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Formation - Paper


See Also:

Foundations of Law: Formation - Acts
Foundations of Law: Formation - People

Terms:

Annual Meeting:
A firm’s annual meeting is where the shareholders elect their new board each year. More about the nuances of the board election process will be discussed in a later chapter. The annual meeting is critical for the company. It must be held, and the shareholders must be allowed to voice their concerns.

Quorum:
A quorum specifies a number of individuals – either shareholders for shareholder votes or board members for board votes – that must be present in order for business to be conducted. In the case of shareholder voting, a typical quorum requirement might read as follows: “The quorum for the vote on this topic requires that a majority of shares outstanding and entitled to vote on this issue must be present.” This translates to mean that for the specific issue being voted on, 50% of the shares plus one additional share must be present at the vote for the vote to be effective. If the quorum requirement is not met, then any resulting vote is invalid and will not obligate the company.

Stock Classes and Rights:
We will cover more about stocks in later chapters, but a basic understanding is necessary at this point. Stocks are more than pieces of paper that say how many shares an individual owns. In truth, stocks represent the full bundle of rights held by that shareholder, with those rights varying among shareholders. Different combinations of these rights result in independent “classes” of stock that represent that set of rights. Any right which confers an advantage to one class vis-à-vis another class is said to be a “preference.”

Typical rights indicated on stocks include the following:

  • Voting
  • Dividend / Dividend Preference
  • Accumulated Dividends (where if no dividend is paid to the shareholders, an amount is calculated anyway which will be due to the shareholder if and when the company does pay a dividend)
  • Participating Dividends
  • Dissolution Preference

Par Value Stock / No Par Stock:
“Par” as applied to stock indicates an amount of money paid as part of purchasing a share of stock at its original issuance, which is held “in reserve” by the company. That is to say that this amount of money cannot be paid out by the company as a dividend, but must be retained by the company for payment to creditors or stockholders in the event of dissolution. No-par stock is issued without any predefined “par” amount. In the modern context, most companies choose to issue no-par stock with the board acting, after the issuance, to designate a certain percentage or dollar value of the total issuance to a par account on the company’s balance sheet.

Super Majority Clauses:
In some cases, a company might choose to require a quorum or vote requirement that calls for greater than 50% of the shares to be accounted for in the vote. So, for example, a company might require that a super majority vote of 75% of shares entitled to vote, vote in favor of any amendment to the Articles of Incorporation. In other words, rather than a “simple majority” of 50% of shares voting for the change to the Articles, the company has required that 75% of the shares allowed to vote do so in favor of the alteration. In some cases, companies might even require unanimous voting on certain issues.

Similarly, some states allow for votes and quorums of less than 50% of the shareholders or directors. However, states that have such allowances often stipulate that the percentage cannot be reduced beyond a specific amount (generally 33%).

Outside vs. Inside Directors:
More will be said later about outside versus inside directors. For now, a working definition is simply that inside directors hold a significant stake– typically a job or substantial investment - in the company, while outside directors hold no such economic or personal interest.

Formation: Paper

As was discussed in the previous section, one way to think about the incorporation process is to remember the three pieces of the process: people, paper and acts. In this section, we will discuss some of the filings that need to be made with various state and local agencies in order to comply with the law and ensure that the corporation is properly formed.

In this section, we will discuss several of the major items that will be created and, in most cases, filed. Note, however, that this is not inclusive and varies from state to state. As such, the legal professional engaged in the incorporation process should consult with attorneys (either in his own firm or elsewhere) along with any documentation provided by the state to ensure that all required material is completed.

Articles of Incorporation

The Articles of Incorporation (sometimes also referred to as a Certificate of Incorporation) for a company represent the basic contract that exists between the corporation and the state of its incorporation; as such, the Articles are filed with the state (usually the Department of State or State Secretary) and are available for review by the public. This same document also serves as a contract between the corporation and its shareholders. As a contract, the Articles define the basic nature of the corporation as well as providing some specific rules about how the corporation chooses to govern its operation. See 8 Del. C. § 102.

Violation of this contract by the corporation may result in potential liability for the corporation or its directors and officers. See N.Y. Bus. Corp. Law 203.

The basic elements of the Articles include: the company’s name and address, the number of shares the corporation is allowed to issue, the address of the corporation’s initial registered office and the name of the corporation’s registered agent for service of process, and the name and address of each incorporator. In addition, the Articles may also designate the duration of the company (if it is something other than perpetual) and the purpose of the company. Very general purposes such as “incorporated to conduct all lawful business” are generally allowed.

EXAMPLE: Big Co. is sued by its shareholders for performing business acts outside the scope of the business. Big Co’s executives say that they did not know that the business they were conducting was outside the scope of their power. When the litigation reaches court, the judge points out that the executives should have known they were acting outside of their powers as the Articles of Incorporation for Big Co., which were filed with the state, specifically limit the manner in which executives may act. 

See Rowe v. Franklin County, 318 N.C. 344 (N.C. 1986).

The Articles also indicate the capital structure of the firm. This includes the number of shares that the company is allowed to issue (authorized stock), the nature of this stock as to voting, class, and dividend rights, and any other elements of the stock which are relevant (including preferences in dilution as to dividends, etc. and the par of the stock). Note, that while the list above is fairly inclusive, different states may require additional information that must be provided in the Articles. See, e.g., N.Y. Bus. Corp. Law §§ 301-308.

Generally, a company’s articles of incorporation, while not necessarily complex, need to be designed with some care. This is particularly true for the capital structure of the firm and the nature of each class of stock and its associated rights. While amendments to the Articles of Incorporation are permitted in every state, such amendments will require, in most cases, votes by the board and shareholders (perhaps even a super majority of the shareholders) and will entail added cost and delay. As such, the well advised company will try and get it right the first time by specifying the exact design of the corporation in this opening stage. This is especially important because a corporation may have a complex system of allocating rights and powers among shareholders. For example:

EXAMPLE: C Corp has stock classes designated as classes X, Y, and Z. Class X is the class of “common stock” indicating that the stock has 1 vote per share, unlimited rights to dividends (payments of cash by the company) and no preference on dissolution (bankruptcy or sale of the company). Class Y was given an extended voting preference whereby each share of Class Y is entitled to ten votes on a particular issue. Finally, Class Z has a preference on dividends or dissolution, where, for example, Class Z shareholders get paid two times the dividends of everyone else or get their distribution from a bankruptcy before other shareholders.

Thus, care should be taken when drafting the original certificate of incorporation.

Corporate Bylaws

While no state specifically requires the formation of corporate bylaws, virtually every U.S. company of substantial size will create bylaws concurrent with the company’s Articles. See 8 Del. C. § 109. While not a binding contract with the state in the way that the Articles are, the bylaws do represent a form of contract with the shareholders. As such, the company should understand and consider the ramifications of each bylaw that it adopts.

EXAMPLE: After incorporating LMN Co., its incorporators hold their first meeting and draft bylaws for the company. They choose to place the bylaws on file with the state. This is fine, but states only require the filing of the Articles of Incorporation, not the bylaws.

In essence, the bylaws of a company contain the internal rules and regulations that the company has chosen to follow. While there is no specific formula for what it is included in a company’s bylaws, there are some typical items that often come up.

  • Voting: The bylaws may specify the rules the company will follow as to who is allowed to vote, what issues are to be voted on, and when votes will occur. Specifically, bylaws will often state when the annual shareholder meeting will occur (when the Board is elected) and will discuss how votes should be conducted. In addition, voting, as it applies to the Board (i.e. not just the shareholders), may be discussed in the bylaws and requirements as to voting – for example if “super majority” voting or certain quorum sizes are required for votes on certain issues – will be indicated.
  • Board: The bylaws may indicate that only people with a specific business or educational background are allowed to run for the board. While most companies leave the field of individuals fairly open, recent laws requiring a certain number of “outside directors” on the board, and in addition to certain requirements relating to directors’ knowledge of accounting and legal rules, may force companies to clearly stipulate as to required characteristics required of candidates. See, e.g., 24-A M.R.S. § 3489.

EXAMPLE: Given the recent spate of accounting scandals, Vavoom Co.’s shareholders pass a bylaw indicating   that any candidate for a position on the company’s board must be a CPA. This bylaw is totally legal and within the power of the shareholders to pass.

  • Other issues: A variety of other issues, such as how meetings will be conducted, further rights and responsibilities on share ownership, and rules regarding corporate business or dissolution may also be discussed in the bylaws.

Bylaws are generally amended with votes taken of the shareholders. In certain circumstances, the board itself is allowed to create bylaws for the company. Bylaws created by the board are often subject to the constraint that any such bylaw may be struck down by a vote of the shareholders. See 8 Del. C. § 110. Additionally, to the extent that the bylaws conflict with the company’s Articles of Incorporation, the nearly universal rule is that the Articles, not the bylaws, will be the controlling rule for the firm.

Employer Identification Number

Paralegals are often called on to request a tax Employer Identification Number (EIN) for a new corporation from the Internal Revenue Service (IRS). If the company is to have any employees at all, then an EIN is required by the taxing authorities to insure that the company complies not only with the various tax requirements imposed by the state and federal government, but also ancillary concerns such as state programs like worker’s compensation and other employee benefit schemes. 

With the evolution of modern technology, the process of applying for an EIN is virtually hassle-free. Typically, all that is required is that the individual requesting the EIN log on to the IRS web page and fill out the necessary forms. Certain information, such as the incorporators’ social security numbers, may be required, but generally, the information is fairly straightforward.

EXAMPLE: After forming his corporation and operating it for several months, Merv decides to hire Sal as a manager to keep the company’s books. Merv realizes that he needs to handle withholding taxes for Sal from Sal’s pay, but is not sure how that is done. He goes to XYZ Law firm who tells him that he needs to apply for an EIN with the Internal Revenue Service and to separately withhold and report Sal’s taxable income on a form W2.

Foreign Registered Company

Companies that do business in a state are typically required to register with the Secretary of State or Commerce Department in that state. The amount of business done by the corporation in the state in order to trigger this requirement is often very moderate. However, the business done in a state must be more than an isolated transaction or two for there to be a filing requirement. See Coyle v. Peoples, 349 A.2d 870 (Del. 1975). The registration process, often known as registration of a “foreign” company, (where foreign does not mean “international” but rather, from a state other than the one where registration is occurring) is generally a simple process, and is accomplished by filing a single form along with providing proof of “good standing” from the company’s state of incorporation. See 8 Del. C. § 371. 

The reason for the registration requirement for a foreign company is quite simple. If an individual in a state other than the company’s state of incorporation wishes to sue the company, that individual may accomplish that goal more quickly if the company is registered in his/her state. The registration of a foreign corporation will entail the company designating the Secretary of State in the host state as its agent for service of process. In that way, the individual suing the company need only go to his/her Secretary of State to serve the litigation papers on the company, and the company may then be required to appear in court in the host state. 

In most cases, failure to register in the host state will have a two-tiered result. First, fines will likely be applied to the company if and when it finally registers. More importantly is the fact that while, even if the company fails to register, an individual in the host state may sue the company, the company itself may NOT sue (or counter-claim) in the host state until it registers. See 8 Del. C. § 383.

EXAMPLE: Huge Co., a New York State incorporated company, has been selling its high-fashion shoes at trendy Las Vegas hotel shops for the last seven years without registering as a foreign corporation in Nevada. Helen, wearing one of Huge Co.’s shoes, is injured when the six inch heel of the shoe breaks off due to shoddy workmanship. Helen sues Huge in a Nevada court. Huge Co. wants to counter claim that Helen had acted negligently herself by filing a hole through the heel that she thought would make the shoe look better. Huge will be denied the opportunity to assert this claim until it files, and will be fined upon that filing.

Stock Certificates

One final set of papers that cannot be overlooked in the incorporation process is the issuance of the requisite stock certificates to the new firm’s owners. See, e.g., Wis. Stat. § 185.21. While this is a fairly simple process, failure to properly create and issue the certificates can result in myriad of problems for the company and its owners when the shares are later transferred.

Generally, there are a variety of services available for the creation of stock certificates, and many mid-to-large size law firms that work with companies will also have internal means for certificate creation. In the process of making the certificates, however, the legal professional needs to be very aware that state and federal ordinances are complied with as to any disclosures that must be made on the face and/or reverse side of the certificates. While this may sound like “nitpicking,” all such laws which require notice as to things like transferability and rights of the shareholder must be complied with for the certificate to validly represent the owner’s interest.