Quality Magazine
Legal Insight

Corporate Governance

Understand the basic legal framework.

May 9, 2013
Corporations are legal entities and one of several ways to structure a business. All corporate stakeholders should have a solid grasp of basic corporate governance. Owners, managers and shareholders should understand their rights and responsibilities.
 
Incorporators, or promoters, form a corporation by filing a certificate (i.e., articles of incorporation, charter) with a state’s department of state. Often, they choose the state that will be a company’s primary place of business. Many companies incorporate in Delaware. Its law gives management great flexibility to manage internal affairs, and the Delaware Court of Chancery has developed a vast amount of corporate law jurisprudence. (In 2002-03, I was a Chancery law clerk.) Corporations that operate outside their state of incorporation may need to register locally as a foreign corporation and pay a fee.
 
After the state approves the certificate, the incorporators (or named directors) draft bylaws. Bylaws establish internal rules for the corporation’s governance, including the location of the company headquarters, directors’ and officers’ powers, and shareholders’ voting rights. The board of directors is the highest level of corporate management. It manages the business, develops general policies (e.g., line of business, compensation, dividends) and hires officers. Officers handle daily business operations.
 
Shareholders own the corporation’s stock. “Close corporations” have a relatively small number of shareholders and no market for shares. A buy-sell agreement may limit share transferability. Usually, some of a close corporation’s shareholders serve as managers. In large corporations, while officers may own some stock, usually there is a separation between management and ownership.
 
Corporations must host and notify shareholders of an annual shareholder meeting. Some states permit companies to host their meetings remotely over the Internet. Shareholders can vote their shares in person, or they can vote by proxy. A proxy is a signed authorization allowing another person to vote one’s shares. Most large publicly traded corporations use proxies, which can be solicited under federal law.
 
A corporation owns its assets and is responsible for its liabilities. Shareholders own stock certificates that represent voting and profits interests in the company. Shareholders have limited liability and cannot lose more than the value of their shares. Shareholders’ voting rights tend to be limited to major issues like choosing directors, amending the articles, merging, selling all or substantially all of the corporation’s assets, and corporate dissolution.
 
Dividends are cash or property distributions paid to shareholders based on their share of ownership. Dividend policy is uniquely within the board’s business judgment and discretion. The board determines whether there will be a dividend and its amount, provided it doesn’t render the company insolvent. Debt instruments (e.g., debentures) and loan agreements may restrict dividend payouts.
 
Directors, officers and majority shareholders owe fiduciary duties to the corporation. The duty of loyalty requires them to promote the corporation’s interests without regard for personal gain. A conflict of interest arises where a corporation contracts with a fiduciary or a company in which a fiduciary has an interest. To overcome the conflict, the fiduciary must fully disclosure the transaction, and independent directors must approve it. 
 
The duty of care requires fiduciaries to act in good faith with the care that an ordinarily prudent, diligent person in a like position would exercise in similar circumstances. Diligent fiduciaries can inform themselves by relying on competent internal personnel and outside professionals (e.g., attorneys, accountants).
 
Normally, corporations’ relationships with creditors are governed by debt instruments. Depending on the jurisdiction, if the company becomes insolvent or enters a “zone of insolvency,” the fiduciary’s duty shifts or expands towards creditors. In Chapter 11 bankruptcy, creditors become the new shareholders of the reorganized corporation. In Chapter 7 bankruptcy, the corporation liquidates its assets, pays creditors, and dissolves. If any assets remain, shareholders are entitled to them based on the rights and priorities of their shares.
 
Ordinarily, under the “business judgment rule,” fiduciaries who act in good faith cannot be held personally liable for mere judgment errors unless they were grossly negligent, committed fraud, or acted illegally. In a derivative lawsuit, a shareholder can sue to vindicate management’s fiduciary duty or a third party’s contractual obligation to the corporation. Favorable settlements or judgments belong to the corporation, but successful plaintiffs can be reimbursed for legal fees.
 
Editor’s note: This column does not constitute legal advice.