Business Entities
Corporations
1
Corporations: “creatures of state law”
• Business entities’ structures are primarily
determined by state law.
• People organizing businesses can choose
which state’s laws to use.
• Federal laws on business structures are
mostly for publicly-traded companies.
– Other federal laws affect all businesses the
same way they affect individuals: tax laws,
anti-discrimination laws, etc.
2
Why Corporations?
Suppose Joan owns/operates as sole proprietor a
software company specializing in providing ecommerce solutions for small businesses. To finance
planned expansion and cash-in on the value of her
business, Joan plans to sell 45% of ownership to a
small group of institutional investors and 45% of
ownership to approximately 750 geographically
dispersed individual investors. Joan will retain 10%
ownership and will continue her active
management role in the firm.
What form of business organization makes sense?
3
• Relationships among the people who
are part of the business structure are
largely governed by state law:
– Equity owners
– Debt holders
– Managers
– Employees
• “Internal affairs doctrine”- state law
controls to generally allow directors to
structure business as they think best.
4
Solving the Problem
• Corporate form solves problems that exist in
partnership form of organization:
– Unlimited personal liability
– Equal participation in management
– Inefficient voting rules
– Dissolution at-will and restrictions on
transferring ownership
– Decentralized agency power
5
Corporation
•
•
•
•
•
Separate legal entity.
Limited liability of shareholders.
Double taxation.
Centralized management.
Name must include “Inc.”, “Corp.”, etc.
6
Delaware: Top
Location for Large
Corporations’ Place
of Incorporation
• 850,000 + business
entities
• > 50% all publicly
traded corporations
• > 60% of Fortune 500
legally incorporated
there
•
49th largest
•
45th most populous
•
•
0.43% of US GDP (TX is
7.95%)
2nd in GDP per capita
7
Why DE?
• Delaware corporate law is “best”
• Delaware business courts (court of chancery)
is “best”
– Experienced judges
– No juries
8
• Delaware’s preeminence in the corporate
charter market results from its ability to resolve
credibly the commitment problem in relational
contracting. This ability depends on investing in
assets, referred to as transaction-specific assets,
whose value is highest when used in a specific
relations rather than in any other use.
– Reputation
– Hostage-like dependence on revenue
– Judicial expertise in interpreting corporate law, case
law
– Administrative expertise in rapid processing
9
Efficient Regulation
• Delaware provides
– Efficient court system with expert judges and no juries
in corporate law cases.
– Experienced service providers in a cluster.
– Widespread knowledge of DE law among lawyers
nationally and internationally.
– Good service.
– Commitment to maintaining quality because of DE’s
dependence on revenue, huge sunk cost investment in
corporate law; strong interest group of lawyers &
service providers committed to keeping business.
10
• To establish a corporation—need:
• Articles of incorporation ~ constitution
– Total shares; classes of shares; powers of board,
shareholders; preemptive rights; indemnity for
directors.
• Bylaws ~ statutes, set by directors
– Procedures for meetings (notice, quorum),
duties of officers, rules of governance.
11
Shareholders
Board of Directors
Officers
12
Shareholder
ABC, Inc.
Shareholder
Shareholder
XYZ, Inc.
Shareholder
Shareholder
Shareholder
13
Who decides?
• Where the next store will be
located?
• Whether a new type of
sandwich should be offered?
• Whether McDonald’s should
begin operations in China?
• Whether McDonald’s will
buy Wendy’s?
• Whether McDonald’s should
liquidate the company?
14
• Dell’s Corporate Governance Principles
• The Board of Directors (the “Board”) of Dell Inc.
(“Dell”), as representatives of the stockholders, is
committed to the achievement of business
success and the enhancement of long-term
stockholder value with the highest standards of
integrity and ethics. In that regard, the Board has
adopted these principles to provide an effective
corporate governance framework for Dell,
intending to reflect a set of core values that
provide the foundation for Dell’s governance and
management systems and its interactions with
others.
15
• Easterbrook & Fischel,
The Economic Structure of Corporate Law
“The first question facing entrepreneurs is
what promises to make, and the second is
how to induce investors to believe them.
Empty promises are worthless promises.
Answering the first question depends on
finding ways to reduce the effects of divergent
interests; answering the second depends on
finding legal and automatic enforcement
devices. The more automatic the
enforcement, the more investors will believe
the promises.” (p. 5)
16
• Debt and Equity
• “Entrepreneurs make promises in the articles of
incorporation and the securities they issue
when they go public. The debt investors receive
… detailed promises in indentures. These
promises concern the riskiness of the firm’s
operations, the extent to which earnings may be
paid out, and the domain of managerial
discretion. These promises benefit equity
investors as well as debt investors. The equity
investors usually receive votes rather than
explicit promises.” (p. 6)
17
Equity: Stock
• Common stock: right to vote and receive
distributions
• Preferred stock: first call on dividends and
distributions, usually non-voting
• Convertible
• Securities laws apply to public sales
18
• Authorization of shares - how many? Not the
same as “issued”
• Dilution
– A, B, & C each own 1,000 shares
– 1,000 new shares issued and sold to D
• Preemptive rights: to pro rata share of new
stock
19
Determining Shares to Issue
• Legal attributes of shares reduce cost of the
market for investment.
– Model Business Corporation Act (MBCA) s6.01(a)
requires shares within a class to have same
preferences, limitations, & relative rights; DE GCL
does not but DE common law does.
– Need one class with unconditional voting rights
and a class that is residual claimant on assets.
20
Determining Voting Rights
• 2 potentially incompatible goals
– Maximizing shareholders’ collective right to select
directors
– Protecting the rights of minority shareholders or
groups of shareholders to have their views
represented by directors of their choice.
21
Straight vs. cumulative voting
• 3 shareholders: A (250), B (300), C (650)
• 4 directors to be elected
A Slate
B Slate
C Slate
Straight voting
250 per
candidate
300 per
candidate
650 per
candidate
Cumulative
voting
1000 total votes,
cast all for A1
1200 total votes,
cast all for B1
2600 votes, cast
1001 for C1, 1201
for C2, now must
divide remaining
398 among C3 &
C4
22
• X = [ ( Y * W) / (N + 1) ] + 1
• N: total number of directors to be elected
• Y: total number of shares outstanding
• W: number of directors a shareholder wants
to elect
• X: number of shares to elect the desired
number of directors
23
Voting Rules
• Acme, Inc. has 1000 voting shares outstanding.
• Shareholders holding 600 shares are present at annual meeting.
• Board recommends 2 amendments to articles of incorporation:
– Change name to Ajax, Inc. (250 Y, 100 N, 250 A)
– Abolish shares’ preemptive rights (450 Y, 125 N, 25 A)
• Current MBCA – both pass
• Older MBCA – 1 passes, 2 does not b/c type of amendment that
triggers appraisal rights. Must pass by majority of outstanding
shares entitled to vote (501) instead of majority present.
• DGCL – both fail
• Abstentions ignored under MBCA, treated as N under DE
• MBCA 7.25(c) vs. DGCL 216
24
Fiduciary Duty & Voting Rules
• Real case: Northern States Power Co. had 14 directors, elected
annually to 1 year terms by cumulative voting.
• Outsiders sought to elect Smaby to the board member.
• Board opposed Smaby and sought to prevent her election by:
– Reducing number of directors from 14 to 12.
– Classifying board into 3 groups with 3 year staggered terms, so
that just 4 directors elected each year.
– Under old rules, Smaby needed cumulative votes of ~7% of
shares to win; changes made that ~20%.
• Despite unilateral power to change election rules, still a violation of
fiduciary duty because changed rules in middle of campaign, without
disclosure, and for purpose of defeating Smaby.
• An otherwise lawful board action can be illegal if undertaken in the
middle of the campaign to stop dissident shareholders from elect a
25
representative.
Purpose of voting
• Firms with small number of shareholders, all with
access to information, and homogenous preferences:
voting as exercise of management power.
• Controlling shareholder firms, where shareholder has
access to info and incentive to cast informed vote:
managerial and oversight function because can vote
management out.
• Dispersed shareholders without information or incentive to
vote, then:
– Voting is “simply one of many corporate accountability
mechanisms-and not a very important one at that.”
– “The corporation is simply a vehicle by which the board of
directors hires capital by selling equity and debt securities
to risk-bearers with varying tastes for risk.”
26
Directors as “Guardians”
• “One of the most basic tenets of Delaware corporate law
is that the board of directors has the ultimate
responsibility for managing the business and affairs of a
corporation. Section 141(a) requires that any limitation
on the board’s authority be set out in the certificate of
incorporation.” Quickturn Design Systems, Inc. v. Shapiro,
721 A.2d 1281 (Del. 1998).
• Principle behind
–
–
–
–
Business judgment rule
Limits on shareholder derivative litigation
Limits on shareholder voting rights
Board power to resist unsolicited takeover offers
• Justifies strong skepticism of the validity of shareholder
adopted bylaws which restrict management discretion.27
Corporate Problem: Double Taxation
Roger Co., Inc.
Profits = $100
Corp. Tax @ 35%
Net = $65
Roger Co., Inc.
Dividend pays $65
divided among 4
shareholders
Shareholders
A
B
C
D
D taxed @ 35%+
Dividend rec’d = $16.25
Net = $10.56 each
28
Double Taxation
Roger Co., Inc.
Profits = $100
Corp. Tax @ 35%
Net = $65
Roger Co., Inc.
Dividend paid of $0
Total stock value rises
by $65
Shareholders
A
B
C
D
Dividend capital
gains taxed @ 15%
Cap Gain of $16.25
Net = $13.80 each
when realize Capital
Gain
29
Duties of Corporate Officers & Directors
• Business Judgment Rule: Schlensky v.
Wright (Chicago Cubs night game case)
• Smith v. Van Gorkom - Duty of Care - 2
hour meeting not enough
– Led to practice of “fairness opinions”
– Delaware amended corporate law to permit
shielding of directors from personal liability.
30
• Breach of duty by inaction: failure to monitor
• Duty of Loyalty
– Is the transaction within the interested director
provisions of state statute?
– If so, has the statute been complied with
(disclosure, permission, etc.)?
– What is the effect of the statute?
31
• Breach of duty by inaction: failure to monitor
• Duty of Loyalty
– Is the transaction within the interested director
provisions of state statute?
– If so, has the statute been complied with
(disclosure, permission, etc.)?
– What is the effect of the statute?
32
• “Ultra vires” - acts beyond the power of the
corporation.
– General charters have made it less important.
• “Subchapter S election” - avoid double
taxation but give up ability to avoid
individual tax on retained assets.
33