The Corruption and Illegal Deals of Expanding the Business Case Study

parta A: Debate This:The sole shareholder of an S corporation should not be able to avoid liability for the torts of her or his employee

Willliam Sharp was the sole shareholder and manager of Chickasaw Club, Inc., an S corporation that operated a popular nightclub of the same name in Columbus, Georgia. Sharp maintained a corporate checking account but paid the club’s employees, suppliers, and entertainers in cash out of the club’s proceeds. Sharp owned the property on which the club was located. He rented it to the club but made mortgage payments out of the club’s proceeds and often paid other personal expenses with Chickasaw corporate funds.

At 12:45 a.m. on July 31, eighteen-year-old Aubrey Lynn Pursley, who was already intoxicated, entered the Chickasaw Club. Chickasaw employees did not check Pursley’s identification to verify her age, as required by a city ordinance. Pursley drank more alcohol at Chickasaw and was visibly intoxicated when she left the club at 3:00 a.m. with a beer in her hand. Shortly afterward, Pursley lost control of her car, struck a tree, and was killed. Joseph Dancause, Pursley’s stepfather, filed a tort lawsuit against Chickasaw Club and William Sharp. Using the information presented in the chapter, answer the following questions.

1. Under what theory might the court in this case make an exception to the limited liability of share-holders and hold Sharp personally liable for the damages? What factors would be relevant to the court’s decision?
2. Suppose that Chickasaw’s articles of incorporation failed to describe the corporation’s purpose or management structure as required by state law. Would the court be likely to rule that Sharp is personally liable to Dancause on that basis? Why or why not?
3. Suppose that the club extended credit to its regular patrons in an effort to maintain a loyal clientele, although neither the articles of incorporation nor the corporate bylaws authorized this practice. Would the corporation likely have the power to engage in this activity? Explain.
4. How would the court classify Chickasaw Club, Inc.—domestic or foreign, public or private?

Bob Daemmrich/Alamy Stock Photo
Corporate Formation and Financing
A corporation is a creature of statute—a legal entity created
and recognized by state law. As John Marshall indicated in
the chapter-opening quotation, a corporation is an artificial
being, existing only in law and neither tangible nor visible. Its
existence generally depends on state law. Each state has its own
body of corporate law, and these laws are not entirely uniform.
The Model Business Corporation Act (MBCA) is a codification of modern corporate law that has been influential
in shaping state corporation statutes. Today, the majority
John Marshall
1755–1835
of state statutes are guided by the most recent version of
(Chief justice of the United States
the MBCA, often referred to as the Revised Model Business
Supreme Court, 1801–1835)
Corporation Act (RMBCA).
Keep in mind, however, that there is considerable variation
among the laws of states that have used the MBCA or the RMBCA as a basis for their statutes.
In addition, several states do not follow either act. Consequently, individual state corporation laws should be relied on to determine corporate law, rather than the MBCA or RMBCA.
“A corporation is
an artificial being,
invisible, intangible,
and existing only
in contemplation
of law.”
33–1
Nature and Classification
A corporation is a legal entity created and recognized by state law. This business entity can
have one or more owners (called shareholders), and it operates under a name distinct from
the names of its owners. Both individuals and other businesses can be shareholders. The
corporation substitutes itself for its shareholders when conducting corporate business and
incurring liability. Its authority to act and the liability for its actions, however, are separate
and apart from the shareholders who own it.
33
Learning Objectives
The four Learning Objectives below are
designed to help improve your understanding. After reading this chapter, you
should be able to answer the following
questions:
1. What is a close corporation?
2. What four steps are involved
in bringing a corporation into
existence?
3. In what circumstances might
a court disregard the corporate
entity (“pierce the corporate
veil”) and hold the shareholders personally liable?
4. What is the difference
between stocks and bonds?
Corporation A legal entity formed
in compliance with statutory
requirements that is distinct from its
shareholder-owners.
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A corporation is recognized under U.S. law as a person—an artificial legal person, as
opposed to a natural person. As a “person,” it enjoys many of the same rights and privileges
under state and federal law that U.S. citizens enjoy. For instance, corporations possess the
same right of access to the courts as citizens and can sue or be sued. The constitutional
guarantees of due process, free speech, and freedom from unreasonable searches and seizures
also apply to corporations.
monkeybusinessimages/iStock/Getty Images
33–1a Corporate Personnel
Who hires corporate officers?
In a corporation, the responsibility for the overall management of the firm is entrusted to
a board of directors, whose members are elected by the shareholders. The board of directors
hires corporate officers and other employees to run the corporation’s daily business operations.
When an individual purchases a share of stock (an equity interest) in a corporation, that
person becomes a shareholder and thus an owner of the corporation. Unlike the members of a
partnership, the body of shareholders can change constantly without affecting the continued
existence of the corporation. A shareholder can sue the corporation, the corporation can sue
a shareholder, and in certain situations, a shareholder can sue “on behalf of” the corporation.
33–1b The Limited Liability of Shareholders
The major advantage of the corporate form is the limited liability of its owners (shareholders). Corporate shareholders’ liability is limited to the amount of their investments.
Shareholders usually are not otherwise liable for the debts of the corporation. To enable
the firm to obtain credit, however, shareholders in small companies sometimes voluntarily
assume personal liability, as guarantors, for corporate obligations.
33–1c Corporate Earnings and Taxation
Dividend A distribution of corporate
profits to the corporation’s shareholders in proportion to the number of
shares held.
Retained Earnings The portion of a
corporation’s profits that has not been
paid out as dividends to shareholders.
When a corporation earns profits, it can either pass them on to its shareholders in the form
of dividends or retain them as profits. These retained earnings, if invested properly, will yield
higher corporate profits in the future and cause the price of the company’s stock to rise.
Individual shareholders can then reap the benefits in the capital gains that they receive when
they sell their stock.
Whether a corporation retains its profits or passes them on to the shareholders as dividends, those profits are subject to income taxation by various levels of government. Failure
to pay taxes can lead to severe consequences. The state can suspend the entity’s corporate
status until the taxes are paid or even dissolve the corporation for failing to pay taxes.
Another important aspect of corporate taxation is that corporate profits can be subject to
double taxation. The company pays tax on its profits, and then if the profits are passed on
to the shareholders as dividends, the shareholders must also pay income tax on them. The corporation normally does not receive a tax deduction for dividends it distributes to shareholders.
This double-taxation feature is one of the major disadvantages of the corporate business form.
In late 2017, Congress voted to reduce the federal corporate tax rate, which had taxed
income over $10 million at 35 percent, to a flat rate of 21 percent. These changes will boost
corporate profits, but do not affect the potential for double taxation.
33–1d Torts and Criminal Acts
Under modern criminal law, a corporation may be held liable for the criminal acts of its
agents and employees. Although corporations cannot be imprisoned, they can be fined.
(Of course, corporate directors and officers can be imprisoned, and many have been in
recent years.) In addition, under sentencing guidelines for crimes committed by corporate
employees (white-collar crimes), corporations can face fines amounting to hundreds of
millions of dollars.
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A corporation is also liable for the torts committed by its agents or officers within the
course and scope of their employment. The doctrine of respondeat superior applies to corporations in the same way as it does to other agency relationships.
Case Example 33.1 Mark Bloom was an officer and a director of MB Investment Partners, Inc.
(MB), at the time that he formed North Hills, LP, a stock investment fund. Bloom and other MB
employees used MB’s offices and equipment to administer investments in North Hills. Later,
investors in North Hills requested a full redemption of their investments. By that time, however,
most of the funds that had been invested were gone. North Hills had, in fact, been a Ponzi
scheme that Bloom had used to finance his lavish personal lifestyle, taking at least $20 million
from North Hills for his personal use.
Barry Belmont and other North Hills investors filed a suit in a federal district court against
MB, alleging fraud. The court held that MB was liable for Bloom’s fraud. MB appealed, and
the appellate court affirmed. Tort liability can be attributed to a corporation for the acts of
its agent that were committed within the scope of the agent’s employment.1 ■
Because corporations can be liable for their employees’ fraud and other misconduct,
companies need to be careful about whom they hire and how much they monitor or
supervise their employees. Some companies are using special software designed to predict
employee misconduct before it occurs, as discussed in this chapter’s Adapting the Law to the
Online Environment feature.
1. Belmont v. MB Investment Partners, Inc., 708 F.3d 470 (3d Cir. 2013).
Adapting the Law to the
Online Environment
Programs That Predict
Employee Misconduct
M
onitoring employees’ e-mails and
phone conversations at work is generally legal.a But what about using software to analyze employee behavior with
the goal of predicting, rather than observing, wrongdoing? We are now entering into
the digital realm of predictive analytics.
Spy agencies around the world today
use analytic software to predict who will
engage in a terrorist act, where it will happen, and when. Software applied to data
mining of employee behavior (usually only
online) actually has been around for several years as well. For instance, Amazon
started using employee-monitoring programs to predict who might quit. But only
recently have such programs been used to
predict misconduct.
a. Electronic Communications Privacy Act, 18 U.S.C. Section
2511(2)(d).
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JPMorgan Chase Attempts to
Reduce Its Legal Bills
JPMorgan Chase, the world’s largest private financial institution, is perhaps the
world’s largest purchaser of legal services
in that business sector. Its legal bills have
exceeded $36 billion since the financial
crisis in 2008. The company’s management
found that employees had engaged in dubious mortgage bond sales and rigged foreign
exchange and energy markets, among many
other transgressions. The company hired
2,500 extra compliance officers and spent
almost $750 million on compliance operations during a recent three-year period.
Today, JPMorgan is using new software to identify—in advance of any
wrongdoing—“rogue” employees. The
software analyzes a wide range of inputs
on employees’ behavior in an attempt
to identify patterns that point to future
misconduct. If successful, the program
will certainly be copied by other financial
institutions.
An Ethical Problem?
Former Federal Reserve Bank examiner
Mark Williams has raised an important
issue with respect to predictive analytics:
“Policing intentions can be a slippery slope.
Do people get a scarlet letter for something
they have yet to do?” In other words, will
employees be labeled as wrongdoers before
they have actually done anything wrong?
Critical Thinking
Is thinking about committing a crime illegal? Is it unethical? Explain your answers.
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Gorodenkoff/Shutterstock.com
33–1e Classification of Corporations
Corporations can be classified in several ways. The classification of a corporation normally depends on its location, purpose, and ownership characteristics, as described in the following subsections.
Domestic, Foreign, and Alien Corporations A corporation is referred
to as a domestic corporation by its home state (the state in which it incorporates). A corporation formed in one state but doing business in another
is referred to in the second state as a foreign corporation. A corporation formed
What are some of the pitfalls employers face
in another country (say, Mexico) but doing business in the United States is
when they use software that attempts to predict
referred to in the United States as an alien corporation.
employee misconduct?
A corporation does not have an automatic right to do business in a state
other than its state of incorporation. In some instances, it must obtain a
Domestic Corporation In a given
certificate of authority in any state in which it plans to do business. Once the certificate has
state, a corporation that is organized
been issued, the corporation generally can exercise in that state all of the powers conferred
under the law of that state.
on it by its home state. If a foreign corporation does business in a state without obtaining a
certificate of authority, the state can impose substantial fines and sanctions on the corporaForeign Corporation In a given
state, a corporation that does
tion, and sometimes even on its officers, directors, or agents.
business in that state but is not
Note that most state statutes specify certain activities, such as soliciting orders via the Internet,
incorporated there.
that are not considered doing business within the state. Thus, a foreign corporation normally
does not need a certificate of authority to sell goods or services via the Internet or by mail.
Alien Corporation A corporation
What constitutes doing business within a state? In the following case, the court answered
formed in another country but doing
business in the United States.
that question.
Case 33.1
Drake Manufacturing Co. v. Polyflow, Inc.
Superior Court of Pennsylvania, 2015 PA Super 16, 109 A.3d 250 (2015).
Background and Facts Drake Manufacturing
IuriiSokolov/iStock/Getty Images
****
Company, a Delaware corporation, entered into a con[15 Pennsylvania Consolidated Statutes (Pa.C.S.)]
tract to sell certain products to Polyflow, Inc., headSection 4121 provides: “A foreign business corporaquartered in Pennsylvania. Drake promised to ship the
tion, before doing business in this Commonwealth,
goods from Drake’s plant in Sheffield, Pennsylvania, to
shall procure a certificate of authority to do so from
Polyflow’s place of business in Oaks, Pennsylvania, as
the Department of State.”
well as to addresses in California, Canada, and Holland.
* * * Typical conduct requiring a certificate of
When Polyflow withheld payment of about $300,000
authority includes maintaining an office to conduct
If a company
for some of the goods, Drake filed a breach of contract suit
local intrastate business [and] entering into contracts
fails to obtain the
in a Pennsylvania state court against Polyflow seeking to
relating to local business or sales. A corporation is
required foreign corporation certificate
collect the unpaid amount. But Drake had failed to obtain
not “doing business” solely because it resorts to the
of authority, can it
a certificate of authority to do business in Pennsylvania
courts of this Commonwealth to recover an indebtedstill undertake legal
as a foreign corporation. Polyflow asserted that this failness. [Emphasis added.]
actions?
ure to register with the state meant that Drake could not
****
bring an action against Polyflow in the state’s courts. The court
[15 Pa.C.S.] Section 4141(a) provides in relevant part that
issued a judgment in Drake’s favor. Polyflow appealed.
“a nonqualified foreign business corporation doing business in
this Commonwealth * * * shall not be permitted to maintain any
In the Words of the Court
action or proceeding in any court of this Commonwealth until the
Opinion by JENKINS, J. [Judge]:
corporation has obtained a certificate of authority.”
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****
* * * The evidence demonstrates that Drake failed to
submit a certificate of authority into evidence prior to the
verdict in violation of 15 Pa.C.S. Section 4121. Therefore,
the trial court should not have permitted Drake to prosecute
its action.
The trial court contends that Drake is exempt from the certificate of authority requirement because it merely commenced suit
in Pennsylvania to collect a debt * * * . Drake did much more,
however, than file suit or attempt to collect a debt. Drake maintains an office in Pennsylvania to conduct local business, conduct which typically requires a certificate of authority. Drake also
entered into a contract with Polyflow, and * * * shipped couplings
and portable swaging machines to Polyflow’s place of business in
Pennsylvania * * * . In short, Drake’s conduct was * * * regular,
systematic, and extensive, * * * thus constituting the transaction
of business and requiring Drake to obtain a certificate of authority.
[Emphasis added.]
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We also hold that Drake needed a certificate of authority to sue
Polyflow in Pennsylvania for Polyflow’s failure to pay for out-ofstate shipments in California, Canada and Holland. A foreign corporation that “does business” in Pennsylvania * * * must obtain a
certificate in order to prosecute a lawsuit in this Commonwealth,
regardless of whether the lawsuit itself concerns in-state conduct
or out-of-state conduct.
Decision and Remedy A state intermediate appellate court
reversed the judgment in Drake’s favor. Under Pennsylvania state
statutes, Drake was required to obtain a certificate of authority to
do business in that state. Drake failed to do so. The court should
not have allowed Drake to prosecute its action against Polyflow.
Critical Thinking
• Legal Environment Why would the appellate court permit
Polyflow to get away with not paying for delivered and presumably
merchantable goods?
Public and Private Corporations A public corporation is one formed by the government to meet some political or governmental purpose. Cities and towns that incorporate
are common examples. In addition, many federal government organizations—such as
the U.S. Postal Service, the Tennessee Valley Authority, and AMTRAK—are public
corporations.
Note that a public corporation is not the same as a publicly held corporation (often called
a public company). A publicly held corporation is any corporation whose shares are publicly
traded in securities markets, such as the New York Stock Exchange or the NASDAQ. (The
NASDAQ is an electronic stock exchange founded by the National Association of
Securities Dealers.)
Private corporations, in contrast, are created either wholly or in part for private benefit.
Most corporations are private. Although private corporations may serve a public purpose, as
a public electric or gas utility does, they are owned by private persons rather than by
the government.2
Public Corporation A corporation
owned by a federal, state, or municipal government to meet a political or
governmental purpose.
Publicly Held Corporation A corporation whose shares are publicly
traded in securities markets, such as
the New York Stock Exchange or the
NASDAQ.
Nonprofit Corporations Corporations that are formed without a profit-making purpose
are called nonprofit or not-for-profit corporations. Private hospitals, educational institutions,
charities, and religious organizations, for instance, are frequently organized as nonprofit
corporations. The nonprofit corporation is a convenient form of organization that allows
various groups to own property and to form contracts without exposing the individual
members to personal liability.
In some circumstances, a nonprofit corporation and its members may also be immune
from liability for a personal injury caused by its negligence. Whether those circumstances
were present in the following case was the question before the court.
2. The United States Supreme Court first recognized the property rights of private corporations and clarified the distinction between public and
private corporations in the landmark case Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheaton) 518, 4 L.Ed. 629 (1819).
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Case 33.2
Pantano v. Newark Museum
Superior Court of New Jersey, Appellate Division, 2016 WL 528771 (2016).
Background and Facts Loredana Pantano was an immigra-
tion attorney for La Casa de Don Pedro, a nonprofit organization in
Newark, New Jersey. La Casa’s director of personal development
told Pantano to go to the Newark Museum for a panel discussion
being held in the museum’s auditorium as part of La Casa’s fortieth
anniversary celebration. The museum—a nonprofit association
organized exclusively for charitable, artistic, scientific, educational, historical, and cultural purposes—hosted the discussion
but charged La Casa a fee for the use of its auditorium.
At a museum entrance, Pantano slipped and fell on icy steps,
sustaining injuries to her back. She filed a lawsuit in a New Jersey
state court against the museum, alleging that it was negligent in
its maintenance of the premises. The museum filed a motion for
summary judgment, contending that as a nonprofit corporation, it
was immune to liability under the state’s Charitable Immunity Act
(CIA). The court granted the museum’s motion. Pantano appealed.
In the Words of the Court
PER CURIAM.
****
In pertinent part, the [state Charitable Immunity Act (CIA)]
provides:
No nonprofit corporation * * * shall * * * be liable to respond
in damages to any person who shall suffer damage from the
negligence * * * of such corporation * * * where such person
is a beneficiary, to whatever degree, of the works of such nonprofit corporation * * * ; provided, however, that such immunity
from liability shall not extend to any person * * * where such
person is one unconcerned in and unrelated to and outside of the
benefactions of such corporation.
The CIA serves two primary purposes. First, immunity preserves
a charity’s assets. Second, immunity recognizes that a beneficiary of
the services of a charitable organization has entered into a relationship that exempts the benefactor from liability. [Emphasis added.]
* * * The established test for determining whether a party
is a beneficiary of the works of a charity has two prongs. The
Close Corporation A corporation
whose shareholders are limited to a
small group of persons, often family
members.
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first is that the institution pleading the immunity, at the time
in question, was engaged in the performance of the charitable objectives it was organized to advance. The second is that
the injured party must have been a direct recipient of those
good works.
****
As to the first prong, * * * a qualifying organization does not
lose its statutory immunity merely because it charges money for
its services, unless it makes a profit or collects fees for services
totally unrelated to its organizational pursuits. * * * Hosting
an educational panel discussion in the auditorium was entirely
consistent with the Museum’s charitable endeavors.
The second prong of the test * * * distinguishes between
persons benefiting from the charity, and persons who contribute
to the charity by virtue of their attendance or participation.
****
* * * [Thus, under the CIA] to be a beneficiary under the second
prong, the injured party must be a direct recipient of the Museum’s
good works. Only those unconcerned in and unrelated to the
benefactions of the organization are not beneficiaries. [Emphasis
added.]
* * * [Pantano], as an employee of La Casa who was ordered
on the day of her fall to attend the panel discussion at the
Museum, was not a direct beneficiary of the Museum’s charitable endeavors.
Decision and Remedy A state intermediate appellate court
reversed the lower court’s judgment and remanded the case. The
museum could be held liable for Pantano’s injuries.
Critical Thinking
• What If the Facts Were Different? Suppose that
the museum had not been hosting an educational panel in its
auditorium but instead had rented the facility to an organization
for a sales conference. Would the result have been different?
Discuss.
Close Corporations Most corporate enterprises in the United States fall into the category
of close corporations. A close corporation is one whose shares are held by relatively few persons, often members of a family. Close corporations are also referred to as closely held,
family, or privately held corporations.
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Usually, the members of the small group constituting a close corporation are personally
known to one another. Because the number of shareholders is so small, there is no trading
market for the shares. In practice, close corporations often operate somewhat like a partnership. The statutes in many states allow them to depart significantly from certain formalities
required by traditional corporation law.3
Under the RMBCA, close corporations have considerable flexibility in determining their
operating rules [RMBCA 7.32]. If all of a corporation’s shareholders agree in writing, the
corporation can operate without directors and bylaws. In addition, a close corporation need
not hold annual or special shareholders’ or directors’ meetings, issue stock certificates, or
keep formal records of shareholders’ and directors’ decisions.4
Learning Objective 1
What is a close corporation?
Hero Images/Getty Images
Management of Close Corporations. Management of a close corporation resembles that of
a sole proprietorship or a partnership in that a single shareholder or a tightly knit group of
shareholders usually hold the positions of directors and officers. As a corporation, however,
the firm must meet all specific legal requirements set forth in state statutes.
To prevent a majority shareholder from dominating a close corporation, a close corporation may require that more than a simple
majority of the directors approve any action taken by the board. In a
larger corporation, such a requirement would typically apply only to
extraordinary actions (such as selling all the corporate assets) and not
to ordinary business decisions.
Transfer of Shares in Close Corporations. By definition, a close corporation has a small number of shareholders. Thus, the transfer of one
shareholder’s shares to someone else can cause serious management
problems. The other shareholders may find themselves required to
share control with someone they do not know or like.
To avoid this situation, the corporation could restrict the transferability of shares to outside persons. Shareholders could be required to
How is a close corporation usually managed?
offer their shares to the corporation or the other shareholders before
selling them to an outside purchaser. In fact, a few states have statutes that prohibit the transfer of close corporation shares unless certain persons—including
shareholders, family members, and the corporation—are first given the opportunity to purchase the shares for the same price.
Misappropriation of Close Corporation Funds. Sometimes, a majority shareholder in a
close corporation takes advantage of his or her position and misappropriates company funds.
In such situations, the normal remedy for the injured minority shareholders is to have their
shares appraised and to be paid the fair market value for them.
S Corporations A close corporation that meets the qualifying requirements specified in
Subchapter S of the Internal Revenue Code can operate as an S corporation. (A corporation will
automatically be taxed under Subchapter C unless it elects S corporation status.) If a corporation has S corporation status, it can avoid the imposition of income taxes at the corporate level
while retaining many of the advantages of a corporation, particularly limited liability. Among
the numerous requirements for S corporation status, the following are the most important:
S Corporation A close business
corporation that has most corporate
attributes, including limited liability,
but qualifies under the Internal
Revenue Code to be taxed as a
partnership.
1. The corporation must be a domestic corporation.
2. The corporation must not be a member of an affiliated group of corporations.
3. The shareholders must be individuals, estates, or certain trusts. Partnerships and nonqualifying trusts
cannot be shareholders. Corporations can be shareholders under certain circumstances.
3. For example, in some states (such as Maryland), a close corporation need not have a board of directors.
4. Shareholders cannot agree, however, to eliminate certain rights of shareholders, such as the right to inspect corporate books and records and
the right to bring lawsuits on behalf of the corporation.
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4. The corporation must have no more than one hundred shareholders.
5. The corporation must have only one class of stock, although all shareholders do not have to have the
same voting rights.
6. No shareholder of the corporation may be a nonresident alien.
An S corporation is treated differently from a regular corporation for tax purposes. It is
taxed like a partnership, so the corporate income passes through to the shareholders, who
pay personal income tax on it. This treatment enables the S corporation to avoid the double
taxation that is imposed on regular corporations. In addition, the shareholders’ tax brackets
may be lower than the tax bracket that the corporation would have been in if the tax had
been imposed at the corporate level.
In spite of these benefits, the S corporation has lost much of its appeal. The newer limited liability business forms (such as LLCs, LPs, and LLPs) offer similar tax advantages and
greater flexibility.
Know This
The shareholders of
professional corporations generally must be
licensed professionals.
Professional Corporations Professionals such as physicians, lawyers, dentists, and
accountants can incorporate. Professional corporations typically are identified by the letters
S.C. (service corporation), P.C. (professional corporation), or P.A. (professional association).
In general, the laws governing the formation and operation of professional corporations
are similar to those governing ordinary business corporations. There are some differences
in terms of liability, however.
For liability purposes, some courts treat a professional corporation somewhat like a partnership and hold each professional liable for any malpractice committed by others in the
firm within the scope of the firm’s business. With the exception of malpractice or a breach
of duty to clients or patients, a shareholder in a professional corporation generally cannot
be held liable for torts committed by other professionals at the firm.
Benefit Corporations A growing number of states have enacted legislation that creates a
Benefit Corporation A for-profit
corporation that seeks to have a
material positive impact on society
and the environment. It is available by
statute in a number of states.
new corporate form called a benefit corporation. A benefit corporation is a for-profit corporation that seeks to have a material positive impact on society and the environment. Benefit
corporations differ from traditional corporations in the following ways:
1. Purpose. Although the corporation is designed to make a profit, its purpose is to benefit the
public as a whole (rather than just to provide long-term shareholder value, as in ordinary
corporations). The directors of a benefit corporation must, during
the decision-making process, consider the impact of their decisions
on society and the environment.
wavebreakmedia/Shutterstock.com
2. Accountability. Shareholders of a benefit corporation determine
whether the company has achieved a material positive impact.
Shareholders also have a right of private action, called a
benefit enforcement proceeding, enabling them to sue the
corporation if it fails to pursue or create public benefit.
Benefit corporations strive to have a positive impact on society. How
do they differ from traditional, for-profit corporations?
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3. Transparency. A benefit corporation must issue an annual benefit report on its overall social and environmental performance
that uses a recognized third-party standard to assess its performance. The report must be delivered to the shareholders and
posted on a public website.
In the following case, a benefit corporation took an action
that it believed would have a positive impact on those it
was established to serve. Two of those affected by the action
disagreed and filed a suit to challenge the action.
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Case 33.3
Greenfield v. Mandalay Shores Community Association
California Court of Appeal, Second District, Division 6, 21 Cal.App.5th 896, 230 Cal.Rptr.3d 827 (2018).
Background and Facts Mandalay Shores is a beach com-
munity in California’s Oxnard Coastal Zone, where nonresidents
have vacationed for decades, renting homes on a short-term basis.
Robert and Demetra Greenfield owned a single-family residence
at Mandalay Shores that they rented to families for periods of
less than thirty days. Mandalay Shores Community Association
is a mutual benefit corporation established for the development
of the community. The association adopted a resolution banning
short-term rentals (STRs), claiming that it was necessary to reduce
parking, noise, and trash problems. Homeowners who rented their
homes “for less than 30 consecutive days” were subjected to fines
of up to $5,000 per offense.
The Greenfields filed a suit in a California state court against
the association, contending that the STR ban violated the
California Coastal Act. The court denied the plaintiffs’ request for
a preliminary injunction to stay the enforcement of the association’s resolution. The Greenfields appealed.
In the Words of the Court
YEGAN, Acting P.J. [Presiding Judge].
****
* * * The California Coastal Act is intended to, among other
things, “maximize public access to and along the coast and
maximize public recreational opportunities to the coastal zone
consistent with sound resources conservation principles and
constitutionally protected right of private property owners.” The
Coastal Act requires that any person who seeks to undertake
a “development” in the coastal zone to obtain a coastal development permit. “Development” is broadly defined to include,
among other things, any “change in the density or intensity of
use of land.” * * * “Development” under the Coastal Act is not
restricted to activities that physically alter the land or water.
[Emphasis added.]
****
33–2
* * * The STR ban changes the intensity of use and access to
single-family residences in the Oxnard Coastal Zone. STRs were
common in [Mandalay Shores] before the STR ban; now they are
prohibited. Respondent asserts that the STR ban is necessary to
curtail the increasing problem of short-term rentals which cause
parking, noise, and trash problems. STR bans, however, are a matter for the City and Coastal Commission to address. STRs may not
be regulated by private actors where it affects the intensity of
use or access to single-family residences in a coastal zone. The
question of whether a seven-day house rental is more of a neighborhood problem than a 31-day rental must be decided by the
City and the Coastal Commission, not a homeowner’s association.
[Emphasis added.]
* * * Respondent’s STR ban affects 1,400 [housing] units and
cuts across a wide swath of beach properties that have historically
been used as short-term rentals. A prima facie showing has been
made to issue a preliminary injunction staying enforcement of the
STR ban until trial.
Decision and Remedy A state intermediate appellate court
reversed the lower court’s denial of the Greenfields’ motion, and
ordered the issuance of a preliminary injunction. The court concluded that “Mandalay Shores Community Association . . . has
erected a monetary barrier to the beach. It has no right to do so.”
Critical Thinking
• Legal Environment Did the STR ban adopted by the
association comport with or contravene its status as a benefit
corporation? Discuss.
• What If the Facts Were Different? Suppose that instead
of adopting an STR ban on its own, the association had petitioned
the city and the Coastal Commission to impose one. Would the
result have been different? Explain.
Formation and Powers
Incorporating a business is much simpler today than it was twenty years ago. Many states
allow businesses to incorporate via the Internet.
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“A man to carry on a
successful business
must have imagination.
He must see things as
in a vision, a dream of
the whole thing.”
33–2a Promotional Activities
Charles M. Schwab
1862–1939
(American industrialist)
In the past, preliminary steps were taken to organize and promote a business prior to incorporating. Contracts were made with investors and others on behalf of the future corporation.
Today, due to the relative ease of forming a corporation in most states, persons incorporating
a business rarely, if ever, engage in preliminary promotional activities.
Nevertheless, businesspersons need to understand that they are personally liable for any
preincorporation contracts made with investors, accountants, or others on behalf of the
future corporation. Liability continues until the corporation is formed and explicitly assumes
the contract by novation.
33–2b Incorporation Procedures
Learning Objective 2
What four steps are involved
in bringing a corporation into
existence?
Each state has its own set of incorporation procedures, which most often are listed on the
secretary of state’s website. Generally, however, all incorporators follow four basic steps,
discussed next.
Select the State of Incorporation Because state corporate laws differ, individuals may
look for the states that offer the most advantageous tax or other provisions. Many corporations, for instance, have chosen to incorporate in Delaware because it has historically
had the least restrictive laws, along with provisions that favor corporate management. For
reasons of convenience and cost, though, businesses often choose to incorporate in the state
in which the corporation’s business will primarily be conducted.
Secure an Appropriate Corporate Name The choice of a corporate name is subject to state approval to ensure against duplication or deception. In today’s online world,
what matters most is to secure a corporate name that can be used as a domain name.
A new corporation’s name cannot be the same as (or deceptively similar to) the name of
an existing corporation. Therefore, the incorporators usually must perform a search to
confirm that the corporate name they choose is available as a domain name. State approval
of the name may also be required. In addition, all states require the corporation name to
include the word Corporation, Incorporated, Company, or Limited, or an abbreviation of one
of these terms.
Prepare the Articles of Incorporation The primary document needed to incorporate
Articles of Incorporation The
document that is filed with the
appropriate state official, usually
the secretary of state, when a
business is incorporated and that
contains basic information about
the corporation.
a business is the articles of incorporation. The articles include basic information about the
corporation and serve as a primary source of authority for its future organization and business functions. The person or persons who execute (sign) the articles are the incorporators.
Articles of incorporation vary widely depending on the jurisdiction and the size and type
of the corporation. Generally, though, the articles must include the following information
[RMBCA 2.02]:
1. The name of the corporation.
2. The number of shares of stock the corporation is authorized to issue [RMBCA 2.02(a)]. (Large corporations often also state a par value for each share, such as $0.20 per share, and specify the various
types or classes of stock authorized for issuance.)
3. The name and street address of the corporation’s initial registered agent and registered office. The
registered agent is the person who can receive legal documents (such as orders to appear in court)
on behalf of the corporation. The registered office is usually the main corporate office.
4. The name and address of each incorporator.
In addition, the articles may set forth other information, such as the names and addresses
of the initial members of the board of directors and the duration and purpose of the corporation. A corporation has perpetual existence unless the articles state otherwise.
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As to the corporation’s purpose, a corporation can be formed for any lawful purpose, and
the RMBCA does not require the articles to include a specific statement of purpose.
Consequently, the articles often include only a general statement of purpose. By not mentioning specifics, the corporation avoids the need for future amendments to the corporate
articles [RMBCA 2.02(b)(2)(i), 3.01]. Similarly, the articles do not provide much detail about
the firm’s operations, which are spelled out in the company’s bylaws (discussed shortly).
File the Articles of Incorporation Once the articles of incorporation have been
prepared and signed by the incorporators, they are sent to the appropriate state official.
They are most often filed with the secretary of state’s office, along with the required
filing fee. In most states, the secretary of state then stamps the articles as “Filed” and
returns a copy of the articles to the incorporators. Once this occurs, the corporation
officially exists.
33–2c First Organizational Meeting to Adopt Bylaws
Monkey Business Images/Shutterstock.com
After incorporation, the first organizational meeting must be held. If the articles of incor- Bylaws The internal rules of manporation named the initial board of directors (as is typical), then the directors, by majority agement adopted by a corporation at
vote, call the meeting. If the articles did not name the directors, then the incorporators its first organizational meeting.
hold the meeting to elect the directors and conduct any other necessary business.
Usually, the most important function of the first organizational
meeting is the adoption of the bylaws, which are the corporation’s
internal rules of management. The bylaws cannot conflict with the
state corporate statute or the articles of incorporation [RMBCA 2.06].
Under the RMBCA, the shareholders may amend or repeal the
bylaws. The board of directors may also amend or repeal the bylaws,
unless the articles of incorporation or provisions of the state corporate statute reserve this power to the shareholders exclusively
[RMBCA 10.20]. The bylaws typically describe such matters as voting
requirements for shareholders, the election and replacement of the
board of directors, and the manner and time of holding shareholders’
What are some of the important functions of a corporation’s
and board meetings.
first organizational meeting?
33–2d Improper Incorporation
The procedures for incorporation are very specific. If they are not followed precisely, others
may be able to challenge the existence of the corporation. Errors in the incorporation procedures can become important when, for instance, a third party who is attempting to enforce
a contract or bring a suit for a tort injury learns of them.
De Jure Corporations If a corporation has substantially complied with all conditions
precedent to incorporation, the corporation is said to have de jure (rightful and lawful)
existence. In most states and under the RMBCA 2.03(b), the secretary of state’s filing of the
articles of incorporation is conclusive proof that all mandatory statutory provisions have
been met.
Sometimes, the incorporators fail to comply with all statutory mandates. If the defect is
minor, such as an incorrect address listed on the articles of incorporation, most courts will
overlook the defect and find that a de jure corporation exists.
Know This
Unlike the articles of
incorporation, bylaws do
not need to be filed with
a state official.
De Facto Corporations If a defect in formation is substantial, such as a corporation’s
failure to hold an organizational meeting to adopt bylaws, the outcome will vary depending
on the court. Some states, including Mississippi, New York, Ohio, and Oklahoma, recognize
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“Gentlemen prefer
bonds.”
the common law doctrine of de facto corporation. In those states, the courts will treat a
corporation as a legal corporation despite the defect in its formation if all three of the following requirements are met:
Andrew Mellon
1. A state statute exists under which the corporation can be validly incorporated.
1855–1937
(American banker)
2. The parties have made a good faith attempt to comply with the statute.
3. The parties have already undertaken to do business as a corporation.
Many states’ courts, however, have interpreted their states versions of the RMBCA as
abolishing the common law doctrine of de facto corporation. These states include Alaska,
Arizona, Minnesota, New Mexico, Oregon, South Dakota, Tennessee, Utah, and Washington,
as well as the District of Columbia. In those states, if there is a substantial defect in complying
with the statutory mandates, the corporation does not legally exist, and the incorporators
are personally liable.
Corporation by Estoppel Sometimes, a business association holds itself out to others as
Maksymowicz/iStock/Getty Images
being a corporation when it has made no attempt to incorporate. In those situations, the
firm normally will be estopped (prevented) from denying corporate status in a lawsuit by
a third party. The estoppel doctrine most commonly applies when a third party contracts
with an entity that claims to be a corporation but has not filed articles of incorporation.
It may also be applied when a third party contracts with a person claiming to be an agent
of a corporation that does not, in fact, exist.
When justice requires, the courts treat an alleged corporation as if it were an actual corporation for the purpose of determining the rights and liabilities in a particular circumstance.
Recognition of corporate status does not extend beyond the resolution of the problem
at hand. Case Example 33.2 Dale Ross bought a farm and formed Big Little Farms, Inc. (BLF),
in Trumbull County, Ohio, to breed and train race horses. Dale failed to pay
BLF’s taxes, and the state cancelled BLF’s corporate status. Dale continued
operating the farm business, however.
Over a number of years, Dale’s brother, Gene, loaned him funds to make
improvements to BLF. At one point, Dale signed—as president of BLF
Corporation—a promissory note to Gene and a mortgage on the farm. A few
months after the mortgage was signed, Gene died. Gene’s wife filed a claim against
Dale and his wife seeking, in part, to foreclose on the mortgage. Then Dale died.
Dale’s wife claimed that the mortgage note her husband had signed was
void because the corporation did not legally exist at the time he had signed it.
Gene’s wife argued that Dale’s estate should not be able to avoid paying a note
that Dale had knowingly signed as president of a corporation whose legal
What are some potential consequences if a
status had been revoked. Ultimately, a state appellate court ruled that the
farming operation loses its corporate status by
mortgage note was valid. BLF was estopped from denying its corporate status
failing to pay its taxes?
for the purpose of invalidating the loan contract.5 ■
33–2e Corporate Powers
When a corporation is created, the express and implied powers necessary to achieve
its purpose also come into existence. Corporations cannot engage in acts that are beyond
their powers, nor can a corporation’s owners (shareholders) avoid liability if they misuse the
corporate entity for their own personal benefit.
Express Powers The express powers of a corporation are found in its articles of incorporation, in the law of the state of incorporation, and in the state and federal constitutions. Corporate bylaws also establish the express powers of the corporation. Because state
5. Lamancusa v. Big Little Farms, Inc., 2013 -Ohio- 5815, 5 N.E.3d 1080 (Ohio App. 2013).
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797
corporation statutes frequently provide default rules that apply if the company’s bylaws
are silent on an issue, it is important that the bylaws set forth the specific operating rules
of the corporation. In addition, after the bylaws are adopted, the corporation’s board of
directors will pass resolutions that grant or restrict corporate powers.
On occasion, the U.S. government steps in to challenge what a corporation may consider
one of its express powers. This chapter’s Beyond Our Borders feature discusses a dispute
between the government and Microsoft Corporation over a demand that the company provide the government with access to e-mail stored in servers on foreign soil.
Does Cloud Computing Have a Nationality?
M
ost people use “the cloud” for the
storage of their digital data—
photos, e-mails, music, documents, and
just about anything else. Not surprisingly,
major global digital players such as Apple,
Amazon, Google, and Microsoft have spent
billions to create “clouds” of servers all
over the world. In the clouds are stored
confidential, organized, and secure data.
The revenues generated by the U.S. cloudcomputing industry exceed $100 billion
a year.
Microsoft and Google Battle
Federal Warrants
The U.S. government issued a warrant
to Microsoft to produce e-mails related to a narcotics case from a Hotmail
account. That e-mail account was hosted
in a Microsoft cloud location in Ireland.
Microsoft refused, arguing that the U.S.
government did not have the power to
issue a warrant for information stored in
a foreign country and that doing so would
threaten the privacy of U.S. citizens.
Some industry experts predicted that if
Microsoft was forced to comply with the
government’s warrant, U.S. technology
companies could lose up to $35 billion a
year from their cloud storage businesses.
Foreign corporations and individuals would
no longer trust U.S. companies to keep
their data secret. A federal district court in
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New York confirmed the government’s right
to the Ireland-located e-mails, but that
decision was reversed on appeal.
Ultimately, the United States Supreme
Court granted certiorari to resolve the
dispute.a
A subsequent case was brought against
Google. In relation to a criminal investigation, the government issued a warrant to
access e-mails that Google had stored outside the United States. Google made the
same arguments that Microsoft had, but a
federal district court ruled in the government’s favor. The court reasoned that there
were differences in the way the two corporations stored the cloud data overseas.
Microsoft had stored the data exclusively
in Ireland, so it “resided” in that location.
Google had separated its cloud data into
components and constantly moved it
around the globe to improve network
efficiency.b
Congress Enacts the CLOUD Act
In March 2018, Congress enacted the
Clarifying Lawful Overseas Use of Data
Act (CLOUD Act), which amended existing law.c The CLOUD Act requires service
a. United States v. Microsoft Corp., 583 U.S. ___, 138 S.Ct.
356, 199 L.Ed.2d 261 (2017).
b. In the Matter of the Search of Content Stored at Premises
Controlled by Google, Inc., ___ F.Supp.3d ___, 2017 WL
1487625 (N.D.Cal. 2017).
c. 18 U.S.C. Section 2703.
Beyond Our Borders
providers to preserve, backup, or disclose the contents of wire or electronic
communications—as well as any record
pertaining to a customer or subscriber
within such provider’s possession, custody,
or control. Under the act, service providers have a duty to preserve this information, regardless of whether it is located
inside or outside the United States.
After the CLOUD Act was passed, the
government in the Microsoft case obtained
a new warrant pursuant to the act. By the
time the case reached the United States
Supreme Court, there was no longer any
dispute to resolve. The Court found that
the government had the authority
under the CLOUD Act to issue warrants to
access information extraterritorially (and
vacated the appellate court’s decision).d
Critical Thinking
How might the CLOUD Act affect the privacy of U.S. citizens who store their information in the cloud?
d. United States v. Microsoft Corp., ___ U.S. ___ 138 S.Ct.
1186, 200 L.Ed.2d 610 (2018).
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UNIT FIVE: Business Organizations
turtix/Shutterstock.com
798
Why are large companies, such as Google, encountering
legal issues by storing large amounts of data overseas?
Ultra Vires Acts Acts of a corpo-
ration that are beyond its express
and implied powers to undertake
(the Latin phrase means “beyond the
powers”).
Ultra Vires Doctrine The term ultra vires means “beyond the powers.” In corporate law,
acts of a corporation that are beyond its express and implied powers are ultra vires acts.
In the past, most cases dealing with ultra vires acts involved contracts made for unauthorized
purposes. Now, however, most private corporations are organized for “any legal business” and
not for a specific purpose, so the ultra vires doctrine has declined in importance. Today, cases that
allege ultra vires acts usually involve nonprofit corporations or municipal (public) corporations.6
Under Section 3.04 of the RMBCA, shareholders can seek an injunction from a court to
prevent (or stop) the corporation from engaging in ultra vires acts. The attorney general in
the state of incorporation can also bring an action to obtain an injunction against the ultra
vires transactions or seek dissolution of the corporation.
33–3
Piercing the Corporate Veil The
action of a court to disregard the corporate entity and hold the shareholders personally liable for corporate
debts and obligations.
Learning Objective 3
In what circumstances
might a court disregard the
corporate entity (“pierce the
corporate veil”) and hold
the shareholders personally
liable?
Implied Powers When a corporation is created, it acquires certain
implied powers. Barring express constitutional, statutory, or other prohibitions, the corporation has the implied power to perform all acts reasonably
appropriate and necessary to accomplish its corporate purposes. For this
reason, a corporation has the implied power to borrow funds within certain
limits, to lend funds, and to extend credit to those with whom it has a legal
or contractual relationship.
Most often, the president or chief executive officer of the corporation
will execute the necessary papers on behalf of the corporation. In so doing,
corporate officers have the implied power to bind the corporation in matters
directly connected with the ordinary business affairs of the enterprise. There
is a limit to what a corporate officer can do, though. A corporate officer does
not have the authority to bind the corporation to an action that will greatly
affect the corporate purpose or undertaking, such as the sale of substantial
corporate assets.
Piercing the Corporate Veil
Occasionally, the owners use a corporate entity to perpetrate a fraud, circumvent the law, or
in some other way accomplish an illegitimate objective. In these situations, the court will
ignore the corporate structure by piercing the corporate veil and exposing the shareholders to
personal liability [RMBCA 2.04].
Generally, courts pierce the veil when corporate privilege is abused for personal benefit or
when the corporate business is treated so carelessly that it is indistinguishable from that of
a controlling shareholder. In short, when the facts show that great injustice would result
from a shareholder’s use of a corporation to avoid individual responsibility, a court will look
behind the corporate structure to the individual shareholder. The shareholder/owner is then
required to assume personal liability to creditors for the corporation’s debts.
33–3a Factors That Lead Courts to Pierce the Corporate Veil
The following are some of the factors that frequently cause the courts to pierce the
corporate veil:
1. A party is tricked or misled into dealing with the corporation rather than the individual.
2. The corporation is set up to never make a profit or always be insolvent, or it is too thinly capitalized—
that is, it has insufficient capital at the time of formation to meet its prospective debts or other
potential liabilities.
6. See, for instance, Xcel Energy Services, Inc. v. Federal Energy Regulatory Commission, 815 F.3d 947 (D.C.Cir. 2016).
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3. Statutory corporate formalities, such as holding required corporation meetings, are not followed.
4. Personal and corporate interests are commingled to such an extent that the corporation has no
separate identity.
Commingle To mix funds or goods
together to such a degree that they
no longer have separate identities.
epromocja/iStock/Getty Images
Case Example 33.3 Dog House Investments, LLC, operated a dog “camp” in Nashville,
Tennessee. Dog House leased the property from Teal Properties, Inc., which was owned by
Jerry Teal, its sole shareholder. Under the lease, the landlord promised to repair damage from
fire or other causes that rendered the property “untenantable” (unusable). Following a flood,
Dog House notified Jerry that the property was untenantable. Jerry assured Dog House that
the flood damage was covered by insurance but took no steps to restore the property.
The parties then agreed that Dog House would undertake the repairs and be reimbursed
by Teal Properties.
Dog House spent $39,000 to repair the damage and submitted invoices for reimbursement. Teal Properties recovered $40,000 from its insurance company but did
not pay Dog House. Close to bankruptcy, Dog House sued Teal Properties and Jerry.
The court pierced the corporate veil and held Jerry personally liable for the repair
costs. An appellate court affirmed. Teal Properties owned no property and had no
assets. It received rent but paid it immediately to Jerry. The court concluded that the
company was not operated as an entity separate from its sole shareholder.7 (See this
If a leased property for dog kennels
chapter’s Business Law Analysis feature, which illustrates a situation in which a court
floods, what is the landlord’s responsibility?
may decide not to pierce the corporate veil.) ■
33–3b A Potential Problem for Close Corporations
The potential for corporate assets to be used for personal benefit is especially great in a close
corporation. In such a corporation, the separate status of the corporate entity and the shareholders must be carefully preserved. Certain practices invite trouble for a close corporation,
7. Dog House Investments, LLC v. Teal Properties, Inc., 448 S.W.3d 905 (Tenn.App. 2014).
Piercing the Corporate Veil
C
ountry Contractors, Inc., contracted
to provide excavation services for
Westside Storage of Indianapolis, Inc.,
but did not complete the job and later filed
for bankruptcy. Stephen Songer and Jahn
Songer were Country’s sole shareholders.
The Songers had not misused the corporate
form to engage in fraud. The firm had not
been undercapitalized, personal and corporate funds had not been commingled, and
Country had kept accounting records
and minutes of its annual board meetings. Are the Songers personally liable for
Country’s failure to complete its contract?
Analysis: A hallmark of the corporate form of business organization is that
30301_ch33_hr_785-806.indd 799
shareholders are not personally liable for
the debts of the corporation. If the corporation fails, the shareholders can lose their
investments, but that is generally the limit
of their liability. A court may pierce the corporate veil to hold the shareholders personally liable in certain instances of fraud,
undercapitalization, or a failure to observe
corporate formalities. But these situations
are exceptions.
Result and Reasoning: The Songers
are not personally liable for Country’s failure
to complete its contract with Westside
Storage. They had not misused the corporate form to engage in misconduct, the
firm had not been undercapitalized, and
Business Law
Analysis
personal and corporate funds had not
been commingled. In addition, Country had
kept accounting records and minutes of its
annual board meetings, thus observing the
formalities required by law. These circumstances fall under none of the exceptions to
the limit on shareholders’ liability for corporate obligations. Thus, as shareholders,
the Songers are not personally liable for the
failure of their company to complete its job.
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UNIT FIVE: Business Organizations
such as the commingling of corporate and personal funds or the shareholders’ continuous
personal use of corporate property (for instance, vehicles).
Typically, courts are reluctant to hold shareholders in close corporations personally liable
unless there is some evidence of fraud or wrongdoing.
Spotlight Case Example 33.4 Pip,
Jimmy, and Theodore Brennan are brothers and shareholders of Brennan’s, Inc., which owns
and operates New Orleans’s famous Brennan’s Restaurant. As a close corporation, Brennan’s,
Inc., did not hold formal corporate meetings with agendas and minutes, but it did maintain
corporate books, hold corporate bank accounts, and file corporate tax returns.
The Brennan brothers retained attorney Edward Colbert to represent them in a family
matter, and the attorney’s bills were sent to the restaurant and paid from the corporate
account. Later, when Brennan’s, Inc., sued Colbert for malpractice, Colbert argued that the
court should pierce the corporate veil because the Brennan brothers did not observe corporate formalities. The court refused to do so, however, because there was no evidence of fraud
or other wrongdoing by the Brennan brothers. There is no requirement for small, close
corporations to operate with the formality usually expected of larger corporations.8 ■
33–4
Securities Generally, stocks, bonds,
or other items that represent an
ownership interest in a corporation or
a promise of repayment of debt by a
corporation.
Bond A security that evidences a
corporate (or government) debt.
Learning Objective 4
What is the difference
between stocks and bonds?
Stock An ownership (equity)
interest in a corporation, measured
in units of shares.
Common Stock Shares of owner-
ship in a corporation that give the
owner a proportionate interest in the
corporation with regard to control,
earnings, and net assets. Common
stock is lowest in priority with
respect to payment of dividends and
distribution of the corporation’s assets
on dissolution.
Corporate Financing
Part of the process of corporate formation involves financing. Corporations normally are
financed by the issuance and sale of corporate securities. Securities—stocks and bonds—
evidence the right to participate in earnings and the distribution of corporate property or the
obligation to pay funds.
33–4a Bonds
Bonds (debentures or debt securities) represent the borrowing of funds. Bonds are issued
by business firms and by governments at all levels as evidence of the funds they
are borrowing from investors.
Bonds normally have a designated maturity date—the date when the principal, or face,
amount of the bond is returned to the bondholder. Bondholders also receive fixed-dollar
interest payments, usually semiannually, during the period of time before maturity. For that
reason, bonds are sometimes referred to as fixed-income securities. Because debt financing
represents a legal obligation on the part of the corporation, various features and terms of a
particular bond issue are specified in a lending agreement.
Of course, not all debt is in the form of debt securities. For instance, some debt is in the form
of accounts payable and notes payable, which typically are short-term debts. Bonds are simply
a way for the corporation to split up its long-term debt so that it can be more easily marketed.
33–4b Stocks
Issuing stock is another way that corporations can obtain financing. Stocks, or equity
securities, represent the purchase of ownership in the business firm. The true ownership of
a corporation is represented by common stock. Common stock provides a proportionate
interest in the corporation with regard to (1) control (voting rights), (2) earnings, and (3)
net assets. A shareholder’s interest is generally in proportion to the number of shares he or
she owns out of the total number of shares issued.
8. Brennan’s, Inc. v. Colbert, 85 So.3d 787 (La.App.4th Cir. 2012).
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An issuing firm is not obligated to return a principal amount per share to each holder
of its common stock, nor does the firm have to guarantee a dividend. Indeed, some corporations never pay dividends. Holders of common stock are investors who assume a residual
position in the overall financial structure of a business. They benefit when the market price
of the stock increases. In terms of receiving payment for their investments, they are last
in line.
Preferred stock is stock with preferences. Holders of preferred stock usually have priority
over holders of common stock as to dividends and payment on dissolution of the corporation, but may not have the right to vote. Although holders of preferred stock have a stronger
position than common shareholders with respect to dividends and claims on assets, they will
not share in the full prosperity of the firm if it grows successfully over time. Preferred stockholders do receive fixed dividends periodically, however, and they may benefit to some extent
from changes in the market price of the shares.
Preferred Stock Stock that has
priority over common stock as to
payment of dividends and distribution of assets on the corporation’s
dissolution.
33–4c Venture Capital
Start-up businesses and high-risk enterprises often obtain venture capital financing. Venture
capital is capital provided to new business ventures by professional, outside investors (venture
capitalists, usually groups of wealthy investors and securities firms). Venture capital investments are high risk—the investors must be willing to lose their invested funds—but offer
the potential for well-above-average returns at some point in the future.
To obtain venture capital financing, the start-up business typically gives up a share of
its ownership to the venture capitalists. In addition to funding, venture capitalists may provide managerial and technical expertise, and they nearly always are given some control over
the new company’s decisions. Many Internet-based companies, such as Amazon and Google,
were initially financed by venture capital.
Venture Capital Financing provided
by professional, outside investors
(venture capitalists) to new business
ventures.
33–4d Private Equity Capital
Private equity firms pool funds from wealthy investors and use this private equity capital to
invest in existing corporations. Usually, a private equity firm buys an entire corporation and
then reorganizes it. Sometimes, divisions of the purchased company are sold off to pay down
debt. Ultimately, the private equity firm may sell shares in the reorganized (and perhaps
more profitable) company to the public in an initial public offering (IPO). In this way, the
private equity firm can make profits by selling its ownership rights in the company to
the public.
Private Equity Capital Funds
invested in an existing corporation
by a private equity firm, usually to
purchase and reorganize it.
33–4e Crowdfunding
Start-up businesses can also attempt to obtain financing through crowdfunding. Crowdfunding
is a cooperative activity in which people network and pool funds and other resources via the
Internet to assist a cause or invest in a venture. Sometimes, crowdfunding is used to raise
funds for charitable purposes, such as disaster relief, but increasingly it is being used to
finance budding entrepreneurs. Basic crowdfunding websites include NextSeed and
StartEngine.
In 2016, new Securities and Exchange Commission rules went into effect to allow companies to offer and sell securities through crowdfunding. The rules removed a decades-old
ban on public solicitation for private investments. In essence, this means that companies can
advertise investment opportunities to the public, which will encourage more crowdfunding
in the future. The new rules are intended to help smaller companies raise capital while providing investors with additional protections.
30301_ch33_hr_785-806.indd 801
Crowdfunding A cooperative activity in which people network and pool
funds and other resources via the
Internet to assist a cause (such as
disaster relief) or invest in a venture
(business).
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802
UNIT FIVE: Business Organizations
Practice and Review
William Sharp was the sole shareholder and manager of Chickasaw Club, Inc., an S corporation that
operated a popular nightclub of the same name in Columbus, Georgia. Sharp maintained a corporate
checking account but paid the club’s employees, suppliers, and entertainers in cash out of the club’s
proceeds. Sharp owned the property on which the club was located. He rented it to the club but
made mortgage payments out of the club’s proceeds and often paid other personal expenses with
Chickasaw corporate funds.
At 12:45 A.M. on July 31, eighteen-year-old Aubrey Lynn Pursley, who was already intoxicated,
entered the Chickasaw Club. Chickasaw employees did not check Pursley’s identification to verify
her age, as required by a city ordinance. Pursley drank more alcohol at Chickasaw and was visibly
intoxicated when she left the club at 3:00 A.M. with a beer in her hand. Shortly afterward, Pursley
lost control of her car, struck a tree, and was killed. Joseph Dancause, Pursley’s stepfather, filed
a tort lawsuit against Chickasaw Club and William Sharp. Using the information presented in the
chapter, answer the following questions.
1. Under what theory might the court in this case make an exception to the limited liability of shareholders and hold Sharp personally liable for the damages? What factors would be relevant to the
court’s decision?
2. Suppose that Chickasaw’s articles of incorporation failed to describe the corporation’s purpose
or management structure as required by state law. Would the court be likely to rule that Sharp is
personally liable to Dancause on that basis? Why or why not?
3. Suppose that the club extended credit to its regular patrons in an effort to maintain a loyal clientele,
although neither the articles of incorporation nor the corporate bylaws authorized this practice.
Would the corporation likely have the power to engage in this activity? Explain.
4. How would the court classify Chickasaw Club, Inc.—domestic or foreign, public or private?
Debate This
The sole shareholder of an S corporation should not be able to avoid liability for the torts of her or
his employees.
Key Terms
alien corporation 788
articles of incorporation 794
benefit corporation 792
bond 800
bylaws 795
close corporation 790
commingle 799
common stock 800
30301_ch33_hr_785-806.indd 802
corporation 785
crowdfunding 801
dividend 786
domestic corporation 788
foreign corporation 788
piercing the corporate veil 798
preferred stock 801
private equity capital 801
public corporation 789
publicly held corporation 789
retained earnings 786
S corporation 791
securities 800
stock 800
ultra vires acts 798
venture capital 801
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