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Chapter 22 Corporations: Formation and Organization 22 -1 Chapter 22 Corporations: Formation and Organization 22 -1

Chapter 22 Case Hypothetical Phoebe Main and Franklin Kilbride, best friends, love to cook. Chapter 22 Case Hypothetical Phoebe Main and Franklin Kilbride, best friends, love to cook. The two are so inseparable that some time ago, those who knew them began to jokingly refer to Phoebe and Franklin as “Ma and Pa. ” One of their kitchen concoctions, kettle corn, became so popular (Phoebe and Franklin loved to share their caloric creations) that others have encouraged them go into business and sell their kettle corn as a product. Phoebe and Franklin agree. They have decided to form a traditional corporation as co-owners, and they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc. In the articles of incorporation (the document Phoebe and Franklin will send to the Kansas Secretary of State’s office for approval of corporate status), the two are required to indicate the total number of stock shares the company is authorized to issue. “Ma and Pa” are perplexed. Both have always considered themselves “good with numbers, ” but they cannot decide what number of shares of stock to indicate in the articles of incorporation. What is your recommendation to Phoebe Main and Franklin Kilbride? (Access the video clip at http: //video. google. com/videoplay? docid=7106559846794044495# to see part of the inspiration for this case study!) 22 -2

Chapter 22 Case Hypothetical and Ethical Dilemma Clyde Monett has been operating an art Chapter 22 Case Hypothetical and Ethical Dilemma Clyde Monett has been operating an art restoration business since 1998, specializing in the refurbishment of portraits and paintings. He operated the enterprise as a sole proprietorship (called Monett’s Art Restoration Services) until 2006, when he attended a “Business Structures, Licenses and Permits” workshop at the local community college, at which time the presenting attorney suggested he convert his business to a corporation, in order to “shield” Monett’s personal property and real estate from liability for his business’ financial obligations (Monett’s personal net worth is approximately $150, 000. ) Through the incorporation process, the only change to the business name was the addition of the word “Incorporated. ” Monett was the only incorporator of the business. He serves as the president, vice-president and treasurer of the corporation; his sister, Georgette O’Keeffe, is the secretary. Since the corporation was formed in 2006, Clyde and Georgette have only convened one “official” corporate meeting; the meeting lasted approximately one hour, and the two shared family gossip forty-five minutes of that hour. Monett’s Art Restoration Services, Incorporated has maintained an average daily balance of $45. 22 in the corporate checking account at Homeland National Bank. Yesterday, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning solution was too acidic, ) and the oversight resulted in irreparable damage to a painting conservatively valued at $75, 000. The owner of the painting, Paul Picasso, demands $75, 000 in damages from Monett; Monett apologizes, offers two free coupons for future restoration services, and refuses to pay the $75, 000. The current corporate checking account balance is $52. 84. Is Clyde Monett personally liable for the $75, 000 damage claim? Is he ethically obligated to pay Paul $75, 000? 22 -3

Chapter 22 Case Hypothetical and Ethical Dilemma Zaxxon-Mobile Oil Company, Inc. , headquartered in Chapter 22 Case Hypothetical and Ethical Dilemma Zaxxon-Mobile Oil Company, Inc. , headquartered in Mobile, Alabama, is a multinational corporation with 2009 annual profits of $45 billion. Zaxxon-Mobile has twelve (12) board members who serve the company on a part-time basis, with each board member receiving an average of $300, 000 per year in compensation. Emily D. Chanel, a pre-law student at The University of Alabama at Mobile, is very familiar with Zaxxon-Mobile Oil Company, Inc. , and she has studied her business law textbook material on corporations and their directors, officers and shareholders very carefully. She recalls that the board of directors and its members owe a strict fiduciary duty to the corporation; as part of this fiduciary duty, the board must exercise oversight in monitoring the actions of corporate employees, including the executives and officers of the corporation. Emily ponders, “How can board members of a major corporation be truly objective when they are being paid such lavish sums of money? Would not board members have a “Don’t rock the boat” mentality in terms of exercising their oversight function? Why, for example, would a Zaxxon-Mobile board member question the practices of the company’s high-ranking executives and officers, when such an inquiry might jeopardize his or her $300, 000 per year annual compensation? ‘Make no bones about it, ’ if I were a board member at Zaxxon. Mobile, I would probably be a ‘yes-woman” and approve of everything the chief executive officer, the chief financial officer and the chief operating officer wanted to do!” How do you respond to Emily D. Chanel’s questions and overall concerns about board member compensation and objectivity? 22 -4

Chapter 22 Case Hypothetical and Ethical Dilemma Dr. Charles Finnegan is a newly-appointed member Chapter 22 Case Hypothetical and Ethical Dilemma Dr. Charles Finnegan is a newly-appointed member of the Board of Directors of Walnut Grove Community College (W. G. C. C. ) in Walnut Grove, California. The position is unpaid, but does come with the “perks” of positive exposure and prestige in the local community. At his first board meeting, the directors are discussing and considering for approval service contracts between W. G. C. C. and the local business community. The third contract for consideration is a janitorial service contract, valued at $150, 000, between W. G. C. C. and Antiseptic Andy Cleaning Service, Inc. Finnegan is quite surprised; after all, “Antiseptic Andy” is owned and operated by his first cousin, Andrew Deere. Cousins Finnegan and Deere have not seen each other in three years, nor have they otherwise communicated during that period of time. The chairperson of the Board of Directors calls for a vote on the janitorial service contract. According to W. G. C. C. regulations, the board must unanimously approve contracts with the business community. Finnegan is perplexed. If he votes and says nothing about his kinship to Deere, he still feels he can “sleep at night, ” since he will not receive any financial gain from the contract. If he discloses his kinship to Deere, he fears that Deere’s business opportunity will be jeopardized. Does Finnegan have a legal obligation to disclose his relationship to Deere? Would it be a “conflict of interest” for Finnegan to vote in favor of the contract? Does he have an ethical obligation to disclose the relationship? 22 -5

Characteristics of Corporations • Legal entity • Rights as person and citizen • Creature Characteristics of Corporations • Legal entity • Rights as person and citizen • Creature of state • Limited liability of shareholders • Unrestricted transferability of corporate shares • Perpetual existence • Centralized management • Corporate taxation • Liability for Officers and Employees 22 -6

Corporate Powers • Corporations have both “express” and “implied” powers -Express Powers: Perpetual existence; Corporate Powers • Corporations have both “express” and “implied” powers -Express Powers: Perpetual existence; right to litigate; right to make contracts; right to borrow/loan money; right to make charitable donations; ability to establish rules for managing corporation -Implied Powers: Whatever actions necessary (within the law) to execute express powers • “Ultra Vires” Act: Corporate action beyond scope of corporation’s authority (i. e. , beyond its express and implied powers) 22 -7

Classifications of Corporations • Public/Private • For-Profit/Non-Profit • Domestic/Foreign/Alien • Publicly Held/Closely Held • Classifications of Corporations • Public/Private • For-Profit/Non-Profit • Domestic/Foreign/Alien • Publicly Held/Closely Held • S-Corporation • Professional Corporation 22 -8

Public Versus Private Corporation • Public Corporation: Corporation created by government to administer law, Public Versus Private Corporation • Public Corporation: Corporation created by government to administer law, with specific government duties to fulfill -Example: Federal Deposit Insurance Corporation (FDIC) • Private Corporation: Corporation created for private purposes 22 -9

For-Profit Versus Non-Profit Corporations • For-Profit Corporation: Objective is to operate for profit; shareholders For-Profit Versus Non-Profit Corporations • For-Profit Corporation: Objective is to operate for profit; shareholders seeking to make profit purchase stock these corporations issue • Non-Profit Corporation: May earn profits, but they do not distribute these profits to shareholders (non-profit corporation does not issue stock, nor does it have shareholders); instead, corporation reinvests profits in business 22 -10

Domestic, Foreign, and Alien Corporations • Domestic Corporation: Doing business within state of incorporation Domestic, Foreign, and Alien Corporations • Domestic Corporation: Doing business within state of incorporation • Foreign Corporation: Doing business in states other than state of incorporation • Alien Corporation: Doing business country other than country of incorporation 22 -11

Publicly Held Versus Closely Held Corporation • Publicly Held Corporation: -Stock available to public Publicly Held Versus Closely Held Corporation • Publicly Held Corporation: -Stock available to public • Closely Held Corporation (a. k. a. “Close”, “Family”, “Privately Held” Corporation): -Generally does not offer stock to public 22 -12

“Subchapter S” Corporation • Named after provision of Internal Revenue Service (IRS) code that “Subchapter S” Corporation • Named after provision of Internal Revenue Service (IRS) code that provides for it • Particular type of closely held corporation (no more than one hundred shareholders) • Combines advantages of limited liability and single taxation 22 -13

Formation of Corporation • Promoters organize corporate formation • Subscribers offer to purchase stock Formation of Corporation • Promoters organize corporate formation • Subscribers offer to purchase stock in corporation in formation process • State selected for incorporation 22 -14

Questions to Consider in Selecting a State For Incorporation • How much flexibility does Questions to Consider in Selecting a State For Incorporation • How much flexibility does the state grant to corporate management? • What rights do state statutes give to shareholders? • What restrictions does the state place on the distribution of dividends? • Does the state offer any kind of protection against takeovers? 22 -15

Legal Process of Incorporation • Selection of corporate name • Drafting and filing articles Legal Process of Incorporation • Selection of corporate name • Drafting and filing articles of incorporation • First organizational meeting held 22 -16

Remedies For Defective Incorporation: • “De jure” corporation: Lawful corporation that has met the Remedies For Defective Incorporation: • “De jure” corporation: Lawful corporation that has met the substantial elements of incorporation process • “De facto” corporation: Corporation that has not met the requirements of state incorporation statute, but courts recognize it as a corporation for most purposes to avoid unfairness to third parties who reasonably believed it was properly incorporated • Corporation by estoppel: Corporation prevented by court from denying its corporate status • Piercing corporate veil: Shareholders personally liable when they have used corporation to engage in illegal/wrongful acts 22 -17

Situations When Courts Likely To Pierce Corporate Veil • Corporation lacked adequate capital when Situations When Courts Likely To Pierce Corporate Veil • Corporation lacked adequate capital when initially formed • Corporation did not follow statutory mandates regarding corporate business • Shareholders’ personal interests and corporate interests are commingled (corporation has no separate identity) • Shareholders attempt to commit fraud through corporation 22 -18

Debt Securities Versus Equity Securities • Debt Securities: Bonds (representing loans to corporation from Debt Securities Versus Equity Securities • Debt Securities: Bonds (representing loans to corporation from another party) • Equity Securities: Stock 22 -19

Equity Securities: Preferred Stock Versus Common Stock • Preferred Stock: Stockholder enjoys preferences regarding Equity Securities: Preferred Stock Versus Common Stock • Preferred Stock: Stockholder enjoys preferences regarding assets and dividends • Common Stock: Stockholder owns portion of corporation, but no preferences regarding assets and dividends 22 -20

Corporate Directors, Officers, and Shareholders 22 -21 Corporate Directors, Officers, and Shareholders 22 -21

Summary of Roles of Directors, Officers, and Shareholders • Directors-- • • • Officers-- Summary of Roles of Directors, Officers, and Shareholders • Directors-- • • • Officers-- • • • Shareholders-- • • Vote on important corporate decisions Appoint and supervise officers Make financial decisions Manage corporation Run “day-to-day” business of firm Agents of corporation Elect board of directors Approve major corporate decisions 22 -22

Fiduciary Duties Definition: Duties to corporation that individuals within corporation have Primary fiduciary duties Fiduciary Duties Definition: Duties to corporation that individuals within corporation have Primary fiduciary duties include: • Duty of Care • Duty of Loyalty • Duty to Disclose Conflict of Interest 22 -23

Business Judgment Rule Definition: Provides that directors and officers are not liable for decisions Business Judgment Rule Definition: Provides that directors and officers are not liable for decisions that harm corporation if they were acting in good faith at time of decision 22 -24

Corporations: Directors, Officers, and Shareholders--Other Relevant Terminology • Stock-Subscription Agreement: Contractually obliges individual to Corporations: Directors, Officers, and Shareholders--Other Relevant Terminology • Stock-Subscription Agreement: Contractually obliges individual to buy shares in corporation • Par-Value Shares: Fixed face value noted on stock certificate • No-Par Shares: Stock shares without a par value • Watered Stock: Stock issued to individuals at a value below fair market value. • Pre-emptive Rights: Preferential rights given to existing shareholders to purchase shares of new stock issue; preference given in proportion to percentage of stock shareholder already owns 22 -25

Corporations: Directors, Officers, and Shareholders-Other Relevant Terminology (Continued): • Stock Warrants: Vouchers issued to Corporations: Directors, Officers, and Shareholders-Other Relevant Terminology (Continued): • Stock Warrants: Vouchers issued to shareholders, entitling them to given number of shares at specified price • Inspection Rights: Protect shareholders’ interests by giving them right to inspect corporation’s books and records after asking in advance to inspect and having proper purpose • Right of First Refusal: Given to existing shareholders to purchase any shares of stock offered for resale by shareholder within specified period of time • Shareholder’s Derivative Suit: Filed by corporate shareholder when corporate directors fail to sue in situation where corporation has been harmed by individual/another corporation 22 -26

Summary of Rights of Directors, Officers, and Shareholders • Directors-- • • Right to Summary of Rights of Directors, Officers, and Shareholders • Directors-- • • Right to Compensation Right to Participation Right to Inspection Right to Indemnification • Officers-- • Rights determined in employment contract • Shareholders-- • • Stock certificates Preemptive rights Right to Dividends Right to Transfer Shares Inspection Rights Right to Corporate Dissolution Right to File Derivative Suit Right to File Direct Suit 22 -27

Mergers and Consolidations 22 -28 Mergers and Consolidations 22 -28

Merger Definition: A legal contract combining two or more corporations such that only one Merger Definition: A legal contract combining two or more corporations such that only one of the corporations continues to exist; in essence, one corporation “absorbs” another corporation 22 -29

Consolidation Definition: A legal contract combining two or more corporations, resulting in an entirely Consolidation Definition: A legal contract combining two or more corporations, resulting in an entirely new corporation; in consolidation, neither of the original corporations continues to exist 22 -30

Procedures for Mergers and Consolidations • Boards of directors of all involved corporations must Procedures for Mergers and Consolidations • Boards of directors of all involved corporations must approve the plan • Shareholders must approve the plan through a vote at a shareholder meeting • The corporations must submit their plan to the secretary of state • The state must review the plan, and if it satisfies legal requirements, grant an approval certificate 22 -31

Other Terminology/Rights Regarding Mergers and Consolidations • Short-form merger (Parent-subsidiary merger): Parent corporation merges Other Terminology/Rights Regarding Mergers and Consolidations • Short-form merger (Parent-subsidiary merger): Parent corporation merges with a subsidiary corporation; does not require shareholder approval • Rights of shareholders: Shareholders vote only on exceptional matters regarding the corporation • Appraisal right: Shareholder’s right to have his/her shares appraised, and to receive monetary compensation for their value 22 -32

“Hostile” Takeover Definition: A takeover to which management of the target corporation objects 22 “Hostile” Takeover Definition: A takeover to which management of the target corporation objects 22 -33

Types of Takeovers • Tender Offer: Aggressor (acquiring corporation) offers target shareholders a price Types of Takeovers • Tender Offer: Aggressor (acquiring corporation) offers target shareholders a price above current market value of their stock • Exchange Tender Offer: Aggressor offers to exchange target shareholders’ current stock for stock in aggressor’s corporation • Cash Tender Offer: Aggressor offers target shareholders cash for their stock 22 -34

Leveraged Buyout Definition: Occurs when group within a corporation (usually management) buys all outstanding Leveraged Buyout Definition: Occurs when group within a corporation (usually management) buys all outstanding corporate stock held by the public; group gains control over corporate operations by “going private” (i. e. , becoming a privately-held corporation) 22 -35

“Legal Death” of Corporation Occurs in two phases: • Dissolution: Legal termination of corporation “Legal Death” of Corporation Occurs in two phases: • Dissolution: Legal termination of corporation • Liquidation: Process by which trustee converts corporation’s assets into cash, and distributes them among corporation’s creditors and shareholders 22 -36

Voluntary Versus Involuntary Dissolution • Voluntary Dissolution: Occurs when directors or shareholders initiate the Voluntary Versus Involuntary Dissolution • Voluntary Dissolution: Occurs when directors or shareholders initiate the dissolution process • Involuntary Dissolution: State government forces the corporation to close 22 -37