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Chapter 39
Corporate Formation and Financing
See Separate Lecture Outline System
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).
This chapter gives your students a detailed introduction to the corporate form. Among the topics in the chapter are the
nature of the corporation, the classifications of corporations, the requirements for forming a corporation, and the items that are
usually included in the articles of incorporation. The powers that may be exercised by a corporation, as well as the situations in
944 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
which the corporate veil may be pierced, are touched on briefly. An outline of the financial foundation of the corporate form of
doing business completes the chapter.
ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
The following video supplements relate to topics discussed in this chapter—
PowerPoint Slides
To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for
Chapter 39.
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips on topics covered in this chapter include the following.
• Ask the Instructor
• Legal Conflicts in Business
Corporation or LLC: Which Is Better?: What’s the best organization method for Wizard Internet?—The software
start-up thinks about changing its structure from a partnership, but can’t agree on whether it should become a
corporation or an LLC.
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.
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Corporate officers and employees run the daily operations of a corporation and answer to the board; directors
manage the firm; shareholders elect the directors. A shareholder can sue the corporation, and the corporation
can sue a shareholder. Under certain circumstances, a shareholder can sue on behalf of a corporation.
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.
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.”
ANSWER TO VIDEO QUESTION LTR. A
Compare the liability that Anna and Caleb would be exposed to as shareholders/owners of a corporation versus as
members of an LLC. In a corporation, Anna and Caleb, as shareholders/owners, would not be held personally liable for
liability in either the corporate or LLC form of business organizations.
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C. CORPORATE EARNINGS AND TAXATION
Corporations can retain corporate profits or pass them on to shareholders in the form of dividends. Profits that
are not distributed are retained earnings and can be invested for higher profits, which may cause the price of the
stock to rise, benefiting shareholders.
1. Corporate Taxation
2. Holding Companies
Holding companies are often established in offshore no-tax or low-tax jurisdictions. A corporation whose
shares are held in a holding company may transfer cash and other investments to be taxed in that
jurisdiction.
ANSWER TO VIDEO QUESTION LTR. B
How does the taxation of corporations and LLCs differ? Corporations pay income tax on net profits, with no
deduction for dividends, and then the shareholders pay income tax on the dividends they receive. In other words,
corporations are subject to double taxation. The LLC is not (necessarily) taxed as an entity, but its members are taxed
personally on profits “passed through” the LLC. If the LLC has more than one member, however, the members can
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 state governments claim
that sales taxes should be imposed on such transactions. They argue that their inability to tax online sales of goods to
in-state customers by out–of-state corporations has caused them to suffer significant losses in sales tax revenues.
Opponents of Internet taxation argue that taxing online sales will impede the growth of e-commerce. They also claim
that because online sellers do not benefit from the state services that are typically paid for by tax revenues (such as fire
departments and road construction), they should not be required to collect sales taxes.
THE SUPREME COURT’S APPROACH
corporations to collect and remit state sales taxes. Congress so far has chosen not to tax Internet transactions.
A STATE COURT’S DECISION
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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
customer to the main computer in New York. Thus, in the court’s opinion, Prodigy was a consumer of
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).
D. TORTS AND CRIMINAL ACTS
E. 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 alien
corporation in another country. To do business outside its state of incorporation, a firm must obtain a
certificate of authority where it plans to do business.
ENHANCING YOUR LECTURE—
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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. As discussed in Chapter 3, 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.
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
A public corporation is formed by the government to meet a political or governmental purpose. Private
corporations are created for private benefit. Most corporations are private.
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.
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THE DISPUTE OVER THE STATUS OF DARTMOUTH COLLEGE
Dartmouth College was founded by the Reverend Eleazar Wheelock, a young Connecticut minister who sought to
establish a school to train both missionaries and Native Americans. In 1769, a corporate charter was obtained from the
royal governor of New Hampshire. The charter made Wheelock and his English patrons who had donated capital to the
college a self-perpetuating board of trustees for the project. When Wheelock died, his son became president of the
college. Under the new, less experienced leadership, many 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.
lating changes in the self-governing structure of the board. The New Hampshire legislature was, therefore, without
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 public corporation
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.
a. 17 U.S. (4 Wheaton) 518, 4 L.Ed. 629 (1819).
b. The forerunner of the modern-day Democratic Party.
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c. The Federalists were an early political group, or party, that advocated a strong national government.
3. Nonprofit Corporations
Corporations formed without a profit-making purpose are nonprofit corporations. Usually private, these
firms include hospitals and universities.
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a. Management of Closely Held Corporations
The shareholders are often the firm’s directors and officers. More than a simple majority vote may be
requited to prevent a majority shareholder from dominating the firm.
ADDITIONAL BACKGROUND—
Closely Held 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 described in the
agreement for transferring the shares in that event. In 1961, Claude Mullen sold his stock, and Leihser and Rench each
bought half of Mullen’s shares. The procedural details outlined in the 1956 agreement were not followed by Mullen,
however, when he sold his shares. Leihser and Rench also violated the 1956 agreement by assigning one share of stock
each to their respective spouses. Then in 1981, Rench died. Leihser sought to buy Rench’s shares from Rench’s wife, in
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.
CASE SYNOPSIS—
Case 39.1: Williams v. Stanford
Paul and James Williams held 30 percent of the stock in Brown and Standard Inc. (B&S), a construction company.
John Stanford owned the other 70 percent. On learning that Stanford had misappropriated at least $250,000 from B&S,
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the Williamses filed a shareholder’s derivative suit in a Florida state court on B&S’s behalf against Stanford. Stanford
quit B&S, and gave its assets and liabilities to a new company, J.C. Stanford & Sons. He offered the Williamses $25,000
each for their B&S stock. They asked for $125,000. The court held that the Williamses’ counteroffer undercut their right
to maintain their suit and issued a judgment in Stanford’s favor. The Williamses appealed.
is offered for shares in a close corporation. A court should not become mired in a dispute about the fairness of the
price. But when shareholders can point to acts of self-dealing or misrepresentation, they are entitled to greater
……………….……………………………………………………………………………………………………………....
Notes and Questions
If Stanford had bought out the Williamses before misappropriating B&S’s funds, would the misappropriation have
been wrong? In other circumstances, this misappropriation would still have been careless, but whether it would have
been illegal or unethical would depend on those other circumstances. For example, if B&S had been unable to meet its
obligations due to a lack of funds, the misappropriation might form a basis for piercing the corporate veil and holding
Stanford personally liable.
ANSWER TO “THE ETHICAL DIMENSION” QUESTION IN CASE 39.1
Was it acceptable for the Williams’ to demand $125,000 each for their shares? Why or why not? In this situation, it
seems quite fair for the Williams brothers to ask for this amount. Indeed, if Stanford had cheated them out of
$250,000, this amount seems small.
d. Misappropriation of Closely Held Corporation Funds
The remedies available to minority shareholders for a majority shareholder’s commission of this tort
follow the remedies available to other corporations in the same circumstances.
5. S Corporations
a. Requirements
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6. Professional Corporations
In general, the law governing the professional corporations is similar to the law governing ordinary business
corporations. There is an important difference, however: despite the otherwise limited liability of a
corporation, a shareholder in a professional corporation may be liable for the malpractice of another
member. Shareholders are protected, however, from tort liability, other than malpractice, imposed by the
acts of other members.
II. Corporate Formation
The text divides the formation of a corporation into two steps: (1) organizational and promotional efforts, and (2) the
legal process of incorporation.
A. PROMOTIONAL ACTIVITIES
Promoters take the preliminary steps of organizing a corporation: issuing a prospectus and securing a charter. A
promoter is personally liable on preincorporation contracts, even after incorporation unless the third party
releases the promoter or the corporation assumes the contract by novation (Chapter 12).
B. INCORPORATION PROCEDURES
1. Select the State of Incorporation
2. Secure the Corporate Name
a. Must Include Words That Disclose Corporate Status
3. Prepare the Articles of Incorporation
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The articles include basic information about the corporation and serve as a primary source of authority for
its future organization and business functions.
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, bylaws are
passed, stock is issued, and so on. What is transacted depends on the state’s incorporation statute, the nature of
the business, the provisions in the articles, and the desires of the promoters.
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 state of Delaware because
it has the fewest legal restrictions on corporate formation and operation. Traditionally, Delaware has also been the
state most often chosen for “mail–order incorporation.” Today, instead of incorporating by mail, entrepreneurs have
the option of incorporating in the state of their choice via online companies that offer incorporation services.
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FINDING INFORMATION ON INCORPORATION REQUIREMENTS
Nearly every state has a Web site at which you can find the individual state’s requirements for incorporation. (To
locate your state’s Web site, go to http://www.statelocalgov.net.) Most state sites post guidelines or instructions on
upload documents related to any corporate transaction or litigation into an online database. This service provides
centralized access to important documents for authorized users anywhere in the world and allows multiple parties to
track ongoing negotiations.
INCORPORATING ONLINE
If you wish to incorporate via an online incorporation service, all you need to do is fill out a form online. For
example, if you fill out the incorporation forms at the TCC Web site, TCC will then file the forms with the appropriate
incorporation service to perform other services such as acting as registered agent for your corporation, obtaining a tax
CHECKLIST OF FACTORS TO CONSIDER WHEN INCORPORATING ONLINE OR OFFLINE
2. Find out not only the initial cost of incorporation but also any continuing costs, such as annual fees and possible
fees for attorneys and accountants.
3. Learn what formalities are necessary and the amount of record keeping that will be required.
4. Determine what should be included in the bylaws.
5. Is “do–it–yourself” online incorporation appropriate? (Depending on the nature and potential growth of your
business, you may wish to contact an attorney to take you through the necessary steps in incorporating your business.)
1. De Jure Corporations
2. De Facto Corporations