Members of LLCs and shareholders of corporations generally have limited liability, which means a creditor of the business cannot seek to collect from them personally for the debts of the business beyond the money they have invested in the business. How does this limited liability affect an investor’s willingness to invest in the company? If this liability were not limited, what additional types of things would members/shareholders want to consider before investing? How would that impact corporate financing? (50 to 100 words)
5/10/21 1 BUSINESS LAW 1 FIN 280, SOUTHERN ILLINOIS UNIVERSITY PROFESSOR TRACY PROSSER MODULE 8 CHS. 38 & 39 OF BUSINESS LAW: TEXT AND CASES, CLARKSON, MILLER & CROSS 1 MODULE 8 OBJECTIVES •Describe the characteristics, advantages, and disadvantages of an LLC. •Describe the management options for an LLC. •Describe the characteristics of a corporation. •Describe the main corporate personnel. •Distinguish between domestic, foreign, and alien; public, private, and non-profit; close, S, and C corporations. 2 MODULE 8 OBJECTIVES •Describe the general procedure for forming a corporation and the consequences of not following it. •Describe the concept of limited liability • Explain what it means to pierce the corporate veil and when it can occur. •Distinguish between the two traditional methods of financing through corporate securities: bonds (debt securities) and stocks (equity securities) 3 5/10/21 2 LECTURE 8.1: LIMITED LIABILITY COMPANIES 4 LLCS AND SPECIAL BUSINESS FORMS: LLC Limited liability company (LLC): •A hybrid business entity that combines: • The limited liability of a corporation • The tax advantages of a partnership • Formed and operated according to state statutes 5 LLCS AND SPECIAL BUSINESS FORMS: LLC Member not personally liable in most situations • LLC is separate legal entity from members • Liability is limited to member’s investment Exceptions when member has: •Guaranteed payment of loan to LLC •Disregarded LLC formalities •Used LLC to commit fraud or other wrongdoing 6 5/10/21 3 LLCS AND SPECIAL BUSINESS FORMS: LLC: FORMATION Formation of LLC: •Articles of organization filed with state agency •Members may have preorganization contracts prior to official formation of LLC • LLC is deemed a citizen of its members’ states of citizenship 7 File Articles of Organization with the Illinois Secretary of State https://www.cyberdriveillinois.com 8 LLCS AND SPECIAL BUSINESS FORMS: LLC: ADVANTAGES/DISADVANTAGES Advantages of LLC: • Limited liability of members • Flexibility in tax treatment • Partnership or corporation at LLC’s option • Flexibility in management and foreign investors Disadvantages of LLC: • Lack of uniformity in state law 9 5/10/21 4 LLCS AND SPECIAL BUSINESS FORMS: LLC: MANAGEMENT Management of LLC: •Options for type of management •Member-managed •Manager-managed •May be governed by operating agreement 10 LLCS AND SPECIAL BUSINESS FORMS: LLC: DISSOCIATION AND DISSOLUTION Dissociation: member ceases association with LLC •Similar triggers as partnership: withdrawal, expulsion, court order, incapacity, bankruptcy, death •Similar effects as partnership: no right to manage, no longer agent of LLC, no duty of loyalty, limited duty of care, interest buyout, members may continue LLC, liability for wrongful dissociation 11 LLCS AND SPECIAL BUSINESS FORMS: LLC: DISSOCIATION AND DISSOLUTION Dissolution: end of the LLC •Similar triggers as partnership: members agree to dissolve, event/time specified in operating agreement, court order •Similar effects as partnership: dissolution and winding up 12 5/10/21 5 LECTURE 8.2: CORPORATIONS GENERALLY 13 NOTE-TAKING TIP Shareholder = s/h 14 CORPORATE FORMATION AND FINANCING Corporation: •Legal entity created under state statutes •Owned by shareholders who own shares •Operates under name distinct from its owners •Recognized as a “person” under federal law •Has person’s rights 15 5/10/21 6 CORPORATE FORMATION AND FINANCING: PERSONNEL Corporate personnel: •Board of Directors •Corporate officers • Shareholders •Not personally liable beyond investment unless • Justice requires piercing the corporate veil • Shareholder personally guarantees corporate obligation 16 CORPORATE FORMATION AND FINANCING: EARNINGS AND TAXES Corporate profits can be: • Passed to shareholders as dividends • Retained by corporation as retained earnings • If reinvested, likely to cause higher profits . . . • Which are likely to cause rise in stock price . . . • Which causes higher capital gains to shareholders • All profits subject to corporate taxation •Dividends subject to shareholders’ income tax 17 CORPORATE FORMATION AND FINANCING: EARNINGS AND TAXES Holding companies: • Parent company whose business consists of holding shares of subsidiary companies •Often established in low-tax or no-tax jurisdiction •US subsidiary often transfers investments to holding company, which pays lower taxes on the profits • Subject to US corporate taxation when repatriated 18 5/10/21 7 CORPORATE FORMATION AND FINANCING: LIABILITIES •Criminal liability: liable for fines for criminal acts of agents and employees • Responsible officers may be subject to prison •Tort liability: under agency/respondeat superior theory, liable for torts of agents committed within the course and scope of their employment 19 LECTURE 8.3: CLASSIFICATION OF CORPORATIONS 20 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY LOCATION •Domestic: what a jurisdiction calls a corporation incorporated under its own laws •Foreign: what a jurisdiction calls a corporation incorporated under another jurisdiction’s laws •May require certificate of authority to do business •Alien: what a jurisdiction calls a corporation organized under another country’s laws 21 5/10/21 8 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY PURPOSE • Public: formed by a government to meet some political or governmental purpose • Publicly-held: shares traded in securities market • Private: owned by private persons or entities, not governments, for the purpose of making a profit •Nonprofit: for the purpose other than making a profit 22 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP Ownership classifications: •Close •S corporation •C corporation •Professional corporation •Benefit corporation •Others 23 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP •Close: shares held by only a few people •Often managed like sole proprietorship/partnership • Some states allow flexibility with formalities • Shareholder agreement may • Restrict share transferability • Provide for distribution of shares on shareholder’s death to preserve proportionality 24 5/10/21 9 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP • S: a small corporation that qualifies under Subchapter S of the Internal Revenue Code may elect to be S • Subchapter S: domestic, not member of corporate group, certain types of shareholders, ≤100 shareholders, one class of stock no non-resident alien shareholders • Pass-through tax treatment like partnership 25 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP •C: regular corporation formed to make profit and increase value for shareholders • Treated under Subchapter C of the Internal Revenue Code •Double-taxation 26 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP •Professional: a group of professionals •Doctors, lawyers, dentists, accountants, etc. • “P.C.” or “S.C.” or “P.A.” •May have liability like partnership: each professional liable for malpractice of others within the scope of the business 27 5/10/21 10 CORPORATE FORMATION AND FINANCING: CLASSIFICATION BY OWNERSHIP •Benefit: for-profit corporation that seeks material positive impact on society/environment rather than solely long-term shareholder value •Directors must consider social impact of decisions • Shareholders may sue the corporation if it fails to pursue or create public benefit • Annual report assessing performance compared to third-party standard 28 LECTURE 8.4: CORPORATE FORMATION 29 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Promotional activities: preliminary steps to organize business prior to incorporating • Promoters personally liable for contracts until corporation substituted through novation • Rarely done to any great extend anymore 30 5/10/21 11 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Incorporation: specific to each state, but usually includes: • Selecting a state • Secure corporate name • Prepare articles of incorporation • File articles of incorporation •Hold organizational meeting • If not followed, corporate existence is subject to challenge 31 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Selecting a state: •Consider tax provisions and other regulations •Delaware: historically had least restrictive corporate laws and provisions favoring corporate management •Primary state of business: may be convenient and less costly 32 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Secure corporate name: •Cannot use a name that is the same or deceptively similar to the name of another business in the state • Many states moving toward the less restrictive “distinguishable on the records” standard •Cannot mislead public about corporation’s nature •Must include indication of incorporation (Corp., Inc., Co., Ltd.) 33 5/10/21 12 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Prepare articles of incorporation: Usually must include: May include: • Corporate name • Number of shares • Registered agent • Registered office • Incorporators • Initial board members • Duration • Purpose 34 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS File articles of incorporation • Incorporators sign and file with state official • Pay required filing fee • State official returns file-marked copy to incorporators •Corporation is said to be “chartered” 35 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Organizational meeting: Shareholders will– • Elect directors, if not in articles of incorporation •Adopt bylaws, internal management rules •Consistent with state law and articles of incorporation • Include shareholder voting requirements, board election, director replacement, shareholder/board meetings • Shareholders may amend thereafter •Hire officers and ratify preincorporation contracts 36 5/10/21 13 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Failure to follow proper incorporation procedures: • If substantially complied with procedures, deemed a de jure corporation •Usually state’s filing of articles of incorporation is conclusive proof statutory provisions have been satisfied 37 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Failure to follow proper incorporation procedures: • If there is a substantial defect in formation: • Some states treat as common law de facto corporation if meets three requirements: 1. Statute exists to validly incorporate 2. Parties have attempted to comply in good faith 3. Already doing business as a corporation • Some states deem corporation nonexistent and hold incorporators liable 38 CORPORATE FORMATION AND FINANCING: FORMATION AND POWERS Failure to follow proper incorporation procedures: •Corporation by estoppel: If there is •No attempt to comply with procedure and • Business holds itself out as corporation and • Third parties reasonably rely to their detriment business cannot deny corporate status in lawsuit with the third party 39 5/10/21 14 LECTURE 8.5: SHAREHOLDER LIABILITY 40 CORPORATE FORMATION AND FINANCING: PIERCING THE CORPORATE VEIL When justice requires, courts may pierce the corporate veil to hold shareholders personally liable: •Corporation is used to perpetrate a fraud, circumvent the law, or achieve an illegitimate objective • Abuse of corporate privilege for personal benefit • Business indistinguishable from controlling shareholder 41 CORPORATE FORMATION AND FINANCING: PIERCING THE CORPORATE VEIL Factors courts consider: 1. Party tricked into dealing with corporation rather than individual 2. Corporation always insolvent or under-capitalized 3. Corporation formed to avoid existing legal obligation 4. Corporate formalities not followed 5. Personal and corporate interests commingled so no separate identity 42 5/10/21 15 CORPORATE FORMATION AND FINANCING: PIERCING THE CORPORATE VEIL Can present danger for close corporations •Especially if personal and corporate funds commingled, shareholders use corporate property, or no director meetings are held • Separate status must be preserved •May escape liability if no evidence of wrongdoing 43 CORPORATE FORMATION AND FINANCING: PIERCING THE CORPORATE VEIL Alter ego theory: corporation