Saudi Electronic University Chapter 8 Board of Directors and Business Law Paper

In 2001, British-Dutch corporation Unilever attempted to purchase the assets of Ben & Jerry’s Ice Cream. The Board of Directors of Ben & Jerry’s refused the offer. Unilever’s offer was very generous and would have resulted in a major windfall for the shareholders of Ben & Jerry’s.

The Shareholders threatened to sue the Board of Directors for a breach of fiduciary duty arguing the Board of Directors had a duty for care to make good decisions on behalf of the Corporation. And denying the purchase offer violated that duty.

In fear of the lawsuit, the Board agreed to the sell terms. Do you believe the Board of Directors had a duty to accept the buyout offer? And did their failure to accept it amount to a breach of the fiduciary duties owned to the shareholders?

Please follow these tips to find the solution. It will help you to understand what’s exactly the requirements.

The answer requires a careful and deeply reading of Chapter 8 from the book below, and an understanding of many terms, the most important of it which must talk about it are:

– Duty of care

– Malfeasance

– Business judgment rule

Understanding
Corporate Law
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Understanding
Corporate Law
FIFTH EDITION
Arthur R. Pinto
PROFESSOR OF LAW EMERITUS
BROOKLYN LAW SCHOOL
Douglas M. Branson
W. EDWARD SELL CHAIR IN BUSINESS LAW
UNIVERSITY OF PITTSBURGH SCHOOL OF LAW
CAROLINA ACADEMIC PRESS
Durham, North Carolina
Copyright © 2018
Carolina Academic Press, LLC
All Rights Reserved
Library of Congress Cataloging-in-Publication Data
Names: Pinto, Arthur R., author. | Branson, Douglas M., author.
Title: Understanding corporate law / Arthur R. Pinto and Douglas M.
Branson.
Description: Fifth edition. | Durham, North Carolina : Carolina Academic
Press, LLC, [2018] | Series: Understanding series | Includes
bibliographical references and index.
Identifiers: LCCN 2018011007 | ISBN 9781531010003 (alk. paper)
Subjects: LCSH: Corporation law–United States.
Classification: LCC KF1414 .P56 2018 | DDC 346.73/066–dc23
LC record available at https://lccn.loc.gov/2018011007
eISBN 978-1-53101-001-0
Carolina Academic Press, LLC
700 Kent Street
Durham, North Carolina 27701
Telephone (919) 489-7486
Fax (919) 493-5668
www.cap-press.com
Printed in the United States of America
Contents
Preface
Chapter 1 · Introduction and Formation
§ 1.01 Introduction
§ 1.02 Sources of Corporate Law
§ 1.03 Historical Background
§ 1.04 Choice of Form
[A] Sole Proprietorship
[B] Partnership vs. Corporation
§ 1.05 Limited Partnerships
§ 1.06 Limited Liability Company
§ 1.07 Taxation
[A] Double Taxation
[1] Subchapter S Corporation
[2] Limited Liability Companies
§ 1.08 Incorporation and Organization
§ 1.09 Choice of Law
[A] Delaware’s Dominance
§ 1.10 Ultra Vires
[A] Corporate Social Responsibility and Philanthropy
§ 1.11 Social Benefit Organizations
Chapter 2 · Promoters’ Liability and Defective Incorporation
§ 2.01 Introduction
§ 2.02 Promoters’ Liability on Preincorporation Contracts
[A] Overview
[B] Liability of the Promoter
[C] The Strict View of Promoters’ Liability
[D] Reliance on the Intent of the Parties
[E] Liability of the Newly Formed Corporation or LLC
[F] Promoters’ Fiduciary Duties
§ 2.03 Defective Incorporation
[A] The Problem
[B] The De Facto Corporation Doctrine and Corporation by
Estoppel
[C] Statutory Abolition of the De Facto Corporation Doctrine
[D] Does Corporation by Estoppel Survive the Model Business
Corporation Act?
[E] Model Business Corporation Act Compromise
[F] Corporate Death
Chapter 3 · Piercing the Corporate Veil
§ 3.01 The Concept of Limited Liability
§ 3.02 The Limited Liability Debate
§ 3.03 Grounds for Piercing the Corporate Veil
[A] Introduction
[B] Intermixture of Affairs
[C] Lack of Corporate Formalities
[D] Veil Piercing in Limited Liability Companies (LLCs)
[E] Inadequate Capitalization
[1] Overview
[2] What Is Capital for These Purposes?
[3] When Is Capital Adequate?
[4] Is Inadequate Capitalization Alone a Sufficient Ground?
[5] Does a Duty Ever Arise to “Top Off” the Original
Capital?
[F] Evasion of a Contract or Statute or Use of a Corporation
Solely to Work a Fraud
[G] Instrumentality Theories
[H] Torts Versus Contracts
§ 3.04 Equitable Subordination
§ 3.05 Piercing the Corporate Veil: Procedural Contexts
§ 3.06 Statutory Liability Under Environmental Laws
§ 3.07 Successor Corporation Liability in Products Liability
§ 3.08 Piercing the Corporate Veil — Structural Settings
[A] Personal Shareholder Liability
[B] Parent-Subsidiary Settings
[C] Brother-Sister (Sibling) Corporation Settings
[D] Enterprise Liability
[E] Reverse Piercing
[F] Participation
[G] Summary
Chapter 4 · Financing the Corporation
§ 4.01 Introduction
§ 4.02 Securities
[A] Debt
[B] Common Shares
[C] Preferred Shares
§ 4.03 Leveraging and Capital Structure
§ 4.04 Legal Capital Rules
[A] Preemptive Rights
[B] Par Value
[C] Dividends and Repurchases of Shares
§ 4.05 Valuation
[A] Liquidation Value
[B] Book Value
[1] Cost Based Accounting
[2] Depreciation
[3] Intangible Assets
[C] Earnings Approach
[1] Capitalization of Earnings
[2] Cash Flow as Earnings
[3] The Rate
Chapter 5 · The Legal Model and Corporate Governance: Themes and the
Allocation of Power Under State Law
§ 5.01 Introduction
§ 5.02 Themes
[A] Focus of Corporate Governance and Stakeholders
[B] Publicly Held Corporation
[C] The Stock Markets
[1] Benefits of Stock Markets
[2] Shareholder Protection and Stock Markets
[D] The Efficient Capital Market Hypothesis
[E] Role of Ownership
[1] The Berle-Means Corporation — Separation of
Ownership from Control
[2] Institutional Investors
[3] Political Significance of Share Ownership
[F] Independent Directors
[G] Gatekeepers
[H] Federalism
[I] Publicly Held vs. Closely Held Corporations
§ 5.03 Theories of the Firm
[A] Regulatory Approach
[B] Management, Director, or Shareholder Approach
[C] Law and Economics Approach
[1] Agency Costs
[2] Markets
[3] Nexus of Contracts
[4] Critics of Contractual Approach
[5] Behavioral Economics
§ 5.04 The Legal Model
§ 5.05 Shareholders
[A] Right to Vote
[1] Cumulative Voting
[2] Right of Expression
[B] Shareholder Meetings and Proxy Voting
[C] The Proxy Fight
[1] Change or Influence Management
[2] Replace Directors to Facilitate an Acquisition
[3] Change Policy
[a] Shareholder Proposals
[b] Withholding Votes
[c] Nominating Directors in Management’s Proxy
Statement
[4] Collective Action Problem
[5] Proxy Expenses
[D] Shareholder Democracy
[1] Fiduciary Duty
[E] Vote Buying
[F] Right to Information
§ 5.06 Board of Directors
[A] Board Structure
[B] Meetings
[1] Actions Without a Meeting
§ 5.07 Officers
[A] Authority
§ 5.08 Financial Scandals
[A] The Sarbanes-Oxley Act of 2002
[B] Dodd-Frank Act of 2010
Chapter 6 · Mergers and Acquisitions
§ 6.01 Introduction
§ 6.02 Mergers
[A] Triangular Merger
[B] Reverse Triangular Merger
[C] Short Form Merger
§ 6.03 Sale of Assets
§ 6.04 Tender Offer
§ 6.05 Other Legal Issues
§ 6.06 Appraisal Remedy
[A] Delaware Block Approach
[1] The New Delaware Methodology
[B] Stock Market Exception
§ 6.07 De Facto Mergers
Chapter 7 · Introduction to Federal Regulation and the Proxy Rules
§ 7.01 Introduction and Overview
§ 7.02 SEC Jurisdiction and Periodic Reporting by Publicly Held
Corporations
[A] SEC Jurisdiction
[B] Periodic Reporting — An Overview
[C] Certifications, Code of Ethics Disclosure, and Penalties for
Earnings Restatements
[D] Private Securities Litigation Reform Act (PSLRA) Safe
Harbor for Forward Looking Statements
[E] Management Discussion and Analysis (MD&A)
[F] Earnings Management and Revenue Recognition Issues
§ 7.03 Securities Issuance
[A] The Federal Disclosure Philosophy
[B] Registration Requirements
[C] The Registration Process
[D] Exemptions From Registration
[1] Scope
[2] The Intrastate Exemption
[3] The Private Offering Exemption
[4] Regulation D Exemptions
[5] Crowdfunding
§ 7.04 Proxy Regulation
[A] Introduction
[B] A Proxy Solicitation Hypothetical
[C] Proxy Contests
[1] The Shareholder’s Role
[2] Inadvertent Solicitation and Other Problems
[3] Regulatory Burdens and Costs
[4] Proxy Contest Procedures and Further Costs
[D] Use of Shareholder Consents
[E] The Internet and the “Notice and Access” Proxy Regime
§ 7.05 The SEC Shareholder Proxy Proposal Rule: SEC Rule 14a-8
[A] Proposals
[B] Eligibility and Procedure
[C] Background on the Nature of the Proposals
[D] Mechanics of the Shareholder Proxy Proposal Process
[E] The 14a-8, Question 9(7), Ordinary Business Operations
Exclusion
[F] Other Rule 14a-8 Exclusions
[G] Proposals to Amend Corporate Bylaws
[H] CA, Inc. v. AFSCME Employees Pension Trust
§ 7.06 The Proxy Rules’ General Antifraud Rule: An Introduction to
General Disclosure Law Concepts
[A] Introduction
[B] SEC Rule 14a-9
[C] Implication of Private Rights of Action
[D] Standing to Sue
[E] Materiality of the Omission of the Misleading Statement
[F] State of Mind (Fault) Required
[G] Causation
[H] Remedies
Chapter 8 · Introduction to Fiduciary Duty: The Duty of Care, the
Business Judgment Rule and Good Faith
§ 8.01 Introduction
[A] Overview of Duty of Care and Loyalty
[B] Sliding Scale
§ 8.02 Policy Issues
[A] Law and Economics Approach
§ 8.03 Duty of Care
[A] Nonfeasance
[B] Malfeasance and the Business Judgment Rule
[C] Causation
§ 8.04 The Smith v. Van Gorkom Case
§ 8.05 The Demise of the Duty of Care
[A] Delaware General Corporation Law § 102(b)(7)
§ 8.06 Good Faith
[A] Disney Litigation and Good Faith
[B] The Duty to Monitor and Stone v. Ritter
§ 8.07 Duty of Disclosure
§ 8.08 Duty to Act Lawfully
Chapter 9 · The Duty of Loyalty and Conflicts of Interest
§ 9.01 Introduction
§ 9.02 Policy
§ 9.03 Interested Director Transactions
[A] Common Law
[B] Statutory Responses
[1] Weak Form Approach
[2] Semi-Strong Approach
[a] The New York Approach
[b] The Current California Approach
[3] Strong Form Approach
[a] Delaware Approach
[b] The MBCA Approach
§ 9.04 Executive Compensation
[A] Stock Options
[B] Good Faith and Compensation
[C] Waste
[1] Delaware’s Waste Standard
§ 9.05 Corporate Opportunity and Abuse of Position
[A] Legal Tests
[1] Interest Test
[2] Line of Business Test
[3] Fairness Test
[4] The ALI Test
[B] Financial Inability
[C] Multiple Boards
[D] Use of Information and Competition
[E] Undisclosed Profits
§ 9.06 Shareholder Voting — Ratification and Optional Voting
[A] Effect of Optional Disinterested Shareholder Voting
Chapter 10 · Controlling Shareholders
§ 10.01 Introduction
§ 10.02 Use of Control
[A] The Zahn Case
[B] Parent-Subsidiary Dealings
[C] Sale of Corporation
§ 10.03 Freezeouts
[A] Policy Issues
[B] State Law
[C] Cases
[1] The Weinberger Case
[2] Post-Weinberger Cases
[a] Appraisal versus Equity in Delaware
[b] Fair Dealing
[i] Negotiating Committee of Independent Directors
[ii] Majority of Minority Shareholder Voting
[iii] Both Independent Board and Shareholder
Approval
[c] Business Purpose
[d] The Controlling Shareholder’s Tender Offer
[D] Federal Law
[1] SEC Rule 13e-3
[2] SEC Rule 10b-5
§ 10.04 Sale of Control
[A] Looting
[B] The Perlman Case
[C] The California Approach
[D] Sale of Office
Chapter 11 · Special Problems of the Closely Held Corporation
§ 11.01 Introduction and Overview
[A] Definitions of a Close Corporation
[B] Illiquidity and Exploitation
[C] Corporate Law Responses to the Illiquidity and Exploitation
Situation
§ 11.02 Obtaining and Maintaining a Measure of Control
[A] Preview
[B] Shareholder Voting Agreements
[C] Irrevocable Proxies
[D] Voting Trusts
[E] Class Voting
[F] Cumulative Voting
[G] Summary
§ 11.03 Protecting Shareholder Expectations in Closely Held Corporations
Ex Ante
[A] Contract
[B] Long-Term Shareholder Tenure and Salary Agreements
[C] Less Than Unanimous Shareholder Agreements
[D] Other Agreements Affecting Directors’ Discretion
[E] Comprehensive Shareholder Agreements
§ 11.04 Restrictions on Share Transferability
[A] Introduction
[B] Umbrella Test — Unreasonable Restraint Upon Alienation?
[C] Other Legal Aspects of Share Transfer Restrictions
[1] Legal Capital and Funding
[2] Procedural Aspects
[3] Disparity Between Buy-Out Price or Formula and Fair
Price
[4] Implied Covenant of Good Faith and Fair Dealing
[5] Notice
§ 11.05 Other Governance Features of the Closely Held Corporation
[A] Overview
[B] Greater Than Majority Quorum and Voting Requirements
[C] Informal Action by Shareholders and Directors
§ 11.06 Close Corporation Statutes
§ 11.07 Protecting Shareholder Expectations in the Close Corporation Ex
Post
[A] Resetting the Problem
[B] Heightened Fiduciary Duty in the Close Corporation Setting
[C] Heightened Fiduciary Duty in Other Jurisdictions
[D] Two Worlds Collide: The Donahue Principle Meets
Employment at Will
[E] Involuntary Dissolution Statutes
[F] Cases of Deadlock
[G] Oppression Grounds
[H] Remedies in Involuntary Dissolution Cases
[I] Valuation Issues in Court Ordered Buyouts
[J] Conclusion
§ 11.08 Limited Liability Companies
[A] Introduction
[1] Hybrid Nature
[2] Manager-Managed
[3] Comparison with Limited Partnership
[4] Comparison with the Limited Partnership Hybrid
[B] Background
[C] Formation of an LLC
[D] Finance
[E] Veil Piercing in LLCs
[F] Authority of Members and Managers
[G] Fiduciary Duties of LLC Managers and Members
[1] Introduction
[2] Implied Covenant of Good Faith and Fair Dealing
[3] The Duty of Loyalty
[4] Competition with the LLC
[5] Opting out of Fiduciary Duties
[6] Exculpatory Provisions
[H] Dissolution of an LLC
[I] Limited Liability Partnerships
[J] Series
[K] Social Enterprises, Mission Driven Companies, and the Low
Profit Limited Liability Company (L3C)
Chapter 12 · Hostile Tender Offers
§ 12.01 Introduction
§ 12.02 The Rise and Fall of Hostile Tender Offers
§ 12.03 Policy Issues
[A] Proponents
[B] Opponents
§ 12.04 Tactics
[A] Bidder Tactics
[B] Target Tactics
[1] Poison Pills
§ 12.05 State Law
[A] Delaware Approach
[1] The Cheff Case
[2] The Unocal Test
[3] The Revlon Test
[4] The Time Case
[5] The QVC Case
[6] The Unitrin Case
[7] Shareholder Voting and Tender Offers
[8] Judicial Scrutiny of Deal Protection
[a] The Omnicare Case (Using Unocal)
[b] The Lyondell Case (Using Revlon)
[9] Summary
§ 12.06 Federal Securities Law — The Williams Act
[A] History
[B] Disclosure Rules
[C] Other Rules
[D] Section 14(e)
§ 12.07 State Takeover Statutes
[A] Introduction
[B] Policy Issues
[C] Constitutionality
[1] The Edgar Case
[2] The CTS Case
Chapter 13 · SEC Rule 10b-5 Disclosure and Insider Trading
§ 13.01 SEC Rule 10b-5 Disclosure and Insider Trading
§ 13.02 Disclosure Concepts and Elements of a Cause of Action Under
Rule 10b-5
[A] Implication of Private Rights of Action
[B] Standing to Sue
[C] Materiality
[D] State of Mind
[E] Pleading State of Mind
[F] Reliance (Transaction Causation)
[G] The Fraud on the Market Theory Reliance Substitute
[H] Loss Causation
[I] The “In Connection With” Requirement
[J] Privity
[K] Secondary Liability for Disclosure Violations
[L] Statutes of Limitation
§ 13.03 The Prohibition of Insider Trading: Is It Good or Bad?
§ 13.04 The Law of Insider Trading
[A] Common Law Background
[B] The Nature of the Insider Trading Prohibition
[C] Who Is an Insider?
[D] Tipper-Tippee Liability
[E] The Misappropriation Theory
[F] The Misappropriation Theory in the Supreme Court
[G] Tippees of Misapporiators
[H] Remedies and Enforcement
[I] SEC Regulation FD
§ 13.05 The Insider Trading Prohibition Under State Law
[A] Common Law
[B] Common Law Exceptions: The Kansas Rule
[C] Common Law Exceptions: Special Facts Doctrine
[D] Modern Expansion of the Special Facts Doctrine
[E] Finding Harm to the Corporation from the Insider’s Trading
§ 13.06 Regulation of Insider Trading Under Section 16 of the Securities
Exchange Act of 1934
[A] Statutory Provisions
[B] Parties Plaintiff and Calculation of Damages
[C] Who Is an Officer for Section 16 Purposes?
[D] Insider Status at Only One End of a Swing
[E] Takeover Players and Section 16(b)
Chapter 14 · Corporate Litigation
§ 14.01 Introduction
§ 14.02 The Nature of the Derivative Suit: Direct Versus Derivative, Pro
Rata Recovery, and Other Preliminary Issues
[A] The Nature of the Derivative Suit
[B] Direct Versus Derivative — Special or Distinct Injury Rule
[C] Direct Versus Derivative — Denial of Contract Rights
Associated With Shareholding
[D] Direct Versus Derivative — Closely Held Corporation
Exception
[E] Pro Rata (Individual) Recovery in Derivative Actions
[F] The Tooley Test in Delaware
§ 14.03 Qualifications of a Proper Plaintiff-Shareholder
[A] Record Ownership
[B] Contemporaneous Ownership
[1] Introduction
[2] Basis for the Rule
[3] Possible Exception: Undisclosed Wrongdoing
[4] Exception: Continuing Wrong
[5] Exception: Double Derivative Actions
[C] Continuous Owner
[D] Clean Hands Requirement
[E] Adequate Representation Requirement
[F] Selection of Lead Counsel
§ 14.04 Reforms of the Earlier Strike Suit Era
[A] Overview
[B] Verification Requirement
[C] Security for Expenses Requirements
§ 14.05 The Demand Rule
[A] Overview
[B] Demand Refused
[C] Demand Accepted
[D] Demand Excused
[1] Introduction
[2] The Futility Exception
[a] Introduction
[b] Legal Tests for Demand Futility
[c] Disabling Conflicts of Interest
[d] Lack of Independence
[3] Threat of Irreparable Harm
[4] Closely Held Corporations
[5] Delay
[6] Neutrality
[E] Demand on Shareholders
§ 14.06 Termination of Litigation: The Advent of the Special Litigation
Committee Device
[A] Background
[B] Application of the Business Judgment Rule
[C] Delaware and the Zapata Second Step
[D] Structural Bias and Other Criticisms
[E] Recent Cases
§ 14.07 Proposed Reforms of the Modern Strike Suit Era
[A] The ALI Proposals Briefly Considered
[B] The American Bar Association (Model Business Corporation
Act) Proposals
[C] Derivative Action Summary
[D] Bylaw and Contractual Impediments to Shareholder
Litigation
§ 14.08 Right to Trial by Jury, Attorneys’ Fees, and Miscellaneous Issues
[A] Right to Trial by Jury
[B] Attorneys’ Fees in Derivative Actions
[1] Entitlement: Common Fund Versus Common Benefit
Cases
[2] The Cosmetic (Collusive) Settlement Problem
[3] Computation of Fee Amounts: Lodestar Versus
Percentage of Recovery Methods
[4] Objectors and Intervenors
[5] The WorldCom Case
[C] Statute of Limitations or Laches?
[D] Who Pays?
§ 14.09 The Reprise of the Shareholder Class Action
[A] The Death of the Derivative Action and the Rise of the
“Stock Drop” Class Action
[B] The Private Securities Litigation Reform Act (PSLRA) of
1995
[C] Particularized Issues Under the PSLRA
[1] Pleading
[2] Loss Causation
[3] Selection of the Most Appropriate Plaintiff
[D] The Securities Litigation Uniform Standards Act (SLUSA) of
1998
[E] Mail and Wire Fraud Government Criminal Prosecutions
§ 14.10 Lawyering Problems in Corporate Litigation
[A] Attorney-Client Privilege
[B] Attorney-Client Privilege in Derivative Litigation
[C] The Corporation as Client
[D] Sarbanes-Oxley Act (SOX) § 307: The Conflict Between
“Reporting Up” and the Prohibition on Disclosure of Client
Confidences
§ 14.11 Indemnification and Insurance
[A] Overview
[B] Indemnification Statutes
[C] Advance of Fees and Other Expenses
[D] Fees on Fees
[E] Implementation by Contract
[F] Non-exclusive Versus Exclusive Statutes, Public Policy
Limits, and Consistency Limitations
[G] Overriding Requirement of Good Faith (Statutory)
[H] Insurance
[I] Summary
Table of Statues & Regulations
Table of Cases
Index
Preface
Understanding Corporate Law is intended to assist law students and lawyers
with a basic understanding of the law of corporations as taught in most
corporations courses. Significant business, economic and policy issues are
highlighted in connection with a thorough analysis of the important cases and
both state and federal statutory provisions used in the study of corporations. It
includes the major theoretical approaches used in current corporate law
literature. In each chapter, the authors identify important policies and discuss the
relationship of the law as it has developed to those policies. The rise of
institutional shareholder ownership and its effect on legal developments is
highlighted. Statutory issues are covered under both the General Corporation
Law of the State of Delaware and the Business Corporation Act. In addition,
significant sections from the Principles of Corporate Governance of the
American Law Institute are covered. The corporate scandals of 2001 and 2002
and the enactment of the federal Sarbanes-Oxley (2002); the financial crisis of
2008 and enactment of Dodd-Frank (2010); and JOBs (2012) Acts are also
covered. Chapter 11 now incorporates material on limited liability companies
(LLCs). This book is designed to be used with all of the major corporate law
casebooks.
We also have written this volume so that non-lawyers who desire to progress
beyond a rudimentary knowledge of corporate law may do so by reading this
book.
Although the book was a collaborative effort, Professor Pinto wrote Chapters
1, 4, 5, 6, 8, 9, 10 and 12. Professor Branson wrote Chapters 2, 3, 7, 11, 13 and
14.
Professor Pinto would like to acknowledge his partner Stephen J. Bohlen for
his constant support.
Professor Branson dedicates this book to Elizabeth, Clare and Annie.
The book is dedicated to our students past and present who have inspired this
project.
Arthur R. Pinto
Douglas M. Branson
Chapter 1
Introduction and Formation
§ 1.01 Introduction
The corporation is one of several ways to structure a business. Partnerships,
limited liability companies and sole proprietorships, as forms of business, far
outnumber corporations. However, the economic impact of the corporate format
is significant, since it is the form chosen by most large enterprises. Although
there is no standard definition for the term “corporation,” the United States
Supreme Court in the Dartmouth College case described it as follows:
A corporation is an artificial being, invisible, intangible, and existing
only in contemplation of law. Being a mere creature of law, it
possesses only those properties which the charter of its creation
confers upon it, either expressly, or as incidental to its very existence.1
A corporation is a separate legal entity2 which owes its existence to the state.
Its owners, called shareholders (sometimes “stockholders” by some state
statutes) because they own shares of stock, elect a distinct group, known as the
board of directors, to oversee the management of the business and select officers
to run it (the directors and officers are often called the “managers”). A
significant aspect of the study of corporate law (which includes state corporate
law and federal securities law) involves corporate governance and the means by
which the relationships between shareholders and managers are governed.3
Experiences vary widely in business formation, but we will describe one that
may help the reader relate to some of the material in this book. A business often
starts with an idea or invention but requires capital (money or contribution of
goods or services is also possible) or other people to get started or expand. The
initial business can be formed as a corporation, partnership, limited partnership
or limited liability company. The capital can be invested in the business in two
general ways.4 If capital is lent, then the relationship between the lenders and
the business creates a debtor-creditor relationship where the creditor is looking
for eventual repayment plus some current return usually in the form of interest
on the loan. If the capital is provided for an ownership stake, then the investors
are willing to forgo a promise to be paid interest or a set return on the
investment for the potential for sharing in the success of the business as owners.
Their investment provides equity for the business. The source of debt or equity
(i.e., ownership) can be friends, family, banks or groups of private investors
who are willing to invest to start up or expand a new business with the hope of
making a profit when the business is successful. Some private investors invest in
a later stage of the development of the business then the initial investors. Those
private investors are often called venture capitalists, which is a sub-category of
investors called private equity.5
Many businesses continue to operate and expand with a small number of
investors. These corporations are called closely-held corporations. But as
businesses grow, they often require substantial capital. To attract capital, a
business may have several options. It can attract capital by finding more private
investors (often called venture capitalists) or having another established
business invest in the business. For some companies, the early investors at some
point want to be cashed out of their investment. A company can raise more
capital or help cash out investors by selling it to another company or selling its
shares or debt to public investors. If selling its equity or debt more widely to the
public, i.e., going public, the corporate form is usually required.6 This initial
going public process for selling equity is called an “IPO,” initial public offering,
and is regulated by federal securities laws.7 If the corporation is selling its
shares to raise capital it is described as a primary offering. The money raised in
going public can be used to fund expansion of the business.8 If the public
offering involves selling the shares to pay back the initial investors, venture
capitalists, or employees, it is described as a secondary offering. Once a
corporation does a public offering, the shares are publicly traded in some stock
market that usually provides liquidity where investors can continually trade their
shares of the corporation.9 With shares trading, the corporation can use shares to
buy other businesses by paying with their shares or offer stock options (the right
to buy shares at a fixed price) to compensate employees and managers.10 Thus,
the option of going public provides flexibility to businesses to raise capital, use
its shares for business purposes, and allow for founders, employees, and private
investors the ability to cash in on their investments. Most of the well known
large businesses in the United States are publicly traded corporations, i.e., the
shares are held by a large number of shareholders and the shares trade in a stock
market.
As discussed in this book, there are different types of corporations which
have particular attributes, rules and legal issues depending upon the ownership
structure. In closely held corporations, where there are few shareholders, the
distinction between the shareholders and managers may be insignificant because
they may substantially overlap. When there is a group of shareholders
constituting the majority who control the business and another group is in the
minority, issues may arise as to their relationships and the control group taking
advantage of the minority.11 In some publicly held corporations, a group of
shareholders (maybe the founders or their family) or another corporation may
retain control and thus the public shareholders are minority shareholders.12
Again, in that context, issues will arise as to the relationship between the
majority and minority shareholders, and policies that favor the majority’s
interest over the minority.13 In many publicly traded corporations in the United
States, the original or controlling shareholders may have sold off most of their
shares and no longer control the corporation. In that case, there may not be any
large group of shareholders controlling the business. Instead there are numerous
and widely dispersed shareholders where no group of shareholders holds enough
shares to control the election of the directors and hence, the management of the
corporation. The dispersion of ownership allows the managers (the directors and
officers) to control the corporation even though they might own relatively few
shares (called separation of ownership from control). In this context, issues arise
as how these widely dispersed shareholders monitor those managers who run the
corporation.14
A basic need for any business is capital and investors need some assurance
that they will be protected. By buying shares they understand that there is risk
that the business may not be successful. The fundamental problem shareholders
face other than business risk when owning shares where they do not control the
corporation is that those who manage or control the business will either
mismanage the business or unfairly self-deal, i.e., steal. In both cases the
shareholders are harmed. Much of the discussion of corporate law in this book
seeks ways to minimize those problems.15
§ 1.02 Sources of Corporate Law
Every state has a corporate law statute that provides the rules for corporations
incorporated in that state (hereinafter “the statute”). The statutes indicate how to
incorporate, deal with financing and legal capital rules, establish the basic
structure of the board of directors, deal with shareholder power and rights, and
disposes of a variety of other issues. Every state also has judicially created law
or common law applicable to corporations. The courts not only interpret the
statutes but create important legal principles. For example, a shareholder’s right
to sue on behalf of the corporation in litigation called a derivative suit was
developed by the courts.16 Federal securities law is also a source of corporate
law and much of its regulation is disclosure- and protection-of-investorsoriented but not intended to directly affect the relationships within the
corporation.17 The stock markets where the shares of publicly traded
corporations are traded also have rules with which corporations must comply.18
Independent legal organizations also influence the legislative and judicial
development of corporate law. The American Law Institute (the “ALI”) which
is known for its restatements of law has produced the “Principles of Corporate
Governance: Analysis and Recommendations.”19 The Project attempts to look at
corporate law and suggest an approach to corporate governance issues. The
Project is not intended to be a restatement of the law but rather as a suggestion
of good corporate practice and rules. The Model Business Corporation Act (the
“MBCA”) is a product of the American Bar Association and has also been
influential in the development of various states corporate law statutes. The
approach has not been to seek uniformity among the states, but to suggest an
approach to issues allowing for local differences. A number of states have
adopted the MBCA as their corporate statute.20
§ 1.03 Historical Background
Since the formation of a corporation is facilitated by the state, understanding
the historical development of state regulation is significant to understanding
modern corporate law. The historical development of American corporate law
provides an interesting study of political and economic forces which influenced
the development of that law.21
In the early 19th century, American law restricted the use of corporations. In
order to form a corporation in the United States, one had to petition one’s state
legislature for a charter or articles of incorporation granting the right to operate
as a corporation. Articles of incorporation were not freely given due to suspicion
of the private power of corporations. However, the state understood that
corporations could serve a useful public purpose. Thus, early American
corporations were often established to allow private resources to accomplish
public functions. For example, corporations were used to run the railroads, or
build roads and bridges.
Over time, business practices changed and the economy grew, resulting in a
greater demand for articles of incorporation. This led to the enactment of
general corporate statutes under which legislative chartering was no longer
required and articles of incorporation were standardized. It also turned the
corporate form into a generally available right, as opposed to the privilege of a
few.
Economic reality also dictated the need to use corporations for broader
purposes. Throughout the 19th century, America expanded its frontiers and
experienced the industrial revolution. The expansion of industry transformed
America from an agrarian to an industrial society, in which large amounts of
capital were required for business. In addition, the public began to invest in
private corporations. With public investment in corporations, there was also a
rise in financial scandals. As a result, corporate law also developed to try to
protect investors. For example, shareholder suits developed to allow injured
investors to recover for frauds or breaches of fiduciary duty by corporate
managers.
In the late 19th century, a number of states lowered taxes on corporations and
enacted corporate statutes that removed many traditional limitations on the
corporation and its managers. These statutes became more enabling and
corporations were allowed broader powers. Some of the changes were viewed as
more pro-management as opposed to pro-shareholders. It has been suggested
that managers would chose a state in which to incorporate which had rules most
favorable to management and least favorable to shareholders, so states tried to
attract incorporations by favoring the managers. New Jersey was the first state
to liberalize its law. Delaware eventually took the lead and became the most
attractive state for publicly held corporations.22 Today, all state corporate
statutes are generally enabling, although there are some differences among the
states.
While state law became more “liberal,” the federal government became more
suspicious as the power of corporations grew. Thus, federal regulations were
developed, including antitrust laws and regulation for certain industries, such as
transportation. The stock market crash of 1929 and many of the frauds
committed against public investors in the 1920s resulted in Congress enacting
federal securities laws during the New Deal in the 1930s to protect these
investors. However, Congress chose not to preempt most state law dealing with
corporations.23 In 2001 and 2002, there were corporate scandals associated with
Enron, WorldCom and other publicly traded corporations that caused Congress
to enact the Sarbanes-Oxley Act of 2002 to protect shareholders.24 The financial
crisis of 2008 was primarily caused by banking and financial institutions, and
Congress passed in 2010 the Dodd-Frank Wall Street Reform and Consumer
Protection Act. Dodd-Frank was primarily designed to promote financial
stability, but several of its provisions were aimed at enhancing corporate
governance of publicly traded corporations.25
§ 1.04 Choice of Form
In organizing and operating a business, the owners may choose a variety of
forms. The major choices are corporations, partnerships, limited partnerships,
sole proprietorships and limited liability companies. Factors that often influence
the choice are the need for limited liability, free transferability of interests,
continuity of existence, centralized management, costs, access to capital and
taxation.
[A] Sole Proprietorship
The simplest form of business is the sole proprietorship, where an individual
decides to go into business as the sole owner. There are no formal requirements
for the formation or operation of a sole proprietorship and ownership and
management can exist in the sole owner. The owner is the principal and can
employ people as agents to represent and work for her business. As owner, she
is personally liable for the obligations of the business. In addition, all profits and
losses are personal and part of her individual tax return.
[B] Partnership vs. Corporation
Once an individual decides to go into business with other people as owners,
there are other choices she can make as to business form.26
Two choices for business format are partnership and corporation. To form
and operate a corporation, one must comply with a list of requirements, one of
which is the filing of articles of incorporation (sometimes called a certificate of
incorporation) with the state.27 The services of an attorney are often needed to
help prepare the necessary documentation, which increases the costs of doing
business.
Another format in which to conduct business is the partnership. The
partnership is defined as “an association of two or more persons to carry on as
co-owners a business for profit.”28 The formation of a partnership requires no
formal action or written agreement. Individuals acting together to run a business
may result in a partnership being formed.29 However, it is advisable to have an
agreement among partners or among shareholders of a closely held corporation
to protect the interests of the parties. In the absence of an agreement, partnership
law is generally more protective of all the owners than corporate law.30
The choice between the corporate form and partnership depends on
comparing the different attributes of the two forms and then determining which
attributes are significant to one’s business. The key considerations are limited
liability, free transferability of interests, continuity of existence, centralized
management, costs, access to capital, and taxation. While these differences are
significant, practical considerations may make them irrelevant.31 It is also
important to note that each of these attributes may be modified by contract
among the interested parties.32
The major differences between the partnership and corporation flow primarily
from the fact that partnerships historically were viewed as an aggregate that is
composed of its owners, while the corporation is viewed as a separate legal
entity distinct from its owners.33 For example, since the partnership was
generally legally viewed as the aggregate of its owners, it follows that each
owner is personally liable for the debts of the partnership. Since the corporation
is a separate legal entity, it is able to incur its own liabilities, shielding the
shareholders as owners from personal liability.34 Thus, the corporation’s
creditors cannot usually go after the personal assets of the shareholders and the
creditors of the shareholders have no right to directly go after the assets of the
corporation. This limited liability means that in most cases, the shareholders will
at most lose their investment in the corporation. In addition, the assets of the
corporation are also shielded from the personal creditors of the shareholders
who cannot go directly after those corporate assets. The shielding advantages
are the primary reason why the corporate form is chosen for many businesses.
Partnership interests are not freely transferable, since any change in the
identity of the partners will alter the aggregate. While new partners may be
added, there must be a unanimous consent for changes in the makeup of the
partnership35 unless there has been a contractual modification of this rule. On
the corporation side, since shareholders are separate from the corporation, they
can freely transfer shares; different owners have no effect on the separate
corporate entity.
If there is any change in the partnership, there is a dissolution of that
partnership under the Uniform Partnership Act. This rule limits the continuity of
the business.36 Therefore, the death or bankruptcy of one partner causes a
dissolution of the partnership because the aggregate changes when the original
partner is replaced by another: death precipitates the appointment of an executor
and bankruptcy heralds the designation of a trustee. Under the Revised Uniform
Partnership Act, which has generally taken an entity approach,37 the term
dissociation is used and reduces the events which would cause a dissolution,
such as death.38 Death or bankruptcy of a shareholder or desire of a shareholder
to terminate ownership does not affect the corporation because it is a separate
legal entity unaffected by changes in ownership. Thus, corporations provide for
a perpetual existence.39
In addition, a partner may at any time cause the dissolution of the partnership
by merely deciding to end the relationship.40
A dissolution of partnership does not necessarily mean an end to the business,
particularly when there is a partnership agreement allowing for continuity.
However, in the absence of such an agreement, there will be a winding up of the
business.
Partners, as co-owners of the business, have the right to participate in the
management of the partnership.41 In addition, each partner has the power to bind
the partnership as agent in the usual course of business.42 In the corporate
context, the corporation, as a separate legal entity from its owners, has a board
of directors that manages the business. The board is elected by the shareholders.
The use of a board of directors allows for a group other than owners to manage
and thus a centralization of management separate from the owners. Since a
majority vote is usually required for election of the board, a minority
shareholder must gain votes of other shareholders to participate in the
management of the corporation. While in closely held corporations, the
shareholders may contract to place minority shareholders on the board, all
shareholders (unlike partners) usually do not have the automatic right to manage
or be on the board.
Businesses that need to raise large amounts of capital by attracting public
investors as shareholders will choose the corporate form. Limited liability, free
transferability, centralized management and continuity are all attributes that are
necessary to attract public shareholders interested in passively investing and
trading shares in the markets.43 For example, it would be hard to imagine every
shareholder of General Electric having a right to participate in management of
the company. Limited liability is another important characteristic of the
corporate format without which every investor would be personally liable for
the obligations of the business. Without limited liability, each shareholder’s joint
liability would depend on the personal worth of the other owners. This would
make it impossible to value and trade shares because share value would be
dependent upon, among other things, the potential liability of different
shareholders.44
§ 1.05 Limited Partnerships
A limited partnership is a business organization which provides partnershipstyle tax treatment and limited liability for some of the owners as limited
partners.45 A limited partnership must have at least one general partner with
unlimited liability;46 the other owners may be limited partners with limited
liability (like shareholders). Unlike corporate shareholders who can serve as
officers and directors and still have limited liability, if a limited partner gets
involved in the control of the limited partnership, she may lose limited
liability.47 Unlike the partnership, it is created by compliance with state law
which includes the paying of fees and the filing of the articles of
incorporation.48 Much of the structure of the limited partnership is usually
established by the provisions of the articles or contract among the participants.
§ 1.06 Limited Liability Company
The Limited Liability Company (“LLC”)49 seeks to combine the most soughtafter features of corporation (limited liability) with those of partnership (“flow
through” federal taxation),50 as does the limited partnership form. Unlike
limited partnership law, LLC law permits unlimited participation in the business
by some or all the owners, seen as another advantage to the LLC form of entity.
A principal dividing line between groups of LLCs is “member managed”
(similar to partnership) or “manager managed” (similar to corporation and board
of directors). A practitioner forms an LLC by filing a brief document,
sometimes known as the articles of organization, with a state official, often the
secretary of state. The heart of an LLC is the operating agreement. The
operating agreement contains governance provisions (e.g., choice between
member versus manager managed, limitations on managers’ authority,
procedures for election or removal of managers). It also contains financial
provisions (e.g., shares, fractional ownership, or, often, assignment to members
of ownership percentages).
A hallmark of the LLC is nearly unlimited flexibility. For that reason, lengthy
agreements may be necessary to select from a wide array of possible choices.
Because agreements are lengthy and often hand-tailored, attorneys often charge
higher fees to form an LLC as opposed to a corporation. Because of the need for
the operating agreement LLCs are often used by sophisticated investors such as
private equity funds and investor vehicles as an alternative to limited
partnerships.51
As to legal issues, courts often employ many analogies to corporate law, for
example, what fiduciary duty is and what it may require, or adopting differing
approaches to piercing the veil issues.52
§ 1.07 Taxation
Another difference between the sole proprietorship, partnership, limited
partnership, limited liability companies, and Subchapter S corporations (“pass
through entities”) and corporate formats is the respective tax treatment given
each entity. One way in which the two are treated differently is that
corporations, apart from their shareholders, pay taxes as legal entities. By
contrast, pass through entities are not subject to taxation. The pass through
entities are required to file a tax return, known as an informational return. The
purpose of an informational return is to determine how much tax the individual
owners will pay on the income derived from the operation of the business but
not to tax the pass through entity.
[A] Double Taxation
Corporations pay tax on the profits they receive and when that profit is
distributed to shareholders in the form of dividends, it is again taxed in the
hands of the individual shareholders This practice has been called “double
taxation.” Since pass through entities pay no tax, the income from the business
flows through to the owners (often referred to as “flow-through taxation”) and is
only taxed individually (even if the pass through entity income is never
distributed). Thus, there is no double taxation.53
In the corporate context, when there is a loss from the business operations, the
corporation can use the loss to offset other corporate profits from the past or in
the future. However, in the pass through entity, the owners report the losses on
their individual tax returns. These losses may be used to offset other personal
income and thus reduce personal taxes.
When there are expected to be business profits, tax advisors seek means of
avoiding double taxation. Often, this means the formation of the business as a
pass through entity that allows a flow through of profits (or losses) to the
investor without being taxed twice. In a large business with numerous owners, it
is usually impossible to operate as a pass through entity because of other
limitations of the form (for example, in partnerships, the lack of free
transferability of interests and the need for limited liability and centralized
management). However, in a business without numerous investors, the pass
through entity form can be advantageous from a tax point of view.
Alternatively, the tax advisor may form the business as a corporation but seek
to structure it to minimize the effect of double taxation. For instance, since
income is only taxed a second time once it is distributed to the shareholder, a
corporation may retain the earnings in the business and not pay a dividend.
Another way to avoid double taxation is to distribute the funds to the
shareholders in a form other than a dividend so that the corporation may deduct
the payment as a business expense and not pay taxes on that amount. For
example, if the shareholder is an employee, the amount which would otherwise
be paid to him as a dividend could be paid to him as a salary. Similarly, if one’s
investment in a corporation is in the form of a bond or a note, the interest paid
may substitute for dividends. If one owns the corporation’s plant or equipment,
rent paid is deductible by the corporation. The payments of salary, interest on
debt and rent are usually tax deductible. There are important caveats to these
comments since unreasonable attempts to avoid double taxation may result in
tax penalties.54
[1] Subchapter S Corporation
Another corporate format which plays a significant role in tax consequences
is the S corporation. The S corporation is a corporation which has elected to be
taxed under the provisions of Subchapter S of the Tax Code. This provision
allows a corporation to pay no tax. Instead, all the corporate income is taxed to
the shareholders, whether or not such income is actually distributed thereto.
Subchapter S corporations are generally treated like partnerships for tax
purposes. Certain restrictions may preclude election as a Subchapter S
corporation, such as the requirement that there be a maximum of 100
shareholders, or the preclusion of non-resident alien or corporate shareholders,
or the use of only one class of shares.
[2] Limited Liability Companies
All states have enacted legislation that authorizes the use of a new kind of
business entity, called the “limited liability company.”55 The limited liability
company for tax purposes is an unincorporated organization.56 The intent is to
provide additional business organizations with limited liability, but without the
double taxation consequence of corporations or the restrictions of the
Subchapter S Corporation.
Unlike the Subchapter S Corporation, the limited liability company is not
restricted as to the number of shareholders who may be called members
(although too large a number may deem it publicly traded and subject it to
double taxation), type of shareholders and capital structure. Although the
legislation differs among the states, limited liability companies generally enjoy
limited liability and other attributes depend on the default legal rules. States
usually require a contract among members called an operating agreement which
establishes or modifies the characteristics of the organization.
In order to provide some certainty on tax treatment, the IRS has provided for
“check-the-box” regulations which simplify the issue of how a business
organization will be treated for tax purposes. The regulations provide that every
business organization that is not a corporation is a “pass-through entity,” which
means it will be treated like a partnership for tax purposes. The regulations list
eight organizations which are corporations per se, including the statutory
corporation.57 More significantly the list does not include other business
organizations such as limited partnerships and limited liability companies. If not
listed, then the organization is an eligible entity, allowing for a pass through tax
treatment and no double taxation. Thus an eligible entity by default is treated
like a partnership for tax purposes unless it elects to be treated like a
corporation.
§ 1.08 Incorporation and Organization
In forming a corporation, at least one person must act as the incorporator. She
is responsible for filing the articles of incorporation (sometimes called a charter
or certificate of incorporation). The articles of incorporation are usually filed
with the secretary of state and in some states the filing can be done
electronically. The process is simple and relatively inexpensive. The articles of
incorporation contain some basic information about the company and must
comply with statutory requirements.58 The name of the corporation must be
different from the name of any other corporation to avoid confusion or
deception. Corporations must also use a denomination after the name, such as
the words “Inc.,” “Corp.,” or “Ltd.” to make clear that the company is a
corporation. The articles may also contain other significant discretionary
provisions authorized by the statute.
Upon acceptance of the articles of incorporation by the state official,
corporate existence commences. Once the corporation exists, all further actions
on the corporation’s behalf must be taken by the incorporator. In order to
complete the formation of the corporation, the incorporator must adopt a set of
bylaws, hold the initial shareholders’ and directors’ meetings, arrange for the
election of directors and officers, open a bank account for the corporation, issue
the shares and conduct other significant initial acts. The bylaws contain the
internal rules dealing with the governance of the corporation.59 Unlike the
articles of incorporation, the bylaws are not publicly filed. Once established, the
corporation must comply with the requirements of the state statutory scheme
such as holding annual meetings of both directors and shareholders.60
Attorneys are often involved in this process. Counsel may advise the client on
the advantages of the different business forms and draft the necessary legal
papers. Often, the incorporation process is pro forma, using standard forms for
the articles of incorporation and the bylaws. As discussed in Chapter 11, the
articles and the bylaws may be modified, particularly to protect minority
shareholders of a closely held corporation from potential oppression by majority
shareholders. Thus, the preparation of the documents may involve potential or
actual conflicts of interests among the shareholders. If retained, an attorney must
identify these conflicts and disclose them. While it is advisable that all
shareholders retain their own counsel to represent their interests, clients
sometimes regard the need for individual counsel as an unnecessary expense,
particularly when the parties prefer not to use corporate funds for legal fees.
The Code of Professional Responsibility allows an attorney to represent the
corporation61 and set up the business. However, it is important that all the
parties understand the potential for conflicts of interest, particularly if a contract
is written among the shareholders which addresses their relationship to the
corporation and each other.
§ 1.09 Choice of Law
In organizing the corporation, the incorporator must choose the state in which
to file the articles of incorporation.62 State statutes indicate how to incorporate,
deal with financing and legal capital rules, establish the basic structure of the
board of directors, deal with shareholder power and rights, and a variety of other
issues. Every state has a corporate statute that sets out the corporate rules.
Although the state statutes are generally standard, a few statutory rules differ
significantly from state to state. These differences may include treatment of
shareholder voting rights, the ability to sue directors, and the extent of the
directors’ fiduciary duty.
Also, every state has a judicially created common law which governs various
aspects of corporate life, such as the concept of fiduciary duty and its
application to the managers of the corporation.63 While fiduciary duty is often
defined by statute, the courts ultimately decide how to apply the statute to a
particular set of facts. Court decisions have resulted in differences among states
concerning the extent of protection of shareholders by corporate law.
The law of the state of incorporation should govern most intra-corporate
relationships, such as between the corporation and its officers, directors and
shareholders.64 This is known as the internal affairs doctrine. With the use of a
single law, the doctrine attempts to avoid a corporation being faced with
conflicting demands, while it also encourages convenience and predictability of
legal application. This does not mean that the law of the state of incorporation
governs other corporate dealings, such as commercial transactions, contracts or
tort law. In addition, a given state may have a sufficient interest in a corporation
incorporated elsewhere but doing business in the state, to subject it to local
taxation, jurisdiction for litigation and filing as a foreign corporation paying
fees.
While Congress could have enacted a federal scheme of incorporation,65 it
has chosen, by not acting, to allow the states to provide the mechanism and law
that govern the internal affairs of the corporation. As we will see in subsequent
chapters, there is an extensive federal presence through federal securities laws
that affects the internal affairs of a corporation. However, defining and
regulating the relationship between the shareholders and the managers of the
corporation remains primarily an issue of state law.
[A] Delaware’s Dominance
Local businesses usually incorporate in the state in which they maintain a
principal place of business to avoid paying extra taxes or fees to a state in which
the business has no real interest.66 Larger corporations do not necessarily
incorporate in the state in which they are headquartered. A large number of
publicly held corporations have chosen to incorporate in Delaware. Of the
corporations that make up the Fortune 500, more than one-half are incorporated
in Delaware.67 However, most of these companies have a small presence in
Delaware. Why do corporations choose Delaware? Why do other states
recognize Delaware law?
Most states have respected the internal affairs doctrine that applies the law of
the state of incorporation and do not attempt to impose their rules on
corporations incorporated in other states. To some extent the “Full Faith and
Credit Clause”68 and the Commerce Clause69 of the United States Constitution
support the idea that states should respect the laws of other states. However, the
application of one state’s corporate law is arguably more a principle of conflict
of laws than constitutional law and some states have provisions of their
corporate law that apply to foreign corporations (that is, corporations
incorporated in another state, but with a presence in that state). Some states have
attempted to apply some of their internal affairs laws to corporations
incorporated in other states.70 This practice is infrequent and its validity remains
unclear.71
Delaware’s prominence as a state of incorporation has been criticized as
causing a “race to the bottom.”72 Some critics claim that Delaware has laws
which favor corporate management over shareholders. Managers who decide
where to incorporate will likely choose a state with favorable laws that protect
their interests over shareholders, such as Delaware.73
Why would Delaware provide this pro-management environment? In 2001
Delaware took in around $600 million in franchise taxes.74 In addition, the
corporate bar of Delaware is actively involved in representing corporations in
litigation arising under Delaware law. Arguably, Delaware has a direct
economic interest in encouraging incorporation within its borders.
Some commentators have argued contrary to the “race to the bottom” theory
that incorporating in Delaware is beneficial to shareholders. They argue that
corporate management would not choose to incorporate in a state with promanagement laws that hurt shareholders because to do so would depress the
value of the shares, reflecting the potential opportunism of the managers. Lower
priced shares would hurt the corporation and the managers. The lower priced
shares could result in various market mechanisms being used to protect
shareholders. For example, if shares are priced too low, the company could
become a takeover target, where the purchasing company would likely replace
the managers. Since managers fear replacement, they are more apt to try to keep
the price of the shares high. According to this argument, managers can be
expected to seek state laws that will benefit shareholders and enhance the
market value of the shares to avoid the takeover.75 Thus, states can be expected
to compete in the market for corporate charters to attract incorporations with
optimal law.76 However, empirical studies concerning manager influence in
choice of state of incorporation fail to resolve the dispute and the debate
continues.77
Some think the real competition is with the federal government and the
increased role of federal law in corporate governance.78 Differences between the
states on corporate law issues are much less than in the past. Ultimately,
Delaware dominates state corporate law in the United States and influences the
development of the law in other states.79 One of the major advantages of
incorporating in Delaware is that with so many corporations incorporated there,
its bar and judiciary have an excellent understanding of the complexities of
corporate law. Its extensive case law also facilitates planning and research on
corporate law issues.
§ 1.10 Ultra Vires
Ultra vires results when a corporation has acted beyond its purpose (the
object of the incorporation) or powers (the means by which the corporation
carries out the object). For example, a corporation established for the purpose of
washing windows would have the power to enter contracts to wash windows.
However, a contract to replace windows might be ultra vires and beyond its
purpose.
In the 19th century, incorporation was difficult because there were concerns
about corporate influence and power. Legislatures would grant articles of
incorporation with limited purposes and powers. If a corporation was authorized
only to build a road and decided to contract to build an inn so that travelers
could stop on their travels, the contract could be ultra vires. The corporation or
the party with which the corporation contracted could thus attempt to avoid the
contract. Courts attempted to avoid the harsh results of ultra vires. For example,
a court could find the corporation had an implied power to build an inn; or could
use an estoppel argument based upon the reliance of the third party; or a quasicontract theory. But even with judicial attempts to alleviate the unfairness of
ultra vires, there was uncertainty.
Ultra vires is less significant now. Incorporation is much easier and there are
no longer legislative restrictions so corporations can be formed with broad
purposes and powers to act in any lawful means and purpose.80 In addition, even
if a corporate action is ultra vires, statutory provisions restrict the use of the
ultra vires defense in order to protect third parties. For example, MBCA § 3.04
limits challenges based upon ultra vires only to shareholders seeking to enjoin
executory contracts; shareholders suing the directors for the violation; or a
proceeding by the attorney general to dissolve the corporation.81 Even if the
contract is executory and there is an attempt to enjoin it under the statute, that
action must be equitable.82
Ultra vires may still be raised in some particular contexts.83 Corporate
guarantees of third party debts that do not benefit the corporation may be
attacked.84 In addition, nonprofit corporate activity such as excessive charitable
contributions or unauthorized, unjustified payments to third parties may be
wasteful and viewed as ultra vires.
[A] Corporate Social Responsibility and Philanthropy
Issues of corporate social responsibility involve issues of corporate
philanthropy and corporate governance. The issue involves determining whether
a corporation should be managed solely to benefit its shareholders or should
both societal concerns and stakeholders other than shareholders such as
employees, consumers, and creditors play a role.85
The advocates of shareholder-gain as the sole motive for corporations believe
that corporations are formed to run a business for a profit and other activities
should not be within their focus. Allowing managers to pick and choose
philanthropic or socially beneficial activities permits use of corporate funds for
management’s personal charities and enables the managers to act as a sort of
unelected civil servant. In addition, critics complain that profit is the yardstick
used to measure the success of a business. Ultimately, profit maximization is the
most socially responsible activity.86
Advocates for a broader view recognize that large publicly traded
corporations have considerable power and resources that play a significant role
in the economy. Corporations as part of the larger community gain from
philanthropic activities by enhanced reputation and helping to preserve the
advantages that the law provides for businesses. Thus philanthropy should be
encouraged and the fiduciary duty of managers should be owed to the enterprise,
not just to shareholders, and viewed in a larger context.87
Reasonable amounts of corporate philanthropy are not only specifically
authorized by state statutes but are common and significant. Originally the issue
of corporate philanthropy was raised in the context of the doctrine of ultra vires,
that is, whether the contribution was beyond the power and purpose of a
corporation. Most state statutes now authorize reasonable philanthropic
activities.88 Even prior to statutory enactments, courts have found philanthropy
to be beneficial and within a corporation’s implied powers. In A.P. Smith Mfg.
Co. v. Barlow,89 the corporation was incorporated prior to a statutory enactment
allowing philanthropic corporate payments. It was argued that the change in the
statute allowing philanthropy violated the Constitution’s Contract Clause
because it was a change in the contract (reflected in the law and the articles of
incorporation) between the State and the corporation. However, the state had in
its corporate statute a reserved power clause which allowed it to change the law
subsequently to alter the articles of incorporation.90 The court also recognized
the importance of such contributions to society and to the corporation as a good
citizen and thus within its power.91
§ 1.11 Social Benefit Organizations
Some investors believe that seeking profits and pursuing social good can be
done in one organization. If they select the corporate form or establish a nonprofit organization, they may face difficulties achieving both goals. As a result
new hybrid organizations have emerged to try to fill the gap by being both
businesses-oriented and promoting social good. The L3C is a limited liability
company authorized in some states to further one or more charitable or
educational purposes and for which neither income production nor property
appreciation may be a significant purpose. A number of states have also
authorized the “benefit corporation” as an organization distinct from the
traditional for-profit or non-profit corporation. The main thrust of benefit
corporation statutes is to require these entities to pursue purposes beyond profitmaking. A benefit corporation must be formed for a “general public benefit,”
meaning a “material, positive impact on society and the environment” and
which is measured by a third-party standard92 In addition to the new legal forms
of organization, standard for-profit firms like corporations can pursue “B Corp”
conferred by the nonprofit B Lab.93 This private certification is available to
companies that demonstrate their commitment to a dual mission of making
profits and promoting social good by, among other things, binding their
fiduciaries to consider various nonshareholder constituencies. If certified by Lab
B, a company can use the “B Corp” mark to market itself to consumers,
investor, employees, and others who might value its hybrid profit-making and
social objectives.
1. The Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheat.) 518, 636 (1819). In theory,
one could establish most of the attributes of a corporation by contract among all participants. For a
discussion of the corporation as a nexus of contracts, see § 5.03[C][3], infra.
2. Issues have been raised to the extent that the corporation, as a separate legal entity, is protected
under the Constitution. In Santa Clara v. Southern Pacific Ry., 118 U.S. 394 (1886), the Supreme Court
held that a corporation is entitled to equal protection under the Fourteenth Amendment. In Minneapolis &
St. Louis Ry. Co. v. Beckwith, 129 U.S. 26 (1888), the Court held it was entitled to due process of law.
But in Hale v. Henkel, 201 U.S. 43 (1906), a corporation was not entitled to the Fifth Amendment
protection against self-incrimination but was protected from unreasonable searches and seizures under
the Fourth Amendment. The corporation’s right to free speech under the First Amendment has also been
raised. In First Nat. Bank of Boston v. Bellotti, 435 U.S. 765 (1978), the majority found that the state had
not shown a compelling interest in regulating corporate expenditures in a referendum. There was no
evidence of either a corrupting influence or need to protect the shareholders. But in Austin v. Michigan
St. Chamber of Commerce, 494 U.S. 652 (1990), the Court upheld a Michigan law that prohibited
corporate expenditures in state elections. The majority focused on the state providing the means by which
corporations can amass large amounts of money that can be used unfairly in political contests. But the
Supreme Court in Citizens United v. Federal Election Comm’n, 558 U.S. 310 (2010), overruled Austin
because it interfered with the “open marketplace” of ideas protected by the First Amendment. In Citizens,
the majority argued that the First Amendment protects associations of individuals in addition to
individual speakers, and further that the First Amendment does not allow prohibitions of speech based on
the identity of the speaker. Corporations, as associations of individuals, therefore have speech rights
under the First Amendment and restriction on corporate independent expenditures violated the right to
free speech. Thus corporation (unions also) can spend to advocate for candidates but are still prohibited
from direct contributions to candidates or political parties. Further the majority suggested that
shareholders can determine whether the corporation’s political speech advances corporate interests. The
dissent argued that the majority’s decision failed to recognize the dangers of the corporate form and the
prevention of corruption, including the distorting influence of a dominant funding source found in Austin.
The unique qualities of corporations and other artificial legal entities made them dangerous to democratic
elections because they have perpetual life, the ability to amass large sums of money, limited liability, no
ability to vote, no morality, no purpose outside of profit-making, and no loyalty. Therefore, the dissent
argued, the courts should permit legislatures to regulate corporate participation in the political process. Id
at 979. These cases are not only interesting from a constitutional point of view, but the different opinions
express a variety of views on the nature of a corporation and its relationship to the state. See Adam
Winkler How American Businesses Won their Civil Rights (2018) (how corporations shaped American
law, particularly in the Supreme Court).
3. For a discussion of Corporate Governance, see § 5.02[A], infra.
4. For a discussion of the financing of businesses in more detail, see Chapter 4.
5. In 2011, venture capitalists invested $32.6 billion, up 10% from the year before. The Daily StartUp: Venture Investment Grew 10% In 2011, WALL ST. J. (Jan. 20, 2012),
http://blogs.wsj.com/venturecapital/2012/01/20/the-daily-start-up-venture-investment-grew-10-in-2011/.
The money supplied to venture capitalists can come from individuals or institutional investors. For a
discussion of institutional investors and corporate governance, see § 5.02[E][2], infra.
6. For a discussion of why the corporate form is used, see § 1.04[B], infra.
7. For a discussion of federal securities laws and the process of going public, see § 7.03, infra.
8. The flow of initial public offerings slowed considerably in 2016, hitting just 128 — the lowest
number since the financial crisis. (In 2014 there were 363.) http://fortune.com/2017/01/20/publiccompanies-ipo-financial-markets/. In 2017, the stock market was strong and there was a rebound of 49%
in IPOs. https://www.bloomberg.com/news/articles/2017-12-26/u-s-ipos-bounce-back-five-keymeasures-of-2017-s-listings. In addition, the number of publicly traded corporation had declined to 3672.
In 1996, there were 7322 listed. There are several explanations for the decline. Initial public offerings
have decreased, meaning less private firms are going public. Private firms that can now attract private
capital more easily may try to avoid the scrutiny and regulations of being public. Several large firms
valued at over $1 billion have chosen to remain private and are described as “unicorns.” In addition,
takeovers of public firms also decrease the number. Schumpeter Why the Decline in the Number of Listed
American Firms Matters, THE ECONOMIST (April 22,2017). Concerns have been raised about this
trend and that investors need to invest in both public and private companies in order to be exposed to
growth and new industry. Jason Thomas Where Have All the Public Companies Gone?, WALL ST. J.
(Nov.17 2017).
9. For a discussion of stock markets, see § 5.02[C], infra. The Securities and Exchange Act of 1934
deals with the stock markets and corporations that have publicly traded shares. See Chapters 7, 13.
10. For a discussion of stock options, see § 9.04[A], infra.
11. For a discussion of closely held corporations, see Chapter 11.
12. For example, Facebook is a large publicly held corporation, but the original founders are
significant shareholders and have effective control.
13. For a discussion of controlling shareholders, see Chapter 10.
14. For a discussion of corporate governance in these publicly traded corporations, see Chapter 5.
15. Often these problems are viewed as an issue of agency costs. For a discussion of this view see §
5.03[C][1], infra.
16. For a discussion of shareholder litigation, see Chapter 14.
17. See MARC STEINBERG, UNDERSTANDING SECURITIES LAW (3d ed. 2001); see also
Chapter 7.
18. For an example of such rules, see § 5.02[C][2], infra.
19. Sections of the ALI project will be cited in the book as ALI Corp. Gov. Proj.
20. The MBCA has been adopted by 24 states. John Armour, Bernard Black & Brian Cheffins,
Delaware’s Balancing Act, 87 IND. L. J. 1345, 1398 (2012).
21. See generally LAWRENCE M. FRIEDMAN, A HISTORY OF AMERICAN LAW (3d ed. 2005).
22. For a discussion of Delaware’s dominance among the states for incorporations, see § 1.00[A],
infra. For an in-depth analysis of Delaware corporate law, see DAVID A. DREXLER, ET AL.,
DELAWARE CORPORATION LAW AND PRACTICE (2003).
23. See generally J. WILLARD HURST, THE LEGITIMACY OF THE BUSINESS
CORPORATION IN THE LAW OF THE UNITED STATES 1780–1970 (1970).
24. For a discussion of Sarbanes-Oxley, see § 5.08[A], infra.
25. For a discussion of Dodd-Frank, see § 5.08[B], infra
26. Although a sole owner can incorporate to take advantage of certain corporate benefits such as
limited liability, a partnership requires at least two owners. U.P.A. § 6(1) (1914); R.U.P.A. § 101(6)
(2008).
27. For a discussion of formation, see § 1.08, infra.
28. U.P.A. § 6(1) (1914); R.U.P.A. § 101(6) (2008).
29. A partnership results from contract, either expressed or implied. If a court finds that the parties
have in fact acted as partners, it will find the existence of a partnership with all the legal consequences
that flow from it. Courts will usually look for two elements of co-ownership in determining the existence
of a partnership: profit sharing and control. For example, under the definition of partnership, creditors
who lend money and receive a share of profits and either contract for or act with extensive control may
be treated as partners with unlimited liability. In Martin v. Peyton, 246 N.Y. 213, 158 N.E. 77 (1927), a
creditor was not found to be a partner and escaped liability even though a contract gave the creditor
considerable control and profit sharing; the court found that the control existed primarily through the use
of negative covenants designed to protect the creditor’s loan. Generally, the receipt of profits is prima
facie evidence of partnership status, except that certain situations are excluded, such as interest on a loan,
wages or rents. See U.P.A. § 7(4) (1914); R.U.P.A. § 202(3) (2008).
30. Partnership law originally developed under the common law, but in 1914 the Uniform Partnership
Act was promulgated and now provides many of the rules governing partnerships. The Uniform
Partnership Act allows partners to modify the rules by contract. In 1994, the Revised Uniform
Partnership Act was adopted with the intent of superseding the Uniform Partnership Act. Partnership law
has been described as supplementary in the sense that if there is no contract, the Uniform Partnership Act
provisions govern, providing default rules. The resulting rules tend to reflect what most parties in small
businesses would have agreed to or expected in most cases. For example, most owners of a small
business would assume that they would have a right to participate in management; this is provided under
partnership law. See U.P.A. § 18(e) (1914); R.U.P.A. § 401(f) (2008). Corporate law provides that to be
involved in management, a shareholder needs to be elected to the board by a majority vote. Most
corporate statutes are traditionally more regulatory and designed to deal with both closely held
corporations and large publicly held corporations. Thus the rules may not be as protective of minority
shareholders in closely held corporations. In order to protect minority interest in a closely held
corporation, there usually needs to be a contract to adapt the law, while most partnership law without a
contract is protective. Thus, minority shareholders should provide by contract to have a voice or a return
on their investment. For a discussion of contracts in closely held corporations, see § 11.03, infra.
31. For example, there is free transferability in the corporate form which allows the shareholders to
freely sell their shares. However, while shareholders may have the legal right to sell, there may be no real
market for the shares, especially if the shares represent a minority interest in a closely held corporation.
For a discussion of the problems of the minority shareholders of a closely held corporation, see § 11.01,
infra.
32. For example, although the corporate form provides limited liability, creditors may insist on
personal guarantees from the shareholders to induce it to loan to the business. Conversely, in a
partnership, if the partners are in a strong bargaining situation, they could contract for limited liability
with the creditors of the partnership, agreeing to only go after the assets of the partnership. Contracting in
the context of a small business is very important in both the partnership and closely held corporate
context.
33. The aggregate concept has been modified by the Uniform Partnership Act for particular situations.
For example, under an aggregate approach, partnership property would have to be held in the name of
each partner. However, the Uniform Partnership Act allows it to be held in the partnership name. See
U.P.A. § 8 (1914). The Revised Uniform Partnership Act uses an entity approach in most cases, but does
not change many of the basic differences between a partnership and a corporation. See R.U.P.A. § 201
(2008).
34. Entity status need not have this or other attributes. For example, under early English law there
were corporations with unlimited liability.
35. See U.P.A. § 18(g) (1914); R.U.P.A. § 401(i) (2008). However, section 27 of the Uniform
Partnership Act permits partners to transfer just their interest in profits of the partnership without
dissolving the partnership or giving the assignee any other partnership rights. See U.P.A. § 27 (1914);
R.U.P.A. § 502 (2008).
36. U.P.A. § 29 (1914). A dissolution only means a change in the partnership makeup and does not
always mean that there is a winding up or termination of the business if there was a contract to allow
continuation.
37. The Revised Uniform Partnership Act uses an entity approach in most cases, but does not change
many of the basic differences between a partnership and a corporation. See R.U.P.A. § 201 (2008).
38. Under R.U.P.A. § 601, dissolution is defined differently, reducing the events which will actually
dissolve the partnership. Instead, a “dissociation” may occur which will not always result in a winding up
and termination. For example, unlike the U.P.A., the death of a partner is not a dissolution and does result
in a winding up. R.U.P.A. §§ 601, 701 (2008).
39. One can, however, provide in the articles for termination or a shorter duration for a corporation.
See, e.g., Model Bus. Corp. Act Ann. § 3.02 (4th ed. 2008).
40. U.P.A. § 31(1)(b) (1914).
41. U.P.A. § 18(e) (1914); R.U.P.A. § 401(f) (2008). A majority vote will resolve differences on
ordinary partnership matters. Unanimity is required for acts in contravention of any agreement between
the partners. See U.P.A. § 18(h) (1914); R.U.P.A. § 401(j) (2008).
42. U.P.A. § 9 (1914); R.U.P.A. § 301 (2008).
43. For a discussion of shareholder passivity, see § 5.05[C][4], infra.
44. For a discussion of limited liability and public ownership of shares, see § 3.01, infra.
45. There are some publicly traded limited partnerships which attempted to avoid the double taxation
of the corporate form. Currently, under I.R.C. § 7704, most publicly traded limited partnership is usually
taxed as a corporation but there are some master limited partnerships that avoid the double taxation.
46. Under the Uniform Limited Partnership Act and the Uniform Partnership Act, corporations can
serve as general partners of a limited partnership. States which permit a corporation to be the sole partner
in a limited partnership have created limited liability for the general partner. A problem arises when a
corporation is a general partner of a limited partnership and an individual limited partner also controls the
corporation (the general partner). Does the limited partner become liable as a result of that control? If the
limited partner acts on behalf of the corporation in controlling the corporation as general partner, there is
usually no individual liability. While section 303(b) of the Revised Uniform Limited Partnership Act
precludes liability when one acts for the corporation, the result is not as clear under the earlier Uniform
Limited Partnership Act. See U.L.P.A. (1914); R.U.L.P.A. § 303(b) (2008); Frigidaire Sales Corp. v.
Union Properties, Inc., 562 P.2d. 244 (1977) (the limited partners acted solely as agents of the
corporation and the third party did not rely on them as general partners).
47. Section 7 of the original Uniform Limited Partnership Act created liability for a limited partner
when she participates in the control of the business. The open ended concept of control resulted in
litigation and uncertainty. U.L.P.A. § 7 (1914). The Revised Uniform Limited Partnership Act attempted
to clarify the situation by enumerating certain conduct that a limited partner may carry on without being
deemed to have taken part in control of the business. Under section 303 of the Revised Uniform Limited
Partnership Act, a limited partner may, among other things, consult with and advise a general partner
with respect to the business of the limited partnership; be a contractor agent, or employee of the limited
partnership; act as surety or guarantor for the limited partnership; propose, approve or disapprove of a
variety of actions involving the limited partnership. R.U.L.P.A. § 303 (2008).
48. The Uniform Limited Partnership Act requires a certificate of limited partnership to be filed with
the secretary of state (or some other state official). U.L.P.A. § 2 (1914). The certificate shall set forth the
following information concerning the limited partnership: the name and address; the names and addresses
of all agents for service of process; the names and business addresses of all general partners; the latest
date upon which the limited partnership is to dissolve; and any matters the general partners determine to
include. The limited partnership is formed at the time of the filing or any date specified in the certificate.
In addition, section 201 of the Revised Uniform Limited Partnership Act allows for substantial
compliance in filing, which is similar to the de facto incorporation doctrine. R.U.L.P.A. § 201 (2008).
For a discussion of the doctrine, see § 2.03[B], infra.
49. For a discussion of limited liability companies, see § 11.08, infra.
50. See the discussion in § 1.07, infra.
51. For a discussion of fiduciary duty in limited liability companies, see § 11.08[E], infra.
52. For a discussion of piercing in limited liability companies, see § 11.08[E], infra.
53. Because of changes in the tax code, the difference between corporations and double tax and flow
through are not as significant as in the past. In 2018, the top federal corporate tax rate was reduced 35%
to 21% while the highest individual tax rate was reduced from 39.6% to 37%. Combined with the
dividend income rate of 20%, the “double tax” on corporate profits (41%) is now roughly equivalent to
pass-through taxation at the individual rate (37%). In order to provide tax relief to pass through entities
that pay no tax but are owned by individuals whose personal tax rate could be as high as 37%, some
owners would be allowed to deduct 20% of “qualified business income” from their taxable income. The
deduction generally does not apply to income received from a personal service business (such as a law
firm, accounting firm, investment advisory business or consulting firm).
54. I.R.C. § 162(a). For example, the Internal Revenue Service may attack the retention of earnings or
the payment of salaries as unreasonable and may consider the payments an illegal attempt to avoid
double taxation. In the event of such a finding, the IRS would likely impose penalties in addition to the
payment of taxes on those amounts.
55. For a discussion of limited liability companies, see § 11.08, infra.
56. Limited liability partnerships and limited liability limited partnerships may also be formed in
many states. These organizations require registration and partnership form, but the partners are exempt
from some of the partnership liabilities (e.g., tortious conduct of a partner may not create liability to other
partners). The limited liability partnership has been used by professional firms like accounting and law
firms.
57. I.R.C. § 7701 and regulations thereunder. Prior to 1997, the classification for tax purposes of
different business entities depended on its characteristics which were: (1) associates, (2) an objective to
carry on a business and divide the profits, (3) continuity of life, (4) centralized management, (5) limited
liability, and (6) free transferability of interests.
58. For example, under Model Bus. Corp. Act Ann. § 2.02(a) (4th ed. 2008), the articles of
incorporation must include: a corporate name; the number of shares which the corporation is authorized
to issue; the street address of the corporation’s initial registered office, the name of its initial authorized
agent; and the name and address of each incorporator.
59. Bylaws often contain rules regarding important aspects of running the corporation such as
shareholders’ meetings (for example, the location, notice, waiver of notice, rules for special meetings,
voting rights, rules for proxies, quorum requirements etc.); the operation of the board of directors, (such
as their number, compensation, method of filling vacancies, and removal of directors and officers); the
rules concerning officers, agents and employees (duties, salaries, titles, etc.); the rules for issuing share
certificates and the transfer of shares; and the method for conducting special corporate acts, such as
signing checks and amending the bylaws.
60. Failure to comply with the formalities may be a factor in deciding whether to hold individual
shareholders liable on a piercing of the corporate veil theory. See § 3.03[C], infra.
61. Model Code of Prof’l Responsibility DR 5 (1980).
62. Most corporations are creatures of state law, but some corporations actually are chartered under
federal law. These federally-chartered corporations include such public and quasi-governmental entities
as Fannie Mae and the FDIC and Congress has chartered railroads, construction companies, banks,
savings associations, credit unions, and many other types of business entities. Paul Lund, FederallyChartered Corporations and Federal Jurisdiction, 36 FLA. ST. U. L. REV. 317 (2009).
63. For an introduction to fiduciary duty, see Chapter 8.
64. Restatement (Second) of the Conflict of Laws § 302 (l971). See also McDermott, Inc. v. Lewis,
531 A.2d 206 (Del. 1987) (the Delaware court used the internal affairs doctrine to apply Panamanian law
to a parent corporation McDermott International which controlled its Delaware subsidiary McDermott
and voted the shares held by the subsidiary in its parent. Under Delaware law the voting of shares in the
parent held by a subsidiary would be prohibited because the parent controls the subsidiary but was
allowed under Panama law which applied to the parent). In Friese v. Superior Court, 36 Cal. Rptr. 3d 558
(Cal. Ct. App. 2006), the court applied California law on insider trading to a foreign corporation because
it involved the sale and trading of shares and did not implicate the internal affairs doctrine but promoted a
broader public interest.
65. This theory would be premised on the Commerce Clause. Under the Commerce Clause, Congress
has the power to regulate interstate activity, which would include most corporate activities.
66. For example, if a local business operates primarily in New York but incorporates in Delaware it
may be considered a foreign corporation in New York, i.e., incorporated in another state but doing
business in New York. As a result, it would pay Delaware fees and still have to file as a foreign
corporation in New York and pay fees pursuant to N.Y.B.C.L. Article 13.
67. It is no wonder that Delaware has become almost a brand name for the “business” of serving as the
“official home for corporations.” Lewis S. Black Jr, Why Corporations Chose Delaware 1 (2007),
available at http://corp.delaware.gov/whydelaware/whycorporations_web.pdf (distributed by the State of
Delaware).
68. U.S. Const. Art. 1, § 10.
69. U.S. Const. Art. 1, § 8.
70. See, e.g., N.Y.B.C.L. §§ 1317–20.
71. See Arthur R. Pinto, The Constitution and the Market for Corporate Control: State Takeover
Statutes After CTS Corp., 29 WM. & MARY L. REV. 699, 754–74 (1988). The Delaware courts have
indicated that the internal affairs doctrine requires application of the law of the state of incorporation
based upon both the commerce clause and the need for uniformity that results from the application of a
single law. Vantage Point Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005). The
holding, of course, furthers Delaware’s dominance. For a discussion of the CTS case and the internal
affairs doctrine application to takeover statutes under the Commerce Clause, see § 12.07[C][2], infra.
72. “Lesser states, eager for the revenue derived from the traffic in articles of incorporation, had
removed safeguards from their own incorporation laws. Companies were early formed to provide articles
of incorporation in states where the cost was lowest and the laws least restrictive. The states joined in
advertising their wares. The race was not one of diligence but of laxity . . . .” Liggett v. Lee, 288 U.S.
517, 557–58 (1933) (Brandeis, J., dissenting).
73. See generally William Cary, Federalism and Corporate Law: Reflections on Delaware, 83 YALE
L.J. 663 (1974).
74. See U.S. Census Bureau, Delaware State Government Tax Collections: 2001 (2002), available at
http://www.census.gov/govs/statetax/0108destax.html.
75. Professor Roberta Romano has described this federalism as “[t]he genius of American corporate
law.” See ROBERTA ROMANO, THE GENIUS OF AMERICAN CORPORATE LAW 1 (1993). While
traditionally the competition is thought to be with other states, some have suggested that Delaware is not
really competing with the other states but with the federal government. See Mark J. Roe, Delaware’s
Competition, 117 HARV. L. REV. 588 (2004). For a discussion of other market mechanisms that protect
shareholders, see § 5.02[C][2], infra.
76. See Ralph K. Winter, State Law, Shareholder Protection, and the Theory of the Corporation, 6 J.
LEG. ST. 251 (1977). North Dakota has enacted a shareholder friendly corporate law to hopefully attract
incorporations. N.D. Cent. Code § 10-35-01 et seq. Nevada has challenged Delaware by enacting
manager friendly corporate law. See Michal Barzuza, Market Segmentation: The Rise of Nevada as a
Liability-Free Jurisdiction, 98 VA. L. REV. 935 (2012).
77. See Romano, The State Competition Debate in Corporate Law, 8 CARDOZO L. REV. 709, 710–
12 (1987).
78. For a discussion of federalism, see § 5.02[H], infra.
79. See generally Brett H. McDonnell, Two Cheers for Corporate Law Federalism, 30 IOWA J.
CORP. L. 99, 138–39 (2004) (“The presence of one dominant state allows companies to benefit from
network effects in corporate law. A multiplicity of states offering corporate law provides for
experimentation and some diversity in the law offered. Even with Delaware’s dominance reducing the
incentive of other states to innovate in order to attract new corporations, they still have incentive to
innovate in order to better serve their own home corporations, or in Delaware’s case, to maintain its
reputation for responsiveness.”).
80. “Every corporation incorporated under this Act has the purpose of engaging in any lawful business
unless a more limited purpose is set forth in the articles of incorporation.” Model Bus. Corp. Act Ann. §
3.01(a) (4th ed. 2008). Certain types such as banking and insurance may be subject to differing and more
extensive formation requirements.
81. In Total Access, Inc. v. Caddo Electric Cooperative, 9 P.3d 95 (Okla. App. 2000), the court
applied its ultra vires statute to a claim of quo warranto which occurs when a corporation “abuses its
power or intentionally exercises powers not conferred by law.” The court found that since a disappointed
competitor has no standing under the ultra vires statute it has no right to a claim of quo warranto.
82. See Model Bus. Corp. Act Ann. § 3.04 (official comment) (4th ed. 2008). In Goodman v. Ladd
Estate Co., 427 P.2d. 102 (Or. 1967), shareholders were unable to challenge a corporate guaranty having
no business purpose even though it was ultra vires because Oregon had a similar statute. Plaintiffshareholder claimed the guaranty was inequitable because it was ultra vires. The fact that the guaranty
may have been ultra vires did not make it inequitable under the statute because the statute now validates
ultra vires transactions. To be inequitable would require something more. In addition, it was not
inequitable because the plaintiffs bought the shares of the corporation from the previous owner who was
involved in the ultra vires guaranty and they had knowledge of the guaranty.
83. When corporations act as partners in a partnership, issues of ultra vires are raised. The other
partners can make decisions which adversely affect the corporation and imp…