] Callable Bonds [34-2e] Equity Securities Issuance of Shares [34-3] Authority to Issue Shares [34-3a] Preemptive Rights [34-3b] Amount of Consideration for Shares [34-3c] Par Value Stock No Par Value Stock Treasury Stock Payment for Shares [34-3d] Type of Consideration Valuation of Consideration Liability for Shares [34-3e] Classes of Shares [34-4] Common Stock [34-4a] Preferred Stock [34-4b] Dividend Preferences Liquidation Preferences Stock Options [34-4c] Dividends and Other Distributions Types of Dividends and Other Distributions [34-5] Cash Dividends [34-5a] Property Dividends [34-5b] Liquidating Dividends [34-5c] Redemption of Shares [34-5d] Acquisition of Shares [34-5e] Legal Restrictions on Dividends & Other Distributions [34-6] Definitions [34-6a] Legal Restrictions on Cash Dividends [34-6b] Earned Surplus Test Surplus Test Net Assets Test Legal Restrictions on Liquidating Distributions [34-6c] Legal Restrictions on Redemption and Acquisition of Shares [34-6d] Declaration and Payment of Distributions [34-7] Shareholders' Right to Compel a Dividend [34-7a] Effect of Declaration of a Dividend [34-7b] Liability for Improper Dividends & Distributions [34-8] Cases in This Chapter Metropolitan Life Insurance Company v. RJR Nabisco, Inc. Cox Enterprises, Inc v. Pension Benefit Guaranty Corporation. Dodge v. Ford Motor Co. Chapter Outcomes After reading and studying this chapter, the student should be able to: • Distinguish between equity and debt securities. • Identify and describe the principal kinds of debt securities. • Identify and describe the principal kinds of equity securities. • Explain what type and amount of consideration a corporation may validly receive for the shares it issues. • Explain the legal restrictions imposed upon dividends and other distributions. TEACHING NOTES DEBT SECURITIES A debtor-creditor relationship is established by sale of a debt security (or bond). The corporation is the debtor and the creditor is the bondholder. Debt securities require payment of a fixed interest rate by the company. Some states, but not the Revised Act, permit articles of incorporation to confer voting rights on debt security holders; a few states allow other rights to be conferred on bondholders. Sale of debt securities is regulated by state law and the federal Securities Act of 1933. Exemption from regulation under these laws is possible. 34-1 AUTHORITY TO ISSUE DEBT SECURITIES The board of directors retains the power to issue bonds without the authorization of shareholders. 34-2 TYPES OF DEBT SECURITIES Bonds are generally issued pursuant to an agreement, called an indenture, which provides the details. 34-2a Unsecured Bonds Referred to as debentures, and are backed by only the promise of the corporation. As a result, debenture holders are unsecured and will recover their claims on an equal footing with other general creditors. 34-2b Secured Bonds Secured bondholders have a claim to specific corporate property as well as against the general assets of the corporation. 34-2c Income Bonds Generally, income bonds base the interest payment to some extent on the level of corporate earnings. 34-2d Convertible Bonds Typically, debentures that may be exchanged for corporate equity securities. This exchange is made at the bondholder's option and will be at a specified ratio. 34-2e Callable Bonds A redemption provision allows these bonds to be called in for redemption by the issuing corporation and paid prior to the date of maturity at a certain interest rate. CASE 34-1 METROPOLITAN LIFE INSURANCE COMPANY v. RJR NABISCO, INC. United States District Court, S.D. New York, 1989 716 F.Supp. 1504 http://scholar.google.com/scholar_case?case=2457879042014277410&q=716+F.Supp.+1504&hl=en&as_sdt=2,34 Walter, J. Introduction The corporate parties to this action are among the country’s most sophisticated financial institutions, as familiar with the Wall Street investment community and the securities market as American consumers are with j the Oreo cookies and Winston cigarettes made by defendant RJR Nabisco, Inc. (sometimes “the company” or “RJRNabisco”). The present action traces its origins to October 20, 1988, when F. Ross Johnson, then the Chief Executive Officer of RJR Nabisco, proposed a $17 billion leveraged buy-out (“LBO”) of the company’s shareholders, at $75 per share. (Court’s footnote: “A leveraged buy-out occurs when a group of investors, usually including members of a company’s management team, buy the company under financial arrangements that include little equity and significant new debt. The necessary debt financing typically includes mortgages or high risk/high yield bonds, popularly known as “junk bonds.” Additionally, a portion of this debt is generally secured by the company’s assets. Some of the acquired company’s assets are usually sold after the transaction is completed in order to reduce the debt incurred in the acquisition.” [See Chapter 36.]) Within a few days, a bidding war developed among the investment group led by Johnson and the investment firm of Kohlberg Kravis Roberts & Co. (“KKR”), and others. On December 1, 1988, a special committee of RJR Nabisco directors, established by the company specifically to consider the competing proposals, recommended that the company accept the KKR proposal, a $24 billion LBO that called for the purchase of the company’s outstanding stock at roughly $109 per share. * * * Plaintiffs * * * allege, in short, that RJR Nabisco’s actions have drastically impaired the value of bonds previously issued to plaintiffs by, in effect, misappropriating the value of those bonds to help finance the LBO and to distribute an enormous windfall to the company’s shareholders. As a result, plaintiffs argue, they have unfairly suffered a multimillion dollar loss in the value of their bonds. * * * Although the numbers involved in this case are large, and the financing necessary to complete the LBO unprecedented, the legal principles nonetheless remain discrete and familiar. Yet while the instant motions thus primarily require the Court to evaluate and apply traditional rules of equity and contract interpretation, plaintiffs do raise issues of first impression in the context of an LBO. At the heart of the present motions lies plaintiffs’ claim that RJR Nabisco violated a restrictive covenant—not an explicit covenant found within the four corners of the relevant bond indentures, but rather an implied covenant of good faith and fair dealing—not to incur the debt necessary to facilitate the LBO and thereby betray what plaintiffs claim was the fundamental basis of their bargain with the company. The company, plaintiffs assert, consistently reassured its bondholders that it had a “mandate” from its Board of Directors to maintain RJR Nabisco’s preferred credit rating. Plaintiffs ask this Court first to imply a covenant of good faith and fair dealing that would prevent the recent transaction, then to hold that this covenant has been breached, and finally to require RJR Nabisco to redeem their bonds. RJR Nabisco defends the LBO by pointing to express provisions in the bond indentures that * * * permit mergers and the assumption of additional debt. These provisions, as well as others that could have been included but were not, were known to the market and to plaintiffs, sophisticated investors who freely bought the bonds and were equally free to sell them at any time. Any attempt by this Court to create contractual terms post hoc, defendants contend, not only finds no basis in the controlling law and undisputed facts of this case, but also would constitute an impermissible invasion into the free and open operation of the marketplace. For the reasons set forth below, this Court agrees with defendants. There being no express covenant between the parties that would restrict the incurrence of new debt, and no perceived direction to that end from covenants that are express, this Court will not imply a covenant to prevent the recent LBO and thereby create an indenture term that, while bargained for in other contexts, was not bargained for here and was not even within the mutual contemplation of the parties. Background * * * The Parties Metropolitan Life Insurance Co. (“MetLife”), incorporated in New York, is a life insurance company that provides pension benefits for 42 million individuals. According to its most recent annual report, MetLife’s assets exceed $88 billion and its debt securities holdings exceed $49 billion. [Citation.] MetLife alleges that it owns $340,542,000 in principal amount of six separate RJR Nabisco debt issues, bonds allegedly purchased between July 1975 and July 1988. Some bonds become due as early as this year; others will not become due until 2017. The bonds bear interest rates of anywhere from 8 to 10.25 percent. MetLife also owned 186,000 shares of RJR Nabisco common stock at the time this suit was filed. [Citation.] Jefferson—Pilot Life Insurance Co. (“Jefferson—Pilot”) is a North Carolina company that has more than $3 billion in total assets, $1.5 billion of which are invested in debt securities. Jefferson-Pilot alleges that it owns $9.34 million in principal amount of three separate RJR Nabisco debt issues, allegedly purchased between June 1978 and June Those bonds, bearing interest rates of anywhere from 8.45 to 10.75 percent, become due in 1993 and 1998. [Citation.] RJR Nabisco, a Delaware corporation, is a consumer products holding company that owns some of the country’s best known product lines, including LifeSavers candy, Oreo cookies, and Winston cigarettes. The company was formed in 1985, when R.J. Reynolds Industries, Inc. (“R.J. Reynolds”) merged with Nabisco Brands, Inc. (“Nabisco Brands”). In 1979, and thus before the R.J. Reynolds-Nabisco Brands merger, R.J. Reynolds acquired the Del Monte Corporation (“Del Monte”), which distributes canned fruits and vegetables. From January 1987 until February codefendant Johnson served as the company’s CEO. KKR, a private investment firm, organizes funds through which investors provide pools of equity to finance LBOs. [Citation.] The Indentures The bonds implicated by this suit are governed by long, detailed indentures, which in turn are governed by New York contract law. No one disputes that the holders of public bond issues, like plaintiffs here, often enter the market after the indentures have been negotiated and memorialized. Thus, those indentures are often not the product of face-to-face negotiations between the ultimate holders and the issuing company. What remains equally true, however, is that underwriters ordinarily negotiate the terms of the indentures with the issuers. Since the underwriters must then sell or place the bonds, they necessarily negotiate in part with the interests of the buyers in mind. Moreover, these indentures were not secret agreements foisted upon unwitting participants in the bond market. No successive holder is required to accept or to continue to hold the bonds, governed by their accompanying indentures; indeed, plaintiffs readily admit that they could have sold their bonds right up until the announcement of the LBO. [Citation.] Instead, sophisticated investors like plaintiffs are well aware of the indenture terms and, presumably, review them carefully before lending hundreds of millions of dollars to any company. * * * Further, as plaintiffs themselves note, the contracts at issue “[do] not impose debt limits, since debt is assumed to be used for productive purposes.” [Citation.] Discussion * * * The indentures at issue clearly address the eventuality of a merger. They impose certain related restrictions not at issue in this suit, but no restriction that would prevent the recent RJR Nabisco merger transaction. * * * * * * In contracts like bond indentures, “an implied covenant * * * derives its substance directly from the language of the Indenture, and ‘cannot give the holders of Debentures any rights inconsistent with those set out in the Indenture.’ [Where]plaintiffs’ contractual rights [have not been] violated, there can have been no breach of an implied covenant.’ [Citation.] (emphasis added). * * * It is not necessary to decide that indentures like those at issue could never support a finding of additional benefits, under different circumstances with different parties. Rather, for present purposes, it is sufficient to conclude what obligation is not covered, either explicitly or implicitly, by these contracts held by these plaintiffs. Accordingly, this Court holds that the “fruits” of these indentures do not include an implied restrictive covenant that would prevent the incurrence of new debt to facilitate the recent LBO. To hold otherwise would permit these plaintiffs to straight-jacket the company in order to guarantee their investment. These plaintiffs do not invoke an implied covenant of good faith to protect a legitimate, mutually contemplated benefit of the indentures; rather, they seek to have this Court create an additional benefit for which they did not bargain. * * * The sort of unbounded and one-sided elasticity urged by plaintiffs would interfere with and destabilize the market. * * * The Court has no reason to believe that the market, in evaluating bonds such as those at issue here, did not discount for the possibility that any company, even one the size of RJR Nabisco, might engage in an LBO heavily financed by debt. That the bonds did not lose any of their value until the October 20, 1988 announcement of a possible RJR Nabisco LBO only suggests that the market had theretofore evaluated the risks of such a transaction as slight. * * * [Judgment for defendant on count of breach of implied covenant.] *** Chapter Outcomes *** Distinguish between equity and debt securities. Identify and describe the principal kinds of equity securities and debt securities. EQUITY SECURITIES Includes common and preferred stock each of which evidences ownership rights in the corporation. These ownership rights may include the right to: 1) participate in control, 2) participate in earnings, or 3) participate in residual corporate assets upon dissolution. 34-3 ISSUANCE OF SHARES Ownership of shares of stock is the method for determining proportionate ownership of the corporation. The issuance of equity securities is regulated by state law (blue sky laws) and the federal Securities Act of 1933, although exemptions may be available. 34-3a Authority to Issue Shares The articles of incorporation will specify the number and types of shares authorized to be issued. 34-3b Preemptive Rights A shareholder's right to purchase a pro rata share of any additional stock offering in order to prevent his interest from being diluted. This common law right has been modified by some state incorporation statutes which provide that the articles of incorporation may limit preemptive rights. 34-3c Amount of Consideration for Shares Board of Directors usually determine the price for which shares will be issued. Par Value Stock — Par value stock may be issued at a price set by the board or shareholders so long as it is at least par value. This can be an arbitrary value selected by the corporation and may or may not reflect the actual value of the share or the price paid to the corporation. It indicates only the minimum price that the corporation must receive for the share. The RMBCA has eliminated the concept of par value. No Par Value Stock — No par value stock has no minimum stated price and may be sold for any amount set by the board or shareholders. Treasury Stock — Treasury stock is stock that was once issued and outstanding, i.e., the corporation repurchases this stock after issuance. These shares have no voting or preemptive rights and receive no dividends. The RMBCA has eliminated the concept of treasury stock. NOTE: See Figure 34-1: Issuance of Shares *** Chapter Outcome*** Explain what type and amount of consideration a corporation may validly receive for the shares it issues. 34-3d Payment for Shares Type of Consideration — Consideration for issuance of capital stock is defined in a more limited fashion than under contract law. In about 30 states cash, property and services actually rendered are valid consideration, but promissory notes and future services are not. The RMBCA and 20 states permit promises to contribute cash, property or services. Valuation of Consideration — Valuation of the consideration exchanged for shares is the responsibility of the directors. 34-3e Liability for Shares A shareholder is responsible for unpaid consideration for shares that are issued prior to full payment. 34-4 CLASSES OF SHARES 34-4a Common Stock This type of stock has no unique contract rights and common stock-holders generally bear a more significant risk of loss should the corporation fail. Common stockholders share more in the upside if the corporation should prosper. These contract rights must appear in the charter. 34-4b Preferred Stock Although the rights of preferred shareholders are secondary to the creditors of the corporation, they do have dividend and/or liquidation rights superior to those of common stockholders. Dividend Preferences — The board of directors determines whether dividends will be paid. If preferred stock has a dividend preference, holders of this stock will receive full dividends prior to any payment to common shareholders. Cumulative preferred stock requires that any failure to pay a dividend during a certain period will result in the unpaid portion accumulating to a later period. This accumulation must be paid before common stockholders have a right to receive any dividends. Noncumulative preferred stock does not require the accumulation of dividend arrearages. Participating preferred stock gives preferred shareholders not only the right to receive dividends first, but also the right to share in the remaining corporate income with the common shareholders in a specified ratio. Liquidation Preferences — Upon liquidation all stockholders will share pro rata in the assets of the corporation after payment of corporate debt. If a class of stock has a liquidation preference, then the preferred stock holders will be accorded a preference in this distribution process. Additional Rights and Limitations—Preferred stock may have additional rights and/or limitations such as limited voting rights or special convertibility. 34-4c Stock Options A corporation may grant an option or contractual right to purchase additional stock. The board of directors will determine adequacy of consideration as to stock options, and their judgment will be set aside only upon a showing of fraud. NOTE: See Figure 34-2: Debt and Equity Securities. DIVIDENDS AND OTHER DISTRIBUTIONS 34-5 TYPES OF DIVIDENDS & OTHER DISTRIBUTIONS The Revised Act definition of a "distribution": "a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness, by a corporation to or for the benefit of any of its shareholders in respect of any of its shares, whether by dividend or by purchase, redemption or other acquisition of its shares, or otherwise." 34-5a Cash Dividends Most common type; paid at regular intervals from legally available funds. 34-5b Property Dividends A distribution other than cash or stock. 34-5c Stock Dividends Not a distribution, but a “payment” of a ratable amount of additional shares to the current shareholders. This does not change the total assets of the corporation or the shareholder’s relative interest. 34-5d Stock Splits A breaking of the currently held shares into a greater number of shares (usually double). Purpose is to lower the individual stock price and attract new shareholders. Does not change the total assets of the corporation or the shareholder’s relative interest. 34-5e Liquidating Dividends A distribution of capital assets. 34-5f Redemption of Shares An option reserved by a corporation in its charter to buy back its own shares. 34-5g Acquisition of Shares A corporation may purchase its own shares; referred to as treasury shares. 34-6 LEGAL RESTRICTIONS ON DIVIDENDS & OTHER DISTRIBUTIONS Dividends may be paid only if the cash flow and balance sheet tests are satisfied. Insolvency in the equity sense means that a corporation is unable to meet its debts as they come due. All states impose a cash flow test — the equity insolvency test — that prohibits a dividend if it would render the corporation insolvent. In addition, states also impose restrictions on dividends based on the corporation’s balance sheet as follows: 34-6a Definitions Earned surplus: Undistributed net profits, income, gains and losses from the date of incorporation. Surplus: Excess of net assets over stated capital. Net Assets: Total assets less total debts. Stated capital: The consideration received for issued stock other than that allocated to capital surplus. Capital surplus: The entire surplus of a corporation other than earned surplus. NOTE: See Figure 34-3. *** Chapter Outcome*** Explain the legal restrictions imposed upon dividends and other distributions. 34-6b Legal Restrictions on Cash Dividends Earned Surplus Test — Earned surplus that is not reserved or restricted may be paid as dividends. Surplus Test — Dividends may be paid out of earned or capital surplus only. Net Assets Test — Dividends may not be paid if after distribution total liabilities plus liquidation amounts payable to preferred stockholders exceed remaining total assets. This test used by the RMBCA. 34-6c Legal Restrictions on Liquidating Distributions Distributions in partial liquidation from capital surplus usually allowed unless corporation is insolvent. 34-6d Legal Restrictions on Redemption and Acquisition of Shares In most states, redemptions are not permitted if the corporation is insolvent or would be rendered insolvent by the distribution. Reacquisitions are usually subject to the same restrictions as cash dividends. CASE 34-2 COX ENTERPRISES, INC. v. PENSION BENEFIT GUARANTY CORPORATION United States Court of Appeals, Eleventh Circuit, 2012 666 F.3D 697 http://scholar.google.com/scholar_case?q=666+f.3d+697&hl=en&as_sdt=2,34&case=11816251525387610788&scilh=0 Cox, J. Marc L. Davidson, Julia Davidson Truilo, Robert Truilo (the “Davidson Directors”), and the Pension Benefit Guaranty Corporation (“PBGC”) appeal following the district court’s order to distribute all of News-Journal Corporation’s (“News-Journal”) assets to Cox Enterprises, Inc. (“Cox”), a long-time shareholder of the closely-held News-Journal. * * * Cox, a minority shareholder of News-Journal, filed suit in May of 2004 seeking relief for misuse of corporate funds and waste of corporate assets. This suit triggered Florida’s election-to-purchase statute, Fla. Stat. § 607.1436. News-Journal elected to pursue the option created by the statute to repurchase Cox’s shares. Because the parties could not agree on the fair market value of Cox’s shares, the statute required that the district court determine their value. The court set the value of Cox’s shares at $129.2 million and directed the terms of payment in a September 27, 2006 order * * *. Following the dictates of the election-to-purchase statute, the repurchase order dismissed Cox's original complaint for waste of corporate assets. * * * [Between the valuation of Cox’s shares and the court ordered date for payment, News-Journal’s ability to pay diminished significantly. In response, the district court appointed a receiver to manage News-Journal and prepare it for sale. After the sale of News-Journal’s assets, the receiver solicited claims from News-Journal’s various creditors. The district court disposed of these competing claims for News-Journal’s limited assets by ordering the distribution of all the assets to Cox as payment for its shares. PBGC and the Davidson Directors appealed this order, contending that to distribute News-Journal’s assets to Cox (a single News-Journal shareholder) pursuant to the repurchase order would render News-Journal insolvent, and that the distributions-to-shareholders provision of the Florida business corporation statute forbids this payment.] * * * The [Florida] election-to-purchase statute allows a corporation or other shareholders to avoid dissolution by purchasing the shares of the petitioning shareholder who initiated a dissolution proceeding. After a corporation has elected to repurchase all of the shares owned by the petitioning shareholder, the parties may agree upon the value of the shares. [Citation.] If the parties cannot agree on the value, then the court must determine the “fair value” and enter an order detailing the terms for the repurchase fixed by the court. * * * * * * The statute, however, places an important condition on these payments. * * * [P]ayments made pursuant to a repurchase order must comply with Fla. Stat. § 607.06401, which governs the distribution of corporate assets to shareholders. This distributions-to-shareholders statute creates a scheme focused on the corporation’s solvency to evaluate the propriety of distributions to shareholders. It provides in part: No distribution may be made if, after giving it effect: (a) The corporation would not be able to pay its debts as they become due in the usual course of business; or (b) The corporation’s total assets would be less than the sum of its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution. [Citation.] Section 607.06401, by placing restrictions on the distribution of corporate assets, maintains the fundamental tenet of corporate law that creditors’ claims on corporate assets are superior to claims of shareholders. To achieve this, a distribution of corporate assets to a shareholder must not result in the violation of one of these insolvency tests contained in Fla. Stat. § 607.06401(3). The statute also explains when to measure the effect of a distribution; in other words, at what point in time must a distribution pass one of these insolvency tests. It requires: Except as provided in subsection (8), the effect of a distribution under subsection (3) is measured: (a) In the case of distribution by purchase, redemption, or other acquisition of the corporation’s shares, as of the earlier of: 1. The date money or other property is transferred or debt incurred by the corporation, or 2. The date the shareholder ceases to be a shareholder with respect to the acquired shares . . . . Fla. Stat. § 607.06401(6) (emphasis added). The exception contained in § 607.06401(8) contains a different timing provision. It provides, “If the indebtedness is issued as a distribution, each payment of principal or interest is treated as a distribution, the effect of which is measured on the date the payment is actually made.” Fla. Stat. § 607.06401(8) (emphasis added). Thus any payment made pursuant to a repurchase order must satisfy the insolvency test of the distributions-to-shareholders statute judged at the time dictated by the distributions-to-shareholders statute. * * * We hold that any payment to Cox based on the district court’s September 2006 repurchase order must comply with the condition of § 607.1436(8) that the payment satisfy Florida’s distributions-to-shareholders statute. This requires that we consider the application of that statute to this case. As mentioned previously, Florida’s distributions-to-shareholders statute forbids distributions by the corporation to shareholders if those distributions would render the corporation insolvent. The parties here dispute when the court should evaluate News-Journal’s insolvency. Cox asserts that News-Journal’s solvency should be measured as of September 2006 based on § 607.06401(6), which states that the effect of a distribution is generally measured on the date the corporation incurs a debt or the date a shareholder ceases to be a shareholder. [Citation.] PBGC suggests that § 607.06401(8) requires solvency be measured on the date of payment. As we have already highlighted, § 607.06401(6) applies “[e]xcept as provided in subsection (8).” If subsection (8) applies in this case, then PBGC correctly recognizes that the effect of a distribution to Cox is measured on the date of payment. Section 607.06401(8) provides, “If the indebtedness is issued as a distribution, each payment of principal or interest is treated as a distribution, the effect of which is measured on the date the payment is actually made.” Fla. Stat. § 607.06401(8). PBGC contends that the court’s September 2006 repurchase order created an indebtedness by News-Journal to Cox so News-Journal’s solvency should be measured on the date of payment. We agree. * * * Thus, on remand, the district court must consider whether a payment to Cox would comply with the insolvency test of the distributions-to-shareholders statute at the time of payment to Cox. * * * If on remand the district court finds a distribution to Cox would violate this section, News-Journal’s other creditors should receive payment before any distribution is made to Cox. * * * We conclude that the district court misinterpreted Fla. Stat. § 607.1436 and in so doing erred in its order for the distribution of News-Journal’s assets. The district court’s order dated August 13, 2010 is VACATED in its entirety. * * * 34-7 DECLARATION AND PAYMENT OF DISTRIBUTIONS The board of directors has a nondelegable power to declare dividends. 34-7a Shareholders’ Right to Compel a Dividend If directors fail to declare a dividend, a shareholder may bring a suit against them and the corporation to seek a mandatory injunction requiring directors to declare a dividend if: 1) a demand for a distribution is made prior to filing suit, 2) there is available earnings or surplus in the form of cash, 3) the directors refusal to declare a dividend was an unreasonable abuse of discretion the violation of the "business judgment rule". Courts, however, are reluctant to order such an injunction because to do so means substituting the courts’ business judgment for that of the directors elected by the shareholders. However, the following case, decided in 1919, is one instance in which the courts supported shareholders by compelling a dividend. CASE 34-3 DODGE v. FORD MOTOR CO. Supreme Court of Michigan, 1919 204 Mich. 459, 170 N.W. 668 Ostrander, J. [Action in equity by John F. and Horace E. Dodge, plaintiffs, against the Ford Motor Company and its directors to compel the declaration of dividends and for an injunction restraining a contemplated expansion of the business. The complaint was filed in November 1916. Since 1909, the capital stock of the company has been $2,000,000, divided into 20,000 shares of a par value of $100 each, of which plaintiffs held 2,000. As of the close of business on July 31, 1916, the end of the company’s fiscal year, the surplus above capital was $111,960,907.53 and the assets included cash on hand of $52,550,771.92. For a number of years the company had regularly paid quarterly dividends equal to sixty percent annually on the capital stock of $2,000,000. In addition, from December 1911 to October 1915, inclusive, eleven special dividends totaling $41,000,000 had been paid, and in November 1916, after this action was commenced, a special dividend of $2,000,000 was paid. Plaintiffs’ complaint alleged that Henry Ford, president of the company and a member of its board of directors, had declared it to be the settled policy of the company not to pay any special dividends in the future but to put back into the business all future earnings in excess of the regular quarterly dividend. Plaintiffs sought an injunction restraining the carrying out of the alleged declared policy of Henry Ford and a decree requiring the directors to pay a dividend of at least seventy-five percent of the accumulated cash surplus. In December 1917, the trial court entered a decree requiring the directors to declare and pay a dividend of $19,275,385.96 and enjoining the corporation from using its funds for a proposed smelting plant and certain other planned projects. From this decree, defendants have appealed.] * * * The case for plaintiffs must rest upon the claim, and the proof in support of it, that the proposed expansion of the business of the corporation involving the further use of profits as capital, ought to be enjoined because inimical to the best interests of the company and its shareholders, and upon the further claim that in any event the withholding of the special dividend asked for by plaintiffs is arbitrary action of the directors requiring judicial interference. The rule which will govern courts in deciding these questions is not in dispute * * *. In [citation], it is stated: Profits earned by a corporation may be divided among its shareholders; but it is not a violation of the charter if they are allowed to accumulate and remain invested in the company’s business. The managing agents of a corporation are impliedly invested with a discretionary power with regard to the time and manner of distributing its profits. They may apply profits in payment of floating or funded debts, or in development of the company’s business; and so long as they do not abuse their discretionary powers, or violate the company’s charter, the courts cannot interfere. But it is clear that the agents of a corporation, and even the majority, cannot arbitrarily withhold profits earned by the company, or apply them to any use which is not authorized by the company’s charter. The nominal capital of a company does not necessarily limit the scope of its operations; a corporation may borrow money for the purpose of enlarging its business, and in many instances it may use profits for the same purpose * * *. When plaintiffs made their complaint and demand for further dividends the Ford Motor Company had concluded its most prosperous year of business. The demand for its cars at the price of the preceding year continued. It could make and could market in the year beginning August 1, 1916, more than 500,000 cars. Sales of parts and repairs would necessarily increase. The cost of materials was likely to advance, and perhaps the price of labor, but it reasonably might have expected a profit for the year of upwards of $60,000,000. It had assets of more than $132,000,000, a surplus of almost $112,000,000, and its cash on hand and municipal bonds were nearly $54,000,000. Its total liabilities, including capital stock, was a little over $20,000,000. It had declared no special dividend during the business year except the October, 1915, dividend. It had been the practice, under similar circumstances, to declare larger dividends. Considering only these facts, a refusal to declare and pay further dividends appears to be not an exercise of discretion on the part of the directors, but an arbitrary refusal to do what the circumstances required to be done. These facts and others call upon the directors to justify their action, or failure or refusal to act. In justification, the defendants have offered testimony tending to prove, and which does prove, the following facts. It had been the policy of the corporation for a considerable time to annually reduce the selling price of cars, while keeping up, or improving their quality. As early as in June 1915 a general plan for the expansion of the productive capacity of the concern by a practical duplication of its plant had been talked over by the executive officers and directors and agreed upon, not all of the details having been settled and no formal action of directors having been taken. The erection of a smelter was considered, and engineering and other data in connection therewith secured. In consequence, it was determined not to reduce the selling price of cars for the year beginning August 1, 1915, but to maintain the price and to accumulate a large surplus to pay for the proposed expansion of plant and equipment, and perhaps to build a plant for smelting ore. It is hoped, by Mr. Ford, that eventually 1,000,000 cars will be annually produced. The contemplated changes will permit the increased output. The plan, as affecting the profits of the business for the year beginning August 1, 1916, and thereafter, calls for a reduction in the selling price of cars * * *. In short, the plan does not call for and is not intended to produce immediately a more profitable business but a less profitable one; not only less profitable than formerly but less profitable than it is admitted it might be made. The apparent immediate effect will be to diminish the value of shares and the return to shareholders. It is the contention of plaintiffs that the apparent effect of the plan is intended to be the continued and continuing effect of it and that it is deliberately proposed, not of record and not by official corporate declaration, but nevertheless proposed, to continue the corporation henceforth as a semi-eleemosynary institution and not as a business institution. In support of this contention they point to the attitude and to the expressions of Mr. Henry Ford. Mr. Henry Ford is the dominant force in the business of the Ford Motor Company. No plan of operations could be adopted unless he consented, and no board ofdirectors can be elected whom he does not favor. One of the directors of the company has no stock. One share was assigned to him to qualify him for the position, but it is not claimed that he owns it. A business, one of the largest in the world, and one of the most profitable, has been built up. It employs many men, at good pay. “My ambition,” said Mr. Ford, “is to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this we are putting the greatest share of our profits back in the business.” * * * The record, and especially the testimony of Mr. Ford, convinces that he has to some extent the attitude towards shareholders of one who has dispensed and distributed to them large gains and that they should be content to take what he chooses to give. His testimony creates the impression, also, that he thinks the Ford Motor Company has made too much money, has had too large profits, and that although large profits might still be earned, a sharing of them with the public, by reducing the price of the output of the company, ought to be undertaken. We have no doubt that certain sentiments, philanthropic and altruistic, creditable to Mr. Ford, had large influence in determining the policy to be pursued by the Ford Motor Company—the policy which has been herein referred to. * * * These cases, after all, like all others in which the subject is treated, turn finally upon the point, the question, whether it appears that the directors were not acting for the best interest of the corporation * * *. The difference between an incidental humanitarian expenditure of corporate funds for the benefit of the employees, like the building of a hospital for their use and the employment of agencies for the betterment of their condition, and a general purpose and plan to benefit mankind at the expense of others, is obvious * * *. A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end and does not extend to a change in the end itself, to the reduction of profits or to the nondistribution of profits among stockholders in order to devote them to other purposes. * * * We are not, however, persuaded that we should interfere with the proposed expansion of the business of the Ford Motor Company. In view of the fact that the selling price of products may be increased at any time, the ultimate results of the larger business cannot be certainly estimated. The judges are not business experts. It is recognized that plans must often be made for a long future, for expected competition, for a continuing as well as an immediately profitable venture. The experience of the Ford Motor Company is evidence of capable management of its affairs. * * * Defendants say, and it is true, that a considerable cash balance must be at all times carried by such a concern. But, as has been stated, there was a large daily, weekly, monthly, receipt of cash. The output was practically continuous and was continuously, and within a few days, turned into cash. Moreover, the contemplated expenditures were not to be immediately made. The large sum appropriated for the smelter plant was payable over a considerable period of time. So that, without going further, it would appear that, accepting and approving the plan of the directors, it was their duty to distribute on or near the first of August, 1916, a very large sum of money to stockholders. * * * The decree of the court below fixing and determining the specific amount to be distributed to stockholders is affirmed. In other respects, except as to the allowance of costs, the said decree is reversed. 34-7b Effect of Declaration of a Dividend Once lawfully declared, a cash dividend is considered a debt of the corporation which cannot be rescinded without the shareholders' consent. 34-8 LIABILITY FOR IMPROPER DIVIDENDS & DISTRIBUTIONS A director is personally liable to the corporation and its creditors if she votes in favor of a dividend in direct violation of the corporate statute or the articles of incorporation. A director will not be liable for an illegal dividend where he relied in good faith on corporate financial documents. Shareholders receiving an illegal dividend must refund the payment to the corporation, if the dividend resulted from his fraud, if he knew of the illegality, or if the corporation is insolvent. NOTE: See Figure 34:4: Liability for Improper Distributions Instructor Manual for Smith and Robersons Business Law Richard A. Mann, Barry S. Roberts 9781337094757, 9780357364000, 9780538473637

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