Corporate Management

Rights of Shareholders

In the modern publicly held corporation, ownership and control are separated. The shareholders “own” the company through their ownership of its stock, but power to manage is vested in the directors. In a large publicly traded corporation, most of the ownership of the corporation is diluted across its numerous shareholders, many of whom have no involvement with the corporation other than through their stock ownership. On the other hand, the issue of separation and control is generally irrelevant to the closely held corporation, since in many instances the shareholders are the same people who manage and work for the corporation.

Shareholders do retain some degree of control. For example, they elect the directors, although only a small fraction of shareholders control the outcome of most elections because of the diffusion of ownership and modern proxy rules; proxy fights are extremely difficult for insurgents to win. Shareholders also may adopt, amend, and repeal the corporation’s bylaws; they may adopt resolutions ratifying or refusing to ratify certain actions of the directors. And they must vote on certain extraordinary matters, such as whether to amend the articles of incorporation, merge, or liquidate.

In most states, the corporation must hold at least one meeting of shareholders each year. The board of directors or shareholders representing at least 10 percent of the stock may call a special shareholders’ meeting at any time unless a different threshold number is stated in the articles or bylaws. Timely notice is required: not more than sixty days nor less than ten days before the meeting, under Section 7.05 of the Revised Model Business Corporation Act (RMBCA). Shareholders may take actions without a meeting if every shareholder entitled to vote consents in writing to the action to be taken. This option is obviously useful to the closely held corporation but not to the giant publicly held companies.

The one-share, one-vote principle, commonly called regular voting or statutory voting, is not required, and many US companies have restructured their voting rights in an effort to repel corporate raiders. 

Shareholders are legally entitled to inspect the records of the corporation in which they hold shares. These records include the articles of incorporation, bylaws, and corporate resolutions. As a general rule, shareholders who want certain records (such as minutes of a board of directors’ meeting or accounting records) must also have a “proper purpose,” such as to determine the propriety of the company’s dividend policy or to ascertain the company’s true financial worth.

Duties of Directors and Officers

Directors derive their power to manage the corporation from statutory law. Section 8.01 of the Revised Model Business Corporation Act (RMBCA) states that “all corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors.” A director is a fiduciary, a person to whom power is entrusted for another’s benefit, and as such, as the RMBCA puts it, must perform his duties “in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances” (Section 8.30). A director’s main responsibilities include the following: (1) to protect shareholder investments, (2) to select and remove officers, (3) to delegate operating authority to the managers or other groups, and (4) to supervise the company as a whole.

Under RMBCA Section 8.25, the board of directors, by majority vote, may delegate its powers to various committees. This authority is limited to some degree. For example, only the full board can determine dividends, approve a merger, and amend the bylaws. The delegation of authority to a committee does not, by itself, relieve a director from the duty to exercise due care.

Section 8.03 of the RMBCA provides that there must be one director, but there may be more, the precise number to be fixed in the articles of incorporation or bylaws. The initial members of the board hold office until the first annual meeting, when elections occur.

Directors must meet, but the statutes themselves rarely prescribe how frequently. More often, rules prescribing time and place are set out in the bylaws, which may permit members to participate in any meeting by conference telephone. In practice, the frequency of board meetings varies.

Liability of Officers and Directors

As a fiduciary of the corporation, the director owes his primary loyalty to the corporation and its stockholders, as do the officers and majority shareholders. This responsibility is called the duty of loyalty. When there is a conflict between a director’s personal interest and the interest of the corporation, he is legally bound to put the corporation’s interest above his own.

The second major aspect of the director’s responsibility is that of duty of care. Section 8.30 of RMBCA calls on the director to perform his duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” An “ordinarily prudent person” means one who directs his intelligence in a thoughtful way to the task at hand. Put another way, a director must make a reasonable effort to inform herself before making a decision.

Although directors and officers are expected to exercise due care when making business decisions, they are permitted to make honest mistakes of judgment or even flat-out bad business decisions. The business judgment rule is a legal principle that protects directors and officers from business decisions that were made in good faith, even if those decisions proved disastrous to the business’s profitability. Courts, therefore, give significant deference to the decisions of business directors and officers when considering the reasonableness of the business decisions. As such, they look at the reasonableness of the decision at the time the decision was made, without the benefit of hindsight. 

The Sarbanes-Oxley Act of 2002, enacted following several accounting scandals, increased the duties owed by the board and other corporate officers. In particular, Title III contains corporate responsibility provisions, such as requiring senior executives to vouch for the accuracy and completeness of their corporation’s financial disclosures. While the main goal of Sarbanes-Oxley is to decrease the incidents of financial fraud and accounting tricks, its operative goal is to strengthen the fiduciary duties of loyalty and care as well as good faith.

Shareholder Meetings

Shareholders’ meetings must occur at least once a year. A corporation must notify its shareholders of the date, time, and place of the meetings at least ten days in advance.

Assume that you own one share of Tesla (or some other publicly traded company) stock. It is unlikely that you will attend the annual shareholder meeting. Therefore, the law allows you and other similar shareholders to appoint another person as agent to vote those shares at the meeting. This authorization given to the agent is known as a proxy. Proxy materials are sent to all shareholders before the meeting. 

Shareholders exercise ownership control by utilizing their votes. For shareholders to act during a meeting, a quorum must be present. Generally, a quorum exists when shareholders representing more than fifty percent of the outstanding shares are present. Once a quorum is present, a simple majority is usually required to pass resolutions, though this may sometimes be changed in the corporate bylaws. Extraordinary matters, such as mergers or dissolutions require a higher percentage than a simple majority. 

Derivative Lawsuits

When a corporation is harmed, the directors can bring a lawsuit in the name of the corporation against the party that caused the injury. When directors fail to bring the suit, the shareholders may bring the suit through a derivative lawsuit. This is common when the injury is caused by the actions of a director of the board itself. To bring the lawsuit, the shareholders must first make a written demand to the corporation, asking the board to take the appropriate action. If they fail to do so within ninety days the lawsuit can proceed unless a majority of the directors or an independent panel determines in good faith that the lawsuit is not in the best interest of the business. 

When shareholders bring a derivative lawsuit, they are not seeking damages for themselves individually. Rather, they are acting on behalf of the corporation. Therefore, any damages recovered from the lawsuit are turned over to the corporation and not to the shareholders. 

The Securities Act of 1933

The Securities Act governs the initial sale of stock by businesses. It was designed to create confidence in initial offerings by United States businesses following the stock market crash and economic turmoil of 1929. The act requires that all securities transactions must be registered with the SEC unless they qualify for an exemption. 

Securities are broadly classified. They include preferred and common stock, bonds, puts, calls, options, and evidence of indebtedness. In interpreting the act, the U.S. Supreme Court held that a security/investment contract is any transaction in which a person:

  1. Invests,
  2. In a common enterprise,
  3. Reasonably expecting profits,
  4. Derived primarily or substantially from others’ managerial or entrepreneurial efforts.

While we usually think of only stocks and bonds when discussing securities, it could also include informal investment opportunities. For example, if your friend purchases land outside Rexburg hoping to start a new real estate development, she may ask you to “invest,” hoping to give you a 10% return on your investment after a year. If your friend doesn’t file with the SEC, she may be convicted of securities fraud.

The Securities Act requires that a security must be registered before being offered to the public unless it qualifies for an exemption. The issuing corporation must file a registration statement with the SEC and provide all investors with a prospectus. A prospectus is a written disclosure that describes the security, the financial operations of the issuing business, and the investment risk.

The registration statement that is filed with the SEC includes the nature of the security being sold, how the corporation is managed, how the corporation will use the proceeds of the sale of securities, and any special risk factors. 

Certain types of securities are exempt from the registration requirements of the Securities Act. This website includes important information about exempt securities. The most important exception for small businesses involves Rule 504 which provides that non-investment companies may offer up to $1 million in securities over a 12-month period without registration.

Insider Trading

Another important legal protection to emerge from the stock market crash of 1929 was to prevent insider trading, which occurs when individuals buy or sell securities on the basis of information that is not known to the public. Corporate directors and officers often have information that can affect the stock price. If they were to take action on this information, they would have a trading advantage over other existing and potential shareholders. As such, it is unlawful for corporate insiders and others with nonpublic information (i.e., accountants or attorneys) to take advantage of such information for their personal gain.

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