the general public. Municipal corporations are typically cities and towns that help the state to function at the local level. Quasi-public cor- porations would be considered private, but their business serves the public’s needs, such as by offering utilities or telephone service. There are two types of private corporations. One is the public corporatio n, which has a large number of investors, called shareholders. Cor- porations that trade their shares, or investment stakes, on SECURITIES exchanges or that regularly publish share prices are typical publicly held corporations. The other type of private corporation is the CLOSELY HELD corporation. Closely held corpora- tions have relatively few shareholders (usually 15 to 35 or fewer), often all in a single family; little or no outside market exists for sale of the shares; all or most of the shareholders help run the business; and the sale or transfer of shares is restricted. The vast majority of corporations are closely held. Getting a Corporation Started Many corporations get their start through the efforts of a person called a promoter, who goes about developing and organizing a business venture. A promoter’s efforts typically involve arranging the needed capital, or financing, using loans, money from investors, or the promoter’s own money; assembling the people and assets (such as land, buildings, and leases) necessary to run the corporation; and fulfilling the legal requirements for forming the corporation. A corporation cannot be automatically liable for obligations that a promoter incurred on its behalf. Technically, a corporation does not exist during a promoter’s pre-incorporation activi- ties. A promoter therefore cannot serve as a legal agent, who could bind a corporation to a contract. After formation, a corporation must somehow assent before it can be bound by an obligation that a promoter has made on its behalf. Usually, if a corporation gets the benefits of a promoter’s contract, it will be treated as though it has assented to, and accepted, the contract. The first question facing incorporators (those forming a corporation) is where to incorporate. The answer often depends on the type of corporation. Theoretically, both closely held and large public cor porations may incor- porate in any state. Small businesses operating in a single state usually incorporate in that state. Most large corporations select Delaware as their state of incorporation because of its so phistica- tion in dealing with corporation law. Incorporators then must follow the me- chanics that are set forth in the state’s statutes. Corporation statutes vary from state to state, but most require basically the same essenti als in forming a corporation. Every statute requires incorporators to file a document, usually called the ARTICLES OF INCORPORATION, and pay a filing fee to the secretary of state’s office, which reviews the filing. If the filing receives approval, the corporation is considered to have started existing on the date of the first filing. The articles of incorporation typically must contain (1) the name of the corporation, which often must include an element such as Com- pany, Corporation, Incorporated, or Limited,” and may not resemble too closely the names of other corporations in the state; (2) the length of time the corporation will exist, which can be perpetual or renewable; (3) the corporation’s purpose, usually described as “any lawful business purpose”; (4) the number and types of shares that the corporation may issue and the rights and preferences of those shares; (5) the address of the corporation’s registered office, which need not be the corporation’s business Wal-Mart’s Executive Vice President and CFO Tom Schoewe addresses shareholders at the company’s annual meeting in 2009. A corporation’s officers are responsible for running day-to- day business affairs and carrying out policies established by the directors. AP IMAGES GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 228 CORPORATIONS office, and the registered agent at that office who can accept legal SERVICE OF PROCESS; (6) the number of directors and the names and addresses of the first directors; and (7) each incorporator’s name and address. A corporation’s bylaws usually contain the rules for the actual running of the corporation. Bylaws normally are not filed with the SECRETARY OF STATE and are easier to amend than are the articles of incorporation. The bylaws should be complete enough so that corporate officers can rely on them to manage the corporation’s affairs. The bylaws regulate the conduct of directors, officers, and shareholders and set forth rules governing internal affairs. They can include definitions of management’s duties, as well as times, locations, and voting procedures for meetings that affect the corporation. People behind a Corporation: Rights and Responsibilities The primary players in a corporation are the shareholders, directors, and officers. Share- holders are the investors in, and owners of, a corporation. They elect, and sometimes remove, the directors, and occasionally they must vote on specific corporate transac tions or operations. The BOARD OF DIRECTORS is the top governing body. Directors establish corporate policy and hire officers, to whom they usually delegate their obligations to administer and manage the corporation’s affairs. Officers run the day-to- day business affairs and carry out the policies the directors establish. Shareholders Shareholders’ financial interests in the corporation is determined by the percentage of the total outstanding shares of stock that they own. Along with their financial stakes, shareholders generally receive a number of rights, all designed to protect their invest- ments. Foremost among these rights is the power to vote. Shareholders vote to elect and remove directors, to change or add to the bylaws, to ratify (i.e., approve after the fact) directors’ actions where the bylaws require shareholder approval, and to accept or reject changes that are not part of the regular course of business, such as mergers or dissolution. This power to vote, although limited, gives the shareholders some role in running a corporation. Shareholders typically exercise their voting rights at annual or special meetings. Most statutes provide for an annual meeting, with requirements for some advance notice, and any shareholder can get a court order to hold an annual meeting when one has not been held within a specified period of time. Although the main purpose of the annual meeting is to elect directors, the meeting may address any relevant matter, even one not that has not been mentioned specifically in the advance notice. Almost all states allow shareholders to conduct business by unanimous written consent, with- out a meeting. Shareholders elect directors each year at the annual meeting. Most statutes provide that directors be elected by a majority of the voting shares that are present at the meeting. The same number of shares needed to elect a director normally is required to remove a director, usually without proof of cause, such as FRAUD or abuse of authority. A special meeting is any meeting other than an annual meeting. The bylaws govern the persons who may call a special meeting; typically, the directors, certain officers, or the holders of a specified percentage of outstanding shares may do so. The only subjects that a special meeting may address are those that are specifically listed in an advance notice. Statutes require that a quorum exist at any corporation meeting. A quorum exists when a specified number of a corporation’s outstanding shares are represented. Statutes determine what level of representation constitutes a quorum; most require one-third. Once a quorum exists, most statutes require an affirmative vote of the majority of the shares present before a vote can Federal law prohibits a corporate insider from using nonpublic information to buy or sell stock. In 2009, the SEC charged Joseph Contorinis, a former portfolio manager, with taking part in an insider trading scheme that produced illegal profits of more than $11 million. AP IMAGES GALE ENCYCLOPEDIA OF AMERICAN LAW, 3 RD E DITION CORPORATIONS 229 bind a corporation. Generally, once a quorum is present, it continues, and the withdrawal of a faction of voters does not prevent the others from acting. A corporation determines who may vote based on its records. Corporations issue share certificates in the name of a person, who becomes the record owner (i.e., the owner according to company records) and is treated as the sole owner of the shares. The company records of these transactions are called stock- transfer books or share registers. A shareholder who does not receive a new certificate is called the beneficial owner and cannot vote, but the beneficial owner is the real owner and can compel the record owner to act as the beneficial owner desires. Those who hold shares by a specified date before a meeting, called the record date, may vote at the meeting. Before each meeting, a corporationmustpreparealistofshareholders who are eligible to vote, and each shareholder has an unqualified right to inspect this voting list. Shareholders typically have two ways of voting: straight voting or CUMULATIVE VOTING. Under straight voting, a shareholder may vote his or her shares once for each position on the board. For example, if a shareholder owns 50 shares and there are three director positions, the shareholder may cast 50 votes for each position. Under cumulative voting, the same shareholder has the option of casting all 150 votes for a single candidate. Cumulative voting increases the participation of minority shareholders by boosting the power of their votes. Shareholders also may vote as a group or block. A shareholder voting agreement is a contract among a group of shareholders to vote in a specified manner on certain issues; this is also called a pooling agreement. Such an agreement is designed to maintain control or to maximize voting power. Another arrange- ment is a VOTING TRUST. This has the same objectives as a pooling agreement, but in a voting trust, shareholders assign their voting rights to a trustee who votes on behalf of all the shares in the trust. Shareholders need not attend meetings in order to vote; they may authorize a person, called a proxy, to vote their shares. Proxy appointment often is solicited by parties who are interested in gaining control of the board of directors or in passing a particular proposal; their request is called a proxy solicitation. Proxy appointment must be in writing. It usually may last no longer than a year, and it can be revoked. Federal law generates most proxy regula- tion, and the Securities and Exchange Commis- sion (SEC) has comprehensive and detailed regulations. These rules define the form of proxy-solicitation documents and require the distribution of substantial in formation about director candidates and other issues that are up for shareholder vote. Not all corporations are subject to federal proxy law; generally, the law covers only large corporations with many shareholders and with shares that are traded on a national securities exchange. These regula- tions aim to protect investors from promiscu- ous proxy solicitation by irresponsible outsiders who seek to gain control of a corporation, and from unscrupulous officers who seek to retain control of management by hiding or distorting facts. In addition to voting rights, shareholders also have a right to inspect a corporation’s books and records. A corporation almost always views the invocation of this right as hostile. Shareholders may only inspect records if they do so for a “proper purpose”; that is, is a purpose that is reasonably relevant to the shareholder’s financial interest, such as deter- mining the worth of his or her holdings. Shareholders can be required to own a specified amount of shares or to have held the shares for a specified period of time before inspection is allowed. Shareholders generally may review all relevant records that are needed, in order to gather information in which they have a legitimate interest. Shareholders also may ex- amine a corporation ’s record of shareholders, including names and addresses and classes of shares. Directors Statutes contemplate that a corpora- tion’s business and affairs will be managed by the board of directors or under the board’s authority or direction. Directors often delegate to corporate officers their authority to formu- late policy and to manage the business. In closely held corporations, directors normally involve themselves more in management than do their counterparts in large corporations. Statutes empower directors to decide whether to declare dividends; to formulate proposed im- portant corporate changes, such as mergers or amendments to the articles of incorporation; GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 230 CORPORATIONS and to submit proposed changes to share- holders. Many boards appoint committees to handle technical matters, such as litigation, but the board itself must address important matters. Directors customarily are paid a salary and often receive incentive plans that can supple- ment that salary. A corporation’s articles or bylaws typically control the number of directors, the terms of the directors’ service, and the directors’ ability to change their number and terms. The shareholders’ power of removal functions as a check on directors who may wish to act in a way that is contrary to the majority shareholders’ wishes. The directors’ own fidu- ciary duties, or obligations to act for the benefit of the corporation, also serve as checks on directors. The bylaws usually regulate the frequency of regular board meetings. Directors also may hold special board meetings, which are any meetings other than regular board meetings. Special meetings require some advance notice, but the agenda of special directors’ meetings is not limited to what is set forth in the notice, as it is with shareholders’ special meetings. In most states, directors may hold board meetings by phone and may act by unanimous written consent without a meeting. A quorum for board meetings usually exists if a majority of the directors in office immedi- ately before the meeting are present. The quorum number may be increased or decreased by amending the bylaws, although it may not be decreased below any statutory minimum. A quorum must be present for directors to act, except when the board is filling a vacancy. Most statutes allow either the board itself or share- holders to fill vacancies. Directors’ fiduciary duties fall under three broad categories: the duty of care, the duty of loyalty, and duties imposed by statute. Gene- rally, a fiduciary duty is the du ty to act for the benefit of another—here, the corporati on— while subordinating personal interests. A fidu- ciary occupies a position of trust for another and owes the other a high degree of fidelity and loyalty. A director owe s the corporation the duty to manage the entity’s business with due care. Statutes typically define using due care as acting in GOOD FAITH, using the care that an ordinarily prudent person would use in a similar position and situation, and acting in a manner that the director reasonably thinks is in the corpora- tion’s best interests. Courts seldom second- guess directors, but they usually find personal liability for corporate losses where there is SELF- DEALING or NEGLIGENCE. Self-dealing transactions raise questions about directors’ duty of loyalty. A self-dealing transaction occurs when a director is on both sides of the same transaction, representing both the corporation and another person or entity who is involved in the transaction. Self-dealing may endanger a corporation because the corpo- ration may be treated unfairly. If a transaction is questioned, the director bears the burden of proving that it was in fact satisfactory. Self-dealing usually occurs in one of four types of situations: transac tions between a director and the corporation; transactions between corporations where the same director serves on both corporations’ boards; by a director who takes advantage of an opportunity for business that arguably may belong to the corporation; and by a director who competes with the corporation. The usurping of a corporate opportunity poses the most significant challenge to a director’s duty of loyalty. A director cannot exploit the position of director by taking for himself or herself a business opportunity that rightly belongs to the corporation. Most courts facing this question compare how closely related the opportunity is to the corporation’s current or potential business. Part of this analysis involves assessing the fairness of taking the opportunity. Simply taking a cor- poration’s opportunity does not automatically violate the duty of loyalty. A corporation may relinquish the opportunity, or the corporation may be incapable of taking the opportunity for itself. Directors who are charged with violating their duty of care usually are protected by what courts call the BUSINESS JUDGMENT RULE. Essentially, the rule states that even if the directors’ decisions turn out badly for the corporation, the directors themselves will not be personally liable for losses if those decisions were based on reason- able information and if the directors acted rationally. Unless the directors commit fraud, a breach of good faith, or an illegal act, courts presume that their judgment was formed to promote the best interests of the corporation. In GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 231 other words, courts focus on the process of reaching a decision, not on the decision itself, and require directors to make informed, not passive, decisions. State statutes often impose additional duties and liabilities on directors as fiduciaries to a corporation. These laws may gover n conduct such as paying dividends when a statute or the articles prohibit doing so; buying shares when a statute or the articles prohibit doing so; giving assets to shareholders during liquidation with- out resolving a corporation’s debts, liabilities, or obligations; and making a prohibited loan to another director, an officer, or a shareholder. If a court finds that a director has violated a duty, the director still might not face personal liability. Some statutes require or permit corporations to indemnify a director who violated a du ty but acted in good faith, who received no improper personal benefit, and who reasonably thought that the action was lawful and in the corporation’s best interests. Indemnification means that the corporation reimburses the director for expenses incurred defending himself or herself and for amounts he or she paid after losing or settling a claim. Officers The duties and powers of corporate officers can be found in statutes, articles of incorporation, bylaws, or corporate resolutions. Some statutes require a corporation to have specific officers; others merely require that the bylaws contain a description of the officers. Officers usually serve at the will of those who appointed them, and they generally can be fired with or without cause, although some officers sign employment contracts. Corporations typically have as officers a president, one or more vice presidents, a secretary, and a treasurer. The president is the primary officer and supervises the corporation’s business affairs. This officer sometimes is referred to as the chief executive officer, but the ultimate authority lies with the directors. The VICE PRESIDENT fills in for the president when the latter cannot or will not act. The secretary keeps minutes of meetings, oversees notices, and manages the corporation’s records. The treasurer manages and is responsible for the corporation’s finances. Officers act as a corporation’s agents and can bind the corporation to contracts and agree- ments. Many parties who deal with corporations require that the board pass a resolution approv- ing any contract negotiated by an officer, as a sure way to bind the corporation to the contract. In the absence of a specific resolution, the corporation still may be bound if it ratified the contract by accepting its benefits or if the officer appeared to have the authority to bind the corporation. Courts treat corporations as having knowledge of information if a corporate officer or employee has that knowledge. Like directors, officers owe fiduciary duties to the corporation: good faith, diligence, and a high degree of honesty. But most litigatio n about fiduciary duties involves directors, not officers. An officer does not face personal liability for a transaction if he or she merely acts as the corporation’s agent. Nevertheless, the officer may be personally liable for a transaction where the officer intends to be bound personally or creates the impression that he or she will be so bound; where the officer exceeds his or her authority; and where a statute imposes liability on the officer, such as for failure to pay taxes. Finances Shares A corporation divides its ownership units into shares, and can issue more than one type or class of shares. The articles of incorpo- ration must state the type or types and the number of shares that can be issued. A corporation may offer additional shares once it has begun operating, sometimes subject to current shareholders’ preemptive rights to buy new shares in proportion to their current ownership. Directors usually determine the price of shares. Some states require corporations to assign a nominal or minimum value to shares, called a par value, although many states are eliminating this practice. Many states allow some types of non-cash property to be exchanged for shares. Corporations also raise money through debt financing—also called debt securities—which gives the creditor an interest in the corporation that ultimately must be paid back by the corporation, much like a loan. If a corporation issues only one type of share, its shares are called COMMON STOCK or common shares. Holders of common stock typically have the power to vote and a right to their share of the corporation’s net assets. Statutes allow corporations to create different GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 232 CORPORATIONS classes of common stock, with varying voting power and dividend rights. A corporation also may issue preferred shares. These are typically nonvoting shares, and their holders receive a preference over holders of common shares for payment of dividends or liquidations. Some preferred divi- dends may be carried over into another year, either in whole or in part. Dividends A dividend is a payment to share- holders, in proportion to their holdings, of current or past earnings or profits, usually on a regular and periodic basis. Directors determine whether to issue dividends. A dividend can take the form of cash, property, or additional shares. Shareholders have the right to force payment of a dividend, but they usually succeed only if the directors abused their discretion. Restrictions on the distribution of dividends can be found in the articles of incorporation and in statutes, which seek to ensure that the dividends come out of current and past earnings. Directors who vote for illegal divi- dends can be held personally liable to the corporation. In addition, a corporation’s cred- itors often will contractually restrict the cor- poration’s power to make distributions. Changes and Challenges Faced by Corporations Amendments The most straightforward and common changes faced by corporations are amendments to their bylaws and articles. The directors or incorporators initially adopt the bylaws. After that, the shareholders or directors, or both, hold the power to repeal or amend the bylaws, usually at shareholders’ meetings and subject to a corporation’s voting regulations. Those who hold this power can adopt or change quorum req uirements; prescribe procedures for the removal or replacement of directors; or fix the qualifications, terms, and numb ers of directors. Most modern statutes limit the authority to amend articles only by requiring that an amendment would have been legal to include in the original articles. Some statutes shield minority shareholders from harmful majority-approved amendments. Mergers and Acquisitions A merger or acqui- sition generally is a transaction or device that allows one corporation to merge into or to take over another corporation. MERGERS AND ACQUISITIONS are complicated processes that require the involvement and approval of the directors and the shareholders. In a merger or consolidation, two corpora- tions become one by either maintaining one of the original corporations or creating a new corporation consisting of the prior corporations. Where statutes authorize these combinations, these changes are called statutory mergers. The statutes allow the surviving or new corporation to automatically assume own ership of the assets and liabilities of the disappearing corporation or corporations. Statutes protect shareholder interests during mergers, and state courts assess these combina- tions using the fiduciary principles that are applied in self-dealing transactions. Most sta- tutes require a majority of the shareholders in order to approve a merger; some require two- thirds. Statutes also allow shareholders to dissent from such transactions, to have a court appraise the value of their stake, and to force payment at a judicially determined price. Mergers can involve sophisticated transac- tions that are designed simply to combine corporations or to create a new corporatio n or to eliminate minority shareholder interests. In some mergers, an acquiring corporation creates a subsidiary as the form for the merged or acquired entity. A subsidiary is a corporation that is majority-owned or wholly owned by another corporation. Creating a subsidiary allows an acquiring corporation to avoid responsibility for an acquired corporation’s liabilities, while providing shareholders in the acquired corporation with an interest in the acquiring corporation. Mergers also can involve parent corpora- tions and their subsidiaries. A similar, though distinct, transaction is the sale, lease, or exchange of all or practically all of a corpora- tion’s property and assets. The purchaser in such a transaction typically continues operating the business, although its scope may be narrowed or broadened. In most states, share- holders have a statutory right of dissent and appraisal in these transactions, unless the sale is part of ordinary business dealings, such as issuing a mortgage or DEED OF TRUST covering all of a corporation’s assets. Not all business combinations are consen- sual. Often, an aggressor corporation will use takeover techniques to acquire a target GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 233 corporation. Aggressor corporations primarily use the cash TENDER OFFER in a takeover: The aggressor attempts to persuade the target corporation’s shareholders to sell, or tender, their shares at a price that the aggressor will pay in cash. The aggressor sets the purchase price above the current market price, usually 25 to 50 percent higher, to mak e the offer attractive. This practice often requires the aggressor to assume significant debts in the takeover, and these debts often are paid for by selling off parts of the target corporation’s business. Restraints and protections exist for these situations. In takeovers of registered or large, publicly held corporations, fe deral law requires the disclosure of certain informatio n, such as the source of the money in the tender offer. In smaller corporations, a controlling shareholder, who holds a majority of a corporation’sshares, may not transfer control to someone outside the corporation w ithout a reasonable investigation of the potential buyer. A controlling shareholder also may not transfe r control where there is a suspicion that the buyer will use the corpora- tion’s assets to pay the purchase price or otherwise wrongfully take the corporation’s assets. Corporations can employ defensive tactics to fend off a takeover. They can find a more compatible buyer (a “white knight”); issue additional shares to make the takeover less attractive (a “lock-up”); create new classes of stock whose rights increase if any person obtains more than a prescribed percentage (a “poison pill”); or boost share prices to make the takeover price less appealing. Dissolution A corporation can terminate its legal existence by engaging in the dissolution process. Most statutes allow corporations to dissolve before they begin to operate as well as after they get started. The normal process requires the directors to adopt a resolution for dissolution, and the shareholders to approve it, by either a simple majority or, in some states, a two-thirds majority. After approval, the corpo- ration engages in a “winding-up” period, during which it fulfills its obligations for taxes and debts, before making final, liquidation distribu- tions to shareholders. Derivative Suits Shareholders can BRING SUIT on behalf of a corporation to enforce a right or to remedy a wrong that has be en done to the corporation. Shareholders “derive” their right to bring suit from a corporation’s right. One common claim in a derivative suit w ould allege misappropriation of corporate assets or other breaches of duty by the directors or officers. Shareholders most often bring derivative suits in federal courts. Shareholders must maneuver through several procedural hoops before actually filing suit. Many statutes require them to put up security, often in the form of a bond, for the corporation’s expenses and attorneys’ fees from the suit, to be paid if the suit fails; this requirement often kills a suit before it even begins. The shareholders must have held stock at the time of the contested action and must have owned it continuously ever since. The shareholders first must demand that the directors enforce the right or remedy the wrong; if they fail to make a demand, they must offer sufficient proof of the futility of such a demand. Normally, a committee formed by the directors handles—and dismisses—the demand, and in- formed decisions are protected by the business judgment rule. Proxy Contests A proxy contest is a struggle for control of a public corporation. In a typical proxy contest, a nonmanagement group vies with management to gain enough proxy votes to elect a majority of the board and to gain control of the corporation. A proxy contest may be a part of a takeover attempt. Management holds most of the cards in such disputes: It has the current list of share- holders; shareholders normally are biased in its favor; and the nonmanagement group must finance its part of the proxy contest, but if management acts in good faith, it can use corporate money for its solicitation of proxy votes. In proxy contests over large, publicly held corporations, federal regulations prohibit, among other things, false or misleading state- ments in solicitations for proxy votes. Insider Trading Federal, and often state, laws prohibit a corporate insider from using non- public information to buy or sell stock. Most cases involving violations of these laws are brought before federal courts because the federal law governing this conduct is extensive. The federal law, which is essentially an antifraud statute, states that anyone who knowingly or recklessly misrepresents, omits, or fails to correct a material or important f act that causes reliance in a sale or purchase, is liable to the buyer or seller. Those with inside information GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 234 CORPORATIONS must either disclose the information or abstain from buying or selling. Permutations Corporations do not represent the only, or necessarily the best, type of business. Several other forms of business offer varying degrees of organizational, financial, and tax benefits and drawbacks. The selection of a particular form depends upon the investors’ or owners’ objec- tives and preferences, and upon the type of business to be conducted. A partnership is the simplest business organization involving more than one person. It is an association of two or more people to carry on business as co-owners, with shared rights to manage and to gain profits and with shared personal liability for business debts. A SOLE PROPRIETORSHIP is more or less a one-person partnership. It is a business owned by one person, who alone manages its operation and takes its profits and is personally liable for all of its debts. A limited partnership is a partnership with two or more general partners, who manage the business and have personal and unlimited liability for its debts, and one or more limited partners, who have almost no management powers and whose liability is limited to the amount of their investment. In a LIMITED LIABILITY COMPANY , the limited liability of a limited partnership is combined with the tax treatment of a partnership, and all partners have limited liability and the authority to manage. This is a relatively new business form. A corporation thus provides limited liability for shareholders, unlike a partnership, a sole proprietorship, or a limited partnership, each of which exposes owners to unlimited liability. A corporation is taxed like a separate entity on earnings, out of which the corporation pays dividends, which are then taxed (again) to the shareholders; this is considered double TAXA- TION . Partnerships and limited partnerships are not taxed as separate entities, and income or losses are allocated to the partners, who are directly taxed; this “flow-through” or “pass- through” taxation allocates income or losses only once. Corporations centralize management in the directors and officers, whereas partner- ships divide management among all partners or general partners. Corporatio ns can continue indefinitely despite the death or withdrawal of a shareholder; partnerships and limited partnerships, however, dissolve with the death or withdrawal of a partner. Shareholders in a publicly held corporation generally can sell or transfer their stock without limitation. Holders of interest in a partnership or limited partner- ship, however, can convey their interest only if the other partners approve. Corporat ions must abide by significant formalities and must cope with a great volume of paperwork; partnerships and limited partnerships face few formalities and few limitations in operating their business. New Issues Faced by Corporations Corporations in the United States have suffered a series of major fiascos in recent years that have cost investors and employees billions of dollars and have eroded public confidence in the governance of major corporations. During the mid to late 1990s, the U.S. economy grew in record numbers, much to the delight of investors and the public in general. Adding to this elation was the success of Internet-based companies, known generally as “dot-coms.” Business com- mentators and the general press referred to this collective success as the “dot-com bubble.” The “bubble” burst during the early part of 2000. Marketing analysts in 1999 predicted that the enormous flow of capital, coupled with a limited range of business models that tended to copy from one another, would lead to a severe downturn or shakedown. Early in 2000, stock in several of these companies sank rapidly, leading to hundreds of BANKRUPTCY filin gs and thou- sands of employees losing their jobs. Although not all of the companies shut down, entrepre- neurs and investors have been weary to follow this model since the collapse. Confidence in American corporations de- creased further with a series of corporate failure based largely upon mismanagement by directors and officers. In 2001 Enron Corporation, a large energy, commodities, and service company, suffered an enormous collapse that led to the largest bankruptcy in U.S. history. Many of the company’s employees lost their 401(k) retire- ments plans that held company stock. The controversy also extended to the company’s auditor, Arthur Andersen, L.L.P., which was accused of destroying thousands of Enron documents. Enron reported annual revenues of $101 billion in 2000, but stock prices began to fall throughout 2001. In the third quarter of 2001 alone, Enron reported losses of $638 million, GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 235 leading to an annou ncement that the company was reducing shareholder equity by $1.2 billion. The SEC began an inquiry into possible conflicts of interest within the company regarding outside partnerships. The SEC investigation became formal in October 2001, and initial reports focused on problems with Enron’s dealings with partnerships run by the com- pany’s chief financial offer. Many additional allegations continued to surface throughout November 2001, including rumors suggesting that company officials sought the assistance of top-level White House officials, including Treasury Secretary Paul O’Neill. In December 2001, Enron’s stock prices fell below $1 per share in the largest single-day trading volume on either the New York Stock Exchange or the NASDAQ. Because the company’s Piercing the Corporate Veil W hen a corporation is a sham, engages in FRAUD or other wrong- ful acts, or is used solely for the personal benefit of its directors, officers, or share- holders, courts may disregard the sepa- rate corporate existence and impose personal liability on the directors, offi- cers, or shareholders. In other words, courts may pierce the “veil ” that the law uses to divide the corporation (and its liabilities and assets) from the people behind the corporation. The veil creates a separate, legally recognized corporate entity and shields the people behind the corporation from personal liability. In these cases, courts look beyond the form to the substance of the corpora- tion’s actions. The facts of a particular case must show some misuse of the corporate privilege or show a reason to cut back or limit the corporate privilege to prevent fraud, misrepresentation, or illegality or to achieve equity or fairness. Courts traditionally require fraud, illegality, or misrepresentation before they will pierce the corporate veil. Courts also may ignore the corporate existence where the controlling shareholder or shareholders use the corporation as merely their instrumentality or ALTER EGO , where the corporation is undercapi- talized, and where the corporation ignores the formalities required by law or commingles its assets with those of a controlling shareholder or shareholders. In addition, courts may refuse to recognize a separate corporate existence when doing so would violate a clearly defined statutory policy. Courts may pierce the corporate veil in TAXATION or BANKRUPTCY cases, in addition to cases involving plaintiffs with contract or tort claims. Federal law in this area is usually similar to state law. The instrumentality and alter ego doctrines used by courts are practically indistinguishable. Courts following the instrumentality doctrine concentrate on finding three factors: (1) the people behind the corporation dominate the corporation’s finances and business prac- tices so much that the corporate entity has no separate will or existence; (2) the control has resulted in a fraud or wrong, or a dishonest or unjust act; and (3) the control and harm directly caused the plaintiff’s injury or unjust loss. The alter ego doctrine allows courts to pierce the corporate veil when two factors exist: (1) the shareholder or shareholders disregard the separate cor- porate entity and use the corporation as a tool for personal business, merging their separate entities with that of the corpo- ration and making the corporation merely their alter ego; and (2) recogniz- ing the corporation and shareholders as separate entities would give court ap- proval to fraud or cause an unfair result. It may appear that a corporation owned by one or two persons or a single family would almost automatically lose its separate legal existence under these doctrines, but this is not necessarily so. A sole owner of a business, for example, can incorporate herself or himself, or the business; issue all shares to herself or himself; and set up dummy directors to follow the necessary corporate formali- ties. However, the sole shareholder may lose the protection of limited liability— just as any other corporation would—if the corporate affairs and assets are confused or commingled with personal affairs and assets, if the sole shareholder abuses her or his control, or if the sole shareholder ignores the necessary corpo- rate formalities. When courts ponder piercing the corporate veil, they consider undercapi- talization to exist when a corporation’s assets or the value it receives for issuing shares or bonds is disproportionately small considering the nature of the business and the risks of engaging in that business. Courts assess undercapita- lization by examining the capitalization at the time the corporation was formed or entered a new business. For example, if a corporation that faces or may face obligations to creditors and potential lawsuits has received only a token or minimal amount for its shares, or has siphoned off its assets through dividends or salaries, courts may find undercapita- lization. Such corporations are called shells or shams designed to take GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 236 CORPORATIONS employees’ 401(k) plans were tied into company stock, these employees lost their retirement plans. Concerns over corporate governance con- tinued to dominate business news in 2002, as WorldCom, Inc., the second-larg est long- distance provider in the United States, filed for bankruptcy. Like Enron employees, World- Com’s employee 401(k) plans held company stock, and by 2003, the value of these plans had decreased by 98 percent from their value in 1999. Moreover, similar to the Enron fiasco, many allegations focused upon the accounting methods that WorldCom’s accountants employed. The company’s board of directors and chief executive officer expressed “shock” that the company had misstated $38 billion in capital expenses and that the company may have lost money in 2001 and 2002 when, instead, it had claimed a profit. advantage of limited liability protections while not exposing to a risk of loss any of the profits or assets they gained by incorporating. The undercapitalization doctrine es- pecially comes into play when courts must determine who should bear a loss—a corporation’s shareholders or a third person. This determination usually depends on whether the claim involves a contract or a tort (civil wrong or injury). In contract cases, the THIRD PARTY usually has had some earlier dealings with the corporation and should know that the corporation is a shell. So, unless there has been deception, courts typically find that the third party assumes the risk and should suffer the loss. In tort cases, the third party normally has not dealt voluntarily with the corporation. Courts thus must decide whether the owners of the business can shift the risk of loss or injury off themselves and onto the innocent general public simply by creat- ing a marginally financed corporation to conduct their business. Courts may disregard the separate corporate existence when a corporation fails to follow the formalities required by corporation statutes. Courts often cite the lack of corporate formalities in finding that a corporation has become the alter ego or instrumentality of the controlling shareholder or shareholders. For example, a court may justify piercing the corporate veil if a corporation began to conduct business before its incorpo- ration was completed; failed to hold shareholders’ and directors’ meetings; failed to file an annual report or tax return; or directed the corporation’s business receipts straight to the controlling shareholder’s or share- holders’ personal accounts. Courts also may ignore the corporate existence when a corporation’s funds or assets are commingled with the control- ling shareholder’s or shareholders’ funds or assets. For example, they may pierce the corporate veil when no sharp dis- tinction is drawn between corporate and PERSONAL PROPERTY; corporate money has been used to pay personal debts without the appropriate accounting, and vice versa; the controlling shareholder’sor shareholders’ personal assets have been depreciated along with corporate assets; or the controlling shareholder or share- holders have endorsed company checks in their own name. Many times, a controlling shareholder is itself a corporation: The controlling shareholder is the parent corporation, and the controlled corporation is a subsid- iary. In some circumstances courts may pierce the corporate veil protecting the parent and hold the parent liable for the subsidiary’s obligations. This happens where the subsidiary loses its independent existence because the parent dominates the subsidiary’s affairs by participating in day- to-day operations, resolving important policy decisions,making business decisions without consulting the subsidiary’s direc- tors or officers, and issuing instructions directly to the subsidiary’semployeesor instructing its own employees to conduct the subsidiary’sbusiness. Courts also hold the parent liable where the parent runs the subsidiary in an unfair manner by allocating profits to the parent and losses to the subsidiary; the parent represents the subsidiary as a division or branch rather than as a subsidiary; the subsidiary does not follow its own corporate formalities; or the parent and subsidiary are engaged in essentially the same business, and the subsidiary is undercapitalized. A final scenario in which courts may pierce the corporate veil involves an enterprise entity, which is a single business enterprise divided into separate corporations. For example, a taxicab enterprise may consist of five corpora- tions with two taxis each, a corporation for the dispatching unit, and a corpora- tion for the parking garage. All the corporations, though separate, essentially engage in a single business—providing taxi service. Courts often harbor suspicions that such arrangements are made in an attempt to minimize each corporation’s assets that would be subject to claims by creditors or injured persons. Courts often will, in essence, put the corpora- tions together as a single entity and make that entity liable to a creditor or injured person, perhaps because treating them as separate entities is unfair to those who believe they really form a single unit. FURTHER READINGS Bainbridge, Stephen M. 2001. “Abolishing Veil Piercing.” The Journal of Corporation Law 26 (spring): 479–535. Huss, Rebecca J. 2001. “Revamping Veil Piercing for all Limited Liability Entities: Forcing the Common Law Doctrine into the Statutory Age.” University of Cincin- nati Law Review 70 (fall): 93–135. Roche, Vincent M. 2003. “Bashing the Corpo- rate Shield: The Untenable Evisceration of Freedom of Contract in the Corporate Context.” The Journal of Corporation Law 28 (winter): 289–312. GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 237 . Contract in the Corporate Context.” The Journal of Corporation Law 28 (winter): 289 31 2. GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 237 . combinations are consen- sual. Often, an aggressor corporation will use takeover techniques to acquire a target GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION CORPORATIONS 233 corporation. Aggressor. net assets. Statutes allow corporations to create different GALE ENCYCLOPEDIA OF AMERICAN LAW, 3RD E DITION 232 CORPORATIONS classes of common stock, with varying voting power and dividend rights. A