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Dynamic business law 4e kubasek 4e CH38

Chapter 38
Corporations: Formation and

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education.

• LO38-1: What are the characteristics of
• LO38-2: What are the powers granted to
corporations by the states?
• LO38-3: How are corporations classified?
• LO38-4: How are corporations formed?
• LO38-5: What are some potential problems
with the formation of corporations?
• LO38-6: How do corporations get funding?


Chapter 38 Hypothetical Case 1
• Tim Ratigan's white-water rafting service has been very
successful, and he has decided to convert his form of business
ownership from a sole proprietorship to a corporation. Ratigan
has 135 friends, family members, and customers who would
like to own stock in Ratigan's Raging Rapids Rafting, Inc.,
including Ratigan's college roommate George Bygraves, a
citizen and resident of England. Ratigan would like to use the S
corporation form of business ownership, since the S
corporation includes the dual advantages of limited liability
and single taxation.
• Can Tim Ratigan use the S corporation form of business
ownership for Ratigan's Raging Rapids Rafting, Inc.?


Chapter 38 Hypothetical Case 2
• Best friends Phoebe Main and Franklin Kilbride love to cook. The two are so
inseparable that, some time ago, those who knew them began to jokingly refer
to Main and Kilbride as "Ma and Pa." One of their concoctions, kettle corn,
became so popular (Main and Kilbride love to share their caloric creations) that
others have encouraged them go into business and sell their kettle corn as a
product. Main and Kilbride 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 Main and Kilbride 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. Main and Kilbride 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?

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

Corporate Powers
• Corporations have both express and implied
• 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

Classifications of Corporations
• Public/private
• For-profit/nonprofit
• Domestic/foreign/alien
• Publicly held/closely held
• S corporation
• Professional corporation

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

For-Profit versus Nonprofit
• For-profit corporation: Objective is to operate
for profit; shareholders seeking to make
profit purchase stock that these corporations
• Nonprofit 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


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

Publicly Held versus
Closely Held Corporation
• Publicly held corporation: Stock available
to public
• Closely held corporation (aka a close,
family, or privately held corporation):
Generally does not offer stock to public


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 100 shareholders)
• Combines advantages of limited liability
and single taxation

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


Considerations When Selecting a
State for Incorporation
• How much flexibility does the state grant
to corporate management?
• What rights do state statutes give to
• What restrictions does the state place on
the distribution of dividends?
• Does the state offer any kind of protection
against takeovers?


Legal Process of Incorporation
• Selection of corporation name
• Drafting and filing articles of incorporation
• First organizational meeting held


Remedies for Defective
• 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


Situations When Courts May
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


Debt Securities versus
Equity Securities
• Debt securities: Bonds (representing loans
to corporation from another party)
• Equity securities: Stock


Types of Bond Debt Securities
• Unsecured bond (debenture): No assets support corporation's
obligation to repay face value of bond
• Secured bond (mortgage bond): Specific property supports
corporation's obligation to repay; creditor can seize secured
interest if bond not repaid
• Income bond: Corporation pays interest on bond in proportion
to earnings
• Convertible bond: Allows shareholders to exchange bond for
shares of company stock
• Callable bond: Allows corporation to call in and repay bond at
specific times

Equity Securities: Preferred versus
Common Stock
• Preferred stock: Stockholder enjoys
preferences regarding assets and
• Common stock: Stockholder owns portion
of corporation, but no preferences
regarding assets and dividends

Chapter 38 Hypothetical Case 3
• Since 2006, Clyde Monett has operated an art restoration business
specializing in the refurbishment of portraits and paintings. He operated the
enterprise as a sole proprietorship called Monett's Art Restoration Services
until 2012, when he attended a business structures, licenses, and permits
workshop at a local community college.
The presenting attorney at the workshop suggested Monett convert his
business to a corporation in order to shield his personal property and real
estate from liability for his business's financial obligations (Monett's
personal net worth is approximately $150,000).
Following the incorporation process, the only change to the business's 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, Rachel Monett, is the secretary.


Chapter 38 Hypothetical Case 3
• Since the corporation's formation in 2012, the siblings have convened only
one official corporate meeting; the meeting lasted approximately one hour,
and the two shared family gossip for 45 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.
Last week, 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, Svetlana Poe, 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 Poe $75,000?


Chapter 38 Hypothetical Case 4
• Nathalie Sawyer is the founder, president, and CEO of Can-Do Fabricators, a
Connecticut-based corporation that fabricates granite, marble, and quartz
countertops. Can-Do is a closely held corporation with 20 stockholders other than
Sawyer. All of the other stockholders are Sawyer's family members or personal
friends. Sawyer herself owns 60 percent of the shares of Can-Do; the remaining
stockholders each own 2 percent of the shares.
Sawyer has plans to expand the company into New York; in order to do so, she needs
a significant influx of capital—$4 million. Sawyer's present facility is valued at $5
Sawyer decides to issue corporate bonds in order to raise the capital she needs. She is
considering issuing unsecured, secured, or convertible bonds. If she chooses
unsecured bonds, Can-Do will end up paying much more interest on the bonds than
either of the other two choices.
• What are the potential downsides (other than higher interest) and benefits of
choosing each of the types of bonds? Explain your answer.


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