Bar Exam Facts: Shareholders

FACT PATTERN 4 – SHAREHOLDERS

Shareholders do not get to manage the corporation because the BOARD manages

• Shareholders can manage in a close corporation

Close Corporation (most are close corps)

• Characteristics
  • No more than 30 shareholders
  • Stock is not publically traded
  • “Statutory Close Corporation” – meets specific legislative definition

• Can have a board of directors, or shareholders can eliminate board and run the corporation
  • Do this by shareholder bylaws or in the articles

• Duties
  • If eliminated, the duties of care and loyalty are owed to corporation by those who run it (shareholders)
  • Shareholders also owe fiduciary dutiesto each other
    • Can be liable for oppressive acts toward minority shareholders
      • Ex:  selling control to someone who loots corp. (not having properly investigated the buyer)
      • Prevents “big guys sticking it to the little guys”
  • EX:  A, B, C own 1/3 each of stock of C. Corp, close corp.  All have jobs with C Corp.  A and B fire C from his job, kick him off premises, refuse to pay him, and have C Corp buy stock in another corp A & B own.
    • Breached duty to minority shareholder

Professional Corporation – only licensed professionals are shareholders.  Can hire non-professionals for other services

• Liable for own malpractice
• Not liable for other members’ malpractice
• Rules of operations generally same as that for a general corporation

Shareholder liability for acts or debts of corporations

• Shareholders generally not liable because corporation is liable for what it does
  • Even if only 1 shareholder
    • But can be liable for corporate acts/debts if court “pierces corporate veil” because it ignores corporation and holds shareholders liable
      • This only happens in closed corporations

• Piercing Corporate Veil– a court might do this only if
  • Shareholders have abused privilege of incorporating, and
  • Fairness requires they be held liable
  • (must always discuss both in essay questions)
  • (strong presumption against this – PA courts only do it to avoid fraud or unfairness)

Remember (and always say this):  Courts may be more willing to PCV for a tort victim than for a K claimant.  

Also – PCV can operate in related corporation situation (where parent company forms subsidiary to escape liability)

Classic Fact Pattern – Alter Ego (Identity of Interests)

• EX:  X & Y are shareholders of Corp.  X is also CEO and commingles personal and corporate funds, uses corp car as own, and uses corp credit card for personal things.  Can creditor of corp who has been unable to collect it from corp collect from either X or Y?
  • Start with general rule (shareholders not liable for acts/debts of corp)
  • Then give PCV standard
  • Then say, “court MIGHT PCV if X’s failure to respect separate corp entity harmed creditors.  Sloppy administration is not enough to PCV but there is a strong argument for it here”
  • Then make the argument
    • Did shareholder abuse corp?
      • Yes, treated assets as own
    • It is unfair to limit liability?
      • Arguably yes.
• Y would not be affected – did nothing wrong

Classic Fact Pattern – Undercapitalization

• S is shareholder of G Corp which disposes of nuclear waste.  G doesn’t have insurance.  G has initial capitalization of $1K.  V is injured when one of G’s trucks melts down.  Can V sue S?
  • General Rule:  shareholders not liable for corp obligations
  • PCV standard
  • Here court might PCV because corp was undercapitalized when formed
    • Shareholders failed to invest enough to cover prospective liabilities
• Remember (and always say this):  Courts may be more willing to PCV for a tort victim than for a K claimant.  

Shareholder Derivative Suits (Shareholder as Plaintiff)

Derivative Suits – shareholder suing to enforce the corporation’s claim – not own personal claim

• Always ask: could corp have brought this suit?
  • If so, probably derivative suit
• EX:  S sues board of directors of C Corp for issuing new stock w/out honoring her preemptive rights.
  • This is NOT a derivative suit – this is direct suit to vindicate S’s personal claim
• EX:  S sues other two shareholders, A & B, for oppressive acts against C.
  • This is NOT derivative.  It’s direct. It’s about duty owed to a shareholder, not corporation
• EX:  S sues board of directors of C Corp for usurping corp opportunities.
  • This IS a derivative suit – breach of duty owed to corp.  Duties of care and loyalty are owed to corp

If shareholder wines the derivative suit, the corporation gets the money from the judgment

• Shareholder plaintiff receives costs, attorney’s fees (usually from the corp), but only if court finds case conferred a substantial benefit on corp

If shareholder loses derivative suits

• SH cannot recover costs and fees
• SH is liable to defendant he sued for D’s costs and fees if S sued without reasonable cause or in bad faith
• Other shareholders cannot later due same defendants for same transaction – res judicata

Six Requirements for bringing shareholder derivative suit

• Stock Ownership -person bringing suit must have owned stock at time claim arose or have gotten it by operation of law from someone who did (divorce, inheritance).  Must have own stock throughout litigation

• Must fairly and adequately represent interests of shareholders

• Must make written demand on directors that corporation bring suit
  • Demand excused only if would be futile to make demand
    • This means PL makes specific showing that irreparable injury to corp would result if demand made
    • Or if directors would be involved in the case

• Plaintiff must plead with particularity her efforts  to get corporation to sue, or why demand futile

• If shareholder bring suit owns less than 5% of any class of stock, corp can demand she post security for costs (unless stock has FMV of more than $200K)

• Corp must be joined as defendant even though it’s the corporation’s claim, because it did not bring the suit itself

• No dismissal or settlement without court approval.
  • Motion is based upon investigation by disinterested directors.  Court will dismiss if these directors determined in good faith that there are legitimate business reasons for not suing
    • But court will scrutinize decision carefully, consider various factors like whether board was disinterested, whether assisted by counsel, conducted adequate investigation, etc.

Shareholder Voting

WHO VOTES

General rule is that record shareholder as of record date has the right to vote

• Record Shareholder is person shown as owner in corporate records.
  • Record date is voter eligibility cut-off, not more than 90 days before the meeting
    • EX: C Corp sets annual meeting 7/7, and record date as 6/6.  S sells B her C Corp stock on 6/25.  S is entitled to vote because owned stock on the record date
• Exceptions:
  • Corp reacquires some of its stock before record date
    • This is “treasury stock”
    • It does not vote this stock
  • Death of shareholder – S’s executor can vote

• Proxies
  • A proxy is
    • A writing (including fax or email)
    • Signed by record shareholder (email treated as such)
    • Directed to secretary of corp
    • Authorizing another to vote the shares
  • Valid proxy is good for 3 years unless it says otherwise
  • A proxy can be revoked when notice is given to secretary in writing or by electronic transmission
    • Can be revoked even if the proxy states it’s irrevocable

• Irrevocable Proxy:  only way to have one is if it is a “proxy couples with an interest” which requires
  • That the proxy says it’s irrevocable, and
  • Proxyholder has some interest in the shares other than voting
    • EX: S sells B shares after record date but before meeting. S gives B irrevocable proxy. S cannot revoke because this proxy is coupled with an interest – proxy owns the shares

Voting trusts and voting agreements (when shareholders with few shares join together in block voting)

• Voting Trusts
  • Requirements for voting trusts:
    • Written agreement controlling how shares will be voted
    • Copy to corporation
    • Transfer legal titles of shares to voting trustee
    • Original shareholders receive trust certificates, retain all s-holder rights except voting
  • No time limit, but trust law might
    • 10 year limit on voting trusts for banks, though

• Voting Agreement (“pooling”)
  • Requirements for Voting Agreements
    • Shareholders can enter into them
    • A contract is required
    • They are specifically enforceable

Where do the shareholders vote?

Two ways shareholder can take valid corporate act

• File with corp unanimous written consent of holder of all voting shares to act w/out meeting ( email print out ok)
• A meeting that satisfies quorum and voting rules

Two types of meetings

• Annual meeting:  unless articles say otherwise, must happen.
  • Date usually in bylaws
  • If not held within 6 months of that date, shareholder can call the meeting
  • Elect directors at annual meeting
• Special meeting – can be called by
  • The Board
  • Holders of at least 20% of voting shares, or
  • Someone else as provided in articles

Meetings can be on internet as long as people can hear or read and vote

Officer must preside over meeting

Shareholders cannot call a special meeting for purpose of removing officer – that is done by Board

Notice Requirements:  written (includes fax/email printout) to every SH entitled to vote, for all meetings

• Contents of notice:  must always say when and where.  Also states purpose of meeting because whatever is stated as the purpose is the only thing the meeting can cover
• If fail to give proper notice, then action taken at meeting is void unless those not sent notice waive the notice defect.  Waiver happens if
  • Express – in writing and signed any time, or
  • Implied – they attend meeting without objection

HOW DO SHAREHOLDERS VOTE?

Must be quorum represented at meeting.

• Quorum determined by number of shares represented, not number of shareholders
• Generally quorum requires majority of outstanding shares
  • EX:  X Corp has 120,000 shares outstanding and 700 shareholders.
    • A quorum is 60,001 shares
• Quorum not lost if people leave meeting
• If quorum requirement is met, action requires majority of shares actually cast on the particular issue
  • Not necessarily majority of all shares present
    • EX:  X Corp has 120,000 shares outstanding.  62,000 shares represented at meeting.  Only 50,000 shares vote on a particular proposal.
      • At least 25,001 MUST vote for the proposal to be accepted – majority of votes

• Cumulative Voting – device to give shareholders a better chance of electing someone to Board
  • Available only when voting for directors
  • Multiple number of shares times number of directors to be elected
    • EX:  You own 1000 shares in C Corp which has 9 directorships open for election.  I want ND to be director.  I can cast 9000 votes for him (1000 shares times 9 directorship spots)
  • If articles are silent as to whether shareholders can vote cumulatively, they can – only can’t if the articles take away the power to do so

Stock Transfer Restrictions (can be established by articles, bylaw, or shareholder agreement)

• Free transferability of ownership interest – can sell or give stock away
• If need to restrict, courts will uphold restriction if reasonable under circumstances (no undue restraint)
  • Right of first refusal is okay if corp offers a reasonable price
• Even if reasonable, cannot be invoked against transferee unless either
  • It is conspicuously noted on stock certificate, or
  • The transferee had actual knowledge of the restriction

Right of Shareholder to Inspect and Copy the Books and Records of Corporation

Standing:  Any shareholder can demand access during regular business hours to books (also Also has CL right to inspect)

Procedure:  verified written demand stating proper purpose – reasonably related to interest as a shareholder

• If corp doesn’t allow inspection, shareholder can seek court order to allow inspection and recover costs and fees
  • Burden is on corp to show shareholder’s purpose is improper
• Each shareholder has right to inspect bylaws without making any showing
• Directors have right of access to all books and records
• Distributions (payments to shareholders as dividend or repurchase of shareholder’s stock) – Board’s discretion

Action to compel distribution is difficult to win – can win only on very strong showing of abuse of discretion (like if Corp keeps making profits and Board just gives themselves bonuses every year)

• Which shareholders get dividends?
  • Board of Corp decides to declare dividends totaling $400K.  Who receives if outstanding stock is:

• 100,000 shares of common stock
  • $4/share

• 100,000 shares of common stock and 20,000 shares of preferred with $2 dividend preference
  • Preferred – gets paid first, so:
    • $40,000 to preferred
    • $360,000 balance goes to common shares, so each gets $3.60

• 100,000 shares of common and 20,000 shares of $2 preferred that is participating
  • Participating means paid again, so 20,000 gets paid first (preferred) and again
    • 20,000 times $2 = $40,000
    • Leaves $360,000 divided by 120,000 shares = $3 each

• 100,000 shares of common and 20,000 shares of $2 preferred that is cumulative (and no dividends paid in 3 prior years)
  • Cumulative means add them up – cum dividends accrue year to year
    • Corp owes them 3 years, plus this year when dividend declared
      • So 4 years worth of $2 preference
        • 4 years times $2 = $8/share each
  • SO:
    • 20,000 shares times $8 = $160,000 paid first (preferred)
    • Then common – $2.40/share

Limitations on any distribution

• Corps can make distributions even if lost $ last year, but can’t if insolvent or distribution would make it insolvent, defined as:
  • Unable to meet debts as they are due (equity test), or
  • Total assets are less than total liabilities (including preferential liquidation rights if corporation dissolves today)
• Directors personally liable for unlawful distributions made intentionally or in breach of care
  • Director votes for distribution while withholding relevant info that would demonstrate it’s unlawful
• Shareholders are only liable if knew it was unlawful when they received it