Chapter 40

Rights of Directors (40.1e)

A corporate director must have certain rights to function properly in that position, including the rights of participation, inspection, and indemnification

Proper Purpose

A shareholder has a right to inspect and copy corporate books and records only for a proper purpose, and the request to inspect must be made in advance

Written Demand Required

Before shareholders can bring a derivative suit, they must submit a written demand to the corporation, asking the board of directors to take appropriate action [RMBCA 7.40]. The directors then have ninety days in which to act. Only if they refuse to do so can the derivative suit go forward

Duty to Exercise Reasonable Supervision

Directors are also expected to exercise a reasonable amount of supervision when they delegate work to corporate officers and employees

Provides Broad Protections

The business judgment rule provides broad protections to corporate decision makers. In fact, most courts will apply the rule unless there is evidence of bad faith, fraud, or a clear breach of fiduciary duties

Notice of Meetings

- A corporation must notify its shareholders of the date, time, and place of an annual or special shareholders' meeting at least ten days, but not more than sixty days, before the meeting date - Notice of a special meeting must include a statement of the purpose of the meeting, and business transacted at the meeting is limited to that purpose - The RMBCA does not specify how the notice must be given. Most corporations do specify in their bylaws the acceptable methods of notifying shareholders about meetings. Also, some states' incorporation statutes outline the means of notice that a corporation can use in that jurisdiction

Dividends (40.4d)

- As mentioned, a dividend is a distribution of corporate profits or income ordered by the directors and paid to the shareholders in proportion to their shares in the corporation. Dividends can be paid in cash, property, stock of the corporation that is paying the dividends, or stock of other corporations - each state determines the general circumstances and legal requirements under which dividends are paid. State laws also control the sources of revenue to be used. All states allow dividends to be paid from the undistributed net profits earned by the corporation, for instance. A number of states allow dividends to be paid out of any surplus

Other Voting Techniques

- Before a shareholders' meeting, a group of shareholders can agree in writing to vote their shares together in a specified manner. Such agreements, called shareholder voting agreements, usually are held to be valid and enforceable. A shareholder can also vote by proxy, as noted earlier - Another technique is for shareholders to enter into a voting trust. A voting trust is an agreement (a trust contract) under which a shareholder assigns the right to vote his or her shares to a trustee, usually for a specified period of time. The trustee is then responsible for voting the shares on behalf of all the shareholders in the trust. The shareholder retains all rights of ownership (for instance, the right to receive dividend payments) except the power to vote the shares [RMBCA 7.30]

Conflicts of Interest (40.2d)

- Corporate directors often have many business affiliations, and a director may sit on the board of more than one corporation - Of course, directors are precluded from entering into or supporting businesses that operate in direct competition with corporations on whose boards they serve. Their fiduciary duty requires them to make a full disclosure of any potential conflicts of interest that might arise in any corporate transaction - Sometimes, a corporation enters into a contract or engages in a transaction in which an officer or director has a personal interest. The director or officer must make a full disclosure of the nature of the conflicting interest and all facts pertinent to the transaction. He or she must also abstain from voting on the proposed transaction

Corporate Officers and Executives (40.1f)

- Corporate officers and other executive employees are hired by the board of directors. At a minimum, most corporations have a president, one or more vice presidents, a secretary, and a treasurer. In most states, an individual can hold more than one office, such as president and secretary, and can be both an officer and a director of the corporation - In addition to carrying out the duties articulated in the bylaws, corporate and managerial officers act as agents of the corporation. Therefore, the ordinary rules of agency normally apply to their employment - Corporate officers and other high-level managers are employees of the company, so their rights are defined by employment contracts

Transfer of Shares (40.4f)

- Corporate stock represents an ownership right in intangible personal property. The law generally recognizes the owner's right to transfer stock to another person unless there are valid restrictions on its transferability, such as frequently occur with close corporation stock - When shares are transferred, a new entry is made in the corporate stock book to indicate the new owner. Until the corporation is notified and the entry is complete, all rights—including voting rights, notice of shareholders' meetings, and the right to dividend distributions—remain with the current record owner

Duty to Make Informed Decisions

- Directors and officers are expected to be informed on corporate matters and to conduct a reasonable investigation of the situation before making a decision - Although directors and officers are expected to act in accordance with their own knowledge and training, they are also normally entitled to rely on information given to them by certain other persons. Under the laws of most states and Section 8.30(b) of the RMBCA, such persons include competent officers or employees, professionals such as attorneys and accountants, and committees of the board of directors

Liability of Directors and Officers (40.2e)

- Directors and officers are exposed to liability on many fronts. They can be held liable for negligence in certain circumstances, as previously discussed. They may also be held liable for the crimes and torts committed by themselves or by corporate employees under their supervision - Additionally, if shareholders perceive that the corporate directors are not acting in the best interests of the corporation, they may sue the directors on behalf of the corporation. (This is known as a shareholder's derivative sui

Dissenting Directors

- Directors' votes at board of directors' meetings should be entered into the minutes. Sometimes, an individual director disagrees with the majority's vote (which becomes an act of the board of directors). Unless a dissent is entered in the minutes, the director is presumed to have assented - If the directors are later held liable for mismanagement as a result of a decision, dissenting directors are rarely held individually liable to the corporation

Illegal Dividends

- Dividends are illegal if they are improperly paid from an unauthorized account or if their payment causes the corporation to become insolvent (unable to pay its debts as they come due) - Generally, shareholders must return illegal dividends only if they knew that the dividends were illegal when the payment was received (or if the dividends were paid when the corporation was insolvent). - Whenever dividends are illegal or improper, the board of directors can be held personally liable for the amount of the payment

Duties of Majority Shareholders (40.5b)

- In some instances, a majority shareholder is regarded as having a fiduciary duty to the corporation and to the minority shareholders. This duty arises when a single shareholder (or a few shareholders acting in concert) owns a sufficient number of shares to exercise de facto control over the corporation. In these situations, the majority shareholder owes a fiduciary duty to the minority shareholders - When a majority shareholder breaches her or his fiduciary duty to a minority shareholder, the minority shareholder can sue for damages - A breach of fiduciary duties by those who control a close corporation normally constitutes what is known as oppressive conduct - A common example of a breach of fiduciary duty occurs when the majority shareholders "freeze out" the minority shareholders and exclude them from certain benefits of participating in the firm

Stock Certificates (40.4a)

- In the past, corporations commonly issued stock certificates that evidenced ownership of a specified number of shares in the corporation - Only a few jurisdictions still require physical stock certificates, and shareholders there have the right to demand that the corporation issue certificates (or replace those that were lost or destroyed). Stock is intangible personal property, however, and the ownership right exists independently of the certificate itself - In most states and under RMBCA 6.26, a board of directors may provide that shares of stock will be uncertificated, or "paperless"—that is, no actual, physical stock certificates will be issued. Notice of shareholders' meetings, dividends, and operational and financial reports are distributed according to the ownership lists recorded in the corporation's books

Proxies

- It usually is not practical for owners of only a few shares of stock of publicly traded corporations to attend a shareholders' meeting. Therefore, the law allows stockholders to appoint another person as their agent to vote their shares at the meeting. The agent's formal authorization to vote the shares is called a proxy - Proxies normally are revocable (can be withdrawn), unless they are specifically designated as irrevocable and coupled with an interest. A proxy is coupled with an interest when, for instance, the person receiving the proxies from shareholders has agreed to buy their shares. Under RMBCA 7.22(c), proxies are valid for eleven months, unless the proxy agreement mandates a longer period

Duty of Loyalty (40.2c)

- Loyalty can be defined as faithfulness to one's obligations and duties. In the corporate context, the duty of loyalty requires directors and officers to subordinate their personal interests to the welfare of the corporation - Cases dealing with the duty of loyalty typically involve one or more of the following: 1)Competing with the corporation. 2)Usurping (taking personal advantage of) a corporate opportunity. 3)Pursuing an interest that conflicts with that of the corporation. 4)Using information that is not available to the public to make a profit trading securities (insider trading). 5)Authorizing a corporate transaction that is detrimental to minority shareholders. 6)Selling control over the corporation

Cumulative Voting

- Most states permit, and many require, shareholders to elect directors by cumulative voting, a voting method designed to allow minority shareholders to be represented on the board of directors. When cumulative voting is not required, the entire board can be elected by a majority of shares

Voting Requirements

- Once a quorum is present, voting can proceed. If a state statute requires specific voting procedures, the corporation's articles or bylaws must be consistent with the statute. A majority vote of the shares represented at the meeting usually is required to pass resolutions - Extraordinary corporate matters, such as a merger, consolidation, or dissolution of the corporation, require approval by a higher percentage of all corporate shares entitled to vote

Shareholder Voting (40.3c)

- Shareholders exercise ownership control through the power of their votes. Corporate business matters are presented in the form of resolutions, which shareholders vote to approve or disapprove. Each common shareholder normally is entitled to one vote per share - The articles of incorporation can exclude or limit voting rights, particularly for certain classes of shares

Shareholders' Powers (40.3a)

- Shareholders must approve fundamental changes affecting the corporation before the changes can be implemented. Hence, shareholder approval normally is required to amend the articles of incorporation or bylaws, to conduct a merger or dissolve the corporation, and to sell all or substantially all of the corporation's assets - Shareholders also have the power to vote to elect or remove members of the board of directors. As described earlier, the first board of directors is either named in the articles of incorporation or chosen by the incorporators to serve until the first shareholders' meeting - Directors usually serve their full terms. If the shareholders judge them unsatisfactory, they are simply not reelected. Shareholders have the inherent power, however, to remove a director from office for cause (breach of duty or misconduct) by a majority vote

Preemptive Rights (40.4b)

- Sometimes, the articles of incorporation grant preemptive rights to shareholders - With preemptive rights, a shareholder receives a preference over all other purchasers to subscribe to or purchase a prorated share of a new issue of stock. Generally, preemptive rights must be exercised within a specific time period (usually thirty days) - A shareholder who is given preemptive rights can purchase a percentage of the new shares being issued that is equal to the percentage of shares she or he already holds in the company. This allows each shareholder to maintain her or his proportionate control, voting power, and financial interest in the corporation - Preemptive rights are most important in close corporations because each shareholder owns a relatively small number of shares but controls a substantial interest in the corporation - Don't exist unless specified in the articles of incorporation

Stock Warrants (40.4c)

- Stock warrants are rights given by a company to buy stock at a stated price by a specified date. Usually, when preemptive rights exist and a corporation is issuing additional shares, it gives its shareholders stock warrants. Warrants are often publicly traded on securities exchanges

Election of Directors (40.1a)

- Subject to statutory limitations, the number of directors is set forth in the corporation's articles or bylaws - Normally, the incorporators may appoint the first board of directors in the articles of incorporation. If not, then the incorporators hold a meeting after incorporation to elect the directors and complete any other business necessary (such as adopting bylaws) - A director usually serves for a term of one year—from annual meeting to annual meeting. Most state statutes permit longer and staggered terms. A common practice is to elect one-third of the board members each year for a three-year term. In this way, there is greater management continuity

Rules for Proxies and Shareholder Proposals

- The SEC has special provisions relating to proxies and shareholder proposals - EC Rule 14a-8 provides that all shareholders who own stock worth at least $1,000 are eligible to submit proposals for inclusion in corporate proxy materials. The corporation is required to include information on whatever proposals will be considered at the shareholders' meeting along with proxy materials - Under the SEC's e-proxy rules, all public companies must post their proxy materials on the Internet and notify shareholders how to find that information. Although the law requires proxy materials to be posted online, public companies may also send the materials to shareholders by other means, including paper documents and DVDs sent by mail

The Role of Shareholders (40.3c)

- The acquisition of a share of stock makes a person an owner and a shareholder in a corporation. Shareholders thus own the corporation - As a general rule, shareholders have no responsibility for the daily management of the corporation, although they are ultimately responsible for choosing the board of directors, which does have such control - The duty of officers and directors is to act in the best interests of the corporation and its shareholder-owners as a whole

Board of Directors' Meetings (40.1c)

- The board of directors conducts business by holding formal meetings with recorded minutes. The dates of regular meetings are usually established in the articles or bylaws or by board resolution, and ordinarily no further notice is required - Normally, a majority of the board of directors constitutes a quorum [RMBCA 8.24]. A quorum is the minimum number of members of a body of officials or other group that must be present for business to be validly transacted - Once a quorum is present, the directors transact business and vote on issues affecting the corporation Each director present at the meeting has one vote. Ordinary matters generally require a simple majority vote, but certain extraordinary issues may require a greater-than-majority vote.

Role of Directors and Officers (40.1)

- The board of directors is the ultimate authority in every corporation - Directors have responsibility for all policymaking decisions necessary to the management of all corporate affairs. Additionally, the directors must act as a body in carrying out routine corporate business. The board selects and removes the corporate officers, determines the capital structure of the corporation, and declares dividends - Each director has one vote, and customarily the majority rules - No individual director, however, can act as an agent to bind the corporation. As a group, directors collectively control the corporation in a way that no agent is able to control a principal. In addition, although directors occupy positions of trust and control over the corporation, they are not trustees, because they do not hold title to property for the use and benefit of others

Voting Lists

- The corporation prepares a voting list before each shareholders' meeting. Ordinarily, only persons whose names appear on the corporation's stockholder records as owners are entitled to vote - The voting list contains the name and address of each shareholder as shown on the corporate records on a given cutoff date, or record date - The voting list also includes the number of voting shares held by each owner. The list is usually kept at the corporate headquarters and must be made available for shareholder inspection [RMBCA 7.20]

The Business Judgment Rule (40.2b)

- Under the business judgment rule, a corporate director or officer will not be liable to the corporation or to its shareholders for honest mistakes of judgment and bad business decisions

The Directors' Failure to Declare a Dividend

- When directors fail to declare a dividend, shareholders can ask a court to compel the directors to do so. To succeed, the shareholders must show that the directors have acted so unreasonably in withholding the dividend that their conduct is an abuse of their discretion - The mere fact that the firm has sufficient earnings or surplus available to pay a dividend normally is not enough to compel the directors to declare a dividend. The courts are reluctant to interfere with corporate operations and will not compel directors to declare dividends unless abuse of discretion is clearly shown

Committees of the Board of Directors (40.1d)

- corporations typically create committees of directors and delegate certain tasks to these committees. By focusing on specific subjects, committees can increase the efficiency of the board - Two common types of committees are the executive committee and the audit committee - An executive committee handles interim management decisions between board meetings. It is limited to dealing with ordinary business matters and does not have the power to declare dividends, amend the bylaws, or authorize the issuance of stock - the audit committee is responsible for the selection, compensation, and oversight of the independent public accountants that audit the firm's financial records. The Sarbanes-Oxley Act requires all publicly held corporations to have an audit committee

Compensation of Directors (40.1b)

- directors are often paid at least nominal sums. In large corporations, they may receive more substantial compensation because of the time, work, effort, and especially risk involved - Most states permit the corporate articles or bylaws to authorize compensation for directors. In fact, the Revised Model Business Corporation Act (RMBCA) states that unless the articles or bylaws provide otherwise, the board itself may set the directors' compensation - In many corporations, directors are also chief corporate officers (such as president or chief executive officer) and receive compensation in their managerial positions - director who is also an officer of the corporation is referred to as an inside director, whereas a director who does not hold a management position is an outside director

Removal of Directors

A director can be removed for cause—that is, for failing to perform a required duty—either as specified in the articles or bylaws or by shareholder action

Right of Inspection

Director also has a right of inspection, which means that each director can access the corporation's books and records, facilities, and premises. Inspection rights are essential for directors to make informed decisions and to exercise the necessary supervision over corporate officers and employees. This right of inspection is almost absolute and cannot be restricted by the articles, bylaws, or any act of the board of directors

Duty of Care (40.2a)

Directors and officers must exercise due care in performing their duties. The standard of due care has been variously described in judicial decisions and codified in many state corporation codes. Generally, it requires a director or officer to: 1) Act in good faith (honestly). 2)Exercise the care that an ordinarily prudent (careful) person would exercise in similar circumstances. 3)Do what she or he believes is in the best interests of the corporation

Quorum Requirements

For shareholders to act during a meeting, a quorum must be present. Generally, a quorum exists when shareholders holding more than 50 percent of the outstanding shares are present

Inspection Rights (40.4e)

Shareholders in a corporation enjoy both common law and statutory inspection rights. The RMBCA provides that every shareholder is entitled to examine specified corporate records, including voting lists [RMBCA 7.20, 16.02]. The shareholder may inspect in person, or an attorney, accountant, or other authorized individual can do so as the shareholder's agent

Shareholders' Meetings (40.3b)

Shareholders' meetings must occur at least annually. In addition, special meetings can be called to deal with urgent matters

When the Rule Applies

The business judgment rule will apply as long as the director or officer: 1)Took reasonable steps to become informed about the matter. 2)Had a rational basis for her or his decision. 3)Did not have a conflict between her or his personal interest and the interest of the corporation

Duties and Liabilities of Directors and Officers (40.2)

The duties of corporate directors and officers are similar because both groups are involved in decision making and are in positions of control. Directors and officers are considered to be fiduciaries of the corporation because their relationship with the corporation and its shareholders is one of trust and confidence. As fiduciaries, directors and officers owe ethical—and legal—duties to the corporation and to the shareholders as a group. These fiduciary duties include the duty of care and the duty of loyalty

Potential for Abuse

The power of inspection is fraught with potential abuses, and the corporation is allowed to protect itself from them. For instance, a shareholder can properly be denied access to corporate records to prevent harassment or to protect trade secrets or other confidential corporate information

Vacancies on the Board

Vacancies occur on the board if a director dies or resigns or when a new position is created through amendment of the articles or bylaws. In these situations, either the shareholders or the board itself can fill the vacant position, depending on state law or on the provisions of the bylaws

Watered Stock (40.5a)

When a corporation issues shares for less than their fair market value, the shares are referred to as watered stock. Usually, the shareholder who receives watered stock must pay the difference to the corporation (the shareholder is personally liable). In some states, the shareholder who receives watered stock may be liable to creditors of the corporation for unpaid corporate debts

Right to Indemnification

When a director becomes involved in litigation by virtue of her or his position, the director may have a right to indemnification (reimbursement) for the legal costs, fees, and damages incurred.

Any Damages Awarded Go to the Corporation

When shareholders bring a derivative suit, they are not pursuing rights or benefits for themselves personally but are acting as guardians of the corporate entity. Therefore, if the suit is successful, any damages recovered normally go into the corporation's treasury, not to the shareholders personally

Shareholder Proposals

When shareholders want to change a company policy, they can put their ideas up for a shareholder vote. They do this by submitting a shareholder proposal to the board of directors and asking the board to include the proposal in the proxy materials that are sent to all shareholders before meetings

The Shareholder's Derivative Suit (40.4g)

When the corporation is harmed by the actions of a third party, the directors can bring a lawsuit in the name of the corporation against that party. If the corporate directors fail to bring a lawsuit, shareholders can do so "derivatively" in what is known as a shareholder's derivative suit

Formula

With cumulative voting, each shareholder is entitled to a total number of votes equal to the number of board members to be elected multiplied by the number of voting shares that the shareholder owns. The shareholder can cast all of these votes for one candidate or split them among several nominees for director

Right to Participation

right to participation means that directors are entitled to participate in all board of directors' meetings and have a right to be notified of these meetings