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Basic overview of corporate law principles

This article was written by Michael Dew, a Vancouver lawyer who practices civil litigation. Click here for contact information and further details about Michael’s practice. This article provides only information, not legal advice. If you require legal advice you should consult a lawyer.

 

The following sets out some basic principles of corporate law and is designed to provide lay persons with a general framework for understanding how corporations work and the rights and responsibilities of shareholders and directors.
 
Vocabulary
It is important to have a clear understanding of some of the terms used when discussing corporate law principles because these terms have meanings which are somewhat different than the everyday meanings of these words.
 
Person and Individual
In law the word “individual” is used to describe an actual fleshy human being that walks and breathes, and the word “person” is used to describe a legal entity that has certain legal powers, such as the power to enter into contracts, to own property, and to sue and be sued.
 
A legal person is not necessarily an individual, but all individuals are legal persons.
 
Corporations are the most common form of legal person who are not individuals. Societies, foundations, and some types of partnerships, are other entities which are legal persons but not individuals.
 
Corporation v. company
The words “corporation” and “company” mean the same thing and are used interchangeably.
 
Sole proprietorship
“Sole proprietorship” is a phrase used to describe a business that is carried on by an individual in their personal capacity and not through a separate legal person such as a corporation. Profits of the business will be reported on the individual’s tax return.
 
Three key components of corporate structure
There are three key components of a corporate structure:
  1. The corporation itself. A corporation is created by filing paperwork with a corporate registry (either federally or provincially). Because the corporation is not alive like an individual, and cannot physically sign a contract or go down the street and open a bank account, all acts of the corporation have to be performed for the corporation by individuals.
  2. The directors. The directors are responsible for making decisions about the operations of the corporation. Although the directors oversee the running of the corporation the directors do not need to perform the day-to-day operations of the corporation themselves, but can hire employees to perform day-to-day tasks. The directors maintain a supervisory role and the employees who work for the corporation report to the directors.
  3. Shareholders. The shareholders are the owners of the business and their ownership rights are determined by the shares they hold in the business. Where there are multiple shareholders, they may have varying rights (such as the right to vote for directors, the right to receive dividends, etc.) depending on the type and number of shares they hold.
A corporation is a separate legal entity
To say that a corporation is a “separate legal entity distinct from its shareholders and directors” is easy to say but is not always properly understood. What it means is that a corporation, although just a paper creation, has certain legal powers similar to those held by individuals. Some of the most important legal powers that corporations have are the powers to:
  • enter into contracts (including to open a bank account);
  • own property; and
  • sue and be sued.
It is said that the corporation is a legal entity “distinct” from the shareholders and directors because the right of a corporation to, for example, open a bank account in the name of the corporation, is separate from the right of a director or shareholder to open his or her own bank account. 
 
Corporations are obligated to obey the law, including paying taxes and abiding by environmental regulations. Corporations will be liable for breaking the law, and in some cases directors of the corporation will also be held liable for wrongful acts of the corporation because the directors are the ones who operate the business of the corporation. Shareholders are seldom liable for acts of the corporation and their liability is generally limited to the amount of money they paid when they purchased their shares in the corporation.
 
Any money in the corporate bank account, and any other assets owned by the corporation, belong strictly to the corporation and are not the property of the directors or shareholders. It is illegal for the directors or shareholders to simply take the corporation’s money or other property and use it for themselves. To be legal, the transfer of money or other property from the corporation to the directors or shareholders must be properly authorized. The type of authorization required depends on the nature of the transaction, but directors resolutions, or even shareholders resolutions, are required for significant transactions.
 
Another aspect of each corporation being a separate legal entity is that one corporation is not liable for the debts of another corporation. For example, if you entered into a contract with Joe’s Plumbing and Drywall Inc. and the work was of a poor quality, you can only sue and recover a judgement against Joe’s Plumbing and Drywall Inc. If there is another company, Joe’s Plumbing and Brickwork Inc., you will not have a contract with that company and will generally not be able to get judgment against Joe’s Plumbing and Brickwork Inc. for the debt of Joe’s Plumbing and Drywall Inc. This is the case even if the two companies have all of the same shareholders and directors. Where members of the public dealing with corporations have concerns about the reliability of the company they should consider seeking personal guarantees from the individuals who are the directors or shareholders of the company. This means that if the company defaults on its obligations, and perhaps goes bankrupt, the person that contracted with the company will be able to rely on the personal guarantee of the director or shareholder to cover any losses associated with default by the company.
 
Rights and responsibilities of directors
The directors are responsible for making decisions about the operations of the corporation and typically hire employees to run the day-to-day business of the corporation. Directors are usually paid a fee for overseeing the operations of the company.
 
The directors cannot consider their own interests when running the company, but must consider the best interests of the company and must consider the interests of all shareholders. For example, the directors cannot hold a board meeting and vote to pay themselves exorbitant directors fees for managing the company; that would be a breach of the directors’ fiduciary duty to manage the company in the best interests of the company.
 
Regardless of who voted them into power, and regardless of whether or not the directors are also shareholders, the directors are not permitted to handle company affairs in a way that unfairly benefits some shareholders to the detriment of other shareholders. Even if a director is voted into power and has the support of a group of shareholders, when that individual is acting as director he or she cannot unreasonably favour the interests of the shareholders that voted him into power, but must fairly consider the best interests of the company and the interests of ALL shareholders. 
 
Directors generally have full access to all corporate records and the right to know about all aspects of the management and operations of the business.
 
Rights of shareholders
It is the shareholders who own the corporation, and they do so according to the type and number of shares owned by each of them.
 
Although the shareholders are the owners of the business, they have no direct say in the running of the corporation. For example, shareholders cannot dictate who should be hired as an employee. However, shareholders can vote on who will be directors and can therefore appoint directors who share the same ideas as the shareholders.
 
The idea of the shareholders being the owners of the business, but not having the right to directly manage the business is a principle some people have trouble with, especially in the case of businesses with few shareholders. However, this rule makes sense when it is realized that it is a rule that was designed for companies with multiple shareholders but is one that applies to all corporations. Where there are multiple shareholders there may be differing opinions as to how the company should be run, and in that case it would be improper to have all the separate shareholders trying to do whatever they, individually, want with the business and company property. Imagine, for example, buying some shares in IBM and then trying to march into IBM’s head office to collect a piece of office furniture for use at home. That suggestion might sound ridiculous, but it is not uncommon shareholders in family businesses to commit similar acts, as further discussed below. 
 
Shareholders generally have the right to view corporate records and to be kept informed regarding the management and operations of the business.
 
One person companies
An individual can be a director and a shareholder, and indeed this is very common especially in small companies. Further, it is possible for a company to have just one individual who is the sole shareholder and the sole director. In that case, that individual can largely do what he or she wants with the company because when asked whether any particular act was authorized, that person can say: “yes, all of the shareholders and directors authorized it”. Ideally, there will be proper paperwork confirming those authorizations were given at the time of the transaction.
 
Because in one person companies the shareholder has the power to implement any decision it makes, disputes regarding ownership of company property or corporate governance do not really arise; an exception being disputes with the government when tax matters are not handled properly.
 
Large corporations
In large corporations there are generally a large number of shareholders such that it is clear to any one shareholder that he or she does not have the right to deal with company property as he or she personally wants. This is why the example of an IBM shareholder removing company property from IBM’s head office sounds ridiculous.
 
The governance of large companies is generally orderly and well documented with shareholders voting for directors who will oversee business operations. Disputes regarding handling of company property and corporate governance do arise, but generally not because a shareholder or directors has totally overlooked the most basic corporate law principles.
 
Family corporations
Family corporations with just a few shareholders (perhaps 2-3) are the most common situation in which disputes arise because the shareholders or directors have overlooked basic corporate law principles. Frequently directors and shareholders will perform acts they are not properly authorized to perform, will deny other directors and shareholders proper access to information (e.g. corporate records), and will treat company property as if it was their own, e.g. taking office furniture home for personal use, drawing money out of the corporate bank account, etc.
 
Although some of these have been mentioned above, it is worth repeating key rights and responsibilities of directors and shareholders that are frequently overlooked in the family corporation context:
  • The directors and shareholders cannot simply use or appropriate company property for their personal benefit e.g. they cannot withdraw money from the company bank account unless properly authorized. Proper authorization may include a directors’ resolution, or perhaps even a shareholder’s resolution, to authorize the payment of a dividend, or the granting of a shareholder loan from the company to the shareholder.
  • Shareholders have the right to vote for directors and to view company records.
  • Directors have the right to access all company records and be informed of all aspects of company business.
  • Shareholders do not have the right to run the business, but must vote for directors who will run the business. It may be that a certain shareholder will hold enough of the shares to vote in a director (perhaps the shareholder himself) who has similar views to the shareholder regarding operation of the company, but when that individual is acting as director he or she is NOT to be merely the puppet of the shareholder, but rather must fairly consider the best interests of the company and the interests of ALL shareholders. 
  • The directors must manage the business in the best interest of the company and cannot conduct matters in a way that unfairly prefers some shareholders of the others. For example, generally:
    • except where anticipated by different classes of shares, directors cannot continually and unfairly declare dividends that are payable to some shareholders and not others; 
    • directors and cannot continually grant shareholder loans from the company to some shareholders and not others, or grant loans that aren’t in the interest of the company; and
    • directors cannot unreasonably favour particular employees who are influential shareholders e.g. by paying them disproportionate salaries or giving them significant gifts.
Problems arise in family corporations because the directors and shareholders overlook the requirements of corporate law and allow the history of family relationships to guide their acts. Unfortunately, doing so can lead to costly disputes and increased strain on family relationships.
 
Conclusion
The foregoing confirms that corporations, directors, and shareholders are different persons with different responsibilities. It is important for directors and shareholders to always keep in mind the particular role they are acting in when dealing with corporate matters. Directors should generally have insurance to protect them from liability with respect to the running of the business, and directors and shareholders should seek legal advice as necessary to ensure they do not breach their obligations or overstep their rights.
 
Members of the public should keep in mind which particular corporate entity they are dealing with, and if they have concerns about the reliability of the company they are dealing with they should seek personal guarantees from the individuals who are the directors or shareholders of the company.
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