Corporations

• Pages: 106-239
• Author: William A. Klein,John C. Coffee Jr.,Frank Partnoy

106

Chapter 3

CORPORATIONS

I. A BRIEF OVERVIEW

A. PRELIMINARY OBSERVATIONS

From a legal perspective a corporation is a particular set of rules for

the organization of economic entities. The core rules are found, for the

most part, in the statutes—the corporation codes—of the various states.

While the rules vary to some degree from state to state, the basic rules

are much the same and are sufficiently complete so that little, if any,

modification is required. The equity1 investors are called shareholders or

stockholders; their ownership interests are reflected in shares of the

common stock of the firm. The shareholders elect a board of directors,

who in turn select the officers who run the business. The rules found in

the corporation codes provide for how the elections take place, for the

authority of the directors, for the duration of the enterprise, for the

distribution of profits, for mergers with other corporations, and so forth.

The founders of a corporation create the corporation (they ‘‘incorpo-

rate’’) by filing certain documents with the appropriate state agency and

may choose to do so in any of the fifty states. Once a firm is incorporated

in a particular state, it is the law of that state that is controlling as to

the matters covered in the corporations code.

The focus in this chapter is primarily on ‘‘public’’ corporations—

that is, large firms with many shareholders and with active trading of

shares. The shareholders in such corporations do not expect to partici-

pate actively in the operation of the business. They are passive investors.

Indeed, an important aspect of the corporation is its facilitation of

passive investments and, thus, the aggregation of individual savings,

which in turn permits large-scale investment and large-scale operation.

For public corporations, federal law has a significant impact on the

rights and duties of shareholders, directors, and officers, and to some

degree on the structure and operation of the enterprise. The core of

federal corporate law is a complex system, enacted originally in 1933 and

1934, requiring disclosure of the important facts relating to operations

and financial performance. See Sec. VII(B)(4). Beyond disclosure, federal

law includes rules prohibiting ‘‘insider trading’’—that is, trading by

corporate officers, directors, and employees on the basis of material

nonpublic information (see Sec. VI(C)); rules relating to shareholder

voting by use of mail or electronic ‘‘proxies’’ (see Sec. VII(B)(1)); and

rules controlling attempted corporate takeovers by the use of tender

offers (see Sec. VII(B)(2)(d)). Class-action suits on behalf of shareholders,

1 ‘‘Equity’’ is described in Chapter 1, Sec.

II(E).

107A BRIEF OVERVIEWCh. 3

based on the federal securities laws and filed in federal courts, claiming

violation of federal disclosure obligations, have become an important

reality in the relationship between shareholders, on the one hand, and

officers and directors on the other hand.2 Moreover, the two major

exchanges on which the shares of public corporations are traded (the

New York Stock Exchange and NASDAQ) both impose rules requiring,

among other things, a minimum number of independent directors.

At the other end of the corporate spectrum is the closely held

corporation. The principal distinguishing feature of the closely held

corporation is a small number of shareholders, though in all likelihood

the firm will also be one of relatively modest economic scope (whether

measured by revenues, by assets, or on any other scale), and generally

(though by no means always) the people owning a substantial portion of

the total shares will occupy the top managerial positions or will be

involved in a meaningful way in the selection and monitoring of the

people who do occupy those positions as well as in the formulation of

corporate strategies and policies.3 For such firms, the Limited Liability

Company (LLC) has become an attractive alternative organizational

device. However, because an LLC blends characteristics of partnerships

and corporations, an understanding of corporate law and of partnership

law is, at the very least, helpful in understanding the nature of an LLC.

A caveat. The strategy of this book has been to develop in the

context of the discussion of sole proprietorships (Chapter 1) and partner-

ships (Chapter 2) most of the important underlying economic principles

and many of the legal doctrines that govern all forms of business

organization, including corporations. Thus, much of the basic material

relevant to an understanding of corporations is found in the two previ-

ous chapters. At the same time, much is deferred to the succeeding two

chapters. Those chapters cover what is usually called ‘‘corporate fi-

nance,’’ which can be thought of as the field that explores in detail the

nature of the claims in a corporation (common stock, bonds, etc.), the

relationships among those claims, and the factors bearing on the choice

of the mix of those claims—a choice, roughly speaking, of the amount of

capital to be contributed by owners and the amount to be contributed by

lenders. These observations should serve as a warning to the reader who

2 See Robert B. Thompson and Hillary A.

Sale, Securities Fraud as Corporate Gover-

nance: Reflections Upon Federalism, 56

Vanderbilt L. Rev. 859 (2003).

3 Many states have special ‘‘close corpora-

tion’’ statutes; typically, these permit a

more informal mode of operation, under

which the shareholders (or some designated

number or group of them) can directly man-

age the firm instead of being required to

act, formally, through a board of directors.

In effect, these statutes do not change the

basic structure of the corporation, nor even

necessarily modify its prevailing default

rules, but they do permit a wider range of

private ordering solutions to reflect the

more detailed, face to face bargaining that

is possible within this context. Most of what

can be accomplished under the close corpo-

ration provisions can be accomplished by

agreements among shareholders of a stan-

dard corporation, or by use of the LLC

form. Relatively little use has been made of

the close corporation statutes.

108 CORPORATIONS Ch. 3

might think that this chapter is the appropriate starting and ending

point for learning about corporations.

B. THE IMPORTANT CHARACTERISTICS

The public corporation has a number of characteristics that, collec-

tively, account for its success in organizing economic activity on a large

scale. These characteristic will be examined in more detail in the

remainder of this chapter, but a brief summary will be helpful.

1. Separate Entity. A corporation is treated as a ‘‘separate entity.’’

This is pure conceptualization—that is, a way of thinking about

a complex reality—but it is a powerful conceptualization, which

plays an important role in determining various rules of corpo-

rate law. As a separate entity, it is the corporation, not the

shareholders, that enters into contracts, incurs debt, and files or

is the defendant in law suits. The officers and other employees

act on behalf of the firm, subject to approval of the board of

directors as to major decisions. Shareholders have no power to

act on behalf of the corporation.

2. Divisible Ownership. Equity ownership is reflected in shares of

stock. Generally, corporations issue enough shares so that each

one is of relatively modest value (rarely more than $100). This

means that corporations can be financed by a large number of

investors, each with a relatively small investment (though nowa-

days most small investors who want to invest in corporate

equities turn their money over to professional managers who

pool the funds of many such investors, in ‘‘mutual funds,’’ and

invest in a diversified portfolio of stocks or bonds or both).

3. Assets Separated from Shareholders. Consistently with the con-

cept of the corporation as a separate entity, the assets of a

corporation are held by the corporation. Shareholders cannot

remove from the corporation their pro rata share of the corpora-

tion’s assets. This protects the stability of the corporation and

the interest of the other shareholders in that stability. Perhaps

more important, it protects the creditors of the corporation.

Personal creditors of a shareholder may be able to gain owner-

ship of the shareholder’s shares, but they cannot go after the

assets of the corporation and if the corporation is liquidated, the

corporate creditors (as holders of debt obligations) will have

priority over the personal creditors of shareholders (as holders of

equity). This result is reached without the corporate creditors

perfecting any security interest in the corporate assets.4

4 This has been called ‘‘affirmative assets

partitioning,’’ while limited liability is

called ‘‘defensive assets partitioning.’’ See

Henry Hansmann & Reinier Kraakman,

The Essential Role of Organizational Law,

110 Yale L.J. 387, 393 (2000).