A corporation is owned by its shareholders. An ownership interest in a corporation is represented by a share or stock certificate. Shareholders have certain rights, including the right to vote in the election of directors and the right to receive dividends as they are declared by the corporation. Shareholders are ordinarily exempt from liability for the acts of the corporation. The term “share” and the term “stock” are interchangeable.
NATURE OF STOCK
Each share represents a fractional interest in the total property owned by the corporation. The shareholder does not own an interest in any specific property of the corporation, and the corporation, as a separate legal entity, is the owner of all of its property.
“Capital” refers to the net assets of the corporation. Stock that has been issued to the shareholders of a corporation are said to be “outstanding.” “Capital stock” refers to the value received by the corporation for its outstanding stock.
Corporate stock may have a specified par value. This means that a person acquiring the stock from the corporation must pay at least that particular amount. If stock is issued by a corporation for a price greater than its par value, some statutes provide that the par value is to be treated as stated capital, and the excess is capital surplus.
The RMBCA eliminates the concept of par value. This is the case in Mississippi. Therefore, stock issued by corporations and States following the RMBCA will have “no par.” This means that the subscriber pays the corporation an amount as determined by the board of directors.
“Book value” is the value which results by dividing the value of the corporate assets by the number of shares outstanding. The “market value” of a share of stock is the price at which the stock can be bought or sold on the open market.
CERTIFICATE OF STOCK
The corporation ordinarily issues a certificate of stock or share certificate to evidence the shareholder’s ownership of stock.
KINDS OF STOCK
The stock of a corporation may be divided into two or more classes. Common stock is ordinary stock and is the most common type of stock issued. Each share usually entitles the holder to have one vote, to receive a share of the profits in the form of dividends, and to participate in the distribution of capital upon dissolution of the corporation. Preferred stock has priority over common stock. This priority may be with respect to dividends, and it may also be with respect to priority over common stock in the distribution of capital upon dissolution of the corporation. Preferred stock is ordinarily nonvoting.
ACQUISITION OF SHARES
Shares of stock may be acquired by (1) subscription, either before or after the corporation is organized, or (2) transfer of existing shares from a shareholder or from the corporation.
STATUTE OF FRAUDS
A contract for the sale of corporate shares must be evidenced by a writing or it cannot be enforced. However, no writing is required for a contract by which a broker agrees with a customer to buy or sell securities for the customer.
SUBSCRIPTION
A stock subscription is a contract or an agreement to buy a specific number of shares when they are issued. A pre-incorporation subscription of shares generally is regarded as an offer to the corporation. It is necessary for the corporation to accept the offer after formation. Some States hold the view that the subscriptions automatically become binding after the corporation is formed.
Stock subscriptions may be made after incorporation, in which event the transaction is like any other contract with the corporation. The offer of subscription may come from the shareholder or from the corporation.
TRANSFER OF SHARES
In the absence of a valid restriction, a shareholder may transfer shares to anyone. Restrictions on the transfer of stock are valid if they are not unreasonable. Small family corporations and other “close corporations” commonly have restrictions regarding the transfer of the corporate stock in order to keep the stock from falling in the hands of an outsider. Such a restriction may provide that other shareholders have the first right to purchase stock before a shareholder may sell it to an outsider. Also, there may be an agreement giving the corporation the right to purchase a shareholder’s shares upon his death. The corporation can fund this transaction through a life insurance policy on the shareholder with the proceeds going to the corporation. The proceeds will then be used to buy the shareholder’s stock.
A restriction on the right to transfer stock is not effective against a purchaser of the certificate unless the restriction is conspicuously noted on the certificate or unless the purchaser has actual knowledge of the restriction.
MECHANICS OF TRANSFER
The ownership of shares is transferred by delivery of the certificate of stock endorsed by its owner in blank or to a specified person. Ownership may also be transferred by the delivery of the certificate along with a separate assignment or a power of attorney executed by the owner.
EFFECT OF TRANSFER
Shares of stock are classified under Article 8 of the UCC as investment securities. Article 8 governs the rights of parties regarding transactions involving securities. Stock certificates are negotiable pursuant to Article 8, and just as various defenses cannot be asserted against the holder in due course of commercial paper, similar defenses cannot be raised against a person acquiring a certificate of stock in good faith and for value. Defenses cannot be raised that the transferor did not own the shares, or did not have the authority to deliver the certificate, or that the transfer was made in violation of a restriction on transfer not known to the transferee and not noted conspicuously on the certificate.
Corporate stock is frequently delivered to a creditor as security for a debt owned by the shareholder. The delivery of the security to the creditor causes a perfected security interest to arise in favor of the creditor without the necessity of filing a UCC‑1.
Until there is a transfer on its books, the corporation is entitled to treat the person whose name is on the books as the owner of the certificate as the true and lawful owner. The corporation can refuse to recognize a transferee when the corporation is given notice or has notice that the transfer is void. The corporation may also refuse to register the transfer of shares when the outstanding certificate is not surrendered to it unless there is satisfactory proof that it has been lost, destroyed or stolen.
RIGHTS OF SHAREHOLDERS
The control of the shareholders over the corporation is indirect. Ordinarily, once a year, the shareholders elect directors, and by this means they can control the corporation. At other times the shareholders have no power or right to control the corporate activity as long as it is conducted lawfully.
RIGHT TO VOTE
The right to vote means the right to vote at shareholders meetings for the election of directors and on other special matters that must be approved by the shareholders. A proposal to sell or mortgage all, or substantially all, of the assets of the corporation must be approved by the shareholders under most States’ laws.
Generally, for each share owned, each shareholder is entitled to one vote on each matter on which there is a vote. This procedure is called straight voting, and it is the normal method for shareholder voting on corporate matters. However, in the case of voting to elect directors, cumulative voting is mandatory in many States. This is a form of voting that is designed to give proportional representation on the board of directors to minority shareholders. Under a cumulative voting plan, each shareholder has as many votes as the number of shares owned multiplied by the number of directors to be elected. Minority shareholders may then cast all of their votes for a candidate who will represent their interests on the board of directors. Under straight voting, minority shareholders would always be outvoted.
A shareholder has the right to authorize another to vote the shares owned by the shareholder. This is known as voting by proxy.
A voting trust exists when, by agreement, a group of shareholders transfers their shares in trust to one or more persons as trustees who are authorized to vote the stock while the agreement is in effect.
PREEMPTIVE OFFER OF SHARES
If the capital stock of a corporation is increased, shareholders can have the preemptive right to subscribe to a certain percentage of the new shares. This percentage is based upon the percentage of ownership they have of the outstanding stock in the corporation. The RMBCA provides that shareholders do not have preemptive rights unless the articles of incorporation give this right.
INSPECTION OF BOOKS
A shareholder has the right to inspect the books of the shareholder’s corporation. A request for inspection must be made in good faith, for proper motives, and at a reasonable time and place. The purpose of the inspection must be reasonably related to the shareholder’s interest as a shareholder. For example, a shareholder is entitled to inspect the records to determine the financial condition of the corporation or the quality of its management. A shareholder is entitled to inspect the books to obtain information needed for a lawsuit against the corporation or its directors or officers.
Sometimes inspection is denied. For example, a corporation has the right to deny the inspection by a shareholder under certain circumstances. For example, if the inspection was being made in order to aid competitors of the corporation, the corporation could deny the shareholder the right to inspect the books.
The RMBCA requires a corporation to furnish annual financial statements. These statements include a balance sheet as of the end of the fiscal year, an income statement for that year, and a statement of changes in shareholders’ equity for that year. These statements are provided to the shareholders.
DIVIDENDS
A shareholder has the right to receive a proportion of dividends as they are declared, subject to the rights of preferred shareholders over common shareholders. There is no absolute right that dividends be declared, but only that dividends, when declared, must be paid in this manner.
State corporation laws commonly provide that no dividends may be declared unless there is a surplus for their payment. The surplus is generally calculated as the amount of corporate assets in excess of the outstanding liabilities and the paid-in capital of the corporation. In some States, statutes provide that dividends may be declared from current net profits.
Assuming that a fund is available for the declaration of dividends, it is then a matter primarily within the discretion of the board of directors as to whether or not a dividend will be declared. The fact that there is a surplus that could be used does not determine that there must be a dividend declared.
In general, a Court will refuse to substitute its judgment for the judgment of the directors of the corporation regarding dividends. However, the Courts will compel the declaration of a dividend when it is apparent that the directors have compiled a surplus beyond any practical business need.
Usually a dividend is paid in money. However, it may be paid in property, such as shares of stock of the corporation itself or shares of stock that the corporation owns in other corporations.
The shareholder who was the owner on the date the dividend was declared (the record date) is entitled to the dividend. This is important when stock is transferred and a cash dividend is declared prior to the transfer being made. Transferor gets dividend. The board of directors may state that the dividend will be payable to those who will be holders of record on a later date than the date the dividend was declared. This later date will then be the record date. The record date of stock dividends is the date of distribution. Whichever party is the owner of the shares when the stock dividend is distributed is entitled to the stock dividend.
CAPITAL DISTRIBUTION
Upon the dissolution of the corporation, the shareholders are entitled to receive any balance of the corporate assets that remain after the payment of all creditors.
SHAREHOLDERS’ ACTIONS
When the corporation has the right to sue its directors or officers or third persons for damages caused by them to the corporation, one or more shareholders may bring such an action if the corporation refuses to bring the action. This is called a derivative action, i.e., a shareholder derivative action. Any money recovered is paid into the corporate treasury. Generally, a shareholder bringing this type of suit must show that a demand was made on the directors to enforce the right in question, and that the directors refused to enforce the right.
Minority shareholders may sue majority shareholders for oppressive conduct, such as causing a corporation to pay unreasonable compensation to majority shareholders who are corporate officers.
LIABILITY OF SHAREHOLDERS
The shareholder is ordinarily protected from liability for the acts of the corporation. The shareholder is not personally responsible for the debts and the liabilities of the corporation. The corporate capital may be exhausted by the claims of creditors, but there is no personal liability to the shareholders for any unpaid balance. However, liability may be imposed on a shareholder as though there were no corporation if the Court ignores the corporate entity because the corporation is so defectively organized, it is deemed not to exist. Also, whenever shares issued by a corporation are not fully paid for, the original subscriber receiving the shares may be liable for the unpaid balance if the corporation is insolvent and the money is required to pay the creditors.
If dividends are improperly paid out of capital, the shareholders generally are liable to creditors to the extent the capital is depleted. In some States, the liability depends upon whether the corporation was insolvent at the time and whether there were debts existing at that time. As a practical matter, these types of situations generally arise only in close corporations.
THE PROFESSIONAL CORPORATION
The liability of a shareholder in a professional corporation is limited to the same degree as that of a shareholder in an ordinary business corporation. The statutes that authorize the formation of professional corporations usually require that share ownership be limited to duly-licensed professionals. If a shareholder in a professional corporation, such as a corporation of physicians, is guilty of malpractice, and the shareholder is also the physician who committed the malpractice, the physician is usually liable personally for the tort. The corporation is also liable.
BONDS
A bond is an instrument promising to repay a loan to a corporation, which is secured by corporate assets. The relation between a bondholder and the corporation is that of a creditor-debtor. The principal on the debt is paid on the maturity date. The interest is paid periodically. Bondholders have no right to vote.
Regulation of Securities
Securities were originally regulated at the state level. However the 1929 Stock Market crash cause Congress to adopt federal statutes which regulated the initial sales of securities (Securities Act of 1933) and the secondary trading of stock on the stock markets (Securities Act of 1934).
The 1933 Act regulates the initial sale of securities to the public. As will be seen later, some securities are exempt from coverage of the Act. The Act does not specifically define what a security is, but lists approximately 20 items that can be considered to be securities. These include stocks, bonds, mineral interests (like an interest in an oil well), and limited partnership interests.
The landmark case on the definition of a security is the case of SEC v. Howey Co. The court in this case defined a security as an investment in a common enterprise with profits to come from the efforts of another. Any investment contract that gives a party to the contract evidence of a debt or a business participation right can be a security covered by the Act. However, the U.S. Supreme Court has excluded pension plans from the definition of a security when employees are not required to contribute to the plan.
Some types of securities are exempt from the extensive registration and filing requirements of the Act. For example:
- Bonds issued by federal, state, county, or municipal governments;
- Commercial paper (e.g., promissory notes) with a maturity of less than nine months;
- Securities issued by banks and charitable organizations;
- Insurance policies;
- Annuities;
- Securities issued by common carriers; The ICC regulates these securities; and
- Stock dividends and stock splits
Certain stock issue transactions are also exempt (i.e., exempt from registration with the Securities and Exchange Commission) . The most common exempt transaction that close corporations take advantage of is the intrastate offering. To qualify for this exemption, both the investors and the issuer must all be residents of the same state. The issuer must also meet the following requirements:
- 80% of its assets must be located in the state;
- 80% of its income must be earned from operations within the state; and
- 80% of the proceeds from the sale must be used on operations within the state.
Also, for nine months after the issuance, the stock can only be sold to state residents.
Exemptions from SEC registration and filing requirements can save a great deal of accounting and legal expenses.
Some Key Terms: The term “subscription” is applied both to agreements to take stock in a prospective corporation yet to be organized and to agreements to purchase unsold and unissued stock in an organized corporation that is a going concern and that is putting its stock on the market to raise funds. Such subscription agreements are included within the definition of “security” provided by the Securities Act of 1933, as amended, and such securities, as separate and distinct from the securities that may be subsequently delivered pursuant to the terms of such contract, are also subject to all applicable provisions of the Act. The term “issuer,” within the meaning of the above definition of underwriter, is expressly stated in such definition to include, in addition to issuer, any person directly or indirectly controlling or controlled by such an issuer, or any person under direct or indirect common control of such an issuer. Underwriting arrangements between an issuer or controlling person of an issuer and any underwriter, or among underwriters prior to the publication and issuance of a security are specifically excluded from the registration requirements of the Securities Act of 1933, as amended
SEC Regulation A is not really an exemption even though it is referred to as a small offering exemption. It is really a shortcut method of registering. A short-form registration statement called an S-1 is filed. This regulation applies to issues of $1.5 million or less during any 12-month period. The SEC can group more than one issue within a year. This could cause the exemption to be lost. For example, three registrations of $600,000 each would not qualify for Regulation A if done in a 12 month period.
Regulation D creates a three-tiered exemption structure that consists of Rules 504, 505, and 506, and permits sales of securities without registration. However, Sellers are required to file a Form D informational statement about the sale. The definition of accredited investor is important regarding this exemption as far as a limitation on the number of shareholders allowed(i.e., 35). Accredited investors do not have to be counted as far as the 35 limitation is concerned. An accredited investor includes any investor who at the time of the sale falls into any of the following categories:
- a private business development firm;
- directors, officers, and general partners of issuer;
- banks;
- purchasers of $150,000 or more of the securities;
- natural persons with a net worth greater than $1,000,000; and
- persons with an income of greater than or equal to $200,000 per year.
Regulation D places limits on advertising the securities and restrictions on the sale of the securities to prevent sales within a short period of time after issuance.
The Rule 504 exemption applies to offerings of $500,000 or less within any 12-month period. Sales to directors, officers, and employees are not counted in the $500,000 limitation. Sales of up to $1,000,000 are allowed if the offering is registered under a state securities statute, commonly called Blue Sky Laws. The term Blue Sky comes from the purpose of these laws, which is to prevent the sale of speculative schemes that have no more value than a small area of blue sky. These statutes commonly contain an antifraud provision which prohibits fraudulent practices and imposes criminal penalties for violations. Also, the statutes contain broker-dealer licensing provisions and provide for the registration of securities, including disclosure statements, with a designated governmental official. This official in Mississippi is the Secretary of State. These Blue Sky Laws apply only to intrastate transactions and do not apply to sales made in interstate commerce.
The Rule 505 exemption covers sales of up to $7.5 million provided there are no more than 35 non-accredited investors. A prospectus must be given to all buyers if both accredited and non-accredited investors are involved. A prospectus is a document given to prospective purchasers of a security that contains information about the issuer of the securities and the securities being issued.
The Rule 506 exemption has no dollar limitation, but the number of investors and the type of investors are limited. There can be any number of accredited investors, but only 35 or less unaccredited investors. These unaccredited investors must be sophisticated, which has been defined as being capable of evaluating the offering and the risks involved.
Stock issued pursuant to a Chapter 11 bankruptcy reorganization are also exempt from registration.
If none of the exemptions apply, then the issuer must go through the registration process. The issuer must first file a registration statement and a sample prospectus with the SEC. The SEC has 20 days from the date of filing to act. If no action is taken, then the registration statement automatically becomes effective. However, the SEC always acts within this 20 day period. It does not have to approve or disapprove of the offering within that time period as long as a comment or deficiency letter is issued. This letter requires additional information or clarification on the proposed offering. It generally takes about six months for a new registration to get through the SEC.
The SEC follows a full disclosure standard in reviewing the registration materials. This means that the SEC makes no judgment as to the soundness of the investments, but just makes sure that certain information is disclosed.
The information required in a registration consists of:
- a description of the securities;
- an audited financial statement;
- a list of assets of the issuing corporation;
- the nature of the business; and
- identification of the management of the issuer.
Before the registration statement is effective, something called a tombstone ad can be run. This is basically an announcement that an issuance will be made, but is not an offer to sale. Also, a sample prospectus call a red herring can be issued. There must be a notice in red print that the registration is not effective yet.
Section 11 of the 1933 Act provides for civil liability for inaccurate information in the registration statement. A violation occurs when there is a failure to make a full disclosure or the registration statement contains a material misstatement or omission. People who could possibly be liable under Section 11 include:
- officers,
- directors,
- independent contractors who provided information used in preparing the statement, and
- anyone who signed the registration.
Defenses for Section 11 violations would include:
- immaterial misstatements,
- situations where the investor knew of the misstatement but bought the security anyway,
- due diligence, i.e., the accused party acted with prudence and had no reason to believe that there was a problem. An officer or director would have to show that he had no reason to know of the omission or misstatement.
The Act imposes criminal penalties on anyone who willfully makes untrue statements of material facts or omits required material facts in the registration statement. The maximum criminal penalty is $10,000 and/or five years in jail.
The Securities Litigation Reform Act of 1995 was passed to stop frivolous suits by “professional plaintiffs.” This Act limits attorneys’ fees and allows some leeway (safe harbor protection) regarding financial predictions in connection with the registration statement.
Section 12 of the 1933 act is a first cousin to Section 11. A Section 12 violation would include:
- selling the securities without registration (unless they are exempt),
- selling before the effective date of the registration statement; and
- false information in the prospectus.
The penalties for Section 12 violations are the same as for Section 11.
The Securities Exchange Act of 1934 is concerned with the secondary distribution of securities on the security exchanges and in over-the-counter markets. Its purpose is to prevent fraudulent practices on the security exchanges and in over-the-counter markets. The exchanges, brokers, and dealers who deal in the securities traded in interstate commerce or on any national security exchange must register with the SEC unless exempted.
All traded securities on exchanges must be registered with the SEC. Also all securities of firms with over $5 million in assets and 750 or more shares must be registered if they are traded in interstate commerce. This registration is somewhat different than 1933 Act registration. The 1933 Act requires issuers to register issuances of securities and these securities are registered only for the term of an issuance. Under the 1934 Act, registered classes of securities remain registered until the issuer takes steps to deregister the securities. The information required in a 1934 registration statement is similar to 1933 Act registration, except the offering information is not included.
In order to maintain a steady flow of material information to investors, the 1934 Act requires public issuers to file periodic reports with the SEC. The 10-K report is the principal annual report form. This report consists of nonfinancial information about the registrant’s activities during the year, such as the nature of the company’s business, the property it owns and a statement concerning any legal proceedings by or against the company. The report also includes financial statements with an analysis by management of the financial condition of the company. It also requires a listing of all directors and executive officers and a disclosure of executive compensation information.
If you are required to file a 10-K, the you must also file a 10-Q on a quarterly basis with quarterly financial information. A monthly report called a Form 8-K must be filed when unusual events occur such as spin-offs, bankruptcies and takeovers.
SEC Rule 10b-5 is the principal antifraud rule relating to secondary sales of securities. It is derived from section 10(b) of the 1934 Act which is basically a statutory version of common law fraud. SEC Rule 10b-5 generally prohibit the use of any manipulative, deceptive, or fraudulent scheme or device in connection with the initial issuance or resale of securities in interstate commerce. The 1934 Act antifraud provisions apply to an offer to sell or sale of any security involving the use of the mail, interstate commerce, or a national stock exchange. The 1934 Act applies to both sellers and buyers of securities. A civil action for damages may be brought by any injured party who purchased or sold securities because of false, misleading or undisclosed information. Criminal penalties may be levied because of willful violations.
A failure to give relevant information or giving overly pessimistic information in connection with a sale could result in a violation of Rule 10b-5. The SEC may bring an action against any individual purchasing or selling a security while in the possession of material, inside information. The sanction for trading on inside information can be a civil penalty of up to three times the profit gained or loss avoided as a result of the unlawful sale. Examples of insiders would be a director or corporate employee, or a temporary insider retained by the corporation for professional services, such as an attorney, accountant, or investment banker. Insiders are liable for inside trading when the insider fails to disclose material, nonpublic information before trading on it, and thus makes a secret profit. For example in the SEC v. Texas Gulf Sulphur case some insiders in a corporation failed to disclose a rich mineral strike prior to buying a chunk of stock. Of course they made a profit. Another example would be buying stock while failing to disclose a pending merger that you as an officer of the company knew about in advance. Any insider who trades based on nonpublic information and makes a profit or avoids a loss because of that information can be liable under 10b-5.
Tippees can also be held liable for trading on inside information. A tippee is a person who is privy to inside information from an insider about a corporation or its securities and uses the information to trade securities and makes a profit as a result of this information.
What should be disclosed? Ask yourself if this is the type of information that would affect a buying or selling decision regarding stock. Examples:
- pending takeovers
- drops in quarterly earnings
- a pending large dividend
- possible major litigation
There must be a breach of fiduciary duty to shareholders before an insider is liable. The tippee does not breach 10b-5 unless he gets information from the insider who breaches a fiduciary duty and the tippee gets financial benefit.
Before a civil action can be brought under 10b-5, the plaintiff must have been an actual purchaser or seller of the stock. The plaintiff must also prove intent to defraud. In a criminal case, the fine can be up to $100,000 and a defendant can be imprisoned for up to five years per violation.
Section 16 of the 1934 Act deals with insider trading and short swing profits. Corporate officers, directors and shareholders of more than 10% of the stock in a company have greater access to inside information than your average person. These officers, directors and shareholders are liable to the corporation for profits made on sales and purchases during any six month period. There are also certain reporting requirements under the Act.
Section 14 of the 1934 Act deals with the regulation of proxy materials. The idea is to have full disclosure in proxy materials. Proxy materials must be filed with the SEC disclosing:
- who is soliciting the proxy;
- how the materials will be sent;
- who is paying for the solicitation;
- how much is being spent on the solicitation;
- what the purpose of the proxy is, e.g., an annual meeting for an election of directors.
Shareholders can submit proposals to be included in proxy solicitation materials. If the company opposes what the shareholders propose, the shareholders have the right of a 200 word statement on the proposal to be included in the proxy materials. However, proposals are not permitted unless they propose something that is legal and related to the business operations of the company. Social, moral, religious, and political views are not permitted. For example, during the Vietnam war many shareholders wanted to state their views on the war if the company was a supplier of goods or services to the war. This was inappropriate.
Compensation to the executives of corporations has become a major concern of shareholders. The SEC has passed disclosure rules on executive compensation which includes the requirement of a series of charts on the firm’s financial performance and a summary of the pay of the top five officers of the company.
If proxies are solicited without following Section 14 guidelines, the proxies are invalid. Actions taken at a meeting where the invalid proxies were used can be set aside.
The Foreign Corrupt Practices Act was passed as an amendment to the 1934 Act. It was passed because of bribe activity from U.S. companies to foreign officials. This Act regulates accounting procedures that would make it easy to hide bribes. It prohibits bribes except so-called grease payments which is the paying of officials to get them to do their jobs. You are not trying to get them to do anything improper, but are “hurrying them along.”
The penalties for violation is a $10,000 fine and/or a five year prison sentence. There is a $100,000 fine available for willful violations by individuals and a $1,000,000 fine available for companies.
Many blue sky laws, like Mississippi’s, follow the SEC standard of full disclosure. If the filing is made with a full disclosure of information, then it is lawful regardless of whether or not the investment is any good. States that follow a merit standard basically say that the offering must be “fair, just, and equitable.”
States have their own exemptions from registration. Mississippi follows the 1933 Act. States like Mississippi also regulate brokers and dealers.
