5. Business Organization – Business Structures
History and Context
Corporation is an ancient concept, recognized in the Code of Hammurabi (1792–1750 BCE), and to some degree a fixture in every other major legal system since its creation. The first corporations were not business enterprises; instead, they were associations for religious and governmental ends in which perpetual existence was a practical requirement. Thus, until relatively late in legal history, kings, popes, and jurists assumed that corporations could be created only by political or ecclesiastical authority. By the seventeenth century, with feudalism on the wane and business enterprise becoming a growing force, kings extracted higher taxes and intervened more directly in the affairs of businesses by refusing to permit them to operate in corporate form except by royal grant.
The most important concessions, or charters, were those given to the giant foreign trading companies, including the Russia Company (1554), the British East India Company (1600), Hudson’s Bay Company (1670, and still operating in Canada under the name “the Bay”), and the South Sea Company (1711). These were joint-stock companies, that is, individuals contributed capital to the enterprise, which traded on behalf of all the stockholders. Originally, trading companies were formed for single voyages, but the advantages of a continuing fund of capital soon became apparent. Many shareholders were encouraged to invest due to the feature of limited liability. They risked only the cash they put in, not their personal fortunes.
Some companies were wildly successful. The British East India Company paid its original investors a
fourfold return between 1683 and 1692. But perhaps nothing excited the imagination of the British more than the discovery of gold bullion aboard a Spanish shipwreck; 150 companies were quickly formed to salvage the sunken Spanish treasure. Though most of these companies were outright frauds, they ignited the search for easy wealth by a public unwary of the risks. In particular, the South Sea Company promised lucrative gains. In return for a monopoly over the slave trade to the West Indies, it told an enthusiastic public that it would retire the public debt and make every person rich.
In 1720, a fervor gripped London that sent stock prices soaring. Beggars and earls alike speculated from January to August; and then the bubble burst. Without considering the ramifications, Parliament had enacted the highly restrictive Bubble Act, which was supposed to do away with unchartered joint-stock companies. When the government prosecuted four companies under the act for having fraudulently obtained charters, the public panicked and stock prices plummeted, resulting in history’s first modern financial crisis.
Consequently, corporate development was severely hindered in England. Distrustful of the chartered company, Parliament issued few corporate charters, and then only for public or quasi-public undertakings, such as transportation, insurance, and banking enterprises. England did not repeal the Bubble Act until 1825, and then only because the value of true incorporation had become apparent from the experience of its former colonies. As industrial development accelerated in the mid-1800s, it was possible in many jurisdictions to incorporate by adhering to the requirements of a general statute or regulations.
Unlike a sole proprietorship or general partnership, a corporation is a legal entity separate and distinct from its owners. In effect, it is an artificial person with all the rights and obligations of any living person. While it can be created for a limited duration, it is typically expected to have a perpetual existence (known as an ‘ongoing concern’). As a corporation takes the form of a legal entity/person, it has the distinct advantage of continuity. Ownership can be changed without the need to dissolve the business and restart it; and without affecting business operations.
Corporations must be formed in compliance with the law of Canada (Federal Corporation) or of the province (Provincial Corporation). Each jurisdiction has its own rules governing corporations and anyone considering a corporation as a business structure should research which jurisdiction’s rules fit best with the business’ objectives. Most corporations incorporate where their principal place of business is located, but some choose a different jurisdiction where rules may be more beneficial.
To start a corporation, the corporate founders must file articles of incorporation within their desired jurisdiction. Articles of incorporation typically include the following elements:
- The name of the company;
- Whether the company is for-profit or nonprofit;
- The founders’ names;
- The company’s purpose;
- How many shares the corporation will issue initially; and
- The par value of any shares issued.
Unlike sole proprietorships, corporations can be quite complicated to manage and often require specialized professional competencies. In addition to filing fees due at the time of incorporation, there are typically annual license fees, franchise fees and taxes, and other costs which can be burdensome on businesses. Additionally, corporations are subject to levels of regulation and governmental oversight that can be challenging and time consuming.
Types of Corporations
There are different types of corporations that may operate in Canada. The first is a ‘Not-for-Profit’ (NFP) Corporation. While NFPs operate like a typical corporation, the purpose is not to distribute profit to members, directors or officers. This does not mean that a NFP cannot generate profit, but that any profit created is used to further the goals of the NFP rather than paying dividends to members. NFPs often incorporate specific social or environmental responsibilities into their legal structure. Non-profit corporations may be formed for charitable, educational, civil, religious, social, and cultural purposes, among others.
Another type of corporation is a governmental entity (often called a municipal corporation). Major cities and counties, and many towns, villages, and special governmental units, such as sewer, transportation, and public utility authorities, are incorporated. An example of this is Metrolinx, an agency of the Government of Ontario created to improve transportation access, integration and infrastructure in the Greater Toronto and Hamilton regions. Governmental corporations are not organized for profit, do not have shareholders, and operate under different statutes than do business corporations. These are typically operated independently of government but have some type of governmental oversight.
The main form of corporation is the business corporation. There are two main types of business corporations: broadly held (or public) and closely held (or private) corporations. Both types are private in the sense that they are not governmental but are distinguished by the number of shareholders.
A public corporation is one in which stock is widely held or available for wide public distribution through such means as trading on a national or regional stock exchange. Its managers, if they are also owners of stock, usually constitute a small percentage of the total number of shareholders and hold a small amount of stock relative to the total shares outstanding. Few, if any, shareholders of public corporations know their fellow shareholders.
By contrast, the shareholders of private corporations are fewer in number. Shares in a private corporation could be held by one person, and usually by no more than thirty. Shareholders often share family ties or have some other association that enables them to be known to one another. Most corporations in Canada are closely held. Though many closely held corporations are small, no economic or legal reason prevents them from being large and some have billions of dollars in annual sales.
Forming a Corporation
The goal of the incorporation process is issuance of a corporate charter. The term used for the document varies from jurisdiction to jurisdiction. Most provinces call the basic document filed in the appropriate public office the “articles of incorporation” or “certificate of incorporation”. Once filed and approved, the business becomes a ‘charter corporation’ under the respective jurisdiction.
Articles of Incorporation
As discussed above, filing for a corporation charter requires the submission of the articles of incorporation. These are the rules (the bylaws) of the corporation. Articles of incorporation typically include the following:
- the corporate name;
- the address of the corporation’s initial registered office;
- the period of the corporation’s duration (usually perpetual);
- the company’s purposes;
- the total number of shares, the classes into which they are divided, and the par value of each;
- the limitations and rights of each class of shareholders;
- the authority of the directors to establish preferred or special classes of stock;
- provisions for preemptive rights;
- provisions for the regulation of the internal affairs of the corporation, including any provision restricting the transfer of shares;
- the number of directors constituting the initial board of directors and the names and addresses of initial members;
- and the name and address of each incorporator.
Managing a Corporation
Power within a corporation is present in many areas. The corporation itself has powers, although with limitations. There is a division of power between shareholders, directors, and officers. Given this division of power, certain duties are owed amongst the parties.
Directors and Officers
A director is a fiduciary, a person to whom power is entrusted for another’s benefit, and as such, must perform duties in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances. A director’s main responsibilities include the following:
- to protect shareholder investments,
- to select and remove officers,
- to delegate operating authority to the managers or other groups,
- and to supervise or hold the company accountable for achieving its objectives.
The board of directors, by majority vote, may delegate its powers to various committees. This authority is limited to some degree. For example, only the full board can determine dividends, approve a merger, and amend the bylaws. The delegation of authority to a committee does not, by itself, relieve a director from the duty to exercise due care. Directors often delegate to officers the day-to-day authority to execute the policies established by the board and to manage the firm. Normally, the president is the chief executive officer (CEO) to whom all other officers and employees report, but sometimes the CEO is also the chairman of the board.
One critical function for boards of directors is to appoint corporate officers. These officers often hold titles such as chief executive officer, chief operating officer, chief marketing officer, and other titles depending on the context.
Officers are involved in everyday decision making for the company and implement the board’s decisions. As officers of the company, they have legal authority to sign contracts on behalf of the corporation, binding the corporation to legal obligations. Officers are employees of the company and work full-time for the company but can be removed by the board.
Although shareholders or members own the corporation, the officers and directors are empowered to manage the day-to-day business of the corporation. The officers and directors owe a fiduciary duty to both the corporation and its shareholders or membership. This means that the officers and directors must act in the best interests of the corporation and shareholders or members.
Duty of Loyalty
As part of their fiduciary duty, officers and directors have a duty of loyalty to the corporation and its
Shareholders or members. The duty of loyalty requires them to act:
- In good faith;
- For a lawful purpose;
- Without a conflict of interest; and
- To advance the best interests of the corporation.
Duty of loyalty issues may arise in the context of a director entering into a contract with the corporation or loaning it money. Other situations may involve a director taking a business opportunity away from the corporation for personal gain. The corporate opportunity doctrine prevents officers and directors from taking personal advantage of a business opportunity that properly belongs to the corporation.
Duty of Care
The duty of care requires officers and directors to act with the care that an ordinary prudent person would take in a similar situation. In other words, they have a duty not to be negligent. The extent of this duty depends on the nature of the corporation and the type of role the director or officer fills. For example, the duty of care imposed on the board of directors of a federally insured bank will be higher than the duty imposed on a small non-profit organization.
In general, directors should understand the nature and scope of the corporation’s business and industry, as well as have the skills necessary to be successful in their role. Officers and directors also should stay informed about the corporation’s activities and hire experts when they lack the expertise necessary to make the best decisions for the corporation. The duty of care requires officers and directors to make informed decisions.
Owners of corporations are called shareholders. Corporations can have as few as one shareholder or millions of shareholders, and those shareholders can hold as few as one share or millions of shares. Shareholders own shares in the company but have no legal right to the company’s assets. As a separate legal entity, the corporation owns any property in its name.
Shareholders can be individuals or other business entities, such as partnerships or corporations. If one corporation owns all the stock of another corporation, the primary is known as the parent company and the secondary as a wholly owned subsidiary.
In a closely held corporation, the number of shareholders tends to be small, while in a publicly traded corporation, the body of shareholders tends to be large. In a publicly traded corporation, the value of a share is determined by the laws of supply and demand, with various markets or exchanges providing trading space for buyers and sellers of certain shares to be traded.
Shareholders of a corporation enjoy limited liability. The most they can lose is the amount of their investment. Shareholders’ personal assets are not available to the corporation’s creditors.
An exception to the rule of limited liability arises in certain cases involving closely held corporations. Many sole proprietors incorporate their businesses to gain limited liability but fail to realize that when they do so they are creating a separate legal entity. If sole proprietors fail to respect the legal corporation with an arm’s length transaction, then creditors can ask a court to ‘pierce the corporate veil’. If a court agrees, then limited liability disappears and those creditors can access the shareholder’s personal assets.
In the modern publicly held corporation, ownership and control are separated. The shareholders “own” the company through their ownership of its stock, but power to manage is vested in the directors. In a large publicly traded corporation, most of the ownership of the corporation is diluted across its numerous shareholders, many of whom have no involvement with the corporation other than through their stock ownership. On the other hand, the issue of separation and control is generally irrelevant to the closely held corporation, since in many instances the shareholders are the same people who manage and work for the corporation.
Shareholders do retain some degree of control. For example, they elect the directors, although only a small fraction of shareholders controls the outcome of most elections because of the diffusion of ownership and modern proxy rules and requirements. Shareholders also may adopt, amend, and repeal the corporation’s bylaws; they may adopt resolutions ratifying or refusing to ratify certain actions of the directors. And they must vote on certain extraordinary matters, such as whether to amend the articles of incorporation, merge, or liquidate.
In most jurisdictions, the corporation must hold at least one meeting of the shareholders each year. The board of directors or shareholders may call a special shareholders’ meeting at any time as stated in the corporation’s articles or bylaws. Shareholders may take actions without a meeting if every shareholder entitled to vote consents in writing to the action to be taken. This option is obviously useful to the closely held corporation but not to the large publicly held companies.
Rights of Shareholders
Not all shareholders in a corporation are necessarily equal. Canadian law allows for the creation of different types, or classes, of shareholders. Shareholders in different classes may be given preferential treatment when it comes to corporate actions such as paying dividends or voting at shareholder meetings.
Shareholder rights are generally outlined in a company’s articles of incorporation or bylaws. Some of these rights may include the right to obtain a dividend, but only if the board of directors approves one. They also typically include the right to attend shareholder meetings, the right to examine the company’s financial records, and the right to a portion of liquidated company assets.
One of the most important functions for shareholders is to elect the board of directors of a corporation.
Only shareholders elect a director. The board is responsible for making major decisions that affect a corporation, such as declaring and paying a corporate dividend to shareholders; authorizing major decisions; appointing and removing corporate officers; determining employee compensation, especially bonus and incentive plans; and issuing new shares and corporate bonds.
A dividend is a portion of a corporation’s profits distributed to its shareholders on a pro rata basis. Dividends are usually paid in the form of cash or additional shares in the corporation. Although shareholders have a right to a dividend when declared, the board of directors has the discretion to decide whether to declare a dividend. The board may decide to reinvest profits into the corporation, pay for a capital expense, purchase additional assets, or to expand the business. As long as the board of directors acts reasonably and in good faith, its decision regarding whether to declare a dividend is usually upheld by the courts.
Shareholders have the right to appropriate notice and the right to attend shareholder meetings. Shareholder meetings must occur at least annually, and special meetings may be called to discuss important issues such as mergers, consolidations, changes in bylaws, and the sale of significant assets. Failure to give proper notice invalidates the action taken at the meeting.
A quorum of shareholders must be present at the meeting to conduct business. A quorum is the minimum number of shareholders (usually a majority) who must be present to take a vote. The corporation’s bylaws define what constitutes a quorum, if not otherwise set by provincial or federal regulations.
Depending on the type of share owned, shareholders may have the right to vote. In general, shareholders of common stock are entitled to a vote for each share of stock owned. Owners of preferred stock often do not have a voting right in exchange for a higher dividend amount or preference in receiving dividends. Common issues that shareholders vote on include:
- Election of directors;
- Mergers, consolidations, and dissolutions;
- Change of bylaws;
- Change in major corporate policies; and
- Sale of major assets.
If a shareholder is not able to be physically present during a meeting, he or she may vote by proxy.
A proxy is the representative of the shareholder. A proxy may be a person who stands in for the shareholder or may be a written instrument by which the shareholder casts her votes before the shareholder meeting. Modern proxy voting allows shareholders to vote electronically. Proxies are usually solicited by and given to management, either to vote for proposals or people named in the proxy or to vote however the proxy holder wishes.
Corporations are subject to double taxation. Because corporations are separate legal entities, they must pay federal, provincial, and local tax on net income. Then, if the board of directors declares a dividend, shareholders are taxed on the dividend that they receive in the form of a dividend tax. However, as a shareholder, dividends received are typically taxed at a lower tax rate than income from sole proprietors and partnerships. As a result, for closely held corporations, there can be significant tax advantages to having a corporation as a business structure.
Separate legal entity from owners
Formal documents required to filed in state of incorporation
Corporation unaffected by change of ownership/shareholders
Can be complicated to manage
Limited liability for shareholders
High formation and maintenance costs
Considered as an “individual” with Constitutional rights
Subject to double taxation
Heavily regulated by government