An introduction to the fundamentals of dynamic business law and business ethics chap022

Chapter 22
Corporations: Formation and
Organization

McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.


Chapter 22 Case Hypothetical
Phoebe Main and Franklin Kilbride, best friends, love to cook. The two are so
inseparable that some time ago, those who knew them began to jokingly refer to Phoebe
and Franklin as “Ma and Pa.” One of their kitchen concoctions, kettle corn, became so
popular (Phoebe and Franklin loved to share their caloric creations) that others have
encouraged them go into business and sell their kettle corn as a product. Phoebe and
Franklin agree. They have decided to form a traditional corporation as co-owners, and
they have agreed on a name for their company: Ma and Pa Kettle Corn Company, Inc.
In the articles of incorporation (the document Phoebe and Franklin will send to the
Kansas Secretary of State’s office for approval of corporate status), the two are required
to indicate the total number of stock shares the company is authorized to issue. “Ma and
Pa” are perplexed. Both have always considered themselves “good with numbers,” but
they cannot decide what number of shares of stock to indicate in the articles of
incorporation.
What is your recommendation to Phoebe Main and Franklin Kilbride?
(Access the video clip at to see
part of the inspiration for this case study!)

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Chapter 22 Case Hypothetical and Ethical Dilemma

Clyde Monett has been operating an art restoration business since 1998, specializing in the
refurbishment of portraits and paintings. He operated the enterprise as a sole proprietorship (called
Monett’s Art Restoration Services) until 2006, when he attended a “Business Structures, Licenses
and Permits” workshop at the local community college, at which time the presenting attorney
suggested he convert his business to a corporation, in order to “shield” Monett’s personal property
and real estate from liability for his business’ financial obligations (Monett’s personal net worth is
approximately $150,000.) Through the incorporation process, the only change to the business name
was the addition of the word “Incorporated.” Monett was the only incorporator of the business. He
serves as the president, vice-president and treasurer of the corporation; his sister, Georgette
O’Keeffe, is the secretary. Since the corporation was formed in 2006, Clyde and Georgette have only
convened one “official” corporate meeting; the meeting lasted approximately one hour, and the two
shared family gossip for forty-five minutes of that hour. Monett’s Art Restoration Services,
Incorporated has maintained an average daily balance of $45.22 in the corporate checking account at
Homeland National Bank.
Yesterday, Monett inadvertently purchased the wrong art refurbishment materials (the cleaning
solution was too acidic,) and the oversight resulted in irreparable damage to a painting conservatively
valued at $75,000. The owner of the painting, Paul Picasso, demands $75,000 in damages from
Monett; Monett apologizes, offers two free coupons for future restoration services, and refuses to pay
the $75,000. The current corporate checking account balance is $52.84.
Is Clyde Monett personally liable for the $75,000 damage claim? Is he ethically obligated to pay Paul
$75,000?
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Chapter 22 Case Hypothetical and Ethical Dilemma
Zaxxon-Mobile Oil Company, Inc., headquartered in Mobile, Alabama, is a multinational corporation with 2009
annual profits of $45 billion. Zaxxon-Mobile has twelve (12) board members who serve the company on a
part-time basis, with each board member receiving an average of $300,000 per year in compensation.
Emily D. Chanel, a pre-law student at The University of Alabama at Mobile, is very familiar with Zaxxon-Mobile
Oil Company, Inc., and she has studied her business law textbook material on corporations and their

directors, officers and shareholders very carefully. She recalls that the board of directors and its members
owe a strict fiduciary duty to the corporation; as part of this fiduciary duty, the board must exercise oversight in
monitoring the actions of corporate employees, including the executives and officers of the corporation.
Emily ponders, “How can board members of a major corporation be truly objective when they are being paid
such lavish sums of money? Would not board members have a “Don’t rock the boat” mentality in terms of
exercising their oversight function? Why, for example, would a Zaxxon-Mobile board member question the
practices of the company’s high-ranking executives and officers, when such an inquiry might jeopardize his or
her $300,000 per year annual compensation? ‘Make no bones about it,’ if I were a board member at ZaxxonMobile, I would probably be a ‘yes-woman” and approve of everything the chief executive officer, the chief
financial officer and the chief operating officer wanted to do!”
How do you respond to Emily D. Chanel’s questions and overall concerns about board member compensation
and objectivity?

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Chapter 22 Case Hypothetical and Ethical Dilemma
Dr. Charles Finnegan is a newly-appointed member of the Board of Directors of Walnut Grove
Community College (W.G.C.C.) in Walnut Grove, California. The position is unpaid, but does come
with the “perks” of positive exposure and prestige in the local community.
At his first board meeting, the directors are discussing and considering for approval service contracts
between W.G.C.C. and the local business community. The third contract for consideration is a
janitorial service contract, valued at $150,000, between W.G.C.C. and Antiseptic Andy Cleaning
Service, Inc. Finnegan is quite surprised; after all, “Antiseptic Andy” is owned and operated by his
first cousin, Andrew Deere. Cousins Finnegan and Deere have not seen each other in three years,
nor have they otherwise communicated during that period of time.
The chairperson of the Board of Directors calls for a vote on the janitorial service contract. According
to W.G.C.C. regulations, the board must unanimously approve contracts with the business
community.
Finnegan is perplexed. If he votes and says nothing about his kinship to Deere, he still feels he can
“sleep at night,” since he will not receive any financial gain from the contract. If he discloses his

kinship to Deere, he fears that Deere’s business opportunity will be jeopardized.
Does Finnegan have a legal obligation to disclose his relationship to Deere? Would it be a “conflict of
interest” for Finnegan to vote in favor of the contract? Does he have an ethical obligation to disclose
the relationship?

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Characteristics of Corporations
• Legal entity
• Rights as person and citizen
• Creature of state
• Limited liability of
shareholders
• Unrestricted transferability
of corporate shares

• Perpetual existence
• Centralized management
• Corporate taxation
• Liability for Officers and
Employees

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Corporate Powers
• Corporations have both “express” and “implied” powers
-Express Powers: Perpetual existence; right to
litigate; right to make contracts; right to borrow/loan

money; right to make charitable donations; ability to
establish rules for managing corporation
-Implied Powers: Whatever actions necessary (within
the law) to execute express powers
• “Ultra Vires” Act: Corporate action beyond scope of
corporation’s authority (i.e., beyond its express and
implied powers)
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Classifications of Corporations
• Public/Private
• For-Profit/Non-Profit
• Domestic/Foreign/Alien
• Publicly Held/Closely Held
• S-Corporation
• Professional Corporation
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Public Versus Private Corporation
• Public Corporation: Corporation created by
government to administer law, with specific
government duties to fulfill
-Example: Federal Deposit Insurance
Corporation (FDIC)
• Private Corporation: Corporation created for
private purposes

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For-Profit Versus Non-Profit
Corporations
• For-Profit Corporation: Objective is to operate for
profit; shareholders seeking to make profit purchase
stock these corporations issue
• Non-Profit Corporation: May earn profits, but they
do not distribute these profits to shareholders (nonprofit corporation does not issue stock, nor does it
have shareholders); instead, corporation reinvests
profits in business

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Domestic, Foreign, and Alien
Corporations
• Domestic Corporation: Doing business within
state of incorporation
• Foreign Corporation: Doing business in states
other than state of incorporation
• Alien Corporation: Doing business country
other than country of incorporation

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Publicly Held Versus Closely Held
Corporation
• Publicly Held Corporation:

-Stock available to public
• Closely Held Corporation (a.k.a. “Close”,
“Family”, “Privately Held” Corporation):
-Generally does not offer stock to public
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“Subchapter S” Corporation
• Named after provision of Internal Revenue
Service (IRS) code that provides for it
• Particular type of closely held corporation
(no more than one hundred shareholders)
• Combines advantages of limited liability and
single taxation

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Formation of Corporation
• Promoters organize corporate formation
• Subscribers offer to purchase stock in
corporation in formation process
• State selected for incorporation

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Questions to Consider in Selecting a
State For Incorporation
• How much flexibility does the state grant to

corporate management?
• What rights do state statutes give to
shareholders?
• What restrictions does the state place on the
distribution of dividends?
• Does the state offer any kind of protection
against takeovers?
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Legal Process of Incorporation
• Selection of corporate name
• Drafting and filing articles of incorporation
• First organizational meeting held

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Remedies For Defective Incorporation:
• “De jure” corporation: Lawful corporation that has met the
substantial elements of incorporation process
• “De facto” corporation: Corporation that has not met the
requirements of state incorporation statute, but courts
recognize it as a corporation for most purposes to avoid
unfairness to third parties who reasonably believed it was
properly incorporated
• Corporation by estoppel: Corporation prevented by court
from denying its corporate status
• Piercing corporate veil: Shareholders personally liable
when they have used corporation to engage in

illegal/wrongful acts
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Situations When Courts Likely To
Pierce Corporate Veil
• Corporation lacked adequate capital when initially
formed
• Corporation did not follow statutory mandates
regarding corporate business
• Shareholders’ personal interests and corporate
interests are commingled (corporation has no
separate identity)
• Shareholders attempt to commit fraud through
corporation
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Debt Securities Versus Equity
Securities
• Debt Securities: Bonds (representing loans
to corporation from another party)
• Equity Securities: Stock

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Equity Securities: Preferred Stock
Versus Common Stock
• Preferred Stock: Stockholder enjoys

preferences regarding assets and dividends
• Common Stock: Stockholder owns portion
of corporation, but no preferences regarding
assets and dividends

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Corporate Directors, Officers,
and Shareholders

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Summary of Roles of Directors, Officers, and
Shareholders
• Directors--

•
•
•
•

• Officers--

•
•

• Shareholders--

•
•

Vote on important corporate
decisions
Appoint and supervise officers
Make financial decisions
Manage corporation

Run “day-to-day” business of
firm
Agents of corporation

Elect board of directors
Approve major corporate
decisions
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Fiduciary Duties
Definition: Duties to corporation that individuals
within corporation have
Primary fiduciary duties include:
• Duty of Care
• Duty of Loyalty
• Duty to Disclose Conflict of Interest
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Business Judgment Rule

Definition: Provides that directors and officers
are not liable for decisions that harm
corporation if they were acting in good faith at
time of decision

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Corporations: Directors, Officers, and
Shareholders--Other Relevant Terminology
• Stock-Subscription Agreement: Contractually
obliges individual to buy shares in corporation
• Par-Value Shares: Fixed face value noted on stock
certificate
• No-Par Shares: Stock shares without a par value
• Watered Stock: Stock issued to individuals at a
value below fair market value.
• Pre-emptive Rights: Preferential rights given to
existing shareholders to purchase shares of new
stock issue; preference given in proportion to
percentage of stock shareholder already owns
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