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Chapter 39
Corporate Formation and Financing
INTRODUCTION
A corporation exists only by statute. Generally, corporations exist only under state law, which can differ from
state to state. The Model Business Corporation Act (MBCA), first published in 1946 and revised every few years, is a
codification of corporation law that has influenced the codification of corporation statutes in many states. Today, the
majority of state statutes are versions of a recent major revision of the MBCA, which is referred to as the Revised
Model Business Corporation Act (RMBCA).
CHAPTER OUTLINE
I. The Nature and Classification of Corporations
A corporation has the right of access to the courts, the right of due process, freedom from unreasonable
searches and seizures, and freedom of speech.
2 UNIT EIGHT: BUSINESS ORGANIZATIONS
A. CORPORATE PERSONNEL
Corporate officers and employees run the daily operations of a corporation and answer to the board;
ADDITIONAL BACKGROUND—
Early Forms of Corporations
Although corporations play a central role in the global economic system, the corporate entity itself is a
relatively recent invention.
The shareholder form of business organization developed in Europe at the end of the seventeenth
century. These so-called joint stock companies frequently collapsed because their organizers absconded
with the funds or proved to be incompetent.
Municipalities were the most common corporations in the eighteenth century.
Several business corporations were formed after the Revolutionary War, but it was not until the
nineteenth century that the corporation came into common use for private business. In 1811 the state of New
B. THE LIMITED LIABILITY OF SHAREHOLDERS
The key feature of a corporation is the limit of its owners’ liability, for corporate obligations, to the
amounts of their investments in the firm. Of course, a lender may require otherwise or a court may
“pierce the corporate veil.”
C. CORPORATE EARNINGS AND TAXATION
Corporations can retain corporate profits or pass them on to shareholders in the form of dividends.
1. Corporate Taxation
2. Holding Companies
CHAPTER 39: CORPORATE FORMATION AND FINANCING 3
D. CRIMINAL ACTS
A corporation may be held liable for the crimes of its agents and employees, if the punishment can be
applied to the corporation. Penalties may include fines of up to hundreds of millions of dollars, depending
on the offense, the amount of money involved, and the extent to which company officers are implicated.
ENHANCING YOUR LECTURE—
THE INTERNET TAXATION DEBATE
Since the advent of the Internet, governments at the state and federal levels have debated the following
question: Should state governments be able to collect sales taxes on goods sold via the Internet? Many
THE SUPREME COURT’S APPROACH
According to a United States Supreme Court ruling in 1992, no individual state can compel an out-of-state
business that lacks a substantial physical presence within that state to collect and remit state taxes.a If the
chosen not to tax Internet transactions.
A STATE COURT’S DECISION
The issue of Internet taxation came before a Tennessee appellate court in Prodigy Services Corp. v.
Johnson.b Prodigy, a Delaware corporation with its principal place of business in New York, is an Internet
service provider (ISP) that offers two software programs for purchase online. A Tennessee statute imposes
an obligation to collect sales taxes on anyone supplying "telecommunication services" to state residents. The
Tennessee Department of Revenue determined that Prodigy’s services constituted telecommunication
services and assessed sales taxes. Prodigy appealed this tax assessment.
Ultimately, the state appellate court held that Prodigy did not have to charge its Tennessee customers the
4 UNIT EIGHT: BUSINESS ORGANIZATIONS
FOR CRITICAL ANALYSIS
Although most states currently do not require corporations that sell goods and services online to collect
state sales taxes, businesspersons should be aware that the law in this area is still developing. Thus,
corporations may be required to collect state taxes on Internet sales in the future. Should the fact that an
out-of-state corporation pays affiliates in a state to direct consumers to its Web site be sufficient to
require the corporation to collect taxes on Web sales to state residents? Why or why not?
a. See Quill Corp. v. North Dakota, 504 U.S. 298, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992).
b. 125 S.W.3d 413 (Tenn.Ct.App. 2003).
E. TORT LIABILITY
A corporation is liable for the torts committed by its agents or officers within the course and scope of their
employment.
F. CLASSIFICATION OF CORPORATIONS
1. Domestic, Foreign, and Alien Corporations
A corporation is a domestic corporation in its home state, a foreign corporation in another state, and
CASE SYNOPSIS—
Case 39.1: Drake Manufacturing Co. v. Polyflow, Inc.
Drake Manufacturing Co. entered into a contract to sell couplings—which the contract defined as
“products designed * * * for use as termination fittings in * * * Thermoflex Tubing”—and portable swaging
machines to Polyflow, Inc. Drake promised to ship the goods from Drake's plant in Sheffield, Pennsylvania.
When Polyflow did not pay for all of the couplings and machines, Drake filed a suit in a Pennsylvania state
court against the buyer, alleging breach of contract. But Drake had failed to obtain a certificate of authority to
Notes and Questions
Three weeks after the verdict, Drake obtained a certificate of authority from the state. Almost two
months after the verdict, Polyflow filed a post-trial motion seeking judgment n.o.v. Drake submitted
the recently-obtained certificate in response. Did this submission make it possible for Drake to sue
CHAPTER 39: CORPORATE FORMATION AND FINANCING 5
ENHANCING YOUR LECTURE—
JURISDICTION OVER ALIEN CORPORATIONS
If a U.S. consumer is injured by a product manufactured by a corporation located in another country, can
the consumer sue the corporation in a U.S. state court? In other words, may a U.S. state court exercise
personal jurisdiction over an alien corporation? The answer depends on whether the defendant corporation
has sufficient “contacts” with the state where the lawsuit is filed. If the defendant corporation meets the
“minimum-contacts” requirement, then the state court can exercise jurisdiction over the corporation.
Generally, the minimum-contacts requirement is satisfied if a corporation does business in the state,
advertises or sells its products in the state, or places its goods into the “stream of commerce” with the intent
that the goods be sold in the state.
Alien corporations that are sued in U.S. courts sometimes claim that forcing them to travel to the United
FOR CRITICAL ANALYSIS
How might a foreign manufacturer that sells its products in the United States avoid being “haled
into court” in this country to defend against a product liability action?
2. Public and Private Corporations
3. Nonprofit Corporations
Corporations formed without a profit-making purpose are nonprofit corporations. Usually private,
these firms include hospitals and universities.
CASE SYNOPSIS—
Case 39.2: Pantano v. Newark Museum
6 UNIT EIGHT: BUSINESS ORGANIZATIONS
Loredana Pantano was an attorney for La Casa de Don Pedro, a nonprofit organization. La Casa told
Pantano to go to the Newark Museum for a panel discussion being held in the Museum’s auditorium as part of
La Casa’s anniversary. The Museum, also a nonprofit, charged La Casa a fee. At an entrance to the Museum,
Pantano slipped and fell, injuring her back. She filed a suit in a New Jersey state court against the Museum,
alleging that it was negligent. The defendant filed a motion for summary judgment, contending that under the
state Charitable Immunity Act (CIA), a nonprofit corporation is not liable to a person who suffers an injury due
to the negligence of the firm if the person is “a beneficiary * * * of the works of such nonprofit corporation.”
The court granted the motion. Pantano appealed.
..................................................................................................................................................
Notes and Questions
Suppose that the Museum had not been a nonprofit corporation. Would the organization or its
shareholders have been liable for Pantano’s injury? If the Museum had been a for-profit firm, the
ENHANCING YOUR LECTURE—
THE DARTMOUTH COLLEGE CASE (1819)
In 1819, the United States Supreme Court heard the case of Trustees of Dartmouth College v.
Woodward.a The decision focused on the continued private existence of a small college in New Hampshire
but had a lasting impact on U.S. corporate law.
THE DISPUTE OVER THE STATUS OF DARTMOUTH COLLEGE
Dartmouth College was founded by the Reverend Eleazar Wheelock, a young Connecticut minister who
CHAPTER 39: CORPORATE FORMATION AND FINANCING 7
disputes arose over the running of the institution, and the participants eventually divided along the prevailing
political party lines of New Hampshire.
The Republican groupb believed that the college should be under the control of the state and become a
public rather than a sectarian institution. The Republicans persuaded the New Hampshire Congress to pass
legislation that significantly altered the composition of the board of trustees and added a board of overseers
with authority to control the college.
The Federalistc board of trustees wanted to preserve the conservative, congregational character of the
THE SUPREME COURT’S DECISION
Chief Justice John Marshall delivered the opinion of the United States Supreme Court. He stated that the
grant of the charter was a contract involving private property within the meaning of Article I, Section 10, and
that the legislative acts of New Hampshire, passed without the trustees’ assent, were not binding on them.
Justice Joseph Story, in a separate opinion, distinguished between public and private corporations. He
stated that if the shareholders of a corporation were municipal or other public officials, the corporation was a
APPLICATION TO TODAY’S WORLD
This case is a landmark in corporate law because it allowed for the continued existence of private
corporations in the United States. Story’s opinion opened an avenue for the future regulation of new
corporations, while at the same time creating vested rights in private corporations. Marshall and Story both
made it clear that the United States Supreme Court would afford the property rights of private corporations the
same protection afforded to other forms of property.
4. Close Corporations
A close corporation is one whose shares are held by relatively few persons (who also often are its
directors or officers). Generally, because the number of shareholders is small, there is no market
8 UNIT EIGHT: BUSINESS ORGANIZATIONS
for the shares. Some states have special statutes that cover close corporations. Permitting them to
avoid many of the formalities of other corporations [RMBCA 7.32].
a. Management of Close Corporations
b. Transfer of Shares in Close Corporations
• In the articles of incorporation or under a shareholder agreement, there is often a restric-
tion on transfer of the shares, which may also limit their market.
ADDITIONAL BACKGROUND—
Close Corporation Stock-Transfer Restrictions
In February 1955, Robert Leihser, Albert Rench, and Claude Mullen bought Loyd Trucking Corporation.
They divided the fifty corporate shares equally and signed an agreement in 1956 that should any of them die
or wish to sell his shares, the remaining shareholder or shareholders would buy the shares. A procedure was
In Rench v. Leihser, 139 Ill.App.3d 889 (1986), the Appellate Court of Illinois reversed the decision of the
trial court, finding that the conduct of Leihser and Rench after their purchase of Mullen’s stock terminated the
agreement in 1961. Although agreements imposing transfer restrictions on the stock of close
c. Shareholder Agreement to Restrict Stock Transfer
Under a shareholder agreement, there is often a restriction on transfer of the shares, which
may also limit their market.
d. Misappropriation of Close Corporation Funds
CHAPTER 39: CORPORATE FORMATION AND FINANCING 9
5. S Corporations
Certain corporations qualify under Subchapter S of the Internal Revenue Code to avoid the impo-
sition of income taxes at the corporate level.
a. Important Requirements
The requirements for S corporation status and its benefits include—
• The corporation must be a domestic corporation.
b. Effect of S Election
An S corpotation is taxed like a partnership. The firm’s entire income can be taxed in the
shareholder’s bracket. Shareholders can use losses to offset other income.
6. Professional Corporations
In general, the law governing the professional corporations is similar to the law governing ordinary
business corporations.
• Despite the otherwise limited liability of a corporation, a shareholder in a professional
7. Benefit Corporations
These corporations differ from traditional corporation in purpose, accountability, and transparency.
• Purpose—Many states have enacted laws allowing for benefit corporations, which are
organized for-profit but seek to have a material positive impact on society and the
environment.
II. Corporate Formation
The formation of a corporation has two steps: (1) organizational and promotional efforts, and (2) the legal
process of incorporation.
A. PROMOTIONAL ACTIVITIES
10 UNIT EIGHT: BUSINESS ORGANIZATIONS
B. INCORPORATION PROCEDURES
1. Select the State of Incorporation
Some states offer more advantageous tax or incorporation provisions. Consequently, companies
CHAPTER 39: CORPORATE FORMATION AND FINANCING 11
2. Secure the Corporate Name
• All state require that a name include Corporation, Incorporated, Limited, Company, or and
abbreviation of one of these terms.
3. Prepare the Articles of Incorporation
• The articles serve as a primary source of authority for the corporation’s future organization and
business functions, and include basic information about the corporation—
The name of the corporation.
The number of shares the corporation is authorized to issue.
4. File the Articles with the State
The articles are sent to the appropriate state official (usually the secretary of state). Many states
issue a certificate of incorporation authorizing the corporation to do business.
C. FIRST ORGANIZATIONAL MEETING TO ADOPT BYLAWS
After issuance of the certificate, the first organizational meeting is held. The first board is elected,
ENHANCING YOUR LECTURE—
HOW TO INCORPORATE ONLINE
Today, just about anybody can form a corporation for any lawful purpose in any state. The requirements
differ from state to state. You do not have to form your corporation in the state where you live or the state
where you are doing business, however. In fact, many individuals obtain their corporate charters from the
