Week Eleven: Limiting Liability. Corporations

Review: Partnerships

Advantages:

Disadvantages

In the last 60 years or so, venture organizers have tried to develop legal structures that would have the advantages of partnership without the disadvantages.

Chapter 35: Limited Partnerships

Concept: the money partner/silent partner. LP's provide p'ship equity and share in profits without taking part in management If statutory formalities observed, then LP's liability for p'ship obligations is limited to the capital they invested or committed to invest.

Who typically needs limited partnership protection? What is the price of that protection?

Note: must be at least 1 general (i.e. generally liable) partner in a Ltd. P'ship

Formation

Registration with secretary of state's office. A LPship is *much* more formal than a GPship, in order to put creditors on notice who stands or doesn't stand behind p'ship debts

Traditionally, couldn't use name of LPtr in that of the LP'ship -- to do so could lead Cr's to think that LPtr stood behind p'ship committments. CA now allows name use -- idea is seeing "L.P." after the entity name puts creditors on inquiry notice

Defective formation

If procedure defective, so that a 3rd party believes in good faith that someone is a GP, then they are liable as such, even if they intended to be an LP

Oops!

LP's can cure by promptly filing new/amended certificate or renouncing their interest

Limited liability means limited participation

LP's can't "participate in control of the business" -- they'll lose the limitation

CA Revised Act allows LP to be officer/agent of the GP, to consult w/ the GP, to make loans, to vote on certain matters without being liable as a GP

Problem had been that LP's who tried to stop a crooked or incompetent GP were taking on liability exposure to 3rds

Do-it-yourself solution was a "dummy" corporation as the general partner -- LLC's now are usually a better solution

LP's in practice

Heavily tax-influenced due to pass-thru characteristics

LP's were the favored way to to raise capital during the tax shelter boom of 1970's and 1980's, and to pass-thru the tax attributes of leveraged depreciable assets. Promoters went far beyond the classic P'ship model, creating partnerships with thousands of partners and publicly traded partnerships

Publicly traded now are taxed like corps, w/ a few still "grandfathered". Here's one of them. And this is what the investors have to cope with at tax time.

Ltd Liab Pships

Chapter 39: Limited Liability Companies

New form of organization: last 20 years. Completely statutory

See Corps Code Sec. 17000 and following

A LLC is a separate legal entity, created by filing of articles of organization w/ CA Sec. of State

"Members" own the capital, "managers" are agents for the entity, without personal liability for debts. Rights are designated in an internal "operating agreement" Members can also be Managers without giving up liability limits

The "unless otherwise provided" operating rules are modeled on LP's

LLC's have succeeded. They are becoming the default form that organizers choose for new non-publicly traded businesses.

The best of both worlds. Limited liability for everyone w/o the tax disadvantages of the corporate form.

For tax purposes is a pass-thru. IRS treats as a partnership unless "check the box" otherwise

Disregarded entities -- The "tax nothing". Election for H&W to treat as Sched "C"

Reasons not to do it: If plan to be publicly traded later. Or if in CA, due to CA's special tax structure for llc's

Also, is a new form of organization. Parameters a bit uncertain. Cheeseman's end of chapter cases here are hypotheticals, not real

Chapter 36: Corporations

A corporation is a "legal person" -- an immortal being, but without a soul. It is formed by a standardized registration with the State, it engages in business through the acts of its human agents, and it has the legal right to own property, to make contracts, and to sue or be sued in its own name.

History

Corporations were rare before 19th century industrialization. In medieval England the idea of an organization as legal person was useful (eg. Church corporations sole and Municipal corporations) but needed special legislation, such as for the East India and South Seas Companies of the 1700's, and the Hudsons Bay Company (originally chartered in 1670, and now a Canadian department store chain)

Rapid evolution w/ development of industrial capitalism in the 1800's: from railroads to Rockefeller. Rail and canal companies flourished in the 1830's and 1840's in the US. Limited purpose charters: eg. Couldn't operate or own property outside state of incorporation (not a "person" anywhere else)

1870-1910: liberalization. "Haven" states like New Jersey and Delaware. The "race to the bottom". US corporate law is state-level. Model Acts bring some commonality. By historical accident, Delaware is home to many large companies. [Maryland has a similar role for mutual funds and investment companies]

Now the dominant form of organization worldwide for business operations.

Corporations separate Management and Ownership

Limited Liability

Shareholders are not liable for the debts of the corporation -- limited risk.

Transferable at will

Esp. with publicly traded corps, the owner of equity is anonyomous, and can sell at will, gaining the benefit of liquidity

Unlimited life

The organization does not depend on any one person, owner or manager, for its existence 

Centralized Management

The owners elect representatives (the Board of Directors) as a monitoring committee, which in turn names the managers (corporate officers) and specifies the authority of each. Organization of routine operations follows a "command and control" pattern (early corporations used armies as models, hence "officers" and "divisions".)

The downside

As a legal "person", a corporation can be subject to tax on its own income, even if that income is taxed again when paid out as dividends to owners. This can mean double taxation. Some countries try to integrate corporate and shareholder taxes. The US does not do so for publicly traded companies, but allows those with a limited number (~100) of individual shareholders to elect "S-Corp" treatment. This is a pass-thru regime similar to partnership tax, tho less flexible.

Theory and Practice can diverge

There is little meaningful shareholder control over most of the "Fortune 500" companies that dominate American Capitalism. Management selects its successors, and the investor views a share of stock as tho it were a lottery ticket. A pseudo-democratic facade for "co-optative" governance

At the other extreme, in a closely held corporation the formalities may be overlooked and the theoretical divide between ownership and management may not be real in practice.

Corporate Formation

"Promoters" create a corporation by finding an available name, filing "Articles of Incorporation" for State certification, designating someone who will receive legal notices on its behalf, and adopting "Bylaws" -- procedural rules for meetings of shareholders and directors, the designation of officers, and other internal management provisions.

Here's the California procedure, per the Secretary of State's office

Here's the NOLO Press guide with checklists

As to contracts made before formation is completed: promoter generally personally liable unless released, on theory of "agent for a nonexistent principal"

Corporate Financial Structures

Equity: common and preferred

Classes of shares: eg. different voting rights

consider possible reasons for including share classes in capital structure, and note S-corp rules

Preferred stock

Usually has liquidation and/or dividend preferences. Can design to make it the real controlling equity, or something very bond-like.

Traditional reasons for including preferred in capital structure - tax arbitrage

Types of Debt:

  • Debentures (can be convertible, etc.)
  • Bonds (secured)
  • Role of "indenture trustee": act for group of bondholders
  • Notes (short term)

Corporate powers

generally, same business powers as natural person

"ultra vires": old rule that actions in excess of powers were void

Terminating corporations

Voluntary dissolution vs. forfeiture

Chapter 37: Corporate Governance

Directors, Officers and Shareholders:

Remember, can be big gaps between theory and practice, esp in closely helds or giant publicly held

The "Agency " problem

To whom are the managers accountable? There is a latent conflict of interest between the owners and the managers of publicly held corporations, and a problem of monitoring managers when ownership is diffused. The problem can be even worse when there are no "owners" as such, as in the case of nonprofit corporations.

The Shareholders

They are the owners, who seek to profit from their investment. Often thought of as the sole or at least the most important "Stakeholders".

Shares were traditionally evidenced by certificates -- now book entry, thru transfer agents for publicly held corps.

Annual meetings to elect board, and for other extraordinary matters requiring shareholder vote. Special meetings also possible

Voting

Voting by proxy, especially those publicly held. Extensive federal regulation here by Securities & Exchange Commission

Voting may be cumulative: concentrate ones votes. See formula for board election: p. 569

Can be written voting trust agreements among shareholders. Also, charter or bylaws may provide for supermajority votes in some situations

Transfer of shares: UCC Article 8

May be transfer restrictions in closely helds, or rights of first refusal: it's an exit strategy issue. Buy-sell and formula prices

Other Shareholder rights

  • Preemption on additional share issues (tho not in CA unless agreed)
  • Receive information: annual report (unless waived)
  • Inspect books and records for a proper purpose

The Board of Directors:

Role: set policy and approve policy resolutions:

minutes kept of meetings: auditors, attys need to rw

select corporate officers (in practice, in large corps may be a co-optation system)

selection of directors

For publicly traded companies, SEC concern about domination by "Insiders" [corporate officers and employees], so special responsibility for non-insiders of publicly held

SEC emphasis on roles of audit and compensation committees

staggered terms for Board members: a takeover defense?

meetings: regular or special: per the bylaws

authorization of dividends

terms: "trade date, record date/ex div date; payment date"

legal restrictions on dividend payments: not if made insolvent. CA also has asset coverage ratio test

Officers: agents of corp. for day to day management and operations

can hold multiple offices, except MBCA and CA: pres. can't also be sec't.

Basic problem: the agency question.

Tendency of corp officers to put self interest above their purchased duty to corp.

Duties of Officers and Directors as agents/fiduciaries:

Duty of obedience: act w/in scope of authority
Duty of care: good faith prudent person w/ belief its good for corp

courts are reluctant to second-guess: the "business judgment" rule

rare exception in Smith v Van Gorkom (1985 case): duty to get best price when corp is "in play"

May in good faith rely on others: eg. accountants

Duty of loyalty: put the corp 1st
Guth v. Loft {background of Guth v. Loft}
  • no self-dealing (procedure for disclosure and disinterested vote)
  • no taking corp opportunity:
  • no competing w/ corp
  • no secret profits

Liability insurance: "d&o e&o", if available

Liability enforced by: Shareholder suits: direct, derivative, class action

Shareholder liability

Piercing the veil: some combination of ignoring separate existence, lack of formalities, and gross undercapitalization

Minority shareholder issues

d&o are fiduciaries for all sh's, even if conflict

if majority sh controls d&o, may have to be fiduciary: fair treatment of minority

proving it and enforcing it can be difficult: eg. Jones v. HF Ahmanson CA case @ 1970

techniques for freezeouts, squeezeouts and oppression

  • control the board // maybe amend charter to end cumulative voting
  • no dividends // take out profits via salary, or via dealings between majority and corp
  • scanty information. Depress reported earnings
  • dilutive issue of new shares // or reverse stock split //or decease minority below 5% and do short form merger
  • loot the company // sell corporate control to a looter and look the other way:
  • the old "saturday night special" the 2-tier short fuse tender offer

The recurring question: Cui Bono? For whose benefit is the corporation to be managed? And who gets to decide? The Dodge v. Ford Motor Company case

notes and format (c) 2001-08 Robert H. Daniels