Understanding Corporate Entities: Key Concepts & Legal Framework

1. THE CORPORATE FORMMay 30, 2007

2. The Nature of Corporations The basic underpinnings of corporations are the same as those of unincorporated forms of businesses: • Agency law: authority and apparent authority • Fiduciary principles: obligations of constituencies to one another • Contract law: nexus of various contractual relationships

3. CORPORATIONS ARE CREATURES OF STATUTE AND ONE MODEL SAYS THEY ARE A NEXUS OF CONTRACTS

4. They have a “contract” with: • The state of incorporation, which sets the basic parameters of corporate existence • Various other constituencies who have “contract” rights or legally enforceable expectations vis-à-vis the corporation (i.e., shareholders, directors, officers, employees, suppliers, agents)

5. Who are the Corporate Constituencies?

6. Shareholders Advisors Board of Directors Customers Creditors ABC, Inc. Management (CEO, COO, CFO, Secretary, VPs, etc.) Employees Suppliers Other Constituencies, The “Community” Subsidiary

7. When a “corporate lawyer” is engaged, which constituent is his/her client? • The Chief Executive Officer? • The General Counsel? • The Chief Financial Officer? • The Corporation? • The Shareholders? • The Board of Directors?

8. When a corporation engages a lawyer, the corporation is the client This frequently leads to conflicts of both an ethical nature and a personal nature.

9. A Corporation is a Separate Entity A corporation is a statutory entity with its own separate legal status. It is legally distinct from its shareholders, directors, officers, and other constituencies. This is called the corporation’s “entity status.” Note: Remember our study of this concept (versus “aggregate” status) on partnerships?

10. Corporate Characteristics • Limited Liability • Corporation shareholders are not personally liable for corporate obligations • Corporation managers, i.e., officers and directors, are not personally liable for corporate obligations

11. Corporate Characteristics • Free Transferability of Ownership Interests • Corporation stock ownership is freely transferable • Transferability may be limited in certain circumstances • Partnership interests are not, generally, freely transferable

12. Corporate Characteristics • Centralized Management • Corporations are managed under direction and authority of boards of directors • Officers manage day-by-day and report to the board • Shareholders, not management, are ultimate authority

13. Corporate Characteristics • Entity Status • A corporation is a “legal entity” that has rights and powers in its own legal capacity • Owners, i.e., shareholders do not act in the corporate capacity of the corporation

14. Corporate Characteristics • Perpetual Existence Corporations usually have perpetual existence (except for “special purpose vehicles”—SPVs—or “special purpose entities”—SPEs—formed solely for unique transactions of a limited duration)

15. Corporate Characteristics • Double Income Taxation Corporations pay income tax on income of the corporate entity and shareholders pay income tax on dividends they receive from the corporation

16. DISTINCTIONS BETWEEN CHARACTERISTICSOFCORPORATIONS AND PARTNERSHIPS(See Comparison Chart on TWEN)

17. Corporations: Shareholders not personally liable for corporation liabilities Directors and officers not personally liable for corporation liabilities Partnerships: Partners personally liable for partnership liabilities Manager-partners personally liable for partnership liabilities Distinctions from PartnershipsLimited Liability

18. Corporations: Ownership of shares is freely transferable, except in certain circumstances (e.g., “restricted securities,” shareholder agreements) Partnerships: Partnership interests are generally not freely transferable without partners’ consent Distinctions from PartnershipsTransferability of Interests

19. Corporations: The board of directors oversees the affairs of the corporation Officers are day-to-day managers and report to the board Shareholders are the ultimate governing authority Partnerships: Absent agreement to the contrary, partnerships are managed by the partners collectively and the majority vote dictates Distinctions from PartnershipsCentralization of Management

20. Corporations: A corporation is a legal entity that acts in its own legal capacity, e.g., it may hold property, dispose of property, and sue and be sued in its own name Partnerships: Although modern partnerships are entities, an act of a general partner of a partnership is an act of the partnership and vice versa because of personal liability of partners Distinctions from PartnershipsEntity Status

21. Corporations: A corporation usually has perpetual existence Partnerships: Partnerships effectively dissolve on exit of a partner unless 2 or more continue without liquidation or settlement of the business Distinctions from PartnershipsDuration of Existence

22. Corporations: Double taxation of corporate income and shareholder dividend income Partnerships: “Pass-through” taxation to partners of partnership income Distinctions from PartnershipsIncome Taxation

23. Factors in Selecting Business Form • Considerations of • Internal efficiency • Operational cost • Organizational convenience • Limited liability and responsibility of owners for debt and other types of liabilities • Minimization of income tax liability

24. Organizing a Corporation Choice of state of incorporation “Close corporations” almost always incorporate in the state of their principal place of business because of: • Convenience • “Doing business” and “franchise” taxes may overlap and tax savings may result • Local advisers (lawyers, accountants, etc.) are familiar with local and state laws • Intrastate securities offering exemption • No “foreign” corporation registration

25. Organizing a Corporation Choice of state of incorporation Publicly held corporations have other considerations and may or may not incorporate in the state of their PPB. Convenience, immaterial tax savings, and local experts are not as important to them.

26. Organizing a Corporation Choice of state of incorporation Delaware has become, since the 1940s, a preferred incorporation forum because of advantageous management and corporate statutory law. There is also an abundant body of corporate case law. More than half a million business entities are incorporated in Delaware including more than 50% of all U.S. publicly-traded companies and 58% of the Fortune 500. 

27. Organizing a CorporationProcess Select, clear, and reserve corporate name. § 10-2B-4.01, -4.02 Choose 1 or more incorporator(s). § 10-2B-2.01 File articles of incorporation. § 10-2B-2.03

28. Organizing a CorporationProcess Question: What is the legal act of incorporation? The filing of articles of incorporation. See § 10-2B-2.03(a).

29. Organizing a CorporationProcess In organizing a corporation, the fundamental documents include, at a minimum: • Articles of Incorporation • Bylaws • Minutes of an organizational meeting of (1) the incorporators, (2) the subscribers for stock or stockholders, or (3) subsequent to incorporation, the initial directors named in the articles of incorporation

30. Organizing a CorporationProcess Articles of incorporation—10-2B-2.02 The mandatory contents of articles of incorporation are dictated by statute, but additional optional provisions may be added. Need capital structure; agent for service-of-process in Alabama; office street address; initial director(s); corporate purpose(s).

31. Alabama Secretary of State Form Articles STATE OF ALABAMA DOMESTIC FOR-PROFIT CORPORATION ARTICLES OF INCORPORATION GUIDELINES PURSUANT TO THE PROVISIONS OF THE ALABAMA BUSINESS CORPORATION ACT, THE UNDERSIGNED HEREBY ADOPTS THE FOLLOWING ARTICLES OF INCORPORATION.

32. Alabama Secretary of State Form Articles Article I The name of the corporation: Article II The duration of the corporation is “perpetual” unless otherwise stated. Article III The corporation has been organized for the following purpose(s): Article IV The number of shares which the corporation shall have the authority to issue is___________.

33. Alabama Secretary of State Form Articles Article V The street address (NO PO BOX) of the registered office: _______________________ __________________________________________________ and the name of the registered agent at that office: _____________________________________________. Article VI The name(s) and address(es) of the Director(s): Article VII The name(s) and address(es) of the Incorporator(s):

34. Alabama Secretary of State Form Articles Any provision that is not inconsistent with the law for the regulation of the internal affairs of the corporation or for the restriction of the transfer of shares may be added. IN WITNESS THEREOF, the undersigned incorporator executed these Articles of Incorporation on this the ____ day of ___________, 20__. (Signature)

35. Organizing a CorporationProcess Bylaws—Section 10-2B-2.06 (a) The board of directors of a corporation shall adopt initial bylaws for the corporation unless the right to adopt the initial bylaws is reserved to the shareholders in the articles of incorporation. (b) The bylaws of a corporation may contain any provision for managing the business and regulating the affairs of the corporation that is not inconsistent with law or the articles of incorporation.

36. Organizing a CorporationProcess The Bylaws are, essentially, the rules of operating the corporation. However, any provision of the Bylaws that is inconsistent with the Alabama Business Corporations Act or the articles of incorporation is trumped by the ABCA or articles.

37. Organizing a CorporationProcess An organizational meeting of the initial directors typically includes the following business items: • Election of a chairman of the board • Election of officers • Adoption of Bylaws • Fixing number of directors (unless fixed in the articles of incorporation)

38. Organizing a CorporationProcess An organizational meeting of the initial directors typically includes the following business items (continued): • Authorization of issuance of capital stock • Approval of bond • Approval of corporate seal • Authorization of corporate bank accounts • Other business

39. Organizing a CorporationProcess Consequences of defective incorporation may be harsh. In Cantor v. Sunshine Greenery, Inc. (NJ Sup. Ct. 1979), what was the effect to the corporate organizers that the corporation was held to be a de facto corporation?

40. Organizing a CorporationProcess In the event of the absence of a de facto or de jure corporation, a defectively formed corporation is not a corporation. The default form of business organization would be a sole proprietorship or general partnership, resulting in personal liability for the owners.

41. De Jure Corporation We’re talking… de jure (Latin: “by law” or “by right”), not du jour (French: du, “of the” + jour, “day”)

42. Organizing a CorporationProcess A de jure corporation is one that exists as a matter of law by reason of full compliance by incorporators with the requirements of law. A de facto corporation is one that is deemed to exist under color of law, despite omission of an essential element of organization, based on a good faith effort to comply.

43. Organizing a CorporationProcess A fundamental condition precedent to protection of the owners afforded by the de facto incorporation doctrine is a good faith attempt to comply with the incorporation statute.

44. Organizing a CorporationProcess In Cantor, did the organizers evidence a good faith attempt to comply? The act of executing the articles, the bona fide effort to file them, and dealings with plaintiffs in the name of the corporation demonstrated the requisite good faith.

45. Organizing a CorporationProcess Incorporation by estoppel. Based on the theory that those who hold forth an enterprise on the basis that it is a corporation or those who deal with an enterprise as if it were a corporation, knowing otherwise, should, as a matter of equity, be prevented—”estopped”—from treating it as anything else.

46. Organizing a CorporationProcess Black’s Law Dictionary (8th ed. 2004) defines “corporation by estoppel” as “a business that is deemed, by operation of law, to be a corporation because a third party dealt with the business as if it were a corporation, thus preventing the third party from holding a shareholder or officer of the corporation individually liable.” The definition can cut both ways.

47. Liability for Preincorporation Transactions The general rule is that when a promoter makes a contract for the benefit of a corporation that has not yet been organized, the promoter is personally liable on the contract and remains liable after the corporation is organized. Further, the corporation is not liable for the contract after the corporation is organized due to a lack of authority unless the corporation ratifies or adopts the contract or there is a novation of the contract.

48. Liability for Preincorporation Transactions The exception to the general rule that a promoter is liable for preincorporation contracts is that if the party who contracts with the promoter knew that the corporation was not in existence at the time of the contract, and nevertheless agreed to look solely to the corporation for performance, the promoter is not deemed to be a party to the contract and is not liable for it.

49. Ala. Code§ 10-2B-2.04 “Any person purporting to act as or on behalf of a corporation, knowing there was no incorporation under this chapter, is liable for all liabilities created by so acting.” This is a MBCA provision and is consistent with the general rule. However, before the adoption of this statute in 1994, the effect of preincorporation transactions Alabama was left to case-by-case development in the courts.

50. Organizing a CorporationProcess § 10-2B-2.04 does not preclude imposition of liability under the doctrine of de facto corporateness or equitable principles of estoppel. These remedies are equitable in nature and may correct, supplement, or supercede the common and statute law as applied to particular circumstances.