Chapter 42 – Organization and Financial Structure of Corporations
CHAPTER 42
ORGANIZATION AND FINANCIAL STRUCTURE OF
CORPORATIONS
I. OBJECTIVES
After reading this chapter, a student should know:
A. The role of promoters in starting corporate businesses and the liability risk of being a
promoter.
B. The importance of selecting an appropriate state for incorporation.
C. The steps to create a corporation and the liability associated with a failure to complete those
steps.
D. The types of securities a corporation may issue.
E. The various rights that may be given to classes of shares.
F. The quality and quantity of consideration that a corporation must receive for its shares.
G. The types, uses, and legality of share transfer restrictions.
II. ANSWER TO INTRODUCTORY PROBLEM
A. Your client and her associates should incorporate the business prior to transacting on behalf
of the corporation. If not, they risk having liability on pre-incorporation contracts as
promoters for a nonexistent corporation. While there are other ways to reduce the risk of
promoter liability, incorporation is the best. To make sure the corporation exists, they should
wait to receive from the secretary of state a copy of the articles of incorporation stamped
“Filed” and a fee receipt, which together are conclusive proof of the existence of the
corporation.
B. As a legal matter, the shares are freely transferable, meaning that any person who buys shares
from an existing shareholder will have the same rights as the selling shareholder. This means
that if one of your client’s associates sells his shares to another person, your client may have
to share power with a new shareholder that she did not want to be in business with. Yet as a
practical matter, it will be difficult for a shareholder to sell his shares. The shares will not be
listed for trading on a securities exchange, and it is unlikely that a buyer can be found who is
willing to be a significant shareholder in a corporation controlled by three other shareholders.
The new shareholder will not be able to elect herself as a director, and she has no assurance
that she will receive dividends or a salary or be able to sell her shares. There are several
share transfer restrictions that can address this problem. A buy-and-sell agreement is
probably the best. It requires a shareholder to sell her shares and requires the corporation or
other shareholders to buy the shares upon the occurrence of triggering events, such as death,
retirement, disability, and deadlock. The buy-and-sell agreement will guarantee shareholders
a market for their shares and prevent a shareholder from selling her shares to a person that the
remaining shareholders do not want to do business with.
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Chapter 42 – Organization and Financial Structure of Corporations
III. SUGGESTIONS FOR LECTURE PREPARATION
A. Promoters
1. Review the rules for determining the liability of the corporation, the promoter, and the
third party, on a preincorporation contract negotiated by the promoter.
a. A promoter is liable on the contract, even if her name does not appear on the contract,
unless:
1) the third party knew of the nonexistence of the corporation, yet insisted that the
promoter sign the contract on behalf of the prospective corporation, or
2) the third party clearly indicated that he would look only to the prospective
corporation for performance.
Example: Problem Case # 3
b. A promoter is released from liability on a preincorporation contract if a novation
occurs. Note that novation must occur with the consent of the corporation and the
third party. If the third party does not consent, the promoter is still liable on the
contract. If the corporation does not consent, the promoter has liability to the
corporation as a co-obligor.
c. Co-promoters are liable for each other’s authorized contracts as joint venturers.
d. Cover the ways a promoter may reduce her risk of liability. Usually today, promoters
incorporate before making contracts. Another alternative is to provide for automatic
novation upon incorporation or upon the corporation’s adopting the contract. With
automatic novation, the promoter must be careful to state clearly that novation will
occur automatically.
Example: Chapter Introductory Problem (p. 1090). The first part of this problem
suggests that the best way to manage liability is to incorporate before transacting for
a corporation.
Additional Example: Problem Case #1.
e. A corporation is liable only after its board of directors adopts the contract.
f. The third party is liable on the contract if either the corporation or the promoter is
bound by it.
SmithStearn Yachts, Inc., v. Gyrographic Communications, Inc. (p. 1092): The court held
that a corporation had adopted the preincorporation contract made by its promoter.
Points for Discussion: Ask your students if they think the court made a decision that
recognized the intent of the parties. It would strain credulity to think that Gyrographic
wanted to make a contract only with an LLC formed by Stearn. It is clear that
Gyrograhic expected whatever business Stearn created with the name SmithStearn Yachts
would be liable on the contract, if it adopted the contract made by Stearn. Gyrographic’s
intent after the contract was made is evident, because it worked toward developing
letterheads, business cards, and other marketing materials for SmithStearn Yachts, Inc.
Gyrographic didn’t seem to care about whether SmithStearn was an LLC or corporation,
until it was sued.
Additional Points for Discussion: The court based its decision on the acts of SmithStearn
Yachts, Inc. to adopt the contract. The court apparently concluded that the contract was
intended to be made for SSY, Inc. even though Stearn signed in the name
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Chapter 42 – Organization and Financial Structure of Corporations
of SSY LLC. Once that conclusion was made, it was easy to find evidence of adoption:
SSY, Inc. received the benefits of the contract, fulfilled obligations under it, and sued on
it.
Additional Example: Problem Case #4.
2. Review the nature of the promoter’s relationship with the prospective corporation: she is
a fiduciary, but not an agent. Cover the watered shares problem that exists when
promoters buy shares at a lower price than public shareholders pay.
3. Note that compensation is a special problem for a promoter. The rule that a promoter is
not entitled to compensation appears especially unjust, since the corporation owes its
existence to the promoter. To ensure compensation, a promoter should obtain an interest
in property that the corporation will need, such as a patent, and obtain her compensation
through its sale to the corporation. To avoid a breach of her fiduciary duty, the promoter
must fully disclose her interest and her profit to the board prior to its approval of the
purchase.
B. Incorporation
1. Give some examples of the importance of the decision where to incorporate. Especially
note the greater freedoms generally given management by the Delaware statute. Note
that some of this freedom has been offset by Delaware Supreme Court opinions, such as
the Trans Union case, 488 A.2d 858 (Del. Sup. Ct. 1985) [discussed on page 1024] and
Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. Sup. Ct. 1981) [excerpted at page 1169].
But the recent Disney decision in 2008 [excerpted at page 1125] confirms the large
degree of latitude that management has in Delaware. Brehm v. Eisner, 906 A.2d 27 (Del.
S. Ct. 2006). Students will study these cases in Chapters 43 and 44.
2. Ethics in Action: Domestic Tax Havens (p. 1095): This issue bears watching. Check
legal newspapers and other periodicals and the Wall Street Journal for current
information on the status of domestic tax havens. A profit maximizer would take
advantage of favorable tax treatment because it is a legal way to maximize profits, unless
he finds that such behavior would lead to changes in tax law that would
disproportionately increase burdens on the business in the future. A believer in rights
theory may consider whether the citizens of a state in which a business has its greatest
contacts have a greater right to taxes on income earned than do the citizens of a state that
is the tax haven. Legislatures of states losing tax revenue may attempt to impose an
income tax that taxes corporations irrespective of the place of incorporation (this is
already being done—see the material on page 1075 in Chapter 41) and claim that income
allocations among the states should be based on factors other than net income from in-
state operations. Legislators may argue that in-state gross revenue is a better indicator of
the relative benefit a corporation obtains from doing business in several states. The
materials on page 1075 seem to support the constitutionality of such allocation grounds.
A utilitarian may support such legislation on the grounds that society benefits most by
making corporations pay for the benefit they receive from a state that protects their
business property and contracts. On the other hand, a utilitarian may conclude that
society benefits most if corporations can limit the amount of tax they pay. A believer in
justice theory will consider which state’s citizens need the tax revenue the most.
3. Review briefly the steps to incorporate a business. List the steps, including the contents
of the articles of incorporation (Figure 1 on page 1094). This list will serve as a lead-in to
your discussion of defective attempts to incorporate. At this point, you may want to refer
back and ahead to the following important issues:
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Chapter 42 – Organization and Financial Structure of Corporations
a. When you mention the purpose clause of the articles, note that such a clause may
cause ultra vires problems. You may want to discuss ultra vires at this point. Ultra
vires is covered in Chapter 43 on page 1115.
b. When you discuss the initial capitalization requirement, mention that meeting this
requirement does not ensure that a corporation will not have its veil pierced due to
thin capitalization. Thin capitalization is covered in Chapter 42. The inability of
initial capitalization requirements to prevent thin capitalization is the major reason
why the MBCA does not require an arbitrary minimum amount of capital.
c. Note that under the MBCA, the secretary of state’s filing of the articles of
incorporation begins the existence of the corporation and ensures that a corporation’s
existence can not be attacked on the grounds of defective incorporation.
d. Note that many organization meetings are purely pro forma. In fact, businesses that
sell corporate kits–which ease a lawyer’s job of incorporating a business--sell
preprinted minutes of the organization meeting. Note the Internet services also ease
the incorporation process.
Example: Log On (p. 1096)
e. Note the content of the bylaws (Figure 2 on page 1095) and that they must be
consistent with the law and, with rare exceptions, the articles also. They are third in
the hierarchy of documents one consults in determining the rights and duties of the
corporation, management, and shareholders: first, the incorporation statute; second,
the articles; next, the bylaws.
4. Close Corporation Election
Briefly state the requirements for electing statutory treatment as a close corporation and
the reasons for doing so. You should note that relying upon statutory treatment is no
substitute for competent legal counsel at the time of incorporation. Better than a statute,
a lawyer will be able to anticipate the unique problems of a specific close corporation and
to provide specific methods of resolving its unique problems.
C. Defective Attempts to Incorporate
1. Introduce this topic by stating that some people will not take all the steps for
incorporation required by statute. Ask rhetorically what we should do when someone
fails to take a required step.
2. State briefly the consequences of defective incorporation, which are discussed on page
1097.
3. Introduce students to the concepts of de jure corporation, de facto corporation, and
corporation by estoppel, then discuss each in detail.
a. Distinguish mandatory provisions from directory provisions. Refer to your list of
steps to incorporate, and designate each step as mandatory or directory. Stress the
factors that distinguish mandatory provisions from directory provisions: use of the
word “shall” in the statute, and necessity to protection of the public interest.
b. Note the effect of the MBCA rule on de facto and corporations by estoppel, according
to many courts. Those concepts have been eliminated. Note the rule of the MBCA:
If the articles are filed there is a corporation; if not, there is no corporation.
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Chapter 42 – Organization and Financial Structure of Corporations
Christmas Lumber Co., Inc. v. Valiga (p. 1098). The court held that Waddell could
not escape liability to Valiga because he knew that the corporation, R.H. Waddell
Construction, Inc., was not formed when he made the contract with Valiga.
Points for Discussion: This is a good case to show the perils of not knowing
corporation law, and specifically not knowing that one should never make contracts
on behalf of a corporation unless it exists. Waddell was in complete control of
whether this corporation came into existence. He should have known that he should
have submitted the articles of incorporation to the secretary state for filing and that he
should have waited until the secretary of state had notified him that the articles were
filed, before making the contract with Valiga.
Additional Points for Discussion: Note that Waddell was his own worst enemy here.
Not only did he not submit the articles for filing until three months after the contract
was made, but also he helped proved that he knew the corporation didn’t exist by
making a joint venture agreement between himself and Graves that did not mention
the corporation and his testimony in court that he and Graves were partners.
Additional Example: Problem Case # 2.
D. Incorporating Nonprofit Corporations
Review the incorporation of nonprofit corporations, noting the differences between
incorporation of for-profit corporations and nonprofit corporations.
Especially point out the differences between public benefit corporations, mutual benefit
corporations, and religious corporations. Give examples from your community of each type
of corporation. Point out why a public benefit corporation may not have members: the
organizers have no cost-saving motive as do the members of a mutual benefit corporation.
Instead, the public benefit corporation is used to provide a public service–such as promotion
of the arts–while protecting the managers from personal liability.
E. Financing the Corporation
Most business students already have a good understanding of corporate finance, so little time
is needed here.
1. Briefly review the types of securities that a corporation may issue. Note that there is
great flexibility or freedom of contract in defining the rights of each class of shares.
Example: Problem Cases # 5 and 10.
2. Define and distinguish authorized, issued, and outstanding shares.
3. Define and distinguish canceled shares, shares restored to unissued status, and treasury
shares.
F. Consideration for shares
Note the two concerns here: that shares are issued for proper types of consideration [quality
of consideration] and that they are issued for proper amounts of consideration [quantity of
consideration].
1. Quality of consideration
a. List the proper and improper types of consideration under the MBCA. Note that the
MBCA allows shares to be issued for nearly anything that is consideration in contract
law. This is contrary to the constitutions or statutes in many states that do not permit
a corporation to issue shares in exchange for promises. The MBCA rule is essentially
a contract consideration rule. Contracts have value, even though
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Chapter 42 – Organization and Financial Structure of Corporations
unperformed. Note that if a contract is not performed, the corporation may collect
damages for breach of contract.
b. The Global Business Environment: Corporation Law Worldwide: Proper
Consideration for Shares (p. 1102): Note that American law serves as a model for
other countries’ laws. This is common in the area of commercial and corporate law.
c. Tedeton v. Tedeton (p. 1103): The court held that the two shareholders, Clayton and
Kirk Tedeton, had paid proper consideration for their shares in the corporation.
Points for Discussion: The court quotes the Louisiana statute regarding proper
consideration for shares. Louisiana does not follow the MBCA. The language of the
statute is quite a bit different from the MBCA and other states’ laws. What are meant
by “corporeal and incorporeal property”? They are the same as tangible and
intangible property. Note also that the Louisiana statute seems to allow shares to be
issued for services performed for the corporation, but not services to be performed in
the future.
Additional Point for Discussion: What was Clayton’s proper consideration for the
shares issued to him? It was his intangible (incorporeal) rights in the formula for the
sold product, Miracle II, which was a trade secret. Trade secrets have value and are a
proper type of consideration in all states.
Additional Point for Discussion: What was Kirk’s proper consideration? One was
the corporation’s use of his home to make Miracle II product. In essence, the
corporation obtained a lease of a portion of Kirk’s home and didn’t make lease
payments. Thus, Kirk received his shares in part in lieu of receiving cash rental
payments. What else did Kirk contribute? It was his services, that is, his
commitment to manage the operations of the business and his actual management of
the business. Note that the court focused first on his commitment to manage, which
was a pledge of future services, finding the commitment to be proper consideration,
because it was incorporeal property, yet seemingly contradicting the Louisiana’s
statute’s requirement that services actually be rendered to the corporation. The court
finessed this point by stating that courts find that the giving of services validates the
issuance of shares for what had been previously future services. Kirk clearly had
fulfilled his obligation and provided services to the corporation.
2. Quantity of consideration
a. Note that the board’s decision as to the amount of consideration received and as to
the value of noncash consideration received is conclusive, absent bad faith, fraud, or
breach of fiduciary duty. This is an example of directors’ decisions being protected
by the business judgment rule. The business judgment rule is covered in detail in
Chapter 43 on pages 1123-1124.
b. Note that many states still recognize the artificial concepts of par value and stated
value. These concepts will probably be only of historical interest in the future as
recognition becomes widespread that par or stated value does little, if anything, to
accomplish their intended purpose of protecting creditors by ensuring that a
corporation has a minimum equity cushion.
3. Examples:
a. Problem Cases ## 6 and 7.
b. Work done for the majority shareholder. Not a proper type of consideration.
c. Goodwill of an existing business. A proper type of consideration, because goodwill
is an intangible asset.
d. Shares of another corporation. Expressly permitted as consideration by the MBCA.
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Chapter 42 – Organization and Financial Structure of Corporations
e. The right to use a copyrighted work. A proper type of consideration as intangible
intellectual property.
f. A vice-president’s written, contractual commitment to work for the corporation for 5
years. Proper consideration under the MBCA, but not in many states.
g. A consultant’s gratuitous promise to work for the corporation for 5 years. Not proper
consideration, because it is not a contract.
G. Share Subscriptions and Executory Contracts to Purchase Shares
You may at this point cover both preincorporation subscriptions (which are covered on pages
1092-93) and post-incorporation subscriptions.
H. Issuance and Transfer of Shares
1. Uncertificated shares and share certificates. Great strides have been made to eliminate
certificated shares. Many investors trade securities through online brokers who hold the
securities for the benefit of the investors. In most of these cases, no certificates are issued
to the online broker or to the investors. Some investors, however, have a basic distrust of
those who handle securities. It is generally believed by individual investors that they can
better protect themselves from theft if paper certificates are used.
When a shareholder loses her share certificate, she should give the corporate issuer notice
of its loss within a reasonable time; if she fails to do so, the issuer has no liability to the
shareholder when it registers the security to another person.
2. UCC Article 8, section 8-113 eliminates the application of the statute of frauds to sales of
securities. It states, “A contract or modification of a contract for the sale or purchase of a
security is enforceable whether or not there is a writing signed or record authenticated by
a party against whom enforcement is sought, even if the contract or modification is not
capable of performance within one year of its making.”
3. Cover the rights of a protected purchaser of securities. Note that a protected purchaser
takes a security free of adverse claims to a security. A protected purchaser who has a
new, reissued, or reregistered security has great rights, including taking the security free
of any prior owner’s claim that his signature was forged on a registered security.
4. Transfer Warranties. When a purchaser of a security fails to obtain clean title to a
security, the purchaser may sue prior transferors for damages. The warranties made by
transferors are in UCC section 8-108.
5. Restrictions on Share Transfers
a. State the share transfer problems of close corporations. Stress that no close
corporation should be formed without a careful consideration of share-transfer
problems. Some students object to such planning, arguing that it is negative thinking
evidencing that persons should not enter business together. We tell students that no
one expects problems, but they are nearly inevitable in close corporations and must
be anticipated by the use of share transfer restrictions. In this respect, they are like
antenuptial agreements.
b. List the types of share transfer restrictions and their uses. Note which types of
restrictions are best for which uses.
Coyle v. Schwartz (p. 1107). This is another sad example of a poorly written and
poorly updated shareholder agreement. This is what happens when people don’t pay
attention to what they sign. The court enforced the valuation provision in the
shareholder agreement, although the price had not been updated to current market
value for 12 years.
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Chapter 42 – Organization and Financial Structure of Corporations
Points for Discussion: Note that corporation law provides a large amount of freedom
of contract to the shareholders who draft articles of incorporation, bylaws, and—in
this case—a shareholder agreement. The court was reluctant to modify the
agreement to provide what some of your students may view as a fairer result. Why?
Because there is no clearer expression of what the parties want than what they have
agreed to in writing. Anything else is speculation or dependent on oral testimony that
is by its nature biased.
Additional Points for Discussion: This case illustrates the need for careful drafting
of share transfer restrictions. What valuation provision would have been better than
the one used by the shareholders here? If they wanted to update the valuation yearly
but were fearful they would forget or not come to an agreement, they could have
required a valuation every year, and if it was not updated, the old price was not valid
and was replaced by an independent valuation by a designated financial analyst.
They could have used a formula, such as three times average 12-month gross
revenues for the last 24 months, to determine the value of the corporation. There are
many other valuation methods. Your finance and accounting majors should be able to
suggest valuation methods.
c. Review the history of the legality of share transfer restrictions. Read a modern
statute (like the MBCA) and note that modern statutes treat shares more nearly as
contracts than as property, allowing individuals more flexibility in restricting the
transfer of shares.
Example: Problem Cases ## 8 and 9.
d. Refer to the solutions to the share transferability problem that appear in the Statutory
Close Corporation Supplement to the MBCA. Note that while these solutions may be
appropriate for someone who has not thought about the problem, they are no
substitutes for share transfer restrictions that meet the particular needs of a specific
corporation and its shareholders. There is no substitute for specialized legal advice.
Example: Problem Case #10.
Additional Example: Chapter Introductory Problem (p. 1090): The second part of
this problem addresses share transfer issues.
e. Figure 3: Model Share Transfer Restriction (p. 1109). This is a good example of a
buy-sell agreement. Note the agreement’s detail and its internal logic.
I. Financing Nonprofit Corporations
Point out how nonprofit corporations are financed differently from for-profit corporations.
Students appreciate examples from your community illustrating the sources of financing for
public service corporations and mutual benefit corporations.
Also point out how memberships of nonprofit corporations differ from shares of corporations
in terms of consideration requirements and transferability restrictions.
IV. RECOMMENDED REFERENCES
See references in Instructor’s Manual Chapter 41.
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