978-0077733735 Chapter 27 Lecture Notes

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Chapter 27 – Managing the Corporate Entity

Chapter 27

Managing the Corporate Entity

I. Key Terms

Actual authority rule (P. 667) Monarch (p. 662)

Audit committee (p. 656) Opt-out rule (p. 656)

Business judgment rule (p. 664) Pooling agreement (p. 661)

Controlled company (p. 656) Preemptive right (p. 669)

Corporate democracy (p. 657) Proxy (p. 658)

Corporate opportunity doctrine (p. 667) Proxy contest (p. 658)

Cumulative voting (p. 658) Proxy solicitation (p. 658)

Demand futility doctrine (p. 662) Proxy statement (p. 659)

Derivative suit (p. 662) Ratification (p. 667)

Direct suit (p. 662) Rule of contemporary ownership (p. 662)

Duty of due diligence (p. 664) Sarbanes-Oxley (SarbOx) Act (p. 654)

Duty of loyalty (p. 664) Self-dealing manager (p. 664)

Duty of obedience (p. 667) Shareholder democracy (p. 667)

Fairness rule (p. 665) Shareholder of record (p. 669)

Government control (p. 654) Shareholder proposal (p. 659)

Independent director (p. 656) Shareholder resolutions (p. 660)

Inside information (p. 665) Stakeholders (p. 653)

Insider trading (p. 666) Trustee (p. 660)

Insider trading rule (p. 666) United States Sentencing Commission (p. 668)

Legal imperialism (p. 655) Voting trust (p. 660)

Managerial control (p. 656)

II. Learning Objectives

1. Explain the central dilemma of corporate governance.

2. Describe the functions of directors, officers, and shareholders.

3. List the five theories of corporate governance.

4. Describe cumulative voting and proxy solicitation.

5. Explain shareholder proposals.

6. Distinguish between voting trusts and pooling agreements.

7. Explain shareholder direct suits, shareholder derivative suits, and the demand futility

doctrine.

8. Contrast the business judgment rule with the fairness rule.

9. List the rights that belong to shareholders.

10. Explain the management of a limited liability company.

III. Major Concepts

27-1 Management of the Corporate Entity

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Chapter 27 – Managing the Corporate Entity

The business affairs of a corporation are managed by a board of directors elected by the

shareholders. The directors have the authority to appoint officers and agents to run the

day-to-day affairs of the corporation.

27-2 Issues in Governing the Corporate Entity

Five theories have been put forth by legal scholars and business experts concerning how

corporations should be managed. These theories are governmental control, independent

director control, managerial control, stakeholder control, and shareholder democratic

control. Shareholders can increase their voting power by purchasing additional stock. If

they cannot purchase additional stock, they may use another device to increase their

voting power, such as cumulative voting, proxies, voting trusts, pooling agreements,

shareholder proposals, shareholder nominations, and unanimous voting restrictions.

Shareholders can also sue the corporation. Direct suits are brought by shareholders to

protect their own rights. Derivative suits are brought by shareholders when they feel that

the corporation has been damaged by a management decision. Derivative suits are limited

by certain rules including that shareholders must exhaust internal remedies before

bringing such suits. However, the demand futility doctrine states that it is not necessary

for a shareholder to exhaust internal remedies if that shareholder can demonstrate that

because a manager controls the board such an approach would be futile.

27-3 Governance Responsibilities

Under the business judgment rule, the court will not interfere with most management

decisions as long as those decisions are legal and are made with due care, in good faith,

and in the best interests of the corporation. If the manager profits personally from a busi-

ness decision, then the court will use the fairness rule to judge the manager’s conduct.

27-4 Shareholder Rights

Shareholder rights include the right to examine corporate records, the right to share

dividends, the right to transfer shares of stock, and the right to buy newly issued stock.

27-5 Governance of a Limited Liability Company

The members of a limited liability company can choose to manage the business

themselves or hire outside management. Regardless of whether the members or the

managers ultimately run the LLC, both groups have a fiduciary duty to the LLC and to

the members of the LLC. Nevertheless, it would be wise to outline specific management

duties in the operating agreement.

IV. Outline

I. Management Of the Corporation (27-1)

A. Directors of the Corporation

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Chapter 27 – Managing the Corporate Entity

1. The business affairs of a corporation are managed by a board of directors elected by

the shareholders.

2. State law and corporate rules set up the qualifications that a person must have to be a

corporate director.

3. Directors are elected at the annual meeting of the shareholders and generally hold

office for one to two years.

4. The directors of most large corporations meet on a regular basis at a precise time and

place of their choosing while the directors of many smaller corporations meet only

when specific items are to be considered.

5. The quorum of directors necessary to conduct business is usually one more than half

of the total number of directors, but bylaws may require more than a quorum to

conduct certain types of business.

B. Officers of the Corporation

1. Directors have the authority to appoint officers and agents to run the day-to-day

affairs of the corporation.

2. By statute, the usual officers are a president, several vice presidents, a secretary, and a

treasurer; and other officers, such as a comptroller, cashier, and general counsel are

often also present.

3. Although the roles of directors and officers differ, they are frequently assumed by the

same people.

C. Shareholders of the Corporation

1. The shareholders are the owners of the corporation.

2. The more shares that a shareholder owns, the more voting power that shareholder has

in the running of the corporation.

D. Stakeholders of the Corporation

1. Corporate law has evolved to include the stakeholders of the corporation in the

decision-making process.

2. Stakeholders are individuals and coalitions who, while outside the corporate

decision-making and ownership establishment, are dramatically affected by the

results of corporate decision making.

II. Issues in Governing the Corporate Entity (27-2)

A. The Corporate Balancing Act Revisited

1. Needs of different groups must be balanced.

2. Five different corporate control paradigms are governmental control, independent

director control, managerial control, stakeholder control, and shareholder democratic

control.

B. Theories of Corporate Governance

1. Governmental Control

a. The governmental control theory of corporate management is based upon the

belief that because corporate decision making impacts upon more individuals and

groups than just the shareholders and managers, those corporate decisions should

be made by an impartial group of corporate outsiders.

b. Usually the corporate outsiders referenced are government officials.

c. Opponents label such an approach as socialistic.

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Chapter 27 – Managing the Corporate Entity

d. A technique other than having government agents on corporate boards is to use

governmental control indirectly through regulatory legislation such as was done

with the passage of the Sarbanes-Oxley Act.

2. Independent Director Control

a. The independent director control theory argues that the most effective way to

ensure that corporate decisions are made in the best interests of those affected is

to make certain that the decision makers themselves are not affected by those

decisions.

b. Some groups have already implemented requirements to ensure the addition of

independent directors to the boards of many corporations.

c. Sarbanes-Oxley requires that all U.S. corporate persons that are publicly traded

and all alien corporations included on an American stock exchange set up an audit

committee consisting of independent members.

3. Managerial Control

a. The fourth approach to corporate governance points out that the officers and the

directors of a corporation are in the best position for judging not only the needs of

the corporation but also the needs of the community and the needs of society at

large.

b. Those who favor managerial control would insulate the managers from

shareholders by limiting the shareholders’ power to vote and by making it difficult

for shareholders to sue managers.

4. Stakeholder Control

a. Stakeholder control is based on the idea that corporate decisions affect more

individuals and groups than shareholders and managers.

b. Under this theory, stakeholders should be represented on the boards of directors of

all major corporations.

5. Shareholder Democracy

a. The shareholder democracy, or corporate democracy theory, holds that the

shareholders have the right to run the corporation because without their money the

corporation would not be able to survive.

b. Supporters of shareholder democracy would make management more responsive

to shareholders by giving shareholders greater voting control and making it easier

for them to take managers to court.

6. Today there is a delicate balance between the theories of managerial control and

shareholder democracy.

C. Shareholder Voting Control

1. Shareholders usually receive one vote per share of common stock held.

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Chapter 27 – Managing the Corporate Entity

2. When shareholders are not able to buy more shares of the corporation, either because

they cannot afford them or because of unavailability, shareholders can resort to other

available voting methods.

a. Cumulative Voting

(a) Some states permit cumulative voting which is a system that allows

shareholders to multiply the number of their voting shares by the number of

directors to be elected.

(b) All the votes may be case for one candidate or distributed among several

candidates.

b. Proxy Voting

(a) A proxy is the authority given to one shareholder to cast another

shareholder’s votes.

(b) The minority shareholder’s voting power increases as the number of proxies

held rises.

c. Shareholder Proposals

(a) Shareholder proposals are governed by the Securities Exchange Act of 1934.

(b) Under SEC guidelines qualifying shareholders of large, publicly owned

corporations can compel management to include their proposals in

management’s proxy solicitation prior to the next shareholder meeting

d. Voting Trust.

(a) A voting trust is an agreement among shareholders to transfer their voting

rights to a trustee.

(b) The trustee votes those shares at the annual shareholders’ meeting at the

direction of the shareholders.

e. Pooling Agreements

(a) Sometimes, shareholders join together in a temporary arrangement agreeing

to vote the same way on a particular issue with an agreement known as a

pooling agreement, shareholder agreement or voting agreement.

(b) In general, pooling agreements are interpreted under principles of contract

law.

f. Shareholder Nominations

(a) A way to increase the voting power of shareholders is to augment their

ability to elect a director or directors who will represent their point of view

in crucial issues.

(b) Ways to do that include enacting state statutes, altering SEC rules, or

changing stock exchange regulations so that certain events will trigger the

ability of shareholders to elect board members.

g. Unanimous Voting Restrictions

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Chapter 27 – Managing the Corporate Entity

(a) An approach to strengthening the power of shareholders involves a change

in the corporate bylaws that makes it more difficult for the board to approve

crucial issues affecting the corporation.

(b) The new voting bylaws would require unanimous agreement among all

directors when the issue before the board involves a critical matter such as a

merger, the sale of corporate assets, or a large increase in the salary of a top

officer.

3. Voting techniques can be combined to increase shareholder voting power.

D. Shareholder Lawsuits

1. Direct Suits

a. A direct suit is brought by shareholders who have been deprived of a right that

belongs to them as shareholders.

b. Such rights include the right to vote, the right to receive dividends, the right to

transfer shares, the right to purchase newly issued stock, and the right to examine

corporate books and records.

2. Derivative suits

a. A derivative suit allows shareholders to sue corporate management on behalf of

the corporation.

b. Unlike a direct suit, a derivate suit is not based on a direct injury to a shareholder

and is instead based on injury to the corporation.

c. Before bringing a derivative suit, shareholders must exhaust internal remedies.

d. The demand futility doctrine applies when shareholders show that because of a

director or officer’s control of the board, any attempt to bring the matter to the

board would have been futile.

e. Under the rule of contemporary ownership, in order to bring a derivative suit, a

shareholder must own stock at the time of the injury and at the time of the suit.

f. Frequently, state corporate laws also require derivative suit plaintiffs to pay a

security deposit to cover the corporation’s potential expenses in defending the

derivative suit.

III. Governance Responsibilities (27-3)

A. The Business Judgment Rule

1. Under the business judgment rule, the court will not interfere with most business

decisions.

2. The rule protects managers who act with due care and in good faith, as long as their

decisions are lawful and in the best interests of the corporation.

3. Protecting directors and officers in this way encourages people to become corporate

directors and managers.

4. The business judgment rule emerges from the duty of due diligence that a manager

owes to the corporation.

B. The Fairness Rule

1. All managers owe a duty of loyalty to the corporation under which managers must

place the corporation’s interests above their own.

2. When managers enter contracts with the corporation or when they are on the boards

of two corporations that do business with each other, they are said to be self-dealing.

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Chapter 27 – Managing the Corporate Entity

3. In self-dealing situations area valid with disinterested board member approval or

shareholder approval

4. Without approval, the fairness rule is applied.

5. The fairness rule requires managers to be fair to the corporation when they personally

benefit from their business decisions.

6. The fairness rule requires that corporate managers disclose all crucial information.

7. Two rules that result from the fairness rule and the duty of loyalty are the insider

trading rule and the corporate opportunity doctrine.

a. The Insider Trading Rule

(a) Because of their role in corporate affairs, directors and officers often possess

inside information which is material, nonpublic, factual data that can be

used to buy or sell securities at a profit.

(b) Corporate insiders who buy and sell stock in their own corporation are not

trading illegally provided they report these transactions to the SEC.

possession by virtue of their corporate office to trade securities in violation

of the fiduciary duties they owe to the corporation and its shareholders have

engaged in illegal insider trading.

(d) When a corporate insider “tips” an outsider about material, nonpublic,

factual data, the “tipper” and the “tippee” who uses that data in a securities

trade may both be liable for illegal insider trading.

(e) A corporate outsider who, by virtue of his or her job, misappropriates such

data and uses the data to make a securities trade is also at least potentially

engaged in illegal insider trading.

b. The Corporate Opportunity Doctrine

(a) The corporate opportunity doctrine states that corporate managers cannot

take a corporate business opportunity for themselves if they know that the

corporation would be interested in that opportunity as well.

(b) Before taking such an opportunity, a manager must first offer it to the

corporation.

C. The Actual Authority Rule

1. Corporate managers are held to a duty to act within their actual authority.

2. The actual authority rule states that a manager may be held liable if he or she exceeds

his or her authority and the corporation is harmed as a result.

3. Some states apply a strict liability standard while some states will consider a manager

in such a case responsible only if the violation results from negligent or intentional

conduct.

4. It is possible for a previously unauthorized act to be ratified.

5. Some states have enacted legislation that is designed to help protect the good faith

and due diligent activities of managers which may take the following three forms:

a. Voluntary protective measures which permits corporate shareholders to fashion

bylaws to limit or eliminate the liability of directors for decisions made while

carrying out their duties so long as deliberate wrongdoing is not involved.

b. Automatic protective measures grant immunity by state law.

c. Protective measures limit the amount of damages that can be recovered against

directors.

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Chapter 27 – Managing the Corporate Entity

6. The Sarbanes-Oxley Act places an affirmative duty on the directors of publicly traded

corporations to monitor whether their corporation is conforming to all legal

requirements.

7. The United States Sentencing Commission has issued a set of rules that control the

discretion of the federal courts in issuing fines against corporations found guilty of

criminal activities.

IV. Shareholder Rights (27-4)

A. Right to Examine Corporate Records

1. A shareholder’s right by statute to inspect the records of the corporation is usually

limited to inspections for proper purposes at an appropriate time and place.

2. When the purpose of inspection is proper, it may be enforced by a court order.

B. Right to Share in Dividends

1. Shareholders have the right to share in dividends after they have been declared by the

board of directors.

2. Once declared, a dividend becomes a debt of the corporation and enforceable by law

as is any other debt.

C. Right to Transfer Shares of Stock

1. Shareholders have the right to sell or transfer their shares of stock.

2. The person to whom stock shares are transferred has the right to have the stock

transfer entered on the corporate books.

D. Preemptive Rights

1. Unless the right is denied or limited by the corporate charter or by state law,

shareholders have the right, known as the shareholder’s preemptive right, to purchase

a proportionate share of every new offering of stock by the corporation.

2. The shareholder preemptive right prevents management from depriving shareholders

of their proportionate control of a corporation simply by increasing the number of

shares in the corporation.

V. Governance of a Limited Liability Company (27-5)

A. Member-Managed LLCs

1. It the managers choose to run the LLC on their own, then management rights are

apportioned among the members according to the capital contributions made by each

member to the LLC.

2. Members of the LLC act as agents of the LLC.

3. The operating agreement may alter statutory provisions.

B. Manager-Managed LLCs

1. If the members hire outside managers, then the LLC is run like a corporation.

2. In the absence of an operating agreement, a single manager operates much like the

CEO of a corporation, while a group of managers acts as a board of directors.

C. Fiduciary Duties

1. Regardless of whether the members or managers run an LLC, both groups have a

fiduciary duty to the LLC and to its members.

2. The specific management duties should be outlined in a written operating agreement.

V. Background Information

A. Historical Notes

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Chapter 27 – Managing the Corporate Entity

1. In early corporate history, the preemptive right was regarded as so basic that it was

assumed to exist in most situations unless there was a contrary express provision.

Today, however, the preemptive right is no longer considered basic in most

jurisdictions. Now, depending on the state jurisdiction involved, no preemptive rights

exist unless explicitly stated in the contract.

2. Nineteenth century corporations differed from contemporary counterparts in regard to

shareholder voting. Providers of local infrastructural services such as transportation,

banking, and insurance commonly deviated from the one share per vote principle and

instead adopted restricted voting practices favoring small over large shareholders.

This prevented the entities coming into the control of monopolists or competitors.

Henry Hansmann & Mariana Pargendler, The Evolution of Shareholder Voting

Rights: Separation of Ownership and Consumption, 123 Yale L.J. 100 (2013).

B. State Variations

1. In Nevada, all directors and the chief executive officers of banks must submit to

background investigations. Presidents of thrift companies must have at least ten

years’ experience in a regulated financial institution, and the manager must have at

least two years’ experience. For more information see the overview of the Nevada

Department of Business and Industry Division of Financial Institutions at

http://fid.state.nv.us/New_Overview.htm.

2. In Tennessee, as is generally true elsewhere, the failure to hold the annual meeting

does not affect the validity of any corporate action.

3. Under California laws governing nonprofit corporations, a court can assign a plaintiff

to pay a bond of not more than $50,000 to cover the expenses of a derivative lawsuit.

VI. Terms

1. The term quorum, which comes from Latin, first appeared in Middle English in

reference to justices of the peace whose presence was necessary to constitute a court.

Today, quorum’s meaning has broadened, referring to the number of people who must

be present before any business is conducted.

VII. Related Cases

1. A minority shareholder brought direct action against a corporation to enforce its right

to obtain financial statements and inspect its corporate records. The court found in the

corporation’s favor, stating that it could reasonably infer that the stockholder’s true

purpose for the inspection demand was to obtain competitive advantage over the

corporation. Advance Concrete Form v. Accuform, Inc., 462 N.W.2d 271 (Wis. App.

1990).

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Chapter 27 – Managing the Corporate Entity

2. The court in Willens v. 2720 Wisconsin Ave. Co-op. Ass’n, Inc., 844 A/2d 1126 (D.C.

App. 2004), recognized that generally the business judgment rule will not apply

where there is a breach of the duty of loyalty.

VIII. Teaching Tips and Additional Resources

1. Ask students for their views on insider trading. Insider trading is discussed on the

Internet site of the U.S. Securities and Exchange Commission at

http://www.sec.gov/answers/insider.htm.

2. An article discussing the conviction of Martha Stewart on obstruction of justice

charges stemming from the sale of stock can be found at

http://money.cnn.com/2004/03/05/news/companies/martha_verdict/.

3. The SEC provides information regarding laws governing the securities industry,

including the Sarbanes-Oxley Act at http://www.sec.gov/about/laws.shtml#sox2002.

4. Information regarding the Public Company Accounting Oversight Board established

by Congress to oversee the audits of public companies in order to protect the interests

of investors is available at http://pcaobus.org/Pages/default.aspx.

5. Information is available from the FDIC at

https://www.fdic.gov/bank/individual/failed/pls/ regarding its actions as receiver of

failed financial institutions against professionals such as directors, attorneys,

accountants, and others.

6. An article titled “The Difficulty in Holding Executives Accountable” available from

the New York Times at

http://dealbook.nytimes.com/2014/07/21/the-difficulty-in-holding-executives-account

able/?_r=0 discusses issues involved with holding corporate officials responsible and

discusses proposed legislation to impose consequences for the failure to report

dangerous conditions.

7. For more detail on the steps that corporate directors should take when facing

wrongdoing in their corporations see Richard Cooper, “Business Crime: Handling

Violations,” The National Law Journal, July 5, 2004, p. 11.

8. A corporation’s board of directors usually has the right to hire officers of the

corporation, determine corporate policy, and authorize loans, real estate purchases,

and pension plans.

9. Inform students that boards of directors traditionally take formal action by vote. Each

member has one vote; and a director may not vote by proxy.

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Chapter 27 – Managing the Corporate Entity

10. Corporations are often held responsible for the actions of their officers. The concept

of implied authority can be used in court to establish an agency relationship between

the directors and the officers of a corporation.

11. Divide the class into five groups and assign one corporate control theory to each

group. Ask the groups to research the history of their theory and provide a descriptive

explanation of the theory. Students could then present their findings to the class,

spurring a discussion about which theory is best for stockholders, directors, and for

the economy in general.

12. Have students discuss the relevance of the government control theory in light of the

poor track record of socialist economies. What parallels are evident between state

control theory and socialist governments? What adjustments could be made to state

control theory to make it more practical?

13. Discuss the pros and cons of running a corporation by managerial control and by

shareholder democracy. Encourage students to share their experiences with

management in the workplace and to express their opinions on how a corporation

should be run. Discuss the interests of other parties, such as shareholders, directors,

customers, and consumers.

14. List the various methods of shareholder voting control on the board (cumulative

voting, proxy solicitation, voting trusts, pooling agreements, and shareholder

proposals). Have the students explain each voting method and then ask them to help

you compile a list of advantages and disadvantages for each. Conclude by asking

students to decide which is the most powerful and which is the weakest of the voting

techniques.

15. States often use the following criteria to identify a true voting trust: There is a grant

of voting rights for an indefinite period of time; the acquisition of voting control of

the corporation is the common purpose of the shareholders to the trust; the voting

rights are separated from the other attributes of stock ownership.

16. Have students study the voting section of Robert’s Rules of Order. Then, stage a mock

shareholders’ meeting to elect the members of the board of directors of an imaginary

company. Student nominees should come to class prepared to present to shareholders

their ideas on the future of the company. Shareholders may present their proposals,

too. Supervise the voting so that correct parliamentary procedure is followed.

17. The American Law Institute Principles state: “A director or officer who makes a

business judgment in good faith fulfills the duty under this section if the director or

officer (1) is not interested in the subject of the business judgment; (2) is informed

with respect to the subject of the business judgment to the extent the director or

officer reasonably believes to be appropriate under the circumstances; (3) and

rationally believes that the business judgment is in the best interests of the

corporation.”

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Chapter 27 – Managing the Corporate Entity

18. Discuss the consequences of holding a corporation liable for the actions of its

officers. Ask students to think of examples of situations in which a corporation should

not be legally accountable for the actions of its officers.

19. Ask students to write about the purpose of the fairness rule and about its

effectiveness. What role does ethics play in the fairness rule? Should laws be passed

to ensure that corporate managers abide by the standards of the fairness rule?

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