California Law
California Publicly Held Corporations Law
- Publicly Held Corporations Law
Publicly Held Corporations Law
Under the classic definition of a corporation the corporation is a fictitious or artificial person. For legal and tax purposes, a corporation is a separate entity from its owners, an entity that can make purchases, can enter into contracts, must pay taxes, and can sue and be sued on its own behalf. A publicly held corporation is generally a corporation that has shares held by a large number of people. In contrast, a close corporation is one that has shares held by a small number of people.
Some states, such as California, specifically define and address close corporations by statute. Federal law requires that publicly held corporations with more than five million dollars in assets and whose outstanding securities are held by more than 500 shareholders of record meet several unique requirements of the Federal Securities and Exchange Act of 1934, including a requirement to submit periodic financial information to the Securities and Exchange Commission.
This chapter discusses how to form a publicly held corporation, the advantages and disadvantages of corporate status, and mergers and acquisitions. The Closely Held Business Law Chapter discusses other ways to organize a business, including organizing as a close corporation. The Associations & Nonprofit Corporations Law Chapter discusses how to form a nonprofit, tax-exempt corporation. The Securities & Venture Finance Law Chapter discusses securities laws and regulations that affect most publicly held corporations. Additional information about corporate mergers and acquisitions can be found in the Mergers and Acquisitions Law Chapter.
Forming a Publicly Held Corporation
A corporation can be created only by complying with the statutes of its state of incorporation. In most states, incorporators initially organize the corporation and shareholders own the corporation and elect a board of directors that is responsible for management and control of the corporation. The board of directors chooses officers who are responsible for overseeing day-to-day operations of the corporation.
Advantages of Corporate Status
Becoming a corporation gives a business several advantages over other forms of business organization such as sole proprietorship or partnership.
Survivability
One advantage of corporate status is that because a corporation is an artificial person, its existence does not depend on who its owners are at any given time. A corporation survives the death of an individual shareholder or director, or the transfer of shares. The corporation "dies" only when it is voluntarily or involuntarily dissolved. The ability to survive the death or departure of any individual person gives the corporation stability and makes it a more attractive candidate for long-term financing. Survivability also permits the corporation to raise funds by selling shares to new investors, because new owners can be added without disturbing the corporate form.
Shareholder Insulation from Debt and Liability
A corporation is liable for its own debts and obligations without limit, but because the corporation can take out loans and be sued in its own name, the shareholders are not personally liable for debts the corporation becomes unable to pay. Absent an agreement to the contrary, a corporation's creditors may not seek to collect debts from the owners of the corporation. In other words, the shareholders enjoy limited liability. Limited liability makes investment in a corporation more attractive to potential investors because the most that can be lost is the initial investment.
Incorporators of new corporations may not be able to enjoy limited liability immediately, however, because owners of a new corporation may be required by financial institutions to give personal financial assurances in order to receive funding. Financial institutions understand the risk they take by lending to young corporations without established credit records. They may try to limit their exposure by requiring shareholders to provide personal guarantees of loans should the corporation become unable to make payments.
In addition to the possibility that financial institutions will require personal guarantees for loans to corporations, on rare occasions a court will ignore a business' corporate status and make its shareholders personally liable for the debts of a corporation. Disregarding corporate status is known as "piercing the corporate veil." In California, as in most states, piercing the corporate veil is rare. California courts primarily consider two issues in deciding whether to pierce the corporate veil and ignore a corporation's corporate status. First, courts consider the unity of interest and ownership between the corporation and the individual officers and directors. Second, they focus on whether piercing the veil is necessary to prevent injustice or fundamental unfairness. In other words, would allowing the individual corporate officer or shareholder to be shielded from liability sanction a fraud or promote injustice? The result of these inquiries depends on the circumstances of each particular case. The courts consider many factors, including:
- Separation or commingling of individual and corporate funds or assets
- Issuance or non-issuance of stock
- Existence or absence of corporate records
- Whether the stockholders dominated or controlled the corporation
- Whether the corporation's capitalization was adequate
- Whether individuals used the corporation as conduit for business
- Openness or concealment of corporate ownership
- Observance or non-observance of corporate formalities such as regular meetings and elections
Centralized Management
Another benefit of corporate status is centralized management. The shareholders of a publicly held corporation are its owners, but management and control of the corporation are the responsibility of the board of directors, who may or may not be shareholders. In contrast, in a partnership each partner has a right to participate in management.
Transferability of Interest
Shares of stock in a corporation may be freely bought, sold, assigned, or otherwise disposed of by their owners unless there are special circumstances. In contrast, partnership interests are freely transferable only with the permission of remaining partners. The free transferability of shares increases their value because investors know they will be able to sell the shares quickly and easily if they choose to do so.
Disadvantages of Corporate Status
Becoming a corporation is not the best option for all businesses, because corporate status does have its disadvantages.
Double Taxation
The biggest drawback of corporate status is double taxation. Most publicly held corporations file their own tax returns and pay taxes on corporate profits before paying dividends to the shareholders. When the shareholders receive the dividends, these profits are taxed again on the individual shareholders' tax returns. In contrast, the profits of a partnership are taxed only once because a partnership pays no taxes before distributing profits. Partners only pay taxes on their individual shares of the profits.
Cost
Given the more complex nature of organizing and running a corporation as compared to other forms of business organization, most corporations pay more for professional services, such as accounting and legal services. In addition, the fees for incorporating generally are higher than fees for other forms of business organization. Finally, a corporation that sells securities faces substantial costs to comply with a myriad of securities regulations.
Inflexibility
Another significant drawback to corporate status is the loss of flexibility in running the business. In order to avoid the possibility of a court piercing the corporate veil, a corporation must observe several formalities, such as regular meetings and elections. For some small businesses, the loss of flexibility may make corporate status more trouble than it is worth.
State of Incorporation
Incorporators usually choose to incorporate under the laws of the state in which the corporation is primarily located, although they can choose to incorporate under the laws of another state. Close to one-third of the corporations in the United States are incorporated under the laws of the state of Delaware, even though most of them do little, if any, business in Delaware. The state of Delaware purposefully seeks to entice corporations to incorporate under its laws by maintaining an especially efficient system of courts that exclusively handles corporate matters. Because so many corporations are organized under Delaware laws, the Delaware Corporate Code has been litigated extensively. A result of the extensive amount of case law interpreting the Delaware Corporate Code is that outcomes of lawsuits are often easier to predict in Delaware, so many business operators now feel more comfortable knowing that corporate disputes will be handled in Delaware courts applying Delaware laws.
California Requirements for Corporations
Corporations formed under California law must comply with the requirements set forth in the California General Corporation Law (GCL.). Any person, partnership, association, or corporation may form a corporation by executing and filing articles of incorporation with the Office of the California Secretary of State.
Articles of Incorporation
The GCL allows corporations to have very simple articles of incorporation. Articles of incorporation only are required to include:
- Name of the corporation
- Statement of corporate purpose as set forth in the statute
- Address of the corporation's initial agent for service of process in the state
- Authorized number of shares the corporation may issue and authorized classes and series of shares, if any
The reason articles of incorporation can be so simple is that the GCL contains a long list of provisions that automatically apply to all corporations unless the provisions are specifically modified in the articles of incorporation, such as:
- The board of directors has the power to adopt, amend, or repeal bylaws
- An affirmative vote of a majority of the directors present at a meeting is required for board action
- All shares of a class or series have equal rights and preferences in all matters
The GCL also sets forth numerous additional provisions that may be included in the articles of incorporation and will not apply to the corporation unless specifically included, such as shareholders' preemptive rights to new shares.
Name Registration
California statutes require that any corporation operating in California under any name other than the corporate name stated in the articles of incorporation must file a Fictitious business name statement with the clerk of the county where the corporation has its principal place of business in the state. If the corporation has no principal place of business in the state, the statement must be filed with the Clerk of Sacramento County. Within 30 days of filing the statement, the corporation must publish the statement in a newspaper of general circulation in the appropriate county and submit an affidavit of publication to the county clerk within 30 days of the publication. The fictitious business name statement is valid for five years.
Tax Issues
A corporation in California must obtain a federal tax identification number. A corporation with employees also must register with the California Employment Development Department if the employer pays over $100 in wages during a year. A business that sells goods or services that are taxable must obtain a license and pay sales and use tax. A corporation operating in California may have to obtain additional federal, state, or local licenses.
Forms of Corporations
There are different forms of corporations. Most large, publicly held corporations are Subchapter C corporations. The Subchapter C corporation takes its name from Subchapter C of the Internal Revenue Code. A Subchapter C corporation is subject to the general corporate taxation rules discussed above. A Subchapter S corporation derives its name from Subchapter S of the Internal Revenue Code. Under Subchapter S, a corporation that meets certain requirements may be treated as a corporation for purposes of insulating its shareholders from personal liability for corporate debts, but treated as a partnership for tax purposes. Shareholders of an S corporation receive limited liability protection, and their profits from the business are included on their individual income tax returns. In general, California has similar tax treatment for such corporations.
To be treated as an S corporation under federal tax laws, the corporation must:
- Be a domestic (not foreign) corporation
- Not be part of an affiliated group of corporations
- Not have more than 35 shareholders
- Have only one class of stock
- Have only shareholders who are individuals, a decedent's estate, or one of a special class of trusts (not corporations or partnerships)
- Have no shareholders who are nonresident aliens
After a business has incorporated, all shareholders must consent to Subchapter S treatment. The election to be treated as an S corporation must be filed with the Internal Revenue Service in a timely manner.
Director's Fiduciary Responsibilities
The attitude of lawmakers toward corporate directors is somewhat contradictory. Because directors hold great power in a corporation's management structure, the law imposes upon them a high standard of fidelity and loyalty to the interests of the corporation. On the other hand, because most Americans value the freedom of corporations to take risks and pursue untested ventures, lawmakers are loathe to restrict the actions of directors.
Directors are said to owe the corporation "fiduciary duties." The parameters of directors' fiduciary duties frequently are the subject of lawsuits alleging that a director had a conflict of interest in his or her dealing with the corporation or failed to exercise good business judgment. California law requires a director to act in good faith, in a manner the director believes to be in the best interest of the corporation and its shareholders, and with reasonable care. Directors who perform their duties in compliance with this standard are not liable for their actions merely by reason of being or having been a director of the corporation. Put another way, a director's decision made honestly and with reasonable prudence does not subject the director to liability even if the decision turns out badly for the corporation.
Mergers and Acquisitions
There are two ways that a corporation can grow--it can add new employees and customers of its own, or it can merge with or acquire another business. There are many reasons why merging with or acquiring another business may be preferable to internal growth.
Benefits of Merging and Acquiring
There are many reasons for mergers and acquisitions. By consolidating purchasing, advertising, and administrative functions, a larger, merged company may be more efficient than two smaller companies. A merger may give a company better access to credit and new products and may help to even out peaks and valleys in cash flow and profits. The Internal Revenue Code provides some tax incentive for a financially healthy corporation to acquire a troubled business. If the acquiring corporation meets several strict requirements, it may be able to use a limited part of the net operating loss carryover of the acquired business against the acquiring company's taxable income.
There may be personal considerations that motivate a merger or acquisition. An owner preparing to retire or to resolve dissent within the company may look to a sale or merger to make assets more liquid. Sometimes a business may be growing so quickly that its owners need the skills and resources of a competitor to keep up with the growth. In some instances an older, more stable company may be interested in sharing its experience in exchange for the higher profit margin of a smaller, up-and-coming business.
Ways of Merging with or Acquiring Another Business
Generally, businesses are acquired or merged by one of three methods. The best method for a particular situation depends on such considerations as tax laws, antitrust laws, and corporate laws.
Asset Acquisition
Asset acquisition is a method of merger in which the buyer purchases some or all of the seller's assets in exchange for securities, cash, or property of the acquiring corporation. If the seller is a corporation, the structure of the selling corporation remains intact until the corporation is dissolved and the proceeds from the sale are distributed to shareholders. Minority shareholders generally do not have a say in the sale of the business and, because the buyer is not purchasing an entire business but only part of the whole, the buyer does not necessarily assume the liabilities of the seller. Asset acquisition is a way to acquire the physical property and accounts of another business without acquiring its liabilities.
Acquiring the assets of a business can be more expensive than other types of acquisitions or mergers. There may be some difficulty in transferring contracts, leases, and licenses from third parties, and the title to each asset sold must be transferred separately.
Stock Acquisition
Under a stock acquisition--frequently called a takeover--the corporation's shareholders sell their shares of stock to a purchaser. In the event that management does not approve of the sale, the acquisition is called a hostile takeover.
Under a stock acquisition, the directors' approval is not needed to purchase the corporation. The only documents that need to be transferred are stock certificates, contracts, or any other form of consideration by third parties.
There are a number of problems with takeovers. The new majority shareholders may be liable for debts incurred under the old ownership prior to the purchase. The Securities and Exchange Commission may require registration for the sale. Minority shareholders may be able to hold out and retain positions within the acquired corporation, which may not be the new owners' preference.
Statutory Merger
Under a statutory merger, two corporations agree to combine and form a single corporation under state law. At least two-thirds of the shareholders from each corporation and both boards of directors must agree to this arrangement. Only one company survives, and it takes over all operations, assets, and liabilities of both companies. The shareholders of the disappearing corporation trade their shares of stock for an equity position in the surviving business. In a related type of merger, called a statutory consolidation, both businesses cease to exist and an entirely new entity is formed.
A statutory merger is beneficial in that all title transfers are automatic if the arrangement follows state guidelines, and because all assets of both companies are retained in the merger.
On the other hand, the surviving corporation runs the risk of assuming all liabilities of the disappearing corporation. Also, the process can be costly and time-consuming due to the necessity of shareholder meetings and the technicalities of state laws.
Corporate Buy-Sell Agreements
As with any buy-sell agreement, price is the cornerstone of an agreement to buy or sell a corporation or its assets. Determining the worth of a company to be purchased or merged can be determined by the book value of the company, by an independent appraisal, by comparing the price/earnings ratio within the seller's industry, or by any of several other methods.
The method of sale can significantly affect the overall cost to the buyer and seller due to tax considerations. Some acquisitions are considered tax-free, while others are taxable. An accountant or tax attorney should be able to help a company understand and take advantage of tax-minimizing schemes.
A corporate buy-sell agreement should guarantee that key employees are retained and that contracts for employment are transferred to the buyer company. The buyer should review any collective bargaining agreements thoroughly, because they may be binding. Retirement plans usually transfer to the buyer company, as well.
A buyer of a business who offers securities in exchange for the business, or for significant shares of the business, may be considered an issuer of the securities and therefore may be required to register with the Securities and Exchange Commission. The buyer may, however, be eligible for exemption under the law. Determining whether a business must register and which kind of registration it must undertake can affect sellers' ability to resell the securities they receive as payment. There are a number of other considerations under both federal securities laws and state "blue-sky" laws to be aware of in mergers and acquisitions that involve the exchange of stocks. The advice of a competent attorney is highly recommended.
The buyer who pays the seller in stock generally warrants that the stock is legal, authorized, and fully paid, and the seller warrants that the stock is legal. The seller also represents that further information about the condition of the business will be noted in financial documents. It is common for an agreement to dismiss the buyer from any future unassumed liabilities from an asset purchase.
Resources
For information on forming or registering a corporation in California, contact the California Secretary of State, Corporate Division, 1500 11th Street, Sacramento, CA 95814, (916) 657-5448, or the California Corporations Department, 3700 Wilshire Boulevard #600, Los Angeles, CA 90010-2901, (213) 736-3481.
For corporate tax forms and information, contact the California Franchise Tax Board, P.O. Box 115, Rancho Cordova, CA 95741-0115, (800) 852-5711, or the Fast Answers about State Taxes (F.A.S.T.) toll-free telephone service at (800) 338-0505. Federal tax forms are available from the Internal Revenue Service, (800) 829-1040.
New businesses with employees should contact the California Employment Development Department, 800 Capital Mall, Sacramento, CA 95814, for a free copy of the California Employer's Guide.
There are numerous other sources of useful information about incorporating a business and operating as a corporation generally, including:
Hoyt L. Barber, How to Incorporate Your Business in Any State (Liberty House, Princeton, NJ 1989).
John Cotton Howell, Forming Corporations and Partnerships (Liberty Hall Press, Blue Ridge Summit, PA, 2d ed. 1991).
Michael G. Trachtman, What Every Executive Better Know About the Law (Simon & Schuster, New York, NY 1987).
Carolyn M. Vella & John J. McMonagle, Jr., Incorporating: A Guide for Small-Business Owners (American Management Associations, New York, NY 1984).
In addition, the Service Corps of Retired Executives (SCORE) can be a valuable resource. SCORE is a fraternity of retired business managers who volunteer to help new or existing businesses and nonprofit organizations. Information about the services offered through SCORE can be gained by contacting one of its regional offices throughout the state.