Business Associations: Corporations
Business Associations: Corporations
Corporations sit at the center of modern commerce because they combine two powerful features: a separate legal identity and limited liability for owners. Those benefits, however, come with a legal architecture that allocates power, imposes duties on decision-makers, and creates mechanisms for accountability when things go wrong. Understanding corporate formation, the corporate veil, directors’ fiduciary duties, shareholder rights, and derivative litigation is essential for anyone advising, investing in, or operating a corporation.
What a Corporation Is (and Why It Matters)
A corporation is a legal person distinct from its shareholders. It can own property, enter contracts, sue and be sued, and exist beyond the lives of its founders. This separateness enables capital formation: investors can contribute funds without personally operating the business, and the enterprise can continue as ownership changes hands.
Limited liability is the companion principle. Shareholders generally risk only the amount invested. Creditors contract with the corporation, not with the owners personally, and ordinary business losses do not flow through to shareholder assets. The “generally” is important, because the corporate veil can be pierced in exceptional cases.
Formation: Building the Legal Entity
Incorporation and Organizational Documents
Formation begins with filing a certificate (often called articles of incorporation) with the state. While details vary by jurisdiction, the filing typically states the corporate name, the registered agent, the authorized share structure, and sometimes the corporate purpose. Once accepted, the corporation exists as a separate legal entity.
After incorporation, the corporation adopts bylaws. Bylaws function as the corporation’s internal operating rules, covering matters such as board composition, officer roles, meeting procedures, voting rules, and how shares are issued or transferred. If the charter is the corporation’s “constitution,” bylaws are its day-to-day governance manual.
The Board, Officers, and the Allocation of Authority
Corporate power is typically divided among:
- Shareholders, who elect directors and vote on fundamental changes.
- Directors, who manage or supervise management of the business and set strategic direction.
- Officers, who run daily operations under the board’s oversight.
This division is deliberate. Shareholders supply capital and receive residual value, but they usually do not manage. Directors and officers make decisions, but they must do so within fiduciary constraints.
Limited Liability and Piercing the Corporate Veil
The Corporate Veil as a Default Rule
The “corporate veil” describes the legal boundary between the corporation and its owners. In routine circumstances, that boundary is respected. A supplier who is not paid, for example, ordinarily sues the corporation, not the shareholders.
Limited liability is not a loophole. It is a policy choice that encourages investment and risk-taking by capping owner exposure. Creditors respond by pricing risk, demanding security interests, or requiring personal guarantees in closely held businesses.
When Courts Pierce the Veil
Piercing the corporate veil is an equitable remedy that allows a court to hold shareholders (and sometimes affiliated entities) liable for corporate obligations. Courts treat it as exceptional because it undermines the predictability on which corporate finance depends.
While tests vary by jurisdiction, veil piercing commonly turns on two themes:
- Misuse of the corporate form: The corporation is used as an instrumentality to commit wrongdoing, evade obligations, or perpetrate fraud.
- Failure to respect separateness: The corporation is not treated as a real entity, but as an alter ego of its owners.
Practical factors that often appear in veil-piercing cases include commingling personal and corporate funds, undercapitalization at formation relative to the business’s risks, ignoring corporate formalities, or using corporate assets for personal purposes. No single factor is always decisive; courts typically look at the overall pattern and whether recognizing limited liability would promote injustice.
The takeaway for operators is straightforward: maintain separate accounts, document major decisions, keep accurate records, and capitalize the business realistically. For counterparties, the lesson is to assess credit risk early and use contractual protections rather than relying on the possibility of veil piercing.
Fiduciary Duties: The Legal Core of Corporate Governance
Corporate governance is not only about who holds power; it is about how power must be exercised. Directors and officers owe fiduciary duties to the corporation, and those duties shape everything from strategic acquisitions to executive compensation.
Duty of Care
The duty of care requires directors to make decisions with appropriate diligence, attention, and deliberation. It does not demand perfect outcomes. Corporate decision-making involves uncertainty, and courts generally avoid second-guessing reasonable business judgments.
This leads to the business judgment rule, a presumption that directors acted on an informed basis, in good faith, and in the honest belief that the action was in the corporation’s best interests. When the rule applies, plaintiffs face an uphill battle because courts will not substitute their judgment for the board’s, even if the decision turns out poorly.
In practice, boards satisfy the duty of care by:
- Reviewing relevant information and asking hard questions
- Seeking expert advice where appropriate
- Documenting the process through minutes and materials
- Ensuring oversight systems exist for major risks
Duty of Loyalty
The duty of loyalty targets conflicts of interest. Directors and officers must put the corporation’s interests above personal gain when acting in their corporate roles. Classic loyalty problems include self-dealing transactions, usurping corporate opportunities, and undisclosed conflicts.
To manage loyalty issues, corporations rely on disclosure, independent board approval, and sometimes shareholder ratification. Transactions involving conflicts are scrutinized more closely, and the protections of the business judgment rule may not apply unless proper procedures are followed.
Good Faith and Oversight
Good faith is often discussed alongside care and loyalty and becomes especially important in oversight. Boards are expected to implement and monitor reasonable reporting and compliance systems. A complete failure to exercise oversight, or conscious disregard of known problems, can trigger liability even when no single “bad decision” is identified.
Shareholder Rights: Voice, Information, and Exit
Shareholders are owners, but their day-to-day control is limited. Their influence is exercised through defined rights.
Voting Rights and Fundamental Transactions
Shareholders typically vote to elect directors and to approve fundamental changes such as mergers, charter amendments, or dissolution. In public corporations, shareholder voting often occurs through proxies, and governance disputes can emerge around board slates, activism, or contested transactions.
Inspection and Information Rights
Shareholders commonly have statutory rights to inspect certain corporate books and records for a proper purpose. These rights support accountability by allowing investors to evaluate management performance, investigate suspected misconduct, or assess the value of their holdings. The scope and procedure depend on state law and the corporation’s circumstances.
Economic Rights and Distributions
Shareholders may receive dividends or other distributions, but only when the board declares them and only if legal solvency and capital requirements are satisfied. Because shareholders are residual claimants, they are paid after creditors and other senior stakeholders.
Derivative Suits: Enforcing Corporate Rights When Management Will Not
A derivative suit is a lawsuit brought by a shareholder on behalf of the corporation, usually against directors or officers for breach of fiduciary duty. The key concept is that the injury is to the corporation itself, and any recovery generally belongs to the corporation, not directly to the suing shareholder.
Direct vs. Derivative Claims
Not every shareholder complaint is derivative. A claim is typically direct when the shareholder suffers an individual injury distinct from the corporation, such as interference with voting rights. It is typically derivative when the harm is to the corporation, such as corporate waste or self-dealing that drains corporate assets.
Demand and the Board’s Role
Because the board ordinarily controls corporate litigation decisions, shareholders must often make a demand on the board to pursue the claim before filing suit. If the board refuses, litigation may still proceed if the shareholder can show demand is excused, often by demonstrating that the board lacks independence or is conflicted regarding the alleged misconduct. This procedural gatekeeping is designed to balance accountability with the need to prevent opportunistic lawsuits.
Practical Consequences
Derivative litigation can lead to monetary recovery, governance reforms, improved disclosures, or changes in compliance systems. It is also expensive and disruptive, which is why corporate governance aims to prevent the underlying conflicts and failures that generate such suits in the first place.
Putting It Together: Corporate Form as a Bargain
The corporate form is a bargain between investors, managers, and society. Investors receive limited liability and tradable ownership interests; managers receive authority to act; the public receives durable enterprises that can raise capital, hire workers, and innovate. In exchange, the law insists on fiduciary discipline, respect for corporate separateness, and mechanisms like shareholder voting, inspection rights, and derivative suits to enforce accountability.
For founders and executives, the practical goal is not merely compliance with formalities, but building governance habits that withstand scrutiny when the stakes rise. For investors and advisers, the goal is to understand where power sits, how duties constrain it, and when the corporate veil and business judgment deference will, and will not, protect those who control the corporation.