As described in our article on Limited Liability Entities, ownership of a corporation allows one to enjoy the potential benefits of business ownership while protecting one’s personal assets. The actual tool utilized to enjoy that advantage is ownership of the stock of the company. Put simply, one owns the company by owning the stock issued by the company and the person or entity that owns the majority of the stock controls the California non public corporation.
Public corporations are defined as stock that is traded on a public exchange. Most companies sell their stock privately, usually offering it to individuals who are engaged directly or indirectly in the business. The rules and regulations relating to publically traded corporations are both federal and state and are copious. This article shall discuss stock ownership in a privately held corporation in California.
The Basic Structure and the Role of Stock Holding:
Corporations are owned by shareholders who usually own a portion of the corporation equal to the percentage of stock owned. Thus, if one owns 40% of the stock of the corporation, one owns 40% of the company. Normally, stock is voted to make major decisions for the corporation and for election of directors. Directors elect the officers of the company who run the day to day operations of the company. In California, cumulative voting is allowed for shareholders in election of directors, assuring minority stock owners the right to vote in a minimum number of directors.
Usually the stock holders only vote on election of directors and major decisions of the company involving mergers, acquisition, ratifying decisions of the Board of Directors, etc. Despite their limited role in day to day operations, it is the stock holders who ultimately control the company since they must agree to critical decisions involving the company and elect the directors who appoint the officers. Ownership of stock thus relates directly to who controls the company. Voting stock is power.
If the company is sold or if dividends are declared, one normally receives proceeds based on percentage of stock owned. Thus, a dividend goes 25% to a stock holder who owns 25% of the stock, etc.
Corporations can issue multiple classes of stock, some voting, some nonvoting, some with restricted rights, etc. In California, stocks that receive a preference upon dissolution of the company or for dividends are often referred to as “preferred stock” and they are paid off before common stock should there be a dissolution. Preferred stock can be voting or nonvoting.
The corporation may also issue other multiple classes of common stock, such as nonvoting common stock or common stock with special dividend rights or stock that may later be converted to other classes of stock or notes.
Unlike common stock, holders of preferred stock may be entitled to fixed dividends and fixed rights to receive a percentage of a corporation’s assets if the company is liquidated. With respect to the dividend rights, an example of such stock would include a name such as “$80.00 preferred,” which means the shareholder has a right to receive $80.00 in dividends per share before dividends are paid to common stock owners.
Most non public companies have only one class of shares, which are common voting stock. In such companies, albeit with some protection of minority rights, the person or entity that owns 51% of the common stock normally has effective control of the company.
Rights and Protections Inherent in Stock Ownership:
Investors who purchase corporate stock enjoy a number of rights pertaining to their ownership. Unlike partnership law, where the owners of businesses are also the primary managers of the businesses, owners of a corporation often do not operate the company. Shareholders in a corporation are shielded from personal liability for the debts and obligations of the corporation unless they sign personal guaranties of corporate debts. However, shareholders can lose their investments in the corporation should the corporation fail.
As the owners of a limited liability entity, shareholders are generally shielded from personal liability for claims against the corporation. Thus, if a corporation incurs a debt or obligation against it, creditors cannot recover the personal assets of the shareholders. However, the average life of a corporation in the United States is only seven years, and more than half fail before seven years have elapsed. Engaging in business is an inherently risky venture and to this writer it is less surprising that half fail than that half succeed.
Laws governing corporations in the United States are often standard from one state to the next. Some states are famous for protecting those that run the company rather than the shareholders (Delaware is a good example) while others are famous for protecting the shareholders far more (New York and California are examples.) Generally, the larger the state, the more developed case law will have been written relating to how corporations should operate. New York, Illinois, Massachusetts and California are the states with the most case law on operation of corporations. And the law is usually quite good, uses common sense and is fair.
The commissioners on uniform state laws drafted the Uniform Business Corporations Act in 1928, though only three states adopted this act. The American Bar Association in 1950 drafted the Model Business Corporation Act, which subsequently has been modified numerous times. The last major redrafting occurred in 1984, but there were substantive revisions in 2002 and 2005. A large majority of states have adopted all or a significant portion of the Model Act. Other states have modified their own state corporation statutes to contain sections similar to the Model Act. Delaware’s corporation statute is also significant, since most large, public corporations are incorporated in that state.
The rights of shareholders depend largely on provisions in a corporation’s articles and by-laws. These are the first documents which a shareholder should consult when determining his or her rights in a corporation. Shareholders also generally enjoy the following types of rights:
Voting rights on substantive issues that affect the corporation as a whole
Rights related to the assets of the corporation
Rights related to the transfer of stock
Rights to receive dividends as declared by the board of directors of the corporation
Rights to require cumulative voting on shareholder election of directors
Rights to inspect the records and books of the corporation
Rights to bring suit against the corporation for wrongful acts by the directors and officers of the corporation such as breach of fiduciary duty or violation of the corporate opportunity doctrine
Rights to share in the proceeds recovered when the corporation dissolves or sells all of its assets
Other rights as may be provided in the by-laws or by statute of the particular state
Shareholders usually hold general meetings on an annual basis or at fixed times according to the by-laws of the corporation. The primary purpose of these meetings is for shareholders to elect the directors of the corporation, though shareholders may also vote on a number of additional issues.
Persons with authority to do so may also call special meetings on matters that require immediate attention, though only those issues set forth in the notice of the special meeting may be the subject of the vote. The by-laws normally provide who may call what meeting, though California statutes also allow some rights to shareholders to require meetings.
A quorum must be present at the shareholder meeting for a decision to be binding. The typical quorum consists of more than half of the outstanding shares of the corporation. Within limits, this percentage may be increased or decreased in the by-laws of the corporation. Prior to each shareholder meeting, a list of shareholders eligible to vote must be prepared. Shareholders have the right to inspect the voting list at any time.
Shareholders may appoint proxies to vote their shares, which is common in publicly-held corporations. Most states prescribe specific rules with respect to the proxy appointment, such as whether this appointment may be revoked. Proxy appointments must be in writing, and the proxy does not need to be a fellow shareholder. Since the relationship between the shareholder and the proxy is one of principal and agent, the proxy must abide by the instructions of the shareholder.
Shareholders by unanimous consent may conduct business without holding a shareholder meeting. Such actions are more common in closely held corporations, where shareholder actions are typically unanimous. In a larger, publicly held corporation, such actions are much less practical, especially because decisions of the shareholders affect a larger number of people. In California, meetings may be by conference call so long as each shareholder is able to listen, speak and vote via that media.
Matters upon which shareholders vote, in addition to the election of the directors, depend on the issues affecting the corporation. The following are the most significant and usual as to these matters.
- Approval or disapproval of changes in the articles of incorporation
- Approval or disapproval of a merger with another corporation
- Approval or disapproval of the sale of substantially all of the corporation’s assets that is not in the ordinary course of the corporation’s business
- Approval or disapproval of the voluntary dissolution of the corporation
- Approval or disapproval of corporate transactions where some directors have a conflict of interest
- Approval or disapproval of amendments to bylaws or articles of incorporation
- Make nonbinding recommendations about the governance and management of the corporation to the board of directors
- As noted above, many of the rights afforded to shareholders are contained in each corporation’s articles of incorporation or bylaws. It is also noteworthy that shareholders generally do not have the right to vote on management issues that occur in the ordinary course of the corporation’s business. Many decisions of the corporation must be made by the board of directors or officers of the corporation, and in many such day to day decisions, shareholders may not compel the board or officers to take or refrain from taking any action. Shareholders, however, can vote to remove directors and appoint new officers, subject to restrictions in the by-laws or any employment contracts.
Minus agreements or restrictions in the by-laws, and with some restrictions imposed by law, corporations retain the right to issue new shares of stock, which could dilute the ownership of existing stockholders. Existing shareholders often hold preemptive rights, which allow the shareholders to purchase these new shares of stock before they are made available to the public. Thus, if a shareholder owns 10 percent of a corporation, and the corporation issues new stock, the shareholder would own less than 10 percent if he or she did not purchase new stock. If the shareholder exercises preemptive rights, he or she may purchase as many new shares as necessary to retain that 10 percent interest.
Litigation by Shareholders:
Shareholders can protect their ownership rights in their shares by bringing a direct action against a corporation if there is good cause. Such cases may involve contract rights related to the shares; rights granted to the shareholder in a statute; rights related to the recovery of dividends; and rights to examine the books and records of a corporation.
Some cases are not allowed for direct actions by a shareholder against a corporation, however. For example, a shareholder may not bring a direct action against a corporation by alleging that an officer has breached a fiduciary duty owed to the corporation. Such a case involves all shareholders and is more appropriate as a derivative action. By comparison, a shareholder may bring a direct action if he or she has been prevented from voting his or her shares in a vote.
Shareholders may bring suit as representatives of the corporation in a derivative action. Such an action is designed to prevent wrongdoing by the officers or directors of the corporation and to seek a remedy for such wrongdoing. These suits are generally brought when the corporation itself (through its officers and directors) refuses to bring suit itself. A party bringing a derivative suit acts as a representative of an appropriate class of shareholders, and in the action the shareholders enforce claims that would be appropriate between the corporation and the officers and directors of the corporation. For example, if the officers of the corporation have breached a fiduciary duty owed to the corporation, shareholders may bring a derivative action to protect the interests of the corporation on behalf of the corporation. While these actions in many cases protect the rights of the corporation and shareholders of the corporation, these actions are often controversial and it is vital to have engaged in preliminary procedures within the corporate structure before the courts will allow such an action. For example, in California, the shareholder must first exhaust the available remedies of corporate governance, or show such efforts would be futile, before seeking a derivative action.
Courts normally give the directors and officers of a corporation wide latitude in making business decisions. Simply disagreeing with a decision will not normally allow relief via derivative action in the courts.
Sale of Stock:
Shares in a company are often transferred by private agreement between the seller and the buyer. Documentation required to initiate transfer of stock differs depending on the reason for transferring stock. Even though specific requirements for transferring shares may differ, there are some general guidelines required by most banks and by law. Both Federal and state securities laws govern the distribution and exchange of stock in a corporation. Adequate legal and tax advice is required before such sale or purchase is attempted.
Conversion rights enable a shareholder to convert the preferred stock for the common stock. Shareholders may also possess redemption rights, which permit the shareholders to redeem their stock to the corporation for a value specified in the articles of incorporation or set by the board or agreed to in a separate document (contract) among the shareholders and the corporation. These are often referred to as Buy and Sell Agreements.
Federal and state securities laws govern the distribution and exchange of stock in a corporation. Many of these laws are designed to avoid fraud by the corporation to the detriment of prospective or existing shareholders, so shareholders must consult relevant securities laws at the time of sale or if they believe they have been defrauded in the sale or exchange of stock. The sale and exchange of stock through electronic media have provided new methods for defrauding investors, and new securities laws have been enacted in the past ten years to address these issues.
Note that sale of shares can radically alter the balance of power within a company and that fact must be factored into any decision. Further, the price of stock is altered often by the control factor. If a sale sells effective control of the company, the value of the stock is usually higher.
Keep in mind that death of a shareholder can also alter ownership control and rights. The heirs of the stock holder suddenly become the owners and this can have catastrophic effect on the company. Buy and Sell agreements commonly provide for sale of stock upon death or divorce of a stockholder at a formula price.
Financing the Corporation:
The two broad types of financing available to a corporation include equity financing and debt financing. Equity financing involves the issuance of stock, which investors purchase and which represent a share in the ownership of the corporation. Debt financing means loaning the money to the corporation with a promissory note reflecting the loan amount and payment methodology.
The two basic types of stock are common stock and preferred stock. Debt financing can also involve a loan of money from an investor to the corporation in exchange for debt securities, such as a bond. Holders of debt securities generally do not enjoy the same rights as shareholders in terms of voting rights, participating rights, or other rights related to the ownership of stock. Loans can be made with or without bonds being issued. A bond is considered a security under the securities laws mentioned above.
It is noteworthy that the board of directors in a corporation usually has the discretion to decide whether dividends are issued in a given year. If dividends are not distributed during one year, whether preferred stock owners receive dividends in a subsequent year depends on whether the preferred stock is cumulative or noncumulative. If the rights are cumulative, the corporation must be dividends during some subsequent year. If the rights are noncumulative, the rights to receive dividends are lost if the corporation does not issue dividends in a given year.
Preferred stock owners generally do not have the same rights to vote as common stock owners. However, a corporation may grant voting rights and additional rights in its articles of incorporation or other provisions. State statutes also provide some rights to preferred stock owners by default.
Corporations may seek to borrow money in addition to issuing stock. One method for borrowing money is to exchange the loan for a debt security that can be traded on a public or private market. Bonds are long-term debt securities that are secured by corporate assets. Debentures are unsecured debt securities. Owners of debt securities generally do not enjoy the same types of rights are owners of stock. However, a corporation may grant voting rights to the owners of debt securities. These owners may also have the right to redeem debt securities in exchange for stock.
When a corporation dissolves, one of its required actions is the liquidation of corporate assets. Taxes and then creditors of the corporation are the first to be paid with the funds received from the liquidation. Owners of debt securities are also paid before shareholders. Once these debts are paid, the remainder is paid to the stockowners. Preferred stock is paid before common stock. Some preferred stock includes a liquidation preference that fixes a price per share of preferred stock. If preferred stock includes this preference, it must be paid before the corporation pays any amount to the common stock. Common stock owners do not have any special liquidation rights and will receive assets on dissolution only after senior claims have been paid. “Insider” loans from owners to the company are usually only paid after loans to third parties are first paid.
Minority Rights of Stockholders:
Some states, such as California, offer additional protection to minority shareholders and provide that if the company is sold or a dividend declared, the same price or dividend per share must be paid to the minority shareholder as to those owning a majority of the stock. Additionally, California can impose a fiduciary duty upon majority shareholders in certain circumstances so that their actions can not harm the interests of the minority shareholders. The law in that area is complex and legal counsel should be sought before any action is undertaken which may harm minority shareholders.
Related to this concept is the corporate opportunity doctrine, discussed in a separate article.
If a corporation is a Subchapter S corporation, there are some additional dangers minority shareholders could face. It is not unusual for the majority shareholders to be the officers and pay themselves a good salary. A subchapter S corporation must pay tax via its shareholders proportionate interest and it is the shareholders themselves who must pay the tax. In power struggles within a company, a typical maneuver is for the majority shareholders not to declare dividends sufficient to pay the taxes, thus the minority shareholder faces the unpleasant prospect of paying taxes on monies never received. The goal is to force the minority shareholder to sell the stock at a discount, of course. Absent correct by-laws, or contracts, this procedure can work.
Shareholders can enter into agreements that provide for supermajority voting on certain specified decisions and statutes in California also require supermajority voting for various major decisions. Nevertheless, in most cases, majority shareholders are free to vote their stock as they wish and effectively control the operations and future of the company.
Shareholders have the ultimate power in corporations and a thorough knowledge of what that means and the limits of the power is essential for anyone who owns or plans to own stock. Careful use of the tools of control can make the difference between effective operation of the company or constant bickering and disappointment. Advance planning for what happens if death, disability or retirement alters the mix and percentage of stock interest is as vital as determining what products or services to sell.
Sadly, our office often sees owners who put off such basic decisions, caught in the stress of day to day business, and only confront the realities of the need to structure stock rights and obligations when it is in the midst of conflict or when a death or divorce has already made discussion impossible. Advance planning and learning the law is essential to any stockholder who wishes to maximize the benefit of the corporate structure.