Week 9

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1 Legal Environment
Quote of the Day
“CORPORATION, n. An ingenious
device for obtaining individual profit
without individual responsibility.”
Ambrose Bierce, American writer,
“The Devil’s Dictionary”
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2 Legal Environment 
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Incorporation Process
 The person who organizes a corporation is
called a promoter. The promoter is
personally liable on any contract signed
before formation.
 The corporation is not liable unless it
adopts the contract after incorporation.
The promoter is no longer liable if the other
party agrees to a novation – a new
contract.
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 Where to Incorporate?
• In a state –either the home state of the
business or a state which has favorable laws
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for corporations (often Delaware)
Legal Environment 
Incorporation Process
 Charter’s Required Provisions
• Name of corporation
• Address and Registered Agent
• Incorporator –person who signs the charter
and delivers it to the Secretary of State for
filing (perhaps the lawyer or the promoter)
• Purpose – this can be a broad statement,
such as “to conduct lawful business”
• Stock – number, par value and types (classes
and series) offered
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Stock
 Stock can be:
• Authorized and unissued
• Authorized and issued or outstanding
• Treasury stock (been issued, then bought
back by company)
 Par value - minimum issue price
 Classes and series
• Owners of preferred stock have preference
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on dividends and liquidation.
• Common stock is last in line for any corporate

payouts, including dividends and liquidation.
7 Legal Environment
After Incorporation
 Directors and officers are elected,
unless all shareholders agree to not
have a board of directors.
• Small corporations may elect directors by
written consent.
 Minute book holds records of all
meetings.
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 Bylaws set the rules for the corporation.

A sample of bylaws can be seen on the Web by clicking here.
8 Legal Environment
After Incorporation (cont'd)
 Shareholder Agreements – set
procedures for voting stock.
 Issuing Debt – corporations often need
to borrow funds for start-up.
• Bonds – long term debt secured by
company assets.
• Debentures – long term, unsecured debt.
• Notes – short term, either secured or
unsecured.
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Death of a Corporation
 May be voluntary (shareholders’ vote)
or forced (by court order).
 Piercing the Corporate Veil -- a court
may hold shareholders liable for debt in
four circumstances:
– Failure to observe formalities (such as holding
meetings, keeping records)
– Commingling of assets (using corporate funds to
pay personal debts, etc.)
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– Inadequate capitalization (the corporation should
obtain insurance against liability for torts)
– Fraud (injured party may recover from the guilty

party, even if the action was the corporation’s)
11 Legal Environment
Termination
 Terminating a corporation is a three-
step process:
• Vote by a majority of the shareholders.
• Filing Articles of Dissolution with the
Secretary of State.
• Winding up – paying debts and distributing
assets.
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Managers vs. Shareholders:
The Inherent Conflict
 Managers – want, first to keep their jobs
and second, to build a strong company.
• Managers have a fiduciary duty to act in the
best interests of the shareholders.
 Shareholders – want the price of stock
to increase.
 Stakeholders – want the business to
grow and continue to use the 17

stakeholders’ services.
Resolving the Conflict: The
Business Judgment Rule
 Business Judgment Rule -- The manager
has a duty of loyalty and a duty of care.
• The manager must act without a conflict of
interest, with the care of an ordinary prudent
person and in the best interests of the
company.
 This rule allows directors to do their job
without fear of excessive court
intervention. 17
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Duty of Loyalty
 The duty of loyalty prohibits managers
from making a decision that benefits
them at the expense of the corporation.
 Self-Dealing is a violation of the duty of
loyalty.
• See next slide for more on self-dealing.
 Corporate Opportunity
• Managers are in violation of the corporate
opportunity doctrine if they compete against 17

the corporation without its consent.
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Self-Dealing
 Business Self-Dealing – decisions that
benefit another company associated
with the manager.
 Personal Self-Dealing --decisions that
benefit the manager directly.
 Self-dealing transactions may be
acceptable if:
• The disinterested members of the board of
directors approve the transaction.
• The disinterested shareholders approve it. 17
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• The transaction was fair to the corporation.
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Duty of Care
 The duty of care requires officers and
directors to act in the best interests of
the corporation and to use the same
care that an ordinarily prudent person
would in the management of her own
needs.
• Decisions must have a rational business
purpose.
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• Decisions and actions are legal.
• Managers must make informed decisions.
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More Conflict: Takeovers
 There are three ways to acquire control
of a company:
• Buy the company’s assets.
• Merge with the company.
• Buy stock from the shareholders.
 Takeovers and tender offers are
regulated:
• Federal Regulation of Tender Offers: The
Williams Act
• State Regulation of Takeovers
• Common Law of Takeovers
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Prevention of Takeovers
 Companies may try to prevent takeovers
in many ways:
• Transferring assets, re-distributing stock, re-
structuring the board of directors, etc.
• When establishing takeover defenses,
shareholder welfare must be the board’s
primary concern.
 If the company must ultimately be sold, it
must go to the highest bidder; it cannot
give preferential treatment to a lower
bidder.
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State Anti-Takeover Statutes
 Most states have passed statutes to
deter hostile takeovers:
• Statutes that automatically impede hostile
takeovers.
• Statutes that authorize companies to fight
off hostile takeovers.
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Rights of Directors
 Directors, not shareholders, have the
right to manage the corporate business.
• Inside directors -- officers in the
corporation, typically control their
company’s board.
• Outside directors (also called independent
directors) -- do not work for the company
and typically have less control.
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Rights of Shareholders
 Shareholders have neither the right nor
the obligation to manage the day-to-day
business of the enterprise.
 Right to Information
• Under the Model Act, shareholders with a
proper purpose have the right to inspect and
copy the corporation’s minute book,
accounting records, and shareholder lists.
 Right to Vote
• A corporation must have at least one class 17
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of stock with voting rights.
Shareholder Proposals
 Under SEC rules, any shareholder who
owns at least 1 percent of the company
or $2,000 of stock can require that one
proposal be placed in the company’s
proxy statement to be voted on at the
shareholder meeting.
 Only a small percentage of these
proposals are passed, but their
presence may cause the directors to
adopt the proposal’s statement anyway. 17
Shareholder Meetings
 A company must hold an annual
meeting of shareholders.
 The board of directors and
shareholders owning at least 10
percent of the stock have the right to
call special meetings as needed.
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Officers and Directors
 Election and Removal of Directors
• Shareholders have the right to elect
directors and also to remove them from
office.
 Compensation for Officers and
Directors
• Typically, directors also set their own
compensation (unless the charter or bylaws
provide otherwise).
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Fundamental Corporate
Changes
 A corporation must seek shareholder
approval before undergoing any of the
following fundamental changes:
• Mergers
• Sales of Assets
• Dissolution
•
•
Amendments to the Charter
Amendments to the Bylaws 17
Right to Dissent
 If a corporation decides to undertake a
fundamental change, the Model Act
and many state laws require the
company to buy back the stock of any
shareholders who object to this
decision.
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Right to Protection
 Controlling shareholders have a
fiduciary duty to the minority
shareholders.
 Minority shareholders have the right to
overturn a transaction between the
corporation and a controlling
shareholder, unless the the transaction
is fair to the minority shareholders.
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Right to Protection (cont’d)
 Controlling shareholders must include
minority shareholders in any favorable
arrangements that they make for their
own stock.
 Many states prohibit a company from
expelling shareholders unless the firm
pays a fair price for the minority stock
and the expulsion has a legitimate
business purpose.
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Enforcing Rights
 Derivative Lawsuits
• Brought by shareholders to remedy a
wrong to the corporation. All proceeds of
the litigation go to the corporation.
 Direct Lawsuits
• Shareholders are permitted to sue the
corporation directly only if their own rights
have been harmed.
 Class Action Lawsuits
• If a group of shareholders all have the
same claim, they can join together and file 17
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suit as a class action.
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“Entrepreneurs often become
impatient with the legal
technicalities required to form
and maintain a corporation.
However, these legalities can
have a profound impact on the
success of the business.”
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