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CHAPTER16.docxCHAPTER 16 Corporations and Corporate Governance
Stock Certificate
Corporations have existed since medieval Europe when individual charters were granted by the ruler, usually a monarch (king or queen). In the United States today, corporations are created by meeting the requirements established by corporation codes. A corporation is owned by its shareholders, who elect members of the board of directors to make policy decisions and who, in turn, employ corporate officers to run the day-to-day operations of the corporation.
Learning Objectives
After studying this chapter, you should be able to:
1. Define corporation and list the major characteristics of a corporation.
2. Describe the process of forming and financing a corporation.
3. Explain the rights, duties, and liability of directors, officers, and shareholders.
4. Describe how the Sarbanes-Oxley Act affects corporate governance.
5. Describe the operation of multinational corporations.
Chapter Outline
1. Introduction to Corporations and Corporate Governance
1. Case 16.1 • Menendez v. O’Niell
1. BUSINESS ENVIRONMENT • S Corporation Election for Federal Tax Purposes
1. BUSINESS ENVIRONMENT • Delaware Corporation Law
5. Shareholders
1. ETHICS • Shareholder Resolutions
1. DIGITAL LAW • Corporate E-Communications
8. Fiduciary Duties of Directors and Officers
1. ETHICS • Sarbanes-Oxley Act Improves Corporate Governance
10. Dissolution of a Corporation
11. Multinational Corporations
1. GLOBAL LAW • Bribes Paid by U.S. Companies in Foreign Countries
“ The biggest corporation, like the humblest private person, must be held to strict compliance with the will of the people.”
—Theodore Roosevelt Speech (1902)
A corporation is an artificial being, invisible, intangible, and existing only in the contemplation of law.
John Marshall, Chief Justice Dartmouth College v. Woodward, 4 Wheaton 518, 636 (1819)
Introduction to Corporations and Corporate Goverance
Corporations are the most dominant form of business organization in the United States, generating more than 85 percent of the country’s gross business receipts. Corporations range in size from one owner to thousands of owners. Owners of corporations are called shareholders. Shareholders are owners of a corporation who elect the board of directorsand vote on fundamental changes in the corporation. The directors are responsible for making policy decisions and employing officers. The officers are responsible for the corporation’s day-to- day operations.
After decades of many financial frauds and scandals involving directors and officers at some of the largest companies in the United States, in 2002 Congress enacted the Sarbanes-Oxley Act (SOX). This federal statute established rules to improve corporate governance, prevent fraud, and add transparency to corporate operations.
The limited liability corporation is the greatest single invention of modern times.
Nicholas Murray Butler
President, Columbia University
This chapter discusses the formation and financing of corporations; the rights, duties, and liability of corporate shareholders, directors, and officers; the rules established by the Sarbanes-Oxley Act; and issues involving corporate governance.
Nature of the Corporation
Corporations can be created only pursuant to the laws of the state of incorporation. These laws—commonly referred to as corporation codes —regulate the formation, operation, and dissolution of corporations. The state legislature may amend its corporate statutes at any time. Such changes may require a corporation’s articles of incorporation to be amended.
corporation codes
State statutes that regulate the formation, operation, and dissolution of corporations.
Revised Model Business Corporation Act (RMBCA)
A 1984 revision of the MBCA that arranges the provisions of the act more logically, revises the language to be more consistent, and makes substantial changes in the provisions.
The Committee on Corporate Laws of the American Bar Association first drafted the Model Business Corporation Act (MBCA) in 1950. The model act was intended to provide a uniform law regulating the formation, operation, and termination of corporations. In 1984, the committee completely revised the MBCA and issued the Revised Model Business Corporation Act (RMBCA) . Certain provisions of the RMBCA have been amended since 1984. Most states have adopted all or part of the RMBCA. The RMBCA serves as the basis for the discussion of corporation law in this text. There is no general federal corporation law governing the formation and operation of private corporations.
The courts interpret state corporation statutes to decide individual corporate and shareholder’s disputes. As a result, a body of common law has evolved concerning corporate and shareholder rights and obligations.
A corporation is a separate legal entity (or legal person) for most purposes. Corporations are treated, in effect, as artificial persons created by the state that can sue or be sued in their own names, enter into and enforce contracts, hold title to and transfer property, and be found civilly and criminally liable for violations of law. Because corporations cannot be put in prison, the normal criminal penalty is the assessment of a fine, loss of a license, or another sanction.
corporation
A fictitious legal entity that is created according to statutory requirements.
They [corporations] cannot commit treason, nor be outlawed, nor excommunicated, for they have no souls.
Lord Edward Coke (1552–1634)
Reports, vol. V, Case of Sutton’s Hospital
Characteristics of a Corporation
Corporations have unique characteristics. Some of the major characteristics of a corporation are as follows:
· Free transferability of shares. Corporate shares are freely transferable by a shareholder by sale, assignment, pledge, or gift unless they are issued pursuant to certain exemptions from securities registration. Shareholders may agree among themselves as to restrictions on the transfer of shares. National securities markets, such as the New York Stock Exchange and NASDAQ, have been developed for the organized sale of securities.
· Perpetual existence. Corporations exist in perpetuity unless a specific duration is stated in a corporation’s articles of incorporation. The existence of a corporation may be voluntarily terminated by the shareholders. The death, insanity, or bankruptcy of a shareholder, a director, or an officer of a corporation does not affect its existence.
· Centralized management. A corporation usually has a centralized management composed of the board of directors and officers of the corporation. The board of directors makes policy decisions concerning the operation of a corporation. The members of the board of directors are elected by the shareholders. The directors, in turn, appoint corporate officers to run the corporation’s day-to-day operations. Together, the directors and officers form the corporate management .
Limited Liability of Shareholders
As separate legal entities, corporations are liable for their own debts and obligations. Generally, the shareholders have only limited liability. The limited liability of shareholders means that they are liable only to the extent of their capital contributions and do not have personal liability for the corporation’s debts and obligations (see Exhibit16.1 ).
limited liability of shareholders
A general rule of corporate law that provides that generally shareholders are liable only to the extent of their capital contributions for the debts and obligations of their corporation and are not personally liable for the debts and obligations of the corporation.
Critical Legal Thinking
1. What does limited liability of shareholders mean? What would be the economic consequences if shareholders were held personally liable for corporate debts and obligations?
Example
Tina, Vivi, and Qixia form IT.com , Inc., a corporation, and each contributes $100,000 capital. The corporation borrows $1 million from State Bank. One year later, IT.com , Inc., goes bankrupt and defaults on the $1 million loan owed to State Bank. At that time, IT.com , Inc.’s only asset is $50,000 cash, which State Bank recovers. Tina, Vivi, and Qixia each lose their $100,000 capital contribution, which IT.com , Inc., has spent. However, Tina, Vivi, and Qixia are not personally liable for the $950,000 still owed to State Bank. State Bank must absorb this loss.
In the following case, the court was asked to decide the liability of a shareholder for a corporation’s debts.
Exhibit 16.1 Corporation
CASE 16.1 STATE COURT CASE Shareholder’s Limited Liability Menendez v. O’Niell
986 So.2d 255 (2008) Court of Appeal of Louisiana
“As a general rule, a corporation is a distinct legal entity, separate from the individuals who comprise them, and individual shareholders are not liable for the debts of the corporation.”
—Welch, Judge
Facts
A vehicle driven by Michael O’Niell crashed while traveling on Louisiana Highway 30. Vanessa Savoy, a 19-year-old guest passenger in the vehicle, sustained severe injuries as a result of the collision. O’Niell, who was under the legal drinking age, had been drinking at Fred’s Bar and Grill prior to the accident. Fred’s Bar is owned by Triumvirate of Baton Rouge, Inc., a corporation. Marc Fraioli is the sole shareholder and president of Triumvirate. Fraioli was not at Fred’s Bar the night that O’Niell was served alcohol at the bar. Savoy, through a legal representative, brought a lawsuit against O’Niell, O’Niell’s automobile insurance company, Triumvirate, and Fraioli, seeking damages for her injuries. Savoy alleged that O’Niell was intoxicated at the time of the accident and that his drinking caused the collision. Savoy alleged that Triumvirate Corporation was liable for serving O’Niell alcohol when he was underage and that Fraioli was liable as the owner of Triumvirate.
Fraioli filed a motion for summary judgment asserting that, as the shareholder of Triumvirate, he was not liable for the corporation’s debts. The trial court granted summary judgment to Fraioli and dismissed him as a defendant in the case. Savoy appealed.
Issue
Is Fraioli personally liable for the debts of Triumvirate, a corporation of which he is the sole shareholder?
Language of the Court
As a general rule, a corporation is a distinct legal entity, separate from the individuals who comprise them, and individual shareholders are not liable for the debts of the corporation. Mr. Fraioli met his burden of proving Triumvirate’s corporate existence. Plaintiff failed to offer any evidence identified by law as indicia that Mr. Fraioli and Triumvirate are not actually separate entities. The involvement of a sole or majority shareholder in a corporation is not sufficient alone, as a matter of law, to establish a basis for disregarding the corporate entity.
Decision
The court of appeal held that Fraioli was not personally liable for the debts of the Triumvirate corporation of which he was the sole shareholder. The court of appeal affirmed the trial court’s grant of summary judgment dismissing Fraioli from the case.
Ethics Questions
1. What reasons could there be for Fraioli to operate his business as a corporation rather than as a sole proprietorship? Was it ethical for Fraioli to assert the corporate shield to avoid liability in this case?
Publicly Held and Closely Held Corporations
Private corporations are formed to conduct privately owned business. They are owned by private parties, not by the government. They range from small one-owner corporations to large multinational corporations such as Microsoft Corporation.
Publicly held corporations are for-profit corporations that have many shareholders. Often, they are large corporations with hundreds or thousands of shareholders, and their shares are usually traded on organized securities markets.
publicly held corporation
A corporation that has many shareholders and whose securities are often traded on national stock exchanges.
Examples
Google, Inc.; Facebook, Inc.; eBay, Inc.; Starbucks Corporation; Apple Computer, Inc.; The Procter & Gamble Company; Wal-Mart Stores, Inc.; Ford Motor Company; and Yahoo!, Inc. are examples of publicly held corporations.
A closely held corporation , or privately held corporation, on the other hand, is a private for-profit corporation whose shares are usually owned by a few shareholders who are often family members, relatives, or friends. However, some privately held companies are large in size, such as S. C. Johnson & Son, Inc. (often referred to as “S. C. Johnson, A Family Company”), which is a global company with more than 10,000 employees.
closely held corporation (privately held corporation)
A corporation owned by one or a few shareholders.
The corporation is, and must be, the creature of the state. Into its nostrils the state must breathe the breath of a fictitious life for otherwise it would be no animated body but individualistic dust.
Frederic William Maitland
Introduction to Gierke, Political Theories of the Middle Ages (1915)
Incorporation Procedure
Corporations are creatures of statute. Thus, the organizers of a corporation must comply with the state’s corporation code to form a corporation. The procedure for incorporating a corporation varies somewhat from state to state. The procedure for incorporating a corporation is discussed in the following paragraphs.
Selecting a State for Incorporating a Corporation
A corporation can be incorporated in only one state, even though it can do business in all other states in which it qualifies to do business. In choosing a state for incorporation, the incorporators, directors, and/or shareholders must consider the corporation law of the states under consideration.
For the sake of convenience, most corporations (particularly small ones) choose the state in which the corporation will be doing most of its business as the state for incorporation. Large corporations generally opt to incorporate in the state with the laws that are most favorable to the corporation’s internal operations (e.g., Delaware).
A corporation is a domestic corporation in the state in which it is incorporated. It is a foreign corporation in all other states and jurisdictions. An alien corporation is a corporation that is incorporated in another country.
domestic corporation
A corporation in the state in which it was formed.
foreign corporation
A corporation in any state or jurisdiction other than the one in which it was formed.
When starting a new corporation, the organizers must choose a name for the entity. The name must contain the words corporation, company, incorporated, or limited or an abbreviation of one of these words (i.e., Corp., Co., Inc., Ltd.). A trademark of the name can be obtained if available and desired. Also, a domain name for use by the corporation on the Internet should also be obtained.
Promoters and Incorporators
A promoter is a person who organizes and starts a corporation, finds the initial investors to finance the corporation, and so on. Promoters sometimes enter into contracts on behalf of a corporation prior to its actual incorporation. Promoters’ contracts include leases, sales contracts, contracts to purchase real or personal property, employment contracts, and the like. Promoters’ liability and the corporation’s liability on promoters’ contracts follow these rules:
promoter
A person or persons who organize and start a corporation, negotiate and enter into contracts in advance of its formation, find the initial investors to finance the corporation, and so forth.
promoters’ contracts
A collective term for items such as leases, sales contracts, contracts to purchase property, and employment contracts entered into by promoters on behalf of the proposed corporation prior to its actual incorporation.
· If the corporation never comes into existence, the promoters have joint personal liability on the contract unless the third party specifically exempts them from such liability.
· If the corporation is formed, it becomes liable on a promoter’s contract only if it agrees to become bound to the contract. A resolution of the board of directors binds the corporation to a promoter’s contract.
· Even if the corporation agrees to be bound to the contract, the promoter remains liable on the contract unless the parties enter into a novation, a three-party agreement in which the corporation agrees to assume the contract liability of the promoter with the consent of the third party. After a novation, the corporation is solely liable on the promoter’s contract.
The parties who sign the articles of incorporation are called incorporators [RMBCA Section 2.01]. Promoters and incorporators often become shareholders, directors, or officers of the corporation.
Articles of Incorporation
The articles of incorporation (or corporate charter) form the basic governing document of a corporation. It must be drafted and filed with, and approved by, the state before the corporation can be officially incorporated. Under the RMBCA, the articles of incorporation must include the following [RMBCA Section 2.02(a)]:
articles of incorporation (corporate charter)
The basic governing documents of a corporation. It must be filed with the secretary of state of the state of incorporation.
· The name of the corporation
· The number of shares the corporation is authorized to issue
· The address of the corporation’s initial registered office and the name of the initial registered agent
· The name and address of each incorporator
WEB EXERCISE
To view the articles of incorporation of Microsoft Corporation, go to http://www.microsoft.com/investor/CorporateGovernance/PoliciesAndGuidelines/articlesincorp.aspx .
The articles of incorporation may also include provisions concerning (1) the period of duration (which may be perpetual), (2) the purpose or purposes for which the corporation is organized, (3) limitation or regulation of the powers of the corporation, (4) regulation of the affairs of the corporation, or (5) any provision that would otherwise be contained in the corporation’s bylaws. Today, corporations most often provide their articles of incorporation online.
Exhibit 16.2 illustrates sample articles of incorporation.
Registered Agent
The articles of incorporation must identify a registered office with a designated registered agent (either an individual or a corporation) in the state of incorporation [RMBCA Section 5.01]. Attorneys often act as the registered agents of corporations. The registered agent is empowered to accept service of process on behalf of the corporation. Service of summons, complaints, and other pleadings to start a lawsuit or legal proceeding against the corporation are served on the registered agent.
registered agent
A person or corporation that is empowered to accept service of process on behalf of a corporation.
bylaws
A detailed set of rules adopted by the board of directors after a corporation is incorporated that contains provisions for managing the business and the affairs of the corporation.
Corporate Bylaws
In addition to the articles of incorporation, corporations are governed by their bylaws . Either the incorporators or the initial directors can adopt the bylaws of the corporation. The bylaws are much more detailed than are the articles of incorporation. Bylaws may contain any provisions for managing the business and affairs of the corporation that are not inconsistent with law or the articles of incorporation [RMBCA Section 2.06]. They do not have to be filed with any government official. Today, corporations most often provide their bylaws online. The bylaws govern the internal management structure of a corporation.
Exhibit 16.2 Articles of Incorporation
WEB EXERCISE
To view the bylaws of Microsoft Corporation, go to www.microsoft.com/investor/CorporateGovernance/PoliciesAndGuidelines/bylaws.aspx .
Examples
Bylaws typically specify the time and place of the annual shareholders’ meeting, how special meetings of shareholders are called, the time and place of annual and monthly meetings of the board of directors, how special meetings of the board of directors are called, the notice required for meetings, the quorum necessary to hold a shareholders’ or board meeting, the required vote necessary to enact a corporate matter, the corporate officers and their duties, the committees of the board of directors and their duties, where the records of the corporation are kept, directors’ and shareholders’ rights to inspect corporate records, the procedure for transferring shares of the corporation, and so on.
The shareholders of a corporation have the absolute right to amend the bylaws, and the board of directors may also usually amend the bylaws [RMBCA Section 10.20]. The bylaws are binding on the directors, officers, and shareholders of the corporation.
The board of directors has the authority to amend the bylaws unless the articles of incorporation reserve that right for the shareholders. The shareholders of the corporation have the absolute right to amend the bylaws even though the board of directors may also amend the bylaws [RMBCA Section 10.20].
Organizational Meeting of the Board of Directors
An organizational meeting of the initial directors of a corporation must be held after the articles of incorporation are filed. At this meeting, the directors must adopt the bylaws, elect corporate officers, and transact such other business as may come before the meeting [RMBCA Section 2.05].
organizational meeting
A meeting that must be held by the initial directors of a corporation after the articles of incorporation are filed.
Examples
Actions taken at the meeting may include accepting share subscriptions, approving the form of the stock certificate, authorizing the issuance of the shares, ratifying or adopting promoters’ contracts, authorizing the reimbursement of promoters’ expenses, selecting a bank, choosing an auditor, forming committees of the board of directors, fixing the salaries of officers, hiring employees, authorizing the filing of applications for government licenses to transact the business of the corporation, and empowering corporate officers to enter into contracts on behalf of the corporation.
The following feature discusses an election that can be made regarding federal tax obligations.
Business Environment S Corporation Election for Federal Tax Purposes
A C corporation is a corporation that does not qualify to or does not elect to be federally taxed as an S corporation. Any corporation with more than 100 shareholders is automatically a C corporation for federal income tax purposes. A C corporation must pay federal income tax at the corporate level. In addition, if a C corporation distributes its profits to shareholders in the form of dividends, the shareholders must pay personal income tax on the dividends. With a C corporation, there is double taxation , that is, one tax paid at the corporate level and another paid at the shareholder level.
C Corporation
A C corporation is a corporation that does not qualify for or has not elected to be taxed as an S corporation. Where there is a C corporation, there is double taxation; that is, a C corporation pays taxes at the corporate level, and shareholders pay taxes on dividends paid by the corporation.
equity securities (stocks)
Representation of ownership rights to a corporation.
Congress enacted the Subchapter S Revision Act to allow the shareholders of some corporations to avoid double taxation by electing Subchapter S corporation status. 1 If a corporation elects to be taxed as an S corporation , it pays no federal income tax at the corporate level. As in a partnership, the corporation’s income or loss flows to the shareholders’ individual income tax returns. Shareholders pay the tax on the corporation’s profits, even if the income is not distributed. Subchapter S election only affects the taxation of a corporation; it does not affect attributes of corporate form, including limited liability.
Corporations that meet the following criteria can elect to be taxed as S corporations:
· The corporation must be a domestic corporation.
· The corporation cannot be a member of an affiliated group of corporations.
· The corporation can have no more than 100 shareholders.
· Shareholders must be individuals, estates, or certain trusts. Corporations and partnerships cannot be shareholders.
· Shareholders must be citizens or residents of the United States. Nonresident aliens cannot be shareholders.
· The corporation cannot have more than one class of stock. Shareholders do not have to have equal voting rights.
An S corporation election is made by filing Form 2553 with the Internal Revenue Service (IRS). The election can be rescinded by shareholders who collectively own at least a majority of the shares of the corporation. If the election is rescinded, however, another S corporation election cannot be made for five years.
Bottom of Form
Financing the Corporation
A corporation needs to finance the operation of its business. The most common way to do this is by selling equity securities and debt securities. Equity securities (or stocks) represent ownership rights in the corporation. Equity securities can be common stock and preferred stock. These are discussed in the following paragraphs.
S Corporation
A corporation that has met certain requirements and has elected to be taxed as an S corporation for federal income tax purposes. An S corporation pays no federal income tax at the corporate level. The S corporation’s income or loss flows to the shareholders and must be reported on the shareholders’ individual income tax returns.
Common Stock
Common stock is an equity security that represents the residual value of a corporation. Common stock has no preferences. That is, creditors and preferred shareholders must receive their required interest and dividend payments before common shareholders receive anything. Common stock does not have a fixed maturity date. If a corporation is liquidated. the creditors and preferred shareholders are paid the value of their interests first, and the common shareholders are paid the value of their interests (if any) last. Corporations may issue different classes of common stock [RMBCA Sections 6.01(a), 6.01(b)].
common stock
A type of equity security that represents the residual value of a corporation.
Persons who own common stock are called common stockholders . Common stockholders are issued common stock certificates to show evidence of their ownership interest in the corporation. However, electronic registration of common stockholder ownership interests is supplanting paper stock certificates. Corporations are no longer required by law to issue paper certificates, and many do not.
common stockholder
A person who owns common stock.
Common stockholders have the right to elect directors and to vote on mergers and other important matters. In return for their investment, common stockholders receive dividends declared by the board of directors.
Preferred Stock
Preferred stock is an equity security that is given certain preferences and rights over common stock [RMBCA Section 6.01(c)]. The owners of preferred stock are called preferred stockholders . Preferred stockholders are issued preferred stock certificates to show evidence of their ownership interest in the corporation. Electronic registration of preferred stockholder ownership interests is supplanting paper stock certificates.
preferred stock
A type of equity security that is given certain preferences and rights over common stock.
preferred stockholder
A person who owns preferred stock.
Preferred stock can be issued in classes or series. One class of preferred stock can be given preference over another class of preferred stock. Like common stockholders, preferred stockholders have limited liability. Preferred stockholders generally are not given the right to vote for the election of directors, or the like. However, they are often given the right to vote if there is a merger or if the corporation has not made the required dividend payments for a certain period of time (e.g., three years).
Preferences of preferred stock must be set forth in the articles of incorporation. Preferred stock may have any or all of the following preferences:
dividend preference
The right to receive a fixed dividend at stipulated periods during the year (e.g., quarterly).
liquidation preference
The right to be paid a stated dollar amount if a corporation is dissolved and liquidated.
· Dividend preference. A dividend preference is the right to receive a fixed dividend at set periods during the year (e.g., quarterly). The dividend rate is usually a set percentage of the initial offering price.
Example
A stockholder purchases $10,000 of a preferred stock that pays an 8 percent dividend annually. The stockholder has the right to receive $800 each year as a dividend on the preferred stock.
· Liquidation preference. The right to be paid before common stockholders if the corporation is dissolved and liquidated is called a liquidation preference . A liquidation preference is normally a stated dollar amount.
Example
A corporation issues a preferred stock that has a liquidation preference of $200. This means that, if the corporation is dissolved and liquidated, the holder of each preferred share will receive at least $200 before the common shareholders receive anything. Note that because the corporation must pay its creditors first, there may be insufficient funds to pay this preference.
· Cumulative dividend right. Corporations must pay a preferred dividend if they have the earnings to do so. Sometimes, however, corporations are not able to pay preferred stock dividends when due. Cumulative preferred stock provides that any missed dividend payment must be paid in the future to the preferred shareholders before the common shareholders can receive any dividends. The amount of unpaid cumulative dividends is called dividend arrearages . Usually, arrearages can be accumulated for only a limited period of time (e.g., three years).
With noncumulative preferred stock , there is no right of accumulation. In other words, the corporation does not have to pay any missed dividends.
Example
The WindSock Corporation issues cumulative preferred stock that requires the payment of a quarterly dividend of $1.00 per share. The WindSock Corporation falls behind with six quarterly payments—$6.00 per share of preferred stock. The next quarter, the corporation makes a profit of $7.00 per share. The corporation must pay the $6.00 per share of arrearages to the preferred shareholders plus this quarter’s payment of $1.00 per share. Thus, the common shareholders receive nothing.
· Right to participate in profits. Participating preferred stock allows a preferred stockholder to participate in the profits of the corporation along with the common stockholders. Participation is in addition to the fixed dividend paid on preferred stock. The terms of participation vary widely. Usually, the common stockholders must be paid a certain amount of dividends before participation is allowed. Nonparticipating preferred stock does not give the holder a right to participate in the profits of the corporation beyond the fixed dividend rate. Most preferred stock falls into this category.
· Conversion right. Convertible preferred stock permits the preferred stockholders to convert their shares into common stock. The terms and exchange rate of the conversion are established when the shares are issued. The holders of convertible preferred stock usually exercise this option if the corporation’s common stock significantly increases in value. Preferred stock that does not have a conversion feature is called nonconvertible preferred stock . Nonconvertible stock is more common than convertible stock.
cumulative preferred stock
Stock for which any missed dividend payments must be paid in the future to the preferred shareholders before the common shareholders can receive any dividends.
participating preferred stock
Stock that allows the preferred stockholder to participate in the profits of the corporation along with the common stockholders.
convertible preferred stock
Stock that permits the preferred stockholders to convert their shares into common stock.
Redeemable Preferred Stock
Redeemable preferred stock (or callable preferred stock) permits a corporation to redeem (i.e., buy back) the preferred stock at some future date. The terms of the redemption are established when the shares are issued. Corporations usually redeem the shares when the current interest rate falls below the dividend rate of the preferred shares. Preferred stock that is not redeemable is called nonredeemable preferred stock . Nonredeemable stock is more common than redeemable stock.
redeemable preferred stock (callable preferred stock)
Stock that permits a corporation to buy back the preferred stock at some future date.
authorized shares
The number of shares provided for in the articles of incorporation.
issued shares
Authorized shares that have been sold by a corporation.
Authorized, Issued, and Outstanding Shares
The number of shares provided for in the articles of incorporation is called authorized shares [RMBCA Section 6.01]. The shareholders may vote to amend the articles of incorporation to increase this amount. Authorized shares that have been sold by the corporation are called issued shares . Not all authorized shares have to be issued at the same time. Authorized shares that have not been issued are called unissued shares . The board of directors can vote to issue unissued shares at any time without shareholder approval.
unissued shares
Authorized shares that have not been sold by the corporation.
A corporation is permitted to repurchase its shares [RMBCA Section 6.31]. Repurchased shares are commonly called treasury shares . Treasury shares cannot be voted by the corporation, and dividends are not paid on these shares. Treasury shares can be reissued by the corporation. The shares that are in shareholder hands, whether originally issued or reissued treasury shares, are called outstanding shares . Only outstanding shares have the right to vote [RMBCA Section 6.03].
outstanding shares
Shares that are in shareholder hands, whether originally issued shares or reissued treasury shares. Only outstanding shares have the right to vote.
CONCEPT SUMMARY Types of Shares
|
Type of Share |
Description |
|
Authorized |
Shares authorized in the corporation’s articles of incorporation. |
|
Issued |
Shares sold by the corporation. |
|
Treasury |
Shares repurchased by the corporation. These shares do not have the right to vote. |
|
Outstanding |
Issued shares minus treasury shares. These shares have the right to vote. |
Debt Securities
A corporation often raises funds by issuing debt securities [RMBCA Section 3.02(7)]. Debt securities (also called fixed income securities) establish a debtor–creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued. The corporation promises to pay interest on the amount borrowed and to repay the principal at some stated maturity date in the future. The corporation is the debtor, and the holder is the creditor. Three classifications of debt securities are as follows:
· Debenture. A debenture is a long-term (often 30 years or more), unsecured debt instrument that is based on a corporation’s general credit standing. If the corporation encounters financial difficulty, unsecured debenture holders are treated as general creditors of the corporation (i.e., they are paid only after the secured creditors’ claims are paid).
· Bond. A bond is a long-term debt security that is secured by some form of collateral (e.g., real estate, personal property). Thus, bonds are the same as debentures except that they are secured. Secured bondholders can foreclose on the collateral in the event of nonpayment of interest, principal, or other specified events.
· Note. A note is a short-term debt security with a maturity of five years or less. Notes can be either unsecuredor secured. They usually do not contain a conversion feature. They are sometimes made redeemable.
debt securities (fixed income securities)
Securities that establish a debtor–creditor relationship in which the corporation borrows money from the investor to whom a debt security is issued.
debenture
A long-term unsecured debt instrument that is based on a corporation’s general credit standing.
bond
A long-term debt security that is secured by some form of collateral.
note
A debt security with a maturity of five years or less.
indenture agreement (indenture)
A contract between a corporation and a holder that contains the terms of a debt security.
Indenture Agreement
The terms of a debt security are commonly contained in a contract between the corporation and the holder; this contract is known as an indenture agreement (or simply an indenture). The indenture generally contains the maturity date of the debt security, the required interest payment, the collateral (if any), rights to conversion into common or preferred stock, call provisions, any restrictions on the corporation’s right to incur other indebtedness, the rights of holders upon default, and so on. It also establishes the rights and duties of the indenture trustee. Generally, a trustee is appointed to represent the interest of the debt security holders. Bank trust departments often serve in this capacity.
The following feature discusses why the state of Delaware attracts corporate formations.
Business Environment Delaware Corporation Law
The state of Delaware is the corporate haven of the United States. More than 50 percent of the publicly traded corporations in the United States, including 60 percent of the Fortune 500 companies, are incorporated in Delaware. In total, more than 500,000 business corporations are incorporated in Delaware. But why?
Remember that the state in which a corporation is incorporated determines the law that applies to the corporation: The corporation code of the state of incorporation applies to details such as election of directors, requirements for a merger to occur, laws for fending off corporate raiders, and so on. Even if a corporation does no business in Delaware, it can obtain the benefits of Delaware corporation law by incorporating in Delaware.
On the legislative side, Delaware has enacted the Delaware General Corporation Law . This law is the most advanced corporation law in the country, and the statute is particularly written to be of benefit to large corporations. For example, the Delaware corporation code provides for corporations incorporated in Delaware to adopt so-called poison pills, which make it difficult for another company to take over a Delaware corporation unless the board of directors of the target corporation agrees and removes such poison pills. In addition, the legislature keeps amending the corporation code as the demands of big business warrant or need such changes. For instance, the legislature has enacted a state antitakeover statute that makes it difficult to take over a Delaware corporation unless the corporation’s directors waive the state’s antitakeover law and agree to be taken over.
On the judicial side, Delaware has a special court—the court of chancery —that hears and decides business cases. This court has been around for more than 200 years. In that time, it has interpreted Delaware corporation law favorably for large corporations in matters such as electing corporate boards of directors, eliminating negligence liability of outside directors, upholding the antitakeover provisions of the Delaware corporation code, and so on. In addition, there are no emotional juries to worry about. The decisions of the chancery court are made by judges who are experts at deciding corporate law disputes. The court is known for issuing decisions favorable to large corporations because the court applies Delaware corporation law to decide disputes. Appeals from the court of chancery are brought directly to the supreme court of Delaware. Thus, Delaware courts have created a body of precedent of legal decisions that provides more assurance to Delaware corporations in trying to decide whether they will be sued and what the outcome will be if they are sued.
The state of Delaware makes a substantial sum of money each year on fees charged to corporations incorporated within the state. Delaware is the “business state,” providing advanced corporate laws and an expert judiciary for deciding corporate disputes.
Critical Legal Thinking
1. Why does Delaware provide corporation-friendly state laws? Should corporations be permitted to “shop” for the best state corporation laws?
Shareholders
A corporation’s shareholders own the corporation (see Exhibit 16.3 ). Nevertheless, they are not agents of the corporation (i.e., they cannot bind the corporation to contracts), and the only management duty they have is the right to vote on matters such as the election of directors and the approval of fundamental changes in the corporation.
Shareholders’ Meetings
Annual shareholders’ meetings are held to elect directors, choose independent auditors, and take other actions. These meetings must be held at the times fixed in the bylaws [RMBCA Section 7.01]. Special shareholders’ meetings may be called by the board of directors, the holders of at least 10 percent of the voting shares of the corporation, or any other person authorized to do so by the articles of incorporation or bylaws (e.g., the president) [RMBCA Section 7.02]. Special meetings may be held to consider important or emergency issues, such as a merger or consolidation of the corporation with one or more other corporations, the removal of directors, amendment of the articles of incorporation, or dissolution of the corporation. A corporation is required to give the shareholders written notice of the place, day, and time of annual and special meetings.
shareholders
Owners of a corporation who elect the board of directors and vote on fundamental changes in the corporation.
Exhibit 16.3 Shareholders of a Corporation
annual shareholders’ meeting
A meeting of the shareholders of a corporation that must be held by the corporation to elect directors and to vote on other matters.
special shareholders’ meetings
Meetings of shareholders that may be called to consider and vote on important or emergency issues, such as a proposed merger or amending the articles of incorporation.
Shareholders do not have to attend a shareholders’ meeting to vote. Shareholders may vote by proxy; that is, they can appoint another person (the proxy) as their agent to vote at a shareholders’ meeting. The proxy may be directed exactly how to vote the shares or may be authorized to vote the shares at his or her discretion. Proxies may be in writing or posted online. The written document itself is called the proxy (or proxy card). Unless otherwise stated, a proxy is valid for 11 months [RMBCA Section 7.22].
proxy
A shareholder’s authorizing of another person to vote the shareholder’s shares at the shareholders’ meetings in the event of the shareholder’s absence.
Quorum and Vote Required
Unless otherwise provided in the articles of incorporation, if a majority of shares entitled to vote are represented at a meeting in person or by proxy, there is a quorum to hold the meeting. Once a quorum is present, the withdrawal of shares does not affect the quorum of the meeting [RMBCA Sections 7.25(a), 7.25(b)]. The affirmative vote of the majority of the voting shares represented at a shareholders’ meeting constitutes an act of the shareholders for actions other than for the election of directors [RMBCA Section 7.25(c)].
quorum to hold a meeting of the shareholders
The required number of shares that must be represented in person or by proxy to hold a shareholders’ meeting. The RMBCA establishes a majority of outstanding shares as a quorum.
Example
A corporation has 20,000 shares outstanding. A shareholders’ meeting is duly called to amend the articles of incorporation, and 10,001 shares are represented at the meeting. A quorum is present because a majority of the shares entitled to vote are represented. Suppose that 5,001 shares are voted in favor of the amendment. The amendment passes. In this example, just over 25 percent of the shares of the corporation bind the other shareholders to the action taken at the shareholders’ meeting.
The articles of incorporation or the bylaws of a corporation can require a greater than majority of the shares to constitute a quorum of the vote of the shareholders [RMBCA Section 7.27]. This is called a supramajority voting requirement (or supermajority voting requirement). Such votes are often required to approve mergers, consolidation, the sale of substantially all the assets of a corporation, and so on.
supramajority voting requirement (supermajority voting requirement)
A requirement that a greater than majority of shares constitutes a quorum of the vote of the shareholders.
Straight Versus Cumulative Voting
Unless otherwise required by a corporation’s articles of incorporation, or by corporate law, voting for the election of directors is by the straight voting (noncumulative voting) method. This voting method is quite simple: Each shareholder votes the number of shares he or she owns for candidates for each of the positions open for election. Thus, a majority shareholder can elect the entire board of directors.
straight voting (noncumulative voting)
A system in which each shareholder votes the number of shares he or she owns on candidates for each of the positions open.
Example
A corporation has 10,000 outstanding shares. Erin owns 5,100 shares (51 percent), and Michael owns 4,900 shares (49 percent). Suppose that three directors of the corporation are to be elected from a potential pool of 10 candidates. Erin casts 5,100 votes for each of her three chosen candidates. Michael casts 4,900 votes for each of his three chosen candidates, who are different from those favored by Erin. Each of the three candidates whom Erin voted for wins, with 5,100 votes each.
A corporation’s articles of incorporation may provide for, or corporate law may require, cumulative voting for the election of directors. This means that each shareholder is entitled to multiply the number of shares he or she owns by the number of directors to be elected and cast the accumulative number for a single candidate or distribute the product among two or more candidates [RMBCA Section 7.28]. Cumulative voting gives a minority shareholder a better opportunity to elect someone to the board of directors.
cumulative voting
A system in which a shareholder can accumulate all of his or her votes and vote them all for one candidate or split them among several candidates.
Example
Suppose Lisa owns 1,000 shares of a corporation. Assume that four directors are to be elected to the board. With cumulative voting, Lisa can multiply the number of shares she owns (1,000) by the number of directors to be elected (four). She can cast all the resulting votes (4,000) for one candidate or split them among candidates as she determines.
Dividends
Profit corporations operate to make a profit. The objective of the shareholders is to share in those profits, either through capital appreciation, the receipt of dividends, or both. Dividends are paid at the discretion of the board of directors [RMBCA Section 6.40]. The directors may opt to retain the profits in the corporation to be used for corporate purposes instead of as dividends. Once declared, a cash or property dividend cannot be revoked. Shareholders can sue to recover declared but unpaid dividends.
dividend
A distribution of profits of the corporation to shareholders.
Piercing the Corporate Veil
Shareholders of a corporation generally have limited liability (i.e., they are liable for the debts and obligations of the corporation only to the extent of their capital contribution), and they are not personally liable for the debts and obligations of the corporation. However, if a shareholder or shareholders dominate a corporation and misuse it for improper purposes, a court of equity can disregard the corporate entity and hold the shareholders of the corporation personally liable for the corporation’s debts and obligations. This doctrine is commonly referred to as piercing the corporate veil . It is often resorted to by unpaid creditors who are trying to collect from shareholders a debt owed by the corporation. The piercing the corporate veil doctrine is also called the alter ego doctrine because the corporation becomes the alter ego of the shareholder or shareholders.
piercing the corporate veil (alter ego doctrine)
A doctrine that says if a shareholder dominates a corporation and uses it for improper purposes, a court of equity can disregard the corporate entity and hold the shareholder personally liable for the corporation’s debts and obligations.
board of directors
A panel of persons who are elected by the shareholders that make policy decisions concerning the operation of a corporation.
Courts will pierce the corporate veil if (1) the corporation has been formed without sufficient capital (i.e., thin capitalization) or (2) separateness has not been maintained between the corporation and its shareholders (e.g., commingling of personal and corporate assets, failure to hold required shareholders’ meetings, failure to maintain corporate records and books). The courts examine this doctrine on a case-by-case basis.
The following ethics feature examines the ability of shareholders to propose shareholder resolutions.
Ethics Shareholder Resolutions
At times, shareholders may wish to submit issues for a vote to other shareholders. The Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) rules permit a shareholder to submit a resolution to be considered by other shareholders if (1) the shareholder has owned at least $2,000 worth of shares of the company’s stock or 1 percent of all shares of the company (2) for at least one year prior to submitting the proposal. The resolution cannot exceed 500 words. Such shareholder resolutions are usually made when the corporation is soliciting proxies from its shareholders.
shareholder resolution
A resolution that a shareholder who meets certain ownership requirements may submit to other shareholders for a vote. Many shareholder resolutions concern social issues.
If management does not oppose a resolution, it may be included in the proxy materials issued by the corporation. Even if management is not in favor of a resolution, a shareholder has a right to have the shareholder resolution included in the corporation’s proxy materials if it (1) relates to the corporation’s business, (2) concerns a policy issue (and not the day-to-day operations of the corporation), and (3) does not concern the payment of dividends. The SEC rules on whether a resolution can be submitted to shareholders.
Examples
Shareholder resolutions have been presented concerning protecting the environment; reducing global warming; preventing the overcutting of the rain forests in Brazil; prohibiting U.S. corporations from purchasing goods manufactured in developing countries under poor working conditions, including the use of forced and child labor; protecting human rights; and engaging in socially responsible conduct.
Most shareholder resolutions have a slim chance of being enacted because large-scale investors usually support management; however, they can cause a corporation to change the way it does business. For example, to avoid the adverse publicity such issues can create, some corporations voluntarily adopt the changes contained in shareholder resolutions. Others negotiate settlements with the sponsors of resolutions to get the measures off the agenda before the annual shareholders’ meetings.
Ethics Questions
1. Why do companies usually not support shareholder resolutions? Does the threat of shareholder resolutions make companies act more socially responsible?
Board of Directors
The board of directors of a corporation is elected by the shareholders of the corporation. The board of directors is responsible for formulating policy decisions that affect the management, supervision, control, and operation of the corporation (see Exhibit 16.4 ) [RMBCA Section 8.01]. Such policy decisions include deciding the business or businesses in which the corporation should be engaged, selecting and removing the top officers of the corporation, and determining the capital structure of the corporation.
Boards of directors are typically composed of inside and outside directors. An inside director is a person who is also an officer of the corporation. An outside director is a person who sits on the board of directors of a corporation but is not an officer of that corporation. Outside directors are often selected for their business knowledge and expertise.
Exhibit 16.4 Board of Directors
inside director
A member of the board of directors who is also an officer of the corporation.
outside director
A member of a board of directors who is not an officer of the corporation.
Examples
The president of a corporation who also sits as a director of the corporation is an inside director. Outside directors are often officers and directors of other corporations, bankers, lawyers, professors, and so on.
The director is really a watch-dog, and the watch-dog has no right, without the knowledge of his master, to take a sop from a possible wolf.
Lord Justice Bowen
Re The North Australian Territory Co. Ltd. (1891)
Meetings and Resolutions of the Board of Directors
Regular meetings of a board of directors are held at the times and places established in the bylaws. A board can call special meetings of the board of directors as provided in the bylaws [RMBCA Section 8.20(a)]. Special meetings are usually convened for reasons such as issuing new shares, considering proposals to merge with other corporations, adopting maneuvers to defend against hostile takeover attempts, and the like. The board of directors may act without a meeting if all the directors sign written consents that set forth the actions taken. The RMBCA permits meetings of the board to be held via conference calls [RMBCA Section 8.20(b)].
A simple majority of the number of directors established in the articles of incorporation or bylaws usually constitute a quorum for transacting business. However, the articles of incorporation and the bylaws may increase this number. If a quorum is present, the approval or disapproval of a majority of the quorum binds the entire board. The articles of incorporation or the bylaws can require a greater than majority of directors to constitute a quorum of the vote of the board [RMBCA Section 8.24].
The board of directors authorizes actions to be taken on behalf of the corporation by adopting resolutions at board of directors’ meetings. The resolution is put forward by a member of the board, usually seconded by another board member, and then put to the vote of the entire board of directors. Resolutions usually pass, but some resolutions do not. Corporate resolutions are recorded in the written minutes of the board of directors’ meetings and specify the action taken by the board of directors. Resolutions can be adopted for many subjects that affect the corporation.
resolution
A vote taken by the board of directors of a corporation that authorizes certain actions to be taken on behalf of the corporation.
Examples
Resolutions taken by the board of directors can include authorizing the corporation to enter into contracts and leases, employ an accountant or other professionals, appoint a new officer, declare a dividend, authorize entering into a banking relationship, and issue shares of stock.
The board may initiate certain actions that require shareholders’ approval. These actions are initiated when the board of directors adopts a resolution that approves a transaction and recommends that it be submitted to the shareholders for a vote.
Examples
Transactions approved by the board of directors that require shareholder vote include mergers, sale of substantially all of the corporation’s assets outside the course of ordinary business operations, amending the articles of incorporation, and the voluntary dissolution of the corporation.
The following feature discusses how modern corporation codes authorize electronic corporations.
Digital Law Corporate E-Communications
Most state corporation codes have been amended to permit the use of corporate electronic communications (corporate e-communications) by corporations to communicate to shareholders, among directors, with regulatory agencies, and others. For example, the Delaware General Corporation Law recognizes the following uses of electronic technology:
· Delivery of notices to shareholders may be made electronically if the shareholder consents to the delivery of notices in this form.
· Proxy solicitation for shareholder votes may be made by electronic transmission.
· The list of shareholders of a corporation that must be made available during the 10 days prior to a shareholders’ meeting may be made available either at the principal place of business of the corporation or by posting the list on an electronic network.
· Shareholders who are not physically present at a meeting may be deemed present, participate in, and vote at the meeting by electronic communication; a meeting may be held solely by electronic communication, without a physical location.
· The election of directors of the corporation may be held by electronic transmission.
· Directors’ actions by unanimous consent may be taken by electronic transmission.
The use of electronic transmissions, electronic networks, and communications by e-mail make the operation and administration of corporate affairs more efficient.
Corporate Officers
A corporation’s board of directors has the authority to appoint the officers of the corporation. The corporate officersare elected by the board of directors at such time and by such manner as prescribed in the corporation’s bylaws. The directors can delegate certain management authority to the officers of the corporation (see Exhibit 16.5 ).
corporate officers
Employees of a corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation.
Exhibit 16.5 Corporate Officers
At a minimum, most corporations have the following officers: a president, one or more vice presidents, a secretary, and a treasurer. The bylaws or the board of directors can authorize duly appointed officers the power to appoint assistant officers. The same individual may simultaneously hold more than one office in the corporation [RMBCA Section 8.40]. The duties of each officer are specified in the bylaws of the corporation.
Officers and agents of a corporation have such authority as may be provided in the bylaws of the corporation or and as determined by resolution of the board of directors [RMBCA Section 8.41]. Because they are agents, officers have the express authority granted to them, as well as implied authority and apparent authority, to bind a corporation to contracts.
The law does not permit the stockholders to create a sterilized board of directors.
Justice Collins
Manson v. Curtis (1918)
CONCEPT SUMMARY Management of a Corporation
|
Group |
Function |
|
Shareholders |
Owners of the corporation. They vote on the directors and other major actions to be taken by the corporation. |
|
Board of directors |
Elected by the shareholders. Directors are responsible for making policy decisions and employing the major officers for the corporation. The board may initiate certain actions that require shareholders’ approval. |
|
Officers |
Officers are responsible for the day-to-day operation of the corporation, including acting as agents for the corporation, and hiring other officers and employees. |
Fiduciary Duties of Directors and Officers
Directors and officers of a corporation owe fiduciary duties of trust and competence to the corporation and its shareholders. These duties include the (1) duty of loyalty and (2) the duty of care. These fiduciary duties are discussed in the following paragraphs.
fiduciary duties
The duties of obedience, care, and loyalty owed by directors and officers to their corporation and its shareholders.
Duty of Loyalty
Directors and officers of a corporation owe a fiduciary duty to act honestly. This duty, called the duty of loyalty , requires directors and officers to subordinate their personal interests to those of the corporation and its shareholders. If a director or an officer breaches his or her duty of loyalty and makes a profit or gain on a transaction, the corporation can sue the director or officer to recover the profit or gain.
duty of loyalty
A duty that directors and officers have not to act adversely to the interests of the corporation and to subordinate their personal interests to those of the corporation and its shareholders.
Some of the most common breaches of the duty of loyalty are (1) usurping a corporate opportunity (taking a corporate opportunity for oneself), (2) undisclosed and unauthorized competing with the corporation , (3) undisclosed and unauthorized self-dealing (e.g., selling property to the corporation), and (4) making a secret profit (e.g., taking a bribe).
Duty of Care
The duty of care requires corporate directors and officers to use care and diligence when acting on behalf of the corporation. To meet this duty of care, the directors and officers must discharge their duties (1) in good faith, (2) with the care that an ordinary prudent person in a like position would use under similar circumstances, and (3) in a manner they reasonably believe to be in the best interests of the corporation [RMBCA Sections 8.30(a), 8.42(a)].
duty of care
A duty of corporate directors and officers to use care and diligence when acting on behalf of the corporation.
A director or an officer who breaches the duty of care is personally liable to the corporation and its shareholders for any damages caused by the breach. Such breaches, which are normally caused by negligence , often involve a director’s or an officer’s failure to keep adequately informed about corporate affairs.
negligence
Failure of a corporate director or officer to exercise the duty of care while conducting the corporation’s business.
Critical Legal Thinking
1. Explain the business judgment rule. What would be the consequences if this rule were not recognized by the law?
Business Judgment Rule
The determination of whether a corporate director or officer has met his or her duty of care is measured as of the time the decision is made; the benefit of hindsight is not a factor. Therefore, the directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment. This is called the business judgment rule . Were it not for the protection afforded by the business judgment rule, many high-risk but socially desirable endeavors might not be undertaken.
business judgment rule
A rule that says directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment.
Example
After conducting considerable research and investigation, the directors of a major automobile company decide to produce large and expensive sport-utility vehicles (SUVs). Three years later, when the SUVs are introduced to the public for sale, few of them are sold because of the public’s interest in buying smaller, less expensive automobiles due to an economic recession and an increase in gasoline prices. Because this was an honest mistake of judgment on the part of corporate management, their judgment is shielded by the business judgment rule.
Sarbanes-Oxley Act
The Sarbanes-Oxley Act, a federal statute, improves corporate transparency, imposes rules for the governance of public corporations, and promotes corporate ethics.
Sarbanes-Oxley Act
During the late 1990s and early 2000s, the U.S. economy was wracked by a number of business and accounting scandals. Companies such as Enron, Tyco, and WorldCom engaged in fraudulent conduct, leading to many corporate officers being convicted of financial crimes. Many of these companies went bankrupt, causing huge losses to their shareholders, employees, and creditors. Boards of directors were complacent and not keeping a watchful eye over the conduct of their officers and employees.
In response, Congress enacted the federal Sarbanes-Oxley Act (SOX) of 2002 . 2 The act establishes far-reaching rules regarding corporate governance. The goals of the Sarbanes-Oxley Act are to improve corporate governance rules, eliminate conflicts of interest, and instill confidence in investors and the public that management will run public companies in the best interests of all constituents.
Sarbanes-Oxley Act (SOX) of 2002
A federal statute that establishes rules to improve corporate governance, prevent fraud, and add transparency to corporate operations.
WEB EXERCISE
Go to http://www.microsoft.com/investor/CorporateGovernance/BoardOfDirectors/Contacts/MSFinanceCode.aspx and read the Microsoft Finance Code of Professional Conduct adopted pursuant to the Sarbanes-Oxley Act.
Even after the passage of the Sarbanes-Oxley Act, some major corporations and banks either were found guilty of fraud, pleaded guilty, or settled charges of alleged fraud. These include AIG, JP Morgan Chase, UBS, Wells Fargo Bank, and Bank of America Corporation.
The following ethics feature discusses some of the major provisions of the Sarbanes-Oxley Act that regulate corporate governance.
Ethics Sarbanes-Oxley Act Improves Corporate Governance
The Sarbanes-Oxley Act is a federal statute that has changed the rules of corporate governance in important respects. Several major provisions of the act regarding corporate governance are discussed in the following list:
· CEO and CFO certification. The CEO and chief financial officer (CFO) of a public company must file a statement accompanying each annual and quarterly report called the CEO and CFO certification . This statement certifies that the signing officer has reviewed the report; that, based on the officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact that would make the statement misleading; and that the financial statement and disclosures fairly present, in all material aspects, the operation and financial condition of the company. A knowing and willful violation is punishable by up to 20 years in prison and a monetary fine.
· Reimbursement of bonuses and incentive pay. If a public company is required to restate its financial statements because of material noncompliance with financial reporting requirements, the CEO and CFO must reimburse the company for any bonuses, incentive pay, or securities trading profits made because of the noncompliance.
· Prohibition on personal loans. The act prohibits public companies from making personal loans to their directors or executive officers.
· Penalties for tampering with evidence. The act makes it a crime for any person to alter, destroy, mutilate, conceal, or create knowingly any document to impair, impede, influence, or obstruct any federal investigation. A violation is punishable by up to 20 years in prison and a monetary fine.
· Bar from acting as an officer or a director. The Securities and Exchange Commission (SEC), a federal government agency, may issue an order prohibiting any person who has committed securities fraud from acting as an officer or a director of a public company.
Although the Sarbanes-Oxley Act applies only to public companies, private companies and nonprofit organizations are also influenced by the act’s accounting and corporate governance rules.
Ethics Questions
1. Will the CEO and CFO certification requirement reduce corporate fraudulent conduct? Will the Sarbanes-Oxley Act promote more ethical behavior from corporate officers and directors?
Dissolution of a Corporation
The life of a corporation may be dissolved voluntarily by the owners or involuntarily by the state. The methods for dissolving corporations are as follows:
voluntary dissolution
Dissolution of a corporation that has begun business or issued shares upon recommendation of the board of directors and a majority vote of the shares entitled to vote.
· Voluntary dissolution. A corporation can be voluntarily dissolved. If the corporation has not commenced business or issued any shares, it may be dissolved by a vote of the majority of the incorporators or initial directors [RMBCA Section 14.01]. After that, the corporation can be voluntarily dissolved if the board of directors recommends dissolution and a majority of shares entitled to vote (or a greater number, if required by the articles of incorporation or bylaws) votes for dissolution as well [RMBCA Section 14.02]. For a voluntary dissolution to be effective, articles of dissolution must be filed with the secretary of state of the state of incorporation. A corporation is dissolved upon the effective date of the articles of dissolution [RMBCA Section 14.03].
· Administrative dissolution. The secretary of state can obtain administrative dissolution of a corporation if (1) it failed to file an annual report, (2) it failed for 60 days to maintain a registered agent in the state, (3) it failed for 60 days after a change of its registered agent to file a statement of such change with the secretary of state, (4) it did not pay its franchise fee, or (5) the period of duration stated in the corporation’s articles of incorporation has expired [RMBCA Section 14.20]. If the corporation does not cure the default within 60 days of being notified of it, the secretary of state issues a certificate of dissolution that dissolves the corporation [RMBCA Section 14.21].
· Judicial dissolution. A corporation can be involuntarily dissolved by a judicial proceeding. Judicial dissolution can be instituted by the attorney general of the state of incorporation if the corporation (1) procured its articles of incorporation through fraud or (2) exceeded or abused the authority conferred on it by law [RMBCA Section 14.30(1)]. If a court dissolves a corporation, the court enters a decree of dissolution that specifies the date of dissolution [RMBCA Section 14.33].
administrative dissolution
Involuntary dissolution of a corporation that is ordered by the secretary of state if a corporation has failed to comply with certain procedures required by law.
judicial dissolution
Dissolution of a corporation through a court proceeding instituted by the state.
Winding up, Liquidation, and Termination
A dissolved corporation continues its corporate existence but may not carry on any business except as required to wind up and liquidate its business and affairs [RMBCA Section 14.05]. In a voluntary dissolution, the liquidation is usually carried out by the board of directors. If the dissolution is involuntary or the dissolution is voluntary but the directors refuse to carry out the liquidation, a court-appointed receiver carries out the winding up and liquidation of the corporation [RMBCA Section 14.32].
winding up and liquidation
The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to creditors, preferred shareholders, and common shareholders.
Termination occurs only after the winding up of the corporation’s affairs, the liquidation of its assets, and the distribution of the proceeds to the claimants. The liquidated assets are paid to claimants according to the following priority: (1) expenses of liquidation and creditors according to their respective liens and contract rights, (2) preferred shareholders according to their liquidation preferences and contract rights, and (3) common stockholders.
termination
The end of a corporation that occurs after winding up the corporation’s affairs, liquidating its assets, and distributing the proceeds and property to the claimants.
Hong Kong
Hong Kong is one of the world’s greatest banking centers. Hong Kong is home to large domestic banks and offices of foreign banks from around the world. Banks in Hong Kong provide a wide range of financial services, including retail banking, deposit taking, trade financing, interbank wholesale transfer, and foreign exchange.
Multinational Corporations
Many of the largest corporations in the world are multinational corporations —that is, corporations that operate in many countries. These corporations are also called transnational corporations. Multinational corporations operate in other countries through a variety of means, including the use of agents, branch offices, subsidiary corporations, business alliances, strategic partnerships, franchising, and other arrangements.
multinational corporation (transnational corporation)
A corporation that operates in more than one country.
Many multinational corporations conduct business in another country by using an international subsidiary corporation . The subsidiary corporation is organized under the laws of the foreign country. The parent corporation usually owns all or the majority of the subsidiary corporation (see Exhibit 16.6 ).
Exhibit 16.6 International Subsidiary Corporation
Examples
Toyota Motor Corporation is based in Japan, and Ford Motor Company is headquartered in the United States; each of these companies owns subsidiary corporations that manufacture and sell automobiles and other vehicles around the world. Citigroup Inc. (“Citi”) operates banking and financial services subsidiaries worldwide.
A subsidiary corporation is a separate legal entity. Therefore, the parent corporation is not liable for the contracts of or torts committed by the subsidiary corporation. There is a liability shield between the parent corporation and the subsidiary corporation.
Example
Suppose American Motor Company, a U.S. corporation incorporated under the laws of Delaware, forms a subsidiary corporation called American-India Corporation, an Indian corporation formed under the laws of India, to sell automobiles in India. American Motor Company is the parent corporation, and American-India Corporation is the subsidiary corporation. If an employee of American-India Corporation negligently injures an Indian citizen while on a test drive, only American-India Corporation is liable; American Motor Company in the United States is not liable aside from the fact that it may lose its capital contribution in American-India Corporation.
Global Law Bribes Paid by U.S. Companies in Foreign Countries
Oil Tanker
It is well known that the payment of bribes is pervasive in conducting international business. To prevent U.S. companies from engaging in this type of conduct, the U.S. Congress enacted the Foreign Corrupt Practices Act (FCPA) . 3 The FCPA makes it illegal for U.S. companies, or their officers, directors, agents, or employees, to bribe a foreign official, a foreign political party official, or a candidate for foreign political office. A bribe is illegal only where it is meant to influence the awarding of new business or the retention of continuing business activity.
