Corporations: Shareholders, Liability, and Litigation

By Paul Share

The prototypes of corporations go back to the royally chartered entities formed to colonialize the Indies and the new world, especially to develop colonies like New Amsterdam. These were projects too expensive and risky for any one person to bear the risk of—especially if one’s whole net worth were available to cover unforeseen costs.  The format of these chartered entities was refined for use in more typical commercial enterprises such as railroads. In the U.S., corporations developed as early as the 1790s as the vehicle for banks to conduct business.

Today, in the U.S., corporations are governed by state law.  This means that there are over 50 different codes of corporate law.  While these codes tend to be similar, there are many small and some not-so-small differences among them.  So, our comments on corporations, by necessity, are general and represent a view from 50,000 feet above.

One of the key characteristics of a corporation is “limited liability.”  This means investors are typically only liable to pay, in full, the subscription price for their ownership interest.  It is important to note, however, that there are atypical situations in which shareholders of a corporation may not be protected from liability.

For instance, a creditor of a corporation can sue shareholders of a corporation for the corporation’s debts (referred to as “piercing the corporate veil”) if:

• The corporation did not maintain the corporate “formalities” (discussed below);
• The capitalization for the corporations was grossly inadequate for the business being conducted;
• The shareholders intermixed personal funds and expenses with the funds of the corporation.

However, a creditor trying to pierce the corporate veil has a heavy burden of proof, and the shareholders of an entity that follows the rules—and advice of legal counsel—are unlikely to be at risk.

The rules for corporations are too numerous and varied among states to discuss in great detail, but there are some basics that tend to be true in most, if not all jurisdictions.

Ownership interests in a corporation are called “shares of stock”.  Their owners are called “shareholders” or “stockholders”. The basic rights and privileges of shareholders (and different classes of shares), along with certain basic information like the corporation’s name and name and address of the corporation’s registered agent, are spelled out in a certificate of incorporation (or amendment) filed in the state where the corporation is formed.

The shareholders of the corporation elect a board of directors.   The number of directors and timing of elections is included in a set of rules adopted by the shareholders (or in some cases, the directors) called the corporation’s “By-Laws”.  Directors approve major corporate decisions, such as issuance of shares and major commitments.   Such approval is typically provided by a vote of directors at board meetings, although directors in most states may properly approve a corporate action without a formal meeting by executing a written consent signed by all of the directors.

The directors are also authorized to elect corporate “officers” (such as the President) and to delegate duties and rights to each such officer, such as making day-to-day decisions of the corporation and signing contracts on behalf of the corporation.

Many states have a provision for so-called “Closed Corporations”.   A corporation that qualifies as a closed corporation, which usually entails a small number of shareholders who all agree to this status, and which makes the election according to the state’s provisions, enjoys relaxed or, in some cases, eliminated required formalities for corporate governance.

In some cases, major decisions require the approval of the shareholders of the corporation as well as the directors.  Such approval is effected by the vote of shareholders at shareholder’s meetings. In some states, shareholders may approve matters by written consent of shareholders—and in some states, this consent does not have to be unanimous.

The various corporate rules, such as the timing of the meeting, determination of who can call a meeting, the required notice to be given of meetings, the number of directors or shareholders required to attend in order for there to be a “quorum” allowing the voting to be official, and more, are all detailed in the corporation’s by-laws. The minutes of directors and shareholder meetings and the written consents of the directors or shareholders are kept in a corporate “minutes” book which can be physical or electronic.

In addition to the requirement to maintain corporate formalities, corporations are taxed differently than sole proprietorships and partnerships.   This can be an advantage in some situations and disadvantageous in others.   We will discuss the advantages and disadvantages in subsequent blog posts.

Thank you for reading this post: we hope you enjoyed it and got some useful information to help you on your entrepreneurial journey. If you have any questions or would like to continue the conversation with our firm, please call our office at (866) 954-7687 or email to info@warren.law  to schedule a free consultation regarding your business.