In this third episode of a six-part series on corporations, I’m going to discuss funding
and shareholder rights.
First we’ll look at stocks and bond sales, and then we’ll examine 13 shareholder rights.
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Today we're going to examine how a corporation is funded and then we are going to look at
shareholder rights.
There are basically two ways that a corporation can get funding: selling stock and borrowing money.
Now, once a business is profitable it might not need to either sell stock or borrow money.
But until it does that, the only two ways a corporation gets money
is through selling stock, borrowing money.
First, let’s examine stocks.
A corporation must include in its Articles of Incorporation, which is filed with the
Secretary of State, all information regarding its stock.
This includes providing the number of shares that the corporation can issue,
the different types of stock the corporation can offer,
and any special stock preferences that are attached to the stock.
Common stock is the only stock issued by most corporations.
Common stock ensures that all shareholders have the same rights for each share that they own.
These rights include an equal share to all the dividends issued by the corporation and an
equal vote at shareholder meetings—these rights are based on the number of shares owned,
not on the number of owners.
For example, if one shareholder owns 1000 shares he gets 1000 votes.
If another person owns 20 shares, that person gets 20 votes.
This is not a democracy where each person gets one vote.
The second type of stock is called Preferred Stock, which a corporation
may choose to issue in addition to Common Stock.
Preferred stock offers its owners preferred dividend rights.
Let me give you an example.
A corporation could offer preferred stockholders $5.00 per year for every share
of preferred stock that they own.
Finally, a corporation might offer various classes of common and preferred stock.
These various classes of stock can provide just about anything that the corporation wants
to provide, as long as the rights and restrictions are written into the articles of incorporation.
One very well-known example involves the Ford Motor Company.
Ford Motor Company has several classes of stock.
One class of stock can only be owned by members of the Henry Ford family.
Henry Ford is the one who created the Ford Motor Company.
This class of stock also allows the Ford family 40% of the voting power
for all shareholder decisions,
even though the family owns less than 2% of all Ford Motor Company.
So here you have a family, they own 2% of the value of Ford Motor Company,
yet they make 40% of all the decisions.
Basically guarantees that the Ford family can elect anyone they want to the board of directors.
In addition to allowing a group of people voting control, other common provisions include
higher dividends and the right to select a certain number of people to the board of directors.
This type of stock is often denominated as Class A stock, Class B stock, Class C stock, etcetera.
The idea is, as long as it's recorded in the articles of incorporation,
corporations are free to create any sort of benefit or restriction that they want of a class of stock.
The second way for a corporation to secure funding is by borrowing money.
The corporation, just like you and me, can go to the bank and borrow money,
but generally the bank is not going to provide the corporation large amounts of money.
So let's say a corporation wants to build a large plant and they need two billion dollars.
Most banks are not going to provide that sort of funding.
So instead, the corporation will issue a bond.
A bond is nothing more than a loan to the corporation, but it is a loan that is broken
down into small amounts that can be transferred to others.
For example, a corporation may issue $100 bonds to the public,
hoping to build that huge facility that they want to build.
I might go in and I might buy $300 worth of bonds. You might go in and buy $2,800 in bonds.
A large pension plan might buy $200,000 in bonds.
The bonds all provide a certain amount of interest, usually in an amount that the corporation
believes will entice investors to purchase the bonds.
So if the bond says half a percent, most people are not going to buy a bond for half a percent.
Because we can insteady buy a U.S. government bond that pays more.
So it has to be a rate that entices investors.
For companies with higher risk, the interest rate is going to be higher to compensate investors
for taking the increased risk.
For companies that are fairly well established the rate of interest will be lower.
As with stocks, investors can sell the bonds to others.
If the corporation is not doing well, then the investor will usually have to sell the bonds at a discount
to account for the increased risk.
There are two types of bonds: secured and unsecured.
A secured bond is one where the debt is secured by a specific asset, which the investors can
sell if the corporation fails to repay the loan.
An unsecured bond, also called a junk bond, is where there are no assets set-aside in
the bond to pay the bondholders if the corporation fails to repay the bond.
So a secured bond. let's say that the corporation owns a hundred acres of land
outside of New York City. It's worth a lot of money.
They could borrow against that, put it in the bond, and so the bond offering is secured by that land.
That lowers the amount of interest the corporation has to pay because it is a less risky bond.
All of a sudden a corporation just says we just need money, we're issuing a bond.
Unsecured, well then the interest rate is going to be higher, so people will purchase the bond.
Let’s move on to shareholder rights.
First and foremost we have limited liability.
As I've mentioned before, limited liability is the right to not be sued
for the liabilities of the corporation.
This is the one right which has allowed corporations to accumulate the largest amount of capital
ever seen in modern times, if not in all of history.
Second is transferability of shares.
This means that shareholders are not required to get permission from the corporation to
sell the shares, as occurs with some other types of business entities.
We are talking about large corporations. Those that are traded on a stock exchange.
If you and I go and start a corporation, and we've already mentioned that we can do that for about $200.
Our shares are going to be harder to transfer.
Sure, we can find people, but if I tell you:
I just started a corporation would you like to buy some of my shares?
You might be a little bit leary because you're thinking:
I think it's a good deal, I think it's a good investment
but what am I going to do with the shares when I want to sell them.
Now that is very different from stocks that sell on a stock exchange like
Apple or IBM or Ford.
For a very limited amount of money I can go to the stock exchange and sell my shares instantaneously.
Within seconds.
Third we have the right to attend the annual shareholder meeting and ask management questions.
Most shareholders choose not to do that for at least large corporations.
Fourth is the right to vote for the board of directors.
In a way, a corporation looks like a representative democracy.
The shareholders vote for the board of directors, who then appoint the officers for the corporation.
What this means that the shareholders do not have a say in the day-to-day operation of the corporation,
and they no not vote for many of the changes that are approved by the board of directors.
Fifth is the right to submit proposals to other shareholders,
which are then voted upon at the annual shareholder’s meeting.
So you have some very active shareholders that want to, let's say improve the world.
One shareholder might say: we think that the corporation should not do business with Cuba
because they're a communist country.
So they have a proposal before the board saying:
this corporation will not conduct business in Cuba.
The shareholders would all vote on that proposal at the annual shareholder's meeting.
Sixth is the right to approve all fundamental changes to the corporation, such as voting
on any changes to the articles of incorporation, mergers, sale of the corporation, or changing
the nature of the corporation.
On this last one, the nature of the corporation, let me give you an example.
Let's say that a corporation, for the last 50 years, has been in the fish business.
and they decide that the fish business is going nowhere. It's getting a bit fishy.
What they would like to do is get into computers.
The board of directors just can't make that decision, since that is a fundamental change to the corporation.
They have to get shareholder approval for moving from the fish business into the computer business.
Seventh is the right to inspect corporate records.
This includes the right to inspect the corporation’s financial records,
other things that may not be publicly available,
but they are made available to shareholders.
The corporation is allowed to charge a reasonable amount of money
in producing those records and copying them for you
but the shareholders do have a right to inspect certain financial records.
Eighth, if the corporation is sold or merges into another corporation, the shareholders
have the right of appraisal.
This is a judicial proceeding where the shareholder can argue that the price that was paid for
the corporation was not high enough.
And if the shareholders win, they are entitled to the higher price determined by the court.
This is becoming more and more common these days as there are mergers,
sales of corporations, and actually some companies,
what they do is they buy stock in a company that is getting ready to be merged
for the sole purpose of then suing later under this appraisal methodology.
The reality is a lot of corporations, after the deal is done,
maybe it was, maybe it wasn't a fair price. But let's assume it was a fair price.
You have a shareholder that is now suing you for two million dollars or a million dollars.
At some point the corporation has to decide, is it worth litigating this claim.
And if the plaintiff's relatively low the corporation just may pay for it.
They say: look, it's just time to move on if it's a small claim, it's a million dollars.
We're going to have our lawyers litigate this for half a million, let's just pay the claim.
Right of appraisal.
Ninth, this is the right to any remaining value if the corporation goes out of business.
Now, in the vast majority of cases, once a corporation goes out of business
there's nothing left of value for the shareholders.
First, employees get paid, pensions, the creditors of the corporation.
But sometimes the corporations just decides its time to get out of business.
Our business model isn't working, let's do it in an orderly fashion.
Then whatever is left after everyone else get's paid, then shareholders get that little bit.
Tenth, we have the proxy.
A proxy is the right to allow someone else to vote your shares for
all matters or some matters at a shareholder meeting.
All corporations require that a certain number of shares be present at each shareholder meeting,
otherwise the meeting cannot be held.
That goes to quorum requirements.
Quorum says that a certain number of shares have to be present, otherwise the meeting cannot proceed.
This percentage can be set at any amount, but it has to be recorded in the Articles of Incorporation
or the Bylaws.
What this means is that the board of directors will solicit the proxies its shareholders
because they need this minimum number of shares to have their annual meeting.
And they are required by law to have an annual meeting.
Because no one person tends to own a very large percentage of a large corporations--
there's not any one person who owns Exxon or Apple--
what that means is the board of directors, in effect these days, has become self-perpetuating.
They solicit the proxies, they then get to decide who gets placed on the board.
Since they're soliciting the proxies, and there's not really anyone else out there
with enough power to vote at the meeting it means the board of directors is very powerful.
Without effective shareholder oversight, what happens?
It means that now the board of directors get to pick their own compensation,
they get to set the compensation for the officers.
A lot of the officers of the corporation are also on the board of directors,
which is why executive compensation has become very very high over the last 15, 20, 30 years.
Eleventh involves private shareholder pooling arrangements.
There are two types of arrangements: voting agreements and voting trusts.
A voting agreement is just a contract.
It's a contract among shareholders to vote their shares in a certain way.
For example, these shareholders agree to vote for the same slate of candidates
for the board of directors.
Individually these shareholders don't have the power to get their people on the board
but if they get two or three relatively large shareholders together they can get their people on to the board.
A voting trust is different. A voting trust is where these same shareholders,
instead of contracting with each other, they transfer the shares to a third party,
usually an attorney, and this third party has instructions on how to vote the shares.
Here is why the trust is generally much more powerful.
It is because once the shares have been transferred, shareholders really can't disagree.
They can't their minds.
Versus a voting agreement, where they can easily, or more easily breach their contract.
So generally, when people are trying to pool their shares they do so through a voting trust,
not with a voting agreement.
Twelfth is the right to initiate a derivative lawsuit against the board of directors.
When a shareholder believes that one, some, or all the board members have violated their
fiduciary duties to the corporation, that shareholder can initiate a lawsuit against
the board of directors in the name of the corporation.
For example, John owns 100 shares of XYZ, inc.
John has information that the XYZ, inc. directors voted to sell property to another
corporation, in which each of the directors has a financial interest.
You can imagine if the corporate directors are stealing from the corporation, where's the oversight?
Who is going to stop them.
Well that's where the derivative lawsuit comes in.
John files a derivative lawsuit against the directors, in their individual capacity,
for violating their fiduciary duty of loyalty to the corporation.
And if John is successful, then the directors are personally liable for the amount that they
harmed the corporation.
Thirteenth involves cumulative voting for the selection or removal of board directors.
A few states, including California--actually, most of these States are out West--
require cumulative voting for board of director elections.
And most other states allow corporations to use cumulative voting.
So if cumulative voting is authorized by statute, required by statute,
or allowed by the articles of incorporation, then it's used for that particular director election.
For most corporations, whoever has more than 50% of the shares makes all the decisions for
the corporation, including who will serve on the board of directors,
changes to the articles of incorporation
Cumulative voting was created as a means to allow shareholders with less than 50%,
in other words a minority shareholder, to elect some people to the board of directors.
A detailed description of how the process works is beyond the scope of this course.
But I do want to let you know this is a technique used by some corporations
to encourage minority directors. Minority again meaning people who own less than 50%
And that wraps up our discussion on this topic.
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