Company Law Introduction

Evaluation of business enterprise

•Part I: Introduction to the Legal Forms for Business Enterprises

–Selecting the legal form for a business enterprise, and the key attributes – sole
proprietorship, corporation and partnership

•Part II: Focus on the Corporation

–Characteristics of the corporation, role of shareholders, directors and management
–Capitalization of a corporation and use of equity and debt capital

•Part III: Limited Liability for Shareholders and “Piercing the Veil”
–Meaning and significance of “Limited Liability”
–Abuse of corporation and “piercing” the corporate veil; examples
Comparison of available business enterprises
Grounds Individual Proprietorship Partnership /Limited Partnership Corporations/ LLCs

Persons Required One – and only one At least two persons or entities Only need one entity to form; but
can be unlimited

Formation No formalities – except local No written agreement required for Formal document and filing
licenses general partnership required to create corporation
Limited partnership requires
written agreement

Liability for Debts Full liability Each general partner liable for all Shareholders not personally liable,
debts of the partnership. Limited except to prevent abuse.
partners have limited liability

Control Individual Control Each general partner as agreed; Board of directors and officers
no control for limited partners (Managers under LLC law)
•Sole/Individual Proprietorships
•Advantages

•Easiest and least expensive form of business enterprise

•Owner reaps all the rewards of ownership
•Owner has complete control over business decisions
•Disadvantages

•No protection from liability for business failure

•No ability to attract “equity” capital from 3rd parties interested in investing in
the business
•Limited duration – ceases upon death of the owner
Partnerships

•Partnerships
•Advantages
•Ability to add capital by increasing number of partners – e.g., law firms;
accounting firms
•Recognized as a separate legal entity – may help in raising funds

•Disadvantages
•No protection from liability for business failure – except for limited partners
•Death or bankruptcy of one partner may cause termination – unless otherwise
agreed
•Shared control may cause disputes – complexity to draft around
Features of corporations

•Corporations
•Advantages
•Shareholders not liable for business failure – more later
•Can have perpetual existence
•Great flexibility to expand – by raising equity and debt capital
• Disadvantages
•Relative expense and complexity to form and maintain
•Complexity in withdrawing capital from the business
•Shared control may lead to owner disputes – same as partnership
•Taxed as a separate entity
 Corporations

•More on key characteristics of a corporation

•Corporation is a “statutorily” created “entity”
•Owns assets and has liabilities as separate legal entity
•Enters into contracts and conducts its own business
•Can sue and be sued - same as an individual
•Can have perpetual existence
•Subject to civil and criminal laws
PERPETUAL EXISTENCE

● Coca-Cola Company – incorporated in 1892

● Procter & Gamble – founded in 1837, and is now one of the largest
sellers of consumer products in the world
● Bombay Dyeing Company
Established in 1879 by Nowrosjee Wadia as a small operation of Indian spun cotton yarn dip
dyed by hand. Today it has grown to be one of the most respected and trusted brands in the
country.

● Teesta Valley Tea Company

Established in 1841 and currently directed by Bharat Bajoria is a 175-year-old company which
exports special tea to Japan, Germany, and the UK, among other developed nations.
CRIMINAL LIABILITY OF CORPORATION

Corporation can’t be imprisoned, but can be fined for criminal

conduct
CAPITALIZATION

•What is Capitalization?
•Exchange between owners and the corporation
•Shareholder “contributes” assets – cash or other assets – to company and receives, in return, shares representing ownership

•What does it mean to “contribute” assets to corporation?

•An irrevocable transfer by shareholder to the corporation; similar to a “sale”, except shareholder receives ownership in return
CAPITALIZATION CONT……...
•What are shares of “common” equity?
•Represents ownership of the corporate entity

•What are the characteristics of “common” shares?

•Common shares have the right to the profits the corporation distributes to shareholders – the “dividends”
•Have the right to control certain aspects of the corporation
•Common shares have “residual” value of the corporation

•Its residual because it’s the value left after creditors are paid
•The residual value is called the “equity” of the corporation
CREDITOR AND OWNER
•Fundamental rule of law is that creditors are given priority in right to
payment over the rights of ownership
•So, if corporation is liquidated debts owed to creditors must first be paid – in full – before any value can be returned to owners
•Same rule limits right of corporation to make distributions to owners if doing so will impair ability to repay creditors
DEBT AS CAPITAL
•Owners often add debt to the capital structure
•Why add debt to the capital structure?
•Because debt is paid only an interest rate, while equity capital gets all increase in business’s value

•So, debt capital can create greater profits and returns for owners
Debt capital
•Owners often invest as debt to better protect their investment –
particularly when banks won’t lend
•If owners’ capital is invested as debt, then – as a general rule – they are entitled to be paid the same as other creditors if the company
fails

•However, abuse of the corporate form by inadequately capitalizing the

corporation can adversely affect the owner
OWNERSHIP AND MANAGEMENT

•A key feature: ownership is separated from management

•Right to control is shared by: (1) shareholders, (2) directors,
and (3) officers
•Shareholders:
•Own corporation – benefit from distributions of profits and increase in
value of shares
•Have right to elect directors, and to vote to remove directors
•Have right to vote on major transactions – such as sale of business,
merger, liquidation
•But don’t have right to operate the business as shareholder
MANAGEMENT

•Board of Directors:
•Elected by shareholders – annual or “staggered” terms; majority or “cumulative” voting
•Have the right to control the business and affairs of the corporation
•Board selects the CEO, President and key officers of the corporation

•Mostly serve a supervisory role – but must be actively engaged to meet duties
Management
•Officers
•Executive officers appointed by directors
•Carry out the corporation’s business on day-to-day basis

•Corporate Governance and Duties:

•Directors and officers have duty of care and duty and loyalty, requiring them to act in best interests of corporation
and shareholders
VOTING RIGHTS
•Voting common shares
•Usual rule is “one share – one vote”
• Usually, only a majority is required; but can require a super majority for some decisions (e.g., to merge
or liquidate)
•Some laws OK different classes of shares with “super” voting rights
•Zuckerberg has “iron grip” control of Facebook
•It has two class of shares: “Class A” with one vote per share and “Class B” with 10 votes per share
•He also gets control through voting agreements with others
•Zuckerberg owns under 20% of Facebook, but has control over almost all shareholder decisions – director elections,
merger, sale.

•Voting rights for director decisions

•Usual rule is to require majority vote of directors, but can require a super majority vote of directors for
some decisions (e.g., to merge or liquidate)
SEPARATION WORKS

•Separation often works well

•Google founded in 1998 by the “Google Guys” Larry Page and Sergey
Brin
•Google became a public company in 2004, with its initial sale of shares to
the public
•The Google Guys added excellent outside directors and management to
help grow Google’s business – Eric Schmidt became CEO
•Shareholders have benefited tremendously over
The years
DIVIDEND
•What are dividends?
•Distributions of cash or property made by the company to its owners – made “on account” of their ownership

•What does company get in return for a dividend?

•Payment of dividends requires approval of directors
•Directors must determine payment of dividend is prudent for the company
•Dividends must be lawful under corporate and fraudulent transfer laws
DIVIDEND CONT…...
•To simplify a complex area, a dividend is lawful if the company is not
rendered insolvent by the dividend – it is made from surplus or profits
•What does “insolvent” mean?

•Assets are less than the amount of its liabilities, or

•Inability of a company to pay its debts when due
•Creditors can recover unlawful dividends

•Why are dividends so limited?

•Directors may be liable for approving unlawful dividends
BENEFIT OF CORPORATE FORM
•Limited Liability: What does it mean?
•Corporation is liable for its own debts as a separate entity
•Shareholders’ liability is limited to their capital contribution
•If corporation becomes insolvent, shareholders are not liable to corporate creditors – absent abuse
•Creditors may only look to the assets of the corporation
•What if shareholder had agreed to contribute more capital?
•Creditors cannot recover from directors or management – absent breach of duty
LIMITED LIABILITY CONT...
“I weigh my words when I say that in my judgment the limited liability corporation is the greatest single

discovery of modern times. . . . Even steam and electricity are far less important than the limited liability

corporation, and they would be reduced to comparative impotence without it.”

—Nicholas Butler, President Columbia Univ., 1911

•What does this mean?

•Why is limited liability so important?
Exceptions to limited liability
•“Piercingthe Corporate Veil”: Doctrine that eliminates limited liability and makes an owner liable for debts
of the company
•In the US, it is a judge created remedy; in many countries, it is statutory
•The standard: (1) Domination of the corporation by the owner, and (2) use of that domination to
perpetuate a fraud or similar injustice on creditors of the company
•Both must be present – domination and use of it to commit an injustice
•Factors that may support shareholder liability
•Corporation is grossly inadequately capitalized
•Siphoning off corporate funds to an owner – “asset stripping”
•Company is a sham entity used by owner to harm creditors
Modes of corporate financing
•Raising debt capital and borrowings
•Commercial law and secured lending principles
•Equipment loans
•Bank loans and bond financing
•Raising equity capital

•Issuance of new common shares

•Issuance of preferred shares; sale of warrants
•The IPO – going “Public”
•Mergers and acquisitions
Debt capital
•Two important commercial law principles:

•First, debts owed to creditors come before ownership

•Second, secured creditors have priority over unsecured creditors – but
only as to their collateral
•Debt financings have the advantage of not diluting ownership, and “leverage” can increase profits
•But they bring the disadvantage of greater risks of default and insolvency
Principles of secured lending
•What is a “lien”, “mortgage” or “security interest”?

•They all refer to a special interest in property that a borrower can give to
a lender – given to hold as security for borrower’s promise to repay the
debt owed to the lender
•The nature of that special interest in property is that the lender can cause
the property to be sold to generate cash to repay the loan owed to him, if
the borrower defaults in payment of the loan
•So, for example, when a company obtains a secured loan to build a factory, it gives the lender a lien on the factory, and if the company
later fails to pay the loan, the lender can enforce the lien by causing the factory to be sold to obtain payment of the loan
•In contrast, an unsecured creditor has no special right to look to specific property of the borrower to assure payment of a debt
Preferred Shares
•Preferred shares – are an equity ownership interest, but are a “hybrid” between equity and debt

•Contribution of cash or assets in return for preferred shares

•Preferred shares have a priority over common shares in liquidation; but they only
receive back the capital invested, plus unpaid dividends
•Unlike common shares, preferred shares do not share in the potential “upside” – the
increase in the value of the company
•Usually have limited voting rights – unless defaults
•Usually receive a higher dividend
•Usually must be “redeemed” by company within a stated time
•But preferred shares are junior to debt in an insolvency – creditors must be paid in full
before preferred shares receive any distribution, and no distributions are permitted if
insolvent conditions exists
•Why invest in preferred shares?
Warrants

•How do warrants work?

•Company sells to buyer the right – but not the obligation – to buy shares at an agreed price,
which right can be exercised over a specified period (e.g., 3 years)
•Company gets consideration in return for sale of warrant, and also gets cash equal to
exercise price if the buyer later exercises warrant
•Buyer gets an option to buy new shares from company at a set price and need not exercise
the right unless the value of the shares exceed the exercise price.
Acquisition
•Stock purchase agreement

•Purchase stock of target company

•Advantages: speed and simplicity of transaction; fewer consents
•Disadvantages: liabilities of target company are retained, and so buyer takes risk of
there being unknown liabilities
• Asset purchase agreement
•Buyer buys assets, and liabilities remain at target company
•Advantages: buyer can acquire assets free of the liabilities, unless buyer agrees by
contract to assume specific liabilities (exception for Liens and some debts)
•Disadvantages: more complexity as each asset must be transferred – e.g., deeds and
assignments; more consents required
Merger
•What is a merger transaction?

•Its an agreement by two or more corporations to combine, so that they become a

single corporation
•By law
•The assets and liabilities are combined into a single entity
•One corporation is the “surviving” corporation, with the other being “merged into” the surviving
entity
•Merger agreement specifies the consideration to be paid:
•Shares of the surviving corporation; or
•Other consideration – cash or shares and cash
•Also, by law, surviving corporation becomes liable for all liabilities of the corporation
that is merged into it
Merger cont…..
•Legal steps and requirements:

•Agreement of merger signed by corporations

•Boards of directors must approve the merger agreement
•Shareholders approve the merger agreement – sometimes a super
majority is required
•Government filings are made to give effect to the merger and create the
combined legal entity
•In some cases, there are special rights for minority shareholders that
refused to vote for the merger
Joint venture

•JV is an arrangement between two or more entities to jointly pursue business

objective
•Venture can be a separate legal entity or just a contract arrangement
•Allows companies to pool capital and share risk
•Essential to document the JV properly, so operations
and finances managed
Corporate governance
•Duties of directors and officers

•Directors and officers owe duties to shareholders and the corporation –

“duty of loyalty” and “duty of care”
•Why?
Corporate governance cont…...

•Directors and Officers owe the corporation a duty of

loyalty
•This duty requires directors and officers to act in the company’s best interest, and not to act to further his or her own personal interests

•This duty is breached, for example, if a director causes the company to

lease property owned by the director at unfair, excessive rent
•It is breached if an officer “steals” a corporate opportunity
Corporate governance cont...
•Duty of Care and the Business Judgment Rule

•Duty of care requires the directors:

•First, to inform themselves “fully and in a deliberate manner” of all information reasonably
available (i.e., understand and study the transaction; consult experts as appropriate); and
•Second, after becoming so informed, directors must use the care of a “careful and prudent”
person in making a decision
•Protection of the Business Judgment Rule: If directors properly inform
themselves, they are protected from liability for honest mistakes made in good
faith. Standard approximates “gross negligence”
•But if directors fail to properly inform themselves – by failing to take into account
facts reasonably available – liability can arise from a negligent decision
Duty of care YAHOO case
•Yahoo receives $50 Billion bid from Microsoft – a 60% premium over share price
•CEO and founder (Jerry Yang) rejects bid, allegedly because of desire to retain control and keep Yahoo independent
•Directors reject bid, and allegedly propose multi-billion severance to employees to deter Microsoft’s bid
•Microsoft drops bid and Yahoo looses more than 60% of market value
•Shareholders file lawsuits:

•Contend directors and Yang

breached duty of care in rejecting bid
•What should be the outcome –
are directors and Yang liable?
Winding up
Companies Act

Insolvency