History and Nature of Corporations

Organization and Financial Structure of Corporations

Management of Corporations

Shareholders’ Rights and Liabilities

Securities Regulation

Legal and Professional Responsibilities of Auditors,

Consultants, and Securities Professionals

© 2010 The McGraw-Hill Companies, Inc. All rights reserved.

Management of Corporations

Managers should work for their people…and not the reverse.

Kenneth Blanchard,

Leadership and The One Minute Manager (2000)

© 2010 The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

v Corporate objectivesv Corporate powersv The Board of Directorsv Officers of the corporationv Directors’ and officers’ duties to the

corporationv Corporate and management liability

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v Shareholders own the corporation, but elect a board of directors to manage the firm and, typically, the board delegates most management duties to officers, who in turn hire managers and employees

Overview

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v The traditional objective of the corporation has been to enhance corporate profits and shareholder gain

v However, corporations may take socially responsible actions to enhance long-term profits or corporate goodwill w Corporate constituency statutes support

these actions

Corporate Objectives

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v Model Business Corporation Act (MBCA) states that a corporation has power to do anything that an individual may do

v Historically, an act of a corporation beyond its powers was a nullity since it was ultra vires (“beyond the powers”)w Now corporate purposes are broadly stated

limiting the use of the ultra vires doctrine

Corporate Powers

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v The MBCA and MNCA state that ultra vires may be asserted by three types of persons: (1) a shareholder seeking to enjoin a corporation from executing a proposed ultra vires action; (2) the corporation suing its management for damages caused by exceeding corporate powers; and (3) the state’s attorney general

The Ultra Vires Doctrine

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v The board of directors supervises the actions of its committees, the chairman, and officers to ensure the board’s policies are being carried out and the corporation is managed wisely

v Some corporate actions require board initiative and shareholder approvalw Amending articles of incorporation, mergers,

and dissolution

The Board of Directors

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v The most common board committee, the executive committee, has authority to act for the board on most matters when the board is not in session

v Audit committees are directly responsible for appointment, compensation, and oversight of independent public accountantsw Sarbanes– Oxley Act requires all publicly held firms

to have audit committees of independent directors

Committees of the Board

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v A nominating committee chooses a slate of directors to be submitted to shareholders at the annual election of directors

v A compensation committee reviews and approves salaries, stock options, and other benefits of high-level corporate executives

v A shareholder litigation committee decides whether a corporation should sue someone who has allegedly harmed the corporation

Committees of the Board

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v Directors are elected by shareholders at the annual shareholder meeting

v Under straight voting, a shareholder may cast as many votes for each nominee as s/he has shares and the top votegetters are elected as directors

Electing Directors

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v Class voting may give certain shareholder classes the right to elect a specified number of directors

v Cumulative voting permits shareholders to multiply their shares by the number of directors to be elected and cast the resulting total for one or more directors

Electing Directors

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v Once public ownership of shares exceeds 50 percent, management must solicit proxies from passive shareholders to have a quorum and achieve a valid shareholder votew A proxy is a person designated to vote for the

shareholderw Wall Street rule: either support management or

sell the shares

Proxy Solicitation

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Grimes v. Donald

v Facts: w The DSC Communications Board of Directors

entered into an employment agreement with Donald, the CEO, that potentially provided $20 million of payments and benefits after Donald’s termination without cause

w Grimes, a shareholder, sued to invalidate the agreement arguing that it illegally delegated duties of the board of directors to Donald

w Trial court dismissed case and Grimes appealed

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v Legal Analysis & Holding: w “Directors may not delegate duties which lie at the

heart of the management of the corporation.”w Agreement does not preclude DSC board from

exercising powers and fulfilling its fiduciary dutyw If an independent and informed board makes a

decision, it normally will receive the protection of the business judgment rule

w “So far, we have only a rather unusual contract, but not a case of abdication.” Judgment affirmed.

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Grimes v. Donald

v For directors to act, a quorum (generally, a majority) of directors must be present and each director has one vote

v Most state corporation laws and the MBCA permit action by directors without a meeting if all directors consent in writing or through telecommunications

Directors’ Meetings

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v Officers of a corporation include the president, one or more vice presidents, a secretary, and a treasurer

v The same person may hold any two or more officesw Except for the offices of

president and secretary

The Officers

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v Officers are agents of the corporation, thus have express authority conferred on them by the bylaws or the board of directors and implied authority to do things reasonably necessary to accomplish duties

v A corporate officer ordinarily has no liability on contracts made for the corporation if the officer signs on behalf of the corporation rather than in a personal capacity

Officer Authority & Liability

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v Statutory Close Corporation Supplement to the MBCA w (a) permits a close corporation

to dispense with a board of directors and be managed by the shareholders

w (b) grants unlimited power to shareholders to restrict the board’s discretion

Close Corporations

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v Board of directors must have at least three directors and members elect directors

v Directors of public benefit corporations and religious corporations generally volunteer services and receive no compensation

v Officers not required, except for an officer performing duties of corporate secretary

Nonprofit Corporations

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v Directors and officers owe a fiduciary duty to the corporation, including duty to act within the scope of the powers of the corporation

v Officers must within the authority conferred by the articles of incorporation, bylaws, and board of directors

v Directors and officers are liable for losses to the corporation caused by their lack of care or diligence

Director & Officer Duties

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v The MBCA duty of care test requires a director or officer to make a reasonable investigation and honestly believe that the decision is in the corporation’s best interests

v Business judgment rule: absent bad faith, fraud, or breach of fiduciary duty, the judgment of directors and officers is conclusive

Business Judgment Rule

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Brehm v. Eisner

v Facts: w Michael Ovitz was hired as Disney president at

the insistence of CEO Eisner w Ovitz hired with employment agreement that

provided a substantial Non-Fault Termination (NFT) payment if termination was without cause

w Ovitz was terminated by Eisner “without cause”w Shareholders brought a derivative action on behalf

of Disney against Eisner for breach of fiduciary duty

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v Legal Analysis: w Eisner argued he met the business judgment rule w The court reviewed the rule and evidence of

Eisner’s hire and subsequent termination of OvitzwKey items of evidence: Eisner knew Ovitz well,

thought Ovitz would be a good president, obtained legal counsel regarding the termination and NFT payment, and even tried to “trade” Ovitz rather than terminate him

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Brehm v. Eisner

v Supreme Court of Delaware Holding: w The Chancery (trial) court concluded that while

Eisner “enthroned himself as the omnipotent and infallible monarch” he acted in good faith and did not breach his fiduciary duty of care

w Moreover, shareholders failed to establish any lack of due care on the board of directors’ part.

w Judgment affirmed for Eisner and other defendants

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Brehm v. Eisner

v When an outsider attempts to gain control of a publicly held corporation (the target), the outsider (raider) makes a tender offer for the shares of a corporation w Tender offer is an offer to shareholders to buy

their shares at a price above current market price

v Raiders hope to acquire a majority of shares, giving control of the target corporation

Acquiring Control of a Corporation

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v A corporation’s management generally opposes tender offers using a variety of defenses, including Pac-Man, white knight, greenmail, poison pill, and lock-up option

v Business judgment rule protects a board’s opposition unless directors decide to oppose a tender offer before carefully studying itw See Paramount Communications, Inc. v. Time,

Inc.

Opposing the Tender Offer

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v As agents, directors and officers owe the corporation duties of loyalty, including the duty not to self-deal (a conflict of interest)

v If a director has a conflict of interest, a court may void the transaction with the corporation if it is unfair to the corporation

v Intrinsic fairness standard: a transaction is fair if reasonable persons in an arm’s-length bargain would have bound the corporation

Conflicting Interest Transaction

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v Directors & officers have the opportunity to steal business opportunities their companies could have exploited

v As fiduciaries, directors and officers are liable to their corporation for usurping corporate opportunitiesw The corporation must be able financially to

take advantage of the opportunity

Usurpation of Corporate Opportunity

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v 1930s case: Court held that Guth, the president of a corporation (Loft) that manufactured beverage syrups and operated soda fountains usurped the firm’s opportunity to become the manufacturer of Pepsi- Cola syrup

Guth v. Loft

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v Shareholders isolated by another group of shareholders may complain of oppression

v A freeze-out is oppression in which the corporation merges with a newly formed corporation under terms by which minority shareholders receive cash instead of shares of the new corporationw Going private is a freeze-out of shareholders

of publicly owned corporations

Minority Shareholders

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v Most states apply total fairness test to freeze-outs: fair dealing and fair price

v Some states apply business purpose test: freezeout must accomplish some legitimate business purpose

v Other states place no restrictions on freeze-outs if minority shareholder has a right of appraisal

The Law of Oppression

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v Court required that freezeout of minority shareholders of New England Patriots football team meet both business purpose and intrinsic (total) fairness tests

Coggins v. New England Patriots Football Club, Inc.

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Freezing out shareholders just to repay majority shareholder’s personal debts was not a proper business purpose!

v A person is always liable for his own torts, even if committed on behalf of a principalw A director is liable for authorizing a tort or

participating in its commissionv Under the vicarious liability doctrine of

respondeat superior, a corporation is liable for employee’s tort that is reasonably connected to the authorized conduct of the employee

Management Liability: Torts

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v A person is always liable for his own crimes, even if committed on behalf of a principal

v Corporations may be liable for crimes when the criminal act is requested, authorized, or performed by: (a) board of directors, (b) an officer, (c) another person with responsibility for formulating company policy, or (d) a high-level administrator with supervisory responsibility over the subject matter of the offense and acting within the scope of his employment

Management Liability: Crimes

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v A director or officer may bear criminal liability if s/he requests, conspires, authorizes, or aids and abets the commission of a crime by an employee

v Example: United States v. Jensen

Management Liability: Crimes

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vStock options to officers, directors, and employees are granted at certain exercise price; if stock price rises after the date of the grant, the option has value

vGranting an option with exercise price lower than market price (backdates, in-the-money) gives employee an instant chance for profit

vBackdating stock options is not illegal unless done for a fraudulent purpose

U.S. v. Jensen

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vBrocade Communications vice president (Jensen) issued backdated options to CEO

vProper accounting would have given the company a loss of $110 million in 2001 rather than the reported profit of $3 million

v Jensen convicted of willingly and knowingly falsifying Brocade’s records over a three-year period to conceal the actual date when stock options were granted to Reyes

U.S. v. Jensen

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v Because officers and directors have a risk of liability, corporations often indemnify those who serve as a director or an officerw Indemnify: to protect or insure; refers to practice

by which corporations pay expenses of officers or directors named as defendants in litigation

v D & O insurance also available as a risk management tool

Indemnification & Insurance

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Test Your Knowledge

v True=A, False = Bw The board of directors own a corporation.w A corporation has legal power to do anything

that an individual may do.w Sarbanes–Oxley Act requires all publicly held

firms to have audit committees comprised of independent directors.

w Class voting permits shareholders to multiply their shares by the number of directors to be elected and cast the resulting total for one or more directors

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Test Your Knowledge

v True=A, False = Bw Officers are agents of the corporation.w A hostile takeover occurs when there is an

offer to shareholders to buy their shares at a price above current market price.

w Under the intrinsic fairness test, directors and officers are protected from liability to their corporation for usurping corporate opportunities.

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Test Your Knowledge

v Multiple Choicew Absent bad faith, fraud, or breach of fiduciary

duty, the rule that the judgment of directors and officers is conclusive is known as:

(a) The fiduciary duty rule

(b) The D&O rule

(c) The business judgment rule

(d) The business purpose test

(e) none of the above

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Test Your Knowledge

v Multiple ChoicewWhich of the following statements is false?

(a) Each person is liable for his/her own torts

(b) A corporation may be criminally liable if an officer or director authorized an employee to do a criminal act

(c) An officer or director cannot be personally liable for a crime

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Thought Question

v Roberto Goizueta, former CEO of Coca-Cola, said in 1992: Business now shares in much of the responsibility for our global quality of life.

v Do you agree or disagree with Goizueta? Support your opinion.

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