Module 5: A Practical Application

Overview

In the first four modules, we covered what business governing agreements are, their relationship to state and federal laws and basic and more advanced provisions that the drafters can include in them. In this final module, we will apply these principles to a simple set of generic corporate bylaws.  

This will be an issue-spotting exercise, beginning with sample provisions from templates followed by suggested changes based on applicable state laws. For our scenario, we’ll choose a newly-created Wyoming corporation, since business-friendly rules have made Wyoming an up-and-coming state for incorporations and business formations. Similar thought processes can be applied to the laws of any state.

The agreement drafters in our exercise are using a template they found on the Internet as the basis for the company’s bylaws. We will examine some of the possible problem areas to look out for when relying on templates, including:

·         Missing information

·         Provisions that should be in a different document

·         Provisions that are too narrow in their application or definition

·         Provisions that apply inapplicable legal standards of conduct on the parties

As we examine the selected bylaw sections and the relevant governing laws, we’ll identify potential legal problems and how the governing agreement drafters might modify the document to avoid those problems.

An important goal of a governing agreement is to anticipate and avoid problems. The more specific the agreement can be in its problem avoidance terms and conditions, the better it will achieve this defensive purpose. Governing agreement templates that attempt to satisfy the requirements of every state’s laws can have difficulty because, to be universal in their application, they must be generic. It is up to the people using the template to know where the coverage gaps are and how to fill in the details to make the agreement complete under the applicable state law.  

Another consideration when choosing to use a general agreement template is to understand in advance how the creators of the business want to structure, operate, and, if need be, to defend it. State laws allow governing agreements to creatively reflect the needs and desires of the parties, such as by placing limits on the abilities of shareholders to bring derivative lawsuits against the corporation or directing the appropriate forum in which to resolve intra-company disputes, but these will likely not be in a basic template.

In short, what users of a universal template will likely start with is a skeletal framework of the most elemental and non-controversial provisions. To make it a complete governing agreement, it is more important to know what such an agreement does not say than what it does say.

Examples of Missing Provisions

With these considerations in mind, let’s examine some shareholder provisions with an eye toward what may be missing and need to be added.

    Example: Adding Flexibility to Shareholder Meeting Provisions

Bylaws commonly refer to two kinds of shareholder meetings: annual and special. One question that applies to both types is where the meeting will take place. Our template offers the following minimal guidance:

All shareholder meetings must be held at the corporation’s principal office or other place determined by the Board of Directors.  

For a small business, such as a corporation with few or even a single shareholder, holding a shareholder meeting at the corporation’s office poses little problem. But what if the corporation is larger, with shareholders who reside in locations distant from the corporate headquarters?

Companies can accommodate shareholders for whom making a pilgrimage to the company headquarters would be inconvenient or preclude their attendance. An increasingly popular option is to use online meeting services, including video conferences or teleconferences. Wyoming law, for example, permits such remote meetings.[1] However, though the generic template provision anticipates that the board can change the physical meeting location, it does not anticipate virtual meetings. Leaving out the virtual meeting option when the template otherwise anticipates different meeting venues can be interpreted as precluding virtual meetings.

Now consider how a minor change to the template text can provide the board with the flexibility to hold meetings in a variety of physical and virtual locations:

All shareholder meetings may be held at the corporation’s principal office or other place determined by the Board of Directors. The Board, in its sole discretion, may conduct any shareholder meeting via remote electronic means. 

Consider also the following template provision governing the conduct of special shareholder meetings:

Special shareholder meetings, for any purpose, may be called at any time by the President, Board of Directors, or the holders of at least one-tenth of all shares entitled to vote at the meeting.

For special meetings, Wyoming law restricts what the shareholders can discuss and vote upon to those topics that the notice of meeting establishes in advance.[2] The template does not make this restriction explicit, however, and that raises the possibility that a special meeting can go outside of its proper scope if the attendees are unaware of the legal restriction. This could result in challenges to actions taken by the shareholders in a special meeting.

The drafters can minimize the possibility of a special meeting going beyond its authorized boundaries by making a simple addition to the template:

Special shareholder meetings, for any purpose, may be called at any time by the President, Board of Directors, or the holders of at least one-tenth of all shares entitled to vote at the meeting. The notice of a special shareholder meeting shall state the business matters to be discussed at the meeting. The shareholders shall not consider, nor vote upon or in any other way take action on matters other than those set forth in the special meeting notice.

This revised text makes it clear for both the board of directors and the shareholders what needs to be done to provide proper notice for a special shareholder meeting and makes it less likely that a special meeting will be subject to challenge afterwards based on an inadvertent violation of Wyoming law.

    Example: Avoiding Invalid Partial Share Certificates and Scrips

If the corporation allows it, a shareholder can own a fractional share. In some cases, a corporation can issue a written note (a “scrip”) that authorizes its bearer to trade it for stock in the company. The legality of using partial shares or scrips are usually not a potential problem when drafting bylaws, but, in Wyoming, to be valid, both shares and scrips must adhere to specific content requirements.[3]

Our template provision for partial shares and scrips states:

The Corporation may issue fractions of a share which the holder may use to exercise voting rights, to receive dividends, and to participate in any of the Corporation’s assets in the event of liquidation, and to issue scrips in registered or bearer form which entitles the holder to receive a certificate for the full share upon surrender of such scrip aggregating a full share.

The template does not include any information on what needs to be included in fractional share certificates or scrips to ensure their validity, nor does it reference the applicable Wyoming statutes. This makes it possible for the corporation to make a technical error that can bring the validity of a certificate or scrip into question.

The fix to this section of the bylaws is simple: borrowing from the relevant statutes to make the validity requirements clear. All that is needed is to add the following to the end of the provision:

All fractional share certificates and scrips shall state on their face the name of the corporation and that it is organized under the laws of the State of Wyoming, the name of the person to which they are issued, and if applicable the number, class of shares and series of stock they represent. In addition, any scrip shall be conspicuously labeled with the word “scrip.”

Provisions in the Wrong Document

We have focused on governing agreements in this course, but it is important to know that other documents can also bear on the question of how to structure the company. Articles of incorporation for corporations and articles of organization for limited liability companies are examples of instruments that can – or are required to – contain terms that might be out of place in a generic governing agreement.

Because the makers of universal governing law templates often do not have the time or resources to check these forms against the requirements of each state, sometimes a governing agreement provision can raise validity questions when it is otherwise uncontroversial. Consider the following generic bylaw section for share certificates:

Certificates of stock must be issued in numerical order. Each shareholder is entitled to a certificate signed by the President or a Vice President and the Secretary or Assistant Secretary. The certificate may be sealed with the Corporation’s seal or a facsimile thereof.

There is nothing “wrong” with this provision as written, but Wyoming law makes it plain that information establishing the number of shares, their classes and their series must appear in the articles of incorporation and not the bylaws.[4] Having this provision in the bylaws may not affect the validity of the bylaws, but for the same information to be missing from the articles of incorporation can create a problem with that document.

Does the Agreement Have Provisions That are Too Narrow in Scope?

The counterpart of missing or incomplete information in a template is a provision that is too confined in its application. This is not always a problem with respect to compliance with state laws, but it can needlessly restrict the ability of the company to act.  

    Example: What Constitutes an Emergency? 

Consider the following bylaws template provision:

The Board of Directors may adopt emergency Bylaws, subject to repeal or change by the shareholders, which operate during any emergency in the Corporation’s conduct of business resulting from an attack on the United States or a nuclear or atomic disaster.  

It is always good practice to read template-based agreements carefully, including what should be seldom-or-never used sections. Sometimes an otherwise well-drafted template can contain provisions the phrasing, intent and effect of which are questionable. Here, aside from vague wording (for example, what is the difference between a nuclear disaster and an atomic one?) the bylaws narrowly define an “emergency” as these three possibilities. But what about other possibilities that are more likely to occur, such as weather-related disasters?  

By leaving out this prospect while mentioning others, these bylaws may be read conservatively. This can create confusion about whether an event like an earthquake or hurricane could qualify as an “emergency.”[5] Wyoming law defines an emergency as an “extraordinary event” that precludes a quorum of the board of directors from meeting.

Rephrasing the emergency bylaws provision to make it a better fit could produce the following section:

The Board of Directors may adopt emergency Bylaws, subject to repeal or change by the shareholders, which operate during any extraordinary event that would otherwise prevent a quorum of the Board of Directors from being able to meet.

Does the Agreement Apply the Proper Legal Standards to the Parties? 

    Example: Imprecise Indemnification Provisions 

A corporation’s board of directors can indemnify a director or officer against legal expenses they incur in connection with defending or settling a legal action arising from their duties to the company. State laws can affect how a corporation exercises this power. The challenge for the drafters of the bylaws is to make sure that the indemnification provisions match the requirements of those laws. Here is a simple template-based indemnification provision:

The Corporation will indemnify directors or officers of the Corporation against expenses incurred by them in connection with the defense or settlement of any action in which they might be made party by reason of being or having been directors or officers. This indemnification will not apply to any matter to which such director or officer is adjudged in such action to be liable for negligence or misconduct in the performance of duty.  

Here, the standard of negligence for both directors and officers in the performance of their duties is to avoid being negligent or engaging in willful misconduct. Wyoming law, however, applies a different standard for directors, and a standard for officers that varies in some ways from that for directors.

For corporate directors, Wyoming requires them to adhere to three standards: good faith, reasonable belief that their actions are consistent with the company’s interests and reasonable belief that those actions do not violate any criminal laws.[6] Although some of these standards are similar to those of the template provision, the template makes no mention of the duty of good faith. Another problem is that in Wyoming law, director indemnification falls under the articles of incorporation and not the bylaws.[7] 

For corporate officers, how Wyoming law treats them for indemnification purposes depends on their status: officers who are also directors are treated the same as directors, while officers who are not directors can be subject to indemnification provisions in the articles of incorporation, the bylaws or a separate resolution by the board of directors.[8]

With these statutory guidelines in mind, the bylaws drafters could modify the document’s indemnification provision as follows:

The Corporation may indemnify officers of the Corporation who are not also directors against expenses incurred by them in connection with the defense or settlement of any action in which they might be made party by reason of being or having been officers. This indemnification will not apply to any matter in which the officer receives a financial benefit to which he or she is not entitled, or to any intentional conduct that results in harm to the corporation or its shareholders or to any intentional violation of criminal laws.

Note that we leave the indemnification of directors to the articles of incorporation, which is why the new bylaws indemnification does not mention directors. The new text borrows from the relevant Wyoming statute, which can save the drafters time in crafting the appropriate terms and help ensure that the indemnification is consistent with the law.

Conclusion  

A carefully considered and properly prepared business governing agreement is more than a simple “file-and-forget” exercise in doing the minimum necessary to comply with legal requirements. For entrepreneurs who are willing to go with a hands-on approach to creating a governing agreement, many Internet-based services exist to provide templates. These documents can vary considerably in price (many basic formats are free) and in how comprehensive they are. Some are state-specific while others are generic. Some are well-written, and others are riddled with spelling errors and mistakes in grammar.

The advantages of these boilerplate templates are convenience, speed of completion, simplicity and low cost compared to creating your own governing agreement with the assistance of an attorney. For simple business structures, such as a one-person LLC or corporation that the owner runs like a sole proprietorship, a no-frills governing agreement can satisfy minimum legal requirements like the need to have a set of bylaws.

For larger businesses with more sophisticated needs, however, a simple template-based governing agreement presents possible drawbacks and even legal risks, including:

1.    A form drawn up for multi-state use might not consider state-specific requirements in the jurisdiction where it is being applied. Worse, the document may not comply with state legal imperatives such as in the case of bylaws that attempt to address matters that should be in the articles of incorporation.

2.    A simple template might lack important provisions that, although their absence may not trigger legal trouble, could, in some situations, still lead to problems in interpreting and applying the governing agreement.

3.    Even state-specific templates might not stay current with changes in the relevant laws.

4.    A one-size-fits-all template can still require the drafters to make extensive changes to the document, negating to some extent the template’s ostensible advantages of simplicity and ease of use.

We’re not discouraging the use of governing agreement templates – they can and do form the basis for many solid bylaws, operating agreements and partnership agreements. It’s just that they should not be overly relied on or considered finished products in need of no review or tweaking. 

Business creators, owners and managers who invest the time and attention to detail to draw up a comprehensive and thorough governing agreement are making an important investment in a business. Whether it is to spend time customizing a template or to create a governing agreement with legal help, the effort spent up front can pay important dividends later on in the form of better profitability, enhanced intra-company personnel relations and even in the continued viability of the company.

Thank you for participating in our course on drafting business agreement. We hope that you are now better equipped to help draft and review such agreements and ensure that they are good fits for businesses and comply with applicable law. Please let us know if you have any questions or feedback.